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What do markets want?

The news that the European Commission's Economic Sentiment Indicator fell sharply in May underlines the economic risks the continent is now facing. With governments around Europe moving towards fiscal austerity, at a time when over-indebted households are still reluctant to spend, the danger is that Europe will move back into recession.


Why are European governments embarking on such a risky strategy? In peripheral economies such as Greece, Ireland or Spain, the governments have no choice: the markets have made it clear that otherwise they will no longer be willing to continue lending to them. Governments have thus had to cut spending and raise taxes at the worst possible time. While this will worsen peripheral downturns, it is what the markets are demanding.  And so it must have been utterly exasperating for the Spanish government when, late last week, Fitch downgraded Spanish debt on the basis that Spain's adjustment process will lower its medium run growth prospects. It seems a case of damned if you do, damned if you don't.


What, might Spanish politicians well ask, do markets want?


As it happens, the EMS crisis of 1992-1993 taught us a lot about what markets want. While the context was entirely different, the lessons are still relevant today. Readers will recall that the commitment of peripheral European economies to stick to the Deutschemark was challenged when German interest rates started to rise after German reunification, and countries like Italy and the UK started to suffer serious competitiveness problems. The initial response of politicians was a macho one: get the fundamentals right and the problem would go away. The fundamentals concerned were low inflation, low deficits, and low levels of government debt.


But speculation did not stop. The lesson of the EMS crisis is that low inflation, low deficits and low government debt are not, it turns out, enough on their own. Low unemployment and economic growth are part of the fundamentals which have to be right, if government policies are to be credible in the eyes of the markets Speculators bet that governments would not, in the long run, be able to sustain policies which led to rising unemployment: far from enhancing credibility, the 'responsible' and deflationary policies which governments thought markets wanted fatally undermined it. And thus it was that the market forced governments in the UK and elsewhere to adopt policies that were softer, and more growth-oriented, than what orthodoxy had been demanding.


This should not have been a surprise to the governments concerned, since it is a constant theme in 20th century economic history. As Barry Eichengreen points out in his classic book, Golden Fetters, a major turning point came with the widespread democratization of European society  in the wake of World War I. During the 19th century, governments' commitment to the gold standard was unquestioned. In consequence, when countries lost gold, and raised interest rates as a result, capital flowed in, thus restoring balance to the system. In the interwar period, however, the markets realised that governments were accountable to their electorates, and that there was a limit to how much unemployment they could tolerate. The lessons for today seem clear. Markets may indeed not be willing to lend to peripheral governments unless they take remedial action to fix their public finances: so be it. But in the long run, markets will not be willing to lend to countries whose economies are continually contracting. This is not just because of the mechanical facts that that shrinking economies will experience rising deficits, and that smaller economies are less able to pay off existing debts -- although these considerations are obviously important. It is also because the markets will eventually start to worry that contractionary economic policies and rising unemployment will not be politically sustainable in the long run.


Markets want debts to be kept under control, but in the long run they also want tolerable levels of unemployment, since this is what democracy demands of governments. In our current circumstances, this means economic growth. Too much austerity at the wrong time will not make governments more credible, but less so.


Where will this growth come from? Like everyone else, Europe hopes that it will export its way to recovery. Looser monetary policy and a weaker currency can also help, but one wonders whether the ECB will be willing to loosen sufficiently to offset the impact of fiscal retrenchment. Furthermore, if it did so, this could lead to US and Asian retaliation against what would be perceived as a beggar-thy-neighbour policy, thus exposing to world economy to dangerous new risks.


Those economies with fiscal room to manoeuvre need to use it now, for the good of the European economy. Furthermore, we should be asking whether the European Union as a whole should embark on a growth and investment strategy. Major European investments in new transportation and energy infrastructures are needed in the long run anyway. If the Union embarked on such a growth strategy now, it would become part of the solution to our problems. If the EU turns itself into a mechanism for imposing asymmetric and deflationary adjustment on the continent, it will be seen, rightly, as one of the causes.

And the markets won't like that.


Kevin O’Rourke is a Professor of Economics at Trinity College Dublin, and a co-organiser of the CEPR’s Economic History Initiative.


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