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The immediate focus needs to be on boosting investment and exports in economies with a current account deficit – such as France, Italy, and Spain (and the United Kingdom) – and stimulating consumption in surplus countries such as Germany and the Netherlands.
The European Central Bank has acted decisively to prop up European banks; now it needs to support the real economy, too. While official interest rates are only 1 per cent, solvent sovereigns such as Spain pay more than 5 per cent to borrow for 10 years, while creditworthy businesses in Italy can borrow only at punitive rates, if at all. So the ECB should do more to unblock the transmission mechanism for monetary policy; the European Banking Authority should discourage excessive deleveraging by insisting that banks raise specific capital amounts rather than hit a uniform 9 per cent ratio; and, where necessary, national governments should provide guarantees for bank lending to small and medium-size businesses.
While improving access to finance is vital, governments also need to do more to boost investment. They should prioritise measures to make it easier to start a business, lift barriers to venture capital, and introduce temporary 100 per cent capital allowances to encourage businesses to bring forward investment. At the EU level, the (callable) capital of the European Investment Bank should be greatly increased, as European Commission President José Manuel Barroso suggested in his State of the Union speech last September, so that the EIB can finance a big wave of pan-European investment, notably in infrastructure.
Boosting exports is also essential. Deficit countries need to become more competitive, increasing productivity while cutting costs. A more competitive currency would be welcome: just as the sterling’s collapse since 2008 has lifted UK exports, a weaker euro would help Mediterranean economies regain competitiveness for price-sensitive exports. A fiscal devaluation – slashing payroll taxes and replacing the revenues with a higher VAT – would also help.
Surplus countries, too, must do their part, which is in their own interest. Just as China needs to allow the renminbi to rise, so Germany – whose current-account surplus exceeds China's both as a share of GDP and in absolute terms – needs a higher real exchange rate. That means that Germans need to earn higher wages, commensurate with their increased productivity, so that they can afford more Greek and Spanish holidays. If businesses will not oblige, an income-tax cut would do the trick.
That brings us to fiscal policy. Governments that cannot borrow cheaply (or at all) from markets have no option but to tighten their belts. But they should pursue smart consolidation rather than unthinking austerity. So they should maintain investment in skills and infrastructure, while cutting subsidies and transfer payments. They should also legislate now for future reforms, notably to encourage people to work longer.
Last but not least, governments that can borrow at unprecedentedly low rates – 0 per cent in real terms over 10 years in the case of Germany – must play their role in supporting demand.