JUNE 25, 2010.
Why Europe Is Cutting Spending
No one can live beyond their means forever—not even governments.
By OLLI REHN
Ahead of this weekend's G-20 summit in Toronto, Europe's exit from stimulus mode and shift toward fiscal consolidation has been criticized as a threat to the still-hesitant economic recovery. Some even claim that Europe is condemning itself to a long period of slow growth and high unemployment by excessive spending cuts and tax increases. I cannot but disagree.
What Europe has put in place is a carefully timed, scaled, and differentiated fiscal-policy strategy to transform the current cyclical upturn into sustained growth.
First, the overall fiscal-policy stance in Europe is still slightly expansionary this year by standard measures. Only in 2011 will the fiscal policy turn tighter. Even then, this contraction will only be on the order of 1% of European GDP, while the overall fiscal deficit is forecast to remain around 6%. By then, though, the growth rate is projected to accelerate to 1.75%, taking into account all but the most recent consolidation measures. So, there is really no way these additional fiscal measures could derail recovery in the European Union.
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Second, while fiscal tightening as such will reduce short-term demand, preventing unsustainable debt developments is certainly beneficial for growth in the longer term. No one can live beyond their means forever—not even governments. Both theory-based modeling and practical experience support the conclusion that stability-oriented fiscal policy is far better for growth in the medium-to-long run than a "spend-spend-spend for growth" approach.
Third, financial markets often transform the famous long run (when "we'll all be dead," as John Maynard Keynes quipped) into something surprisingly immediate. At one extreme, a country perceived as being overly indebted is completely shut out of the markets, or its borrowing becomes progressively so expensive that further borrowing is not a real option anymore. Anybody who has followed Greece's recent difficulties knows that this is not just a theoretical case. Unfortunately, other countries with much stronger fundamentals tend to also feel the impacts of such solvency doubts through contagion.
Once serious doubts about the quality of government debt start to arise, fiscal consolidation is likely better for growth—even in the short run—than its only true alternative: continued high interest rates, depressed and volatile asset prices, and disturbances in financial intermediation.
For these reasons the European Union—whose aggregate debt level is set to rise by 20 percentage points in just three years, to more than 80% of GDP in 2011, from 60% in 2008—has established a carefully timed and differentiated consolidation strategy. Those countries with bigger fiscal-sustainability challenges are taking faster and stronger measures towards consolidation, while others are starting later and taking more moderate steps.
One country that has been especially criticized for "excessive" fiscal tightening is Germany. This criticism is misplaced. German consolidation will only start in 2011, in line with the EU's jointly agreed exit strategy. Furthermore, the scale is not excessive, given that Germany, too, has a public-debt ratio of around 80% of GDP and its age-related expenditures are set to increase rapidly. The new measures amount to some 0.5% of German GDP in 2011, and to 1.25% of GDP cumulatively over a four-year span.
The composition of consolidation also has an impact on growth. Europe's announced fiscal-tightening measures focus mainly on cutting expenditures, and less on increasing taxes. Furthermore, growth-friendly spending in such areas as research and education will be broadly spared from cuts. Equally important is that in several countries the fiscal measures are flanked by growth-promoting structural reforms of, for example, labor markets and pension systems.
Contrary to what some people argue, Europe is not suffocating growth with its fiscal austerity. What we are doing is putting our fiscal houses in order in a gradual and differentiated way. This is essential to reinforce consumers' and investors' confidence, and thus turn the evident but still fragile recovery into a period of sustainable growth and job creation.
Mr. Rehn is European commissioner for economic and monetary affairs.
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