Behind the more headline-grabbing aspects of Europe’s endless debt negotiations, the great debate over austerity and growth continues. As with so much else in the European conversation these days, this one has taken a wrong turn.

Popular thinking presents the alternatives as a binary choice, growth or budget discipline. But others in Europe see a useful third way. This approach would accept the need for overall austerity but would pursue growth regardless through structural reforms in labor markets, product regulation and the mix, not the overall level, of government spending. Remarkably, some in Europe’s periphery already have begun to move down this path.

Much in the Franco-German debate has, sadly, ignored this third approach and gone off in the fruitless, binary direction. German chancellor Angela Merkel seems to view anything but a single-minded focus on budget restraint and deficit reduction as a waste of rescue monies and an effort to reestablish the old fiscal profligacy that brought Europe to its current crisis. French president Francois Hollande seems to reject austerity as if nothing were wrong with past patterns. He campaigned in France’s recent elections against budget restraint as too much to ask the nation to bear and would place spending restraint, deficit reduction and debt control low on the national priority list. He would, in fact, seek more spending to promote growth.

There are problems with both these positions. In Hollande’s approach, the rescue funds would have little lasting value. They simply would finance a continuation of profligate budget policies, this time at the expense of the German taxpayer. But there are equally severe problems with the German position. Budget cuts and tax hikes alone will drive already beleaguered economies deeper into recession. The increased demand for social services and the inevitable revenue shortfalls would then increase, rather than reduce, budget deficits. Since, in the German scheme, this circumstance only would elicit still more austerity, chances are the recession would only get worse, forcing these nations into a vicious downward cycle in which rising deficits prompt more austerity that prompts still worse economic and budget performance.

But despite this Franco-German blindness, Europe need not choose between such potentially disruptive extremes. Championing the alternative approach are Mario Monti, the Italian premier, Mario Draghi, the president of the European Central Bank and the International Monetary Fund (IMF). Their answer would do nothing to resist overall budget austerity. Though accepting overall budget constraints, it would build a parallel growth agenda by, among other things, liberalizing labor laws, softening regulatory strictures and adjusting government spending priorities with an eye to economic returns. These growth aspects would ease the strain of austerity on these economies and avoid the vicious cycle that would emerge from austerity alone. IMF research supports this expectation, indicating that such efforts could add as much as 4.5 percent to the gross domestic products of these countries over the next five years, an annual growth premium of almost one percentage point a year, a not inconsiderable amount in today’s slow-growth, recession-prone environment.

But Monti and Draghi could improve their sales pitch with more specifics. To date, they have remained maddeningly vague on most points. The only area where either has offered anything concrete, at least in their summit suggestions, is in the need to upgrade Europe’s economic infrastructure. Monti has insisted that such spending, because it has an economic return, should not count in budget deficit calculations. Both Monti and Draghi have recommended greater funding for the European Investment Bank as a way to finance such infrastructure spending without burdening national budgets. All this might sound like a gimmick simply to avoid austerity demands, but the arguments at base are sound and only ask, reasonably, that Europe rethink its fiscal priorities to distinguish, in Monti’s words, between “virtuous” public investments and less productive state spending.

Still, even as Monti and Draghi have remained coy at European summits, the governments in the periphery have begun to take more concrete steps along these structural lines. Following the pattern of German reforms, set some years ago under then chancellor Gerhard Schröder, all these nations have begun the difficult task of labor reform. There seems to be a widespread recognition among them that past restrictive policies have hindered growth by rendering their labor markets horribly inflexible. Rules that all but forbid firms from laying off or firing full-time employees, for instance, have discouraged hiring generally or forced firms to rely more on temporary workers with fixed-term contracts. In addition to interfering with businesses’ ability to secure and promote the best workers, these rules have wasted talent generally by denying new, mostly younger workers secure jobs with decent pay. Combined with other strictures on pensions, hours and the terms of contracts, these old policies have made it difficult for firms to adjust to changing economic conditions, rendering whole economies slower-growing and less competitive.

Political factions have a vested interest in these labor rules, not least the powerful unions. Thus, it is remarkable that the Italian parliament, under Monti, has voted overwhelmingly to modify Article 18 of the country’s 1970 labor law, which imposes most of the Italian version of these restrictive structures. Unsurprisingly, business complains that Monti has not gone far enough. What is surprising is that he got anywhere at all, that the protests were not larger and that not even all unions joined them. After all, in 1999 and 2002, the Red Brigade murdered the leading lights of Italian labor reform. Spain, too, seemingly against the odds, has moved similar legislation, as have Portugal and Greece. But labor law is not the only fertile area for such structural reform. The same IMF work that estimated the effects of reform on growth makes a number of other promising suggestions.

One is a relaxation in what the IMF research labels “excess product market regulation.” Calling attention to ill-considered rules across the entire European Union (EU), this research shows how restrictions on product design, overzealous licensing, as well as limits on the location, size and nature of facilities have made for inefficient uses of both physical and financial capital as well as labor. To test the weight of such impediments, this research developed a “regulatory liberalization index.” With this gauge, the IMF work determined that the most liberal third of the countries in their sample have income levels 5 percent above those in the lower third. The IMF, of course, has no desire for a sweeping removal of regulations. Rather, it would have the EU and its national governments review all rules, modifying those that threaten growth prospects and detract from economic efficiency. The European Commission has picked up this tone, in an admittedly narrow area. It has argued that Europe could become much more innovative by offering regulatory exemptions to smaller businesses and seeking their input when preparing new laws.

If Europe, and especially its periphery, were to build on the structural growth agenda that it has already begun, it could pursue growth even as it implements needed budget discipline. The combination would avoid fiscal profligacy as well as the vicious cycle that comes from a single-minded focus on austerity. If the initial lift from structural reform cannot counteract all the immediate contractionary effects of austerity, it could surely ameliorate them—and lay the groundwork for a more impressive and lasting recovery.

Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. and an associate of the Center for the Study of Human Capital at the State University of New York at Buffalo. He writes frequently on economic and social issues and is just completing a book on demographics and globalization.

Image: Garitan

