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.

Grexit now more likely after latest Eurozone ‘deal’

The Eurozone has announced  what the headlines refer to as a ‘deal’ on Greece , emerging  from yet another all-night negotiating session. History suggests that agreements reached in the wee small hours by sleep deprived participants can look very different to at least some  bleary eyed negotiators in the clear light of day, but that aside the agreement is  quite extraordinary, and breaks new ground in terms of euro zone governance. Indeed, such is the departure from previous discussions with debtors that, if anything, it increases the risks of Greece leaving the euro.

The text of the Euro Summit on Greece opens with a statement on  the need to rebuild trust with the Greek authorities and to that  end  Athens has to pass legislation, by Wednesday 15 July, on a range of measures, including pension reform , changes to the VAT system, the independence of  the state statistical service and the setting up of a Fiscal Council. In addition the legislation should include ‘quasi-automatic spending cuts in case of deviations from ambitious primary surplus targets’ and by the following week new laws  changing the civil justice system. The ECB will maintain the existing level of ELA for a little longer, to focus Greek minds, while the banks will remain shut.

Upon a satisfactory conclusion of the above, and subject to the approval of ESM member states, negotiations may start on a new loan, but Greece has also to set out a timetable for the implementation of  another raft of reforms, including further changes to the pensions system and  significant moves to liberalize retail markets , the professions, labour markets and the financial system. The energy transmission mechanism is also to be privatized, and in that context the text also proposes  an unprecedented step, in that Greek assets are to be sequestered into a separate fund for privatization, with the intention of raising €50bn, to be used to finance the recapitalization of the banks, to run down debt and to fund investment.  Moreover, Greece also has to undo some of the legislation brought in by the new Administration  and is required to ‘consult and agree with the Institutions on all relevant areas before submitting it for public consultations or to parliament’

The Hellenic Republic will also have to seek a further IMF loan and a total bailout figure of €82bn to €86bn is envisaged, although the text also notes that fulfilling the initial conditions does not guarantee that a  loan will follow. The Eurogroup may consider debt extensions and changes to interest rates but ‘ nominal haircuts on the debt cannot be undertaken.’

Some might consider all of this a move to shift Greece towards a Northern European style market economy and one consistent with euro membership  while others have already branded it as a ‘coup’, with the Eurogroup  accused of seeking regime change . The degree of interference and control from Brussels is certainly a new departure as is the idea of preconditions before negotiations can even begin. The latter certainly increases the risk that political support in Greece will not materialise, particularly as the electorate have already rejected a less severe version of the measures now mandated. In addition, implementing reforms, even if passed by parliament, may prove extremely difficult , if not impossible.  A debt write down is also not on offer, even though many, including the IMF, see the debt situation as effectively unsustainable.

Perhaps the most striking development over the weekend was the German proposal that Greece could take a 5-year timeout from the euro area. Leaving aside the practicality of such a move the fact that it was put into the open ( although not in the final text)  shows that Grexit is no longer seen by some creditors as a disaster, Indeed, the ‘take it or leave it ‘ tone  of the offer is also striking (‘the risks of not concluding swiftly the negotiations remain firmly with Greece’) and one can only conclude that the probability of a Greek exit from the eurozone has increased, either  through a Greek rejection of the proposals or via some creditors still  baulking at what they see as the futility of throwing good money after bad.

When Debtor Fatigue meets Creditor Fatigue

The euro has always been a politically driven project, and the inevitable economic fault lines that emerged  as it expanded  have been met with a surprisingly strong will on the part of  member governments to maintain the single currency. That determination has surprised markets and often confounded analysts , although  any decisive political action has often emerged from crisis meetings in the early hours of the morning. Decision making in such an environment raises issues of democratic accountability and  risks serious policy errors ( for example the determination to prevent a sovereign default within the EA) and  post-meeting disagreements on what was actually signed off ( see Ireland’s belief that the ESM would be able to retrospectively recapitalize banks). The euro is also now left with fiscal rules  and constraints which are  both extraordinarily complex and lacking in credibility; no one believes that a euro member will be fined for a breach and the Commission has repeatedly backed down when faced with one of the larger member states, notably France .

In the absence of a fiscal union the euro member states have funded bailouts for sovereigns who have lost market access, first directly (as per the first Greek loan) and then through the EFSF. Initially the loans carried relatively high interest rates ( as a form of punishment for fiscal impropriety) but that soon changed as debt sustainability came to the fore, an issue of particular importance to the IMF, which was brought on board  to help design loan programmes and the incorporated conditions.

The Fund’s modus operandi is to  project what it considers to be a sustainable medium term debt ratio  and then derive the required primary fiscal surplus needed to get to that target, given other assumptions including economic growth. Those assumptions can prove spectatularly wrong , and they did in Greece ; the  negative impact on the economy of the required fiscal contraction was much greater than envisaged (  GDP fell 25%, a depression rather than a short lived recession) and  the  forecast €50bn receipts from privatization failed the matrialise ( the figure to date is around €3bn).

Such programmes also assume that creditor governments can deliver the required primary surpluses, however large and sustained they are deemed to be , and ignores the electorates role. Debtor fatigue can set in. In most  countries that has been confined to  (growing) opposition parties but in Greece resulted in a new government pledging an end to austerity, new loans, a debt write down and ongoing euro membership,

Much of that is not in the gift of the Greek authorities to deliver (who knows what electorates can decide )  and that debtor fatigue is now meeting creditor fatigue, which has not been eased by the unusual negotiating stance adopted by the Hellenic Republic, which some characterise as driven by game-theory and others see as inconsistent and bordering on farce. The creditors are not united, it has to be said, with France notably sympathetic to Greek requests, although most , to date at least, appear willing to see Greece exit the euro, such is the lack of faith in Greece’s ability to deliver reforms or to meet the terms of any new loan. Some of that hostility emanates from other debtor countries fearful of the impact of a perceived Greek success on their own political futures- we are all creditors now, it would seem.

Any new money, should it materialise,  will come from the ESM, and that requires a unanimous decision by the Board of Governors, made up of member states. Consequently  any one country can prevent disbursement. In addition, ESM debtors are required to be in a programme which it is envisaged would involve the IMF, so Greece’s default with the fund poses a difficulty.

The Greek crisis has also highlighted the Lender of Last Resort issue . The ECB is not willing to fulfill that role unconditionally and has limited the amount of emergency liquidity the Central Bank of Greece can provide to its banking system. So the ECB, despite its claims to the contrary, emerges as a key player; its actions put pressure on the Greek government to reach an agreement with the creditors and could be the  catalysts for  Grexit, as the pulling of ELA would require Greece to print its own notes to fund the economy.

The markets have shown little in the way of panic reaction to  the Greek saga  and probably feel that some compromise will emerge to keep Greece in the euro, if only because such last-minute deals have been the norm in recent years. Whatever the outcome the stark emergence of debtor and creditor fatigue into the light is a profound  development , and one which is likely to have significant longer term implications for the euro regardless of any short-term fix.

 

Ireland’s fiscal adjustment-too soon to know

Ireland’s 2015 Budget is four months away but the debate about the scale of fiscal adjustment required has intensified, with contributions from the IMF, the Irish Fiscal Advisory Council, the Minister for Finance and  other assorted politicians. Some argue for the €2bn figure  set out some time ago while others claim that  a lower figure will suffice. In truth it is far too early to be definitive as there is a high degree of uncertainty , both about the fiscal outlook and prospects for the Irish economy, and given this lack of clarity it is puzzling that so many can take a dogmatic position.

Ireland’s total fiscal adjustment since 2008 amounts to some €30bn, and was required to keep the fiscal deficit on a declining path with a target for the latter of under 3% of GDP by the end of 2015. So the adjustment in any given Budget, be it cuts to government spending or measures to raise additional revenue, is a residual with the size determined by the forecast deficit ratio in the absence of any new policy measures. Note that the target is not the actual deficit itself but the deficit relative to GDP, so there are two areas of uncertainty, one relating to the performance of the economy and the other to the evolution of exchequer spending and receipts, although the latter is of course strongly influenced by the pace of economic activity. Inevitably, the actual deficit and the level of GDP will diverge from that forecast, making any projected adjustment less meaningful, particularly into the medium term. Yet in recent years the forecast Irish fiscal adjustment figure has become  a target in itself, rather than the residual. Some claim that sticking to an announced adjustment enhances credibility, which seems to be the IMF view, although it is not clear why a figure projected a few years earlier must be adhered to even if circumstances have changed, and given that such adjustments will dampen economic activity.There is also a temptation for the government to ‘spin’ the Budget presentation in order to be seen to ‘achieve’ the  previously announced adjustment.

Take the 2013 Budget. The  adjustment figure ahead of time was seen as €3.5bn and according to the  pre-Budget Estimates  the 2013 fiscal deficit would be €15bn, or 8.9% of forecast GDP , on unchanged policy.The deficit target was set at 7.5% of GDP, with an actual deficit of  €12.7bn, and the government duly proclaimed an adjustment of €3.5bn, even though the measures announced on Budget day amounted to €2.8bn, with the remainder mainly due to ‘carryover’ effects from previous spending and revenue decisions. In the event the deficit came in almost €1bn below forecast, at €11.8bn, thanks to a significant overestimation of debt interest  and higher non-tax receipts than projected, including profit from the Central Bank. However, real GDP actually contracted in 2013 instead of growing as expected and nominal GDP emerged €3.6bn lower than forecast, so the deficit ratio came in only marginally below target, at 7.2% of GDP, despite the much better than projected outturn in the deficit itself.

The 2014 Budget projected a deficit of €9.8bn in the absence of any adjustments, or 5.8% of forecast GDP. Consequently, policy measures were required to hit the deficit target , announced at 4.8% of GDP, with an adjustment figure of around €3.0bn widely discussed. Indeed, that was the figure announced by the Minister ( actually €3.1bn ) although the measures introduced on the day amounted to just €1.9bn, with the residual due to the familiar ‘carryovers’ and  previously unidentified ‘resources’ on the expenditure side , including ‘savings’ and lower debt interest. So the €3bn ‘adjustment’ was anything but, although the announced measures are forecast to reduce the deficit to €8.2bn, or 4.8% of GDP.

Five months into the year  the authorities are confident that the deficit figure will be achieved and  tax receipts are running 2.9% ahead of profile, which may persuade the Department of Finance to revise up their tax projections for 2015, hence implying a lower deficit figure before any adjustments. It is early days yet, however, as we do not  even know how Ireland’s GDP performed in the first quarter- retail sales have picked up at the headline level but the value of merchandise exports actually fell on an annual basis in q1 thanks to a decline in price, which will dampen nominal GDP. Uncertainty over the latter is also compounded by the change to a new standard for national accounts (ESA 2010) which will count R&D as capital spending for the first time,  and this along with other minor changes may boost the level of Irish GDP  by 2% or more and so impact the deficit ratio, albeit marginally.

So it is by no means clear at this stage what adjustment will be required to meet a 3% deficit target next year, be it  lower or indeed a higher figure. Austerity fatigue has set in across many European countries and the IMF call to maintain a previously forecast adjustment can be seen in that light, but any adjustment involves serious economic and social costs and  is a means to an end rather than an end in itself.