It may be a good thing that financial markets suddenly seemed to realise this week that the euro zone crisis is far from over. Reforming the sick economies of Europe will take years and there will be setbacks along the way. Renewed tensions in Spanish and Italian government bond markets, and to a lesser extent in the French one, were a helpful reminder that trust is something indebted governments must strive to earn every day.
It would be better if the realisation that the crisis is not going away soon helped end the furious “never enough” approach to austerity which engulfs the euro: never enough spending cuts, never enough tax rises. A twin-track way out of the crisis — fiscal discipline coupled with serious reforms — becomes self-defeating when austerity ayatollahs rule the day, under the auspices of Germany and the European Central Bank.
Euro zone governments are rushing to comply with their interpretation of investors’ demands, in the refreshing belief that markets are currently sending them intelligible signals. The politicians are also constrained by the European Commission’s target fetishism, which keeps insisting that agreed deficit reduction goals be met, regardless of changes in economic expectations.
Hence the Spanish determination to shrink its budget deficit to three per cent of GDP by 2013, come what may. Even though everyone knows the target will not be reached — and more importantly, shouldn’t be reached. Similarly, Italy’s four austerity plans in 18 months have provided more than Euro 230 billion of deficit reduction over four years — but two-thirds of those will come from tax hikes, which are less growth-friendly than structural spending cuts.
Reforms to remove the impediment to growth on the supply side are indispensable in Italy, Spain and France. But savage and indiscriminate deficit cuts on the demand side will eat into those countries’ potential output. The euro zone will not grow if its only economic policy is to cut health care spending, fire teachers, curtail public investment and depress real wages while taxing everything in sight — just because that’s the best way to meet Brussels’ targets.