No simple answer to EU growth vs austerity conundrum

Fierce debate is growing in Europe over whether austerity or growth offers the best strategy to overcome the continent’s sovereign debt crisis. As if it were that simple.

As the eurozone hovers on the brink of its second recession in three years, the battle launched in academic journals, blogs and the financial press has spread to the hustings in France, Greece and soon in EU economic powerhouse Germany too.

“Europe can’t cut and grow,» Sony Kapoor, head of the Re-Define think-tank, and Peter Bofinger, a member of the German Council of Economic Advisers, said in an article before European Union leaders adopted a budget discipline pact last month. «The EU needs a growth compact, not a fiscal one. Swift action on tax and jobs is the way out of the crisis.”

The growth camp argues that synchronized austerity across Europe will only aggravate economic contraction, swell the ranks of the unemployed and make it harder for debt-laden countries to reduce their deficits and restore market confidence.

Less government spending reduces public sector jobs and shrinks demand, depressing consumer spending and investment, and risks pushing the economy into a self-defeating vicious cycle.

“The question is whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from granted,» economist Giancarlo Corsetti said in a debate on the VoxEU website.

The austerity crowd contend that cutting spending is vital to make public finances sustainable, build credibility with investors and create conditions for healthy growth that is not based on ever more borrowing or on real estate bubbles.

“It would be very easy to lose the credibility we have built with fiscal consolidation,» said a senior EU policymaker, speaking on condition of anonymity.

Both sides agree that structural economic reforms to boost potential growth by removing barriers in Europe’s single market and making labor laws more flexible can help in the medium term. They differ mostly about the pace of debt reduction.

The growth brigade features a coalition of US economists such as former Treasury Secretary Lawrence Summers, Nobel Prize winner Paul Krugman, academic Brad DeLong and French Socialist presidential candidate Francois Hollande.

The debt scourges are led by German Chancellor Angela Merkel, and includes the European Central Bank and the European Commission.

While heavily indebted states under bailout programs such as Greece and Portugal have no alternative to tough austerity, Summers and DeLong say short-term spending cuts elsewhere can worsen the long-run fiscal position.

“Unless we believe that the long-term real borrowing costs for western Europe as a whole will be more than 5 percent per year, spending cuts now to reduce the deficit are likely to erode rather than bolster the overall fiscal situation,» DeLong said in a contribution to the VoxEU debate.

US private economist David Hale, who runs a Chicago-based consultancy, said European countries should be reducing deficits more incrementally, stretched out over a longer timetable than the EU Commission has set.

“What the Europeans are doing now is depressing revenue, which means they’ll miss their fiscal targets,» he told Reuters.

EU paymaster Germany pushed through a treaty imposing quasi-automatic fines on eurozone countries that miss their deficit reduction targets because Merkel and others were determined not to repeat what they see as the causes of the bloc’s debt crisis.

According to the German narrative, peripheral eurozone governments and consumers borrowed beyond their means to finance a spending binge that lumbered the state, banks and households with unmanageable debts when the economic wind changed.

The executive European Commission and the International Monetary Fund recommend that countries achieve most of their deficit reduction by cutting spending rather than raising taxes.

Both would also like to see Germany in particular, which has a low budget deficit and decent growth, boost domestic demand to help stimulate the European economy. But Berlin is cautious, and it is not clear whether German consumers will actually spend rather than save the above-inflation wage rises they are getting this year.

Italy and Spain are both in the throes of sharp austerity programs driven by severe pressure in bond markets that had lost confidence in their ability to repay their debts.

Both countries’ borrowing costs reached euro-era peaks last year, forcing them to announce deep public spending cuts as well as reforms in pensions and labor laws.

Spanish bond yields have risen again since Prime Minister Mariano Rajoy rejected a deficit target his predecessor had agreed with EU authorities and set a higher target.

Analysts say the market move was due both to a loss of credibility of Spanish policy and to fears that Madrid will not meet its new goal due to deeper-than-expected recession, with 23 percent unemployment including one young person in two.

That complicates the policy choices for Spain and Brussels, which IMF chief economist Olivier Blanchard summed up as «damned if you do and damned if you don’t».

In Germany, Merkel faces a challenge to her deficit-cutting ideology in a key regional election next month in the state of North-Rhine Westphalia, where the Social Democrats are running on a platform of putting growth before austerity.

France’s Hollande, favorite in opinion polls to oust conservative President Nicolas Sarkozy next month, has said he will focus more on reviving growth rather than cutting spending.

“The credibility of debt reduction depends first and foremost on economic recovery,» he said last week.

The problem, many economists say, is not with his aim of increasing growth but with his way of going about it. Hollande plans to cut the deficit mostly by raising taxes on the rich, investment income and banks, while creating hundreds of thousands of subsidized jobs for young people.

This in a country where public spending already accounts for 55 percent of economic output and the tax burden is among the highest in Europe.

Even those who want Europe to ease the pace of deficit reduction reckon France needs to do more to shrink the state.

“In France, cutting public spending would free up resources for the private sector. Elements of fiscal reform would be positive for growth over 2-3 years, especially if you could match it with tax cuts,» said US economist Hale. [Reuters]