Has Europe given up?

June 3, 2013: 5:00 AM ET

By saying it's officially OK to skirt debt ceilings, Europe is abandoning austerity and reigniting the risk of another sovereign debt crisis.

By Cyrus Sanati

greece-eu-flags-monsterFORTUNE -- Europe's largest economies shouldn't be able to skirt European Union debt ceilings rules just because it's "too hard" or "unpopular." To do so would not only be hypocritical, as they have insisted on crippling austerity measures in much smaller and more vulnerable EU member countries in the past, but it is also dangerous, as it risks reigniting the sovereign debt crisis.

It is still possible to have economic growth while pursuing belt-tightening policies if meaningful structural reforms are made -- something that the big European economies have been slow to recognize.

The result of such inaction has been overblown deficits and negative growth -- a trend that will surely continue if Brussels allows countries too much leeway as they have recently done this week. Failed promises and unrealistic fiscal targets just won't cut it anymore. While the markets have cut the EU some slack post-Cyprus, it has proven to be mercurial in the past. It is much better to take reforms on now when it is calm than to do so under pressure from an angry market.

It has been over three years since the European sovereign debt crisis paralyzed the continent. While there has been much progress made in fixing the fiscal imbalances in Europe's periphery, such as in Greece, Portugal, Spain, and Ireland, Europe's core, namely France, Italy, the Netherlands and Belgium, have failed to take on the tough reforms necessary to have a meaningful impact on their own fiscal mess. While the periphery had a much larger hill to climb in respect to pension, labor, and tax reform, the time has come for the core countries to follow suit and align their fiscal policies to match their economic output.

MORE: Lloyd Blankfein is wrong about Europe

From the inception of the euro, member countries have been required to adhere to a number of fiscal measures to ensure the strength and stability of the single currency. The most important measure was the so-called stability and growth pact, which stated, among other things, that a nation could not run a budget deficit that exceeded 3% of its GDP in any given year. If a nation broke that rule there would be consequences, ranging from fines to ejection from the monetary club. But in the decade leading up to the sovereign debt meltdown, Brussels failed to seriously enforce this key rule. As a result, pretty much all EU states, including supposedly prudent ones, like Germany, consistently ran deficits exceeding the 3% rule. This eventually led to an unbalanced and debt-ridden eurozone.

The 3% threshold seems like an arbitrary line in the sand, one that some believe should be seen as a goal rather than a threshold. But given the troubles of the last few years, that line has come to symbolize to the markets and sovereign debt investors the true creditworthiness of a nation.

It is no surprise that those nations that had consistently run afoul of the 3% threshold are the same ones that have faced the wrath of the bond market vigilantes. Greece, for example, never ran a deficit below 3%. Its budget deficits in the decade or so since it joined the euro have ranged from 4.5% in 2001, the first year it joined, to as much as 16% in 2009, the year it started to melt down. Ireland seems to have taken the prize, running a budget deficit of 31% of its GDP, more than 10 times that of the threshold, when the government decided to take on the bad debts of its banks to avoid a total economic meltdown.

The periphery has a long way to go to get their fiscal houses in order, no doubt, but many have made great progress. Ireland, for one, was successful in lowering its debt levels to 7.6% of GDP in 2012. But for others, namely Greece and Portugal, harsh austerity measures imposed by their richer neighbors in the core of Europe have caused their GDPs to shrink to such a degree that it has made their budget deficits jump even after massive cuts in government spending. This has led some leaders in the core of Europe to say that austerity isn't the answer to solve the eurozone's problems. As a result, governments in France and Italy have reversed austerity measures and tax increases implemented by former, more prudent, regimes, in an effort to prove their theory.

MORE: Former Treasury official: Let's keep running big deficits

The core European nations have far different economic problems than that of their nouveau riche neighbors on the periphery so it is understandable why some are jockeying for a "different" solution. But austerity is still needed in core nations, just not to the extent as was needed in, say, Greece. The core's main problems are legacy issues, namely that of pension and retirement benefits, and inefficiencies dealing with taxation and employment. But unless they get their spending under control, they will never be able to create workable solutions to those long-term issues.

France, in particular, is in need of a total economic makeover, but its leaders refuse to do anything about it. France had a budget deficit of 4.8% in 2012, well above the 3% threshold. But instead of fining or forcing Paris to change its course, Brussels this week gave it a two-year grace period. As things currently stand, France will bust through that 3% threshold again, posting budget deficits of 3.9% in 2013 and 4.2% in 2014.

Brussels has chastised François Hollande, France's President, for reversing changes to the pension laws instituted by former President Nicholas Sarkozy, who raised the pension age from 60 to 62. As a result, France is expected to have a pension deficit of around 20 billion euros by 2020. While Hollande says his government will reveal pension reforms later this year, it is doubtful that he will propose anything that will go far enough to address this dangerous overhang in the system.

France was just one of the nations taken to task by Brussels for violating the budget deficit rules this week, but it seems to be the only one that lacks a credible plan of action to put the country back on sound economic footing. Hollande has tried to excuse his inaction by saying austerity doesn't work. Unfortunately, praying for growth doesn't work, either. France can easily maintain fiscal prudence if it wanted to, but it is choosing not to. It still has one of the most generous social welfare systems and unemployment schemes in the EU, something that Brussels highlighted this week. Bringing the country in line with its neighbors, which by U.S. standards are already super-generous, is a no-brainer. Raising the pension age and reforming archaic employment laws would go far to increase French competitiveness, which has a much better chance of boosting growth and lowering budget deficits than by reversing pension reforms or taxing your richest citizens at 75%.

MORE: Investors cast doubt on Spain's rosy economic picture

Brussels may be too weak to enforce its own rules, but the markets aren't going to stand for such arrogance indefinitely. The governments of France and other core European nations who are violating budgetary rules are playing with fire. Why would investors continue to park their money with governments that are on a one-way trip to insolvency?

Just because funding costs are low now doesn't mean it will stay that way forever -- the market is fickle, and as we have seen, rates can explode overnight. While such a scenario was deeply troubling when it played out in Greece and Ireland, if it were to play out in Italy and France the results would be catastrophic. There simply isn't a bailout fund or a printing press big enough to keep the likes of Italy and France going for very long. But if the markets see the core nations taking concrete steps to correct their bad budgetary behavior, that will go a long way to rebuilding trust, helping to avoid  yet another "crisis."

  • 'Austerity' isn't an evil word

    Europeans are rejecting austerity measures in favor of growth policies. Unfortunately, the terms are too often misunderstood.

    FORTUNE -- With François Hollande's victory in France and the poor showing of both major parties in the Greek legislative elections, European voters are punishing parties and politicians that champion the economic reforms branded "austerity." In France, Hollande won on a platform of shelving "l'austerité" in favor of policies that favor the his version of MORE

    - May 8, 2012 9:26 AM ET
  • Welcome to austerity, America!

    Those calling for smaller government should be pleased: State and local municipal employees are losing their jobs at a much faster pace than the private sector.

    FORTUNE – For all of Washington's bickering over the debt ceiling and all the battle cries for government budget cuts, it's important to point out that there's already a back-door austerity plan well under way and it's showing its very dreary colors in cities and MORE

    - Jun 3, 2011 11:36 AM ET
  • U.K. inflation and the limits of austerity

    Think you've got stagflation? Check out the U.K.

    Inflation hit 4.5% in April, the government said Tuesday, up from 4% in March. Year-over-year price increases are on their way to 5% this summer, according to official forecasts.


    Yet there is no rush at the Bank of England to raise interest rates, with the economy spinning its wheels. The U.K. economy contracted in the fourth quarter and barely expanded in the first, as MORE

    - May 17, 2011 10:25 AM ET
  • Here comes austerity

    Don't think for a second that the Portuguese are going to hog all the belt-tightening fun for themselves.

    No, austerity is coming to the United States too, investment banker and Washington insider Roger Altman said Thursday.

    Altman, who founded the Evercore (EVR) investment bank and was deputy Treasury secretary under Bill Clinton, said on Bloomberg TV that the latest installment in Europe's debt crisis shouldn't distract anyone from the need to make tough choices MORE

    - Mar 24, 2011 3:39 PM ET
    Posted in: , , ,
  • U.K. shows limits of austerity

    Just in time for tonight's big speech comes a reminder of the limits of austerity.

    The U.K. economy posted a 0.4% fourth-quarter output decline, stunning economists who had expected to see gross domestic product rise 0.5%. Perhaps half the shortfall came from bad weather, but the news in any case was "shockingly bad," economists at Capital Economics in London said.

    The shortfall is noteworthy because Great Britain, unlike the United States, has MORE

    - Jan 25, 2011 1:00 PM ET
    Posted in: , , ,
  • Moody's warns on Greece again

    Today's target on the Moody's warpath is Greece.

    The rating agency said Thursday it may downgrade Greece's credit ratings again, just five months after it cut the country's bonds to junk, in the latest sign that mere austerity is no match for a massive debt overhang.

    Moody's cited weak government revenue trends, a surprisingly large recent rise in reported debt levels and rising questions about whether Europe will stand behind Greece.

    Touchingly, the firm MORE

    - Dec 16, 2010 12:11 PM ET
    Posted in: , ,
  • Austerity fails to save Ireland

    Troubled European governments are discovering that fasting is no cure for a giant debt hangover.

    Just ask Ireland, which is on the verge of signing up for a big bailout from Europe – despite the fact that by belt-tightening standards Ireland has been one of Europe's rare success stories.

    "Ireland has been doing 'all the right things' policy-wise," says Jan Randolph of IHS Global Insight.

    The country has stopped spending beyond its means, MORE

    - Nov 15, 2010 1:03 PM ET
    Posted in: , , , ,
  • S&P boosts U.K. outlook, lauding cutbacks

    So far, austerity is working for the U.K.

    Standard & Poor's raised its outlook on the United Kingdom Tuesday to stable from negative. The move effectively removes any threat that the world's sixth-biggest economy will lose its gold-plated triple-A credit rating in the next two years, barring unforeseen disaster.

    S&P said it boosted the U.K. outlook after the new coalition government led by Prime Minister David Cameron showed "a high degree of MORE

    - Oct 26, 2010 10:33 AM ET
  • UK keeps triple-A rating

    The United Kingdom isn't in danger of losing its top credit rating, Moody's said Monday, citing a government belt-tightening pledge.

    The rating agency, issuing its annual report on the world's sixth-biggest economy, said the U.K. won't soon return to its precrisis growth rate. It cited softness in the banking sector and the tattered finances of trading partners.

    But Moody's said it believes the government's commitment to shoring up its balance sheet should MORE

    - Sep 20, 2010 9:42 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.