How the Euro zone can solve its challenges and preserve integrity


The Eurozone’s sovereign debt crisis continues to threaten its integrity and thus far a solution that addresses the main challenge of fiscal sustainability while preserving the integrity (and advantages) of the monetary union continues to elude policy makers.

The avenues explored so far are showing their limitations. In the periphery social and political tensions continue to escalate as vested social interests resist the assault on their privileges while at the centre politicians are faced with increasing resistance from public opinion to continued financial support to the distressed economies of Greece, Ireland and Portugal. When the financial support packages already agreed amount to 50% of the combined beneficiaries GDP this is perfectly understandable.

There can be no doubt that any solution must primarily involve the acceptance by Greece, Ireland and Portugal of the inevitable sacrifices involved in repairing the massive imbalances which are theirs. The centre must also understand that its financial contribution to supporting fiscal consolidation in the periphery is in its own best interests.

Sovereign debt crisis are not new. Recent successful examples of fiscal consolidation (Canada, Sweden, Norway) in the early nineties have benefited from a favourable economic environment where export markets took up a significant part of the slack in domestic demand. What is new, and baffles policy makers, is the strategy to be adopted in order to pursue fiscal consolidation in a context of a monetary union (excluding a devaluation of the currency and an independent monetary policy). Moreover, interest rates can’t provide accommodation when the starting point has already been one of record low levels.

Greece, which has failed to meet its targets in the first year of fiscal consolidation, has experienced 10 general strikes over the last year, and further austerity will likely induce additional social stress creating substantial hurdles for elected politicians.

Can massive fiscal consolidation to restore debt sustainability be achieved in the Eurozone? The answer is possibly yes, on two conditions:

Regaining lost competitiveness

In the absence of the option of currency devaluation, lost competitiveness needs to be recaptured by lowering domestic costs. Short of lowering wages this needs to be achieved by substantial measures that boost productivity and curtail collateral costs. This is essentially achieved through important reforms that remove institutional and bureaucratic impediments that regulate company formation, wage negotiation, competition and distribution networks. Collateral costs need to be reduced by a major improvement in public sector productivity that will allow the state to perform its necessary tasks with greater efficiency and a lesser social cost. Public sector workers must be submitted to the conditions that prevail in the private sector and measures taken to dismiss unaffordable and pervasive privileges such as lesser working hours, and low pension and health personal contributions. A reduction in excessive headcount on payrolls is also critical. A simple policy of natural “wastage” (by not replacing those that leave on retirement) reduces payrolls by approximately 3% a year.

A better tuned fiscal policy.

Structural reform to regain lost competitiveness needs time however and restoring a sustainable fiscal balance is an urgent task. What is more, fiscal policy retrenchment tends to depress domestic demand with consumer spending and investment declining and contributing to a fall in employment and disposable incomes. Fiscally induced recessions are a major threat to the achievement of fiscal consolidation and exacerbate acute stress upon the fabric of society.
The European strategy of fiscal consolidation needs a better tuned fiscal policy. Private consumption needs to be preserved from excessive retreat and investment must be stimulated through simple and starkly effective measures. The immediate enacting of more generous depreciation of investment would have a powerful positive impact upon capital spending and therefore employment. Allowing companies to immediately depreciate 50% or 100% of investments done in fiscal 2011 and 2012 (and possibly 2013) would generate a surge in investment and corporate spending that would powerfully sustain domestic demand and employment at the most critical time of fiscal consolidation. Moreover the cost of such a measure in terms of foregone tax receipts would be compensated by the avoided costs of higher unemployment with the eventual balance easily covered by loans from the Eurozone.

A more supportive private employment situation sustained by the stimulus upon investment would preserve consumer spending from the worst contraction. In additional a temporarily reduced rate of VAT upon consumer essentials might, at a modest cost for the budget, also help to allay losses in purchasing power and reduce unfettered socially distressed situations.

If the inevitable contractionary impact of fiscal consolidation can be at least partly offset by such measures, the probability of success of the adjustment policies is greatly improved.

Eurozone support for the adjustment policies of the stricken periphery should allow, indeed encourage, these and similar initiatives that, at a reduced and quite manageable cost, permit the implementation of a sustainable effort towards a regaining fiscal equilibrium and reduced debt levels.

Failure to support private investment and its beneficial impact on employment, in order to reduce the contraction domestic demand in the critical years of fiscal consolidation, can place the whole strategy in jeopardy and threaten the ultimate integrity of the Eurozone.

A. Ferreira
May 20th 2011