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.
#ad#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.
#page#If austerity measures are adopted only after considerable delay or are not implemented as enacted, investor reactions are unlikely to be positive. Then the directly negative impact of austerity policies will dominate, leading to low or negative revenue growth and increased budget deficits. This can also occur when policymakers appear to change their minds and retract budget-consolidation measures midstream in response to political pressure. The resulting loss of market confidence can be long-lasting and damaging to prospects for economic growth.
Moreover, if adverse market reactions occur when particular policies are announced and implemented, it must mean that policymakers did not do their homework: They did not correctly judge the expectations of market participants. Indeed, some observers may believe that strongly adverse market reactions are themselves a source of economic shocks that need to be countered through policy revisions. This appears to be the case with the IMF’s recommendation, following its recent forecasts of reduced growth in Europe, to go slow on austerity measures.
#ad#What about the United States? It’s also an example of economic underperformance resulting from a wavering implementation of policies. No sooner was the Budget Control Act of 2011 signed into law than leaders of both parties began to explore ways to avoid its sequester provisions. The U.S. economy already faces gargantuan uncertainties: the fate of the health-care law, the future course of the Bush tax cuts, unsustainable Medicare and Social Security commitments, unavoidable post-election skirmishes on extending the federal debt ceiling, and strife over sorely needed fixes to the Alternative Minimum Tax and Medicare’s doctor-reimbursement rates. Such a long to-do list is surely curbing the willingness of investors to take risks and of employers to hire. Unfortunately, no cures will be forthcoming until after the elections in November, and perhaps not even then.
Leaders in Europe and the U.S. have used the trial-and-error method to precisely calibrate an optimal set of policies for boosting economic growth while simultaneously curbing government expenditures to reduce debt over the medium term. Given the political and economic uncertainty facing developed nations, that appears to be an exercise in futility. Policymakers should set a particular fiscal course for Europe as it faces its debt crisis — and then go on an extended vacation, to avoid continually recalibrating austerity measures. In the U.S., where medium-term national debt continues to escalate, expensive political theater will have to continue for a while longer.
— Jagadeesh Gokhale is a senior fellow at the Cato Institute.