Highly indebted European countries remain exposed to shocks
The benefits of fiscal stimulus in Europe
Highly indebted European countries remain exposed to shocks
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ANALYSIS
In the most indebted countries in the European Union, public debt ratios have stabilised, their fiscal deficits have declined, the EU current account balance is in surplus, and growth has returned.
Why then are so many countries still struggling to place their debt to GDP ratios on a firm downward path? There are four main reasons for this struggle: sluggish growth, low inflation, limits on the effectiveness of extraordinary monetary stimulus to foster faster economic growth, and the still significant fiscal adjustments needed among highly indebted countries. (See Exhibits 1 and 2.)
In spite of very low interest rates, the economic recovery has been sluggish across the EU, the pace of growth is decelerating, and inflation remains below 1%, even if food and energy prices are excluded. Low inflation is perpetuating expectations that inflation will remain low, making a change in wage- and price-setting behaviour more difficult. Negative rates are also hampering a more rapid return to strong health in all the financing systems across the EU. Demand for European goods and services from outside the EU is weak. Incidents of terrorism, increasing immigration, the ongoing Greek negotations, and a rise in populism – most evident in the British vote to leave the European Union – have contributed to uncertainty over economic prospects, and the pace of European economic and financial integration. These unresolved issues have diverted the attention of policy makers from the task of economic adjustment.
In considering other ways to stimulate growth, the ECB could adopt additional measures, such as an increase in inflation targets; or the use of helicopter money, or direct central bank support of fiscal spending. However, it is not clear that these measures would be any more successful in promoting growth.
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Those countries that have fiscal space are starting to shift away from fiscal austerity in favor of fiscal stimulus. This is materialising in public investment and other spending. This shift is also a response to popular opposition to fiscal austerity. The extent of fiscal stimulus has so far been modest, since in many countries the fiscal adjustment needed to stabilise their debt ratios is still significant. Are the highly indebted countries therefore condemned to live with high debt burdens indefinitely? If so, it is only a matter of time until an external shock derails their debt stabilisation efforts.
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For the highly indebted countries, there are therefore limited policy options. In the Eurozone, a more flexible fiscal union and the mutualization of Eurozone debt might help to restore investor, business and consumer confidence. Yet greater burden-sharing of debt is politically difficult and therefore unlikely. After years of austerity, structural adjustments to foster higher productivity growth are politically difficult to implement. The most compelling action, as the European Council has recently recommended, would be for the less indebted countries to provide growth-friendly, countercyclical fiscal stimulus, such as spending on infrastructure, education, and research and innovation. However, fiscal austerity is embedded in the Stability and Growth Pact rules, and despite the Council’s recommendations would be difficult to change.
Greater public investment by less indebted countries could stimulate regional growth
A recent study by the European Commission suggests that an increase in public investment among the less indebted Eurozone countries would be effective in significantly reducing the debt burdens of the highly indebted countries.
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The argument is as follows. Under normal monetary conditions, fiscal stimulus is typically accompanied by higher interest rates and currency appreciation. Both of these factors tend to dampen GDP growth. However, under current monetary conditions with monetary policy at the zero lower bound, fiscal stimulus would be more likely to spark higher inflation, a further decline in real interest rates and a depreciation of the currency. These factors would tend to lead to an acceleration in economic activity.
One scenario considered in this study that illustrates the spillovers is for Germany and the Netherlands to increase their public investment by 1% of GDP, lasting ten years. Under the assumption that ECB policy interest rates would remain at the zero bound for the first two years before returning to normal monetary conditions in the following years, the output elasticity of public capital would rise from 0.09 to 0.17. This additional public investment would raise GDP growth by 1.1% in Germany, by 0.9% in the Netherlands, and by more than 2% in each country after 10 years.
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Of even greater significance are the spillovers from this stimulus to other Eurozone countries. Strong demand in Germany and the Netherlands, as well as some depreciation of the Euro, would raise GDP by about 0.5% per year in France, Spain, Italy, and the rest of the Eurozone. The adjustment in the current account would be minimal. The deterioration in public finances would be limited, since the extra growth would push up tax receipts. Most significant is that the debt ratio would be only about 2% higher after 10 years for Germany and 2.8% higher for the Netherlands, while the debt ratios in the rest of the Eurozone would be 2% of GDP lower. (See above Exhibits 3 and 4.)
The size of the spill-overs to other Eurozone countries would depend on the efficiency of the investment programmes. On this issue, there are three points worth noting: first, the investment programs in the study do not involve public investment levels above the pre-crisis trend, but rather a catch up. Public investment has been declining for years, and the study would represent a reversal of this trend to the pre-crisis level. Second, during the Great Recession and Eurozone crisis, cuts to public investment created backlogs in the maintenance of existing infrastructure, which could likely be addressed at minimal cost. Third, low borrowing costs provide an opportunity to lock in low rates of return on public infrastructure projects. In the study, the anticipated two-year delay in the monetary policy response to fiscal stimulus would represent another major benefit of the current period of extraordinary monetary accommodation. Another benefit of a more expansionary fiscal stance is that it could allow a more rapid return to a normal monetary policy.
Fiscal stimulus is not without risks
Of course, the analysis in the study is based on the premise that there exists the political willingness and public support in both Germany and the Netherlands to increase public investment over the course of ten years, partly to the benefit of other Eurozone member countries. As elections in both countries approach, such a programme might not be politically viable.
There are also risks associated with fiscal stimulus. A shift from deficit reduction to higher public investment would raise borrowing, and in countries where growth is sluggish the debt ratio would likely rise. Hence greater spending could perpetuate their exposure to shocks.
A second risk is that fiscal stimulus would cause a sudden recalibration of central bank policies, resulting in a rapid reversal of monetary easing. With greater fiscal stimulus and higher growth, and unemployment back to the pre-crisis level in the UK and Germany, central banks could feel less of a need to extend bond purchases or further lower short-term interest rates.
Should this sentiment extend to the United States and induce the Fed to raise rates more quickly, a sudden pull-back by investors in government bonds could ensue. Nevertheless, low growth and high debt burdens leave many European countries exposed to shocks, and the benefits of growth-friendly fiscal stimulus could outweigh these risks, if they succeed in fostering economic activity.
