February 24, 2013 3:08 pm
Austerity obstructs real economic reform

In Europe, the wordreform” is as misleading as it is ubiquitous. You heard it during the Italian election campaign, when politicians – such as Mario Monti, the country’s outgoing prime minister – were classified as pro-reform. Others, the rest of Italy’s political class, have been deemed anti-reform. It is as though reform has become an issue of religious dogma. You are either in or you are out.

In or out of exactly what, one may ask? What, exactly, is reform? Growing up in Germany in the 1960s and 1970s, I recall Willy Brandt, West Germany’s chancellor during some of those years, talking endlessly about reforms. For him, the word meant more workers’ rights and an increase in welfare payments. This has always been the meaning I first think of when I hear it.

A decade later, in the UK under Margaret (now Baroness) Thatcher, reform became synonymous with privatisation and deregulation, and a reduction in the rights of trade unions. This is closer to the meaning that it holds for most people today.

There is certainly a clear, positive – though often overstated case for structural changes such as the liberalisation of services, changes to labour markets to help younger workers and pension reforms to ensure long-term fiscal solvency. These reforms would probably increase the gross domestic product of several countries by a non-trivial but unknown amount.

A former editor of The Economist used to advise young reporters to “simplify, then exaggerate”. This is exactly what happened to the debate on reform in Europe. You might want to adddistort” as a third element. The simplification consisted of the notion that there is a link between some vague idea of reform and economic success, as measured in GDP per capita. No such link exists.

The richest countries in the world include those with both liberal and regulated labour markets. Per capita GDP in the highly regulated French economy has been higher than in the deregulated UK. The relatively solid performance of a largely unreformed France does not obviate the need for reforms. But it shows that the relationship is much more subtle than the dogmatists acknowledge.

The exaggeration consists of overstating the actual impact of reforms when they take place. Has financial liberalisation really increased long-run economic growth, or may it merely have given us a housing bubble? Has German labour market reform really increased long-term productivity or were other factors at work?

This distortion has become even worse recently, as reform has been conflated with austerity. Whenever you hear a European official applauding Mr Monti’sreforms”, what they are really praising is his fiscal consolidation. In other words, they applaud the many of his policies that reduced economic growth, and not the few that might have a chance to increase it one day.

Austerity and reform are the opposite of each other. If you are serious about structural reform, it will cost you upfront money. If you want to open your labour market to a hire-and-fire rule, you will need policies to deal with those who are laid off. These costs may outweigh the financial benefits of reforms in the short term but the reforms may still pay off in the long run. Structural reforms, properly done, are not suited to the task of delivering austerity.

By contrast, austerity higher taxes and cuts in public sector investmentsweaken the economy’s capacity in the short run, and possibly also in the long run. If you have youth unemployment of more than 50 per cent for a sustained period, as is now the case in Greece, Italy and Spain, many of those people will never find good jobs in their lives.

Economists speak of a so-calledhysteresis effectpermanent economic damage that will not be repaired even if there is a full recovery. Austerity could well leave an economic and social scar across the eurozone.

Italy and Spain would have been a lot better off to come up with a list of front-loaded targeted structural reforms and backloaded fiscal consolidation. When you do it the other way round, cutting investment and raising taxes in a recession, you never get out of the hole, and you waste your political capital on austerity, leaving none for reforms.

By putting fiscal consolidation first, the political establishment also took a big gamble against what we know from history. A senior Italian official told me a while back that they had the situation under control. There would be a slight bump but the economy would take off afterwards.

He was wrong. As last week’s European Commission forecasts confirm, the southern European economies are behaving as was predicted by those who thought austerity would sap growth and using monetary policy to offset it would be ineffective.

I am not surprised that European electorates are rejecting these policies, and the politicians who delivered them. Tonight we will know how Italy has voted. My hunch is that it is not going to be a good evening for the “Austerians”.

Copyright The Financial Times Limited 2013.

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