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For example, while GDP is supposed to measure the value of output of goods and services, in one key sector – government – we typically have no way of doing it, so we often measure the output simply by the inputs. If government spends more – even if inefficiently – output goes up. In the last 60 years, the share of government output in GDP has increased from 21.4% to 38.6% in the US, from 27.6% to 52.7% in France, from 34.2% to 47.6% in the United Kingdom, and from 30.4% to 44.0% in Germany. So what was a relatively minor problem has now become a major one.

Likewise, quality improvements – say, better cars rather than just more cars – account for much of the increase in GDP nowadays. But assessing quality improvements is difficult. Health care exemplifies this problem: much of medicine is publicly provided, and much of the advances are in quality.

The same problems in making comparisons over time apply to comparisons across countries. The United States spends more on health care than any other country (both per capita and as a percentage of income), but gets poorer outcomes. Part of the difference between GDP per capita in the US and some European countries may thus be a result of the way we measure things.

Another marked change in most societies is an increase in inequality. This means that there is increasing disparity between average (mean) income and the median income (that of the “typical” person, whose income lies in the middle of the distribution of all incomes). If a few bankers get much richer, average income can go up, even as most individuals’ incomes are declining. So GDP per capita statistics may not reflect what is happening to most citizens.

We use market prices to value goods and services. But now, even those with the most faith in markets question reliance on market prices, as they argue against mark-to-market valuations. The pre-crisis profits of banks – one-third of all corporate profits – appear to have been a mirage.

This realization casts a new light not only on our measures of performance, but also on the inferences we make. Before the crisis, when US growth (using standard GDP measures) seemed so much stronger than that of Europe, many Europeans argued that Europe should adopt US-style capitalism. Of course, anyone who wanted to could have seen American households’ growing indebtedness, which would have gone a long way toward correcting the false impression of success given by the GDP statistic.

Recent methodological advances have enabled us to assess better what contributes to citizens’ sense of well-being, and to gather the data needed to make such assessments on a regular basis. These studies, for instance, verify and quantify what should be obvious: the loss of a job has a greater impact than can be accounted for just by the loss of income. They also demonstrate the importance of social connectedness.

Any good measure of how well we are doing must also take account of sustainability. Just as a firm needs to measure the depreciation of its capital, so, too, our national accounts need to reflect the depletion of natural resources and the degradation of our environment.

Statistical frameworks are intended to summarize what is going on in our complex society in a few easily interpretable numbers. It should have been obvious that one couldn’t reduce everything to a single number, GDP. The report by the Commission on the Measurement of Economic Performance and Social Progress will, one hopes, lead to a better understanding of the uses, and abuses, of that statistic.

The report should also provide guidance for creating a broader set of indicators that more accurately capture both well-being and sustainability; and it should provide impetus for improving the ability of GDP and related statistics to assess the performance of the economy and society. Such reforms will help us direct our efforts (and resources) in ways that lead to improvement in both.

Why Big Banks Will Get Bigger

Harold James

05-01-2010

Harold James is Professor of History and International Affairs at Princeton University and Marie Curie Professor of History at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle.

FLORENCE – Severe banking crises bring painful and long-lasting disruptions. But they also lead to surprises. The lessons learned in the immediate aftermath bear little relationship to the eventual outcome. There are immediate and obvious answers to the question of who was to blame, but they rarely correspond with the new shape of the financial landscape that ultimately emerges.

The crisis that began in 2007 originated in the sub-prime mortgage sector in the United States, and in US banks that were “too big to fail,” prompting many observers at the outset to predict the end of American financial capitalism. But the banks that were most affected were elsewhere, and the long-term winners will be a few American banks – including some of the most notoriously weak banks – which will get bigger as a result of the crisis. Fueled by the injection of taxpayers’ money, American capitalism is back in force.

The explanation of why the obvious lessons of the crisis are being not drawn lies in the curious character of financial activity. Banking is inherently competitive; but at the same time, it is not an industry where competition ever worked very well.

The core of financial activity depends on reputation, information networks, and the ability to make markets as well as trade on them. The result is that there are indisputable advantages to being big, as well as the disadvantages that have become obvious over the past two years. The market tends to be dominated by a relatively small number of firms.

In the old days, when banking was stable and regulated securely in a national setting, three or four leading banks tended to form an oligopoly: Barclays, Lloyds, Midland, and National Westminster in the United Kingdom; Commerzbank, Deutsche, and Dresdner in Germany. There were always suspicions of formal or informal banking cartels, which would agree on conditions and interest rates. Regulators generally turned a blind eye to these suspicions.

In the 1990’s and 2000’s, internationalization promised to produce a new landscape, in which a small handful of banks would once again divide up a single global market. Banks maneuvered to get the best position to take advantage of financial globalization, which usually meant locating themselves where the regulatory regime was least restrictive.

Banks got much bigger very quickly, and bigness brought problems. As they grew, banks found it difficult to manage the multiplicity of their divergent activities. They were beset with incompatible computer software systems, rogue employees, and the need to account for the different national cultures in which they were now operating.

Almost inevitably, the biggest banks in the world got into trouble. In the 1990’s, the largest banks were mostly Japanese. Who now remembers Daiichi Kangyo?

The financial crisis has produced a new answer to where the greatest competitive advantages lie. From banks’ perspective, the most obvious lesson was the need for a strong national government to bear the potential costs of a rescue. It is no longer best to be subject to the most favorable regulatory regime, but to be where the state has the deepest pockets.

Very large banks in small territories with small-scale governments are vulnerable. The US is big enough to handle behemoths like Bank of America or Citigroup. China can handle its large banks, even if they have large portfolios of poor credits.

European banks are in a more precarious situation. Ireland and Iceland have become notorious cases where a financial sector metastasized and destroyed the host country. Even in France and Germany, large and internationally active banks potentially exceed the government’s capacity to mount a rescue. In addition, there is the complexity of disentangling which country is responsible for what part of a rescue, when, for instance, Central European banks are controlled by an Austrian bank that is bought by a German bank that is then bought by an Italian bank.

As a result, the big transnational institutions are lobbying hard for a pan-European approach to banking supervision and regulation (and implicitly for fiscal bailouts should that supervision and regulation fail).

In the case of the banks that required state rescues, European competition rules are requiring divestment and downsizing. Institutions such as Royal Bank of Scotland, which for a time in 2009 headed the list of the world’s largest international banks, are being pruned by the EU’s Directorate General for Competition.

Even the stronger banks are being pressed to increase their capital reserves. In most cases, this means that they will continue to cut back on lending, worsening the impact of the financial crisis on the rest of the economy.

By contrast, in the US, the government pushed big banks into buying up smaller and vulnerable banks, and is now doing everything it can to press them to lend more.

Government reactions are full of paradoxes. The more we insist that a banking system should be competitive, the greater the risks that individual banks will take. The more governments are prepared to step in, and the greater the resources of those governments, the more big banks and big countries will be favored.

The last 20 years of globalization saw the emergence of small, open economies as global leaders. The next 20 years will see a different globalization, in which the winners are large, powerful countries that mobilize government resources in the interest of creating winners in the race for financial supremacy.

Is Modern Capitalism Sustainable?

Kenneth Rogoff

02-12-2011

CAMBRIDGE – I am often asked if the recent global financial crisis marks the beginning of the end of modern capitalism. It is a curious question, because it seems to presume that there is a viable replacement waiting in the wings. The truth of the matter is that, for now at least, the only serious alternatives to today’s dominant Anglo-American paradigm are other forms of capitalism.

Continental European capitalism, which combines generous health and social benefits with reasonable working hours, long vacation periods, early retirement, and relatively equal income distributions, would seem to have everything to recommend it – except sustainability.

China’s  Darwinian capitalism, with its fierce competition among export firms, a weak social-safety net, and widespread government intervention, is widely touted as the inevitable heir to Western capitalism, if only because of China’s huge size and consistent outsize growth rate. Yet China’s economic system is continually evolving.

Indeed, it is far from clear how far China’s political, economic, and financial structures will continue to transform themselves, and whether China will eventually morph into capitalism’s new exemplar. In any case, China is still encumbered by the usual social, economic, and financial vulnerabilities of a rapidly growing lower-income country.

Perhaps the real point is that, in the broad sweep of history, all current forms of capitalism are ultimately transitional. Modern-day capitalism has had an extraordinary run since the start of the Industrial Revolution two centuries ago, lifting billions of ordinary people out of abject poverty.  Marxism and heavy-handed socialism have disastrous records by comparison. But, as industrialization and technological progress spread to Asia (and now to Africa), someday the struggle for subsistence will no longer be a primary imperative, and contemporary capitalism’s numerous flaws may loom larger.

First, even the leading capitalist economies have failed to price public goods such as clean air and water effectively. The failure of efforts to conclude a new global climate-change agreement is symptomatic of the paralysis.

Second, along with great wealth, capitalism has produced extraordinary levels of inequality. The growing gap is partly a simple byproduct of innovation and entrepreneurship. People do not complain about Steve Jobs’s success; his contributions are obvious. But this is not always the case: great wealth enables groups and individuals to buy political power and influence, which in turn helps to generate even more wealth. Only a few countries – Sweden, for example – have been able to curtail this vicious circle without causing growth to collapse.

A third problem is the provision and distribution of medical care, a market that fails to satisfy several of the basic requirements necessary for the price mechanism to produce economic efficiency, beginning with the difficulty that consumers have in assessing the quality of their treatment.

The problem will only get worse: health-care costs as a proportion of income are sure to rise as societies get richer and older, possibly exceeding 30% of GDP within a few decades. In health care, perhaps more than in any other market, many countries are struggling with the moral dilemma of how to maintain incentives to produce and consume efficiently without producing unacceptably large disparities in access to care.

It is ironic that modern capitalist societies engage in public campaigns to urge individuals to be more attentive to their health, while fostering an economic ecosystem that seduces many consumers into an extremely unhealthy diet. According to the United States Centers for Disease Control, 34% of Americans are obese. Clearly, conventionally measured economic growth – which implies higher consumption – cannot be an end in itself.

Fourth, today’s capitalist systems vastly undervalue the welfare of unborn generations. For most of the era since the Industrial Revolution, this has not mattered, as the continuing boon of technological advance has trumped short-sighted policies. By and large, each generation has found itself significantly better off than the last. But, with the world’s population surging above seven billion, and harbingers of resource constraints becoming ever more apparent, there is no guarantee that this trajectory can be maintained.

Financial crises are of course a fifth problem, perhaps the one that has provoked the most soul-searching of late. In the world of finance, continual technological innovation has not conspicuously reduced risks, and might well have magnified them.

In principle, none of capitalism’s problems is insurmountable, and economists have offered a variety of market-based solutions. A high global price for carbon would induce firms and individuals to internalize the cost of their polluting activities. Tax systems can be designed to provide a greater measure of redistribution of income without necessarily involving crippling distortions, by minimizing non-transparent tax expenditures and keeping marginal rates low.  Effective pricing of health care, including the pricing of waiting times, could encourage a better balance between equality and efficiency. Financial systems could be better regulated, with stricter attention to excessive accumulations of debt.

Will capitalism be a victim of its own success in producing massive wealth? For now, as fashionable as the topic of capitalism’s demise might be, the possibility seems remote. Nevertheless, as pollution, financial instability, health problems, and inequality continue to grow, and as political systems remain paralyzed, capitalism’s future might not seem so secure in a few decades as it seems now.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

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What Can Save the Euro?

Joseph E. Stiglitz

05-12-2011

NEW YORK – Just when it seemed that things couldn’t get worse, it appears that they have. Even some of the ostensibly “responsible” members of the eurozone are facing higher interest rates. Economists on both sides of the Atlantic are now discussing not just whether the euro will survive, but how to ensure that its demise causes the least turmoil possible.

It is increasingly evident that Europe’s political leaders, for all their commitment to the euro’s survival, do not have a good grasp of what is required to make the single currency work. The prevailing view when the euro was established was that all that was required was fiscal discipline – no country’s fiscal deficit or public debt, relative to GDP, should be too large. But Ireland and Spain had budget surpluses and low debt before the crisis, which quickly turned into large deficits and high debt. So now European leaders say that it is the current-account deficits of the eurozone’s member countries that must be kept in check.

In that case, it seems curious that, as the crisis continues, the safe haven for global investors is the United States, which has had an enormous current-account deficit for years. So, how will the European Union distinguish between “good” current-account deficits – a government creates a favorable business climate, generating inflows of foreign direct investment – and “bad” current-account deficits? Preventing bad current-account deficits would require far greater intervention in the private sector than the neoliberal and single-market doctrines that were fashionable at the euro’s founding would imply.

In Spain, for example, money flowed into the private sector from private banks. Should such irrational exuberance force the government, willy-nilly, to curtail public investment? Does this mean that government must decide which capital flows – say into real-estate investment, for example – are bad, and so must be taxed or otherwise curbed? To me, this makes sense, but such policies should be anathema to the EU’s free-market advocates.

The quest for a clear, simple answer recalls the discussions that have followed financial crises around the world. After each crisis, an explanation emerges, which the next crisis shows to be wrong, or at least inadequate. The 1980’s Latin American crisis was caused by excessive borrowing; but that could not explain Mexico’s 1994 crisis, so it was attributed to under-saving.

Then came East Asia, which had high savings rates, so the new explanation was “governance.”  But this, too, made little sense, given that the Scandinavian countries – which have the most transparent governance in the world – had suffered a crisis a few years earlier.

There is, interestingly, a common thread running through all of these cases, as well as the 2008 crisis: financial sectors behaved badly and failed to assess creditworthiness and manage risk as they were supposed to do.

These problems will occur with or without the euro. But the euro has made it more difficult for governments to respond. And the problem is not just that the euro took away two key tools for adjustment – the interest rate and the exchange rate – and put nothing in their place, or that the European Central Bank’s mandate is to focus on inflation, whereas today’s challenges are unemployment, growth, and financial stability. Without a common fiscal authority, the single market opened the way to tax competition – a race to the bottom to attract investment and boost output that could be freely sold throughout the EU.

Moreover, free labor mobility means that individuals can choose whether to pay their parents’ debts: young Irish can simply escape repaying the foolish bank-bailout obligations assumed by their government by leaving the country. Of course, migration is supposed to be good, as it reallocates labor to where its return is highest. But this kind of migration actually undermines productivity.

Migration is, of course, part of the adjustment mechanism that makes America work as a single market with a single currency. Even more important is the federal government’s role in helping states that face, say, high unemployment, by allocating additional tax revenue to them – the so-called “transfer union” so loathed by many Germans.

But the US is also willing to accept the depopulation of entire states that cannot compete. (Some point out that this means that America’s corporations can buy senators from such states at a lower price.) But are European countries with lagging productivity willing to accept depopulation? Alternatively, are they willing to face the pain of “internal” devaluation, a process that failed under the gold standard and is failing under the euro?

Even if those from Europe’s northern countries are right in claiming that the euro would work if effective discipline could be imposed on others (I think they are wrong), they are deluding themselves with a morality play. It is fine to blame their southern compatriots for fiscal profligacy, or, in the case of Spain and Ireland, for letting free markets have free reign, without seeing where that would lead. But that doesn’t address today’s problem: huge debts, whether a result of private or public miscalculations, must be managed within the euro framework.

Public-sector cutbacks today do not solve the problem of yesterday’s profligacy; they simply push economies into deeper recessions. Europe’s leaders know this. They know that growth is needed. But, rather than deal with today’s problems and find a formula for growth, they prefer to deliver homilies about what some previous government should have done. This may be satisfying for the sermonizer, but it won’t solve Europe’s problems – and it won’t save the euro. 

Joseph E. Stiglitz is University Professor at Columbia University, a Nobel laureate in economics, and the author of Freefall: Free Markets and the Sinking of the Global Economy.

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London vs. the Eurozone

Howard Davies

2011-12-14

LONDON – Ever since the United Kingdom joined the European Economic Community in 1973, after the French withdrew Charles de Gaulle’s veto of its membership, Britain’s relationship with the European integration process has been strained. The British are reluctant Europeans, for historical and cultural reasons.

[Që kur Mbretëria e Bashkuar u bashkua me Komunitetin Ekonomik Europian në vitin 1973, pas tërheqjes të vetos franceze të Charles de Gaulle rreth anëtarësimit të saj, marrëdhëniet e Britanisë me procesin e integrimit evropian kanë qenë të tensionuara.Britanikët janë evropianë që hezitojnë, për arsye historike dhe kulturore.]

For centuries, British foreign policy strove to avoid permanent European entanglements; but, most importantly, it aimed to prevent a single continental power from achieving dominance – especially if that power happened to be France. In the meantime, the British colonized large portions of the globe. Later, after the sun set on their empire, they tried to maintain a “special relationship” with the United States. Joining the European Union was not an affirmation of belief in European integration, but rather a reluctant recognition that the transatlantic strategy had run its course. British public opinion concerning the EU has since remained lukewarm, at best.

In recent years, having opted-out of the single currency and the Schengen area (which allows Europeans to cross borders without passports), the UK has distanced itself from important EU initiatives. Nonetheless, Prime Minister David Cameron surprised everyone by vetoing a new EU treaty on December 9 – a first for the UK since joining the Union – leaving the other 26 member states to press ahead with greater fiscal integration on their own. More surprisingly, the negotiations broke down over arcane details of financial regulation.

For example, Cameron wanted to strike a “red line” through the proposal to subject the planned Deposit Guarantee Scheme Directive to the Qualified Majority Voting procedure (meaning that no member state would have veto power). Cameron also objected to the requirement that third-country financial firms in London without business in other EU states be required to hold a “single passport,” which would enable them to operate in any member country, but would also require them to submit to Europe-wide regulations.

These points are not entirely insignificant, but I would not care to explain them to a meeting of ordinary voters puzzled about Britain’s new European policy. So why has financial regulation become the unlikely casus belli between the UK and its partners?

The explanation is partly political. Cameron’s Conservative Party includes members who have been spoiling for a fight with the EU for a long time. For them, any excuse will do, and EU Internal Market Commissioner Michel Barnier has provided them with ammunition by pursuing what many see as an excessively restrictive regulatory agenda. When horse-trading for Commission jobs took place in 2009, former UK Prime Minister Gordon Brown was warned of the danger of allowing the French to hold the Internal Market post. But he chose instead to bid for the EU foreign-policy job for his Labour Party ally, Baroness Ashton.

When Barnier was appointed, French President Nicolas Sarkozy described it as a “defeat for Anglo-Saxon capitalism.” And so it has proved – though perhaps not in the way he envisaged.

But beneath the politics, there are other substantial conflicts between the UK and its continental neighbors. Barnier favors European directives that impose uniform rules for all member states – so called “maximum harmonization” measures. Previously, EU directives tended to impose minimum standards, which individual countries could supplement if they wished. They could outlaw initiatives that the UK holds dear, such as new rules to ring-fence retail banks’ subsidiaries and impose higher capital requirements on them. The governor of the Bank of England, Mervyn King, has voiced his anxieties on that point.

British officials are also deeply concerned about measures that would oblige clearinghouses that transact their business primarily in euros to be located within the single-currency area. Indeed, the British government was already taking the European Central Bank to court to challenge that policy before the treaty veto. They may have a point; arguably, the ECB’s proposal is inconsistent with single-market principles.

The key point of contention, however, is the pan-European Financial Transactions Tax, which the European Commission proposed with support from both Sarkozy and German Chancellor Angela Merkel. From a UK perspective, the FTT is highly unattractive. Between 60% and 70% of the revenue would be raised in London, yet the EU would spend most of the money to shore up eurozone finances.

For Britons, this idea stirs sentiments akin to what Germans might feel if the EU proposed a new tax on liverwurst, with the proceeds to go into the central pot. They also point out that, unless an FTT were agreed globally, financial companies would quickly migrate from London to New York.

This is Cameron’s best argument on the financial front. But he did not deploy it strongly, for the simple reason that tax policies in Europe are still subject to the unanimity rule. In other words, Britain can block the proposed FTT without a special protocol. This lends weight to the argument that Cameron’s veto was essentially a political move, intended to bolster his domestic support.

That is a big gamble, given that the UK now appears to be shuffling towards the EU exit. Certainly, the new status quo looks unsustainable, with 26 countries moving towards greater integration while the 27th remains aloof.

How will financial firms react? Will they be pleased that London has stamped its collective foot, even though Cameron’s regulatory demands were not accepted? Or will some simply begin to contact real-estate agents to line up office space in Paris or Frankfurt?

The game – London versus the eurozone – has only just begun. It will make for fascinating viewing in the months and years to come.

Howard Davies, a former chairman of Britain’s Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics, is a professor at Sciences Po in Paris.

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Will anyone rescue Europe from its economic crisis?

By Robert J. Samuelson, Published: November 15, 2011

Amid Europe’s economic turmoil, a question nags: Where is the IMF?

Created in 1945 — and reflecting the breakdown of global cooperation in the Great Depression — the International Monetary Fund was intended to prevent a few countries’ problems from dragging down the world economy. Countries that got in trouble would borrow temporarily from the IMF. Under IMF supervision, they would adjust their economies gradually so that they wouldn’t destabilize the entire system. Well, that’s exactly the danger now posed by Europe.

It’s tempting to think that new governments in Rome and Athens will resolve Europe’s deepening economic crisis. Perhaps they will, but the odds against this are long: more like 20 to 1 than 2 to 1. Already, high interest rates have barred Greece, Portugal and Ireland from borrowing in private markets. In 2012, Italy has to refinance 360 billion euros (nearly $500 billion at current rates) of maturing debt. If it can’t, it will default or require a huge rescue that, for the moment, seems beyond any European or global entity.

The fallout could be tumultuous. A default would probably cause mass failures among Italian banks, which hold 164 billion euros (more than $220 billion) of Italian government debt. Depositors might stage a run. French banks, with 53 billion euros of Italian debt (nearly $72 billion), would also be imperiled. If Italy defaulted, bond buyers might abandon France and Spain. Already, financial markets have raised interest rates on Italian, Spanish and French debt.

Facing these grim possibilities, the IMF has been mostly missing in action. It has provided some funds for Greece, Portugal and Ireland. But more is needed, as economist Arvind Subramanian of the Peterson Institute makes clear in an open letter to IMF Managing Director Christine Lagarde. What the IMF should do is organize a huge rescue fund — at least $1 trillion to $2 trillion, says Subramanian — to backstop Europe in case more countries lose access to private credit markets.

Countries could tap it in return for agreeing to IMF conditions to overhaul their economies. This way, the IMF might fulfill its basic mission. It couldn’t avert a European recession, which may have already started. But it could preempt a chaotic implosion of credit, confidence and spending that would threaten the wider world economy.

Three realities define Europe’s situation.

First, the crisis is as much political and social as it is economic. The “European model” of generous social benefits and secure jobs is besieged. Welfare states have become too costly for many countries’ economies to support. Benefits must be curtailed. The austerity being imposed or recommended inflicts direct hardship and assaults beliefs and expectations that have been nurtured for decades.

Second, Europe can no longer rescue itself. There are too many potentially needy debtors and too few credible lenders. The main rescue mechanism — the European Financial Stability Facility (EFSF) — has already committed about 250 billion euros of its 440 billion euros to Greece, Ireland and Portugal, reports the Institute of International Finance, an industry group (and the source of most data cited here). Even an expanded EFSF probably couldn’t handle Italy and certainly not Spain and France. The European Central Bank — Europe’s Federal Reserve — could buy unlimited amounts of government bonds. But it has so far disdained this role, fearing the inflationary consequences.

Finally, the IMF (whose European department head resigned Wednesday) is in no position to rescue Europe. At last count, it had about $400 billion in available funds. This wouldn’t cover Italy’s refinancing needs for a year. So the IMF needs more money.

Getting it would be a chore, notes Subramanian. The Europeans don’t want to admit that they need help. The United States, he says, is resistant because its own high debts would prevent it from contributing, thereby diminishing its power. China fears being hoodwinked into throwing good money after bad; but without China, contributions from other countries (Brazil, India, Saudi Arabia) would be meaningless. Against these obstacles, he says, Lagarde could argue that, absent IMF help, a financial meltdown might cause a new global slump.

When created, the IMF was a political institution dedicated to stabilizing the world economy. Does it still work? “A tectonic shift has occurred in the global economy,” Subramanian writes. Traditional creditors (rich countries) and traditional debtors (poor countries) have switched places. Meanwhile, the social contracts written by most advanced nations, including the United States, will be rewritten by either design or events. Economic stability depends on managing political change.

Can China, Brazil, India and some major oil exporters deploy their financial power for the collective good — including the health of their export markets? Can Europe modify its welfare systems without being paralyzed by civil strife and feuds among nations? Or are we on a collision course with some future crisis whose advancing outlines we can dimly perceive but seem powerless to stop?

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The Worst and the Best of Austerity

Jean Pisani-Ferry

15-12-2011

BRUSSELS – In June, it was Greece. In August, it was France, Italy, Spain, and Portugal. In September, it was Greece again – and Spain. In November, France took another turn, before Italy again in December, this time in a major way. Every month, despite an ever-darker outlook for economic growth, countries announce new spending cuts and tax hikes in the hope of restoring confidence in the bond markets. Only Germany stands out, having recently announced a tax cut, albeit a modest one.

In other words, while all indicators point to a severe economic downturn in Europe, the eurozone’s current interest-rate spreads are provoking a shift to austerity. It looks like a no-brainer: accelerated budget cuts are preferable to a lethal interest-rate surge on public debt, even if the cuts increase the risk of recession. But there are caveats.

First, while indiscriminate austerity may be the only option for those eurozone countries that no longer have access to capital markets, others have more choice of policy options. Consolidation is required, but governments are responsible for its speed and its design.

Second, a sound fiscal strategy requires establishing, on the basis of prudent economic assumptions, an ambitious budgetary target for the medium term, determining what mix of taxation and expenditure cuts are required in order to achieve it, and then sticking to the plan throughout economic fluctuations. This allows the so-called “automatic stabilizers” – lower receipts in a slowdown, higher in a boom – to come into play, preventing the economy from overheating at the top of the business cycle and providing stimulus at the bottom.

Third, headlong consolidation is not always the best way to reassure markets, which may worry more about growth. Italy is a case in point. The country’s budget deficit this year, at 4% of GDP, is far below that of Spain or France. Indeed, it was not the country’s deficit that finally led investors to shun Italian bonds, but rather a forbidding cocktail of high debt, desperately slow growth, and political paralysis. In a situation like this, nibbling at the edges of a deficit is at best a sideshow. The markets are demanding reforms that lift growth rates durably and an approach to fiscal consolidation that is consistent with higher potential growth.

Fourth, the cost of rushed austerity is that it generally relies on immediate fixes, such as indiscriminate spending cuts and tax hikes that are expected to yield revenue in the short term, but that have an economically damaging impact. Smart consolidation should, instead, minimize short-term economic damage and foster longer-term growth.

Governments know this only too well. At the end of 2010, most eurozone countries were penciling spending cuts into their consolidation programs while preserving the most productive areas, such as education and infrastructure. Moreover, they were planning to broaden the tax base rather than raise rates.

But, since this summer, governments have done the opposite. Rather than focus on spending, they have zeroed in on tax measures, for the most part increasing existing rates. This is a bad sign for growth.

What should they be doing instead? Fiscal consolidation is unavoidable, but that is a medium-term process. Instead of undertaking knee-jerk cuts, eurozone governments must first reestablish their credibility through policy rules enshrined in national legislations, as recently decided by the European heads of state and government.

Second, they should design and implement smart consolidations, even if they take a little more time to design and a little more time to implement. This entails finding the optimal balance between spending cuts and tax increases, and identifying the least harmful measures over the medium term. Doing so will take time, thought, and an iron will.

Jean Pisani-Ferry is Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.

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PM: You help us and we’ll help EU

Secret rescue talks with German leader Angela Merkel

By TOM NEWTON DUNN, Political Editor

Published: 19 Nov 2011