A need for flexibility.

Beware of Europe's Policy Hardening

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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Judging from the recent remarks by European officials, policy positions are hardening once again in the euro zone. Fueled by disappointing economic performance, the risk is that the deepening difference in views in Europe will further complicate a much-needed recovery. This is regrettable because it need not be so.

Having flirted with a disorderly disintegration, the euro zone embarked on an impressive period of sustained financial normalization starting in July 2012. The immediate crisis receded as borrowing costs came down, bank deposits stabilized and lending resumed. In the process, the blame game played by member countries gave way to collective relief and more constructive dialogues.

Despite the valiant efforts of the European Central Bank, this stable period hasn't been accompanied as yet by a strong overall economic recovery. The improved growth performance of Greece, Ireland and other peripheral countries has been offset by weaknesses in the three largest economies -- Germany, France and Italy. The weakness seems to be getting worse as suggested by this week's disappointing data on industrial production, including a much-worse-than-expected contraction of 4 percent in Germany.

Economic slippages inevitably fuel disenchantment in policy making, which, in the euro zone, excessively pushes officials to corner solutions -- meaning they are unwilling to make policy compromises. As such, much of the narrative is now regressing to the old debate between austerity and growth, with the same advocates on either side. And, once again, exaggerated differences among individual governments are spilling over into the ranks of the ECB.

Before positions harden even more, all sides would be well advised to remember four simple yet consequential points.

For most countries in the euro zone, economic and financial sustainability depends on a fraction that requires a balance between the numerator (debt and budgets) and the denominator (growth and jobs). Excessive emphasis on just one part of this fraction results in a dangerously unsustainable and ultimately ineffective policy.

So far, progress has been more pronounced on debt and budgets than on jobs and growth. As a result of this, support for reforms is eroding, growth potential is under pressure and the unemployment problems are deepening.

Many countries are now in a position to pursue pro-growth infrastructure programs without threatening financial sustainability. In a few cases, this can be readily financed through government revenues; others require a mix of low-cost borrowing, use of regional development funds and private-public partnerships. Indeed, for the euro zone as a whole, it's more an issue of willingness than ability.

Finally, none of this will work unless governments, more generally, step up to their responsibilities in a manner consistent with what ECB President Mario Draghi described last August and supported by many economists -- namely, using "existing flexibility within the rules" to loosen fiscal conditions and adopt pro-growth tax reforms while simultaneously carrying out meaningful structural reforms in "labor markets, product markets and actions to improve the business environment."

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed Aly El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Katy Roberts at kroberts29@bloomberg.net