The European economy rather than the euro is now on life support – and with it the authority of the established political order

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May 30, 2013 6:41 pm

By Philip Stephens

ut a bunch of European leaders in a room and it is fair bet that the conversation turns to the rise of populist politics across the continent. A year or so ago, the same politicians would have been obsessed with the markets’ threat to the euro. Now they worry about whether European democracy can survive the shock of saving the single currency.

The age of austerity is passing. The other day the Paris-based OECD hosted a debate called

“Austerity versus Growth”. This is a false choice – austerity is a policy, growth an objective.

But I was struck, anyway, by the overwhelming hostility of the assembled experts and policy makers to any idea that Europe should hold fast to deflationary fiscal policies; Europeans should instead consider how accelerating growth (albeit with some spending cuts) has transformed the US budgetary outlook.

So this week’s decision by the European Commission to loosen the reins of fiscal retrenchment was a welcome recognition of both economic and political realities. The European economy rather than the euro is now on life support – and with it the authority of the established political order.

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The about-turn was not quite as dramatic as the headlines. France and Spain were among those given extra time to meet their deficit-reduction programmes. Italy escaped the “special

measures” applied to its budgetary process. Belgium avoided a fine for being blown off course.

What has happened is that nominal fiscal targets have been replaced by a focus on structural deficits. No one is advocating a big discretionary stimulus.

Austerity had to wind down some time. Deficits in the peripheral economies worst hit by the euro crisis have come down sharply. So have bond market spreads. Some of these countries are now heading into structural surplus. Most will make primary balance by 2014. Those hit

hardest by soaring spreads have seen sharp improvements in their current account deficits.

In part this reflects the collapse of domestic demand, particularly in Italy. But in most cases exports have also been rising sharply. Ireland’s current account is in hefty surplus; Spain and Portugal expect to be in balance this year.

These countries are no longer dependent on foreign bond investors. Their fiscal deficits can be financed domestically. This has prompted Daniel Gros of the Centre for European Policy Studies to come up with an intriguing theory. In the terms in which it had been framed, the fiscal austerity debate had missed the point. The real crisis, Dr Gros says, had been as much about “foreign” as “sovereign” debt.

Belgium, with a debt-to-national income ratio of about 100 per cent, was never really in the markets’ sights. The recent fall in spreads elsewhere reflects the fact the southern peripheral states can, like Belgium, fund their own deficits.

In any event, the turnround in current account positions will make Germany a little (I

underline “little”) more relaxed about the commission’s change of tack. There will always be some in Berlin horrified by attempts to throw off the fiscal sackcloth, but those close to Chancellor Angela Merkel have long focused on competitiveness as much as budget deficits.

Germany’s ambition in all this has been to achieve sustainable convergence in the eurozone.

Current accounts have moved significantly in the right direction.

A less draconian fiscal squeeze provides an opportunity to step up the pace of structural reforms. These work best in promoting investment and jobs when there is a decent prospect that economies will grow. Opening opportunities to a generation of young people locked out of jobs is the priority.

The other day I was in Rome interviewing Enrico Letta, Italy’s new prime minister, at a gathering hosted by Aspen Institute Italia, a think-tank. The social democrat Mr Letta knows better than most the dangers of populism. His government, a grand coalition of left and right, emerged from the deadlock created by the rise of Beppe Grillo’s Five Star Movement. Like populists across the continent, Mr Grillo appealed to the dispossessed.

My sense is that Mr Letta, who may survive longer in his post than speculation suggests, is not about to roll back the frontiers of fiscal prudence or abandon efforts to modernise the Italian

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economy. But he is right to say no prime minister can ignore the disaffection of 8m voters; and to warn that the biggest winners in next year’s European elections could turn out to be

anti-Europeans of left and right.

Italy has Mr Grillo; France has its National Front; Britain its UK Independence party; Finland its True Finns; and Greece its fascists. What unites them is a readiness to blame foreigners for national ills and a capacity to turn youth unemployment into rage against the political

establishments.

There are things governments can do. Europe still has a dysfunctional banking system. Fixing it would generate growth. The European Central Bank can do more to stimulate domestic

demand. Supply-side reforms would dismantle some of the barriers keeping young people out of employment markets.

It is encouraging that the political discourse has shifted from austerity to growth; and that when Germany hosts a special ministerial summit in July the subject will be youth unemployment rather than austerity.

Time, though, is running out. The eurozone is in a race between economics and politics. A year ago the bond markets were the enemy; now the threat to the euro comes from populists seeking to overturn the liberal order upon which all European integration depends.

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