Fiscal consolidation is no indiscriminate belt-tightening

In June it was Greece. In August it was France, Italy, Spain and Portugal. In September it was Greece and, once again, Spain. In November, France again. Soon very likely Belgium. And perhaps France for a third time. In spite of an ever-darker economic outlook, every month countries under pressure in the bond markets are announcing new budget restrictions in the hope of limiting their deficits and halting the slippage in their borrowing terms. Only Germany stands out, announcing a tax cut, though a modest one.

The cause of this shift to austerity at the very moment a downturn is materialising is obviously the interest-rate spreads in the eurozone. While the yield on German ten-year debt remains under two percent, it exceeds three percent for France, is close to six percent for Spain, and Italian yields have burst through the seven-percent barrier. It looks a no-brainer: even if it dopes the risk of recession, accelerated budget cuts are preferable to a lethal surge in rates.

As some no longer have access to capital markets, they do not actually have the option. But for others, this logic ignores three factors.

The first is that a sound budget strategy implies setting a target for the outturn (deficit or surplus) under prudent economic hypotheses, establishing a tax and spend profile consistent with this projection, and then sticking to it. This allows the ‘automatic stabilisers’ to come into play. This strategy is not a loose one, in fact it may even be very rigorous, but it avoids amplifying cycles, especially recessionary ones.

The second factor is that headlong consolidation is not necessarily the best way to reassure markets. This is particularly clear in the case of Italy, whose deficit (four percent of GDP this year) is much below those of Spain and France. It is not the deficit which finally spooked investors and turned them off Italian bonds but a cocktail of high debt, desperately slow growth and political paralysis. In a situation like this, nibbling at the deficit is at best a sideshow. What the markets expect is the implementation of reforms designed to durably lift the rate of growth and the installing of credible economic governance in the euro zone.

The third reason to doubt the benefit of hurried budgetary adjustments is that they generally operate through the channel of fiscal measures with immediate impact, which are economically damaging. Governments know this only too well: at the end of 2010 they were pencilling in spending cuts in their consolidation programmes while preserving the most productive, such as education and infrastructure. And on the tax side they were planning to broaden the base rather than raise rates. But since the start of the summer they have actually done the opposite. Rather than focus on spending, they have zeroed in on tax measures, for the most part increasing the rates of existing taxes. This is a bad signal.

So what should be done? No one doubts the need for a budgetary clean-up, but this is a long-term process. Instead of making knee-jerk cuts, governments should first sit down and set precise and detailed targets for the medium term and explain what they intend to do in consequence about spending and revenue.

Governments should then invest in the means to reestablish their credibility. This was the purpose in France of the ‘golden rule’ proposed by the government, which the Socialist Party has just rejected out of hand. This particular rule is not the only possible one but it is key that a stable and ambitious budgetary policy framework be adopted as of the start of the next term. This would add weight to the objective of a balanced budget by 2017.
Finally, governments should ensure that their budget and fiscal programmes are consistent with the aim of increasing growth potential. This entails on the one hand finding the sweet spot in terms of spending cuts and tax rises and, on the other, identifying on each side of the ledger the least harmful measures over the mid term. This takes time, thought and steel. In France it is to be hoped that, in this area, the coming presidential debate will provide the opportunity for an ordered debate on the candidates’ choices.

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