EUROPEAN policy makers just don’t get it. To hear them talk, you’d think that Europe was on the right path. Troubled countries just need more of the same, they say — more fiscal austerity, more labor market flexibility, more price stability — and the European crisis will be licked.
Have they looked at their own numbers? It has been two years since moves to austerity started, but the crisis is still with us. Growth in European gross domestic product was negative in the last quarter of 2011. Unemployment in the entire euro zone in February was 10.8 percent; in Spain it was an astounding 23.6 percent. And judging from the renewed turbulence in bond markets, investors don’t believe that prosperity is just around the corner.
Fiscal austerity is normally a sensible response to a loss in confidence in a country’s solvency, as has occurred in parts of Europe. But the current situation is exceptional. Short-term interest rates are very low, so large rate reductions to offset the negative impact of budget cutting are impossible.
In addition, the troubled countries of Europe are part of a common currency area. This means that the other obvious tool for stimulating growth during a time of fiscal austerity — depreciating the currency relative to that of their main trading partners — is not available, either.
The result is that austerity is uniquely destructive right now. Indeed, because of the harsh effect of budget cutting on growth, debt-to-G.D.P. ratios in Europe have continued to rise.
If stringent belt-tightening isn’t the answer, what is? It’s not to just ignore the deficit. Many European countries have long-run fiscal situations that are unsustainable and must be dealt with.
The core of a more sensible approach is to pass the needed budget measures now, but to phase in the actual tax increases and spending cuts only gradually — as economies recover. To use economists’ terminology, the measures should be backloaded.
They should also be specific — no more deficit targets without specifying how they’ll be achieved. Instead, lay out right now whose taxes will be raised and what spending will be cut. And specify when the measures will take effect — either along a set schedule, or tied explicitly to indicators of economic recovery.
BUT can such plans actually work? What’s to stop policy makers from promising the moon and not delivering?
History shows that countries have done such gradual consolidations before. In 1983, for example, the United States passed a Social Security reform plan that was backloaded in the extreme: it specified tough changes, including higher taxes and increases in the retirement age, to be phased in over almost three decades. They’ve all occurred on schedule and without debate. Likewise, in 1995, Sweden laid out a plan to cut its deficit by a whopping 8 percent of G.D.P. over the next three years. It worked as intended. Australia did the same thing on a somewhat smaller scale starting a year later.
Once legislation is on the books, politicians, even from opposing parties, have little incentive to change it. Why mess with a consolidation that’s already last year’s — or sometimes the last decade’s — news?
But what about bond markets? Don’t fiscal consolidation plans need to put the pain up front to persuade investors that they’re serious? After all, a number of European countries desperately need their borrowing rates to fall.
Investors, however, are very aware that low growth and high unemployment devastate a country’s fiscal outlook. I did the simple exercise of looking at news reports after the biggest increases in Spanish government bond interest rates over the last year. The most common cause was concern about whether European leaders would take needed measures to help troubled countries. But in about a third of the cases, bad news about Spanish growth was viewed as the culprit.
Markets don’t want counterproductive measures. For credibility, what matters is the nature and the composition of the tax and spending measures, and the clarity of the phase-in schedule.
Other steps could help bring markets along and allow distressed countries to follow a more gradual approach. In a very positive move, the European Union and the International Monetary Fund have greatly increased their rescue funds over the past month. Thus, if the authorities put their seal of approval on more gradual fiscal consolidation plans and stand ready to support troubled countries if needed, market interest rates on the countries’ debts will most likely come down.
If that doesn’t work, the European Central Bank could effectively cap the cost of borrowing for countries like Italy or Spain by buying large amounts of their bonds. If this were done after the countries had enacted specific, backloaded consolidation plans, the risk to the central bank would be manageable.
More generally, the European Central Bank could take further expansionary action. For example, it could reduce its benchmark interest rate, which is not yet at zero, and pursue quantitative easing by buying a range of assets. Any measure that would raise European growth even a little would make it easier for troubled countries to get their budget deficits under control.
Expansionary monetary policy could also help these countries to become more competitive. European policy makers talk about structural reforms — increasing labor market flexibility and reducing regulation — as the way to reduce wages and costs. But when overall inflation in Europe is very low, this strategy requires wages in troubled countries to fall, which rarely happens. If the European Central Bank aimed for slightly higher overall inflation — say, 3 percent — for a few years, these countries could become more competitive just by holding wage growth below that of their trading partners. That would help them to grow by increasing their exports.
FINALLY, countries that are not in distress, both inside and outside Europe, could help by stimulating their own economies. For example, Germany has a relatively modest long-run deficit and an enormous trade surplus. A tax cut for German consumers would raise domestic growth at a time when it’s anemic, and increase imports from its neighbors, helping them to grow as well.
What about the United States, which faces a terrible long-run budget problem, but no immediate threats from the bond market? The best policy here is to combine the backloaded consolidation I’m recommending for troubled countries with the short-run stimulus I’m advocating for countries like Germany. We could enact something like the Bowles-Simpson plan to reduce the deficit sharply over 10 years, and include in it more near-term investment in infrastructure, education and scientific research.
This would lower unemployment faster, and put us on a path to fiscal health. And, by strengthening our growth, it would help the world economy, too.
These policies are nuanced, so they are easily caricatured as doing something with one hand and undoing it with the other. Their key element is dynamics — using credible plans to lower borrowing costs and address long-run fiscal problems, while not taking immediate austerity measures that would raise unemployment when what countries need most is growth.
Current measures aren’t working. Sooner or later, politicians and citizens will demand a strategy that does.
Christina D. Romer is an economics professor at the University of California, Berkeley, and was the chairwoman of President Obama's Council of Economic Advisers.
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