The eurozone periphery is on a risky path to end fiscal austerity and accept larger budget deficits. Portugal is the most recent dramatic shift in that direction; Italy, Spain and even France are also abandoning plans to cut spending and raise taxes.
This move away from budget discipline reflects a combination of popular political pressure, more accommodating bond markets and encouragement from the International Monetary Fund.
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But ending fiscal austerity is not a strategy for achieving growth. It will reduce downward pressure on aggregate spending but will not lift growth and employment. Instead, it will raise interest rates and threaten a new fiscal crisis.
Europe needs three things: structural changes to boost long-run potential gross domestic product, a short-term stimulus to increase employment, and a commitment to longer-term spending reductions to shrink the national debt.
The political pressure to end austerity is widespread. Italian voters demanded relief from the higher taxes and the reduced pension benefits previously introduced by the Monti government. In France, President François Hollande won his election with a promise to end austerity and recently rejected the European Commission’s demands for specific budget cuts. Spain and Portugal reacted to public riots by negotiating with Brussels to delay deficit targets.
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The high interest rates on sovereign bonds that put pressure on governments to cut fiscal deficits fell sharply with the announcement last August by Mario Draghi, president of the European Central Bank, of a central bank Outright Monetary Transaction bond-buying facility. The pressure was further reduced when IMF officials encouraged the shift away from budget tightening.
The IMF staff responded by raising estimates of the fiscal deficits of France and the peripheral countries. The increase in current budget deficits and the expectation of higher future deficits have caused long-term interest rates to begin rising in all of these countries. As investors see fiscal deficits increase during the coming year, interest rates are likely to rise further and faster.
The relatively moderate pace of the recent increase in sovereign interest rates suggests that markets have forgotten the conditional nature of Mr Draghi’s promise. The ECB’s willingness to limit interest rates on peripheral country bonds depends on each country having an approved fiscal programme. With the countries shifting away from sound budgets, the ECB is no longer committed to act and would be unwise to do so.
Rising interest rates could bring back the fiscal crisis of a mutually reinforcing spiral of increasing national debts and rising borrowing costs. That could revive the risk that some countries would be unable to borrow and might therefore choose to leave the euro. If the ECB tried to prevent that despite the lack of fiscal discipline, the result would be escalating rates of inflation.
To prevent this, governments must combine long-run deficit reductions with short-run fiscal stimulus. Slowing the growth of pensions and other transfers would reduce future debt and prevent near-term increases in interest rates. To make these changes politically acceptable, governments should combine them with an immediate programme of infrastructure investment and manpower training. This would not only raise current GDP but would also strengthen long-run productivity and real incomes.
The slower growth of transfer programmes would also permit lower payroll tax rates, cutting the cost of labour and increasing employment. Lower labour cost would also raise the competitiveness of European products in international markets.
A lower value of the euro could provide a further boost, making it possible to lift employment while shrinking the short-term fiscal deficits. Although a lower euro would not change the exchange rate within the eurozone, countries outside the eurozone account for roughly 50 per cent of the peripheral countries’ trade.
Policies to allow budget deficits to rise are a dangerous mistake. Italy, France, Spain and Portugal should instead combine longer-term debt reduction with short-term fiscal stimulus. Together with a slowing in the growth in pensions and other transfers, this would boost productivity and lower deficits and payroll taxes to the benefit of all Europeans. The eurozone needs to adopt such policies.
The writer, a former chairman of the Council of Economic Advisers, is professor of economics at Harvard