“Does Europe need some ‘austerity austerity?’” observes J.P. Morgan Funds’ Market Strategist Andrew Goldberg. Goldberg’s question is economic but also political. The EU often seems focused on added austerity as the best route out of its continuing sovereign debt crisis, but this itself is a policy decision, and one increasingly contested in struggling peripheral countries.

How Europe can—and should—respond to its ongoing sovereign debt crisis, and whether further austerity helps or hurts remains an open question. The answer to this question and hence ultimate outcome of the crisis will affect the future of the euro, and even the EU itself. Planners closely tracking the European austerity debate have to pay attention to both ever-changing European treaties (and how they are actually implemented) as well as government balance sheets.

On the political front, the European summit meeting in Brussels in early March created a new fiscal compact limiting budget deficits. The treaty, pushed by austerity proponent Germany, would impose strict fiscal discipline demanding greater austerity in deficit countries.  Under the still unratified treaty, euro countries will face heavy fines if they don’t meet their deficit targets.

The limitations of the fiscal compact were apparent almost immediately. Spain announced it was going to break the rules: Its planned budget deficit for 2012 will be 5.8%, as opposed to the target of 4.4%. Spain could be fined but this would further worsen its fiscal situation, creating even larger deficits.

The obvious concern about the austerity is that it will only make a bad situation worse. The new EU austerity policies risk being pro-cyclical rather than anti-cyclical. Imposing a fiscal contraction in a time of a recession or even depression could damage already fragile economies and create more economic pain. Spain for instance, even without further austerity, is facing unemployment approaching 25%.

The European debt crisis is multi-dimensional, with calls for further austerity addressing merely one dimension. Instead, Europe is caught in a unique version of what economists call a negative feedback loop, linking together sovereign debt, banks and the real economy. A weakening in the economy creates a decline in government tax revenues, resulting in higher deficits. European banks are loaded up on sovereign debt because they have incentives to do so. The governments’ financial problems therefore show up on bank balance sheets, leading to a decrease in loans and further economic contraction and so on and on.  

In terms of staunching or even reversing this deteriorating loop, further austerity—or alternatively government expansionism—largely misses the point. Instead, economists argue for the need for substantial reform in the structure of Eurozone sovereign debt markets to break the negative feedback loop. The most obvious is the creation of a Eurobond, but so far this is a political non-starter.

European policy makers should keep in mind that their goal should be growth, rather than austerity for its own sake which seems to often be the case. As Andrew Goldberg states, “The best solution to a fiscal problem is, at least in part, to facilitate growth, not force retrenchment."

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