Fiscal profligacy did not cause thesovereign-debt crisis engulfing Europe, andfiscal austerity will not solve it. On the contrary, such austerity has aggravated the crisis and now threatens to bring down the euro and throw the global economyinto another tailspin.

In 2007, Spain and Ireland were models of fiscal rectitude, with far lower debt-to-GDP ratios than Germanyhad. Investors were not worried about default risk on Spanish or Irishsovereign debt, or about Italy’schronically large sovereign debt. Indeed, Italy boasted the lowest deficit-to-GDP ratio in theeurozone, and the Italian government had no problem refinancing at attractiveinterest rates. Even Greece,despite its rapidly eroding competitiveness and increasingly unsustainablefiscal path, could attract the capital that it needed.

Deluded by the convergence of bond yields that followed theeuro’s launch, investors fed a decade-longprivate-sector credit boom in Europe’s less-developed periphery countries, andfailed to recognize real-estate bubbles in Spainand Ireland, and Greece’sslide into insolvency. When growth slowedsharply and credit flows collapsed in the wake of the Great Recession, budgetrevenues plummeted, governments were forcedto socialize private-sector liabilities, and fiscal deficits and debt soared.

With the exception of Greece,the deterioration in public finances was a symptom of the crisis, not itscause. Moreover, the deterioration waspredictable: history shows that the real stock of government debt explodes inthe wake of recessions caused by financial crises.

Overlooking the evidence, European leaders, spearheadedby Germany,misdiagnosed the problem as one of fiscal profligacy for which painful austerity is the onlycure. On this view, significant and rapid reductions in government deficits anddebt are a precondition to restoringgovernment credibility and investor confidence, stemming contagion, bringing down interest rates, and reviving economic growth.

There is also a moral-hazard aspect tothe austerity argument: easing repayment terms for spendthrift governments will onlyencourage reckless behavior in the future – forgiving past sins perpetuates sinning. Moreover, virtuous creditors should not bail out irresponsible borrowers, be they privateor public. From this perspective, austerity is the necessary and just penance for reprobateslike Greece, Spain, and Italy.

But austerity is not working; indeed, it is counterproductive. In theshort to medium run, fiscal consolidation – whether in the form of cuttinggovernment spending or increasing revenues – results in lower output andemployment, which means lower tax collection, higher deficits, and escalatingdebt relative to GDP. Savvy investors, likefrustrated voters, recognize that low growth and high unemployment actually enlarge deficits and add to debt in the short run.That is why, after more than two years, interest rates are rising, not falling,in countries crushed by onerous austeritymeasures.

In fact, there is no simple relationship between the size of agovernment’s deficit or debt and the interest rate that it must pay. Britishgovernment bonds now offer significantly lower interest rates than those of France, Italy,or Spain, even though the United Kingdom’sfiscal position is considerably worse.

Greece is caught in a classic debt trap, as the interest rate on its public debthas soared beyond its growth rate by a considerable margin; Spain is teeteringon the brink. Austerity in Europe hasconfirmed the International Monetary Fund’s warning that overdoing fiscal consolidationweakens economic activity, undermines market confidence, and diminishes popularsupport for adjustment.

In the long run, many eurozone countries, including Germany,require fiscal consolidation in order to stabilize and reduce their debt-to-GDPratios. But the process should be gradual andback-loaded – with much of the consolidation coming after Europe’s economies have returned to a sustainable growthpath.

Structural reforms are also necessary in most European economies to bolster competitiveness and boost potentialgrowth. But such reforms take time: German Chancellor Angela Merkel appears tohave forgotten that it took more than a decade and roughly