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In Place of Austerity: What Comes Next?

Thursday 11 July 2013


Europe stands at a crossroads. Italy’s new prime minister, Enrico Letta, says "austerity is no longer sufficient." A leaked draft of a French Socialist party document accuses German Chancellor Angela Merkel of "selfish intransigence" for her insistence on austerity. Spanish Prime Minister Mariano Rajoy unilaterally abandons his country’s deficit targets for the next two years and rules out new fiscal measures. European Commission President José Manuel Barosso provocatively claims austerity has reached the limits of social and political acceptance.

The backlash against austerity may be real. But much of the debate is fake. Behind much of the antiausterity campaign lies an assumption that the euro zone’s crisis response reflected a political choice whose intellectual underpinnings have been fatally undermined—not least by a furious debate over an academic paper by Kenneth Rogoff and Carmen Reinhart that suggested government debt above 90% of gross domestic product is a drag on growth.

This is nonsense: What has been driving the euro zone’s hand isn’t academic theory but market pressure. For peripheral euro-zone countries facing high borrowing costs or reliant on international aid to fund their budget deficits, fiscal consolidation wasn’t a choice but a necessity. At the same time, core euro-zone countries understood only too clearly that no country in a currency union can afford to take market confidence for granted.

What has changed is that market pressure to rapidly shrink budget deficits has eased, largely in response to the European Central Bank’s promise to buy the bonds of countries that have agreed to a bailout package. Bond yields have fallen sharply in crisis countries, even as their economies deteriorate.

As a result, even some investors, such as Bill Gross of Pacific Investment Management Company, who had previously supported fiscal consolidation, have now joined the chorus saying that austerity has gone too far.

So what should governments do now? Despite the row over the Reinhart-Rogoff paper, their conclusion is supported by a welter of other studies: In its latest World Economic Outlook, the International Monetary Fund cited no less than six academic papers that had come to a similar conclusion—amusingly including one by Nobel Laureate Paul Krugman but none by Professors Reinhart or Rogoff. Of course, in this kind of analysis, there will always be outliers. The task for today’s policy makers is to learn the lessons of those countries that escaped the high-debt trap.

Take the U.K. in the 19th century, sometimes held up as an example of a country that grew its way out of a post-Napoleonic war debt that stood at 240% of GDP in 1816. Curiously, the government’s response wasn’t only to embark on a rapid fiscal consolidation—after all, it made no sense to carry on racking up debts to buy cannons just to keep the cannon-makers in business—but to re-establish the prewar gold standard. This was the 19th-century equivalent of joining the euro.

Inevitably this led to deflation and social unrest (sufficiently alarming to lead to the creation of a full-time police force). In words that will strike a chord with politicians today, Robert Peel, the architect of this policy, was accused of causing "more misery, more poverty, more discord, more of everything that was calamitous to the nation, except death, than Attila caused in the Roman Empire."

Even so, British governments didn’t abandon their commitment to "sound money." Instead, they embraced a radical program of economic and political reform that swept away a system built on cronyism, corruption and entrenched privileges for special-interest groups. Protectionist tariffs were dismantled, forcing companies to become more competitive through innovation, embracing new technologies and finding new markets—a process that culminated in the abolition of the hated system of agricultural subsidies known as the Corn Laws which had inflated the price of bread. So successful was this program of what would today be known as "supply-side reform" that by the eve of World War I, the gold standard had been adopted by all major economies.

Of course, one should be careful of parallels between then and now. But it is worth noting that we live in an era of similarly remarkable technological innovation. Europe’s failure to fully capitalize on the opportunities this creates and the persistent lack of sustainable growth in countries like Italy points to deep weaknesses in the structure of many European economies.

The euro zone’s misfortune is that its political leaders have allowed the vital structural overhauls needed to restore growth to become conflated in the public debate with the necessary fiscal adjustments needed to curb borrowing under the toxic label of austerity. This has allowed vested interests to pose as populists while obstructing reform of broken economic and political models.

Breaking this link in the public mind between fiscal measures and supply-side overhauls is an urgent priority. Does it matter whether the euro zone allows governments an extra year or two to bring deficits back to levels required under the fiscal compact? Hardly: the rules contain sufficient flexibility and, with debt levels so high, markets are unlikely to worry about a few extra percentage points of borrowing.

What matters—and what will concern the markets—is that crisis countries use the political space created by any easing of targets to push ahead with structural overhauls.

Of course, structural reforms can often be politically even harder than fiscal consolidations. But with unemployment in Spain and Greece now over 25% and youth unemployment over 50%, political leaders have a responsibility: No one can blame them for failing to rekindle the Spanish construction boom or sustain Greece’s crazy public-sector expansion; but they can be blamed for failing to create the conditions for economies to rebalance and viable companies to create new jobs.

Do Mr. Letta, Mr. Rajoy and France’s President François Hollande—and other leaders behind the austerity backlash—really have the stomach to take on vested interests, break down barriers to entry, cut unnecessary regulations, speed up bureaucracy, re-skill the unemployed, improve the life chances of the next generation through better schools, and ensure an adequate supply of finance to support growing businesses via a restructured and recapitalized properly functioning banking system?

If the euro zone uses this period of ECB-induced market calm to repackage tough choices in a more politically palatable way, then some good may yet come of this antiausterity backlash. But if instead it confirms the fears of those who warned that governments would use any ECB intervention to abandon essential structural reforms, then this period of calm may not last too long.

Write to Simon Nixon at simon.nixon@wsj.com

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