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10 July 2023

Austerity is back

I called it the worst policy mistake of my lifetime - the austerity after the onset of the eurozone crisis. It permanently damaged the eurozone's economic resilience, contributed to the rise of the far-right, and drove a wedge between eurozone countries. They are about to do it again.

Austerity is not a trade-off between short-term pain and long-term gain. It makes people worse off in the long run too. The New Economics Foundation recently came up with an estimate of the total cost of austerity during the entire period: a shortfall of €533bn in investment in infrastructure, including renewable energy. You can see it everywhere - in the form of underfunded armed forces and police, deteriorating railways and closed motorways.

The European Commission, to its credit, has proposed a reform of the old fiscal regime - the stability and growth pact. This is a set of rules to ensure fiscal convergence inside the eurozone. The Commission says it wants to apply the rules more flexibly, and tailor them to countries' economic conditions. The German finance minister, Christian Lindner, distrusts the Commission and many of his European colleagues. Lindner wants to return to the old regime, with only a few changes. I expect there will be a compromise. But even that would mean a lot more austerity to come.

It is going to be worse than last time because of where we are starting from. Italy had a deficit of 8% of economic output last year. This is projected to go down to 3.7% next year. From then onwards, Italy will need additional fiscal tightening. Together, this constitutes an unbelievable fiscal squeeze. France, which has more than its fair share of civil unrest, also needs to make fiscal cuts of a similar magnitude.

Now consider the politics. The EU's climate change agenda is now moving into a phase where it starts to cost real money. The German government is just about to pass the domestic heating bill to force homeowners to replace cheap gas heaters with expensive heating pumps. A lot more costly environmental legislation is on the way from Brussels. The phase-out of the motor car will impose burdens on car owners. Opposition to Green policies are one of the causes for the surge in far-right support in Germany. 

Now add austerity to the mix. With the return of the fiscal rules comes the return of the hard budget constraint. The Green agenda is the costliest project in the EU's entire history. It will affect people unevenly. House owners, commuters and farmers will be much worse off than urban dwellers who are renting apartments. Austerity makes it harder for governments to compensate the losers. Brexit-style country-vs-town divisions are opening up. 

There are quite a few similarities to the pre-Brexit political economy. On average, the UK performed reasonably well in the EU, but the spoils were unevenly distributed. If the losers are not compensated, they register their discontent at the ballot box.

Austerity will also constrain other large financial commitments such as financial and military aid to Ukraine. Now that the fiscal rules are back, this will now compete with domestic spending. In March, just after the anniversary of Russia's invasion, the cost of the reconstruction of Ukraine was put at around $400 billion. It could easily double as the war goes on. Full EU membership would have further costs as the EU would have to support Ukraine for a long time after accession. 

If Ukraine were to join the EU, it would become the largest net recipient of EU funds, crowding out current recipients, mostly from eastern and southern Europe. Germany's net contributions, already the largest, would rise by a lot. I struggle to see how any of this is possible once the fiscal constraints kick back in.

The EU could resort to financial wizardry. It is a master of the dark art of fiscal smoke and mirrors. But there are limits to that too. The EU could launch a Ukraine reconstruction facility on lines similar to the recovery fund they created at the start of the pandemic. But this mechanism was sold as a one-off, and is not supported by everyone. The EU could try to co-opt international institutions and the private sector. It could divert the frozen Russian assets - some €200 billion in central bank reserves. But this is legally problematic, and might lead international investors to shun the eurozone. There are no easy choices. The bulk of the funding for the reconstruction will have to be guaranteed by national governments, and everything will require unanimity. That's the bottleneck.

The combination of fiscal austerity and competing funding needs makes me sceptical about any uncosted big proposals - like large-scale financial support for Ukraine or a European army. The big question is not whether these are good ideas. I believe they are. I just cannot see how you can organise a political majority in favour of it, and still do all the things necessary for the EU to function, and then some.

Austerity has many economic consequences, but the political side effects are utterly toxic. Our deficits are much higher now than they were back then; we have high inflation; the extreme right is much stronger; and the EU has pre-committed itself to an expensive Green agenda. All this constrains the EU's foreign policy choices just at a time when the EU is starting to discover its geopolitical role. 

The maths just does not add up. We are reaching the limits of what a decentralised, rules-based EU can do.

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