There is no contradiction in austerity and stimulating growth

There is a fierce battle in the Eurozone between the weak countries in need of financial support without to much conditions and the strong countries, which want austerity and reform measures in return for their financial support. The German plan is to work towards a fiscal union that is based on German principles of budget discipline and a strong work ethic. However, the weak countries and many economists argue budget discipline under current circumstances aggravates the economic slump in the weak countries and will therefore yield an even deeper recession, instead of growth. Is this true? (This is an extract of our Global Financial Markets report, in which we also explain why this is an important topic, for the financial markets as well as for European growth prospects.)

 

A fiscal union means that all countries will have to relinquish a large part of their sovereignty because, for example, the participating countries’ budgets will largely be determined by the European authorities. They will also largely have to act as guarantor for each other’s debts. This entails several drawbacks:

 

1. Expenditures running via the government are less efficient than those running via the private sector (government expenditure is preceded by a political decision debate, so compromises always have to be found between varying opinions). The further the government’s proportion is increased, the more this is to the detriment of the private sector, while that is the sector where tax revenues have to come from to cover government expenditure. While governments often have assumed tasks that cannot be fulfilled by the private sector (such as defense, police, road building and justice, although there are many more issues the government might be involved in), the role of many euro area governments have gone far beyond this.

 

2. Government expenditures often rise faster than tax revenues. That creates a deficit in public finances, which has to be borrowed on the capital market. If that rises too far, then in time the government is no longer able to fulfill its commitments. Moreover, each euro the government borrows is one euro less available for the private sector to borrow. That inhibits developments in the private sector.

 

3. At least as important is what the government spends its money on: Supporting consumption or investment. In the former case, the effect rapidly wears off, but in the latter case something is created that can be expected to generate income in the future. The difference is day and night, especially if the expenditure has to be financed with loans.

 

4. This last point is closely linked to the business climate. If the private sector is overtaxed and restricting regulations are imposed then the dynamism disappears from the private sector, so no new products are invented and marketed, for instance, and too few new companies are established that can take on personnel.

 

Naturally, these are all issues where opinions can differ greatly, but for Chancellor Merkel things are quite clear. In her view, in most euro countries the government’s role grown too great and the private sector is far too restricted in its development. Citizens have therefore become too reliant on the government in recent decades. Normally, that would have seriously suppressed growth, but for a long time that was avoided by continually increasing debts. That process has now ground to a halt. To get things moving again, therefore, the government’s role has to be substantially reduced and measures have to be taken to allow the private sector to flourish again. That can be achieved by reducing taxes and regulations and by liberalizing the labor and goods markets, for instance.

This is why, according to the German government, there is no contradiction to argue against reducing budget deficits and stimulating growth.