Did austerity end last week? This is what the headlines suggested when the European Commission gave five eurozone countries more time to meet their fiscal targets. The message from Brussels is that policy is no longer focused on austerity but on structural reforms.
I am afraid that this apparent shift in policy amounts to little more than a tactical retreat by the champions of austerity. Rather than being abandoned, austerity has simply been prolonged. I struggle to think why people consider this to be a relief. In addition, since structural reforms are, by definition, structural, they will not have any short-term effects - if, in fact, they are ever enacted. So let us focus on austerity.
The commission’s latest forecast shows a steady fall in the structural public sector deficit of the eurozone from 3.6 per cent of gross domestic product in 2011 to a projected 2.1 per cent in 2012, 1.4 per cent in 2013 and 1.5 per cent in 2014. Structural balances are adjusted for the business cycle and asset price fluctuations, so show the real scale of the adjustments.
The data show that, before last week’s apparent U-turn, it was already clear that the first big phase of fiscal adjustment would end this year. In fact, most of the adjustment took place in 2012. But, like a B-movie monster, austerity will rise from the dead in 2015 and 2016 when countries have to meet their delayed fiscal targets and, in addition, implement a commitment to repay a portion of their excessive debt each year. I assume that most countries will not have fixed their banks by then, so that overall growth will probably still be low because credit conditions will still be tight. Austerity will once again be pro-cyclical.
What makes the arguments over economic policy so unnecessarily complicated is the intellectual haze over the macroeconomic nature of a monetary union. What is happening in the eurozone is best understood at the aggregate macro level. Take as a simple example the recent debate about whether or not to cut European Central Bank policy rate. It was plainly wrong to state, as some conservative commentators did, that a rate cut would cause inflation in Germany. The only inflation that can logically exist in the monetary union is at the level of the eurozone itself because this is where the currency happens to exist. Of course, prices fluctuate between countries. But it is normal for prices to rise in some countries and fall in others. As long as aggregate inflation is pinned down, there is no reason to be concerned about “German inflation” or “Spanish deflation”. This is all you need to know.
The same haze is common in the debate on fiscal policy. I am aware that fiscal policy is a sovereign matter, constrained by various treaties and regulations. But from a macroeconomic perspective, the eurozone is still best understood as a fiscal unit. When you jump up to that level, it is not hard to see why austerity wreaked so much damage.
We know that, with interest rates near zero, fiscal multipliers become larger. It is unsurprising that a total structural fiscal adjustment of 2.2 per cent over two years should produce negative growth rates in 2012 and this year. Since there is little fiscal space for manoeuvre in the south, the only logical way for the eurozone to avoid such extreme austerity would have been for Germany to accept a fiscal stimulus.
Now, I know Germany has tied its own hands by imposing its own domestic fiscal rules. But once you move your perspective from a domestic to a eurozone level, you will find that such national rules become too restrictive. An argument I have recently heard against a more flexible policy that would, for example, allow a German stimulus right now is that the extra consumption would not benefit southern Europe because Germany imports so little from them. Those who make such arguments would never dream of analysing the dynamics of the US economy purely on the basis of state-level information. But this is exactly what they do over here.
Despite its debt crisis, the eurozone behaves like a regular large, closed economy. The trouble is that it is run, and often analysed, as no more than the sum of its parts. The tragic error of the eurozone’s policy makers is to repeat this fallacy of composition again and again. It is the same with austerity. That, too, will return.
Copyright The Financial Times Limited 2013.