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After austerity

9 January 2012 By Hugo Dixon

Semantics could help save the euro zone. There is a crying need to distinguish between fiscal austerity and structural reform. The endless austerity programmes adopted by the GIIPS – Greece, Ireland, Italy, Portugal and Spain – threaten to crush their economies so much that they are socially unbearable. By contrast, reforming pensions, labour markets and the like would be good for long-term growth. A policy mix that emphasises the latter and draws some sort of line under the former is needed to stop the euro crisis spinning out of control.

Europeans have become grimly familiar with austerity spirals over the past two years. A government that needs to cut its fiscal deficit embarks on a programme of tax hikes and spending cuts. The snag is that this fiscal squeeze, in turn, squeezes the economy – partly via the direct impact of cash being sucked out of the private sector and partly because the private sector loses confidence. The depressed economy means the government’s tax take doesn’t rise nearly as much as envisaged. So the deficit doesn’t decline much and, as a percentage of shrunken GDP, it falls even less. The governments’ creditors, led by Germany, then demand another round of austerity to get the programme back on track. With each round, the howls of pain from the population increase, belief that there is light at the end of the tunnel declines and the government’s political capital shrinks.

The Greeks, Irish and Portuguese have been trying to run up this down escalator the longest. Italy and Spain are now embarking on the same regime. Yet more doses will be required over the coming year if the policy mix is unchanged. After all, last year’s budget deficits are expected to be about 10 percent for Greece and Ireland, 7-8 percent for Spain and Portugal (if a one-off pension transfer is ignored) and 4 percent for Italy.

Some austerity was needed given that expenditure had run out of control in the boom times and that, in some cases, there was a deliberate fiscal boost in the aftermath of Lehman Brothers’ bankruptcy in 2008. In Greece’s case, there was also a failure to implement the programmes properly, meaning time and credibility were lost. But endless rounds of austerity are debilitating. The better approach would be to have one chunky programme that is properly implemented and then rebuild.

Of course, the creditors aren’t willing to give something for nothing. But this is where a semantic distinction between austerity and structural reform could be helpful. Both require political courage by a government and sacrifices by its people. But the former pushes an economy down, while the latter boosts it – albeit in the long term. A virtuous cycle is even possible with the economy reviving, tax income rising, the deficit falling and confidence returning.

Pushing up retirement ages is a case in point. This doesn’t just reduce government spending, especially in the long run as savings build up year after year; it also increases the productive potential of an economy by expanding its work force. Or take labour reform. Making it easier to hire and fire people puts downward pressure on wages, improving an economy’s competitiveness and reducing unemployment – which, in turn, cuts government spending on social security.

Other desperately needed reforms – privatisation, liberalisation of product markets, and increasing the efficiency of the public sector and the judiciary – would also improve long-term growth. Privatisation would have the added benefit of cutting government debts, as would crackdowns on tax evasion.

The GIIPS have all done something in the field of structural reform. Italy, Spain and Greece, for example, are pushing up retirement ages. But the reforms have been slow in coming and sometimes half-hearted. Greece is the worst example: little has happened on tax evasion or privatisation. Meanwhile, the new governments in Rome and Madrid have yet to get to grips with labour reform, although they are indicating that they will do so soon.

If the GIIPS could convince their creditors that they were serious about such reforms, they would win brownie points. That would put them in a better position to avoid yet more rounds of austerity. After all, Germany’s Angela Merkel would still be able to argue to her people that the peripheral economies were serious about change. What’s more, the economies of Germany and other creditor nations would benefit. Austerity in their neighbourhood combined with the threat that the whole euro zone could blow up is not good for business. But to start the process, policymakers and pundits need to stop talking about austerity and reform as if they are the same.

 

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