08 July 2013

Martin Feldstein: An end to austerity will not boost Europe

Ending fiscal austerity is not a strategy for achieving growth, writes Feldstein for the FT. It will reduce downward pressure on aggregate spending but will not lift growth and employment. Instead, it will raise interest rates and threaten a new fiscal crisis.

Europe needs three things: structural changes to boost long-run potential gross domestic product, a short-term stimulus to increase employment, and a commitment to longer-term spending reductions to shrink the national debt.

Rising interest rates could bring back the fiscal crisis of a mutually reinforcing spiral of increasing national debts and rising borrowing costs. That could revive the risk that some countries would be unable to borrow and might therefore choose to leave the euro. If the ECB tried to prevent that despite the lack of fiscal discipline, the result would be escalating rates of inflation.

To prevent this, governments must combine long-run deficit reductions with short-run fiscal stimulus. Slowing the growth of pensions and other transfers would reduce future debt and prevent near-term increases in interest rates. To make these changes politically acceptable, governments should combine them with an immediate programme of infrastructure investment and manpower training. This would not only raise current GDP but would also strengthen long-run productivity and real incomes.

The slower growth of transfer programmes would also permit lower payroll tax rates, cutting the cost of labour and increasing employment. Lower labour cost would also raise the competitiveness of European products in international markets.

A lower value of the euro could provide a further boost, making it possible to lift employment while shrinking the short-term fiscal deficits. Although a lower euro would not change the exchange rate within the eurozone, countries outside the eurozone account for roughly 50 per cent of the peripheral countries’ trade.

Policies to allow budget deficits to rise are a dangerous mistake. Italy, France, Spain and Portugal should instead combine longer-term debt reduction with short-term fiscal stimulus. Together with a slowing in the growth in pensions and other transfers, this would boost productivity and lower deficits and payroll taxes to the benefit of all Europeans. The eurozone needs to adopt such policies.

Full article (FT subscription required)

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