Anti-austerity fever is sweeping Europe as policy makers decide the way to get from crisis to growth involves higher spending. Well, not so fast.
The fever has already spread to the highest levels. At the International Monetary Fund’s recent spring meetings in Washington, IMF Managing Director Christine Lagarde and her deputy, David Lipton, repeatedly urged euro-area countries to focus on investment rather than budget cuts.
Then came the European Commission president, Jose Manuel Barroso, who said April 23 that austerity has reached the limits of political and social support. A day later, Italy’s prime minister designate, Enrico Letta, wasted no time declaring that “Europe’s policy of austerity is no longer sufficient.”
The argument is compelling: Less retrenchment will allow more money to feed into the economy, which should support domestic investment and consumption, and so stimulate growth. That in turn should reduce budget deficits by increasing tax revenue, creating a virtuous circle.
Yet easing austerity involves trade-offs that might not be worth making for the weaker euro-area economies. Paradoxically, it is healthier euro-area countries such as Germany, which aren’t considering a relaxation of austerity, that should do it.
Ireland, held up as Europe’s poster child for austerity, is a good example of the pitfalls of loosening deficit targets for a country in fiscal crisis.
The government has passed half a dozen austerity bills over the past four years, and in many ways the policy is working. Last week the European Commission said Ireland’s budget deficit was 7.6 percent of gross domestic product, below its 8.6 percent of GDP target. Bond markets seem to have regained confidence in Ireland’s creditworthiness, with 10-year government bond yields hovering around an affordable 3.6 percent.
Austerity measures have gone smoothly thanks in part to an acquiescent population. In Dublin, which during the boom had an oxygen bar where one could go to breathe different flavors of oxygen, people recognized they had partied too hard and would have to tighten their belts.
But even the Irish are starting to push back against austerity. Labor unions recently rejected a motion called Croke Park 2, which the government proposed to further cut the public-sector wages. Some government ministers have begun to say Ireland should ease up on spending cuts and use the savings from February’s restructuring of promissory notes to plug budget gaps.
Loosening austerity to stimulate growth is a classic Keynesian approach and makes a lot of sense -- unless you are dealing with a country that has unsustainable public finances, such as Ireland. Ireland’s budget deficit remains the third highest in the European Union, behind only Spain (10.6 percent of GDP) and Greece (10 percent of GDP). Ireland’s public debt burden rose to 118 percent of GDP in 2012, behind only Greece (157 percent), Italy (127 percent) and Portugal (124 percent).
High government deficit and debt burdens aren’t inherently bad, and the relationship between these and growth was recently thrown open for debate when a seminal academic study by Carmen Reinhart and Kenneth Rogoff was challenged. What we do know, however, is that high deficit and debt levels can only be sustained over the medium- to long-term as long as a country’s growth model works.
Unfortunately, few countries in the developed world now meet that condition, and Ireland isn’t among them. Its economy slipped back into a technical recession -- defined as two consecutive quarters of contraction -- in the second half of last year. Looser deficit targets won’t fix the cause of this weakness.
Many of Ireland’s nominal exports don’t add value to the economy: They are profits booked by multinational companies that have their headquarters on the island to take advantage of its low corporate tax rates, location and language. Production happens elsewhere. Some of Ireland’s more successful and productive export industries, such as pharmaceuticals and chemicals, have slowed considerably over the past six months, in part because two of their main export markets -- the euro area and the U.K. -- are stagnating at best. Relaxed austerity in Ireland can’t do anything to reverse this.
Domestic demand is an even bigger worry. Unemployment remains stubbornly high, at 14 percent in March, and just less than half of those looking for work are long-term unemployed. Bad mortgages have left many families with negative equity, further dragging down private consumption.
Nonperforming loans are also undermining bank lending and investment. A new personal bankruptcy law and targets established by the Central Bank of Ireland will force banks to address bad property loans in a sustainable way. Worryingly, the central bank said recently that about half of all loans to small and medium enterprises are also nonperforming.
It will take years for the banks to repair their balance sheets and may require further recapitalizations. Looser fiscal policy won’t clean up the mortgage mess or the bank balance sheets, and therefore won’t stimulate enough domestic demand to justify the higher deficit and debt it would create.
The news for Ireland isn’t all bad. It won important concessions on repaying its international creditors in February, and never have its chances of exiting its bailout program on time looked so good. Yet exiting a bailout program is a marker, not a goal. The big question is whether Ireland can go on borrowing at affordable rates over the medium- to long-term, and not get locked out of the bond market again.
Given Ireland’s fiscal trajectory, the answer to that question is probably no. If the country wants to return to debt sustainability, it will not only need to hold the course on fiscal consolidation now but also need to do so for several years to come.
And therein lies Ireland’s problem. Easing austerity is unlikely to result in the extra growth that might increase tax revenue and bring down deficits the easy way. Without either austerity or growth, Ireland’s fiscal position will get worse, shutting it out of bond markets again and forcing it back into a bailout program.
None of this applies to countries that have healthy national balance sheets and are less likely to come under threat from the bond markets. If Germany and other core euro-area economies were to shift from cutting spending to providing a stimulus, then imports from Europe’s weaker economies would grow and those countries wouldn’t be forced to do all of the adjusting. Their recessions would be shallower as a result.
Regrettably, there is little sign that there is the political will for this in Germany. The risk is that by the time the euro area’s stronger economies do support a more symmetrical adjustment, they may themselves be too fiscally burdened to help.
(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. She is also a senior fellow at the Atlantic Council in Washington. The opinions expressed are her own.)
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