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Austerity wrong way to solve Europe’s problems

Austerity wrong way to solve Europe’s problems

US the winner in international economy stakes
Spain’s EMU future depends on core countries’ acceptance of higher inflation

by Trevor Greetham, Director of Asset Allocation, Fidelity Worldwide Investment, OMFIF Advisory Board

Mon 1 Oct 2012

Fiscal austerity is the wrong path to solve Europe’s debt problems – underlined by last week’s Spanish budget announcement.

Comparing Spain to the UK and US, the US has been the clear winner so far with its anti-austerity, loose money path. This path would be open to Spain only if stronger euro nations are willing to make substantial commitments to preserve the euro.

I’ve always opposed austerity as the solution to the global debt crisis, and the strictures of the common currency make it particularly ill-suited to the euro periphery. Efforts to deflate Spain into competitiveness raise the prospect of many years of wage cuts and property price falls that will necessitate ever larger fiscal transfers from the stronger countries, either directly or via pan-euro institutions like the European Central Bank.

Five years into the worst financial crisis in generations we are starting to see how effective various policies have been. Spain, the UK and the US offer three interesting test cases, each dealing with the after effects of a real estate bust in different ways:

  • Spain = austerity with tight money (austerity, no devaluation, no quantitative easing, market interest rates too high)
  • UK = austerity but with loose money (austerity, currency devaluation, quantitative easing)
  • US = no austerity with loose money (no austerity, stable currency, quantitative easing)

The chart of real GDP levels below suggests that the US is following the best policy path, at least on the metric of economic performance. Activity in both the UK and Spain remains well below its pre-crisis level – suggesting the benefits of the UK printing its own currency may not be as great as might be supposed. It appears to be the lack of austerity in the US that is the distinguishing aspect of a successful policy mix.

In my view the least painful approach to reducing the burden of private sector debt is a period of higher than usual inflation – one underpinned by rising wage levels rather than tax and energy price increases. An effective quantitative monetary policy plays a key role in raising inflation expectations. Back-end loaded fiscal reforms to reduce state spending are important but they can come into place once a sustainable recovery in growth is under way. The so-called ‘fiscal cliff’ is the first serious test of the US desire to maintain what I see as a winning policy. Most likely the political parties will see sense and spread tax rises and spending cuts over a period of years.

As for Spain, its future in the euro will rely on the willingness for partners to finance budget deficits that should be allowed to remain in place for a period of years, and the willingness for core countries to accept higher levels of inflation so Spain can regain competitiveness without nominal wage and price cuts that endanger its ability to repay its debts.

(missing chart)

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