Weekly Macro Update: How Will Europe Tackle the Biggest Question of the Year?
This is an important year for Europe. Besides the rollout of vaccines that will save us from life inside four walls, we will know how governments want to handle the bill of the pandemic. Fiscal policy has been very generous, providing financial support to households and companies in an effort to help resume normal activity when this is over. Nearly a third of a year’s output has been spent in the effort: fiscal measures add up to 32% of euro area GDP.
The crucial decision this year will be when to pay the bill for the pandemic—and how. Governments cannot delay the financing decision for another year, as the escape clause from the EU’s 3% of GDP deficit limit expires at the end of 2021. A decision will need to be made mid-year so that next year’s budget can be prepared accordingly. Some argue that talks of austerity need not return: low, even negative, interest rates make public debt easily serviceable and the stock can just be rolled over, transforming public debt into a sort of perpetual bond. Others see the 3% fiscal deficit rule a necessary condition for growth and economic stability. After having crossed many Rubicons in 2020, a new one has presented itself already this year.
There is an interesting twist to the debate. The change-of-paradigm side of the argument is aided by tailwinds from the West. A number of former U.S. government officials and policy advisors, including a Nobel Prize winner, are recommending that their new president implement (another) large spending program, despite an 18% or so deficit in 2020. They explain that, in the context of a shock like the pandemic, fiscal deficits are expansionary: each dollar spent on investments in infrastructure and R&D will return more than a dollar of GDP.1 In other words, the spending will pay for itself. Top-down fiscal anchors should be done with and debt does not matter.2 In times of low interest rates, borrowing to spend productively is a no-brainer.
Back in Europe, where interest rates are at or below zero, cheap debt servicing makes the case for more spending. The EU recovery fund is preparing to borrow hundreds of billions to invest in digital and green technologies that will raise potential growth. The cost will stay low, as inflation is nowhere to be seen. Core inflation is at its lowest level ever, and the European Central Bank is further from its target than ever. When the economy recovers, inflation will likely return to its pre-pandemic level of around 1%, much below its 2% target. With the need to stimulate inflation further, rather than slowing it, monetary policy needs to remain accommodative. With its most efficient tool, the Pandemic Emergency Purchase Programme, expiring at the end of the pandemic, the ECB will have to stay on the sidelines and cheer national governments as they deploy their recovery stimulus to relaunch growth and, hopefully, a bit of inflation.
Even though debt is cheap, it is impossible to imagine that Europe will let go of a framework that emphasizes fiscal discipline. In the absence of a common fiscal policy, national budget targets are considered a useful tool to maintain a degree of harmonization among members of the single currency area. Reactivating the old 3% deficit limit next year is not only unrealistic, it is also dangerous. A brutal adjustment through large tax increases or spending cuts would risk putting Europe back in recession. As for the 60% of GDP debt limit, it has been irrelevant for long. So how will Europe reform its fiscal guidelines?
The decision will likely take time. The argument from across the Atlantic to impose a maximum limit on the amount of GDP spent on annual debt service should really be examined. Other options remain to be conceived. Governments could consider adjusting for investment in education and research the deficit that counts against a new limit. A limit could also be set on net financing needs every year as a ratio of GDP. This was, in fact, the very metrics used to assess debt sustainability during the 2010 Greek debt crisis. The pros and cons of every option will be weighed. In the meantime, the big decision this year will likely be to give governments a long period of transition to balance their books. This will kick the can down the road a little farther, but what a nice road it could be.
1. “Fiscal policy advice for Joe Biden and Congress”, J. Furman, L. Summers, B. Bernanke, and K. Rogoff, Brookings Institute, 1 December 2020.
2. “Fiscal Resiliency in a Deeply Uncertain World: The Role of Semi-autonomous Discretion”, P. Orszag, R. Rubin, and J. Stiglitz, Peterson Institute for International Economics, January 2021.
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