Hugo Dixon

Semantics could help save the euro zone. There is a crying need to distinguish between fiscal austerity and structural reform.  The endless austerity programs adopted by the GIIPS — Greece, Ireland, Italy, Portugal and Spain — threaten to crush their economies so much that they are socially unbearable. By contrast, reforming pensions, labor markets and the like would be good for long-term growth. A policy mix that emphasizes the latter and draws some sort of line under the former is needed to stop the euro crisis spinning out of control.

Europeans have become grimly familiar with austerity spirals over the past two years. A government that needs to cut its fiscal deficit embarks on a program of tax hikes and spending cuts. The snag is that this fiscal squeeze, in turn, squeezes the economy — partly via the direct impact of cash being sucked out of the private sector and partly because the private sector loses confidence. The depressed economy means the government’s tax take doesn’t rise nearly as much as envisaged. So the deficit doesn’t decline much and, as a percentage of shrunken GDP, it falls even less. The governments’ creditors, led by Germany, then demand another round of austerity to get the program back on track. With each round, the howls of pain from the population increase, belief that there is light at the end of the tunnel declines and the government’s political capital shrinks.

The Greeks, Irish and Portuguese have been trying to run up this down escalator the longest. Italy and Spain are now embarking on the same regime. Yet more doses will be required over the coming year if the policy mix is unchanged. After all, last year’s budget deficits are expected to be about 10 percent for Greece and Ireland, 7-8 percent for Spain and Portugal (if a one-off pension transfer is ignored) and 4 percent for Italy.

Some austerity was needed given that expenditure had run out of control in the boom times and that, in some cases, there was a deliberate fiscal boost in the aftermath of Lehman Brothers’ bankruptcy in 2008. In Greece’s case, there was also a failure to implement the programs properly, meaning time and credibility were lost. But endless rounds of austerity are debilitating. The better approach would be to have one chunky program that is properly implemented and then rebuild.

Of course, the creditors aren’t willing to give something for nothing. But this is where a semantic distinction between austerity and structural reform could be helpful. Both require political courage by a government and sacrifices by its people. But the former pushes an economy down, while the latter boosts it — albeit in the long term. A virtuous cycle is even possible with the economy reviving, tax income rising, the deficit falling and confidence returning.

Pushing up retirement ages is a case in point. This doesn’t just reduce government spending, especially in the long run as savings build up year after year;  it also increases the productive potential of an economy by expanding its work force. Or take labor reform. Making it easier to hire and fire people puts downward pressure on wages, improving an economy’s competitiveness and reducing unemployment — which, in turn, cuts government spending on social security.

Other desperately needed reforms — privatization, liberalization of product markets, and increasing the efficiency of the public sector and the judiciary — would also improve long-term growth. Privatization would have the added benefit of cutting government debts, as would crackdowns on tax evasion.

The GIIPS have all done something in the field of structural reform. Italy, Spain and Greece, for example, are pushing up retirement ages. But the reforms have been slow in coming and sometimes half-hearted. Greece is the worst example: little has happened on tax evasion or privatization. Meanwhile, the new governments in Rome and Madrid have yet to get to grips with labor reform, although they are indicating that they will do so soon.

If the GIIPS could convince their creditors that they were serious about such reforms, they would win brownie points. That would put them in a better position to avoid yet more rounds of austerity. After all, Germany’s Angela Merkel would still be able to argue to her people that the peripheral economies were serious about change. What’s more, the economies of Germany and other creditor nations would benefit. Austerity in their neighborhood combined with the threat that the whole euro zone could blow up is not good for business. But to start the process, policymakers and pundits need to stop talking about austerity and reform as if they are the same.

PHOTO: A one euro coin is held in an adjustable spanner in this picture illustration taken in Ljubljana, January 4, 2012. REUTERS/Srdjan Zivulovic

The euro zone will probably get another short-term fix at its summit this week. Exactly how the fix will work isn’t clear. But both Germany and the European Central Bank have softened their positions so much that some sort of solution is in the works. The ECB will probably cut interest rates and spray more liquidity at the troubled banking system; it may also step up its purchases of government bonds; and some scheme for assembling enough money to bail out Italy and Spain — probably by getting national central banks to lend money to the International Monetary Fund, which could then pass it on to Rome and Madrid – may be unveiled.

All this would be cause for celebration. The problem is the price that Germany and seemingly the ECB are demanding for their help: fiscal discipline, embedded in a treaty. Merkel wants the European Commission in Brussels to have the power to overturn irresponsible national budgets and for the European Court of Justice to fine governments that step out of line.

This idea for a treaty is stirring up all sorts of problems. One is that Britain, which is not part of the euro zone but is a member of the European Union, wants a quid pro quo for signing a revised treaty – probably in the form of returning powers over social and judicial affairs to London or getting some veto over the regulation of financial services, the UK’s largest industry.

An even bigger problem is the objection of many people in the euro zone to Disziplin being imposed by Berlin. Even France’s Nicholas Sarkozy, who is backing Merkel’s plan, has had to swallow hard before embracing a policy which would involve a loss of sovereignty, and is still wrangling over the details. The opposition socialists, which look likely to defeat Sarkozy in May’s presidential elections, have been quick to dub the plan an “austerity treaty.”

Handing powers to Brussels at Germany’s insistence isn’t popular with France’s right-wing parties either. In fact, it is likely to be pretty unpopular right across the euro zone. Even the president of the European Parliament, a body which normally supports anything that increases the European Union’s power, has said treaty change could be “dangerous” because citizens were unlikely to warm to the idea.

This is not to say that Europe’s governments won’t sign up to the German plan. Fear over what would happen if the euro collapsed is now so high that they will probably fall into line if this is what is needed to unleash the ECB. But a marriage based on fear is not the most attractive or most sustainable one. It will breed resentment. This could be expressed in the growing popularity of right-wing nationalist parties. There is even a chance that the proposed treaty changes, which will require unanimity, would be voted down by at least one parliament or torpedoed in at least one national referendum.

Merkel says she wants “more Europe.” But she is offering a lot less than the fiscal union that many pundits outside Germany are clamoring for. They want the euro zone’s governments to guarantee each others’ debt, by issuing euro bonds. A fully functional fiscal union would also have a large central budget that would transfer resources from booming regions to struggling ones. Germany’s chancellor is against these ideas for the simple reason that her people are not remotely ready to bail out other parts of Europe on a permanent basis. Nor, for that matter, are the Dutch, the Finns and some other nations.

Merkel’s idea of discipline is not in itself a bad idea, mind you. Governments ought to run their finances responsibly. The problem is that she is trying to achieve this through rules.  An alternative would be to impose discipline through the market. If bond investors knew that profligate states might have to restructure their debts in future, they might rein governments in before their debts got out of hand in the first place.

It might be objected that the markets did a terrible job holding governments to account during the bubble years. This is true. But that’s partly because governments gave investors artificial incentives to buy their bonds. There’s now a golden opportunity to set a new baseline for market discipline by making clear that investors will have to share the pain if a euro zone country racks up excessive debts. To be fair, Germany has been pushing this idea, but France wants it abandoned. Even if Berlin gets its way on this, it won’t be giving ground on the need for rules.

The discipline of the bond markets may not be an appealing slogan. But it is less unpalatable than the discipline of remote bureaucrats dictated to by Berlin. Europe’s citizens can probably understand that, if you borrow too much money, you have to dance to your creditors’ tune. Unfortunately, this doesn’t seem to be the way the debate is going. The price for a short-term fix could be a long-term problem.

PHOTO: German Chancellor Angela Merkel makes a point during her speech at the German lower house of parliament Bundestag in Berlin December 2, 2011. REUTERS/Tobias Schwarz

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can’t they see that all that’s needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a Plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone’s fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven’t been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany’s Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won’t rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country’s debts below the promised level of 60 percent of GDP.

What’s more, there’s no guarantee that the current treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result — say by having new treaties signed by a smaller group of countries.

Given all this, pressing ahead with Plan A might suggest that the decision makers in Frankfurt and Berlin are indeed stupid. That would be true if they were sure it would work. But they don’t seem to be. Indeed, the German finance minister called for extra resources for the International Monetary Fund on Friday in seeming recognition that the EFSF on its own won’t be enough to bail out big euro zone countries. Nevertheless, the policymakers in Frankfurt and Berlin still think that everything in Plan A is still necessary or at least desirable, even if it proves insufficient to solve the crisis. It is, for example, really important to keep the pressure on the new Italian and Spanish governments so that they deliver on their potential.

What’s more, coming up with a Plan B is problematic given that the ECB is forbidden from directly funding governments. This doesn’t mean that there’s no way saving the euro if Plan A fails. There are, after all, various gimmicks that could be used to get round the prohibition on directly funding governments. One is for the ECB to lend to the EFSF, making its fire extinguisher fully functional. Another is for the central bank to lend to the IMF and let it then lend to Italy and Spain.

The problem is that either manoeuvre would be extremely controversial as well as possibly open to legal challenge. That’s not to say the ECB would never contemplate unusual measures if that was the only way of preventing the euro breaking apart. But it would seem that, even then, it would only do so if it had political cover.

Such cover is gradually coming. Following the scares of the past week, both Finland and the Netherlands — which, along with Germany, have been the strongest advocates of austerity — started to crack. The Finnish finance minister said that if there were no other alternatives, an increased role for the ECB had to be considered. Similarly, her Dutch counterpart said he’d prefer the EFSF to be strengthened but, if that didn’t work, other measures would have to be considered: “In a crisis, one should never exclude anything beforehand”.

Meanwhile, the ECB seems likely to offer some short-term palliatives. First, it is continuing with its programme of buying sovereign bonds in the secondary market as a way of preventing Italian and Spanish yields going through the roof — a programme that Berlin has studiously avoided criticising. Second, the central bank looks likely to offer longer-term money to banks as well as accepting more types of collateral in return for it — measures that should counteract to some extent a looming credit crunch.  Finally, it may cut interest rates again in December to reduce the deflationary potential of the coming recession.

Fingers crossed, such short-term palliatives will prevent an explosion until Germany implements Plan A and figures out that it isn’t working. But even in the best case, such an approach probably won’t be enough to prevent a nasty recession. Meanwhile, there’s the ever-present risk that a panic could trigger a chain reaction which even a Plan B would be unable to contain.