As the depressing economic and unemployment picture from the European Commission’s growth forecasts makes clear, we at Re-Define have been right to be heavily sceptical of the current strategy being pursued by EU policy-makers.
As we warned in July 2012 in our analysis on Spain, the fiscal multipliers being used were highly underestimated. We warned that on the path being pursued, the Spanish economy and employment would be pulled downwards by a combination of fiscal adjustment and related emergent banking problems. This is exactly what has happened. Our analysis was later confirmed by the IMF, when it issued a Mea culpa on having underestimated fiscal multipliers.
When we first publicly proposed a “Growth Compact for the EU” in January 2012 working with Peter Bofinger, it was ignored. It was only after a sustained effort from us that it became fashionable, but by the time it was adopted it had been watered down to such an extent that its impact was macro-economically insignificant.
Instead of a more relaxed fiscal and monetary policy supporting the structural reforms that were necessary, as we have been suggesting for a long time now, the EU has followed a deeply flawed policy of fiscal contraction. This is the result of the application of a ‘small economy mentality’ (that prevails in the German economic debate) to what is the largest economic area in the world. The current economic policy betrays a level of macroeconomic illiteracy that is shocking for an otherwise well-educated policy-making elite.
Instead of focusing on a 5-10 year strategy and a financially, politically and socially sustainable adjustment path for re-balancing, EU leaders have taken a very short-termist view of policy. At the same time that they rant against the short-termism of financial markets, their own policies have been even more myopic. What may be rational for a small country in the short-run, which is the policy lens they have used, will be self-defeating and irrational for the EU-wide economy over a longer time horizon.
Even narrow questions such as ‘what is the best policy to minimise German tax-payer exposure?’, ‘how can we reduce fiscal deficits and bring debt/GDP ratios under control?’ produce very different answers when considered over a 1-year or a 10-year horizon.
The failure to agree on a grand political bargain that we have repeatedly suggested the EU needs, means that we may no longer have the political space necessary to tackle the size of the economic problems we now face. The devastating logic of ‘why the hell should we pay when even Catalonia refuses to pay for the rest of Spain’ that we hear with increasing frequency in EU capitals means that the crisis may become progressively more insoluble.
Unless an approach that better balances the burden of adjustment between creditor/surplus and debtor/deficit countries and between fiscal consolidation and growth is adopted, the EU is doomed to continue down a path that is simply not politically or socially sustainable in the medium term, something we recently highlighted in the first installment of our new ‘Conversations with Re-Define’ series.
This was why we at Re-Define had strongly pushed for an IMF program for the whole of the Eurozone, something we think has become increasingly necessary. As the domestic political space within the Eurozone has shrunk and the distribution challenges become ever more difficult and contentious, we think that such an externally umpired program is urgently needed.
While others were celebrating the ECB’s promise to ‘do whatever it takes’, we warned that, while this was the bare minimum step necessary to stop the risk of a breakdown, it would do little to tackle the bigger macroeconomic challenges that afflicted the real economy and the financial sector. And we were right. The markets have prematurely celebrated the ECB’s ‘non-actions’ and the fact that Grexit seems to be off the table at least for now. But we should remember that the prospect of a Euro break-up was put into the headlines by EU politicians, not markets. Partly removing the tail-risks that politicians themselves introduced was necessary, but far from sufficient and does not present a solution to the crisis.
Even as a looser fiscal and monetary policy was necessary, EU leaders buried their head in the sand ‘ostrich-like’ and all took part in a the one-horse race that is the ‘Banking Union.’ While there is some intellectual merit in the idea, we at Re-Define have been very skeptical of the manner in which the discussion has proceeded. The obsession with the Banking Union crowded out any discussion of fiscal and growth related policy-measures that were far more important and urgent, and may eventually prove to have been counter-productive.
The fact is, as we have illustrated in our piece ‘Europe’s Sham Banking Union’ in the Wall Street Journal, that even under the most optimistic scenario, this discussion will do little to help with the present crisis.
Meanwhile, even as the folly on the fiscal front continues and monetary conditions effectively remain very tight for exactly those crisis countries that most need looser credit conditions, the EU has thoroughly failed to address the endemic problems of the Financial System in any sensible way. The deeply flawed approach to financial reform, that we highlighted in a recent piece in the Financial Times, has ensured that even 5 years into the crisis we have no credible way to shut down failing banks. The private sector has fled the banking system, which remains on near-permanent life support from the public sector. Fragile banks and weak economies are locked into a dance of death, as they continue to pull each other down.
So where does that leave us?
When the history of this crisis is written, there will be no heroes. It is hard to be hopeful from where we now stand. We have built a constituency of millions of people who have very little stake in society, who face a very bleak future and who have nothing to lose. This is exactly the breeding ground for social unrest at a large scale. Who knows what may happen the next time Spanish youth protest and the police cracks down, with somebody getting injured or killed? What may happen the next time yet another Spanish house holder, tragically commits suicide? We do not know and we best not find out.
The path of adjustment currently being followed by the Eurozone is not robust against political breakdown and the fracturing of the social fabric, so EU leaders better beware. The current macro-economic strategy being followed in the EU has failed the test of the real economy. It has failed even when judged on its narrow goals of reducing fiscal deficits and stabilizing debt to GDP ratios.
As the atrocious growth and jobs forecasts released today show, the EU is continuing on a strategy that is economically illiterate, politically irresponsible, socially indefensible and eventually self-defeating, even when it comes to reaching the deficit reduction targets that it seeks to achieve.
If one looks at the combination of the political, financial, economic and social factors, the Eurozone remains in very deep trouble. The relative optimism in the markets is simply not justified on the basis of these developments on the ground and in the real economy, so it cannot continue without further political action, more measures by the ECB and a long-overdue change in strategy.
What we need at this point is a grand political bargain, and that is one that only Mrs Merkel can offer. We will require a period of five to ten years of adjustment in the European economies that needs to happen both in deficit countries and in surplus ones that are not suffering from the immediate crisis. During the course of this adjustment, financial support needs to be made available at reasonable cost to the economies, in order to provide political and economic space for structural reforms and medium-term fiscal adjustment.
Without such a grand political bargain, which gives certainty, predictability and which puts us onto an economically, financially socially and politically sustainable path, we are in deep-deep trouble. But such a bargain is not likely, at least not before the German elections. Let us see what happens after, but we are not holding our breath.
Sony Kapoor is Managing Director of Re-Define a Senior Visiting Fellow at the London School of Economics and Chairman of the Banking Stakeholder Group at the European Banking Authority