European Council on Foreign Relations

Ancora Austerity!

Ancora! Cutting public expenditures in the eurozone has yet to begin and cries already multiply against so-called austerity. We need instead decidedly more (ancora) of such cuts if we want to make room for private and public investments that would be capable of reviving growth.

Everybody wants economic growth, of course. Like the perpetual motion machine or the philosopher’s stone, growth solves all problems. Unfortunately, however, it cannot be obtained by just doing away with a fictional enemy called austerity – as the successful Socialist sloganeering during the French presidential elections would have us believe.

Whatever austerity may mean in practice, public spending has been growing steadily everywhere in the EU over the last ten years, in nominal terms as well as a percentage of GDP. The Economist blog “Free exchange” contends that Yes, there is austerity because public spending in 2011 was, relative to GDP, generally lower than 2009. The latter, however, is the year of the great contraction and what really moves in this comparison is GDP rather than spending.

A serious economic case has been made (see here) that cutting spending is the key to economic recovery. But even accepting as legitimate the concerns about how to sustain aggregate demand in a recession, one should be wary of concluding that all public spending, since it is a part of that demand, is good. In the real world not all public spending is good simply because fiscal expansion is limited by the cost of borrowing. Within that limit, bad public spending displaces good, pro-growth public spending, as well as private consumption and investments.

Fiscal expansion is therefore not limited by the stability (and growth) pact, or by the European Commission, or by Angela Merkel. It is limited by the price financial markets request to buy government bonds. That price is getting higher and higher precisely because markets are sceptical of the Chancellor’s ability to get her message of fiscal sustainability across to the rest of the eurozone.

Of course, zero or negative growth makes everything even less sustainable. Here a moderate amount of German bashing is more justified, because Germany does have the private and public breathing space, together with the sheer size, to sustain demand in the eurozone. Recent official hints to let wages grow, or tolerate higher inflation, seem to signal a new readiness to soften an economic policy stance not hitherto renowned for its flexibility. On the other hand, one has to credit the ECB for having had so far a monetary policy as accommodative as its rules (and the Bundesbank) allow.

Still, the sovereign debt problem won’t go away by simply ousting Mrs Merkel from power – or, for that matter, her former French ally Nicholas Sarkozy. Nor will it go away battling a windmill called austerity. If anything, it will get worse.

With public spending hovering everywhere around 50% of GDP (and France, for example, is well beyond that mark) one does not need to enter into much detail to substantiate the assumption that there is much fat to cut. Since that fat is also food for a number of special interests, it always turns out to be extremely difficult to cut. Regulations are also food for special interests, and that’s why structural reforms also always turn to be just as difficult to make.

In his piece Time to say basta to the nonsense of austerity, José Ignacio Torreblanca contends that Spain is doing all it has to do to put its economic house in order, spending cuts and structural reforms included. I wish I could say the same of Italy.

Even the best intentioned of governments, such as Mario Monti’s, began its austerity drive by raising taxes rather than cutting expenditures. The prime minister has just appointed an outside expert, Enrico Bondi, as commissioner in charge of a “spending review”. That such a review is taking place at all is the perfect admission that serious reductions did not occur in the first six months of office. There is also very little to show in terms of structural reforms, with those in the labour market still under negotiation.

By raising taxes rather than cutting expenditures, (bad) public spending certainly displaces private consumption and investments. If we want to sustain growth, we need more than discounting public investments from the computation of fiscal balances (the so-called golden rule long advocated by Monti among others). Markets care very little for formal EU accounting rules. Perhaps they would be better persuaded if at least the composition of eurozone public spending, other things being equal, showed a shift toward more productive uses.

Let’s take the EU budget as an example. Is it not senseless that almost half of it, or more than € 50 billion, still goes to agricultural subsidies? Would it not be incomparably more pro-growth to use this money for, say, research and development? But the farm lobby is very powerful, especially in France, and it evidently pays more in a French presidential campaign to attack austerity, the European Commission and Mrs Merkel.

Public spending expands easily, constantly and indiscriminately. It is then extremely difficult to contain it and/or make it more discriminate. Only crises and the scarcity of resources can make this possible at all. We have yet to begin. Austerity? Ancora!

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