Making Austerity less destructive: Don’t count on the German Left

While everyone looks for signals from the French president François Hollande and from the German chancellor Angela Merkel about how a compromise on the fiscal compact might look like, another important negotiation on the future of Europe is largely ignored: The negotiation between Ms Merkel and the German opposition on the fiscal compact.

Little known outside Germany, Ms Merkel will need the votes of the German opposition to ratify the fiscal compact. As the provisions are “a substantial transfer of sovereignty” to the European level, according to the German constitution, Ms Merkel needs a two-third majority in both the Bundestag and the Bundesrat (the chamber which represents the Länder). This brings not only the Social Democrats into play, but also the Green party (which shares power in many Länder with the Social Democrats and is thus needed as Länder governments) the party DIE LINKE will most likely not vote in favor of the fiscal compact.

However, as negotiations have started in earnest this week, any hopes that the German opposition will make a real difference for Europe are set to be disappointed very soon.

Struggling not to appear as fiscally unsound, the opposition’s demands do not touch the core of the fiscal compact. Instead, the opposition has brought forward the following five rather modest demands (well, the last one is not quite as modest):

  • Increase the capital of the European Investment bank by €10bn in the hope to increase financing of the EIB by €100bn
  • Use unspent EU structural funds more effectively
  • Introduce European project bonds
  • Introduce a financial transaction tax
  • Push for a debt redemption fund along the line of the proposal of the German council of economic advisors 

While none of these elements is wrong in principle (and some of them have already been agreed to by the Merkel government), neither any single one of it nor the combination of all will contribute much towards economic recovery in the euro-area. The underlying problem of the current policy mix in Europe is excessive austerity (which I have analysed here) and that thus the euro-area is trapped in a recession which only makes the debt burden worse. And while the above proposals might look nice on paper, they will not change this situation in any recognizable way. Or to be more blunt: They will not produce any measurable positive impact on growth.

Let me go through the five above elements one by one:

EIB capital increase: It is not clear in how far the increase in the EIB’s capital will really lead to more investment. It cannot really solve the problem of cuts in public demand as any loans from the EIB to governments (be it national or local) is counted towards the country’s overall budget deficit. As all EU crisis countries have pledged a certain budget reduction, the higher EIB capital will not change the overall fiscal stance or overall amount of public investment.

It is also questionable whether the EIB capital increase can induce the private sector to invest more. In many of the crisis countries, the problem at the moment is that the situation of small and medium enterprises has deteriorated so much because of the recession that they just do not want to borrow and invest. Those who still want to borrow have seen their collateral reduced in value and often do not get loans from their banks. Moreover, given the uncertain economic situation, many banks are afraid to lend to companies which might default tomorrow. As the EIB usually only lends directly for volumes of above €50 million and relies for smaller loans on the national banking systems (and the banks’ credit analysis), I do not see how the increase in EIB capital will solve the problem of collapsing private investment.

A similar point applies for project bonds which are supposed to guarantee companies’ bond issuance for specific transport, energy and information technology infrastructure projects. Again, the underlying analysis here is that companies want to invest, but do not have access to funds. My reading of the situation is different: Companies in core euro countries such as Germany have funds or access to funds, but because of uncertainty and contracting economic activity in the periphery, this does not translate into actual investments. Or do you think that any manager in his right mind at an international telecommunications company would now invest in the upgrading of the Greek internet infrastructure just because he gets funds a few basis points cheaper?

Structural funds: The EU commission has floated the figure that unspent structural funds for the budget until 2013 amount to about €80 billion. While this sounds like a lot of money, according to budget experts in Brussels, there are a lot of technical problems related to accessing these funds. For example, it is not clear how much the EU could actually pay out on short notice given that the actual payments must be made out of the annual budget, not out of the multi-year financial framework and these funds are just not readily available now.

In addition, one must not forget that even if €80 billion could be activated, it is money for the EU, not for the euro-area alone and it will definitely not be spent on the euro countries alone. Relative to the EU’s GDP, this amounts to a mere 0.6 percent of GDP. Spending half of it in 2012 and half in 2013 would at most give a growth impact of 0.3 percent of GDP. However, this is probably a grossly overoptimistic estimate as there is a side-effect of recycling unspent structural funds: Normally, unspent structural funds go back to the EU budget and thus lower the deficit of the member states. Hence, if structural funds are spent as they are supposed to, this takes the money out of the member states’ pockets through the back door and might force them to new austerity elsewhere. Given that finance ministers have committed to specific deficit targets, it is not unlikely that the net growth effect of the reallocation of structural funds is zero.

And while a financial transaction tax is a nice demand, I do not see any way that it could either come quickly or could be used to boost short-term growth.

Finally, the debt redemption fund does not solve the problems of Spain, which is now the most critical for the future of the euro-area. It proposes to take over the debt of each country which is above the limit of 60 percent of GDP and put it into a special purpose vehicle through which it is paid back over time while the countries earmark specific tax revenue for servicing this debt. However, the problem making investors nervous in the case of Spain is not past debt, but the future debt to be incurred by the need to stabilize the banking sector. Actually, the current debt level even is not much above 60 percent of GDP. Hence the debt redemption fund would not help Spain much. There might have been a time when a debt redemption fund would have been sufficient to solve the debt crisis, but this point has long passed.

The attempts of the German left to ease the pain of austerity thus will prove futile. There is no way around the simple truth that you cannot get around the negative side effects of austerity without at least taken the insane elements out of the current consolidation plans. As I have written before it would be crucial to give crisis countries more time to consolidate their budget, relax fiscal rules as to allow for more public infrastructure investment and solve the financing problems in the periphery.

Given the precarious state of the European economy, the proposals debated now in Germany are the equivalent of treating acute pneumonia, high fever and respiratory distress with a cup of hot lemon. One might argue that the cup of hot lemon might at least make the patient feel slightly better. However, negotiating about placebos wastes precious time. As any doctor pretending that hot lemon cures pneumonia and not insisting on administering an antibiotic has to be held responsible if the patient dies, with its vote in favor of a fundamentally uncorrected fiscal compact, the German left assumes part of the responsibility for the coming period of economic stagnation and recession in the euro-area.

This column was first published by the European Council on Foreign Relations (ECFR)

  • http://www.facebook.com/Fiskalpakt Sozialdemokraten gegen den Fiskalpakt

    Very sound text, Mr. Dullien. It seems to me that the Social Democratic Party of Germany is not listening at all to economists that are traditionnally close to the party. It’s a shame.

    http://www.facebook.com/Fiskalpakt