The Eurozone aggregate fiscal stance has been an issue of increasing importance since its introduction in the Two Pack. Reinforcing the Eurozone dimension in budgetary policy and surveillance is one of the main objectives of this piece of legislation. In particular, the Two Pack requires the Commission to present an overall assessment of the budgetary situation and prospects for the Eurozone as a whole on the basis of the national draft budgetary plans and their interaction. In response to this request, the Commission annually adopts a Communication providing horizontal Eurozone context to the national budgetary decisions.
The fiscal stance is usually understood as the orientation given to fiscal policy by governments' discretionary decisions on tax and expenditures, noticeably with a view to their contribution to the economy.
Growth is still weaker than desirable in the Eurozone. Downside risks remain and challenges originating from geopolitical developments further complicate the economic outlook. Responsible, growth-friendly fiscal policy needs to play a bigger role in supporting demand in the Eurozone today. This is a concern shared by the global community: at its September meetings, the G20 re-iterated its members' commitment to a three-pronged growth strategy, stating their determination to "use all policy tools – monetary, fiscal and structural – individually and collectively to achieve our goal of strong, sustainable, balanced and inclusive growth".
In this context, the Commission has adopted a Communication on Eurozone fiscal policy, which outlines what a "positive fiscal stance" for the Eurozone would look like (European Commission 2016).
Why a positive fiscal stance for the Eurozone?
As the Communication explains, the role of fiscal policy is now given more prominence than usual because the combination of three factors makes the economic environment exceptional. First, as often observed following financial crises, the Eurozone has experienced a more protracted period of slow recovery than after other kinds of crises. This is characterised by unusually high long-term unemployment and low investment, with a corresponding low level of internal demand and inflation. Figure 1 illustrates the degree of slack in the Eurozone economy: persistently low inflation and a large external surplus are associated with feeble internal demand. Second, there are large outstanding risks which call for pushing to support stabilisation based on internal demand, notably investments. External demand cannot be relied upon to buttress the economic recovery in the current circumstances. Third, monetary policy is facing constraints as the interest rates have reached the zero lower bound and unconventionally measures have been intensively used, while credit demand remains subdued despite the low credit costs.
Figure 1. Eurozone current account balance and inflation compared to their respective benchmarks
Source: Commission services
Note: Inflation* and CA* respectively denote the benchmark inflation and current account balance. The benchmark current account balance represents the current account balance implied by fundamental determinants (such as demographics and ageing, relative income, resources, reserve currency status, and manufacturing intensity) with respect to the rest of the world. The estimates are derived from panel regressions for 67 countries representing 95% of world GDP, akin to the IMF's EBA model (European Commission, 2015).
Against this background, a responsible fiscal policy reaction is to act decisively boldly, rather than reluctantly, in support of demand. While the Brainard principle suggests that policy should exhibit conservatism in the face of uncertainty (Brainard 1967), exceptions to this principle are found in the literature, particularly when the uncertainty involves a high degree of inflation persistence. This exception may very well characterise today's context, making a vigorous response – rather than a conservative response – optimal in these circumstances.
The current response is not about adjusting short-term demand through fiscal policy fine-tuning, but instead to adequately face unusual circumstances that require a decisive growth stimulus. Two elements in particular speak to this need:
First, the likelihood of abrupt negative effects on the macroeconomic side is now assessed to be higher (these abrupt negative effects are also referred to as "cliff effects"). The need to address the cyclical lethargy by promoting an increase in aggregate demand appears urgent. Otherwise, crisis legacies, such as low investment or high unemployment could eventually become structural with long-lasting effects on potential growth (hysteresis effects) or on the social fabric.
Second, the efficiency of fiscal policy to attain the desired stabilisation goal is now judged to be higher than in normal economic times. In a situation where monetary policy is constrained by the zero lower bound, fiscal stimulus is found to be more effective to stabilise the economy than usual.
The need to preserve the sustainability of public finances also calls for supporting demand in the Eurozone as a whole in the current context. Albeit stabilising or receding, government debt ratios still stand at high levels in a number of Eurozone member states. Reducing debt levels becomes a strenuous task when low real GDP growth is coupled with low inflation for a significant period of time. At the same time, sustainability is a key issue for some member states, for which prudent fiscal policy in compliance with EU fiscal rules will be necessary. However, as mentioned in the last section of this column, stimulus in countries with fiscal space will not only boost their GDP, but also have a beneficial impact on the sustainability of other Eurozone countries.
Figure 2 shows that an expansionary fiscal stance such as the one advocated by the Communication would leave the Eurozone economy closer to its potential growth in 2017. Compared to that, the fiscal stance that results from member states' 2017 draft budgetary plans (DBPs) is suboptimal: member states’ national fiscal policies add up to a broadly neutral overall fiscal stance which would be insufficient to properly address current stabilisation concerns.
Figure 2. Eurozone fiscal stance over 2011-2017
Source: Commission services
The desirable fiscal stance from a Eurozone standpoint
What is the desirable fiscal stance in the Eurozone for 2017? Thinking of the Eurozone as a single entity, the size of desirable expansion should provide a meaningful fiscal impulse to the economy and help lift inflation.
As shown in Table 1, assuming a multiplier of 1, the Eurozone’s output gap can be expected to half in 2017 following a fiscal expansion of 0.3% of GDP. Conversely, the output gap will close if the fiscal expansion would amount to 0.8% of GDP. A multiplier of 1 is deemed to best characterise the growth impact of fiscal policy in the current context. This is both compatible with a high quality stimulus and a zero-lower-bound monetary environment. The Communication calls for prioritising budgetary variables with the largest growth impact, such as public investment. Well-designed fiscal expansions result in stronger growth effects, as captured by larger multipliers. Moreover, as stated above, fiscal stimulus is most effective in an accommodative monetary environment.
In all, a fiscal expansion of up to 0.5% of GDP, within the range identified in Table 1, appears appropriate for the Eurozone as a whole; still a tension remains between considering the euro area as a single entity and the decentralised fiscal policy across the 19 different member states.
Table 1. Fiscal stance consistent with different closures of the output gap and different multipliers
Source: Commission services
Note: Fiscal stances expressed as change in the structural primary balance as pp of GDP, derived from the analysis based on Eurozone numbers.
Toward a better composition of the Eurozone fiscal stance
The Communication also stresses that the current fiscal situation is sub-optimal from a geographical point of view. In other words, the repartition across member states of the neutral fiscal stance that results from the aggregation of 2017 DBPs is clearly not appropriate. Paradoxically, some countries facing higher sustainability challenges seem to privilege stabilisation needs, while member states with fiscal space do not use it to address stabilisation concerns.
Thus, the Eurozone would not only benefit from a more supportive orientation of overall fiscal policy, but also from its more appropriate geographical repartition. This is especially so in the current context where spillover effects are higher than usual (In't Veld 2016). Similarly to fiscal multipliers, the literature finds spillover effects (the impact of fiscal policy on other countries' GDP) to be also much larger if monetary policy operates in a zero interest rate environment, compared with normal times. In addition, larger spillover effects are associated with an intensification of government spending on the most productive categories, such as public investment, as opposed to other categories of government expenditure.
QUEST simulations suggest – in line with other studies on infrastructure investment – that additional government investment in Germany and the Netherlands could substantially raise both domestic and other Eurozone regions' GDP. In the case of high efficiency of public investment, QUEST simulations run by DG ECFIN illustrate that additional government investment of 1% of GDP in Germany and the Netherlands, sustained over 10 years, could raise domestic GDP by 1.1% and 0.9%, respectively (In't Veld 2016). Over the 10-year horizon, real GDP in Germany and the Netherlands would increase by more than 2% thanks to a positive supply effect, that is, government investment raises the productivity of private capital and labour over a sustained period of time. The real GDP in other Eurozone regions (France, Italy, Spain and the rest of the Eurozone) would increase by around a range of 0.3-0.5 percentage points already after one year. These spillovers derive from the trade channel (the demand boost in Germany and the Netherlands will partly leak out to other countries via increased demand for imported goods) and some depreciation of the exchange rate (which will increase demand from the rest of the world for goods exported from the Eurozone).
Crucially, such a fiscal stimulus would have a very modest impact on these two countries' public finances and could actually decrease their debt ratios in the long run. The impact on public finances in Germany and the Netherlands is small, as higher growth would also boost tax returns. Government debt would in fact be less than 2% of GDP higher in Germany after ten years, and a bit more in the Netherlands, while debt ratios in the rest of the Eurozone would actually fall by around 2 percentage points due to the positive spillovers. In case of a permanent increase in public investment, debt ratios in Germany and the Netherlands would actually decline in the long run and the stimulus would become self-financing.
At the same time, intensified government investment efforts are vital to keep the existing infrastructure stock in good working conditions, without hampering its long-run service to the economy. The perceived quality of existing infrastructure stock in the euro area has considerably declined. Survey data shows that this is particularly the case in several Eurozone member states, including Germany, where this declining trend has been ongoing for more than a decade already (World Economic Forum 2015). Furthermore, the decline in the perceived quality of existing public capital stocks concerns all categories of core infrastructure such as roads, railways, air transport and ports infrastructure.
The debate on the appropriate fiscal stance of the Eurozone is an essential one and it constitutes an important milestone in the deepening of the EMU. The Communication recently adopted by the Commission says that every member state should take into account the objective of the Eurozone as a whole in the definition of its own national fiscal stance.
The design of an appropriate fiscal stance for the Eurozone remains the collective responsibility of its member states. In the absence of rules or instruments to directly manage the aggregate fiscal stance of the Eurozone, attaining a sound macroeconomic policy mix requires close coordination of national fiscal policies, within the requirements of the Stability and Growth Pact.
As advocated by the Five Presidents' Report for stage 2 of EMU deepening, the Eurozone needs an autonomous fiscal stabilisation capacity in the medium term. This stabilisation capacity can be for smoothing out country-specific shocks, common shocks to the area as a whole, or both kinds of shocks. Indeed, the recent experience suggests that the EMU setup may not allow for stabilising large economic shocks. In particular, the impossibility to force member states with fiscal space to use it and the soft nature of the recommendations on the composition of public expenditure constrain the possibility of reaching a 'positive fiscal stance'. The Commission will come up with concrete orientations for this common fiscal capacity in the White Paper in early 2017.
Blanchard, O, Ch Erceg and J Lindé (2015), "Jump Starting the Euro Area Recovery: Would a Rise in Core Fiscal Spending Help the Periphery?" NBER Working Paper No. 21426.
Brainard, W C (1967), “Uncertainty and the Effectiveness of Policy.” American Economic Review, 57(3), pp. 411-25.
European Commission (2015), "Drivers and benchmarks of current account balances, update", 4 November 2015.
European Commission (2016), "Towards a positive fiscal stance for the euro area" (COM(2016) 727).
In 't Veld, J (2016), Public Investment Stimulus in Surplus Countries and their Euro Area Spill-overs", European Economy Economic Brief 16. Summarised on the Vox here.
Roeger W and J in't Veld (2010), “Fiscal stimulus and exit strategies in the EU: a model based analysis,” Economic Papers 426, European Commission.
World Economic Forum (2015), "Executive Opinion Survey of the Global Competitiveness Index".
 There is a somewhat smaller positive GDP effect for the Netherlands, as the country is characterised by larger trade openness, which implies stronger demand leakage to imports.