A ray of sunshine in an otherwise gloomy Europe

The picture in Europe seems to get bleaker and bleaker. Austria, Germany, Greece, Ireland, the Netherlands, Portugal and Spain have all just recorded quarterly falls in GDP. The consensus forecast for 2012 is for an annual decline of 0.5 per cent across the eurozone.

Even that forecast is likely to be revised down. Purchasing managers’ index numbers, revealed on May 4, were bleak. For the composite figure, covering manufacturing and services, the final number was 46.7, down from the flash estimate of 47.4 and the 49.1 recorded in March. Anything less than 50 indicates contraction. The services component was 46.9, compared with the flash estimate of 47.9 and March’s 49.2. The composite figures for Italy and Spain were a dreadful 42.7 and 42 respectively. The trend seems remorselessly down – the new business component has fallen for nine months in a row.

To the Keynesians, the answer is simple: reverse course. Europe, they say, is headed on a kamikaze drive to austerity. An individual country might be able to slash its budget if the rest of the European economy was buoyant. But if every nation, or a large majority, wields the knife, demand will be slashed across the continent. Economic output will fall and the debt-to-GDP ratio will rise, the obverse of policymakers’ intentions. Instead, governments should slow the pace of fiscal contraction and let the economy grow out of the problem.

Nonsense, say the opposing camp, in which German economists seem to be prominent. Take Norbert Walter, the former chief economist of Deutsche Bank, who said recently “if you are in a cul-de-sac, the only way out is to go backward. Countries clearly living beyond their means must reverse.”

The argument of this camp is really that greater fiscal stimulus simply means more state involvement in the economy, which is not good for long-term growth. The French government already spends 56 per cent of France’s GDP a year. Boosting European growth requires reforms to the labour market and to cartels like the retail sector. Governments will only tackle such reforms under pressure. Easier policy in Germany (or from the European Central Bank) will only undermine their resolve.

This impasse may only be resolved by political pressure. The election of François Hollande as French president and the recent fall of the Dutch government, one of Germany’s most reliable allies, may mean that an anti-austerity tide is sweeping across Europe. This backlash might be slightly more apparent than real since Mr Hollande is planning to balance the budget by 2017, one year later than Nicolas Sarkozy. Mr Hollande has also called for a growth compact although it is not clear what this would mean – especially as he plans to reverse Mr Sarkozy’s supply-side reforms.