Analysis: Politics force growth back on to Europe’s agenda

(Reuters) – It’s early days, but powerful political currents could be sweeping Europe away from its

hair-shirt obsession with reducing debt and deficits regardless of the economic cost.

Any course correction will be

a tug on the tiller rather than a U-turn. The euro zone will not suddenly abandon budget discipline and spend its way back to

growth as Germany, Europe’s paymaster,

would not stand for it. Nor, in their current mood, would the bond markets.

But one three-pronged strategy under

discussion, according to economists and academics, would give governments more time to lower their budget deficits to the

mandated threshold of 3 percent of national output in return for a demonstrated commitment to far-reaching reforms that

improve growth over the medium term.

At the same time, more funds would be mobilized from the European Union budget

and the European Investment Bank to finance

infrastructure and other development schemes, boosting the euro area’s chronically weak demand.

If all went well, the

vicious circle of contracting output triggering ever more growth-sapping budget cuts to meet self-imposed deficit reduction

targets would be broken.

Andre Sapir, a scholar at Bruegel, an influential think tank in Brussels, believes a

political commitment to a deal along these lines, if not agreement on a detailed package, could crystallize in time for the

next meeting of EU leaders in June.

“We are headed for a June summit where there will be a growth initiative of some

sort,” Sapir said.

MESSAGE RECEIVED

Pressure on Europe to take it easier on fiscal retrenchment has been

growing. The impeccably orthodox International Monetary Fund and the Organisation for Economic Cooperation and Development

have both warned of the economic dangers of over-rapid budget cuts. But international institutions do not vote. It’s the

ballot box that is transforming the debate.

On Sunday, candidates broadly opposed to the EU won almost 30 percent of

votes in the first round of France’s presidential election. Socialist candidate Francois Hollande, who has promised to add a

pro-growth dimension to the EU’s fiscal discipline treaty, is favorite to beat incumbent Nicolas Sarkozy in the second round

on May 6.

Greeks elect a new parliament on the same day and opinion polls suggest that, as in France, fringe parties will do well because of popular fatigue

with austerity.

Sapir said the challenge for mainstream politicians was to craft a package that switches the focus

from short-term austerity to medium-term sustainability of public finances.

Winning the agreement of Germany and other

discipline-minded countries to allow more time for deficit reduction would be difficult. But Sapir saw scope for a trade-off

if free-spending governments were making reforms to tackle labor market rigidities and critical budget problems related to

ageing, notably spending on pensions and health care.

There are already signs of a marginal shift in official thinking

in this direction, according to Riccardo Barbieri, chief European economist at Mizuho in London.

The European

Commission softened Spain’s 2012 deficit reduction target after Madrid brusquely rejected its initial proposal as too

demanding.

For its part, Italy is

postponing its goal for achieving a balanced headline budget – presumably with the blessing of the Commission, the EU’s

executive arm, which is due to rule soon on the viability of each member country’s plans.

Barbieri would go further

and allow governments in budget planning to use more optimistic forecasts of their countries’ economic growth potential if

they can show convincingly that they are making fundamental changes to how their economies work.

“Personally, I would

hope to see a change in the fiscal approach,” he said. “I would favor a more explicit policy that combines in an intelligent

way deficit reduction goals with structural reforms.”

ALL EYES ON GERMANY

Watering down the euro zone’s new

fiscal compact would be difficult for German Chancellor Angela Merkel to accept.

But the collapse of the Dutch

coalition government after it failed to win enough support for budget cuts was likely to make an impression on fellow fiscal

hawks, said Malcolm Barr, an economist with JP Morgan in London.

As a result, Germany and the European Central Bank

would probably tolerate some slippage in near-term fiscal targets in return for a program of structural reforms and

acceptance of the fiscal compact’s medium-term rules, Barr said in a note.

Such reforms are all well and good; they

are indispensable for reversing the divergence in economic performance within the euro zone that has brought the single currency close to

collapse.

But Philip Whyte, a senior research fellow at the Centre for European Reform, a London think-tank, is

skeptical that the euro zone can regain the path of growth unless it corrects what he sees as fatal flaws in the design of

the single currency.

In the absence of a fiscal union similar to that in the United States, heavily indebted euro zone

members such as Spain and Italy are vulnerable to sudden stops in private-sector capital flows, robbing them of policy

autonomy, Whyte argued.

“The euro zone would still be working as an austerity machine without the fiscal compact

because flaws in the structure force countries to pursue self-defeating economic policies,” he said.

George Magnus,

senior economic adviser to UBS in London, agreed that fiscal integration was necessary to put the euro zone on a stable

footing; the other requirements were pan-European banking supervision and a recovery of competitiveness by the euro zone

periphery to drive growth.

Crucial in this last respect, Magnus said, would be the recognition by Germany that it must

tolerate higher inflation to help its southern neighbors narrow differentials in real costs without driving their economies

into a deep recession.

Would Germany, with its loathing of inflation, ever sign up for such a program? In the course

of the euro zone debt and banking crisis, Berlin has drawn red lines more than once, only to cross them in

extremis.

But even if Hollande wins the French presidency and follows a growth agenda that attracts broad support from

the euro zone periphery, Magnus said Germany would have great difficulty yielding power in the three areas he identified as

critical.

“The spectre of a euro break-up fills most people with dread, so it is assumed the Germans will ultimately

do whatever they have to do in order to keep the euro together. But this is beginning to test the limits of realpolitik in a

serious way,” Magnus said.

(editing by David Stamp)