Unless the EU signs up to a Growth Compact soon, we face social, political and economic disaster. Swift action on tax, banking and investment is the way out of the crisis.
Overspending by governments, we have been told, triggered this crisis. Thus the cure lies in immediate austerity, hence the German-led push for a eurozone fiscal compact. But, as demonstrated by the experiences of Greece, Portugal, Spain and Italy & now the broader EU, this course leads to biting, deep recessions, rising unemployment and worsening public indebtedness. The IMF has acknowledged as much and the latest alarming data on rising unemployment in the EU is a case in point. A focus on growth, not austerity, is the correct answer for Europe’s ills.
The case for “growth-friendly austerity” relies on the argument that public cuts are compensated for by consumers and businesses spending more, and with greater efficiency. However, the collapse of confidence wherein everyone expects the economy to worsen before (if) it gets better, along with excessive levels of private indebtedness, means that consumers and firms are busy repaying debt or building rainy-day funds, not spending and investing. In terms of exports, what works for small open economies with flexible exchange rates will not work for the economic giants the EU and the Eurozone are, especially as the troubled economies of the Eurozone have fixed exchange with their largest trading partners.
When EU leaders meet next, they must adopt a binding pledge to increase growth-enhancing public investments in the EU, outlining a firm strategy for funding these – in effect, a growth compact that Re-Define first published in January. This idea is slowly catching on with the European Council, the Parliament, the Commission and even the ECB having expressed support. Importantly Hollande, potentially the next French president and Monti the widely respected Italian Prime Minister are also talking about growth pacts or compacts.
However, to date the political support only amounts to lip-service, not substance. Unless this changes soon, we may be sowing the seeds for the destruction of Europe as economic problems continue to worsen in crisis economies even as the political space available to tackle problems in the Eurozone shrinks. In fact, the Eurozone may already be stuck in a dumbbell shaped trap of economic and political divergence that makes it hard, if not impossible, to tackle the crisis. The immediate dangers of the social fabric tearing at the seam in the worst affected countries are rising fast.
The axe of austerity falls first and foremost on public investment, as it is politically easier to cut than other forms of public expenditure. This undermines current growth by shrinking the level of economic activity, but even more importantly jeopardises the potential for future growth. Every euro of cuts today could result in many euros of lost growth.
Most important, the focus of efforts to reduce public indebtedness should be on raising tax revenue, not cutting spending. Increasing consumption or employment taxes may be counterproductive when consumer spending is depressed and unemployment high, but other taxes have a less negative effect on growth, even in the short term. The taxation of property, land, wealth, carbon emissions and the under-taxed financial sector needs to be increased across the EU. Dividing this revenue between public investment, deficit reduction and cutting income tax for low earners would boost both growth and employment.
EU states also need to redouble efforts to crack down on tax evasion and avoidance. Greece and Italy (which have large “black” economies) as well as France, Germany and the UK have enacted recent measures to increase compliance. The results are mixed, since domestic measures that have squeezed the tax avoidance balloon at one end have inflated it at the other. London, a haven for the rich rascals, is now adding southern Europeans to its mob, but Greek and Italian money is also flooding into Germany.
Sharing and implementing the most effective anti-tax avoidance/evasion strategies across all EU countries and an agreement to help other members enforce their domestic measures would multiply the revenue from such crackdowns. Urgently renegotiating the EU savings tax directive, that at present captures less than 1% in annual tax revenue on untaxed wealth transferred to other EU members, would also provide a big boost to revenues to fund public investments. EU member states must use the EU’s status as the largest economic area in the world to aggressively negotiate under the banner of the EU and strike much better deals with tax havens so tax losses can be minimised and past, unpaid taxes clawed back.
The UK-Liechtenstein and German-Swiss bilateral deals, on the fate of untaxed UK and German money in these tax havens, have been rightly criticised as being very weak. The US has used its weight as the largest economy in the world to negotiate a much better deal for its tax collectors. This is what the EU must do. Also, the US, under its foreign account tax compliance act, obliges EU banks to share data on accounts held by US citizens. The EU must immediately push for reciprocal arrangements.
Doubling the capacity of the European Investment Bank, which has a good record of providing credit to the employment-intensive smaller business sector, would need limited amount of up-front cash, and generate investments of several times that amount. Some or all of the €250 billion of unused guarantees of the EFSF, the temporary crisis management fund should be allocated to the EIB as callable capital, significantly increasing what it can do in terms of infrastructure investment and supporting businesses. Every Euro of EIB investment typically crowds-in five Euro of private investment and this would be a good way of unlocking some of the record levels of cash that EU corporates are sitting on.
The European banking system remains very fragile and deleveraging is reducing credit to the real economy and weighing economic confidence down. The dangerous sovereign-bank dance of death wherein weak sovereigns and banks keep pulling each other down must be halted. For this, the European Crisis Management Fund, the ESM, must be allowed to inject equity directly into weak banks, for example those in Spain facing large real estate losses. A pan-European funding guarantee scheme should also be implemented together with a banking compact that binds banks on sovereign, EU-fund or ECB support to abide by a set of rules to retain profits and bonuses and support the real economy better.
Unless the funding costs for Spain and Italy fall soon, the sovereigns would need to be supported. In truth any lowering of ECB interest rate would not really help the real economy in these countries nor the sovereigns as the transmission channels for monetary policy are broken. Sovereign yields, which remain far too high, provide a floor on borrowing costs for most entities in the real economy so are a legitimate target for the ECB in its narrow pursuit of effective monetary policy for the Eurozone. So a preannounced ceiling on sovereigns yields accompanied by a credible secondary market purchase program would do the trick allow these countries.
Finally, the structural reforms in crisis countries must continue and the liberalisation of services in the single market must be accelerated. These policies will help boost future growth but work best in a growing, not shrinking, economy. Freeing up the licensing process for taxis in Athens does little in terms of inducing competition and lowering costs as long as everyone expects that the demand for taxis will be shrinking in the foreseeable future. That is why the transition path is so critical and demand cannot be allowed to fall precipitously because of an excessive pace of austerity.
Without a growth compact, the social and employment crises in Europe will only get worse. With it, we have a fighting chance to emerge stronger.
This blog is an updated version of A Growth Compact for the EU Originally published by Sony Kapoor together with Peter Bofinger, Member Council of German Economic Experts in January 2012 which also appeared as an Op-Ed in several European Newspapers including the Guardian.