In the recent financial and economic crisis, some members of the Eurozone faced the threat of sovereign default. The Eurozone managed to avoid fiscal and financial mayhem through large-scale bailouts, drastic fiscal consolidation programmes in the countries concerned and unprecedented measures by the European Central Bank. Eurozone countries must now strike the right balance between short-term consolidation of public finances and long-term growth boosting investments.

Given the still significant debt burden in many EU countries, the focus must now shift onto the underlying ability to repay. This ability will depend on the growth and competitiveness of the countries concerned. In fact, there are complex linkages between economic growth and the level of public debt.

In the short term, fiscal consolidation usually suppresses growth. By how much depends on the design of the fiscal reform programme, among other things. Governments often choose to raise taxes to plug fiscal holes, rather than going down the more difficult but sustainable route of cutting expenditure. Higher taxes risk stifling business investment and private expenditure.

Yet, Europe today has no alternative to fiscal consolidation. Continued fiscal and financial instability would undermine Europe’s fledgling economic recovery. The banking and financial sectors of European countries are closely interconnected. If one country faces the risk of sovereign default (or a crisis in its banking sector that threatens to overwhelm its overly indebted government), instability would quickly spread through the Eurozone and beyond.

In the medium to long term, too, public debt has an impact on growth rates. Much depends on how governments spend the money they borrow. If they spend it on consumption, the longer-term growth effects will be zero – or even negative, if public borrowing crowds out private investment. If governments spend the borrowed money on education, research or infrastructure, they can help to raise the economy’s trend growth rate going forward. Higher growth, in turn, makes it easier to repay the initial debt.

Governments often find it easier to cut back on research or road building programmes than to curtail social support and subsidies to which voters have become accustomed. However, such short-term political expediency tends to impose heavy economic costs.

Bearing in mind the risk of social dislocation, European governments should gradually cut subsidies, make their social support programmes more targeted and effective and then shift spending towards growth-boosting investments. They should also do more to leverage private investments into infrastructure, education or healthcare. Such a strategy could create a virtuous circle in which higher spending today generates the additional growth that, in turn, makes it easier not only to repay debt but also to maintain a fair social market economy.

European politicians could start laying the groundwork today by explaining to their voters that fiscal reform is needed to safeguard their future standard of living. Only by getting the voters onside will they stand a chance of success in building a sustainable recovery from the crisis.

This blog is an extract from The Europe 2020 Competitiveness Report.

Author: Katinka Barysch is Director of Political Relations, Allianz SE, Germany. She is also a World Economic Forum Young Global Leader and Global Agenda Council Member. The views expressed here are her own.

Image: The euro sculpture is seen outside the headquarters of the European Central Bank (ECB) in Frankfurt, November 5, 2013. REUTERS/Kai Pfaffenbach