The EU’s Great Growth Debate

As Mondays go, Spain had a particularly blue one: Official data showed an economy back in recession, unemployment hit an EU-high 24.4% and S&P downgraded 11 large Spanish banks as a follow-up to their recent sovereign rating change. Overall, the news confirmed what most have long known—austerity can have painful near-term knock-on effects on growth and employment—but the headline numbers added urgency to the debate over how to help struggling nations grow again.

Most European officials agree pro-growth policy changes are necessary to improve the region’s medium- to long-term prospects, and they’re aware citizens are increasingly austerity fatigued as the economic fallout of fiscal consolidation becomes more apparent. French presidential candidate (and poll leader) FranÇois Hollande captured this sentiment with his call to add pro-growth measures to the EU’s fiscal compact. ECB chief Mario Draghi, meanwhile, called for a separate “EU growth compact,” and German Chancellor Angela Merkel and French President (for now) Nicolas Sarkozy pledged support.

That’s where the growth consensus ends, though—the actual agendas vary widely. Hollande’s plan, outlined last week, calls for financing infrastructure projects with Eurobonds and proceeds from a financial transactions tax, increasing efficiency of EU development funds, and enhancing investment financing by the EU’s long-term lending arm. The European Commission, striking a similar chord, is reportedly considering a €200 billion investment fund, supported by private enterprises and the ESM/EFSF and aimed at infrastructure and renewable energy projects. On balance, both plans appear to be typical demand-side stimulus.

But Merkel, Italian Prime Minister Mario Monti and European Commission chief Jose Manuel Barroso indirectly refuted that Keynesian approach. Said Merkel: “We need growth in the form of sustainable initiatives, not stimulus programs which would increase debt, but growth in the form of structural reforms.” Barroso and Monti asserted, “the revival of growth must come through a relentless focus on improving competitiveness and not through higher levels of debt.” In short, it seems they prefer a supply-side approach—reforming labor markets, liberalizing protected segments of the economy and, in general, removing barriers keeping firms from functioning as efficiently as they could.

Thus far, Hollande’s approach seems to be currying popular favor, and it’s easy to see why. Fiscal stimulus might provide short-term pop, which could help ease the sting of the painful sacrifices many Europeans have made in recent years. However, shoring up demand in the near term doesn’t fix all that ails the EU, assuming these measures would even work as intended—a big “if,” considering the likely unintended consequences of tools like the financial transactions tax. Absent other measures, once the initial pop (assuming one occurs) fades, Europe’s likely left with the same structural problems and not much flexibility for further stimulus.

Supply-side reforms, though perhaps less obviously appealing, would likely do far more to foster long-term growth and competitiveness. Opening protected trades to competition would likely promote entrepreneurship and overall economic activity. Temporary workers’ share of the labor force has increased in many European nations—labor market reforms that smooth the way for increased permanent hiring and reduce temporary help could add a measure of certainty for employers and the employed. And lowering “non-labor wage costs,” like lengthening the work week or cutting federally mandated vacation time, can increase productivity and output.

It’s premature to guess which path leaders choose—perhaps it’ll be a combination of the two. Or they may ultimately not even agree on anything. Then again, more important than any growth pact is whether the stressed nations, most notably Italy and Spain, take the necessary steps to continue improving their competitiveness. Thus far, the leaders of both nations seem to understand there’s no quick permanent fix, and they’ve pushed reforms that, while politically unpalatable, can make a real, positive difference over time. And, perhaps most important in the near term, as these nations continue meeting their 2012 funding needs, they buy additional time to make these difficult adjustments.