On April 21, the Dutch coalition government collapsed, after right-wing populist Geert Wilders refused to endorse the spending cuts needed to limit the budget deficit to 3 percent of GDP. The next day, candidates who advocated backtracking on European integration captured one-third of the vote in the first round of the French presidential election. On May 6, France is expected to turn left and elect François Hollande, who questions the EU's German-inspired fiscal compact, agreed last December, and has called for Europe to emphasize growth.
These are the first skirmishes in a highly significant debate for Europe. The debate revolves around two major issues: austerity and integration.
Start with austerity. The question here is not whether deficits should be reduced. They must be, given the dire state of European public finances, and also because the countries whose competitiveness deteriorated during the first decade of monetary union must tighten fiscal policy in order to deliver the necessary adjustment of wages and prices.
Indeed, it is revealing that, as eurozone countries with severe external imbalances at the onset of the crisis have benefited from the European Central Bank's (ECB) wholesale liquidity provision, they have reduced their current-account deficits much less than non-euro countries in a similar situation. Germany, the arch-advocate of austerity, is right on this point.
The problem is that austerity has perverse effects. Private and public deleveraging can hardly take place at the same time, unless trade partners generate demand for exports. Recession and price deflation reduce tax receipts and worsen the dynamics of public debt, threatening the return to sustainability. Moreover, deficit targets lead governments to respond to recessions by doubling down on austerity, generally without much regard for the adverse supply-side effects.
So there is a need to approach austerity and rebalancing strategically. And here, the EU has made three mistakes.
First, finance ministers tried to reassure markets last October by demonstrating toughness and endorsing headline, instead of cyclically adjusted, deficit targets. This may be justified for a country on the verge of losing access to capital markets, but not for a country with relatively low debt and a moderate deficit. Ministers should change course and revert to their original 2009 commitment, which was to plan consolidation efforts and adhere to them through fluctuations and shocks.
Second, the eurozone still shies away from a comprehensive approach to its internal rebalancing. Price competitiveness is a relative concept, not an absolute value, yet the policy discussion still ignores this basic fact. This is paradoxical, because the ECB's policy framework provides clear guidance. The ECB is committed to 2 percent inflation in the eurozone as a whole, which implies that lower wage and price increases in southern Europe arithmetically mean higher wage and price increases in northern Europe. The wider the gap between the two, the sooner the rebalancing will be achieved.
It is time to say loud and clear that the ECB will fight hard to keep average inflation on target, and that northern Europe -- especially Germany -- will not attempt to counter higher domestic inflation as long as price stability is maintained in the eurozone as a whole. This would help significantly in mapping out a sensible rebalancing strategy.
The third mistake is one of omission: as ECB President Mario Draghi recently said, Europe has a fiscal compact, but lacks a growth compact. To be sure, there are no quick fixes: headline-grabbing initiatives often fail to measure up to the challenge of reviving growth. Nevertheless, serious discussion is needed concerning how to use the EU budget to enhance economic performance, rather than for redistribution only; how to foster pro-growth reforms at the national level; and how to boost investment in the periphery countries' tradable sectors.
A credible growth compact would help to overcome immediate hurdles. After all, the post-war Marshall Plan was so successful not because of its size, but because it helped to counteract zero-sum games and self-fulfilling pessimism. That is a lesson to keep in mind today.
But austerity is not the only dimension of the debate. Developments over the last two years have exposed the weaknesses of a bare-bones monetary union based only on a single monetary policy and fiscal discipline. While reforms enacted in the wake of the Greek crisis have equipped the eurozone with crisis-management capabilities, more is needed to restore confidence, ensure financial stability, and ward off financial fragmentation.
A key characteristic of the European crisis has been the strong correlation between banking stress and sovereign distress. Time and again, banks' woes have affected governments' borrowing costs, and concerns over governments' solvency have affected banks' balance sheets.
This major potential threat to financial stability has been alleviated, but not eliminated, by the ECB's large-scale provision of liquidity. The recent re-emergence of concerns about Spain has shown that the problem has not gone away.
Systemic reforms to resolve the problem all involve significant further integration: joint issuance of government bonds that play the role of safe asset in banks' portfolios, a “banking union” with a common regime for deposit insurance, supervision, and crisis resolution -- or both. Either one involves risk-sharing among eurozone members.
In France, the Netherlands, and elsewhere, many citizens view Europe as a threat to their way of life. Telling them that the euro is an unfinished construct that requires even more commitment is a hard call for politicians. The question for the coming months is whether European leaders will have enough political capital to embark on further reforms and make the case for them to angry publics. If not, it is to be feared that they will agree only on platitudes and hope for the best.
*Jean Pisani-Ferry is director of Bruegel, an international economics think tank, professor of economics at Université Paris-Dauphine, and a member of the French prime minister's Council of Economic Analysis. © Project Syndicate 2012