Is austerity on its way out?

The anti-austerity crusaders

When the EU sovereign debt crisis started, there seemed to be unanimous political commitment amongst Europeans to start living a decent balanced-budget life. Almost three years on, political momentum has shifted. Spanish Prime Minister Rajoy is now openly asking the ECB (and Germany) to do more for growth, whilst he presented himself as a champion of austerity and a solid partner of Germany when he came to power. In Italy, a growth-focused Enrico Letta replaced an austerity-minded Mario Monti. The International Monetary Fund (IMF) – a historic symbol of austerity – recognised last year that it had underestimated the fiscal multiplier (i.e. the extent to which austerity impacts growth) in euro rescue programmes, and recently vehemently criticised the way it – and Europeans – managed the first Greek bailout. Finally and most importantly, the European Commission offered between one and two extra years to five European countries to achieve their budget deficit targets, thereby acknowledging the detrimental impact on growth and asking member states to focus on structural reforms. All this, on the back of ever-increasing unemployment, deepened recession and Europe-wide demonstrations and political upheaval, has given a hard time to austerity.

Austerity, was ist das?

Austerity has become so intensely fought that some seem to have even forgotten what it actually means. It is broadly defined as a reduction in public spending and/or an increase in taxes in order to reduce public deficits. Being ‘against’ austerity suggests that Europe can continue running deficits as long as it wants. This is both false and misleading. False, because financial markets will not continue to blindly lend money to European states (and don’t even ask the European Central Bank). Misleading, because the problem is elsewhere. In most cases, the accumulation of debt was a response to low growth. However, today’s crisis shows that the hopeful cure to low growth (increased public spending) has now become the illness. European states now have to start living within their means and find other sources of growth. The adjustment between what they earn and what they spend will happen anyways, whether through gradual budget consolidation (the soft way, as is currently enacted) or through devaluation and inflation, if some euro members decide to quit the single currency (the hard way). For this reason, austerity – understood as this natural adjustment – is bound to continue until completed.

In fact, austerity alone is damaging because European states are unwilling to find other sources of growth. Boosting investment through a few European projects and increasing the European Investment Bank’s capacity can help, but these efforts appear cosmetic compared to the broad structural reforms that are deeply needed to boost growth. It is a mathematical truth that reducing public spending reduces GDP, which in turn increases debts and deficits, when measured as a share of GDP. But it is also an economic truth that artificially sustaining aggregate demand without boosting productivity or repairing banks’ balance sheets (forgoing debts that will never be paid back, increasing capital ratios) merely delays the adjustment and makes it more painful.

Starsky and Hutch

The current crisis is a crisis of the entire European social model. If we pretend to even care about it, then we should reform it quickly and thoroughly, or it will simply die. This involves reducing the weight of the State in the economy (currently at an EU average of 49%), reforming labour markets to make them more dynamic, and most importantly suppressing vested interests in every part of the economy, as they harm everyone.

Austerity without structural reforms is like Starsky without Hutch: it just doesn’t make sense. In a perfect world where politicians only pursue the long-term interest of their people, the ECB would temporarily refinance the debts of countries that are shut out of financial markets, to give them enough time to undergo structural reforms, until they make their way back to growth. But in the real world, most politicians would not undergo such structural reforms as they consist in breaking vested interests (e.g. elected officials guaranteeing market shares of locally dominant companies), which are often deeply rooted in local economic and socio-political structures and behaviours. Those who are against such reforms argue that these types of behaviour are part of the ‘local culture’, and hence cannot be changed. This is a very hypocritical way to defend the short-term interests of the few, while jeopardising the long-term prospects of the many.