Thursday, November 27, 2014

Europe’s Misguided Search for Growth

BRUSSELS – A few months ago, 25 of the 27 members of the European Union solemnly signed a treaty that committed them to enshrining tough deficit limits in their national constitutions. This so-called “fiscal compact” was the key condition to get Germany to agree to increase substantially the funding for the eurozone’s rescue funds, and for the European Central Bank to conduct its €1 trillion “long-term refinancing operation” (LTRO), which was essential to stabilizing financial markets.

Today, however, the eurozone’s attention has shifted to growth. This is a recurring pattern in European politics: austerity is proclaimed and defended as the pre-condition for growth, but then, when a recession bites, growth becomes the pre-condition for continued austerity.

About 15 years ago, Europe endured a similar cycle. In the early 1990’s, when the plans for the European Monetary Union (EMU) were drawn up, Germany insisted on a “Stability Pact” as a price for giving up the Deutschmark. When Europe fell into a deep recession after 1995, attention shifted to growth, and the “Stability Pact” became the “Stability and Growth Pact” (SGP) when the European Council adopted a resolution on “growth and employment” in 1997.

The need for growth is as strong today as it was 15 years ago. In Spain, the unemployment rate then was as high as it is now, and in Italy, it was higher in 1996 than it is today. Politically, too, the background is the same: the “G” was inserted into the SGP under pressure primarily from a new French administration (at the time headed by Jacques Chirac). Today, France has again given the political impetus for a shift to growth.

Making growth a political priority is uncontroversial (after all, who could be against it?). But the real question is: what can Europe do to create growth? The honest answer is: rather little.

The key elements of a growth strategy discussed among Europe’s leaders these days are actually the same as in 1996-1997: labor-market reforms, strengthening of the internal market, more funding for the European Investment Bank (EIB) for lending to small and medium-size enterprises (SMEs), and more resources for infrastructure investment in poorer member states. The last two, in particular, attract a lot of attention because they involve more spending.

But circumstances are also quite different today. The EIB’s business model would have to be radically changed to make it useful to promote growth, because it lends only against government guarantees, whereas southern Europe’s fiscally stressed sovereigns cannot afford further burdens. Moreover, contrary to a popular misconception, the EIB cannot lend directly to SMEs. The EIB can only provide large banks with funding to lend to local SMEs. But the ECB is essentially already doing this with its three-year LTRO loans.

There is also talk about a “Marshall Plan” for southern Europe. Fifteen years ago, there was a clear need for better infrastructure there. But, since then, the southern countries have had a decade of rather high infrastructure investment – more than 3% of GDP in Spain, Greece, and Portugal.

As a result, most countries in the EU’s south probably have a sufficient stock of infrastructure today. In fact, more infrastructure investment would actually make most sense in Germany, where infrastructure spending has been anemic (only 1.6 % of GDP, or half the rate of Spain) for almost a decade. That is why Germany’s famous Autobahnen are notoriously congested nowadays.

But one does not need European funding to finance infrastructure in Germany, where the government can raise funds at negative real cost. At the rates that it is paying today, the German government should be able to find many investment projects that yield a positive social rate of return. Given that Germany is close to full employment, more infrastructure spending there would probably suck in imports (and attract unemployed construction workers from Spain), contributing to much-needed rebalancing within the eurozone.

Unfortunately, this is unlikely to happen, because infrastructure spending runs up against popular opposition. Indeed, such spending is decided at the local and regional level, where grass-roots opposition to any large project is strongest (it took more than 20 years, for example, to push through the modernization of Stuttgart’s railway station).

The urge to be seen to be “doing something” is leading Europe’s policymakers to rely on the few instruments with which the EU can claim to foster growth. But they should recognize that today’s growth crisis is different. The real bargain should not be austerity plus a Marshall Plan for the south, but rather continued austerity plus labor-market reforms in the south, combined with more infrastructure investment in Germany and other AAA-rated countries like the Netherlands.

Deep service-sector reforms in Germany would also help to unlock the country’s productivity potential and open its market to services exports from southern Europe. That way, the South would have a chance to find jobs for its rather well-educated young people, whose only choice now is between unemployment and emigration.

Read more from our "The Euro at Bay" Focal Point.

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    1. CommentedAndré Rebentisch

      Another option would be a general strengthening of EU competition law, as you know Sarkozy blocked an earlier EU treaty reform in this respect. Strengthening competition enforcement would add the stick to the carrots. "Too big too fail" implies "sizing it down" by regulatory intervention to make it suitable for the single market.

    2. CommentedOliver R

      Although it is of course right to aim for growth, many of the policy prescriptions being mooted, such as those you mentioned in your article are supply side reforms which would raise the long run growth rate but have little or not effect on growth today.
      Unfortunately, growth today is exactly what is needed. Economies right across Europe are being choked by the misguided drive for austerity, spearheaded by the German Chancellor Mrs Merkel. This is simply sending economies into a tail spin, with lower growth leading to lower tax receipts, higher spending on unemployment benefits, and lower investment. This makes it even harder to reduce the budget deficit.
      To go for growth in the short term, the pace of fiscal tightening must be lessened. Northern countries must be prepared to fund extra investment in the struggling south; infrastructure investment for example has a large multiplier effect and would have an immediate impact on growth.
      It is all very well talking about growth in the long term, but unless we get growth today there may be no long term, if European countries buckle under the strain of austerity and the Euro collapses.

    3. CommentedJohn Doe

      Mr. Gros has no idea what he is talking about, until he gets to the last when he mentions "services exports."

      There is a very simple reason that the West, Europe and the United States, are screwed. They are for the most part service economies and services cannot be exported. Not in a 1000 years will the Chinese let American trial lawyers into their Courts, yet who is better positioned to assure the rule of law will protect business and property rights.

      The world stupidly bought "international trade," never realizing that over time trade destroys. Why, because with trade comes irresistible pressure to move closer to the action (look at the pressure on firms to move everything to China).

      If Europe wants prosperity, the answer is simple. Close your ports and borders to imported goods and products, including even oil

    4. CommentedPaul A. Myers

      So we have a long-term refinancing operation (LTRO), essentially a monetary policy technique which has had some success.

      Therefore, why don't we have a E1 trillion "long-term fiscal operation" (LTFO) as a companion initiative. Since we don't need infrastructure (so the expert says), then we could spend 1 trillion euros on skill-building programs for young people and older people needing re-training. A better target would be to have an overall goal of spending on projects that would enhance future overall international competitive advantages. The idea is to create new economic money in the future, not this constantly reshuffling of bank paper.

      Let's call this Operation Fiscal Twist: spend short and reform long. In return for short term spending, national governments would pass (not "commit to") legislation reforming labor markets, entitlements, and taxes to generate budget resources to repay the spending. Pass the laws, collect the money.

      The people who are going to loan Europe money now want to see the enhanced economic prospects that will permit future repayment, not a balanced budget next year.

    5. CommentedZsolt Hermann

      We do not have historical precedence for our present situation.
      First of all we cannot talk about a "European problem" as today's economy and financial institutions, labour markets, consumer markets and manufacturing are all global, any change whether it is positive or negative is affecting us all.
      Besides the main problem is that we keep repeating the mantra of "we need growth, we need growth..." but it has become like a religious exercise without any meaningful suggestions how to actually achieve it.
      And with good reason: we have run out of steam, the constant growth, expansive machinery has exhausted itself, it was always going to happen since it was established on unnatural foundations, creating an artificial "hyper" production, consumption dream creating products we simply do not need and are mostly harmful.
      Humanity has to return to a natural, necessity and resource based lifestyle adjusted to the comfortable, healthy way of life of the 21st century.