Has Europe's Love Affair with Austerity Hit a Rough Patch?

Impervious to international criticism, European policymakers remain fundamentally faithful to the path of fiscal restraint advocated by Germany

Jose Garcia Zarate 24 June, 2013 | 3:29PM
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Is Europe's love affair with austerity going through a rough patch? Many international observers may have reached that conclusion in the wake of the European Commission's decision in late May to grant a number of countries—including Spain, France and Portugal—extra years to meet their budgetary consolidation targets. This move came along with a raft of official pronouncements from key members of the Commission (such as President Barroso) on the imperious need to foster economic growth in a continent where unemployment, particularly affecting the young, has reached unacceptably high levels.

However, concluding that austerity is in the process of being phased out would be wrong. Leeway in the shape of extra time to get national budgets in order, plus a few, insufficiently funded, initiatives to deal with the plight of the unemployed, do not threaten austerity's role as the cornerstone of economic policy formulation in Europe. Indeed, impervious to international criticism (consider the EU Commission's disdain at the IMF's critical review of the handling of the Greek bailout), European policymakers remain fundamentally faithful to the path of fiscal restraint advocated by Germany.

Meanwhile, hopes for some extra relief via the monetary policy route were quickly dashed when the European Central Bank, or ECB, chose to keep interest rates on hold at 0.5%. This, despite current—and expected—inflation well under the ECB's price stability target of 2.0% and mounting evidence of a deterioration of growth prospects. The ECB's updated round of macroeconomic projections foresee the eurozone's GDP contracting by 0.6% in 2013 and growing by a paltry 1.1% in 2014, while average annual inflation should remain in a 1-3-1.4% throughout.

Rumour has it that Mr. Draghi and his cohorts are unlikely to make any move while the German Constitutional Court discusses the validity of the Outright Monetary Transactions, or OMT, programme. Maybe so. A more plausible explanation for the ECB's reluctance to act is its belief that the impairment of the transmission mechanism of monetary policy in the eurozone cannot be solved by a token decrease in interest rates.

In a world of monetary policy hyperactivity, the ECB does cut something of a lone figure. Clearly uncomfortable with the demigod status nowadays enjoyed by central banks, the ECB wastes no opportunity to remind eurozone politicians that monetary policy is no substitute for government action. In any case, the ECB's door for further action remains open, as it has to. After all, the ECB "never pre-commits."

One that has pre-committed, even before taking the reins this coming July, is the new governor of the Bank of England, or BoE, Mark Carney. His predecessor's tenure ended without much fanfare. Interest rates were kept at a historically low of 0.5%, and the QE programme was inactive at the June policy meeting. A raft of "better-than-expected" macroeconomic data ahead supported the policy decision. UK inflation has come down and key confidence survey readings have notched up. The services PMI rose to 54.9 in May from 52.9 in April, while equivalent readings for the manufacturing and construction sectors also came in above the 50-expansion line.

Mr. Carney takes on the BoE's helm against an apparently improving outlook, which puts him in a bit of a pickle as he has been specifically—and expensively—hired to inject a more aggressive tone in monetary policy formulation. If further QE is off the table, Carney may still resort to introducing some kind of forward forecast on rates á la Fed. However, linking such a forecast to a real economic variable such as unemployment may be problematic given that the BoE does not have a clear-cut mandate other than price stability. We shall wait and see. Mr Carney has been sold to the British public as the best thing since sliced bread. Expectations are terribly high, but so is the risk of disappointment. That's the problem of "pre-committing."

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Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe