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The Eurozone's Austerity-Growth Debate

Interviewee: Thomas Philippon, Associate Professor of Finance, Leonard N. Stern School of Business, New York University
Interviewer: Christopher Alessi
May 3, 2012

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Spain, the new focal point of the ongoing eurozone sovereign debt crisis, found itself back in recession this week (BBC). The news raised fresh concerns over whether Berlin- and Brussels-mandated austerity measures are doing more harm than good by preventing indebted euro states from achieving a modicum of growth. "In terms of economics, it's not optimal to try to balance the budget too fast," says NYU's Thomas Philippon. But, he explains, the Germans believe "it is only now that they have the upper hand to ask for these reforms" because of the pressures of the crisis. Nonetheless, Philippon says, shifting political winds on the continent are tempering Germany's austerity push by changing the emphasis of the discourse from austerity to growth.

What has been the effect of German-mandated austerity measures on the indebted eurozone? And what do you make of the argument that these budget cuts and tax increases have been implemented too quickly and strangled growth?

Every country that has had high debt has had trouble with growth in the years afterward. Now the eurozone is special because of its political construction. One [difference] is the fixed exchange rate, which makes default more complicated in the sense that if a country borrows in its own currency and its exchange rate depreciates, then the external debt becomes cheaper. That option is not available for countries that stay in the eurozone.

The second difference is the perfect storm of the 2000s. If you look at the history of sovereign debt crises, countries getting to above 100 percent of GDP of debt--that just does not happen. Greece [which has a debt-to-GDP ratio of around 160 percent], never happened in the past, just because the market would freak out way before you got to 100 percent.

We are clearly going to see a change in emphasis--from austerity to growth.

Third is the political economy. Because these countries retain sovereignty, there's a game of credibility. In an ideal world, you would clearly want to do the transition much more slowly, and you wouldn't ask austerity to come so fast. In terms of economics, it's not optimal to try to balance the budget too fast, but the constraints that are important in the crisis have nothing to do with optimal policy: you want to back load the adjustments so that you don't kill growth. But the idea that [these southern eurozone states] could commit today to reform to implement in ten years--that's just not credible. [It] is only here and now, because of the crisis, [and] because of the pressure, [that] some of these countries are willing to accept reforms [austerity measures]. It's not optimal for Greece or Spain to do so much right now. But the Germans think that it is only now that they have the upper hand to ask for these reforms. It's now or never.

How is the political situation in the eurozone--with French President Nicolas Sarkozy facing a tight presidential race that is seen, in part, as a rejection of his austerity policies--affecting the discourse over austerity versus growth?

Nobody--in particular, not [French Socialist presidential candidate] Francois Hollande--is asking to renegotiate any of the fiscal compact, all the measures that say you have to balance your budget. There's no doubt in my mind that that is going to happen in France. What [Hollande] wants is to essentially add something which says, "OK, fine, but in the short- and medium-run, we still need to grow, because if we don't grow, we won't be able to do any of this." Many people in Europe are pretty happy to see Hollande win the election--even in Germany. A hugely important fact is that [European Central Bank President Mario] Draghi said the same thing. Draghi essentially used the same words as Hollande that we don't need to change the things we agreed on; we need to add growth to the agenda.

What [the ECB has] in mind is that to boost growth in Europe, you need to have more flexible labor markets, especially in the southern countries. What's the key common feature of Spain, France, and Italy? Unemployment. Spain has a completely dysfunctional labor market. Italy has a completely dysfunctional service sector. The service sector is not competitive, is not open, so they need to deregulate that. And Spain needs to reform its labor market. And France needs to do both.

If the ECB approach to growth is labor market reform, what would Hollande's approach be if he were to win the French presidency?

[Hollande] would definitely like more quantitative easing. He looks at the United States and the UK, and there's clearly more quantitative easing going on there and that's clearly helping those governments to implement some of their [austerity] programs.

It's not optimal for Greece or Spain to do so much right now. But the Germans think that it is only now that they have the upper hand to ask for these reforms. It's now or never.

Now, it's obviously going to be a bargaining game. What is everybody willing to accept or give up? Germany--they can accept a little bit more inflation, and they can accept a bit more stabilization of sovereign debt -- in other words, some type of euro bonds. If they agree to start that discussion, they are going to ask for stuff in exchange, and this is going to be labor market reform [from Hollande].

Draghi called for a so-called growth compact, but what does that actually entail policy-wise?

Take Italy. The whole service sector of Italy is heavily regulated, totally not competitive, with huge barriers to entry. The barriers to entry protect the incumbents, who don't want to hear about reforms. If you want to do it [reform], you have to pick a fight with all the protected lobbies--be it from taxi drivers to retail trade to legal services. [Italian Prime Minister Mario] Monti is completely aware of that. It's insane to imagine that they are going to try to do these things under pressure, without anything in exchange to help in the short term--be it through more quantitative easing by the ECB, a bit more inflation in the north of Europe, also perhaps some kind of euro bonds.

Can these growth policies and austerity policies be implemented in tandem?

Some of them are complementary. If you deregulate services in Europe then you can have competition coming from other European countries--and the same thing for labor market reforms. But what's not good to do in tandem is everybody raising their taxes and cutting their spending at the same time.

The center of the sovereign debt crisis seems to have shifted from Greece toward Spain. What is the situation in Spain, and might the country require a bailout?

The market is looking at Spain and trying to figure out whether Spain is going to be like Ireland. The Spanish government was fiscally responsible; the Spanish [local banks] were not. That's very similar to Ireland. Ireland was the same story, where the public debt was quite low, and they were running a balanced budget. But the private debt is very high, and everybody thinks that the debt of the Spanish local banks at some point is going to end up on the balance sheet of the government--which is exactly again what happened in Ireland. And we know that Ireland, because of that, needed a bailout.

The market is looking at Spain and trying to figure out whether Spain is going to be like Ireland. The Spanish government was fiscally responsible; the Spanish [local banks] were not.

The news is on the macro side, which is that the Spanish economy is shrinking and Spanish unemployment is rising. In that situation, the government won't be able to have enough money to meet all the targets, which is to balance its budget, reduce its current account deficit, and also protect or bail out its banks. But Spain is like a poster child for this adjustment. There's no question that Spain could successfully adjust, if the reforms are done correctly. There's no reason that Spain should go the way Greece went. But if there's high deflation and GDP starts to shrink, then that's going to be a bit harder.

The center-right Dutch government collapsed late last month because of its inability to agree on the austerity measures. How do you read that situation and its implications for the eurozone-wide debate over austerity?

That's the one I think is the most important new element. It's very clear that Germany, in any scenario you can imagine for the eurozone, needs the full support of the Netherlands. So the fact that even in the Netherlands, there was enough backlash that the government collapsed because of austerity measures, this means that we've hit the wall, that we cannot go further [with the German-engineered austerity push]. Immediately after that, [German Chancellor Angela] Merkel started talking about growth, as well. That is a very important signal.

If you start losing the support of countries like the Netherlands, then you know you've gone too far already. We are clearly going to see a change in emphasis--from austerity to growth. Also because we have agreed on much of the austerity, in a sense, and now we just need to implement it and pass the laws. There's no question that we are going to see a shift in emphasis. But what are they going to agree on? We are going to have to find policies that are acceptable in all of these countries. Right now, they agree that we need some growth--even Germany--but they are not yet at the point where they agree on the specific measures. So that's going to be the next bargaining.

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