Germany now faces recession and possibly deflation, while France
and Italy are not faring much better. This underperformance is not
new: Europe's economies have grown more slowly than the US since
1980, and the recent weakness has contributed to rising global
imbalances and widening growth differentials within the EU.
The European Central Bank's monetary policy is often blamed, but
Europe's biggest problem is low potential growth resulting from
excessive government spending and taxation, unsustainably generous
pensions and a wide array of burdensome regulations and
Recent deregulation initiatives in the labour, product and
capital markets have generated positive results, but significant
cuts in government spending and taxes are essential for growth.
Relying on a deficit-GDP ratio to guide fiscal policy - and
coordinate policies across EU nations - allows the tail to wag the
dog. A focus on deficits (and the stock of debt) has its place, but
it is frequently a distraction from the underlying spending and tax
structures, the shares of the economy they represent and their
implications for the allocation of national resources and household
and business decisions. Consider the following: Germany's deficit is
about 4 per cent of GDP - not quite as large as the US ratio - but
its spending and taxes as a share of GDP are roughly 50 per cent
higher than in the US. Obviously, these two nations have different
fiscal policies, with different economic implications.
Not surprisingly, research shows that higher government spending
is inversely correlated with economic growth, and higher tax burdens
harm both economic growth and job creation. By contrast, the impact
of deficits on economic growth and jobs is ambiguous, depending on a
host of factors. So why rely on deficits as the exclusive fiscal
policy trigger? The Maastricht Treaty imposed the deficit limitation
to promote fiscal responsibility and rein in government debt. Along
with the other criteria, the deficit cap successfully contributed to
a convergence toward narrower budget imbalances, lower inflation and
interest rates. But in recent years the deficit cap has not led to
lower spending and taxes. Rather than promoting fiscal
responsibility, it has been an obstacle to fiscal reform. Moreover,
the deficit cap is rigid, so when tax receipts fall and spending
rises, during economic slumps, it may lead to destructive
The pact should be altered to make it easier to enact the
pro-growth initiatives highlighted by the G7, particularly tax cuts.
As well as allowing the deficit cap to fluctuate to reflect economic
conditions, the pact should be modified by adding several new fiscal
guidelines that would cap government spending and taxes - the true
sources of Europe's malaise. These caps should be set well below EU
nations' current average ratios of spending and tax ratios to GDP.
They should be phased in over a number of years, as the Maastricht
criteria were. A formula that eased the deficit ratio in response to
tax cuts would also be established.
This would be radical, but these changes would address the most
pressing economic and fiscal issues facing EU nations. Pension
reform is a necessary component of spending reduction, but it must
be implemented over a long period to allow older workers to adjust.
Tax cuts, on the other hand - particularly reductions in marginal
tax rates that stimulate economic growth and job creation - cannot
This new formulation would provide incentives and flexibility to
fiscal policymakers and re-establish the credibility of the pact. I
am aware of the fierce political opposition to pension reform and
fiscal restraint. Technical details would need to be ironed out.
Some EU nations face high government debt-GDP ratios, and even
temporary increases in deficits may be perceived as negative.
However, Europe can learn from the dramatic fiscal reforms in the US
in the early 1980s, which lifted economic performance and standards
of living. Fiscal reform that increases potential growth and jobs is
the best way to reduce the long-term problems of high deficits and
debt - and the most positive strategy for reducing global
The writer is chief economist of Bank of America