The German government’s reaction to newly elected French PresidentFrançois Hollande’s call for more growth-oriented policies was to say thatthere should be no change in the eurozone’s austerity programs. Rather,growth-supporting measures, such as more lending by the European InvestmentBank or issuance of jointly guaranteedproject bonds to finance specific investments, could be “added” to these programs.

Many inside and outside of Germanydeclare that both austerity and more growth are needed, and that more emphasison growth does not mean any decrease in austerity. The drama of the ongoingeurozone crisis has focused attention on Europe, but how the austerity-growth debate plays out there is morebroadly relevant, including for the United States.

Three essential points need to be established. First,in a situation of widespread unemployment and excess capacity, short-run outputis determined primarily by demand, not supply. In the eurozone’s membercountries, only fiscal policy is possible at the national level, because theEuropean Central Bank controls monetary policy. So, yes, more immediate growth doesrequire slower reduction in fiscal deficits.

The only counterargument is that slower fiscal adjustmentwould further reduce confidence and thereby defeat the purpose by resulting inlower private spending. This might betrue if a country were to declare that it was basically giving up on fiscalconsolidation plans and the international support associated with it, but it ishighly unlikely if a country decides to lengthenthe period of fiscal adjustment in consultation with supporting institutionssuch as the International Monetary Fund. Indeed, the IMF explicitly recommendedslower fiscal consolidation for Spainin its 2012 WorldEconomic Outlook.

Without greater short-term support for effective demand, many countries incrisis could face a downward spiral ofspending cuts, reduced output, higher unemployment, and even greater deficits, owing to an increase in safety-net expenditures and adecline in tax revenues associated with falling output and employment.

Second, it is possible, though not easy, to choosefiscal-consolidation packages that are more growth-friendly than others. There is the obvious distinction between investment spending and current expenditure, whichItalian Prime Minister Mario Monti has emphasized. The former, if welldesigned, can lay the foundations for longer-term growth.

There is also the distinction between government spending with highmultiplier effects, such as support to lower-income groups with a high propensity to spend, and tax reductions for therich, a substantial portion of which would likely be saved.

Last but not least, there are longer-term structural reforms,such as labor-market reforms that increase flexibility without leading tolarge-scale lay-offs (a model rather successfully implemented by Germany).Similarly, retirement and pension reformscan increase long-term fiscal sustainability without generating socialconflict. A healthy older person may well appreciate part-time work if it comeswith flexibility. The task is to integrate such work into the overallfunctioning of the labor market with the help of appropriate regulation andincentives.  

Finally, particularly in Europe,where countries are closely linked by trade, a coordinated strategy thatallows more time for fiscal consolidation and formulates growth-friendlypolicies would yield substantial benefits compared to individual countries’strategies, owing to positive spillovers (and avoidance of stigmatization ofparticular countries). There should be a European growth strategy, rather thanSpanish, Italian, or Irish strategies. Countries like Germany thatare running a current-account surplus would also help themselves by helping tostimulate the European economy as a whole.

Slower fiscal retrenchment,space for investment in government budgets, growth-friendly fiscal packages,and coordination of national policies with critical contributions from surpluscountries can go a long way in helping Europe to overcome its crisis in the medium term.Unfortunately, Greecehas become a special case, one that requires focused and specific treatment,most probably involving another round of public-debt forgiveness.

But insufficient and sometimes counterproductive actions, coupled withpanic and overreaction in financial markets, have brought some countries, suchas Spain,which is a fundamentally solvent and strongeconomy, to the edge of the precipice, andwith it the whole eurozone. In the immediate shortrun, nothing makes sense, not even a perfectly good public-investment project,or recapitalization of a bank, if the government has to borrow at interestrates of 6% or more to finance it.

These interest rates must be brought down through ECB purchases ofgovernment bonds on the secondary market until low-enough announced targetlevels for borrowing costs are reached, and/or by the use of European StabilityMechanism resources. The best solution would be to reinforce the effectivenessof both channels by using both – and by doing so immediately.

Such an approach would provide the breathing space needed to restoreconfidence and implement reforms in an atmosphere of moderate optimism ratherthan despair. The risk of inaction or inappropriate action has reached enormousproportions.

No catastrophic earthquake or tsunami has destroyed southern Europe’s productive capacity. What we are witnessing –and what is now affecting the whole world – is a man-made disaster that can bestopped and reversed by a coordinated policyresponse.