BRUSSELS – In June, it was Greece. In August, it was France, Italy, Spain, and Portugal. In September, it was Greece again – and Spain. In November, France took another turn, before Italy again in December, this time in a major way. Every month, despite an ever-darker outlook for economic growth, countries announce new spending cuts and tax hikes in the hope of restoring confidence in the bond markets. Only Germany stands out, having recently announced a tax cut, albeit a modest one.
In other words, while all indicators point to a severe economic downturn in Europe, the eurozone’s current interest-rate spreads are provoking a shift to austerity. It looks like a no-brainer: accelerated budget cuts are preferable to a lethal interest-rate surge on public debt, even if the cuts increase the risk of recession. But there are caveats.
First, while indiscriminate austerity may be the only option for those eurozone countries that no longer have access to capital markets, others have more choice of policy options. Consolidation is required, but governments are responsible for its speed and its design.
Second, a sound fiscal strategy requires establishing, on the basis of prudent economic assumptions, an ambitious budgetary target for the medium term, determining what mix of taxation and expenditure cuts are required in order to achieve it, and then sticking to the plan throughout economic fluctuations. This allows the so-called “automatic stabilizers” – lower receipts in a slowdown, higher in a boom – to come into play, preventing the economy from overheating at the top of the business cycle and providing stimulus at the bottom.
Third, headlong consolidation is not always the best way to reassure markets, which may worry more about growth. Italy is a case in point. The country’s budget deficit this year, at 4% of GDP, is far below that of Spain or France. Indeed, it was not the country’s deficit that finally led investors to shun Italian bonds, but rather a forbidding cocktail of high debt, desperately slow growth, and political paralysis. In a situation like this, nibbling at the edges of a deficit is at best a sideshow. The markets are demanding reforms that lift growth rates durably and an approach to fiscal consolidation that is consistent with higher potential growth.
Fourth, the cost of rushed austerity is that it generally relies on immediate fixes, such as indiscriminate spending cuts and tax hikes that are expected to yield revenue in the short term, but that have an economically damaging impact. Smart consolidation should, instead, minimize short-term economic damage and foster longer-term growth.
Governments know this only too well. At the end of 2010, most eurozone countries were penciling spending cuts into their consolidation programs while preserving the most productive areas, such as education and infrastructure. Moreover, they were planning to broaden the tax base rather than raise rates.
But, since this summer, governments have done the opposite. Rather than focus on spending, they have zeroed in on tax measures, for the most part increasing existing rates. This is a bad sign for growth.
What should they be doing instead? Fiscal consolidation is unavoidable, but that is a medium-term process. Instead of undertaking knee-jerk cuts, eurozone governments must first reestablish their credibility through policy rules enshrined in national legislations, as recently decided by the European heads of state and government.
Second, they should design and implement smart consolidations, even if they take a little more time to design and a little more time to implement. This entails finding the optimal balance between spending cuts and tax increases, and identifying the least harmful measures over the medium term. Doing so will take time, thought, and an iron will.