03 May 2012

Sebastian Dullien: Reinventing Europe - From the fiscal compact and austerity, to a growth compact and prosperity

Elements of a Growth Compact

Given the limited material impact, and the diplomatic complications caused by the passage of the Fiscal Compact outside the EU treaties, one might think that simply scrapping it was the easiest option. However it is not clear how such a move would now be perceived by financial markets. Before the first round of the French elections, spreads on French government bonds rose as François Hollande’s prospects improved in the polls. Pulling out of the Fiscal Compact altogether might cause a new capital flight. In addition, attempts to reopen the Fiscal Compact will be resisted, especially in Germany. As the compact is Chancellor Merkel’s trademark policy in the fight against the euro crisis (and has been widely applauded in German media), the current government cannot be expected to step back from the already agreed treaty.

A more promising solution would perhaps be to add a “Growth Compact” to the Fiscal Compact, as proposed by ECB president, Mario Draghi. However, while the label coined by Mr Draghi is ideal, his proposals would be insufficient to alleviate the growth-inhibiting impact of current austerity. These proposals – for better and more focused use of existing EU funds, along with structural, growth-enhancing reforms – would bring in little that is new, relative to current conditions in IMF programmes. The existing EU funds would be too small to make a real impact, particularly in larger economies, and structural reforms usually take years before their positive impact can be seen.

An appropriate Growth Compact would therefore have to do more, getting relevant funds of a suitable magnitude moving again in Europe.

In addition to whatever can be done to activate dormant funds from cohesion funds and other EU budget lines, three main elements would be needed, all of which could be enacted without altering the Fiscal Compact:

1. Allow for a longer adjustment period: Crisis countries with large deficits (such as Spain) should be given more time to get back to the deficit-threshold of 3 per cent of GDP. This could help break the downward spiral of contracting GDP, rising unemployment and rising deficits, by allowing the countries to exit recession before more austerity is applied.
2. Reorganise the financing of public investment in Europe: To make sure that public investment is not reduced beyond any sensible level, the financing of public investment could be taken out of the national budgets (and hence the measured deficit). One possibility would be to give the European Investment Bank a central role in public investment financing. Under such a scheme, national governments could lease new infrastructure investment from the EIB. The EIB would borrow the necessary funds in the market and pay for construction, while the national governments would, over the time of their use, pay the EIB a user fee that covers interest rates and depreciation. Under such a scheme, national governments could bring down their national budget deficits and debt-to-GDP-levels without having to cut investments into the future.
3. Relieve crisis countries from excessive interest rate burdens: One current critical problem is that crisis countries have to pay stiflingly high interest rates, which then impact private sector companies in those countries as their financing costs are often linked to their sovereign’s interest rates. A move towards eurobonds or the introduction of a European debt redemption fund (as recommended by the German Council of Economic Advisors) would significantly lower these interest rates, and so help the countries back towards the path of economic growth.

Adding such a meaningful Growth Compact to the Fiscal Compact might provide the best way out of the current stalemate. Countries such as Germany may be willing to sign up for it as the price for ratifying the Fiscal Compact. For their part, countries sceptical of the current austerity stance might be willing to accept the Fiscal Compact if they see that the overall package is better than the status quo (especially as the Fiscal Compact is unlikely to have as large an impact as they fear). For Europe, this would be a large step forward, potentially helping to end the current down-turn and return the world’s largest currency area back to economic growth.

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