The austerity consensus, of course, never had complete support. French president Francois Hollande, after all, ran for office last year on a platform of fiscal relaxation. Because the preference for austerity was still dominant at the time, he glossed over specifics enough to allow voters to see him simultaneously as both for and against austerity. But the signs were there. The first major cracks in the austerity consensus emerged in Italy's February election. The electorate there, enraged by the economy's decline, returned an inconclusive vote that clearly threatened the fiscal and regulatory reforms set in motion by the outgoing prime minister, Mario Monti. For a while, Italy could not even form a government. When recently it did, the new prime minister, Enrico Letta, was clearly constrained. Though his Democratic Party had endorsed the previous fiscal program, he could hold power only by making concessions to the contrary positions of his powerful opposition.1
Since then, policy fissures have grown even wider. Hollande has seized on the changing environment to climb off the fence he had made for himself. He has reneged on his former promise to bring down the budget deficit to 3.0% of the nation's gross domestic product (GDP) this year, and instead now talks of a target closer to 4.5%. Spanish prime minister Mariano Rajoy, having endorsed rigid austerity for the entire 16 months since his election, recently outlined new policies that would allow less pressing deficit targets. Portugal has actually decided on a policy of fiscal stimulus, including corporate tax cuts. It has promised to bring its budget deficit, presently at 6.4% of GDP, down to the promised 3% by 2015, but many question the prospect given the government's new policy posture. Prime Minister Letta, even though he recently announced in Berlin that he would continue ongoing budget rigor, had already softened policy, proposing, almost on taking office, to cut taxes on sales and property and widen Italy's welfare net, including jobless benefits.2
European Commission president José Manuel Barroso joined the chorus, bluntly telling the media that austerity had "reached its limits," having lost the public support it needed to work. He, too, now wants more latitude for countries to run deficits wider than 3% of GDP.3Even the International Monetary Fund (IMF) has changed. Having long promoted strict budget discipline, the IMF's managing director, Christine Lagard, in just the last month or so, has begun questioning the value of such a harsh policy. Also acknowledging the change is European Commission economic chief Olli Rehn. He has embraced a "smoother pace to fiscal consolidation," telling the United States and others who argue against austerity: "Can I tell you a secret? We have already slowed down fiscal consolidation." Of course, Greece and Cyprus, desperate for aid from the rest of the eurozone and the IMF and bound by past agreements, continue austerity measures, but the cracks in the former consensus are apparent.4
On the positive side, this new tone does relieve some of the downside risk implicit in strict austerity. Because severe budget restraint slows and often halts economic activity, it also stems the flow of tax revenues while it increases demands for government services, such as unemployment relief and welfare. If severe enough, the net effect can enlarge budget deficits, even as governments increase taxes and trim government spending. But since a single-minded austerity approach only then demands more restraint, it can set an economy into a vicious cycle of decline in which austerity creates recession that only evokes more austerity. Part of the recent policy change no doubt reflects fears that just such a cycle is developing. After all, business activity has fallen steeply across Europe, and especially in those countries that have pursued the most aggressive austerity programs. Unemployment has risen to 26.7% of the work force in Spain, for instance, 25.7% in France, 17.5% in Portugal, 27% in Greece, and 12.1% for the eurozone as a whole.5
But if the policy rethink helps alleviate such risks, it carries problems of its own. One is obvious: Europe really does need budgetary reform. The profligate fiscal policies of the past were clearly unsustainable. A realization of that fact brought on this crisis in the first place, when lenders refused to advance more credit to the Continent's periphery. Approaching fiscal sanity along a gentler, less demanding path might seem reasonable in the face of Europe's present intense economic pain, but the best these nations practically can do is reduce the intensity of restraint. Were they to go any further to, say, something openly stimulative, they might relieve the symptoms of economic illness for a time, but the relief would run its course very quickly. Soon, the renewed profligacy would prompt lenders again to withhold credit, shutting down these economies even more severely than would a regime of austerity.
The policy turn carries political risks as well. Germany has an election in September 2012. Many Germans still resist their country's prominent role in the financial rescues. Chancellor Angela Merkel has until now placated these elements by insisting on budget austerity as a quid pro quo for the aid. But the fiscal softening in France, Italy, and elsewhere will likely fortify this internal opposition to Merkel's approach. Germans will ask, not without justice, why German taxpayers should bear such burdens when Italians, Spaniards, and others who benefit from the funds refuse to cooperate fully. The fear of throwing good money after bad might have an answer in a gentler path to budgetary reform, but such fine points could easily get lost in the cut and thrust of the election campaign, especially since polls show German citizens very concerned about the use of their taxes. Those same polls do, though, also show little support for a German departure from the eurozone—and the polls reveal that Merkel is still popular enough to retain her office.6But if the opposition can gain enough ground to limit her ability to help Europe, credit markets will almost surely become less responsive to eurozone reassurances about its weaker members.
The biggest problem with this changing tone, however, is that it seems to have distracted policymakers from the important structural reforms on which they had embarked. These started in Italy under Monti. He understood the downside risks of a single-minded focus on austerity, however necessary budget reform was. Impressed by the success of German labor market and regulatory reforms under former chancellor Gerhard Schröder, Monti pushed a similar agenda in Italy as a growth antidote to the depressing effects of austerity. He also saw structural reform as a way to improve the economy's underlying growth potential and so offer a fundamental answer to the country's fiscal-financial dilemma. He made remarkable strides easing Italy's rigid labor regulations, allowing firms more flexibility on hiring, firing, and setting work rules. He was looking to produce regulatory reform as well as additional labor market reforms when he exited office. Seeing his reasoning and his progress, Spain, Greece, Portugal, and others in Europe's troubled periphery also began to make similar changes. But in this latest discussion of easing the severity of budget restraint, such structural reform efforts seem to have taken a back seat.7
To be sure, European leaders still pay lip service to such fundamental changes. Prime Minister Rajoy alluded to "new structural reforms" when he announced less stringent deficit targets. But, disappointingly, his comments lacked specifics. President Hollande has overseen efforts to allow employers more flexibility in hiring, firing, and work rules, and has spoken of renewed entrepreneurial effort. But his solutions have lacked breadth and, in fact, are a very limited, controlling, and highly selective series of tax breaks. More troubling, he has said little about any such reform since he announced his eased deficit targets. The only strong French voice for structural change is that of Christian Noyer, governor of the Bank of France, and he, notably, is outside the government. Perhaps this neglect is simply a matter of timing, that structural reform will wait until Europe's leaders can sort out how much general fiscal restraint is optimal. Perhaps Berlin, which realizes how much of Germany's own economic success grew from its past structural reforms, will insist going forward that Europe's periphery continue along a similar path. But for now, the relative silence on such matters from Italy, Spain, and others raises questions about Europe's ability to promote lasting growth and, thus, a fundamental solution to its fiscal-financial failings.8
1Milton Ezrati, "Italy: Welcome to the Bungle," Economic Insights, March 11, 2013.
2For more detail, see, for example, Matina Stevis, "EU Sounds Alarm on Spain,"The Wall Street Journal, April 11, 2013; Jonathan House, "Still Sputtering Spain Turns Away from Cuts,"The Wall Street Journal, April 26, 2013; Patricia Kowsmann, "Portugale Sets New Stimulus After Setback,"The Wall Street Journal, April 24, 2013; and Christopher Emsden and Giada Zampano, "Italy Sets Ambitious Agenda,"The Wall Street Journal, April 30, 2013.
3Alessandro Torello and Frances Robinson, "Limit Austerity, EU Official Says,"The Wall Street Journal, April 23, 2013.
4Thomas Catan, "Europe Officials Expect Slow Growth,"The Wall Street Journal, April 22, 2013.
5Art Patnaude and William Horbin, "Europe's Unemployment Problems Worsen,"The Wall Street Journal, April 26, 2013.
6Milton Ezrati, "Murkier Prospects for Merkel," Economic Insights, April 22, 2013.
7Milton Ezrati, "Easing Labor Pains for Europe," Economic Insights, October 8, 2012.
8Gabriele Parussini, "Bank of France Official Urges Faster Action on Economy,"The Wall Street Journal, April 24, 2013.
Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, includingThe New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.
The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.
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