• Challenge. The global recession may be over, but the same cannot be said for the aftershocks of the financial market crisis. Fiscal policy is facing a delicate balancing act here: On the one hand, it must ensure sustainable growth, on the other hand reduce the ballooning public-sector budget deficits and meet the challenges of an ageing society.

  • Silver bullet. A mere austerity policy will not meet these challenges. Our calculations for Germany show that a combination of spending cuts and moderate tax cuts is by far superior. Such a strategy could not only lower the debt ratio by 20 percentage points within 10 years but over the medium term also ensure solid, sustainable growth of 2%-3% (cf. pages 3-5 & chart below).

  • Transmission channels. Business fixed investment and private consumption profit from this combined strategy twofold over the medium term. First, sustained debt reduction sees long-term interest rates decline. Second, the tax relief and elimination of the fears of later tax hikes (Ricardo effect) stimulate economic growth.

  • Costs. The inevitable budget consolidation does, however, also have its price. It has a dampening effect, bringing GDP growth for the next few years below the 1½% mark. That would accentuate our picture of belowaverage GDP growth over the medium term. Long term, however, the combination strategy pays off according to the principle "a long-term gain for short-term pain".

  • Further topics:

    – Weekly Comment: IMF after all (page 2)?

    – Spain: No illusion of sweet-tasting medicine (page 6).

    – EMU: Output gap ensures lower core inflation (page 8)

    – US: Fed to hike Fed funds target rate not before early 2011 (p. 11).

    – Data outlook: Slight improvement in EMU sentiment (p. 14).

    – Market outlook: Euro to stabilize; rise in government bond yields not before autumn this year (page 22).


IMF after all?

It would be nice to call it “a stunning turn of events”, but unfortunately it is very much in line with the hesitant and contradictory stance that has characterized Europe’s reaction to the Greek crisis from the very beginning. Germany is now reported to favor IMF intervention, after having been adamantly opposed to the idea and having even proposed the creation of a European Monetary Fund. Moreover, German Chancellor Merkel apparently argued for the introduction of a mechanism for expelling from the eurozone countries which repeatedly breach the fiscal rules. While spreads on Greek government debt have widened on the news, I think short term risks are limited, as we seem to have reached the endgame and financial support should soon be pledged, whether by the EU or the IMF. There is no shame in calling in the IMF, indeed it is the most efficient solution. The shame is having failed to ensure fiscal discipline, and then spent months dithering and bickering on how to react – and this will likely prove to be a further blow to the EUR. What is potentially explosive, though, is the idea of an explicit mechanism for expulsion from the eurozone, as this would risk bringing back the bad old days of speculative attacks against unsustainable EMS pegs, only that now the impact would be far more serious. Any serious discussion of “exit strategies” to expel countries from the eurozone could at this stage have a serious destabilizing impact on the market, fuelling risk aversion and undermining both the euro and the sovereign bonds of high-debt eurozone countries.

EU authorities seem to have explicitly broken ranks on the issue of support to Greece, with Italy, Finland, the Netherlands, Sweden, UK and now Germany reportedly in favor of IMF involvement, and France and some others, plus the European Commission, strongly opposed. Battle lines have been drawn for the EU Council meeting on 25-26 March. The turning point seems to center on German domestic politics: the idea of rescuing what is seen as a reckless and profligate neighbor has engendered a visceral negative reaction in the German electorate, and meanwhile the governing coalition has seen its support slip in the run-up to key state elections in North Rhine-Westphalia in early May. The Greek crisis has made fiscal discipline an even more powerful political issue, to the point that the government is reportedly considering scaling back its planned tax relief in a bid to reassure voters of its fiscally conservative credentials. Against this background, the German government also seems much less sure that it would be wise to engineer a financial rescue that could bypass the legal no-bailout stipulations.

While spreads have immediately widened in reaction to the new uncertainty, I think short term risks are limited, as financial support will most likely be pledged soon by either the EU or the IMF. Greece has made it clear that it does not want to keep borrowing at current spreads after having announced a major fiscal package – and most importantly, it probably wants to avoid the risk of spreads blowing out further as we get closer to the April redemptions, at which stage help would need to be provided in a true crisisresponse mode. At the same time, Germany realizes that financial support is needed to avoid contagion as well as an adverse impact on some eurozone banks, but is coming to the realization that an IMF rescue is politically more palatable. So expect more volatility on Greek yields in the coming days, but they should stabilize once support is announced. And if it is an IMF program, then we will be in very familiar territory, and markets will switch to monitoring the implementation of the adjustment, guided by the timeline of the regular program reviews. For the EUR though, this will likely prove to be a further blow. Not because the IMF might get involved – indeed I have argued from the beginning that the IMF is best placed to intervene – but for how we have come to it. Calling in the IMF is not an embarrassment. The embarrassment is having failed to ensure fiscal discipline across the eurozone. The public disagreement and indecision on whether and how Greece should be helped, however, made the embarrassment significantly worse, and could seriously undermine the market’s confidence in the likelihood that the eurozone will come out of this with stronger institutions.

The greatest risk, however, lies in the idea of setting up a mechanism for expulsion. This would suddenly open up the possibility of speculative attacks against poorly performing countries, along the same lines of traditional speculative attacks against unsustainable fixed exchange rate regimes. Once investors start fearing that a country might be expelled, they will sell the country’s bonds. You can then call this speculation, you can call it a conspiracy, or you can call it reducing risk exposure, but the end result will be tremendous market pressure that will push the country in question even closer to the brink. Such a proposal may be politically expedient, but it is potentially explosive and should be treated with extreme care. Indeed just discussing it will confirm concerns that the eurozone in its current form is unsustainable, and that rather than a strengthening of its institutions we will see a breakup or slimming down of the area itself.