Notwithstanding the recently enacted EU fiscal pact, Europe is again facing a sovereign-debt crisis. Standard & Poor’s has downgraded a number of Spanish banks and Spain’s sovereign debt. For two years, Spain and other European countries, including those not facing an immediate crisis, such as France and Italy, have struggled to establish appropriate austerity policies to reduce fiscal deficits. Besides being unpopular, such measures produce an immediate negative result — a reduction in economic output. Will that effect continue to overshadow the expected positive result from improved market confidence among households and investors? It depends on how plans for reducing budget deficits are implemented.
The fortitude of Europe’s political leaders in the face of setbacks will be critical. Indications are that, although the thrust of budget consolidations that have been initiated by European governments is appropriate, policymakers lack the necessary conviction to stay the course.
Initially, with the backing of economists and prominent international institutions such as the IMF and OECD, European policymakers decided to cut government expenditures and adopt selective tax increases to reduce projected budget deficits and national debt. These policies were expected to set the stage for a robust European economic recovery.
The austerity policies, however, are generating severely adverse political reactions to the reduced investment and hiring that, as expected, ensued. It’s now doubtful that these policies will deliver deficit reduction. This raises the risk that stopgap and reactive policies will be adopted in an attempt to counter every economic shock and to seek every political advantage. But when policymakers waver on budget consolidations in order to pursue short-term economic and political goals, the economic uncertainties facing households and investors increase. This could prolong the recession in Europe.
Financial markets cannot proactively indicate what policy should be. All they can do is react positively or negatively to economic and political news. Markets reveal information by influencing asset prices and interest rates based on participants’ trading actions. In turn, those actions are based on expectations about the future economic environment under current policy settings. Market reactions would be generally positive if participants were convinced that budget consolidations would be sustained and national debt effectively reined in rather than continually revised. Uncertainty created by frequent policy adjustments is likely to dampen investor enthusiasm, cause greater volatility in markets, and postpone the recovery.