The Wrong Problem by David Atkins

After more than a year of aggressive budget cutting by European governments, an economic slowdown on the continent is confronting policymakers from Madrid to Frankfurt with an uncomfortable question: Have they been addressing the wrong problem?

With the euro-zone economy slowing and governments aggressively cutting, the ECB may need to concede its rate increases and tight money were a mistake, Peter Vanden Houte, an analyst at ING, wrote Wednesday in a research note. “Loose monetary policy seems to be the only medicine left to prevent a painful fall back into recession,” he said.

Recent statistics showed that the combined economy of euro-zone countries nearly stalled from April through July, with growth of just 0.2 percent. Germany’s economy, one of the main props of the region, grew just 0.1 percent. Analysts project Spain’s annual growth at about 0.7 percent for the year, far below prior government estimates of 2.3 percent. That may force a choice: further belt-tightening, or missing the deficit targets that international markets now expect.

IMF Managing Director Christine Lagarde recently warned that government officials could be overreacting to the debt crisis.

“Spain’s is not a fiscal problem,” said Gail Allard, a professor of economics at Spain’s IE Business School. Like many analysts in Spain, Allard noted that the country’s overall debt level remains below the average for euro-zone nations.

But the financial crisis, which started in 2007, and the subsequent recession hit Spain’s banking industry hard. Real estate tax receipts, a major source of government revenue, fell sharply, and annual budget surpluses turned to deficits in excess of 10 percent of annual economic output. The overall debt level, which had been considered reasonable, began to increase fast.

But the immediate rush to trim deficits, some analysts now suggest, may be diverting attention from politically difficult structural decisions needed to clear the way for growth. These could include selling off public companies in Greece and consolidating Italy’s millions of small firms into more efficient enterprises. In Spain, it could mean curbing the power of trade unions...

Allard and other analysts agree that the government needed to take action. But they say the focus should have been on restoring growth by, for instance, revising labor policies that hamper investment and hiring, rather than on cutting deficits in an economy that was already reeling.

Investors were still comfortable lending money to Spain. So there was little reason, analysts say, for Spain to seek to reassure them by raising sales taxes — especially at a time when local demand was plummeting and unemployment was rising above 20 percent, the highest in the region. Investors may have respected the budget cuts, but they also would have taken note of pro-growth structural changes, these analysts say.

“Unless you start with some sort of labor market reform, it is not going to change anything fundamental about the Spanish economy,” Allard said.