In a speech in Berlin on Jan. 23, International Monetary Fund Managing Director Christine Lagarde implored European leaders to boost stimulus spending and contribute to a bigger bailout fund or risk plunging the world into a “1930s moment.” The speech was Lagarde’s latest call for Europe to pull back on austerity and focus on growth. And while she was addressing all European policymakers, former IMF Chief Economist Simon Johnson says she clearly had an audience of one in mind. “She’s trying to get the Germans to do some fiscal stimulus in their own economy,” he says. “The Germans are the only ones with the fiscal space to do it.”
True enough. According to the IMF’s latest forecast, Germany’s fiscal deficit for 2012 is projected to narrow to just 0.7 percent of its gross domestic product, compared with 3.4 percent for the entire euro area. Yet with German Chancellor Angela Merkel focused on securing fiscal union among European Union member countries, it seems unlikely that she will heed Lagarde’s call to stimulate its economy. She’s ignored Lagarde before; just two years ago, while serving as French finance minister, Lagarde fruitlessly pleaded with the Germans to boost their domestic spending.
Lagarde and her chief economist, Olivier Blanchard, fear European reformers may be getting too zealous. Their working theory is that after a year when wayward economies reined in their budgets—Greece’s budget deficit has declined to an estimated 9.6 percent of GDP, from 10.6 percent in 2010—it’s time for Europe to stimulate its economies. And IMF policymakers want them to do it before its too late. “Decreasing debt is a marathon, not a sprint,” Blanchard told reporters during a Jan. 24 press conference. “Going too fast would kill growth and further derail the recovery.” Spain’s economy, to name one, is expected to shrink by 1.5 percent in 2012.
This leaves European leaders with a predicament. Their challenge is to yoke two opposing objectives, deficit reduction and spurring growth, by charting a path between two conflicting policies: austerity and stimulus. The problem is that those countries that can afford stimulus don’t need it, while the countries that do need stimulus probably can’t afford it. Europe’s most afflicted countries must be able to borrow to finance their spending. Yet at the rates the bond markets are charging most of Southern Europe right now, that’s not possible, since borrowing costs would eat up any GDP growth gained.
One possible way out: Promote stimulus in Europe while also forcing structural change on its southern tier. “Unless you reform the labor markets of Southern Europe, nothing is going to change,” says Steven Dunaway of the Council on Foreign Relations. Squaring the circle was never easy.