There is a heated debate in Brussels now about whether the European Commission should take a hard-line approach against Spain and other countries that will violate the three-percent deficit rule in 2012. And that debate, of course, is a microcosm of the larger debate about fiscal consolidation in Eurozone countries with wrecked public finances: will not new austerity packages to compress deficits only drive down economic activity and make it harder to balance the budget?
I think one has to separate between countries that really are in different positions in order to get a balanced policy. There are countries that most certainly have to use 2012 and 2013 to consolidate fiscal policy and lower deficits. If they do not, they will pay by higher bond yields. Among these countries are those that have had extraordinarily high deficits in the past years. Yet flexibility to violate debt rules should be allowed, but it should be conditioned: only those countries that clearly are undertaking public finance reforms that will have significant effects in the years to come (but not in 2012 and 2013) should be allowed departure.
But that is not enough. The important thing should be to allow flexibility to those countries that clearly undertakes structural economic reforms to boost productivity, competitiveness and growth. That is the key to fiscal consolidation – fiscal consolidation cannot be achieved without substantial economic growth above the Eurozone trend between 2001 and 2007. And part of such a reform agenda is that the government is on track with fiscal policy consolidation which will help to foster growth rather than the other way around.
This is where I have some doubts about Spain. Spain has certainly started to undertake economic growth reforms. In contrast to Italy and Greece, its unit labour cost has moderated in the past three quarters. But these reforms are insufficient. They alone are not going to turnaround the Spanish economy. Furthermore, Spain – and this applies also to the new government – has done a couple of austerity-related tax reforms which have increased taxes in a way that, in the first place, will make private-sector debt deleveraging harder (and prolong it), and, in the second place, put a damper on economic growth.
Tax reform is certainly needed parts of improved fiscal policy. But many of the tax increases that have been done will most likely slow down economic growth. This is certainly true for the slash-and-burn tax increases in Greece. But it is also true for Spain. Its increasing capital gains tax, for instance, will slow down much needed new investment in the Spanish economy. While a traditional Keynesian would say that non-utilization of investments in Spain is the problem and motivates efforts to increase aggregate consumption, the difficulty for Spain and other countries is that past investments were made in wrong areas. A low utilization ratio is not a temporary phenomenon but a permanent condition for a good part of these invested resources. For growth to emerge, new investments in post-bubble sectors will have to be made.
Spain is one of the countries that enjoyed the fastest rise of government spending in the pre-crisis years. Spending increased by levels similar to Ireland and Greece – much faster than for instance in Portugal or Italy. Many of the push factors behind that increase are yet not under control (e.g. pension system) and further reforms need to be done. Rather than a new austerity package to cut the deficit in 2012, Spain needs such structural reforms.