It has become fashionable to talk about the need for a euro zone “growth compact” as weariness mounts over a diet of nothing but austerity. France’s new president Francois Hollande has popularised the idea. Even Mario Draghi has backed it. That gives the concept credibility as the European Central Bank president was one of the main supporters of the austerity-heavy “fiscal compact”, which requires governments to balance their budgets rapidly. Olli Rehn, the European Commission’s top economic official, has joined the bandwagon too: at the weekend, he advocated a pact to boost investment, while hinting that there may be scope to ease up a bit on the austerity.
But all this chit-chat won’t lead to much unless politicians are prepared take unpleasant decisions on reforming labour, welfare and banking – measures which would boost growth in the long run. That has to be the quid pro quo for loosening the current fiscal squeeze or further easing monetary policy – measures that would help in the shorter term.
Without such a grand bargain, any growth compact is likely to amount to little more than extra funds for investment. Rehn mentioned the main ideas at the weekend: using EU budget funds to guarantee lending to smaller firms; encouraging countries with fiscal surpluses to increase public investment; and boosting the capital of the European Investment Bank. While these measures are worthy, they are not of the scale needed to change the course of one of the biggest economic crises in recent history.
The main guts of a growth compact ought to be somewhat looser fiscal and monetary policy married to deep structural reform.
Look first at fiscal policy. It is great that policymakers such as Rehn seem to understand the dangers of an austerity spiral – where excessive budget squeezes crush the economy which in turn makes it harder to balance budgets and so requires further austerity. He says Europe’s fiscal rules are “not stupid”.
But even if Germany, Europe’s paymaster, can be persuaded to go along with a laxer interpretation of the rules, there is a limit to what will pass muster with the bond markets. While investors aren’t enamoured with growth-crushing austerity, they won’t finance profligacy either. Credible long-term plans to rein in deficits and restore competitiveness are needed. With those in place bond investors would be happy if the European Commission allowed governments another year or so to balance budgets.
The need for substantial change is not limited to countries already in crisis. In France, industry is increasingly uncompetitive and the government spends 57 percent of GDP. Tackling that ought to be the government’s priority, though it got little mention during the election campaign. Even Germany would benefit from reforming its weak services industries. Meanwhile, across Europe there needs to be a determined drive to deepen the region’s single market.
To gain the full benefits of monetary policy, there also needs to be a quid pro quo with the politicians. It’s important not to misinterpret Draghi’s new fondness for the word “growth”. The ECB is still keen on fiscal rectitude and is not signalling looser monetary policy. When Draghi talks about a growth compact, what he has in mind is structural reform – something that will not bear fruit for some time. Indeed, Draghi talks about the need for a 10-year vision.
While the central bank has engaged in exceptional measures to prevent the system collapsing – buying government bonds and spraying cheap money at the banking system – it has done so with a heavy heart. It rightly fears that such monetary rescues reduce the pressure on both governments and banks to reform themselves. Germany’s Bundesbank is even calling for the ECB to prepare to exit from these exceptional measures. While it won’t get its way – Draghi has made clear he thinks it’s too early to do this – talk of an exit is already making the money markets and the banks nervous. And that is undermining some of the benefits of the current loose policy.
For the ECB to be happy to pursue further monetary laxity, it will need to be convinced that governments are going to use the time they are being given wisely. A priority is to recapitalise zombie banks. So long as lenders have weak balance sheets, they will find it hard to fund themselves in the markets and will therefore lack the confidence to finance growth.
The key short-term imperatives are in Spain and Greece. But weak balance sheets are not confined to these two countries. Other governments have shown themselves unwilling to impose higher capital requirements on their lenders. Last week, for example, both Germany and France argued for changes in the way the new Basel 3 capital rules are applied to Europe so that their banks won’t need to raise so much capital. If politicians could bring themselves to grasp the nettle on banking, lenders would find it easier to fund themselves in the markets and the ECB would be less grudging about providing emergency assistance if it was still needed.
The ideal growth compact would match reform of banks, labour and welfare with less short-term austerity and accommodative monetary policy – and throw in some extra money for investment. Given the difficult political choices required, such a deal won’t be easy to pull off. But the tectonic plates are shifting across Europe. Now is the time to push for it.
