The renewed phase of tension in Europe, and the Eurozone in particular, since the second half of 2011, with the prospect of a double-dip recession alternating with that of a sovereign-debt crisis, has reignited the debate on fiscal austerity, to which European governments have been committed since the end of the most acute phase of the crisis in 2009.
Before entering the debate, it is important to stress that there should be little question that European economies share the need to reduce public deficits and debts from levels that, as confirmed by a growing strand of empirical literature (Reinhardt and Rogoff 2009, Kumar and Woo 2012), are likely to be harmful for growth in the medium term, and even more so if one factors in the large implicit government liabilities linked to ageing. In fact, a striking feature of the current financial crisis compared to previous comparable episodes in industrial economies is not so much the increase in public debt from the onset of the crisis, which appears to have followed a well-trodden path, but the (much) higher level from which the increase started (Figure 1). This heightens the concern for threshold effects.
Figure 1. Gross public-debt crises (% of GDP)
Notes: (1) Based on 49 crises episodes. Unweighted country averages. t = start of the crisis. (2) Includes crisis episodes in Czech Republic, Finland, Hungary, Latvia, Poland, Slovak Republic, Spain and Sweden. For new Member States data from 1991. (3) Includes crisis episodes in Finland, Spain and Sweden.(4) Includes crisis episodes in Finland, Norway, Sweden, Japan and Spain. Sources: Calculations based on IMF International Financial Statistics and AMECO.
The debate on fiscal austerity is therefore also about the timing and speed of consolidation, not only its overall size.
The debate on fiscal austerity: A stylised representation
In economic terms, it can be seen as revolving around the size of the fiscal multipliers – the higher the multiplier, the more costly, in terms of growth, the austerity. The following stylised representation (borrowed from Roeger and in't Veld 2012) may help to illustrate the matter.
For a given composition of the fiscal adjustment, the multiplier can be expressed as:
Multiplier = [1 – 'confidence'] / [1 + (monetary policy) + (competitiveness) - (financial constraint)]
The 'confidence' term refers to i) 'non-Keynesian' wealth effect on consumption and investment stemming from the expected reduction in future taxes, and ii) the credibility effect on the real interest rate stemming from the reduction in risk premia (both effects are supposed to follow an adjustment that is, and perceived to be, permanent and successful,, hence the 'confidence' label). 'Monetary policy' and 'competiveness' stand, respectively, for the accommodating reaction of monetary policy to, and the gains in international competitiveness from, the negative impact of adjustment on inflation, which partially offset its negative impact on private demand. Finally, the proportion of households and firms that are liquidity- or credit-constrained will increase the multiplier, by making it difficult or impossible for the private sector to compensate by borrowing the impact of adjustment on current income.
The composition of fiscal adjustment interacts with the multipliers' determinants to produce different growth outcomes depending on the choice of the instrument, with the ranking inverting, however, when one moves from the short to the medium-to-long term. In particular, (exhaustive) expenditure cuts have more negative short-term output effects, but positive effects in the long term (through the non-Keynesian confidence channel), the short-term output loss of tax increases is smaller, but persistent over time (for a summary set of simulations of the effect of different instruments using the Commission QUEST III model, see European Commission 2010).
Last but not least, the effects of adjustment are likely to differ depending on whether the economy is in a recession or expansion phase. The response effect of output is likely to be larger in a recession, reflecting the presence of unused resources.
If one compares this stylised representation of the effects of fiscal adjustment with the current situation in the Eurozone, the following conclusions stand out:
- The state of the economy can be characterised as a balance-sheet recession, namely, a major financial-cycle bust following a boom against a backdrop of low inflation (Borio et al 2011). This implies that the multipliers determinants are working in different directions.
- On the one hand, the debt and capital overhang in the private sector and the corresponding impairing of the financial sector make further borrowing to offset the impact of fiscal adjustment on current income a difficult, if not impossible, proposition. The very low level of inflation and interest rates constrain the room for accommodating monetary policy and for achieving competitiveness gains (under fixed exchange rates);
- On the other hand, ballooning public deficits and debts, largely a consequence of the unrecognised unsustainable nature of revenues and build-up of contingent liabilities during the long boom phase preceding a balance-sheet recession, raise doubts on government solvency, thereby increasing the 'confidence' term, working through the sovereign-risk channel linking public and private borrowing costs.
- Moreover, conventional fiscal stimulus measures fail to address directly the debt overhang and balance-sheet repair problem. Addressing balance-sheet repair problems head on is instrumental to reducing the size of the multipliers in the adjustment process and ultimately unlocking a 'virtuous cycle' of self-sustained recovery (Buti and Padoan 2012).
- Therefore, while economies share the need for reducing deficit and debts, the appropriate pace of consolidation should differ across countries. Countries with very high and/or rapidly rising debts may be well-advised to pursue a fast adjustment, in spite of an unfavourable economic environment, if the alternative of a sovereign-debt crisis is sufficiently plausible. While the composition of the adjustment should be tilted towards expenditure, which typically would have risen too much throughout the period when windfall revenues were flattering public accounts, a mix of expenditure cuts and tax rises is likely to be inevitable. Besides considerations of political economy, it may also produce a smoother response of output to consolidation.
These conclusions find support in an analysis of successful fiscal consolidations focusing on the probability of reducing the public-debt ratio relative to its pre-consolidation levels (European Commission 2010b). In particular, it shows that while gradual consolidations are in general more likely to succeed than cold-shower ones, the superiority of a gradual strategy tens to evaporate for high levels of debt and is also less pronounced for consolidation episodes following a financial crisis.
It has been recently argued that fiscal consolidation can be 'self-defeating' if, for example, risk premia respond positively to the debt-to-GDP ratio and the latter increases instead of diminishing as a result of consolidation. While this result is plausible in the short term for a range of values of the multiplier and the debt ratio, the reaction of risk premia presupposes myopia on the part of financial markets, since the initial increase in the debt ratio would be followed by a movement in the opposite direction as the multiplier effect fades away and the primary balance is permanently improved by the adjustment (Gros 2011).
How the EU fiscal framework fits in the policy debate
The EU fiscal framework is sometimes characterised as imposing a 'one-size-fits-all' fiscal-consolidation model, which ignores the need for differentiation outlined above (Wolf 2012). This characterisation is less than accurate. Admittedly, the EU fiscal framework is rule-based, which implies a presumption of reaction on the part of the budgetary authorities when certain trigger indicators of unsound fiscal policies are activated. In turn, for the rules to be workable, the triggers need to be easily readable. Hence the choice of 'reference values' for the government deficit (level) and debt (level and change) for triggering the excessive deficit procedure (in fact, considerations of simplicity led, until recently, to privileging the deficit indicator at the expense of debt dynamics). At the same time, the framework leaves considerable scope for modulating the fiscal policy reaction, both in terms of the initial prescription of the adjustment path and its subsequent adaptation to economic shocks. These characteristics have been accentuated by the recent reform of the Stability and Growth Pact (European Commission 2011, 2012) and are borne out by the fiscal exit strategy that EU countries commonly agreed already in 2009 and subsequently confirmed with some modifications. The strategy revolves around three pillars:
- Countries are given a multi-year horizon, ranging from two to five years, to correct the excessive deficit position. Setting a deadline for the correction is a requirement of the excessive-deficit procedure, but also serves the economic purpose of anchoring expectations of return to sound public finances.
- The speed of adjustment and the degree of frontloading broadly reflect the availability of fiscal space and economic conditions. Specifically, countries facing market pressures were already recommended to start their (typically larger) adjustment in 2010, while for the others adjustment should effectively start from 2011. Consolidation is generally gradual, albeit substantial.
- Countries are encouraged to pay attention to the quality of the adjustment, in terms of composition and accompanying structural reforms. Policy recommendations in these areas, which already figure prominently in adjustment programmes, are to be sharpened for all countries through the implementation of the macroeconomic imbalances procedure, which complements the recent reform of the Stability and Growth Pact.
Concerning the response to shocks, it needs stressing that the Stability and Growth Pact explicitly allows for the playing of automatic stabilisers around the adjustment path, that is, the adjustment is formulated in structural terms. Acknowledging the problems inherent in the measurement of structural balances, the framework calls for an 'in-depth analysis' of the reasons behind a country' s failure to meet the budgetary targets, including revisions in potential growth and endogenous changes in revenue elasticities. To these elements of flexibility, the recent reform has added the possibility of extending deadlines for the correction of the excessive deficits irrespective of a country's individual predicament, if the situation of the Eurozone or the EU as a whole calls for a relaxation of fiscal policy.
It should also be noted that the operationalisation of the debt criterion of the excessive-deficit procedure through the '1/20' debt-reduction benchmark - possibly the most visible innovation of the reform - is accompanied by greater allowance for an economic reading of the debt trigger. Of particular interest in the current context is the provision whereby capital injections to preserve the stability of the banking sector are counted as mitigating factors when assessing a breach of the benchmark.
The greater-than-commonly-appreciated flexibility afforded by the Pact entails a considerable room for discretionary judgement when it comes to its application. In particular, while the occurrence of economic shocks allows for an extension of the deadline for the correction of the excessive deficit, on condition that the prescribed structural effort has been delivered, it is left to the discretion of the Commission and the Council whether an extension should be effectively granted. In this connection, the second pillar of differentiation of the EU fiscal exit strategy, namely, differentiation according to fiscal space, comes into play. It may be warranted to ask an additional fiscal effort of a country facing the risk of a debt interest spiral, while longer correction deadlines certainly make sense for countries where sovereign risk is subdued.
The attention drawn by a few problematic cases should not obscure the fact that most countries in the Eurozone and the EU are making steady progress towards the correction of the excessive deficit in line the multi-year adjustment path defined by the Council in 2009. For these countries, the EU framework has provided an anchor, in the absence of which adjustment might have less credible and hence even more costly, according to the stylised discussion presented above. Nor is it clear, including from the revealed preferences of national authorities, that even the minority of countries that are struggling to meet the deadlines would necessarily benefit from a generalised relaxation of the current targets.
A differentiated application of flexibility, trading the risk to stabilisation against those to financial stability, may in fact be the preferable approach. Nor should the quest for flexibility be concentrated on the relaxation of deficit targets. When balance-sheet repair is the pre-condition for the restoring of normal economic relationships, it may be preferable to concentrate the limited fiscal firepower on the recapitalisation of the banking sector rather than on conventional tax and expenditure programmes (for model simulation lending support to prioritising bank recapitalisation see Kollmann et al 2011).
To sum up, the EU fiscal framework can certainly be criticised. As with every rule-based framework, it represents an imperfect answer to the basic credibility problem of economic policy. Depending on their overall persuasion and their reading of the current situation, critics may reproach a lack of flexibility or even an excess of it. The framework is not, however, disconnected from the economic debate on austerity. In fact, it can rationalised broadly consistent with the view that “weak growth in countries facing precarious fiscal positions is not sufficient evidence against fiscal austerity” (Corsetti 2012).
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