There is an alternative to austerity

THE backlash to the backlash against austerity seems now to be underway. For months, if not years, complaints have grown that the euro-zone's austerity-first approach to the crisis is somewhere between inadequate and counterproductive. That message now seems to be winning converts across Europe. 

Euro-zone leaders are increasingly acknowledging the need for a growth agenda, and the success of François Hollande in the first round of the French election is being hailed as a decisive blow against austerity. Perhaps predictably, the pushback is on. The Financial Times' Gideon Rachman captures the essence of the counterargument in a piece titled "No alternative to austerity". What Mr Rachman manages to do quite effectively is illustrate how muddled the conversation has become. He writes:

Mr Hollande says that he will replace austerity with growth. Why didn’t anybody think of that before? Unfortunately, a vacuous slogan is underpinned by ineffectual proposals. Mr Hollande’s programme stresses small, badly-targeted boosts to public spending, while virtually ignoring the structural reforms that are the only route to sustainable growth...
Spending on infrastructure – “shovel-ready” projects, as President Barack Obama has called them – is, of course, a standard Keynesian solution for an economy that is caught in a downward recessionary spiral. Under normal circumstances, such spending might be a great idea.
In Europe, however, there are plenty of reasons to be sceptical. If building great roads and trains were the route to lasting prosperity, Greece and Spain would be booming...
As for Italy and Spain, they are not cutting their budgets out of some crazed desire to drive their own economies into the ground. Their austerity drives were a reaction to the fact that markets were demanding unsustainably high interest rates to lend to them. There is no reason to believe that the markets are now suddenly prepared to fund wider deficits in southern Europe.

Mr Rachman does an excellent job constructing the framework through which most serious observers see the crisis. Unfortunately, it's deeply flawed. Let's start with his last point: do unsustainably high market interest rates signal a need for austerity? It would be peculiar if they did; Spain's fiscal and growth prospects aren't demonstrably worse than those in other places where markets are happy to lend cheaply. The problem, rather, is that Spain lacks its own currency and has therefore become stuck in a nasty loop in which financial concerns hurt growth and sovereign yields, and high sovereign yields lead to an austerity push which hurts growth and financial conditions.

Mr Rachman is right that, left on its own, Spain has no choice but to react to high yields by embracing drastic austerity in order to reduce its borrowing needs. The question facing Europe is not whether this is a true dynamic—obviously it is, and it's strange that Mr Rachman would see a need to point it out. The question is whether it should be allowed—or encouraged—to play out, given the euro zone's deep commitment to economic integration. That's what the anti-austerity folks are complaining about. Enforced rapid, deep austerity in places that don't obviously need it entrenches a bizarre halfway integration that's ultimately doomed to fail.

What, then, are the alternatives to austerity? Well, first up would be an integration that would help break the diabolical loop now gutting the periphery. Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that. America doesn't expect Delaware to shoulder the costs of failures of banks headquartered in Delaware. That's an important contributor to the stability of the American federal system. The euro-zone must recognise that it is the failure to build appropriate euro-zone-wide institutions—equal in scope to the considerations and resources of the central bank—that is contributing to soaring yields around the periphery and creating the illusion of the need for dramatic austerity in places that could do without it.

What else? Next up would be an appropriate level of euro-zone-wide aggregate demand; when the euro-zone as a whole is in recession odds are good that stabilisation policy is failing. Perhaps fiscal stimulus is out of the question, even in Germany and the Netherlands. One puzzling mistake Mr Rachman makes is in implying that the only fiscal alternative to austerity is stimulus; in fact, less austerity is also a decent option. Less austerity would be entirely appropriate in Spain, where gross debt levels remain low by rich world standards. It would be appropriate in Germany. It would be appropriate in lots of places not called Greece or Portugal. The European Central Bank should also do considerably more to support recovery, including through countercyclical macroprudential policy. Efforts to calm the financial system are lovely; they'll do little but buy time if aggregate demand is too low.

Of course, structural reforms are necessary. If the German labour market is running too hot (maybe it is; this is increasingly in doubt), leading the ECB to conclude that more easing would merely generate rapid wage inflation, then structural reforms to boost mobility across borders would be very helpful. But structural reforms are not an inseparable part of some reform cocktail that necessarily includes austerity. On the contrary, structural reform and adequate demand are two great tastes that taste great together; without some wage inflation in Germany, efforts to boost Spanish mobility won't succeed in generating sufficient migration.

I think the reaction to Mr Hollande's success is telling. The overwhelming criticism is a sort of "look how inappropriate fiscal expansion would be for the French economy" take. The point is that the economy that matters is that of the euro zone as a whole. And when one steps back and looks at the dynamics in play, it becomes clear that the robotic push for national-level austerity across the euro zone is undermining integration and thereby exacerbating the crisis.

Now of course, long-run euro-zone success depends on institutions that limit the impact of moral hazard on national budgets. No part of that sentence implies that Spain must embrace crash austerity now. Quite the opposite; crash austerity now is the best way to ensure that in the long run, the euro zone is dead.

The Economist