Wednesday, February 22, 2012

Hope for Europe

A provocative Wall Street Journal OpEd by Donald Luskin and Lorcan Kelly gives me hope for Europe.

No, I'm not talking about Greece, and the latest bailout deal. That's more of the usual charade. But in the end Greece is small. Europe can bail Greece out if they feel like it; or let it default.Or let it rot, which seems where they are headed. 

Italy and Spain are where the real issue lies. Italy and Spain are too big to bail.

Growth is the only hope for paying back large government debts. "Growth" to an economist means long-run growth, growth that lasts decades. Even the most hard-bitten Keynesian, if honest,  has to admit that "stimulus" does not produce long-run "growth."   Growth comes from more people or more productivity. Period. Italy and Spain can only grow if they free up their markets, clean up their tax systems, put themselves quite a few notches higher on the list of good places to do business.

Growth  is also essential for solving the more immediate debt problems. Italy and Spain need to roll over debts. Markets can be quick to do that, and even lend more, if they see countries have good long-run growth prospects. Markets will stay away as long as they do not see a coherent plan for long-term growth. ("Growth" is distinct from "austerity." "Austerity" means high and distorting taxes, spending cuts but no liberalization of the economy. This quickly runs the economy into a death spiral as people and money leave.)

I had long thought that like the Greeks -- or, increasingly, like the Americans -- Italy, Spain and the rest of Europe (Belgium? France?) simply did not have the will to free their economies. If so, Europe seemed to me destined for a huge bout of inflation. The ECB is basically buying up the debt (via the banks); if the debt can't be bailed out, defaulted on, or repaid, it must end up with inflation.

But, as Luskin and Kelly point out, I may have for once been too Grumpy. Mario Monti, Italy's prime minister, is on a rampage of liberalization. They quote him, growth "will have to come from structural reforms or supply-side measures." Spain's prime minister Mariano Rajoy is headed in the same direction. Monti and Rajoy recognize that companies will only hire people if they can later fire them; that barriers to entry for all the professions ("from pharmacy and baking to taxi-driving") just drag down the economy, that state industries don't provide "jobs," but instead suck the lifeblood out of growth.

Will they get there? Will they reestablish growth soon enough to get the bond markets to roll over debt, or pay back the ECB before it needs to unwind its purchases to avoid inflation? It will be dicey. There is a lot of entrenched opposition to liberalization -- which is why obviously good ideas have such a hard time being implemented for decades. But, as my mayor once said, a crisis is a terrible thing to waste. Maybe Monti and Rajoy can achieve the needed "grand bargains."

What is remarkable -- what gives me hope --  is that they are even talking about "supply side" growth measures and liberalization at all!

The Conventional Wisdom makes no connection between stifling labor market regulations and a debt crisis. The debt crisis is about "confidence" and "contagion," to be met with bailout funds, "firewalls,"  financial engineering,  and ECB debt schemes.

For example, in her most recent speech, IMF Director Christiane Lagarde recommends that "stronger growth"  come first of all from "additional and timely monetary easing." Then, "raising [bank] capital levels" (Note the usual passive policy voice -- who does this raising and how? Translation: taxpayers give money to banks.) Then, "maintaining orderly funding conditions" whatever that means. (Watch your wallet.)

She warns that " On fiscal policy, resorting to.. budgetary cuts will only add to recessionary pressures...those with fiscal space should support the common effort by reconsidering the pace of adjustment planned for this year." Translation: Economies with stratospheric debt/GDP ratios need just a little more fiscal stimulus. As St. Augustine lamented,  Lord give me frugality, but not quite yet.

The bond market?  She wants a  "larger firewall.... Adding substantial real resources..folding the EFSF into the ESM, increasing the size of the ESM,.." Then, "Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets would also be essential." Translation: ECB to buy debt with printed Euros. 

Eventually, yes, "some countries still have much to do to boost their competitiveness and growth potential." Some? What, most of Europe is right on its "growth potential? And finally, at the very end, "..structural reforms are critical, however medium or long-term their impact might be. ... fiscal sustainability depends, ultimately, on generating long-term growth." Four or five years down the line, maybe, meekly approach Italy's unions and government-run industries with a request for "structural reforms." Sure, that's going to work. 

I don't mean to pick on Lagarde. Her speech is just a good example of global bien-pensant policy Conventional Wisdom. I'm sure everyone murmurs this sort of thing at Davos.  Grumpy's favorite columnist, Paul Krugman is, believe it or not, arguing for more spending and stimulus across Europe. I'm not exactly clear how he wants Italy, Spain, Portugal or Greece to borrow more money to spend it. Budget constraints are never the forte of Keynesian economics. He seems to saying that  multipliers are so large that spending is self-financing:  "Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to G.D.P." It's either that or the Easter bunny: I don't see bond markets ponying up more stimulus. But "growth," tackling absurd regulations, unions, labor market rigidity denying employment to a generation of Italians and Spaniards... that' s not even on his agenda.

In this noxious intellectual environment, it is remarkable and praiseworthy that Monti and Rajoy are putting "supply side growth" on the front burner at all; that they make a connection between a debt crisis and sclerotic microeconomics. This is a Reagan / Thatcher moment, when courageous politicians may seize the moment of crisis to jump to the long run; let their economies grow and pay off a mountain of debt, ignoring the Conventional Wisdom. It could happen. Or not, but at least there finally is hope.  

In bocca al lupo ("good luck" in Italian -- and, literally, "into the mouth of the wolf," an unusually apt expression) Signor Monti!