The Eurozone’s Strategy of Pain

Likewise, Eurobonds are officially off the agenda, at least for now. Rather, Europe is putting in place a new fiscal compact to ensure that all eurozone countries adopt and implement stringent budgetary rules.

These choices partly reflect pragmatic concerns: all of the financial-engineering schemes that have been proposed to protect Italy and Spain from aggravated borrowing conditions raise legal, political, or governance difficulties. But there is a principle at issue as well: it is thought (particularly in Germany) that protection from market pressure would only impede adjustment and reform.

Indeed, the perception in Northern Europe is that only serious strains provide the required incentives to overcome domestic political and social obstacles to slashing public spending and reforming labor markets. For Southern Europe, no pain means no gain: a deep recession and a sharp increase in unemployment may be the price of lasting improvements in productivity and competitiveness.

This reasoning is not without justification. Soon after the ECB began buying Italian bonds last August, then-Prime minister Silvio Berlusconi’s government backtracked on its commitments to tax reform. Even though it later reversed its stance, the episode was widely regarded as clear evidence of the moral-hazard effect of ECB support. Only after the bond market turned on Berlusconi again was he replaced by the reform-minded Mario Monti.

But the strategy is a high-risk gamble. Governments may need incentives to act, but they also need to be able to show their citizens that reform pays. If, after a few quarters of fiscal adjustment and painful reform, output is lower, unemployment higher, and the outlook darker, governments may soon lose public support and reform may stall, as we have seen in Greece. Reform-minded teams may lose power to populists.

Furthermore, a degraded macroeconomic and financial environment increases the likelihood of bank failures, with immediate consequences for public finances and economic confidence.

These risks are compounded by the need for reform in several countries at once. Indeed, there is a fallacy of composition in the current approach: the countries in need of serious adjustment and improved competitiveness include the whole of Southern Europe and France, and jointly account for more than one-half of eurozone GDP. True, competition for investment is an incentive to act. But macroeconomic and financial interdependence may render success elusive if reforming countries face an adverse regional environment of stagnating or falling demand.

It is one thing to believe that governments act only under pressure, and that societies accept reforms only if they believe that there is no other alternative; it is quite another to believe that adjustment and reform will proceed if all of Southern Europe is struggling with recession. Keeping Southern Europe on a short leash would be a more credible strategy if accompanied by a growth program for the entire eurozone. And, at this stage, such a program is nowhere in sight.

Jean Pisani-Ferry is Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.

Copyright: Project Syndicate, 2012.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:

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