The Eurozone was staring at the abyss last week; the Spanish government sought financial assistance in order to recapitalize the nation’s banks, whose balance sheets have become too weak during the recession. Many expect that an additional bail-out package for the Spanish government is to follow soon. If this happens, it would effectively leave no Eurozone money for another rescue – at a time when Italy has also been flirting with a debt crisis.
This past weekend, Greece has been holding its second election in six weeks. The country’s political system has been in tatters since the first poll in early May. Pretty much all parties have been campaigning on populist promises of a denouncement or a renegotiation of the fiscal austerity measures which have conditioned the Greek bail-outs. The Greek people and European policymakers have been bracing themselves for a potential exit from the Eurozone, the potential consequences of which are very difficult to predict. What everyone seems to agree on is that, should the ‘Grexit’ occur, there would be turmoil both in the European and the global economy which could very conceivably lead to the disintegration of the Eurozone.
Greece and Spain could not have been further apart in the management of their public finances from the launch of the Euro currency in 1999 until 2008, when the global crisis broke out. According to the rules of the European “Stability and Growth Pact,” Greece was a fiscal offender par excellence, given its high output growth rates. Spain, on the other hand, had an exemplary record of compliance (unlike Germany, for example). Their current predicament helps illustrate the shortcomings of the strategy of fiscal austerity which, advocated by Germany and other creditor member states, has been at the heart of EU attempts to deal with the public debt crisis.
One of the main problems with fiscal austerity is that it prolongs and deepens the recession that member states would have to experience anyway, given their earlier unsustainable growth rates. The other problem is that, as the case of Spain illustrates, austerity does not even address the causes of its public debt crisis, which were related to excessive borrowing by the private sector and the subsequent development of account imbalances, rather than to fiscal profligacy.
The claim that austerity programs with front-loaded, politically difficult measures can improve confidence among investors and consumers is not realistic. Austerity does not improve the ability of a government to service its debt and set it into a virtuous cycle of lower interest rates, higher growth and budget surplus. Such improvements in confidence would require a national monetary policy that would reward fiscal adjustment efforts with lower interest rates and/or the possibility to export one’s way out of the recession.
The European Central Bank, however, does not set its policy according to what happens in Greece or Spain alone. Exporting one’s way out of recession could happen soon enough if a country could either devalue its nominal exchange rate or if demand conditions in its main trading partners (in this case the EU) are sufficiently buoyant. With a common currency in place, and with 23 out of 27 EU member states currently tightening their fiscal belts, this is not the case. In the real world, cutting wages and prices to improve competitiveness can only be a lengthy and painful process that risks deepening the recession.
What unfettered fiscal austerity has achieved thus far is to drive up unemployment rates – especially among the young – to stratospheric levels, make fiscal adjustment a moving target, destabilize national banking systems, and undermine the implementation and potential benefits of any structural reforms that could help with competitiveness in the longer run. On top of everything else, these developments provide fertile ground for the rise of populist and nationalist discourse across the political spectrum in member states, a discourse that can only be detrimental for the European integration project.
Sound public finances are necessary for the effective macroeconomic stabilization of an economy, especially during times of crisis. What should have been learned from the current crisis is that in the context of a monetary union, there can be reasons other than fiscal profligacy that lead to fiscal imbalances. In such cases, emphasis on fiscal austerity can only add to the problem without addressing it. But even when fiscal profligacy has been at the root of fiscal imbalances, the sole reliance on fiscal austerity as a solution that may have worked in the past for economies with full control over their macroeconomic policies, may not provide the appropriate mix for restoring sound public finances in the context of a monetary union.