Can Europe Declare Fiscal Victory and Go Home?

Rules are rules and all.

But the application of poorly conceived rules is still a problem. Especially in the face of a negative external shock.

The eurozone’s fiscal policy is, more or less, the fiscal policy adopted by its constituent member states.

Wolfgang Schauble (do follow the link) should be happy: Europe’s fiscal policy is almost entirely inter-governmental.

The eurozone’s big five—Germany, France, Italy, Spain, and the Netherlands—account for over 80 percent of the eurozone GDP. Summing up their national fiscal impulses is a decent approximation of the eurozone’s aggregate fiscal policy.

And, building on the point I outlined two weeks ago (and that my colleague Rob Kahn echoed on his Macro and the Markets blog), 2017 could prove to be a real problem. Bank lending now looks poised to contract, and eurozone banks face (yet again) doubts about their capital. And the sum of national fiscal policies—best I can tell—is pointing to a fiscal consolidation.

In the face of the Brexit shock, standard (MIT?) macroeconomics says that a region that runs a current account surplus, that has a high unemployment rate, that has no inflation to speak of, that cannot easily respond to a short-fall in growth by lowering policy interest rates (policy rates are, umm, already negative, and negative rates are already, cough, adding to problems in some banks), and that can borrow for ten years at a nominal interest rate of less than one should run a modestly expansionary fiscal policy.

The eurozone as a whole clearly has fiscal space. The eurozone’s aggregate fiscal deficit is lower than that of the United States, Japan, the United Kingdom, and China. Adjusted for the cycle, the IMF puts the eurozone’s overall fiscal deficit at about 1 percent of GDP (without adjusting for the cycle, the eurozone’s overall deficit is around 2 percent of GDP). Even without any cyclical adjustments, the eurozone now runs a modest primary surplus, and simply refinancing maturing debt at current interest rates should lead to a lower headline deficit.

But the eurozone isn’t a unified fiscal actor. Right now the countries that could run a bigger fiscal deficit without violating the eurozone’s rules have said they won’t, and the countries that are already running deficits that violate the rules are facing new pressure to comply with the rules. The aggregate fiscal stance of the eurozone thus is likely to be contractionary.

Germany of course is the best case of a country that the market wants to finance. Germany actually did do a fiscal expansion in 2016. It had a fiscal surplus of almost a percent of GDP in 2015, and in 2016 it is projected to be in balance. (See the IMF Article IV report) But on current plans Germany won’t do more in 2017 as more would mean a deficit. The fiscal impulse from here out is thus likely to be flat, barring a major policy shift.

The Dutch have, by any reasonable estimate, enormous fiscal space (massive current account surplus, low gross debt, tons of pension assets, and, the market is willing pay the Dutch government to borrow, at least for maturities shorter than ten years). But the Dutch too do not seem to want to use their fiscal space. The European Commission lauded the Netherlands fiscal policy precisely because it was committed to bring a 2 percent of GDP fiscal deficit down to between 1 and 1.5 percent of GDP in 2017. With a structural deficit estimated to be a bit over 1.5 percent of GDP in 2015, the commission believes further consolidation is required to get the Dutch structural deficit down to the target of half a point of GDP. No matter that there has been a persistent problem with demand in the Netherlands.

France has somewhat higher debt levels than Germany or the Netherlands. But a country that currently can borrow for ten years at twenty basis points, a rate well below the interest rate the market charges the United States, also doesn’t need to consolidate today. Consolidation now—if you believe Fatás and Summers—might well raise debt to GDP levels. But that doesn’t seem to be the commission’s view. The commission’s 2015 report emphasized that France had failed to do enough structural consolidation in 2015, and argued it wasn’t planning to do enough in 2016 either. It is hard to see the commission changing its tune for 2017.**

Italy is gearing up for a bit of bank recapitalization. Without a bit of flexibility, the accounting for the recapitalization will push Italy’s headline deficit above 3 percent. The odds are Italy will be called to tighten, at least a bit. Especially because Italy is going to be more or less permanently in violation of the rule that says that European countries with high debts need to bring down their debt-to-GDP ratios with austere budgets.

And then there is Spain. Together with Portugal, it runs the risk of being sanctioned by the commission for an excessive deficit. Five percent of GDP isn’t all that close to three percent of GDP. The Financial Times reported back in March:

"Spain has veered sharply off course in its long-running effort to reduce the budget deficit, unveiling a 5.2 per cent shortfall in 2015 that is likely to raise alarm inside the European Commission and impose significant political constraints on the next Spanish government... The shortfall is almost a full percentage point above the deficit target set by Brussels ... Crucially, the gap also makes it all but impossible for Madrid to comply with its target of reducing the shortfall to below 3 per cent of gross domestic product this year."

Spain is now set to be sanctioned by the commission, which made clear in its 2015 report that Spain has been running far too loose a fiscal policy (never mind that demand is still down 10 percent relative to pre-crisis levels, that unemployment is shockingly high, and that the period of too-loose-for the-commission fiscal policy was a period of recovery) over the last two years. The commission recently indicated that Spain would have needed to do about 2 percent of GDP more consolidation to have hit European targets over the last several years.

"The cumulative structural fiscal effort over the 2013-2015 period is estimated at 0.6% of GDP, significantly below the 2.7% of GDP recommended by the Council."

It isn’t much of a leap to think that Spain will be asked to do to a bit of structural consolidation in 2017, and the fiscal impulse in Spain will turn significantly negative.***

So if Germany and the Netherlands won’t run a bigger deficit, and if France, Italy, and Spain are all supposed to consolidate, how exactly can the eurozone, as currently constituted, generate a positive fiscal impulse?

It certainly won’t come from Portugal.

While there is room to debate the correct fiscal stance for each individual country, it also seems clear to me that the sum of the commission’s national fiscal recommendations would imply a reasonably contractionary fiscal policy for the eurozone as a whole. And if applying the national rules produces a policy that it is too tight for the eurozone as a whole, that to me implies that the rules as currently constructed are part of the problem.

Tis a shame really.

In 2016 the eurozone was actually experiencing somewhat decent growth pre-Brexit. Eurozone growth exceeded U.S. growth in q4 2015 and q1 2015.

And if you have a Keynesian bent, you can explain the eurozone’s 2016 growth pretty easily. Events conspired to make the eurozone’s fiscal stance for 2016 fairly expansionary. The Germans stopped running a 1 percent of GDP fiscal surplus. The Dutch, it seems, quietly allowed their structural deficit to widen a bit. And Spain got a reprieve going into its election cycle. The IMF recently estimated the eurozone structural deficit widened by about 40 basis points of GDP in 2016, generating a positive fiscal impulse in Europe for the first time in a long time.

Many smart observers of European policy tend to think the eurozone’s 2017 fiscal stance won’t be as bad as I fear. They argue that the commission’s position is just an opening bid designed to raise their credibility in Germany, and pragmatism will win out in the end. I am not so sure. On Europe’s current course, there is a real risk that renewed bank deleveraging will be combined with renewed fiscal consolidation.

* One percent comes from looking at the GDP weighted average 10 year rate.

** The IMF, unfortunately, echoed the commission in its Article IV report on France: "Structural adjustment over 2015–18 is projected to average 0.1 percent of GDP, well below the EC’s recommendation. Without further efforts, France will not reach the structural balance objective within the five-year projection horizon." See p. 11.

*** More on Spain from the commission; the cumulative shortfall in fiscal effort now looks to be about 3 percent of GDP: “On a cumulative basis over 2013-2016, the shortfall with respect to the effort that was recommended by the Council amounts to 3.1 pps, when measured against the uncorrected change in the structural balance, and to 4.4 pps. when referring to the corrected indicator."