Larry Summers and Christina Romer both argue--convincingly, it seems to me--that Europe's pursuit of creditworthiness through fiscal austerity is failing. Their point is not that fiscal restraint is always bad. Normally, reining in deficits would strengthen the public finances. The point is that current circumstances are unusual. As Summers explains:
Systematic comparisons of the experience of different European countries or more global comparisons at the IMF are salutary. They suggest that, when economies are constrained by demand and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 per cent have a multiplier of 1 to 1.5. This implies a 1 per cent reduction in a country's ratio of spending to GDP or an equivalent tax increase reduces its GDP growth rate by 1 to 1.5 per cent.
This means austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only very limited reductions in deficits once the adverse effects of contraction on tax revenues and benefit payments are taken into account. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which takes a toll on the capacity and willingness of the unemployed to work.
In ordinary times, fiscal tightening would improve creditworthiness because its negative effect on demand and employment would be small, and monetary policy could be used to offset that effect in any case. Today the negative effect is bigger and the scope for monetary easing is limited. Belt-tightening by itself just won't work.
However, it isn't enough to say "choose growth". As Gideon Rachman says of Francois Hollande's promise to replace austerity with growth if he wins the French presidency, "Why didn't anybody think of that before?" If France unilaterally announced big new spending plans, the markets would drive its borrowing costs up. That goes double for Spain, where the cost of debt is already so high as to threaten the country's solvency, and where the future of the European Union may very well be decided.
Fiscal tightening won't restore Spain's creditworthiness: it shrinks the economy. Fiscal expansion won't do it either: that would spook the markets. So there's no way out? That's right--not for Spain acting alone.
Europe has to act collectively. The euro area as a whole is an economy comparable in size to the US. Its gross public debt is about the same, its balance of payments is stronger and its aggregate fiscal deficit is smaller. If euro area governments jointly backed its borrowing, Spain wouldn't need to pay 6% to persuade investors to buy its debt. That's the way out.
It's not a question of "choosing growth". Europe has to choose fiscal union. It might not want fiscal union, but it had better consider the alternatives. Adopting the euro was a mistake but there's no way back from that without truly colossal damage. The price of maintaining the current half-way position--monetary union without fiscal union--will be years of intolerably high unemployment in Spain and other parts of the EU. The only way to avoid this is for Germany to grit its teeth and embrace the closer political (i.e., fiscal) union it always said it wanted.