Jun 12th 2013

Europe’s Way Out

CAMBRIDGE – It seems that austerity is out of fashion in the eurozone – at least for the moment. The European Commission has given Spain, France, and the Netherlands more time to comply with the European Union’s 3%-of-GDP deficit ceiling. Even German government officials now concede that something more than fiscal belt-tightening is needed to revive the economies of the eurozone periphery. 

According to the Commission, that “something more” is structural reform: easing of firing restrictions and other labor-markets regulations, liberalization of closed professions, and removal of controls on markets for goods and services.

But this is merely old wine in a new bottle. From the outset of the eurozone crisis, the “troika” (the Commission, the International Monetary Fund, and the European Central Bank) insisted on such structural reforms as part of any financial-assistance package. Greece, Spain, and the others were told all along that these reforms were needed to spur productivity and competitiveness and help revive growth. 

After three years, Greece’s experience is telling. As a new IMF report acknowledges, structural reforms there have failed to produce the intended effects, partly because they ran up against political and implementation difficulties, and partly because their potential to increase growth in the short run was overstated. Nor have Spain’s labor-market reforms worked as expected.

None of this should come as a surprise. Structural reform increases productivity in practice through two complementary channels. First, low-productivity sectors shed labor. Second, high-productivity sectors expand and hire more labor. Both processes are needed if the reforms are to increase economy-wide productivity. 

But, when aggregate demand is depressed – as it is in Europe’s periphery – the second mechanism operates weakly, if at all. It is easy to see why: making it easier to fire labor or start new businesses has little effect on hiring when firms already have excess capacity and have difficulty finding consumers. So all we get is the first effect, and thus an increase in unemployment.

There is little new in the European Commission’s approach, and few reasons to be optimistic that its “new” strategy will work better than the old one. Structural reform – however desirable it may be for the longer term – simply is not a remedy for these countries’ short-term growth conundrum. 

The eurozone periphery suffers from both a stock problem and a flow problem. It has too large a debt stock, and too little competitiveness to achieve external balance without significant domestic deflation and unemployment. What is required is a two-pronged approach that targets both problems simultaneously. The prevailing approach – targeting debt through fiscal austerity and competitiveness through structural reform – has produced unemployment levels that threaten social and political stability.

So, what can be done differently? 

The most direct way to address the debt problem is a write-down, coupled with recapitalization of those banks that will suffer large losses as a result. This may seem extreme, but it simply recognizes the reality that much of the existing debt will not be paid back without new flows of official financing. As the IMF now acknowledges, it might have been better to restructure Greek debts from the outset than to engage in a “holding operation.”

Debt reduction by itself clears the way for growth, but does not directly trigger it. Policies that directly target expenditure rebalancing within the eurozone and expenditure switching within the peripheral economies are also needed. These include: policies to boost eurozone-wide demand and stimulate greater spending in creditor countries, especially Germany; policies that aim to reduce non-tradable prices; income policies to reduce the peripheral economies’ private-sector wages in a coordinated fashion; and a higher ECB inflation target to allow room for movement in the real exchange rate via nominal changes. 

These policies would require Germany to accept higher inflation and explicit bank losses, which assumes that Germans can embrace a different narrative about the nature of the crisis. And that means that German leaders must portray the crisis not as a morality play pitting lazy, profligate southerners against hard-working, frugal northerners, but as a crisis of interdependence in an economic (and nascent political) union. Germans must play as big a role in resolving the crisis as they did in instigating it.

France will most likely play a critical role as well. France is big enough that if it threw its support fully behind the peripheral countries, Germany would be isolated and would need to respond. But, so far, France remains eager to separate itself from the southern countries, in order to avoid being dragged down with them in financial markets. 

Ultimately, a workable European economic union does require greater structural homogeneity and institutional convergence (especially in labor markets) among its members. So the German argument contains a kernel of validity: In the long run, EU countries need to look more like one another if they want to inhabit the same house.

But the eurozone faces a short-term problem that is much more Keynesian in nature, and for which longer-term structural remedies are ineffective at best and harmful at worst. Too much focus on structural problems, at the expense of Keynesian policies, will make the long run unachievable – and hence irrelevant.

Copyright: Project Syndicate, 2013.
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