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After austerity

29 April 2013 By Hugo Dixon

The austerity debate misses half the point. It is true that governments, especially in the euro zone, shouldn’t chase an austerity spiral ever downwards. But they can’t just sit on their hands. They must drive even harder for structural reforms.

The last few weeks have witnessed a sea-change in the debate over fiscal austerity. A seminal academic paper by Carmen Reinhart and Kenneth Rogoff, which purported to show that economic growth was impaired if government debt levels exceeded 90 percent of GDP, has been discredited.

Meanwhile, the European Commission has softened its line on the merits of further deep budget cuts in peripheral economies. Spain, for example, looks like it will get until 2016 to bring its deficit down below the European Union’s magic number of 3 percent of GDP. Portugal, Greece, Italy and France are also being shown greater leniency by Brussels. One of the first things Enrico Letta, Italy’s new prime minister, said last week was that country needed to focus on growth not austerity.

The change in attitude didn’t all happen in the past few weeks. The International Monetary Fund, which in the old days used to be considered the high priest of austerity, has been advocating looser policies for a good year. And, as more countries have got sucked into the austerity spiral – slamming on the brakes, which crushes the economy, making it harder to hit budget targets – the folly of continuing with the same policies has been hard to ignore.

It is astonishing to think that it was only in December 2011 that virtually the entire EU, including most countries outside the euro zone, signed up to the German-inspired “fiscal compact” – a misguided treaty which hardwires austerity into governments’ constitutions. It will be interesting to see whether this has any residual role or, like the euro zone’s original growth and stability pact, is viewed as a piece of waste paper.

But there are dangers in the new consensus too. The so-called austerians do have a point that excessive debt acts as a brake on an economy, even if there is no discontinuity at 90 percent of GDP. There is also the small matter of how rising debt – Italy’s is heading to 130 percent of GDP and Spain’s to over 100 percent – is going to be funded.

At the moment, the markets don’t seem worried. The ECB’s pledge to do whatever it takes to preserve the euro is keeping governments’ borrowing costs down. One of the most dramatic examples of this is Portugal, whose 10-year bonds now yield 5.9 percent down from 11.4 percent before the ECB’s jawboning.

That said, the euro crisis was not caused by austerity but rather stemmed from the fact that many economies became flabby and uncompetitive. Welfare states were too generous, labour had excessive privileges, civil services were bloated, swathes of industry were riddled with uncompetitive practices, judicial systems were sometimes dysfunctional, while tax evasion and corruption were often rife. What’s more, in many countries, there has been an unhealthy nexus between banks and politics.

These problems have been tackled, but only partly. Until they are more fully dealt with, the euro zone will not be able to return to sustained growth; unemployment, especially among the young, will stay unacceptably high; and the debt crisis will remain at risk of returning.

Look at Italy. Mario Monti, the outgoing prime minister, did reform pensions. But he botched his shake-up of the labour market, making it harder for young people to get jobs. He also failed to do much to liberalise services markets and did nothing to clean up politics. The best that can be hoped of Letta, who shouldn’t count on holding power for more than a few months, is that he will reform the electoral system.

Things are a bit better in Spain, where labour liberalisation seems to be working. But Madrid is still being too vague on what will be in its next batch of reforms.

Meanwhile, Greece has been drinking bitter medicine for three years but has still to crack its problem of rampant tax evasion. Nor is it clear that Antonis Samaras, the Conservative prime minister, really wants to tackle vested interests in the business community.

Last but not least, France under Francois Hollande has only taken baby steps to restore its competitiveness. Public spending and taxes are too high, sucking vitality out of the private sector. Labour practices are too rigid.

More generally, right across the euro zone, banks have resisted coming clean on their bad loans. National and European policymakers have often connived in this denial, partly because the banks are well-connected and partly because doing so might require taxpayer-funded bailouts. But this is another drag on the economy.

Europe is over-dependent on a broken bank system. It should be emulating the United States which relies much more on capital markets to fund industry and households. But Brussels is deeply suspicious of markets. Indeed, its misconceived financial transactions tax will gum up financial markets, which is exactly the opposite of what is needed.

Austerity and structural reform are not the same. But they are often confused, because they both cause pain. With reform, the pain is mainly felt by well-entrenched vested interests. If the euro zone is going to have a healthy future, it must now tackle these with vigour – even as it goes easy on austerity.


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