European austerity: Turn or TINA?

Will European governments reverse the austerity course that has done so much to damage their already enfeebled economies? With the revelation of mathematical errors in the work of two Harvard economists, Carmen Reinhart and Ken Rogoff – who had claimed to show that economic growth falls off a cliff once a country’s ratio of debt to GDP reaches 90 per cent – another of the intellectual underpinnings for the current strategy has been swept away. As foreseen by the majority of mainstream economists, eurozone countries’ debt positions continue to worsen rapidly despite wrenching austerity and there is no sign of a rebound in consumer and business confidence. Mass unemployment and chronically weak business investment is waking people up to the folly of synchronised austerity in a depressed economy, hastening what President Barroso has termed (in an unguarded moment) the ‘political limits of austerity’. Everything argues for a change of course, but it could be slow in coming.

The assertion that fiscal austerity would actually boost economic growth – made by another pair of Harvard economists, Alberto Alesina and Silvia Ardagna – was always highly questionable, as was the Reinhart and Rogoff thesis. But the European Commission and European governments (including the British one) latched onto the work of Alesina and Reinhart and Rogoff to provide intellectual support for austerity. Even as the body of evidence against Alesina’s research accumulated, European policy-makers were slow to reject it. When they eventually did, they continued to argue that it was still necessary to pursue fiscal austerity so as to prevent ratios of debt to GDP exceeding the magical level of 90 per cent of GDP, despite the fact that austerity was depressing growth and increasing countries’ debt ratios. The question marks over the soundness of Reinhart’s and Rogoff’s work on debt levels and economic growth are certainly embarrassing for European governments and the Commission, but it is unlikely to dispel the myths around austerity. 

On the face of it, things do seem to be changing. The Commission has given eurozone countries a bit more time to meet their fiscal targets. In particular, it is dealing cautiously with France, which has resisted cutting its deficit as quickly as demanded. The Commission is being careful to place as much stress on the need for structural reforms as austerity. But all this amounts to less than it seems. The decision to give countries a bit more time is simply an acknowledgement that deficits are higher than they were supposed to be because economies are weaker than the Commission expected them to be. It does not represent a significant change of strategy. The fiscal position across the eurozone remains contractionary despite the region’s economy being stuck in a depression. For their part, the Germans are actually tightening policy despite the country’s budget being in surplus and the German economy having stalled. There is still no acceptance that running a budget deficit in a recession is a perfectly sensible economic strategy or that structural reforms will only pay off economically in the long-term, and only then if accompanied by a recovery of business investment.

Why is a policy U-turn unlikely, at least for the time-being? Many policy-makers probably did (and some probably still do) believe that the current austerity strategy is the correct one. Politicians in a number of core eurozone countries like to say, ‘We did our homework, it’s time for others to do theirs.’ Theirs was always a very partial reading of the causes of the crisis, but it has obvious appeal to national vanity and has become central to the narrative of the crisis in these member-states. Many policy-makers never believed in austerity as a solution to the crisis, but went along with it because it was the only politically possible course. They acknowledged that it made little sense to institutionalise pro-cyclical fiscal policy in the form of the fiscal compact, but understood that it was necessary in order to keep the Germans and other core members on board and ensure they acquiesced in a more activist approach by the ECB. This latter policy has ensured that French borrowing costs have come down steadily despite frustration at the slow pace of fiscal consolidation under Hollande’s government. 

However, the eurozone needs a big change of direction, not just a bit more time for countries to meet their fiscal targets. The possibility of this happening depends to a large extent on Germany. How could they be brought around? One way would be for the French, Italians and Spanish to unite in an attempt to face down the German government. It is quite possible that it will eventually to come to this, but it would be a risky strategy to play in the run-up to a German general election. Such a manoeuvre could easily backfire and would certainly be seen as an aggressive move by many Germans. Another way would be to redouble efforts to persuade Germany of the risks that austerity poses to itself. After all, the German economy is slowing quickly under the combined impact of falling exports to the eurozone and a slowdown in exports to China. This is exposing the underlying weakness of the country’s economy: stagnant domestic demand. But the politics are formidably difficult. The Germans might modify their narrative and agree to take some steps to strengthen domestic demand in Germany. But they are unlikely to accept that austerity is self-defeating, not least because this would leave them having to acknowledge the need for far-reaching institutional reforms of the eurozone.

For example, if struggling member-states face high borrowing costs because investors treat them as if they are borrowing in a foreign currency (rather than because their economic policies lack credibility), this strengthens the arguments in favour of allowing the ECB to act as a fully-fledged lender of last resort, or in favour of a degree of risk mutualisation. The ECB’s promise to stand behind the debts of eurozone countries (its so-called Outright Monetary Transactions) has proved remarkably effective so far. But ultimately the central bank will have to put money on the line, which it cannot do at present unless countries promise to abide by strict conditionality. The evidence of the last five years strongly suggests that attempting to meet these conditions would prove very damaging economically and politically. 

But the German and other core eurozone governments understandably want to avoid having to try to sell such reforms to their sceptical electorates, for fear of turning their voters against the single currency. This is why it will continue to suit many policy-makers to argue that the crisis is all down to rule-breaking, and the responsibility of individual member-states. Despite the overwhelming weight of evidence, both empirical and theoretical, many politicians will continue to trot out Margaret Thatcher’s favourite line: there is no alternative – TINA.

Simon Tilford is chief economist at the Centre for European Reform.