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Is Lord Keynes back in Brussels?

Should the European Commission’s decision to waive the 3% deficit limit for three of the Euro’s largest economies be extended to fuel growth and jobs? AAP

The European Union (or at least its periphery) is a big, sick patient that so far has been treated with robust injections of fiscal austerity. This seemed to be the right course of action to cure the “debt crisis” disease.

The patient, however, has failed to recover. According to the last economic outlook from the Organisation for Economic Cooperation and Development (OECD), released this week, 2013 is going to be the second consecutive year of negative economic growth in the Euro area, with GDP declining by 0.6% after a drop of 0.5% in 2012.

The International Monetary Fund (IMF) is not much more optimistic, and projects growth in the Euro area to be -0.3% in 2013. At the same time, unemployment should continue its rise, from 10.2% in 2011 to 11.4% in 2012 and 12.3% in 2013.

Some weak improvement is expected for 2014, with both OECD and IMF predicting a return to positive growth (barely above 1%), while unemployment should start declining moderately in 2015.

Most likely, the reason why the patient is not responding well to the treatment is that doctors are tackling the disease from the wrong angle.

Consider that the debt crisis is essentially a situation where the debt to GDP ratio is too high. In the case of Europe, the treatment applied until now aims at reducing the numerator of this ratio, while instead it would be probably better to try to increase the denominator.

In other words, sustained long-term economic growth would make the debt to GDP ratio sustainable without the need for draconian fiscal austerity measures.

One might even argue that the European disease is more than “just” a debt crisis. It is the culmination of long-term stagnation, fragile financial sectors, and failed structural change in several peripheral economies. These are illnesses that austerity does not fix.

Hence, a change of therapy is urgently needed. For several months now, many economists and observers have been arguing against fiscal austerity and in favour of a more flexible, pro-growth approach.

The big news today is that maybe — just maybe — this view is now gaining some support in Brussels as well.

Waiving deficit limits (but for some countries only)

On Wednesday, the European Commission announced the decision to waive the budget deficit limit for three of the five largest EU economies: France, Spain, and the Netherlands. The Commission also recommended lifting the excessive-deficit procedure against Italy.

The decision to allow three relatively large countries to overshoot the budget deficit target can indeed be read as a first attempt of the Commission to move away from the austerity logic. Now, freed from the constraint on the budget, these three countries can undertake the type of expansionary fiscal policy that is needed in times of recession.

The situation for Italy might be slightly different, because the termination of the excessive-deficit procedure does not in itself allow for much flexibility in conducting fiscal policy.

However, the recommendation of the Commission comes at a time when the new Italian government is considering reducing some of the heavy taxes previously introduced as part of the austerity package. Therefore, it does seem that the Commission is prepared to accept some more expansionary fiscal policies in Italy too.

Resuscitating Lord Keynes and more

The imposition of tight fiscal targets on countries’ budgets, and the associated austerity measures needed to meet those targets, has led to a distortionary, pro-cyclical use of fiscal policy.

Europe, and its periphery in particular, would need exactly the opposite of pro-cyclical fiscal policy. In a recession, fiscal policy ought to be more expansionary and countries should be allowed to run the deficit required to stimulate domestic aggregate demand. Then, once the economy recovers, countries should run a surplus to offset the previous deficit.

This counter-cyclical policy approach arises from a Keynesian logic, but it has the merit of (i) allowing countries to use fiscal policy as a tool to stabilise the cyclical fluctuations of the economy and (ii) to ensure that the budget is balanced over the medium term and that debt does not accumulate in the long-term.

The current European fiscal rules allow for some adjustment depending on the cyclical phase of countries, but clearly this has proven insufficient in the current situation. Waiving the deficit limit is a first indication that, possibly, the lesson of Lord Keynes is coming back with a vengeance.

Actually, the case can be made for the deficit limit to be waived for all countries of the Euro area. It is the whole of the Euro area that is facing a crisis and hence it is the whole of the Euro area that should adopt a counter-cyclical fiscal policy approach.

The greatest potential of the EU lies in the coordination of national policies. A coordinated fiscal stimulus undertaken by all countries would determine a faster and stronger recovery in the periphery than what could be ever achieved by a single country working alone.

This joint fiscal stimulus would be in the interest of all countries as it is the Euro-wide economic system that is going through a recession. That is, all countries face the same problem, albeit some more intensively than others, so they should all act cooperatively and move in the same direction.

Of course, this expansionary fiscal stance should not be permanent, but limited to a recession period and followed by fiscal consolidation. In fact, it is not through persistent deficit that countries can hope to relaunch economic growth in the long-term and to fix the structural unemployment problem which has afflicted the continent for decades now.

The road to steady long-term growth and high employment goes through reforms. This list might differ somewhat across countries: financial sector reforms in Spain, Slovenia, and Cyprus, labour market reforms in France and public administration reforms (but also labour market and competition laws) in Italy, for instance.

What should be recognised, however, is that these reforms are the primary responsibility of national governments. The EU can encourage Member States to act on reforms, but these will only happen if national governments are prepared to push them forward.

One can perhaps blame the EU for having insisted too long on austerity as the only cure for the crisis, but national governments must shoulder the blame for the lack of reforms that are the root of the prolonged economic stagnation of the continent.

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