In 2005, France and the Netherlands both voted “no” to a constitutional treaty for the EU, derailing years of integration efforts. They seem to be poised to disrupt Europe once again.
On April 21, the Dutch coalition government collapsed, after right-wing populist Geert Wilders refused to endorse the spending cuts needed to limit the country’s budget deficit to 3 percent of GDP. The next day, candidates who advocated backtracking on European integration captured one-third of the vote in the first round of the French presidential election. On May 6, France is expected to turn left and elect Francois Hollande, who questions the EU’s German-inspired fiscal compact, agreed last December, and has called for Europe to emphasize growth.
These are the first skirmishes in a highly significant debate for Europe. The debate revolves around two major issues: austerity and integration.
Start with austerity. The question here is not whether deficits should be reduced. They must be, given the dire state of European public finances, and also because the countries whose competitiveness deteriorated during the first decade of monetary union must tighten fiscal policy in order to deliver the necessary adjustment of wages and prices.
Indeed, it is revealing that, as eurozone countries with severe external imbalances at the onset of the crisis have benefited from the European Central Bank’s (ECB) wholesale liquidity provision, they have reduced their current-account deficits much less than non-euro countries in a similar situation. Germany, the arch-advocate of austerity, is right on this point.
The problem is that austerity has perverse effects. Private and public deleveraging can hardly take place at the same time, unless trade partners generate demand for exports. Recession and price deflation reduce tax receipts and worsen the dynamics of public debt, threatening the return to sustainability. Moreover, deficit targets lead governments to respond to recessions by doubling down on austerity, generally without much regard for the adverse supply-side effects.
So there is a need to approach austerity and rebalancing strategically. Here the EU has made three mistakes.
First, finance ministers tried to reassure markets last October by demonstrating toughness and endorsing headline, instead of cyclically adjusted, deficit targets. This might be justified for a country on the verge of losing access to capital markets, but not for a country with relatively low debt and a moderate deficit. Ministers should change course and revert to their original 2009 commitment, which was to plan consolidation efforts and adhere to them through fluctuations and shocks.
Second, the eurozone still shies away from a comprehensive approach to its internal rebalancing. Price competitiveness is a relative concept, not an absolute value, yet the policy discussion still ignores this basic fact. This is paradoxical, because the ECB’s policy framework provides clear guidance. The ECB is committed to 2 percent inflation in the eurozone as a whole, which implies that lower wage and price increases in southern Europe arithmetically mean higher wage and price increases in northern Europe. The wider the gap between the two, the sooner the rebalancing will be achieved.
It is time to say loud and clear that the ECB will fight hard to keep average inflation on target, and that northern Europe — especially Germany — will not attempt to counter higher domestic inflation, as long as price stability is maintained in the eurozone as a whole. This would help significantly in mapping out a sensible rebalancing strategy.