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The Euro Area’s Fiscal Ability to Handle Another Recession Is Limited

Summary:
With a possible recession looming, the euro area would normally be preparing to mobilize monetary and fiscal policies to cushion the shock. The problem is that, as previously detailed, there is no room for further monetary easing in the euro area. There does seem to be significant room for fiscal action, but the nonunified status of the euro area severely limits the actual scope for discretionary stabilization. This post assesses the margin of maneuver within the EU rules. General government debt in the euro area at the end of 2018 amounted to 85 percent of GDP. By contrast, US general government debt was 104 percent of US GDP.[1] The general government deficit was also far lower in Europe (0.5 percent of GDP) than in the United States (5.7 percent of GDP). With bond rates 1.7 percentage

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With a possible recession looming, the euro area would normally be preparing to mobilize monetary and fiscal policies to cushion the shock. The problem is that, as previously detailed, there is no room for further monetary easing in the euro area. There does seem to be significant room for fiscal action, but the nonunified status of the euro area severely limits the actual scope for discretionary stabilization. This post assesses the margin of maneuver within the EU rules.

General government debt in the euro area at the end of 2018 amounted to 85 percent of GDP. By contrast, US general government debt was 104 percent of US GDP.[1] The general government deficit was also far lower in Europe (0.5 percent of GDP) than in the United States (5.7 percent of GDP). With bond rates 1.7 percentage points lower in Europe, and even considering differences in potential growth and inflation, fiscal space looks larger than in the United States.[2] But for a euro area that comprises 19 different countries, collective action is extremely challenging.

An Intricate Web of Rules

Market-determined fiscal limits are hard to gauge, because debt crises involve multiple equilibria. For now, financial conditions are benign enough to make even Italian debt sustainable.[3] Barring a major change in these conditions, institutional constraints, rather than market sentiment, are likely to be binding.

The central institutional constraint is embodied at the European level in the Stability and Growth Pact, adopted in the late 1990s and amended several times since its entry into force. It consists of several rules:[4]

  • The 3 percent of GDP limit on the annual general government budget deficit of each member country, which if exceeded systematically subjects the erring country to an “excessive deficit procedure” mandating it to fiscal adjustment.
  • The debt reduction rule, which mandates member countries with gross public debt exceeding 60 percent of GDP to reduce it annually by 1/20th of the gap between the actual debt level and the 60 percent target.
  • The structural balance rule, which commits participating countries to flexibly target a country-specific Medium-Term Objective (MTO). The value of this objective is determined by the most binding of three criteria. These criteria depend on the budgetary margin of maneuver available for letting automatic stabilizers play their role without exceeding the 3 percent  threshold; the long-term budgetary outlook, taking into account the consequences of aging; and the initial debt level.
  • The expenditure benchmark rule, which limits primary expenditure growth net of discretionary revenue measures to potential output growth, adjusted for a factor that depends on the initial debt. 

These rules have been only partially effective (European Fiscal Board 2019). Enforcement of the debt reduction rule has been softened to avoid excessive consolidation in a low inflation environment. The structural deficit and expenditure rules have been enforced flexibly, especially in larger countries. And member states have often been allowed to rely on windfall gains to reach the 3 percent limit. But on the whole institutional constraints have contributed to reducing deficits.

Only Germany and the Netherlands Have Fiscal Space within the EU Rules

The escape provisions and flexibility clauses make it hard to assess the availability of fiscal space within the EU rules, but a rough quantification is possible.

The table below gives the fiscal space (column 5) as the difference between the 2019 structural balance (column 2) and the MTO (column 3). I then relax the debt-related criteria (assuming they would be softened in a recessionary situation) to consider the sole margin of maneuver needed to remain within the limits of the 3 percent threshold (the “minimum benchmark” in European jargon, column 4). This results in an “extended fiscal space” (column 6), where the margin of maneuver is set at zero for the countries where rules would call for a contraction.[5]

Fiscal space available to the main euro area countries, 2019 (percent of GDP)

Country

Budget balancea

Structural balancea

Medium-Term Objectiveb

Minimum benchmarkb

Official fiscal space

Extended fiscal space

 

(1)

(2)

(3)

(4)

(5)

(6)

Germany

+1.0

+1.1

-1.0

-1.5

+2.1

+2.5

Francec

-3.1

-2.6

-1.0

-1.4

0

0

Italy

-2.5

-2.4

+0.5

-1.4

0

0

Spain

-2.3

-2.9

-1.0

-0.8

0

0

Netherlands

1.4

0.7

-1.0

-1.5

+1.7

+2.2

Belgium

-1.3

-1.4

0

-1.5

0

+0.1

a. Source: European Commission, annual macro-economic (AMECO) database, spring 2019 forecasts (extracted on October 9, 2019).
b. Source: European Commission, Vademecum on the Stability and Growth Pact 2019, 2020 methodology, https://ec.europa.eu/info/sites/info/files/economy-finance/ip101_en.pdf.
c. The 2019 deficit for France includes one-off measures.

These calculations are approximations. Structural deficits are subject to significant revisions, and fiscal adjustment paths are ultimately determined by political bargaining. But the data suggest that among the largest countries, only Germany and the Netherlands have latitude for fiscal stimulus within the rules. The other four countries would have no such scope.

Could Germany and the Netherlands provide stimulus for the rest of the currency union? Quantitatively yes, as they jointly constitute 35 percent of 2018 euro area GDP.[6] But because of domestic constraints, both countries have limited margin of maneuver.

In the Netherlands, an accord among governing parties imposes multi-year real expenditure ceilings (Vierke and Masselink 2017), leaving room for automatic stabilization but not discretionary action. This agreement can be revisited, however. The Dutch government announced tax cuts in September 2019 because of the uncertain global economic outlook.

The German case is more complicated. Two different fiscal targets coexist. The so-called black zero (Schwarze Null) is a political commitment to keep the federal budget in surplus. More precisely, it excludes net ex ante debt issuance while permitting unanticipated deficits caused by economic factors.

The second, known as the debt brake (Schuldenbremse), has constitutional status. It limits the ex ante structural deficit of the federal budget to 0.35 percent of GDP and cumulative ex post budget overruns as recorded in a control account to a maximum of 1.5 percent of GDP (Federal Ministry of Finance 2015).[7] The debt brake also mandates structural balance for state governments from 2020 onwards.

Both these rules permit automatic stabilizers, and the debt brake provides some room for discretionary fiscal action. Furthermore, federal financial investments that build up or replenish the capital of public entities are excluded from the calculation of the deficit.

Assuming political agreement to discontinue compliance with black zero, the German federal government could:

  • Increase the federal structural deficit by about 0.3 percent of GDP. The latest official projections envision for 2020 a general government structural surplus of 0.5 percent of GDP, with the federal government exactly on balance (and surpluses at state and local levels). [8] The debt brake would therefore leave room for discretionary fiscal action up to 0.35 percent of GDP in 2020. That margin would be exhausted in 2021.
  • Record in 2019 and the coming years larger ex post deficits, provided the cumulated deficit remains within a 2.1 percent of GDP limit corresponding to the sum of the balance of the control account (€37 billion at end-2018 or 1.1 percent of GDP) and the lower of the two thresholds that limit cumulated budgetary overruns (1 percent of GDP).[9]
  • Provide funds to help build up or replenish the capital of investment-financing institutions. For example, the government could endow its development bank, KfW, with a fund dedicated to the goal of a decarbonized economy. The corresponding deficit would be exempt from the Schuldenbremse. Economy Minister Peter Altmaier has recently floated such proposals.

Overall, such steps could provide a stimulus of 0.35 percent of Germany’s GDP in 2020, or 0.1 percent of euro area GDP. Additionally, Germany could undertake: (1) fiscal expansion at the Länder level (but assuming it would be politically feasible, the constitutional room for it would be limited to a third of a percentage point of GDP), (2) ex-post budgetary overruns, and (3) off-budget investment through a dedicated fund.

The Euro Area’s Fiscal Latitude Is Inadequate to Cope with a Recession

Europe is constrained by narrow and uneven tools to prevent or cope with a possible recession. Only Germany, the Netherlands, and some smaller countries have room to act without breaching their rules. The available tools are subject to political and constitutional constraints. Furthermore, Berlin is likely to be reluctant to act on behalf of the euro area.

This concern must be qualified. The euro area can cope with a mere slowdown, because of automatic stabilizers and some flexibility within the rules. And in the event of a major recession, escape clauses would be activated as they were in 2008. Article 126 of the Treaty on the Functioning of the EuropeanUnion actually authorizes “exceptional and temporary” departures from the rule, and the German debt brake also authorizes parliament to pass exceptional measures in case of “emergency situations” that are “outside the control of the government.”

But the European policy system is not equipped to address what lies between these two cases. A recession that is neither particularly mild nor exceptionally severe would quickly test its limits. Failure to respond would risk reopening socioeconomic scars and reviving political tensions. Policymakers should concentrate on possible options beyond the confines of the current framework.

The author thanks Olivier Blanchard, Laurence Boone, Grégory Claeys, Zsolt Darvas, Fabien Dell, André Sapir, David Wilcox, and Guntram Wolff for comments.

Notes

1. IMF data, October 2019. To ensure better comparability, US data are adjusted to exclude unfunded pension liabilities of government employees’ defined-benefit pension plans.

2. On November 6, 2019, 10-year government bond yields were 1.8 percent in the United States and 0.12 percent on average in the euro area (US Treasury and European Central Bank data). The medium-term nominal growth was typically projected at 4 percent for the United States and 3 percent for the euro area (see, for example, the IMF’s October 2019 World Economic Outlook). The difference between the interest rate and the nominal growth rate is thus negative in both cases, and more negative in the euro area than in the United States.  

3. For an early assessment, see Blanchard, Leandro, Merler, and Zettelmeyer (2018).

4. For a concise presentation and discussion, see Blanchard, Leandro, and Zettelmeyer (“Revisiting EU fiscal rules in an era of low interest rates,” preliminary conference draft, 2019); for an effectiveness assessment, see European Fiscal Board (2019); and for the legal basis, see European Commission (2019).

5. For example, Belgium’s structural balance is forecast to be –1.4 percent of GDP in 2019, whereas the MTO (column 3) has been set at zero, resulting in a zero official fiscal space (column 5 = column 2 – column 3). As the minimum benchmark is –1.5 percent (column 4), however, the extended fiscal space is 0.1 percent of GDP (column 6 = column 2 – column 4).

6. Eurostat database.

7. Precautionary provisions apply as soon as the deficit of the control account reaches 1 percent of GDP. See paragraph 7 here.

8. Table 5 in German Stability Programme for 2019; data provided by the Federal Ministry of Finance.

9. The source for the balance of the control account is the Federal Ministry of Finance’s Monthly Bulletin of September 2019. See Bundesministerium der Finanzen, “Abrechnung der grundgesetzlichen Regel zur Begrenzung der Neuverschuldung 2018,“ Monatsbericht der BMF, September 2019.

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