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Peterson Institute
21 April 2012

Peterson/Funk Kirkegaard: Why Europe needs austerity—it’s not why you think


Simply getting "back to trend" will not suffice for the euro area. Unless Europe reforms its system, it faces a long-term economic decline.

Obviously, the euro as designed in the Maastricht Treaty of 1992 has not proved viable. Without a federal state, the euro area will remain economically suboptimal. Many economists might thus dismiss the entire project as unworkable and unworthy. But plenty of suboptimal economic entities survive if the political will exists to implement sufficient reforms to prevent their collapse.

The euro area crisis has shown that threatened with disaster, the political will has emerged to sustain the euro. Though European self-identities are not likely to recede, the currency union can function sufficiently. That is why the fiscal austerity and debt and deficit rules underway are important. The new EU fiscal surveillance packages in the so-called Six-Pack (consisting of five new regulations and one Directive), the Two-Pack (the two new regulations under discussion), the Fiscal Compact Treaty, and the austerity in Spain and elsewhere might appear to be doing senseless damage to short-term macro-economic growth. But these steps make sense as laying out a path to new and necessary institutions to sustain the euro area.

Once one recognises that optimal is not feasible, one can see that the euro area suffers from an acute version of the difficulties that have faced many existing federations and unitary states. For example, Spain at present, and Argentina in the 1990s, have their own troubles controlling the expenditures of politically powerful and independent provinces. The euro area may actually need strong spending curbs for the provinces or state within its Member States far more than it needs the fiscal federation across the region. As the current crisis has illustrated, the illusion of a no-bailout clause in a closely integrated modern currency union has not been enough to prevent rampant and instantaneous financial contagion. Strong fiscal rules have thus attained additional importance.

Of course, the euro area must not be based on austerity alone. But austerity measures must be undertaken to produce euro area integration with the benefits of eurobonds, integrated bank supervision, resolution and deposit insurance—and a more directly political role for the fiscal rules overseer at the European Commission, perhaps through a directly elected Commission President. Like it or not, fiscal austerity has to precede fiscal solidarity.

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© Peter G Peterson Institute for International Economics


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