European Commission latest to convert to Fiscal Expansionism

The widely accepted view on the Great Depression is that it was exacerbated by a series of policy errors- trade protectionism, tight monetary policy and contractionary fiscal policy. Consequently, given the lessons learned,  the Great Recession in 2008-9 prompted a substantial policy reaction across the globe, with a massive easing in monetary policy accompanied by counter cyclical fiscal policy. Oddly, though, policy makers then decided that debt reduction should take priority, and fiscal policy generally became contractionary even when the global recovery began to falter and lose momentum, with monetary policy seen as ‘the only game in town’. That emphasis on the  perceived dangers of high and rising  sovereign debt resulted in new and stricter fiscal rules in the Euro Area (EA), emphasising the need for a steady and persistent reduction in budget deficits.

Policy doubts eventually began to emerge, including from the IMF, with evidence questioning whether ‘austerity’ actually reduced debt levels and claiming that the  negative multiplier effects of contractionary fiscal policy were steeper than previously believed. Doubts also grew about the effectiveness (and  possible adverse consequences ) of loose monetary policy particularly after the adoption of negative interest rates and large scale QE. The ECB has also changed its tone of late, accepting the need for monetary policy to be complemented by some expansionary fiscal policy in the EA, albeit while still respecting the existing fiscal rules.

Academic debates  on fiscal policy have also intensified, with the case being made that budgetary policy can be more effective at or around the zero rate lower bound, but  events have transpired to take fiscal policy centre stage in the real world. The UK government has already announced , post the Brexit vote, that it has abandoned its previous pledge to balance the budget by 2020, and is expected to announce a more expansionary fiscal path later this month. In the US,  markets now expect fiscal policy to be far more expansionary under the incoming Trump Administration, although it remains to be seen how much of the campaign rhetoric will translate into policy action.

Closer to home, the European Commission has just announced , for the first time, a recommendation on the overall fiscal stance in the EA, and is advocating that it should be expansionary in the coming year, amounting to 0.5% of GDP , equivalent to a €50bn budgetary injection. On existing  national plans , the  overall  EA fiscal stance is expected to be neutral in 2017, after being modestly expansionary in 2016, and the Commission believe that a number of countries have the fiscal space available to raise spending and/or cut taxation, although it cannot force any action. The group comprises Germany, Estonia. Malta, Latvia, Luxembourg and the Netherlands. In practice, the Federal Republic is the only member with the size to affect the EA as a whole, and while calls for Germany to adopt a more expansionist policy in the interests of the wider zone have been made before, it is novel and perhaps surprising to see Brussels join in that chorus.

Stagnation and relative performance in the euro area

The new year has brought greater optimism in relation to the global economic outlook, with a number of international economic organizations revising up their growth forecasts or indicating that such a move is imminent. Time will tell whether the more upbeat mood is warranted ( the last few years have seen initial forecasts subsequently revised down) and it is noticeable that the ECB remains very cautious on prospects for the euro area, pointing to downside risks, although the Bank is in line with the consensus in expecting a modest upturn, with growth of 1.1% forecast for this year and 1.5% in 2015, following a 0.4% contraction in 2013 and a 0.6% fall the previous year. Those figures refer to the euro area as a whole, of course, and are a weighted average of the constituent countries, and as such can hide significant variations across the zone.

Indeed, the divergence in  relative economic performance since the inception of the euro in 1999 is extraordinary. Eleven countries adopted the single currency at that time (the total has now risen to eighteen following Latvia’s entry at the turn of the year) and some of that initial group has prospered while others have stagnated, as measured by real GDP per capita. According to the IMF’s data on the latter , Finland has been the best performer over that period, with  real income per head rising by 20%, marginally outstripping Germany (19.4%) . Austria is in third position, at 18%, followed by Ireland in fourth, with a cumulative gain of 17.6% despite a sharp decline since 2007. These figures are better than that achieved by the major advanced economies over the same period, led by the UK at over 16% followed by the US around 15%,

The figures cover a fourteen year period and so even the strongest performance, such as  that of Germany, translates into  annual average  growth in GDP per head of 1.25% with the majority of the original eleven euro members not achieving 1% per annum. France is notable in that regard, with average growth per head of only 0.6% and a cumulative increase of just 8.7%, putting it in eighth position. That is only marginally better than the that of Spain, which is often portrayed as a chronically poor performer. Portugal is viewed through a similar lens but the data is still surprising, showing zero growth in Portuguese real income  per head since 1999. Yet that dismal statistic is dwarfed by the figures for Italy, as real GDP per capita is actually 3.5% lower now than it was at the birth of the single currency.

Economic growth in the medium to long run is the product of growth in the labour force  and the capital stock alongside technological progress so this pronounced divergence in performance could be put down to  respective differences in these ‘real’ factors  and not to the single currency per se- hence the emphasis from the ECB and the European Commission on ‘structural’ reforms in the euro area, which one takes to mean measures to boost the supply side of the economy and potential growth. Yet it is also undeniable that some countries have found it very difficult to cope within a monetary union dominated by a super-efficient industrial powerhouse and it is remarkable  that the electorates in those economies  have apparently learned to live with that stagnation.