When it comes to finding ways out of the European sovereign debt crisis, views appear to range widely.
At last week’s World Economic Forum Martin Wolf, chief economic commentator for the Financial Times expressed some cautious optimism.
“Instead of feeling the imminent prospect of a catastrophe, there is a sense that things have been done that have eliminated very substantially the immediate risk of a disaster, particularly in Europe,” he said.
Others felt less reassured. “I have never been as scared as I am about the world,” said Donald Tsang, chief executive of Hong Kong Special Administrative Region.
The general consensus was that growth was essential. But how would it be achieved? Most of the panellists and commentators seemed to agree on four main issues.
Four things about Europe
First, in spite of some positive signals, such as the decline in the Italy-Germany and Spain-Germany 10-year bond spreads over the past few days, the economic outlook for Europe remains gloomy.
The International Monetary Fund (IMF) projects a rate of GDP growth of -0.5% for the Euro-area in 2012. New York University Professor Nouriel Roubini told Business Week magazine last month he believes Europe will suffer a severe recession, with a high probability that Greece will leave the common currency within 12 months and a 50% probability that over the next three to five years the Eurozone will break up.
Second, in a highly interconnected world, the European problems are global problems. The risks of contagion are high and no countries are immune.
The updated World Economic Outlook of the IMF reports a projected growth of 3.3% of the world economy in 2012. This is a downward revision of the projections published in September 2011. The advanced economies are expected to grow at a modest 1.2%, while growth in all of the other regions of the world will significantly slow down relative to 2011 and 2010.
In the words of IMF’s economic counsellor, Olivier Blanchard: “The world recovery … is in danger of stalling. The epicentre of the danger is Europe, but the rest of the world is increasingly affected."
Third, in the short term, Europe needs to build a strong firewall to protect its members by expanding and strengthening its bailout fund. In practice, this amounts to a call on European leaders to boost the European Stability Mechanism well above the current limit of €500 billion. An increase in the size of the fund can be expected to strengthen credibility and confidence in the euro zone. Furthermore, it would facilitate the attempt of the IMF to ramp up its resources for contingency intervention.
Fourth, the long-term solution to the Euro crisis necessarily requires a sustained and persistent increase in the rate of economic growth of its members. The maths are rather simple: when the interest rate on debt is higher than the rate of GDP growth, then the debt to GDP ratio grows exponentially and eventually becomes unsustainable.
Therefore, the debt problem is not just one of fiscal profligacy. It is also – perhaps mainly – one of sluggish growth. The key phrase in Davos was “strengthen European growth”. Yes, but how?
Growth in the European model
A World Bank report released this week called Golden Growth: Restoring the Lustre of the European Growth Model seems to offer some perspective on this question.
The report highlights two distinctive features of the European growth model over the past several decades: convergence and social welfare.
Convergence refers to the fact that through the process of economic integration, initially poorer European countries have caught up with the most advanced ones and have become high-income economies. Social welfare means that European countries much more than any other countries in the world have spent on social policies to provide their citizens with more income security, a better work-life balance, and ultimately the highest quality of life in human history.
However, these two admirable features are now themselves a central part of the European growth problem. The “convergence machine” has jammed, while large social spending is burdening national budgets.
The report identifies a number of areas of intervention to revitalise the European growth model. One is to strengthen economic integration in the region, particularly in terms of mobility of labour and modern services trade. Another set of interventions should aim at creating an environment more conducive to enterprise and innovation.
In this regard, different countries have different needs.In southern Europe, reforms to improve the business climate ought to be combined with better incentives to induce the private sector to sponsor research and development. Public investment in research and development as well as tertiary education should also be increased. Northern European countries already offer a very favourable climate for doing business. What they need is fuller and effective market access in the rest of Europe.
Finally, unsustainable spending and demographic pressures – such as an ageing population and falling rate of fertility – call for a rethinking of the social welfare system. Europeans can no longer work shorter hours per week, fewer weeks per year, and fewer years than Americans. Pension and labour market reforms are necessary to induce longer work-life, greater labour force participation (especially among women), and more selective access to certain social benefits. This will help make social spending more affordable and free some resources for pro-growth investments. New immigration policies might be needed to address labour shortages.
Dealing with the business cycle
But there is one aspect that the World Bank report does not address and yet is likely to have a relevant effect on the growth performance: how should Europe deal with business cycle fluctuations?
For a long time, the prevailing approach in macroeconomics has been to decouple growth from the cycle, treating long-term economy’s performance and short term fluctuations as two separate bodies. With this approach, stabilisation policy (that is, the monetary and fiscal actions undertaken in response to cyclical fluctuations) would be of no significant relevance for long-term dynamics and hence it could play no role in reinvigorating European growth.
However, there is convincing evidence that the volatility of growth reduces the long-term average rate of growth. Intuitively, volatility generates uncertainty and discourages firms from investing in growth-enhancing investments, such as research and development.
This has a crucial policymaking implication: counter-cyclical monetary and fiscal policy (that is, macroeconomic policies that are expansionary in times of economic downturn and restrictionary in times of economic upturn) can foster long-term growth. The recent research of Harvard professor Philippe Aghion and his co-authors confirms that this is indeed the case, especially in countries that have lower asset tangibility or rely heavily on external finance.
In Europe, the inflation target of the European Central Bank (ECB) and the fiscal rules in the Stability and Growth pact significantly reduce the space to run macroeconomic policy counter-cyclically. Provided that it might difficult to ask the ECB to adopt a more counter-cyclical stance, a strong case can be made to re-write European fiscal rules to allow national government enough flexibility to run fiscal policy counter-cyclically.
This does not mean encouraging fiscal profligacy and large deficits. Quite the contrary: a fiscal rule establishing that countries must keep in equilibrium the cyclically adjusted budget balance (instead of the overall fiscal balance) or that the budget must be balanced on average over a period of a few years (and not every single year) would ensure a stable fiscal stance while allowing for a counter-cyclical use of fiscal tools in the short term.
This is what a fiscal policy paradigm for a revitalised European growth model should look like.