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The debate on austerity in Europe has intensified after the publication of disappointing growth data for last year. The debate has been given further momentum by the recent Italian election, which has been typically interpreted as a rejection of austerity policies.

In this post I would like to assess the aggregate fiscal stance of the euro-area and the rationale for reconsidering austerity policies in fiscally sound (‘North’) and weak (‘South’) countries. I’ll also briefly discuss growth policies and monetary policy issues.

Let me summarise here the main messages:

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; There is a need for a major about-turn: fiscal expansion in euro-area countries with fiscal space and a major European investment programme, possibly through the European Investment Bank (EIB);

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; There is a need to “press ahead relentlessly”: in the South fiscal consolidation, albeit at a suitable pace and with a view to structural deficit targets, as well as structural reforms, should continue;

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; There is a need for a twist: more expansionary monetary policy by the European Central Bank (ECB).

These suggestions are motivated by the data for 2009-2013 from the Commission forecast published last week (see the table at the end). Yes, the Commission expects, once again, a brighter outlook for 2014, but such longer-term forecasts have typically not performed well*.

Growth and output gap

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; In 2012 euro-area GDP fell and is expected to continue to fall in 2013. The output gap is forecast to widen from -1.2 percent of GDP in 2011 to -2.9 percent in 2013. (Certainly, the output gap is measured imprecisely and therefore this data should be only indicative. But it does indicate a sizeable deterioration.)

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; There is also a growth deceleration in Germany and the output gap widens to -1.0 percent in 2013. In the Netherlands, the output gap widens to -3.6 percent and even more in Spain and Portugal.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; In contrast, the output gap narrows in the US.

Clearly, the cyclical position in the whole euro area has worsened since 2011.

Public debt and deficit

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; The structural budget balance of the euro area (ie the balance cleaned from the impact of the economic cycle and one-time items) is expected to improve from -3.6 percent of GDP in 2011 to -1.3 percent. (The structural budget balance is also measured imprecisely.)

Therefore, a rather significant fiscal consolidation was implemented at a time when the cyclical position of the euro area deteriorated considerably. There is no model that claims that this was an optimal policy. Instead, fiscal stabilisation should allow automatic stabilisers to run in a cyclical downturn (in which case the structural deficit remains stable and the actual deficit worsens), or even implementing a fiscal stimulus (when the structural deficit also worsens).

The usual claim for fiscal austerity is the need to restore trust, keep control of the debt, and thereby lay the foundations for sustainable growth. But premature fiscal consolidation at the euro-area level has side effects, as I warned in 2010 (and unfortunately, all four of my predictions seem to be borne out). In any case, such claims apply differently to countries with different fiscal space:

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; The public debt to GDP ratio is indeed high and rising significantly in Portugal and Spain, but is not that high and is now falling in Germany, and is even lower in the Netherlands.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Germany has a structural budget surplus of 0.4 percent of GDP in 2012-13, while the Netherlands consolidates from -3.6 percent in 2011 to -1.6 percent in 2013 in a structural sense.

Again, it is difficult to rationalise the Dutch efforts in economic terms given the significant cyclical deterioration of the economy and the low level of debt. It is also unclear why Germany needs a structural budget surplus at a time when the output gap is widening and domestic demand is weak. These two countries have strong policy regimes and fiscal policies more aligned to their own economic realities and the needs of the euro area are unlikely to wreak havoc in their government bond markets. As a comparison, the US and Japan continue to borrow at super-low interest rates despite their much higher public debts and deficits.

Inflation and wage developments

Related to the cyclical position of the euro-area economy, there is widespread recognition that pre-crisis intra-euro wage trends (when Germany and other Northern countries had much slower price and wage growth than Southern countries) need to be reversed. Nobody wants Germany to be less productive, but an important element of rebalancing is the correction of the emerged discrepancies between North/South wages and prices.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Headline inflation in Germany was lower than the euro-area average in every year between 2009 and 2012, while in 2013 it is expected to be equal to the euro-area average at 1.8 percent per year. To be fair, inflation in the Netherlands is slightly faster, 2.6 percent in 2013.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; In Spain, the average inflation in 2009-2013 is exactly equal to the euro-area average and higher than in Germany, while in Portugal the average is equal to the German average.

Clearly, the adjustment of intra-euro price differentials is anything but satisfactory, even if we consider that Southern members raised consumption taxes more than Northern members. And German inflation at 1.8 percent in 2013 does not suggest an overheated economy, despite the low unemployment rate (5.7 percent in 2013).

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Wage growth in Germany (2.4 percent increases both in 2012 and 2013) is somewhat faster than the euro-area average (1.8 percent). Here the Dutch figures are quite low, 1.5 percent per year, during 2010-13.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Spain and Portugal recorded close to zero, or even negative wage growth during some recent years; yet in 2013 the expected wage increases are 1.4 and 1.6 percent, respectively.

Therefore, the adjustment of relative wages between the South and the North is faster than price adjustment, but the speed of adjustment is rather small compared to the estimated misalignment of the real exchange rates of southern countries, which is typically given in the range of 20-30 percent.

Trade balance

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Trade balances have improved throughout the euro area, especially in the South, but also in the North.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; At the same time, unit labour costs (ULC) in some Southern countries declined.

However, while e.g. the export performance of Spain and Portugal is indeed impressive, it is not easy to determine the parts played by improved competitiveness and the collapse of domestic demand in the improvement of the trade balance. In Darvas (2012a) I studied ULC developments and concluded that a major reason for the fall in ULC was massive layoffs, with adverse social consequences. But in any case, since Spain, Portugal and Greece (not Italy) has about minus 100 percent of GDP net external debt, the trade balance should shift to a sizeable surplus in order to ensure external debt sustainability. Therefore, major adjustments still lie ahead.

Fiscal policy conclusions

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; The overall fiscal stance of the euro area, significant consolidation from 2011 to 2013, was inconsistent with the sizeable deterioration of the cyclical position. Lack of an authority responsible for the aggregate fiscal stance is therefore a major handicap for the euro area, as I argued in a Darvas (2012b) (see section 2.9).

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; In the South, where public debts and deficits are high and the permanent drop in output is presumably sizeable (ie the previously booming sectors, and the tax revenues from these sectors, are unlikely to return), the best strategy is indeed a gradual fiscal consolidation with structural deficit targets (see page 10 of the paper noted above for further details). Interestingly, while Wolff (2013) and argue with each other, both conclude the same (“The desirable budgetary stance for the Eurozone as whole consists in the south pursuing austerity, albeit spread over a longer period of time, …”, De Grauwe and Ji).

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; But there is a strong case for a fiscal expansion in the North, as I also argued in the paper noted above, and as also De Grauwe and Ji argue (the continuation of their quotation from the previous bullet point: “…, while the north engages in some fiscal stimulus so as to counter the deflationary forces originating from the south.”). Indeed, a stimulus in Northern countries would not just help to improve their own cyclical positions, but would likely lead to somewhat faster price and wage increases. (Note that Wolff (2013) considered specific aspects of the De Grauwe and Ji analysis of the South without enlarging to the broader adjustment questions and therefore his title (Austerity needed to start…) should not necessarily have been generalised to the whole euro area.)

Alternatives to national fiscal policy measures

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Wolff (2012) rightly argues that the first best would be a fiscal union equipped with an instrument for cyclical stabilisation. I argued the same in my paper. But in the near term (and perhaps in the longer term as well) the political reality means that the likelihood of this is close to nil.

On the contrary, giving tax breaks to domestic households and tax incentives for domestic corporate investment may be acceptable for national parliaments. The Commission should broker a deal between euro-members on appropriate fiscal measures considering the fiscal space of each country. Even better, all EU countries should be involved.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Another option is transfers from the North to the South.

Different people interpret transfers differently. I can find a rationale for, eg a one-time write-off of certain claims (toward both the sovereign and the private sector) to restore debt sustainability, or for help to address the cyclical unemployment problem, or recapitalising banks in the South directly. Yet the inclination of the Bundestag for these kinds of support can be questionable. But keeping the South attached to a permanent lifeline from the North is certainly an idea I would disagree with, and I hardly think it likely that the Bundestag would approve such transfers to the South, instead of leaving this money with German taxpayers.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Some argued that increasing the minimum wage in Germany would be more effective than a fiscal stimulus.

I disagree. An increase in the minimum wage may help somewhat in correcting wage differentials between Germany and the South, but at the expense of increasing the cost of unskilled workers relative to the cost of skilled workers (a distortion with negative side effects), because minimum wage increases do not pass through to all income levels. And this option would do much less to increase German demand, and thereby German growth. Also, the overall impact on companies employing low-skilled workers can be negative.

Europe’s growth policy

The growth policy is rather ineffective. It largely depends on structural reforms, which in any case, it should be underlined, are inevitable. I see no alternative to rigorous reform of labour and product markets, public administration, state-owned companies, healthcare, completion of the single market, and so on. But such reforms won’t deliver growth in the short term, when the major problem is weak demand, partly stemming from private sector deleveraging and  credit-supply limitations.

One option to revive demand is the fiscal expansion of fiscally sound countries, as I argued above. This should be augmented by a very significant increase of the capital of the European Investment Bank (much more than the €10 billion provided in the “”), as I argued, for example, here, the removal of the technical hurdles holding up the fast mobilisation of EIB funds, and by commanding the EIB to invest throughout the EU.

Monetary stance

Finally, a few words on the ECB’s monetary stance and the euro’s exchange rate. The ECB is right in claiming that the monetary stance in the euro area is accommodative, but there is always the question of if it is accommodative enough, and therefore corresponds to the optimum needs of the euro-area economy.

One thing seems to be clear: it is not as accommodative as in other advanced countries and this keeps the euro relatively strong (despite the recent weakening since the Italian elections). Again, the ECB is right to point out that the real effective exchange rate (REER) of the euro is close to the historical average. I also found in this post that in February 2013 the euro’s REER is a mere 1 percent below the 1980-2013 average. But three comments are in order:

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; The historical average is not the best benchmark: economic theory predicts real effective appreciation in countries that grow faster than their trading partners, such as China, and conversely, countries that fall behind, such as those of the euro area, should see a gradual fall in their real exchange rates. This has not happened.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; The US REER is 11 percent below the 1980-2013 average and the US has had a better growth performance. Therefore, the euro should have in fact depreciated more than the dollar.

·&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����;&�Բ�����; Due to intra-euro REER divergences, any certain euro exchange rate is more favourable for the euro-North and less favourable for the euro-South. Now the South is in a deep trouble and a weaker euro would greatly help the adjustment process. A weaker euro would increase the external current account surplus of the euro area further, but a fiscal stimulus in the euro-North would reduce it and I call for both.

Some say that a call for a weaker euro is a call for a currency war, but I disagree. The ECB has to do only what other major central banks have done (further interest rate cuts, forward guidance, and quantitative easing), and not more.

Finally, let me also clarify that I do not call for higher aggregate inflation in the euro area. While that would help rebalancing and deleveraging, it would be such a major change that could not be swallowed by the German constituency. The ECB should continue to target two percent inflation, but it should ensure that there will be no undershooting, implying that inflation has to be higher than two percent in the North and close to zero in the South. Otherwise, the South would need to enter a deflationary period, which is difficult to achieve and would worsen both the public and private debt situation even more, as nicely argued by Merler and Pisani-Ferry (2012).

Source: European Commission Winter Forecast 2013 (published on 22 February 2013).

References

Darvas, Zsolt (2010), ‘Europe’s role in global imbalances’, 22 July, Bruegel blog

Darvas, Zsolt (2012a), ‘Compositional effects on productivity, labour cost and export adjustments’, 22 June, Bruegel Policy Contribution 2012/11

Darvas, Zsolt (2012b) ‘The euro crisis: ten roots, but fewer solutions’, 19 October, Bruegel Policy Contribution 2012/17

Darvas, Zsolt (2013a) ‘The Euro Crisis: Mission Accomplished?’, World Policy Journal, Spring Issue

Darvas, Zsolt (2013b) ‘Can Europe recover without credit?’, 15 February, Bruegel Policy Contribution 2013/03

De Grauwe, Paul and Yuemei Ji (2013)‚ ‘‘, 21 February, voxeu.org

Merler, Silvia and Jean Pisani-Ferry (2012) ‘The simple macroeconomics of North and South in EMU’, 30 July, Working Paper 2012/12, Bruegel

Wolff, Guntram B. (2012) ‘A budget for Europe's monetary union’, 3 December, Bruegel Policy Contribution 2012/22

Wolff, Guntram B. (2013) ‘Austerity needed to start, now we need a fiscal union’, 25 February, Bruegel blog

* The Commission used to be optimistic about the outlook (eg now they expect 1.4 percent euro-area growth in 2014), but longer term forecast proved be unreliable. For example in May 2012, before the ECB’s OMT and the Banking Union decision, two initiatives that played a major role in improving financial stability and that therefore should have contributed to a brighter outlook, the Commission expected 1.0 percent growth in 2013; now they expect a 0.3 percent contraction.