Euro Area: Watch What Policymakers Do, Not What They Say Editor: It now looks as though a growing number of countries (particularly those on the Eurozone periphery), have concluded that “austerity doesn’t work”. However the problem is not austerity per se, the problem is that the aggressive cuts in government spending have not been accompanied by the necessary policy reforms. It should go without saying that cutting government spending while doing little else to promote economic growth will worsen a nation’s debt-to-GDP ratio. 

Euro area policymakers may continue with austerity rhetoric, but their actions will differ.

The growth of the world’s major economies from 2010-12 can be almost perfectly explained by just one variable: the change in government deficits. Unless the private sector makes a remarkable recovery, the same story will apply in the next couple of years: government austerity will continue to drive the global growth rankings.

Austerity can paradoxically worsen a distressed nation’s solvency – for both the public and private sector. By reducing growth more than the deficit, austerity increases rather than reduces an economy’s debt problem. Therefore, it becomes self-defeating. Fortunately, euro area policymakers seem to finally understand this dynamic.

We expect that in 2013, policymakers may continue to talk tough on austerity and deficit reductions, but show leniency in their actions when it is in the interests of the aggregate euro area. Brussels has already eased the deficit targets for Spain and Greece. Now it might be France’s turn. The IMF has already paved the way, suggesting:

“Whether (France’s 2013 deficit) is 3% or 3.5% matters less than whether the government can give credible assurances about the direction of policy.”

The bottom line

There are good odds that the push for austerity in Europe has peaked. Stay tuned.

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