Do Not Count (European) Fiscal Chickens Before They Hatch

The Wall Street Journal, building on a point made by Peterson’s Jacob Kirkegaard, seems convinced that the policy mood has shifted, and Europe is now poised to use fiscal policy to support its recovery.

I, of course, would welcome such a shift. The eurozone runs an external surplus, is operating below potential (in large part because of a premature turn to austerity in 2010 that led to a double-dip recession) and in aggregate has ample fiscal space.

And the public policy case for such a fiscal turn keeps getting stonger. Jan in ’t Veld’s new paper (hat tip Paul Hannon of the WSJ) suggests that a sustained fiscal expansion in Germany and the Netherlands could have a substantial impact on the rest of the eurozone. A sustained 1 percent of GDP increase in public investment in Germany and the Netherlands helps raise output and lower debt in their eurozone partners.* in ’t Veld writes:

"Spillovers to the rest of the eurozone are significant ... GDP in the rest of the eurozone is around 0.5% higher."

But it seems a bit too early to break out the champagne.

Actual 2017 fiscal policy has not been set in the key countries, but it is not clear to me that the sum of the fiscal decisions of the main eurozone countries will result in a significant fiscal expansion across the eurozone. Indeed, I cannot even rule out a small net consolidation.

Germany has put forward its 2017 budget. Schauble’s rhetoric has changed a bit. But Citibank estimates that it only would reduce Germany’s structural fiscal surplus by about 0.1 percent of GDP (10 basis points of GDP). It is a step in right direction, but only a baby step. Real loosening doesn’t seem on the cards before 2018.

I do not think the Dutch have put forward their 2017 budget. But their 2016 stability report suggests that they are aiming for a structural fiscal consolidation of about 0.3 percent of GDP. They still want to bring their structural deficit down to around one percent of GDP.

The French would likely need to do a bit of consolidation if they still intend to get their 2017 fiscal deficit under 3 percent of GDP, but I will grant that Hollande is likely to get a bit of flexibility heading into the election.

Renzi would certainly like to provide a fiscal jolt to Italy’s economy. But the pressure on the Italians from the Commission and others is still to consolidate. Rules and all. The Commission’s target for Italy’s fiscal deficit in 2017 is 1.8% of GDP.

I doubt Italy will do the consolidation that would be required to get the deficit under 2 percent of GDP, but I also am not convinced that Italy will be given space to loosen. The battle lines have been drawn up, but the actual battle has not yet been fought.

If the impact of the Dutch consolidation is offset by the modest German expansion, and if France and Italy end up with a fiscal stance that is roughly unchanged, Spain becomes the wild card that could determine the eurozone’s overall fiscal stance.

And, well, there seems to be a risk that in the absence of government, Spain’s spending will be held constant in nominal terms – resulting in a meaningful consolidation. HSBC’s Fabio Balboni:

“If the 2017 budget cannot be approved by the end of the year, all of the main spending items will be frozen at current levels, including wages and pensions. That would be equal to spending cuts of about 1% of GDP. This might help to reduce the deficit, but it would also have negative consequences for growth.”

Even if Spain forms a government that avoids sequester style cuts, it will face pressure to bring its deficit down.

Daniele Antonucci of Morgan Stanley: “Spain will tighten the belt ... the question mark is to what degree, and that also depends on the political situation.”

Bottom line: If Spain – which has the largest deficit of any of the eurozone’s main economies – ends up doing a significant consolidation, whether as a result of the absence of a government or as a result of a conscious decision by the Europeans to push Spain to move closer to its targets after it elects a new government, someone else has to do an actual expansion to keep the eurozone’s overall fiscal stance neutral. Best I can tell, Germany 2017 budget won’t do the trick. And until the 2017 budgets for France and Italy get approved, we won’t know if they will be able to offset a likely tightening in Spain.

* Jan in ’t Veld’s paper assumes the fiscal stimulus is not offset by monetary policy in the first two years, and the euro initially depreciates. His argument is thus a bit different than the argument made by the IMF in its external stability report, as the IMF was looking at fiscal expansion in surplus countries as a partial offset for monetary expansion.

** I suspect Japan’s fiscal stance has changed more than Europe’s fiscal stance. But I would like to confirm that the new stimulus will do more than offset the roll-off of past stimulus packages. If anyone reading this has a good estimate of Japan’s actual fiscal stance, please do let me know. Japan has carried out a meaningful fiscal consolidation over the past three years -- with more consolidation than implied by the rise in the consumption tax.