With Spanish 10-year bond yields soaring again above 6 percent, many critics question the wisdom of the Spanish government's €10 billion in new austerity measures. As discussed on this blog last week, Madrid has been listening to the political demands of the broader euro area and the European Central Bank (ECB). The bank, after all, has persuasive leverage because of its power to stabilize the situation by restarting its bond purchases under the Securities Market Program (SMP). Markets were unsettled a few weeks ago when Prime Minister Mariano Rajoy talked about abandoning Spain's original 2012 deficit target.1 Today the tune in Madrid is different, and more attentive to the austerity peddlers.
What is the real role of austerity in the region? Why are countries almost volunteering to submit to it?
Some would argue that senior euro area officials and leaders are stupidly infatuated with the euro area crisis as a "morality tale" of the evils of government debt—and that they fail to understand Keynesian economics and its lesson that deleveraging in both the private and public sectors will devastate the economy short term. Paul Krugman (and many others)2 advanced this point, deriding the politically disingenuous doctrine of "expansionary consolidation"—the idea that austerity can itself spur investor confidence. Early in the crisis, the European Commission and the ECB and its president Jean-Claude Trichet mused that such fiscal consolidation would somehow boost private sector demand—as if belt tightening could be pain free. It was always too good to be true. Krugman and others (including the IMF, or International Monetary Fund) were quick and correct to dismiss the argument. Fortunately Trichet's successor as ECB president, Mario Draghi, has distanced himself from this specious line of thought.3
But just because top euro area policymakers succumbed to promises of what my colleague John Williamson, in another context, once dubbed an "immaculate transfer" does not mean they are all imbeciles or members of the hardcore cult of austerity presided over by retired Bundesbankers. The reality is more nuanced.
In declaring austerity a failure, some American critics on the left are advancing their own domestic political agenda, for example. They frankly fear that if austerity works in Europe, it could legitimize the cause in the United States. But even after budget cutbacks, the public sector and social safety net in the euro area will remain larger than in America. Government spending there will still amount to close to half of total GDP in 2012,4 compared to 40 percent for the United States (including state and local governments). That fact is likely to be lost in the toxic US political debate, unfortunately. The dangerous and misguided Path to Prosperity budget advanced by Representative Paul Ryan and the Republican House Majority envisions cuts to the federal government that would be unthinkable in the euro area. Small wonder that a large number of American critics want euro area austerity to fail.
Beyond this bias, too many macro economists and market bond strategists are obsessed with the short-term need to get back to trend growth, ignoring the deep political scope of the challenge before euro area leaders. But Europe is mired in the aftermath of the kind of massive financial crisis that Carmen Reinhart and Kenneth Rogoff have identified in their book This Time Is Different as producing sluggish and slow recoveries. Even with the right policies, a quick return to pre-crisis growth levels in the euro area is illusory. Europe is also still an ageing continent plagued by large internal imbalances, too.
My late great colleague Michael Mussa, in one of the last papers he wrote for the Peterson Institute in late 2011, stated as much with his trademark lucidity and wit:
I will take a medium-term perspective on growth prospects—the next 5 to 10 years, covering both the United States and Western Europe….The main conclusion of this paper is that both the United States and most of Western Europe, especially the euro area, face significant and persistent problems in significantly and rapidly reducing large existing margins of slack and in restoring their economies to growth paths similar to those that prevailed on average for the quarter century before the great recession.
There are important similarities between the problems facing the United States and the euro area, notably in the need for medium-term fiscal consolidation, but there are also important differences. In particular, wide disparities in the economic problems faced by different euro area members, the constraints implied by a unified currency, and the absence of other powerful policy instruments to address regional disparities, makes the achievement of adequate medium-term economic growth especially difficult. I do not have a magical solution for these difficulties; they exist and to a considerable extent will need to be endured.
More generally, I will argue that sound economic policies can only play a limited role in improving medium-term growth prospects, either in the United States or Western Europe—although it is always possible for bad policy to make matters worse.
As fatalistic as this advice sounds, one must add a note of caution. Simply getting "back to trend" will not suffice for the euro area. Unless Europe reforms its system, it faces a long-term economic decline. Labor markets, for example, must be further liberalized in Spain, Italy, and other countries to scrap a system that has long favored insiders (in unions and guilds) over outsiders (the young trying to break into the economy). Services sectors, even in relatively robust Germany, must be deregulated in order to further deepen Europe's Internal Market.
The example of Spanish youth unemployment is instructive. Youth unemployment in Spain is at a catastrophic level of 50 percent. Of course the recession has led to this spike. But in early 2008, before the collapse of Lehman Brothers, that rate was already at a devastating 32.7 percent. Even in the false prosperity heyday of the Spanish housing and construction bubble in 2006 it was between 15 and 20 percent,5 higher than US youth unemployment today of 16.4 percent.6 The main culprit is Spain's archaic and dual labor laws, which forced young Spanish workers to accept flexible and temporary jobs while older workers enjoyed permanent contracts with generous severance payments. No surprise, then, that when the bubble burst, the young were dismissed disproportionately. Without an overhaul of this system, youth job creation in Spain will never be at an acceptable level. In the absence of change, reflating the Spanish economy is meaningless and the crisis opportunity will be wasted.
By contrast, the United States faces few of these impediments to renewed job creation. Indeed more austerity in an already depressed economy might produce hysteresis effects in the labor market, compounding the difficulties of the long-term unemployed to return to the market and raising new doubts about the effectiveness of short-term austerity in improving the sustainability of long-term US debts7. Accordingly, US policymakers should worry more than their European counterparts about fiscal policy and the fiscal multiplier making the situation worse.
The reforms discussed here will also require an unprecedented surrender of national sovereignty by euro area member states. As stated in the IMF's April 2012 Global Financial Stability Report Box 1.1, the process will also "take political determination and time." Indeed the IMF staff may have underestimated the obstacles by stating that "a credible commitment to a truly integrated EMU [economic and monetary union] would have immediate benefits." That is not so clear.
Such a "credible commitment" is a deeply political issue, requiring some taxpayers (in Germany and other AAA rated nations) to stand behind the government debt of other euro area members, which the elected leaders in the guaranteeing nations would be undertaking at great political peril. Sequencing of events is key. Despite the wishes of the IMF staff and markets for an immediate introduction of eurobonds, an early announcement of such a step at the next European Union Council in June would lack credibility. Even if it were constitutionally legal (which it is not), skeptics would question the resolve of German taxpayers in standing behind Spanish deficits or Italian debt stocks. Hastily raising such prospects could simply provoke a Tea Party-like political revolt.
What might make German taxpayers willing to stand behind the debts of governments in whose election they have no voice? This is not just a matter of Germany benefitting from the euro. It is about what might make the Swabian housewife say: "OK, I will chip in, too." Only then can fiscal risk sharing in the euro area become a political reality.
This is where the euro area's new and numerous fiscal rules become important. For Germans to backstop other people's debts, every benefitting country must first prove able to sustain their social models and finances within agreed upon fiscal rules. In the words of Doubting Thomas: "Except I shall see in his hands the print of the nails, and put my finger into the print of the nails, and thrust my hand into his side, I will not believe."
Fiscal consolidation today should be viewed as a political down payment by countries seeking guarantees from German taxpayers. It would be wonderful and much easier if a cooperative solution were available free of moral hazard. But few are so blessed in the real world.
An overly dominant centralized fiscal authority is not a necessity for Europe, though one might be optimal. Europe may be able to prosper under a relatively stable and "functioning" currency union, a legacy of currencies historically dictated by wars, conquests, and taxation of nation states that arose in the 17th century. The euro area, by contrast, results from a voluntary sovereignty pooling by democratic states. As Bordo, Jonung, and Markiewicz (NBER Working Paper 17380, A Fiscal Union for the Euro: Some Lessons from History, 2011) discerned, the economics profession lacks historical cases to guide policy in novel entities like the euro area. Caution is warranted when contemplating what types of currency unions are feasible.
Obviously, the euro as designed in the Maastricht Treaty of 1992 has not proved viable. Without a federal state, the euro area will remain economically suboptimal. Many economists might thus dismiss the entire project as unworkable and unworthy. But plenty of suboptimal economic entities survive if the political will exists to implement sufficient reforms to prevent their collapse.
The euro area crisis has shown that threatened with disaster, the political will has emerged to sustain the euro. Though European self-identities are not likely to recede, the currency union can function sufficiently. That is why the fiscal austerity and debt and deficit rules under way are important. The new EU fiscal surveillance packages in the so-called Six-Pack (consisting of five new regulations and one directive), the Two-Pack (the two new regulations under discussion), the Fiscal Compact Treaty, and the austerity in Spain and elsewhere might appear to be doing senseless damage to short-term macro-economic growth. But these steps make sense as laying out a path to new and necessary institutions to sustain the euro area.
Once one recognizes that optimal is not feasible, one can see that the euro area suffers from an acute version of the difficulties that have faced many existing federations and unitary states. For example, Spain at present, and Argentina in the 1990s, have their own troubles controlling the expenditures of politically powerful and independent provinces.8 The euro area may actually need strong spending curbs for the provinces or state within its member states far more than it needs the fiscal federation across the region. As the current crisis has illustrated, the illusion of a no-bailout clause in a closely integrated modern currency union has not been enough to prevent rampant and instantaneous financial contagion.9 Strong fiscal rules have thus attained additional importance.
Of course, the euro area must not be based on austerity alone. But austerity measures must be undertaken to produce euro area integration with the benefits of eurobonds, integrated bank supervision, resolution, and deposit insurance—and a more directly political role for the fiscal rules overseer at the European Commission, perhaps through a directly elected Commission President. Like it or not, fiscal austerity has to precede fiscal solidarity.
3. See for instance http://www.ecb.int/press/pressconf/2012/html/is120404.en.html.
8. The United States has had the historical advantage that a series of state defaults in the early 19th century created a strong state-level norm for constitutional balanced budget requirements (something the euro area is of course now trying to recreate), which combined with the powerful taxing and spending capacity of the federal government has helped prevent state defaults for more than 150 years.
9. In other words, there are—unlike in the United States in the 1830s and 1840s—not going to be any examples in the euro area to illustrate to everyone just how bad a default is, and thereby why it is important to maintain fiscal sustainability. The euro area will have to develop its fiscal norms without the "power of the example."