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The writer is a professor at Columbia University and a Nobel laureate in economics. He will be speaking at the Fiscal Matters online conference, September 27-30
Ahead of Sunday’s German federal election the opinion polls suggest that Olaf Scholz, leader of the centre-left SPD and current finance minister, will succeed Angela Merkel as chancellor. But many questions remain about the shape of the coalition that Scholz would lead and the direction Germany, and by extension Europe, will take in the post-Merkel era.
In responding to the coronavirus emergency, European countries have abandoned the EU’s fiscal rules governing deficits and debt-to-gross domestic product ratio, borrowing and spending to keep their economies afloat. There will and should be a debate about how well those borrowed funds are spent. But few would argue that spending was the wrong course of action.
Germany has long been perceived to be the most enthusiastic proponent of hard and fast rules on borrowing, even if it has not always been the strictest adherent. In 2004, for example, Germany’s fiscal deficit was running at 3.7 per cent of GDP, significantly over the 3 per cent stipulated by the post-Maastricht rules.
Now, as Europeans hope for some return to “normal” by the end of 2021, the question is whether the principles governing spending and borrowing should revert to pre-pandemic norms.
With the Next Generation EU recovery programme, Europe has already signalled its willingness to go well beyond the rules. Italy, whose economy was severely damaged by the pandemic, will look to invest €235bn in the coming years as part of its national recovery plan. After two decades in which its economy slowly contracted following the adoption of the euro, this presents a huge opportunity for expansion. The data to date suggest the well-designed programme will work.
All EU countries will benefit from Next Generation grants and loans, but member states across the south and east of the bloc will be particularly keen to see this spending as a precedent rather than an exception.
Naturally, with the huge increase in the debt-to-GDP ratio, many worry whether an economic programme based on breaking away from the old rules is sustainable. The short answer is an unambiguous yes. There are two ways to restore the debt-to-GDP ratio to a more reasonable level: reduce the numerator through austerity or increase the denominator through investments. A decade ago, the EU went down the former route during the eurozone crisis and it proved an enormous failure. The US took the latter route after the second world war and it proved a great success. Given the crises Europe faces today, austerity would be doubly calamitous.
Some ask if all this spending will lead to spiking inflation, but the big lesson of the past 30 years is that fears of excessive spending in one country giving rise to inflationary pressures across the eurozone were greatly exaggerated. Not even Germany’s massive deficits had that effect. Indeed, for much of the time the worry in Europe has been deflation, so much so that the concern has been that the European Central Bank may lose credibility from inflation being so much lower than its target of 2 per cent.
Even without the pandemic, hard rules on debt ratios, inflation and so on were not achieving the “stability and growth” as promised. Some of the countries that suffered most in the 2008 crash — Ireland and Spain, for example — were obsessively rigid in following the rules. But when the crisis hit the rules didn’t protect them.
The pandemic has showed that instead of worrying over arbitrary ratios, societies would have been wiser to invest more in health and strengthening supply chains to make the economy more resilient.
The EU would be taking an enormous risk were it to return to the old discredited rules. To bring the debt-to-GDP ratio back to 60 per cent quickly when some countries are at twice that ratio would again punish with higher taxation and lower welfare a generation that has been on the rack since 2008. Social cohesion, which is a vital part of any recovery plan, would be sacrificed on the altar of a number that has little justification. To rebalance the system toward the young and low-wage earners will take sustained investment. With populists ready to feed on discontent, the dangers for the European project are obvious.
Now is the chance to chart a better course for Europe. The old rules will not keep afloat a vessel navigating choppy waters. What is needed is a new, more flexible and more thoughtful approach to macroeconomic and fiscal management.
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