European Voters Have Rejected Austerity—So What Happens Next?

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Luca Bruno/AP

A woman begs for money in Milan, Italy, Tuesday, May 8, 2012

So voters in France and Greece sent an inescapable signal to the euro zone: No more austerity. In doing so, they showed that the average guy on the street understands economics better than the people in power. Rather than reducing debt and returning the European economy to health, the all-austerity approach to solving the debt crisis was sending the weaker economies of Europe into a death spiral of recession, unemployment, and ultimately, continued strain on national finances.

But there’s a problem. Whatever the verdict of the ballot box, Europe can’t avoid austerity. Its indebted governments can’t simply return to spending and borrowing as they had in the past. Financial markets just wouldn’t stand for it. So the question going forward is not what replaces austerity, but what new mix of policies along with austerity are needed to restore prospects for growth, fix national finances and quell the debt crisis.

There are no easy answers. Austerity, by its very nature, is growth-killing. The trick is finding a combination of policies, both at the national and Europe-wide levels, that can balance out that effect. There is no agreement on how that can be achieved. What we are about to see in Europe is a continent-wide debate on what the next steps might be to both end the debt crisis and restore the euro zone to economic health. The outcome of that debate is highly uncertain.

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There is a case to be made that the problem with austerity is not the austerity itself, but the pace at which it is being imposed. Rather than a mad rush to meet euro-zone deficit limits, more flexibility is needed to allow governments to adjust over a longer period of time and benefit from economic recovery. Here how Christina D. Romer, an economics professor at the University of California, Berkeley, explained it in a recent essay in The New York Times:

The core of a more sensible approach is to pass the needed budget measures now, but to phase in the actual tax increases and spending cuts only gradually—as economies recover. To use economists’ terminology, the measures should be backloaded. They should also be specific—no more deficit targets without specifying how they’ll be achieved. Instead, lay out right now whose taxes will be raised and what spending will be cut. And specify when the measures will take effect—either along a set schedule, or tied explicitly to indicators of economic recovery.

But will the markets let that happen? The reason why governments have been pushing ahead with austerity programs even as their economies contract is because jittery investors have been pressuring them to cut deficits and control debt. Romer counters, however, that investors aren’t stupid—they understand the damage being done by austerity and would be satisfied with clear plans to restore fiscal health:

Investors… are very aware that low growth and high unemployment devastate a country’s fiscal outlook… Markets don’t want counterproductive measures. For credibility, what matters is the nature and the composition of the tax and spending measures, and the clarity of the phase-in schedule.

(MORE: The Future of the Euro: Why Sentiment Alone Can’t Save the Union)

Such a “phased-in” approach to austerity would take some of the strain off Europe’s economies. But there is still a need to do more to promote growth. One way of achieving that is through structural reform—for example, making labor markets more flexible, cutting red tape to allow entrepreneurs to start new firms more easily and liberalizing protected service industries. Taking steps such as these would improve Europe’s prospects for growth by breaking down unnecessary barriers to investment and job creation. The governments in Italy and Spain are already implementing such reforms, and, like austerity, they are likely impossible to avoid. It would also be helpful if these structural reforms took place across the European Union. For example, as Italian Prime Minister Mario Monti has championed, dismantling remaining barriers to cross-border business to forge a true common market would spur growth opportunities, as well.

Yet there are problems with this approach, too. First, these structural reforms are often no more popular with the general public than austerity. Look at the political battle Monti has had over labor reform in Italy. Secondly, the positive effects of these types of structural changes are often not immediate. It could even take years for the real benefits to kick in. So though structural reform is necessary, it is not necessarily an antidote to the crisis Europe faces today.

So what Europe requires along with these long-term reforms is some way of generating a quick burst of growth. The new French President, François Hollande, believes that despite the continued need to control government spending, the state still has the ability to provide that boost. He wants to hire more teachers, create jobs for unemployed youth and give tax breaks to small companies. These steps would have at least a small positive impact on growth, but Hollande is playing a dangerous game. He thinks he can still balance France’s budget while undertaking such stimulus measures, in part by raising taxes on the wealthy. But investors will be watching closely. Hollande may have some wiggle room in which to fiddle around with state spending, but if investors believe his government is significantly worsening France’s financial position, he could be headed for trouble.

That’s why Hollande and others advocate for E.U.-wide efforts to support growth, as well. He suggests bolstering the European Investment Bank so it can better finance projects across Europe. Other ideas include convincing countries not under great pressure to implement austerity measures (like Germany) to increase fiscal spending and give the euro zone a stimulus bump, or having the usually conservative European Central Bank engage in the sort of massive monetary easing (like the Fed’s QEs) to support the euro-zone economy. These, too, might all help, on the margins, but would not be sustainable over any period of time.

So where does that leave us? What Europe needs is not one solution, but a mix of them—austerity plus structural reforms plus a short-term growth stimulus. That will entail a level of policy flexibility and coordination so far missing from the euro zone. The deficit hawks in Berlin and elsewhere will have to put away their claws for awhile. Most of all, investors must show some patience and realize the best way to ensure sovereign solvency in Europe is to return to growth. In all, it’s a tall order, a policymaking nightmare. But with austerity alone failing, a new strategy is not only necessary, but inevitable.

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