Almost every member of the eurozone is rushing to slash public spending. While there is no doubting the scale of the fiscal challenge, the eurozone economy is not strong enough to cope with the contractionary effects of a generalised budgetary tightening. And if the eurozone falls back into recession, there will be no chance of putting public finances on a sustainable footing. Furthermore, excessive austerity in Europe will make it even harder to bring about the necessary rebalancing of the global economy, risking a protectionist backlash in the US. Unfortunately, these risks will receive scant attention when European leaders come together for this week’s summit in Brussels.
Eurozone policy-makers appear to believe that fiscal policy has no impact on levels of economic activity, even when private demand is as weak as it is in Europe. Of course, some eurozone economies – Greece, Portugal and Spain, for example – have little option but to cut now. However, those member-states running big trade surpluses with the rest of the currency bloc need to hold off tightening fiscal policy until their domestic economies are growing sustainably. The German government believes it is leading by example in embarking on a severe round of budget cuts. But this is the last thing the eurozone needs at this point and demonstrates an alarming parochialism. The fiscal crisis cannot be solved without economic growth. And the eurozone will only return to decent economic growth if the bloc’s surplus economies, in particular Germany, start to consume more.
The German economy is very unbalanced. The weakness of domestic demand (a reflection of an extremely high savings rate and years of eye-watering wage restraint) means the country is running a massive current account surplus with the rest of the eurozone. This surplus is a drag on the eurozone economy. Germany’s austerity programme all but guarantees very weak domestic demand in the country and effectively ends any chance of narrowing its trade surplus with the rest of the currency union. But unless this surplus narrows substantially, it will be very hard to get the eurozone economy growing, and all but impossible to address the eurozone’s fiscal crisis.
Germany’s Chancellor Merkel argues that her government’s cuts will make Germany more competitive (and hence boost its export sector). In short, Germany’s economic growth strategy is predicated on a further increase in its exports relative to its imports. For a country with a huge external surplus and a relatively sound fiscal position to be cutting public spending at this point is highly irresponsible. Germany is defining its economic policy purely in national terms without consideration for the impact on the sustainability of the common currency or the outlook for the broader international economy.
After years of relying on demand generated elsewhere in Europe, Germany now needs to become a source of it. The country is sending a damaging signal to the financial markets – it does not care about economic growth. No-one should be surprised that bond spreads (the difference in government borrowing costs) within the eurozone have widened sharply since Germany announced its budget plan. Instead of some masochistic rush to see who can cut by most, the eurozone needs a co-ordinated response. Germany, whose borrowing costs have fallen to just 2.5 per cent, should be doing all it can to boost its domestic demand, not depress it further.
The Netherlands’ external surplus – relative to the size of its economy – is as large as Germany’s, and the Dutch rely even more than the Germans on trade with other eurozone economies. But assuming that the conservative People’s Party for Freedom and Democracy (VVD) succeeds in forming a coalition government with Geert Wilders’ Freedom Party (PVV) and the centre-right Christian Democratic Appeal (CDA), Holland will adopt the same beggar-thy-neighbour strategy as Germany. It is possible that fiscal austerity and further wage restraint will work for Germany and the Netherlands, on the assumption that their firms can take further market share within the eurozone. But this is a zero-sum game : it is not as if every economy can allow domestic demand to stagnate and rely on exports. One country’s surplus is another’s deficit. They are banking on being able to export the consequences of their austerity to others.
Nor are the Europeans giving any thought to how their austerity (and neglect of economic growth) will impact on the rest of the world. An uncoordinated and premature fiscal contraction against the backdrop of a stagnant eurozone economy will prove contractionary for the world as a whole. The weakness of economic growth will prevent a rise in eurozone interest rates, which will keep the euro weak and boost the exports of those member-states, such as Germany, that trade a lot internationally. As a result, it will throw a further obstacle in the way of the urgently needed rebalancing of the global economy away from its excessive reliance on the US consumer. This reliance can only be reduced if surplus economies in Europe and Asia consume more, not less.
With China resolutely refusing to reduce its export dependence and Europe retreating into a destructive beggar-thy-neighbour cul-de-sac, it will not be long before protectionist sentiment in the US rises. And this will be understandable, despite the inevitable condemnations by European governments.