A Bridge to Nowhere

The task of officials at last week’s EU summit in Brussels can be likened to building a bridge. The fiscal and structural adjustments required of Europe’s heavily indebted economies will take time to complete. Time will be needed in Italy to get parliamentary agreement on new taxes and even more time to begin collecting them. Rooting out tax evasion and privatizing public enterprise in Greece will take time. Whether pro-growth reforms actually succeed in producing growth similarly will take time to tell.

The problem is that the indebted and struggling European-periphery governments will not be able to fund their operations without official support in the meantime. With the outcome of the policy process uncertain, investors prefer to wait before buying bonds. They want to see not just good intentions but also good results.

So the crisis countries need help to get from here to there. They need the European Central Bank (ECB), the European Financial Stability Facility, the European Stability Mechanism, and IMF, in some combination, to step up and finance their governments while the requisite reforms are put in place.

The subtext of last week’s negotiations concerned the terms on which this official support will be provided. The implicit question was whether the European Commission, the ECB, or the IMF would negotiate the conditions attached to the loans. The focus on legal reforms designed to strengthen fiscal discipline by giving the European Commission and the European Court of Justice roles in overseeing the fiscal conduct of member states was designed to make official creditors more comfortable about opening their pocketbooks.

Many details remain to be worked out, to make an understatement. But the outlines of the bridge can now be discerned. There will be strengthened fiscal rules and enforcement, whether through national legislation as a balanced-budget law or protocols to existing agreements. Consolidation and structural reform will proceed. And with governments doing their part, the ECB and its partners will provide the bridge finance needed to fund governments in the meantime.

But the danger is that the European Union and the international community are building a bridge to nowhere. Fiscal consolidation is needed, no doubt. Structural reform is well and good. Emergency financing is necessary to buy time. But none of this actually ensures the resumption of economic growth. And without growth there is no way that the eurozone crisis countries can make it to the other side.

It’s a vicious cycle: Without growth, fiscal progress will be slower than promised. If economies stagnate, revenues will inevitably stagnate. Without growth, public support for policies of austerity will dissipate. And if pro-reform governments fall, there is no knowing what kind of governments will come next.

In addition to growing, Europe will have to rebalance internally. While the current account of the eurozone as a whole is roughly balanced, the Southern European countries are running chronic current account deficits with their northern neighbors. In some cases, like Portugal, it was the private sector that consumed more than it produced and became heavily indebted; in others, like Greece, it was mainly the public sector. Either way, now that debts have grown to unsustainable levels, rebalancing must take place. This will require not just slower growth of demand and spending in Southern Europe but concomitantly faster growth of demand and spending in Northern Europe. If Southern Europe is now to produce more than it consumes, then someone else has to do the opposite.

The solution is straightforward in principle. First, fiscal stimulus in Northern Europe. German politicians may be loath to transfer resources to spendthrift southerners, but why not transfer them to their own households through tax cuts? More household spending in Northern Europe is essential if there is to be intra-European rebalancing. Second, rates of fixed investment in Germany are strikingly low. A targeted investment tax credit would address this internal economic weakness while stimulating the demand for traded goods. Germany’s demographics point to the need for fiscal consolidation at some point, but not now when demand across Europe is collapsing.

Stronger demand from the rest of the world can also help Southern Europe rebalance. A weaker euro that prices European goods into international markets would make it easier for the crisis countries to export their way out of their bind. Although the ECB’s recent rate cuts are a step in the right direction, additional rate cuts and U.S.-style quantitative easing that push the euro down on the foreign exchange market will be essential if Europe is to grow.

The financial bridge tentatively agreed to last week buys time to put in place a lasting solution. But a bridge makes sense only if there is something on the other side.