Solving Europe’s Credibility Problem

PARIS – As the eurozone debates how to escape the stagnation trap in which it finds itself, one question has become increasingly important: Can governments credibly commit to trim public spending in the future while avoiding immediate cuts? Fortunately, the answer is a qualified yes: there are ways to ensure that fiscal accommodation now is followed by consolidation later.

Growth and inflation in the eurozone remain much too weak. The European Central Bank’s latest assessment is bleak, and ECB President Mario Draghi has made no secret of the fact that risks remain on the downside. Nominal GDP growth – that is, real growth plus inflation – will not exceed 1.5% this year and may well end up perilously close to 1%.

Though monetary policy is supportive, it is close to reaching its limits, and the ECB’s initiative to stimulate credit by lending to commercial banks on super-cheap terms has not proved as effective as hoped. AAA ten-year government bonds currently yield about 1%, suggesting that markets do not expect a strong rebound.

This is the type of situation in which fiscal policy should come to the rescue. Draghi made that very point in his speech at the annual gathering of central bankers in Jackson Hole, Wyoming, in late August, and several economists have suggested that it is time for the eurozone to engineer a temporary fiscal expansion.