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04 Dec 2013

Eurozone needs new austerity

by Karen Ward and Janet Henry

Economists, HSBC

Is the eurozone pursuing the wrong type of austerity? Other developed countries – notably the US and UK – are demonstrating that it is possible to have both growth and belt-tightening, but eurozone growth remains depressed.

This is not because eurozone austerity has been tougher. The US tightened fiscal policy by more than Spain or Portugal in 2013, according to the Organisation for Economic Cooperation and Development (OECD) estimates, and was second only to Greece. UK tightening wasn’t far behind Italy’s. And cuts in public-sector staff in the UK and US are equivalent to, if not greater, than in the peripheral eurozone countries.

Cutting public investment is quick and more socially acceptable than firing workers, but academic evidence suggests this is the worst type of austerity in terms of the impact on growth

But capital spending by governments has been cut more dramatically in the eurozone periphery than elsewhere. Cutting public investment is quick and more socially acceptable than firing workers, but academic evidence suggests this is the worst type of austerity in terms of the impact on growth.

And government revenues have fared far better outside the eurozone periphery. Despite hefty VAT rises in many European countries, beyond France the rise in receipts cannot be attributed to broad-based taxation increases.

There are three main reasons why eurozone government receipts have suffered so badly relative to other developed countries.

First, monetary conditions have loosened much more meaningfully in the UK, the US and elsewhere.  The European Central Bank (ECB) was slower to cut interest rates: indeed, it raised them in 2008 and twice more in 2011 before resuming a loosening cycle.

And the ECB has not embarked on quantitative easing like other major western central banks. This has kept the euro materially stronger than the dollar or sterling. While this has not deterred export growth, it has squeezed margins.

Second, although the ECB lowered governments’ borrowing costs – thanks to president Mario Draghi’s 2012 “whatever it takes” speech – it has been less successful in ensuring that its policies feed through into the real economy.

Transmitting monetary policy depends largely on the health of the banking system, and again, the eurozone sits woefully behind its OECD counterparts. The UK and the US were more willing to put the past behind them to revive their banking systems, completing stress tests early and force-feeding capital into banks. Five years on, the eurozone has still to complete such an exercise.

And the third factor is the lack of flexibility of eurozone labour markets. Economies with less rigid jobs markets cut costs by reducing real wages, and avoided large job cuts. Weak wage growth depresses a recovery, but it is less damaging: it allows moderate consumption rises, fewer foreclosures or downward pressure on house prices, which in turn feeds back to the banks.

Any eurozone urgency for reforms has gone since the 'whatever it takes' speech. But other reforms are also necessary to raise potential growth rates. A little growth and low inflation are not enough to stabilise eurozone government debt burdens any time soon – even outside the periphery.

The eurozone would also benefit from creditor countries – namely Germany – lowering their savings-investment gaps and supporting domestic demand growth with tax cuts. Without such rebalancing, the current-account surplus will keep growing with inflation likely to continue undershooting the ECB’s definition of price stability.

As a result, much of the eurozone austerity will continue to prove counterproductive, exacerbating the vicious cycle and making government debt even less sustainable. And high unemployment makes political situations fragile.

This research was first published on 2 December 2013.

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