No Pain, No Gain

The economic rationale of the current crisis is remarkably simple: Without fiscal stability, there will be no economic growth.

On March 2nd 2012, European policymakers signed a new fiscal compact in record speed. Its main pillar consists of the implementation of domestic debt rules, which should ideally be on a constitutional level, similar to the debt brake instituted by Germany in 2010. But after the election weekend in France and Greece, left-wing and radical parties voiced opposition towards this policy: Hollande in France demands a growth pact in addition to the fiscal compact, while Greece’s left parties want to remove the austerity measures completely. A fair question is raised: Are the economic impacts of stability and growth programs contrary to each other, or do they constitute interrelated necessities?

Establishing economic growth is obviously a long-term project. Growth theory suggests investments in education, research and development, and infrastructure to be the most promising in order to sustain future economic growth. Short-term stimulus packages, however, are not effective in the long-run and just a flash in the pan. These packages won’t generate any growth, but at best promise a short rebound for one or two years. Even if we would have supposed such a stimulus to be slightly helpful, recent economic research disproved it. Reinhard and Rogoff, two well-known macroeconomists from Harvard University, show that in case of a debt-to-GDP ratio above 80%, growth will decline.

Applying this finding to the situation in Europe is quite easy: In a crisis of confidence, which was created by excessively high debt levels, growth packages financed via deficit or higher taxes will have no effect either in the short-, medium-, or long-term. There is no hope for an effective demand stimulus during a confidence crisis, according to Keynesian economists. It is surprising that some policymakers, and especially the left-wing parties, don’t seem to have learnt the lessons of the past two years. The current situation with high public debt and deficit is a problem for all European economies. There is frankly no money to finance ineffective growth measures.

The German approach – which stresses sound public finances – is exactly in line with the most recent research findings in macroeconomics. The fiscal compact is at least a step in this direction. 25 European countries agreed to the compact, the only dissenters being the United Kingdom (the homeland of John Maynard Keynes) and the Czech Republic. Stability established by sound public finances is a pre-condition for growth. Stability and growth are not opposites, they are interrelated necessities.

However, even Germany has been arguing in favor of concessions to more growth stimulus since the last round of elections. German officials are talking about complementing the fiscal compact with a growth compact. Is that a good idea for the euro area? What can the history of European integration tell us about growth and stability?

In order to answer these questions, let’s briefly study the history of European integration. In 1995, Germany’s finance minister Dr. Theodor Waigel proposed a “Stability Pact” for the euro area. Similar to the fiscal compact today, this stability pact focused exclusively on the sustainability of public finances. The stability pact demanded budget deficit levels below 3 percent of GDP, total debt below 60 percent, and a balanced budget in the medium term. Furthermore, the German proposal in 1995 already contained automatic enforcement mechanisms to address excessive deficits. Even today, such automatic mechanisms are severely lacking, which can be identified as a major reason why the pact has failed in the past 12 years. Due to France’s opposition to the stability pact in 1995, it was expanded with a growth pact. Finally, the two documents were merged into the famous “Stability and Growth Pact” and implemented in 1997. The only growth element of this agreement was the economic rationale that without fiscal stability, there will be no economic growth. This fact was, and still is, crucial.

The danger today is that people may agree to the need of stability due to the crisis of confidence, but they may not agree on the true meaning of growth. Unfortunately, we know that even the stability pact has failed. If we extend the fiscal compact with a wrong demand-sided growth pact now, the whole fiscal governance is doomed to fail. If policymakers depart from the economic rule that without stability there will be no growth, the next backlash is just a matter of time. An agreement to this “exclusive” fiscal compact in times of crisis caused by sovereign debt and lacking confidence is the only way to restore financial markets in the foreseeable future. Yes, this requires harmful budget consolidation measures and strict austerity. Economics is sometimes very simple: Without pain, no future gain!

Read more in this column Bodo Herzog: The False Appeal of Central Banks

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