ECFR: Three Elements for a European Recovery Strategy
By Sebastian Dullien
Over the past weeks, a lesson which the arithmetic of debt dynamics has taught us long ago has finally seeped into the European politicians’ minds: Without growth, there will be no solution for the European debt crisis. Hence, the term “growth” has popped up everywhere in the debate. The newly elected French President François Hollande wants it, the German Social Democrats want it, and even the conservative German Chancellor Angela Merkel wants it.
However, a policy promoting growth is easier proclaimed than designed. The conservatives reiterate their old mantra: Growth should come from structural reforms. And after all, austerity paves the way for growth. Hence, according to them, there is no need for any policy change from what has been prescribed to Greece and the other countries in the euro periphery since the onset of the crisis in Greece in 2010. The Social Democrats in Germany in contrast would like to spend a little more on growth friendly policies, such as more research and development and more education, yet they lack really path-breaking proposals and do not want to be painted as being fiscally profligate and hence hesitate to change the basic fiscal course Europe has taken. Experience from the past years tells us that both approaches are extremely unlikely to jump-start the European economy and lead us into a sustained recovery.
So, what do we really need for a growth program in Europe? In my eyes, all the dabbling with marginal programs will not really be helpful. Instead, we need three elements in order to return to a new growth trajectory both in the medium and the long term:
- Soften extreme austerity: The first element would be to allow the periphery countries more time to reach their consolidation targets. Research, for example by the investment bank Goldman Sachs, proposes that there might be a “speed limit for consolidation”. According to IMF data, for countries with fixed exchange rates (as the euro countries are vis-à-vis their European partners), the maximum of actual deficit correction is reached if the planned budget correction is roughly 1.5 percent of GDP per year in structural terms. Any attempt of stronger fiscal restraint just leads to more slippage and the actual deficit correction is lower. (For economists: There is hence some kind of Laffer curve for consolidation, with a maximum at 1.5 percent of GDP per year). The European stability programs in Spain and Greece have gone far beyond this speed-limit, with planned deficit correction of 3 percentage points and more. The new programmes should have these lessons in mind and bring down annual consolidation requirements. Note that – contrary to what the ECB’s Jörg Asmussen has claimed, this need not necessarily imply higher financing needs for the periphery country. If there really is this Laffer-curve-type relationship between attempted budget cuts and actual outcome, a slower speed of planned austerity might actually even improve debt sustainability and thus lower financing needs. Note also that this does not mean “more debt for more growth” which according to conservatives has not worked. It means merely to give the economy more time to grow to have less debt in the end. So the motto here is “more growth for less debt”.
- Allow for more public investment: The new fiscal framework in Europe, embodied in the so-called “six pack” and the new fiscal compact prescribe harsh austerity for European countries for the decade to come. First, countries will be forced to cut back their existing deficits aggressively. Then, in the medium term, countries will be forced to run an all-but-balanced budget. While this rule is sometimes called a “golden rule”, it has nothing to do with traditional golden rules for fiscal policy. The traditional golden rule claimed that governments should not run budget deficits for current consumption or transfers, but might do so for investment – just as any well-run private firm. The current fiscal rules in Europe, however, do not distinguish between the two types of government spending. In addition, past experience with austerity programs has shown that public investment and spending in education and research and development are the first to be cut if just overall austerity targets are given. Public investment in Europe is now already at a very low level. Over the medium and long term, hence, the new framework means too little public investment in Europe. This will slow growth, not only from the demand side, but also from the supply side, as infrastructure and human capital will deteriorate. We thus need to find a solution to allow for more public investment, even if the budgets have no space according to Europe’s fiscal rules. One possibility would be a European-national, public-public partnership: The European Investment Bank could be used to allow national and regional governments to lease public infrastructure and investments in education. Under such a model, if a national government wanted to build for example a new university, but lacked the funds, the EIB would lend the money, keep legally the ownership of the university, but lease it to the national government. Over the life span of the building, the national government would pay a fee including interest rate and depreciation to the EIB. Such a proposal had a number of advantages: First, it would allow for investments even if a country has no room for additional borrowing according to the existing EU fiscal rules, as only the leasing fee would be counted in the national budget. Second, it would allow a clear distinction between unproductive public investments, i.e. in military equipment or representative buildings (which could be easily excluded from this scheme) and productive investments. Third, it would allow to design the rules that also education spending is counted as investment. Fourth, it would allow some degree of macroeconomic management, as the EIB could allocate funds available for leasing operations according to the macroeconomic situation in the applying country.
- Solve the financing and banking problems: Unfortunately, just turning around austerity at this moment will not be enough to reignite growth. One problem is that the banking system in many of the crisis countries is in deep trouble. In addition, the yield on sovereign debt is usually an important yard-stick for lending rates to the private sector. Thus, as the risk of deepening recessions and a euro-break-up lingers over the periphery countries, risk premia for private sector borrowing are high and firms and households have to pay extremely high interest rates. These high financing costs stifle investment. The only way around this is to solve the banking crisis and the liquidity problems of the periphery governments. At the moment, there is a vicious downward loop in which countries with fragile banking systems are trapped. As new capital needs in the banking system become evident, markets suspect new financing problems for the governments. Hence, investors sell the bonds of the country concerned. As a consequence, bond prices plunge and the national banks (which tend to hold a lot of debt of their own government) see themselves forced to write down their holdings, creating new capital needs. This vicious circle can only be broken if bank recapitalization is moved to a European level, for example into the ESM. Of course, such a transfer is only feasible if the European level also gets the right to oversee and supervise national banks. Moreover, in the medium term, such a solution can only be viable if the European level gets some own source of revenue, i.e. the right to tax corporate profits, as otherwise, the capital needed for recapitalization might easily outgrow the funds promised by national governments. Second, to solve the liquidity problems of the periphery government, new approaches for providing them with funds need to be introduced, with at least a certain degree of joint liability. Of course, introducing Eurobonds (i.e. under the blue bonds/red bonds proposal by the Brussels think tank Bruegel) would be one solution here. Alternatively, a banking license for the ESM and hence access to the ECB’s refinancing facility with a firm commitment to stabilize national bond prices might also work. Also the debt redemption fund could work, if it is introduced jointly with a banking union as described above.
I am well aware that this growth package is much larger than anything politicians at the moment discuss and that hence this three-point plan will easily be dismissed as being completely unrealistic. This might be true. However, this would be very bad news for the euro-area. Europe has now for more than two years tried to solve the crisis on the cheap. The result has always been the same: A deterioration of the situation and a huge increase of rescue costs. Do not fool yourself: Growth in a situation like the current will not be created with marginal policy measures, but only by a fundamental correction of the current policy approach.