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Towards the end of this week, European leaders will meet in Brussels for the European Council to discuss their economic policies. The basis of their discussion is the economic guidance provided by the European Commission in the framework of the European Semester, most notably in the so called Annual Growth Survey. In the document, the European Commission rightly argues for fiscal consolidation in member states with unsustainable public finances which are at risk of being priced out of the market. The Commission also rightly emphasizes that they should not chase nominal targets but rather focus on structural fiscal adjustment. There is, however, a big thing missing in the policy guidance on which Heads should focus.

In a situation in which everybody consolidates and the euro area is still in a recession, the macroeconomic policy stance of the area as a whole has become too restrictive. The euro area’s recession has deepened significantly according to all available indicators. The output gap is forecast to widen from -1.2% in 2011 to -2.9% of GDP in 2013 according to European Commission estimates. One-year-ahead inflation rates as measured in financial markets are now down to 1.4% while the 5-year-ahead market expectation is 1.6%, still significantly below the euro area’s goal of close to 2%. Finally, sovereign bond yields have fallen to very low levels indicating insufficient investment demand. Urgent action is needed to prevent that the recession turns into an outright depression.  Two elements are central from a fiscal point of view.

First, countries with fiscal space should use public funding to increase investment. The sovereign bond market in Germany gives a clear signal that Germany has significant fiscal space. When sovereign interest rates are close to zero, it is time to use the opportunity to engage in long-postponed public infrastructure projects. Such a stimulus makes sense from a German point of view as any investment project that has a higher return than zero would be profitable. Arguably, Germany should have many of those projects, for example in the area of R&D, university research, education and even public infrastructure. Public demand is also needed to close the German output gap which is now predicted to amount to 1% of GDP. Larger German demand would also benefit the rest of the euro area and in particular those countries that have recently seen their exports strengthen significantly such as Spain. At the same time admittedly, it would be of little help to countries that do not have a significant export sector such as Greece.

Investing in the future of the South of Europe will also make sense to increase political and social stability which is arguably crucial for the euro. Contracts could be a good way to combine policy change with support. Some urgently needed reforms in some countries of Southern Europe have been postponed because they involve significant political cost in the short run. Other reforms have not been undertaken due to the lack of resources. With youth unemployment rates of more than 50% in Spain and more than 20% in other Southern countries, it would be wise to offer significant help to undertake pertinent labour and product market reforms. Significant resources to build-up a dual education system for instance would be a convincing signal and contribute to mitigating a serious unemployment problem. If in addition the help is of macroeconomic size, it would also be a powerful way of overcoming the recession in the euro area. This is the case since a euro spent in Spain will have a much larger macroeconomic effect than a euro spent in Germany in current economic circumstances.

The European Commission has rightly highlighted the need to adjust public finances in the South of Europe, in particular when market access is close to being lost. Yet now the discussion should focus on how to address the recession in the euro area. Germany will have to play a role.