Merkel Must Pitch In to Make Europe’s Growth Pact Work

Stung by a backlash against austerity policies, Europe’s leaders are planning to draw up a new agreement aimed at boosting economic growth in the euro area.

If they want the pact to have any effect, all the region’s politicians -- and particularly German Chancellor Angela Merkel -- will have to step out of their comfort zones.

Vague battle lines have already been drawn. Merkel and European Central Bank head Mario Draghi want to encode the kinds of labor-market, pension-system and other so-called structural reforms that’ll make the likes of France, Greece and Spain more competitive. French presidential front-runner Francois Hollande wants infrastructure projects, funded by special-purpose European bonds, to boost jobs and demand.

Whatever other ideas might arise before the agreement is drawn up, possibly as soon as mid-June, it must include at least three elements if it is to really help reverse Europe’s recessionary trend.

First, Europe’s leaders must recognize that common deficit rules alone will not guarantee the currency union’s survival. When countries such as Italy and Spain fall into a spiral of shrinking output and rising budget deficits, countries with stronger economies must be willing to help, either by transferring funds or by stimulating their own demand.

German Spending

Currently, that would mean more German spending. If Europe’s largest economy were to increase its aggregate demand by a percentage point, it would boost output in the rest of the euro area by roughly half a percentage point, as Germans bought more imports and spent more euros sunning themselves on Greek and Portuguese beaches. The Bundesbank would also need to live with a little more German inflation than the current 2.1 percent. Higher prices in Germany would help make other euro-area economies and their exports more competitive, reducing both their current account deficits and Germany’s surplus.

Second, the agreement should give Spain and Greece in particular more time to bring down debts piled up over the past 30 years. Requiring them to slash education, research and development, and other budgets will only stunt their future growth potential. To calm markets concerned about Spain’s deficits, the rest of Europe -- Germany again -- and the International Monetary Fund would have to provide more bailout funds.

Finally, the pact should acknowledge one of the most immediate requirements for a return to economic expansion: Recapitalization of private sector banks so that they can start providing businesses with more credit. Without that, Europe is doomed to anemic growth and a persistent confidence crisis, no matter what documents its politicians may sign.

Structural reforms, of course, are essential for stricken parts of Europe to return to sustained growth. Unemployment in the euro area is now 11 percent, with huge variations from Andalusia in Spain (31 percent) to Bavaria in Germany (just over 3 percent). Given Europe’s aging population, future growth is going to have to come from raising both employment levels and productivity, which means more labor market flexibility.

A new commitment to structural reform -- assuming it applied to everyone, including the Germans and Dutch -- could help take some of the sting out of measures that Greeks and Spaniards feel are being forced upon them by Merkel and unelected Eurocrats.

Such reforms, though, take a lot of time to produce growth, and it’s hard to imagine an agreement that could successfully monitor and enforce them. Back in 2000, for example, European leaders signed up to the so-called Lisbon Agenda, committing to labor-market and other changes that would make Europe “the most competitive and dynamic knowledge-based economy in the world.” Governments ignored the promises, and there’s no reason to believe writing them down again will make them happen now.

More immediate measures are needed to pull Europe out of its combined debt, banking and economic crisis.

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