In my earlier blog, why government austerity measures are a bad idea , I had mentioned how Austerity is a bad idea because it puts a spanner in the economic growth. Austerity alone does not deliver the rewards it is meant to and the threats of stunted economic growth and recession remain high in the Euro zone even today. Case in point is Portugal, a country that had taken the austerity route and followed all the rules but was still struggling with its debt problems.
There is a risk of that; look at Portugal, it has done all the right things, it has stuck to austerity, it has stuck to the programs set by the EU and others and yet Portugal's bond yields are incredibly high today.
The expectation from austerity was that markets reward countries for delivering austerity in the form of much lower borrowing costs and that hasn't happened. Despite the austerity drive, the euro zone was still plagued by talk of default and speculation that it might break up. These things effectively mean that austerity does not deliver the rewards it is supposed to deliver. The consequence is that you are left with countries that have zero growth, possibly recession and interest rates which are painfully high and that combination is unsustainable.
The failure of austerity put fiscal transfer back to the top of the agenda. Germany has been vehemently opposed to direct fiscal transfers from the better performing northern euro zone to the struggling southern countries. If they can't get the rewards from the markets, presumably there would have to be some kind of fiscal transfer mechanism to allow their yields to come back down. This brings the whole issue of what the ECB does, what happens with a fiscal union. It has to help these countries, not just deliver austerity.
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