By Jérôme Creel, Paul Hubert and Francesco Saraceno

The European Council meeting being held at the end of the week should have been spent, according to the wishes of the French authorities, on renegotiating the European Fiscal Compact adopted on 2 March 2012. However, renegotiation has not been on the agenda. Alas, the Fiscal Compact does need to be re-opened for debate: it should be denounced for being poorly drafted, and its overly restrictive character needs to be reviewed; ultimately, the text should be amended. The focus of the debate on the structural deficit rule, which is unfairly described as the “golden rule”, is wide of the mark in so far as it is the rule on the reduction of public debt that is the more restrictive of the two rules included in the Fiscal Compact. This is the rule that demands to be discussed, and urgently, in order to avoid sinking deeper into a contagion of austerity plans that are doomed in advance…

The conflict over European growth between the French and Italians on the one side and the Germans on the other was probably defused by the agreement late last week with Spain in favour of a coordinated European recovery plan. The plan represents 1% of Europe’s GDP, i.e. 130 billion euros, though its contours and funding remain to be clarified. The slogan of the European Council has thus been, by a process of elimination, “banking union”, in an effort to prevent a new wave of banking and financial crises in the European Union. Is the creation of a banking union important? Certainly. Is it urgent? Less so than a return to growth, which, while it certainly cannot be decreed, can be prepared. Given the state of the current Fiscal Compact, we can conclude that what is being prepared is not economic growth, but recession [1].

The Fiscal Compact, which is contained in Title III of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, explicitly includes two fiscal rules. The first clarifies what constitutes a budgetary position that is “balanced or in surplus”, a term enshrined long ago in the Stability and Growth Pact. According to the Fiscal Compact of March 2012, a budgetary position that is “balanced or in surplus” means a structural deficit of at most 0.5% of GDP. The structural deficit is the cyclically adjusted public deficit, i.e. adjusted for the well-known automatic stabilizers; this includes interest charges, among other items. When the structural deficit is exceeded, apart from exceptional circumstances, e.g. a “significant” downturn in activity, an automatic adjustment mechanism, whose nature is not specified, must bring it back below this limit. The structural deficit rule is relaxed for Member States whose public debt is below 60% of GDP: the structural deficit ceiling is increased to 1% of GDP.

The second fiscal rule is also a requirement for euro zone Member States with a public debt in Maastricht terms that is greater than 60% of GDP. In 2012, this rule applies to 12 out of the 17 Member States of the euro zone. This second rule aims to reduce the public debt by one-twentieth every year. Unfortunately, the text adopted is poorly written and opens the door to different interpretations, as we show below. It is therefore inapplicable. Even worse, given the current state of the economy, this rule is the more restrictive of the two rules in the Fiscal Compact. It is therefore urgent to pay attention to it and modify it to make it enforceable.

According to Article 4 of the Treaty, “When the ratio of a Contracting Party’s general government debt to gross domestic product exceeds the 60% reference value…, that Contracting Party shall reduce it at an average rate of one-twentieth per year as a benchmark….” The problem is that “it”, which we have put in italics, refers to the public debt ratio rather than to the difference between the public debt and the 60% reference value. So, in 2012 should Germany, with a public debt in 2011 of a little more than 80% of GDP, reduce its debt by 4 GDP points (one-twentieth of 80% of GDP) or by 1 GDP point (one-twentieth of the difference with the reference value of 60% of GDP)? Legally, it is essential that a clear answer can be given to this kind of question.

Moreover, the Fiscal Compact is silent on the nature of the surplus to be used to reduce the debt: if, to leave room for maneuver in case of a cyclical deficit, this rule were to address the structural deficit — which would therefore need to be explained in the Compact — the debt rule would be even more restrictive than the golden rule: a structural surplus would be systematically required to reduce the public debt to 60% of GDP in the 12 Member States whose debt exceeds the reference value. Again, the formulation needs to be clear.

Suppose now that the “it” in Article 4 concerns the difference between the debt and the reference value, and that the rule on debt reduction applies to the entire public deficit. The question can then be asked, which of the two rules – the “golden rule” or the debt reduction rule – places greater restrictions on the Member States, and thus needs to be applied. We have set out, in an appendix [2], the small set of fiscal rules compatible with the Fiscal Compact. The total deficit is the sum of the cyclical deficit and the structural deficit. The cyclical deficit depends on the difference between actual and potential GDP, i.e. the output gap, which has an elasticity of 0.5 (average elasticity customary in the literature on the European countries, cf. OECD). The “golden rule” relates only to the structural deficit, while the debt reduction rule concerns the total public deficit, and thus depends on both the output gap and the structural deficit.

For what values of the public debt and the output gap is the “golden rule” more restrictive than the debt reduction rule? Answer: when the output gap is greater than 1 plus one-tenth of the difference between the original debt and the reference value. This means that, for a country like Germany, the debt reduction rule would predominate over the “golden rule” except in cases of very high growth: the real GDP would have to be at least two points higher than the potential GDP. According to the OECD economic forecast published in May 2012, Germany’s output gap in 2012 will be -0.8. The debt reduction rule is thus much more restrictive than the “golden rule”. This is also true for France (debt of 86% of GDP in 2011), which would have to have an output gap of at least 3.6 points for the “golden rule” to be binding; yet the OECD forecasts an output gap of -3.3 in 2012. The same holds true for all the countries in the euro zone with a debt greater than 60% of GDP, without exception.

Except in cases of very strong growth, the debt reduction component dominates the structural deficit component. Yet it is the latter that is the focus of all the attention.

When a treaty is open to such differences in interpretations, isn’t it normal to want to revise it? When a treaty requires intensifying austerity measures in an area like the euro zone, whose GDP is almost 4 percentage points below its potential, according to the estimates of an organization, the OECD, that is generally not suspected of overestimating the said potential, is it not desirable and urgent to renegotiate it?

[1] A recent post emphasized the risks of social instability and the potential losses that might result from austerity-induced contagion in the euro zone (cf. Creel, Timbeau and Weil, 2012).

[2] Annex:

We start by defining with def the total public deficit, which includes a structural component s and a cyclical component dc:

def = s + dc

All the variables are expressed as a proportion of GDP. The cyclical component is composed of the variation in the deficit that occurs, thanks principally to the action of the automatic stabilizers, when the economy deviates significantly from its potential. A reasonable estimate is that the deficit increases by 0.5 point per point of lost output. The cyclical component can thus be expressed as:

dc = – 0.5 y

where we define y as the output gap, i.e. the difference between GDP and its potential level.

The rules introduced by the fiscal compact can be expressed as follows:

s₁ < 0.5,

that is, the structural deficit can never exceed 0.5% of GDP (s₁ refers to the first aspect of the rule), and

def = – (b₀ – 60)/20,

that is, the total deficit must be such that the public debt (expressed as a proportion of GDP) is reduced every year by one-twentieth of the difference between the initial public debt (b₀) and the 60% reference level. The debt rule can thus be re-written in terms of the structural deficit as:

s₂ = def – dc = 0.5 y – (b₀ – 60)/20.

We thus have 2 possible cases for when the structural deficit component is less restrictive than the debt reduction component:

Case 1

s₁ < s₂ if y >1 + (b₀ – 60)/10.

Assume the case of a debt level like Germany’s (b₀ = 81.2 % of GDP). Case 1 implies that the structural deficit component will be less restrictive than the debt reduction component if and only if y > 3.12%, that is, if Germany has a GDP that is at least three points higher than its potential. If a country has a higher level of debt (e.g. Italy, at 120% of GDP), then y > 7%!

Case 2

If the debt reduction rule concerns the structural deficit (rather than the total public deficit), then we have:

s₁ < 0.5

and

s₂ = – (b₀ – 60)/20

In this case, s₁ < s₂ if 1 < – (b₀ – 60)/10, which will never happen so long as the public debt is greater than the reference level.

Eric Heyer and Xavier Timbeau

The European Commission has just released its spring forecast, which anticipates a recession in 2012 for the euro zone (“mild” in the words of the Commission, but still -0.3%), which is in line with the OFCE’s economic analysis of March 2012.

The brutal fiscal austerity measures launched in 2010, which were intensified in 2011 and tightened even further in 2012 virtually throughout the euro zone (with the notable exception of Germany, Table 1 and 1a), are hitting activity in the zone hard. In 2012, the negative impact on the euro zone resulting from the combination of raising taxes and reducing the share of GDP that goes to expenditure will represent more than 1.5 GDP points. In a deteriorating fiscal situation (many euro zone countries had deficits of over 4% in 2011) and in order to continue to borrow at a reasonable cost, a strategy of forced deficit reduction has become the norm.

This strategy is based on declarations that the 3% ceiling will be reached by 2013 or 2014, with balanced budgets to follow by 2016 or 2017 in most countries. However, these goals seem to be overly ambitious, as no country is going to meet its targets for 2013. The reason is that the economic slowdown is undermining the intake of the tax revenue needed to balance budgets. An overly optimistic view of the impact of fiscal restraint on activity (the so-called fiscal multiplier) has been leading to unrealistic goals, which means that GDP growth forecasts must ultimately be systematically revised downward. The European Commission is thus revising its spring forecast for the euro zone in 2012 downward by 0.7 point compared to its autumn 2011 forecast. Yet there is now a broad consensus on the fact that fiscal multipliers are high in the short term, and even more so that full employment is still out of reach (here too, many authors agree with the analyses made by the OFCE). By underestimating the difficulty of reaching inaccessible targets, the euro zone members are locked in a spiral where jitters in the financial markets are driving ever greater austerity.

Unemployment is still rising in the euro zone and has hardly stopped increasing since 2009. The cumulative impact on economic activity is now undermining the legitimacy of the European project itself, and the drastic remedy is threatening the euro zone with collapse.

What would happen if the euro zone were to change course in 2012?

Assume that the negative fiscal impulse in the euro zone is on the order of -0.5 percent of GDP (instead of the expected total of -1.8 GDP points). This reduced fiscal effort could be repeated until the public deficit or debt reaches a fixed target. Because the effort would be more measured than in current plans, the burden of the adjustment would be spread out more fairly over the taxpayers in each country, while avoiding the burden of drastic cuts in public budgets.

Table 2 summarizes the results of this simulation. Less austerity leads to more growth in all the countries (Table 2a), and all the more so as the fiscal consolidation announced for 2012 intensifies. Our simulation also takes into account the impact of the activity in one country on other countries through trade. Thus, Germany, which has an unchanged fiscal impulse in our scenario, would experience an 0.8 point increase in growth in 2012.

In the “less austerity” scenario, unemployment would decline instead of continuing to increase. In all the countries except Greece, the public deficit would be lower in 2012 than in 2011. Admittedly, this reduction would be less than in the initial scenario in certain countries, in particular those that have announced strong negative impulses (Spain, Italy, Ireland, Portugal and … Greece), which are the ones most mistrusted by the financial markets. In contrast, in some countries, such as Germany and the Netherlands, the government deficit would shrink more than in the initial scenario, with the indirect positive effect of stronger growth outweighing the direct effect of less fiscal consolidation. For the euro zone as a whole, the public deficit would be 3.1 percentage points of GDP, against 2.9 points in the initial scenario. It is a small difference compared to more favorable growth (2.1%), along with lower unemployment (-1.2 points, Table 2) instead of an increase as in the initial scenario.

The key to the “less austerity” scenario is to enable the countries in greatest difficulty, those most obliged to implement the austerity measures that are plunging their economies into the vicious spiral, to reduce their deficits more slowly. The euro zone is split into two camps. On the one hand, there are those who are demanding strong, even brutal austerity to give credibility to the sustainability of public finances, and which have ignored or deliberately underestimated the consequences for growth; on the other are those who, like us, are recommending less austerity to sustain more growth and a return to full employment. The first have failed: the sustainability of public finances has not been secured, and recession and the default of one or more countries are threatening. The second strategy is the only way to restore social and economic – and even fiscal – stability, as it combines a sustainable public purse with a better balance between fiscal restraint and employment and growth, as we proposed in a letter to the new President of the French Republic.

by Jérôme Creel, Xavier Timbeau and Philippe Weil [1]

Dear Mr. President,

France and the European Union are at a crucial economic juncture. Unemployment is high, the output loss to the financial crisis since 2008 has not been recovered and you have promised, in this dismal context, to eliminate French public deficits by 2017.

Your predecessor had committed to achieving the same objective a tad faster, by 2016, and a distinctive feature of your campaign has been your insistence that the major burden of the coming fiscal retrenchment be borne by the richest of taxpayers. These differences matter politically (you did win this election) but they are secondary from a macroeconomic viewpoint unless the long-run future of France and Europe depends on short-run macroeconomic outcomes.

In the standard macroeconomic framework, which has guided policy in “normal” and happier times, fiscal multipliers are positive in the short run but are zero in the long run where productivity and innovation are assumed to reign supreme. In such a world, giving your government an extra year to reduce public deficits spreads the pain over time but makes no difference in the long run. When all is said and done, austerity is the only way to reduce the debt to GDP ratio durably – and it hurts badly:

• The fantasy that short-run multipliers might be negative has been dispelled: a fiscal contraction depresses economic activity unless you are a small open economy acting alone under flexible exchange rates and your own national central bank runs an accommodative monetary policy – hardly a description of today’s France. Since France 2012 is not Sweden 1992, the prospect of a rosier fiscal future is not enough to outweigh the immediate recessionary effects of a fiscal contraction.
• To add insult to injury, if the financial crisis has lowered economic activity permanently (as previous banking or financial crises did, according to the IMF), public finances are now in structural deficit. To insure long-term debt sustainability, there is no way to escape fiscal restriction.
• On top of this, the consensus now recognizes that short-run fiscal multipliers are low in expansions and high in recessions. As a result, accumulating public debt in good times and refraining from running deficits in order to control debt in bad times is very costly: it amounts to squandering precious fiscal ammunition when there is no enemy and to scrimping on it in the heat of combat.

It increasingly looks like, that we are living, since the financial crisis, in a “new normal” macroeconomic environnent in which fiscal multipliers are still positive in the short run but non-zero in the long run because of two conflicting effects:

• A primal fear of French and European policy makers – fed by the outstanding historical work of Carmen Reinhardt and Kenneth Rogoff and the difficulties encountered by Italy, Spain or Greece to roll over their public debt – is that bad things might happen when the debt to GDP ratio steps over 90%. For instance, the sudden realization by investors that, past that level, there is no easy way to bring debt back to “normal” levels without inflation or outright default might lead to a rapid rise in sovereign interest rates. These high rates precipitate an increase in the debt to GDP ratio by raising the cost of servicing the debt and impose intensified deficit reduction efforts that further shrink GDP. Thus, crossing the 90% threshold might lead to a one-way descent into the abyss. This implies that fiscal contraction, although recessionary in the short run, is beneficial in the long run. Fiscal pain now is thus an evil necessary for long-run prosperity and debt sustainability. According to this narrative, we may survive – but only if we stop dancing right away.
• An opposite danger is that fiscal contraction now – in a context of public finances damaged (except for Greece) not by fiscal laxity but by the slowdown in economic activity engendered by the financial crisis since 2008 – might cause a social, political and economic breakdown or durably destroy productive capacity. Fiscal contraction is thus recessionary both in the short run and in the long run. Short-run fiscal expansion is then a necessary condition for long-run prosperity and debt sustainability. In this narrative, we may survive – but only if we keep dancing!

The advisability of your proposal to reduce the public deficits to zero by 2017 depends, Mr. President, on which of these two dangers is the most intense or the most difficult to thwart. Should you be more concerned that loose fiscal policy may hurt long-run growth by increasing the cost of debt service, or should you fear instead first and foremost that strict fiscal policy may harm output durably by leading to social unrest or by reducing productive capacity?

To answer these portentous questions, whose answer is not a matter of ideology or of economic paradigm, we urge you to look at the evidence:

• The sovereign rating of countries with large deficits and debts, like the US and the UK, has been downgraded without any adverse effect on interest rate. This suggests that markets understand, seemingly better than policymakers, that the key problem with EU public finances nowadays is not deficits and debt per se but the governance of the euro zone and its fiscal and monetary policy mix. With a lender of last resort – the euro zone has none –, managing a national debt crisis would be easy and straightforward. The counter-argument that it would lead the ECB to monetize public debts, in sharp contrast with the statutes of this institution and its duty to reach price stability, is invalid: the ex-ante ability to monetize debt would reduce risk premia by eliminating self-fulfilling runs on national debts.
• Ugo Panizza and Andrea Presbitero have shown that there is no convincing historical evidence that debt reduction leads to higher economic growth. Hence the statement that public debt reduction is a prerequisite to economic growth is at worse an assumption, at best a correlation, but in any case not a causal relation supported by data.
• Twenty years of Japanese stagnation remind us that deflation is a deadly and durable trap. Under-activity pushes prices down slowly but surely. Paul Krugman and Richard Koo have shown how real expected interest rates feed a spiralling of deleveraging when deflation locks into prices expectation. If deleveraging extends to the banking sector, it adds a credit squeeze to the contraction.
• One of the pernicious drawbacks of fiscal austerity is the destruction of human capital by long unemployment spells. Young cohorts entering now on the job market will undergo a problematic start and may never recover. The longer unemployment remains over its natural rate, the larger the frustration stemming from a bleak future will grow.
• Beyond human capital, firms are the place where all sorts of capital are accumulated, ranging from social capital to immaterial assets such as R&D. Philippe Aghion and others have argued that this channel links short-term macroeconomic volatility to long-term growth potential. Moreover, in a competitive world, underinvestment in private R&D impairs competitiveness. Hence, austerity, by making output more volatile, has a negative long-term impact.
• What is true for private immaterial assets is even truer for public assets, that is to say assets that generate flows of public goods that individual incentives fail to produce. Typically, so-called golden rules neglect such assets which are by their very nature hard to measure. As a result, the pursuit of quick deficit reduction is usually carried out at the expense of investment in assets which have a high social profitability and are essential to ensure a smooth transition to a low carbon economy.

Drawing on these facts, please let us suggest you a four-pronged strategy:

1. You should argue that fiscal austerity is bad for both short-term and long-term growth and remind Mrs. Merkel that, as a result, it should be handled with the utmost care.
2. Slowing down the pace at which austerity is imposed on EU countries is vital – both to reduce unemployment in the short-run and to maintain the long-run prosperity without which the reduction of debt-to-GDP ratios will be impossible.
3. You should acknowledge that the fears of your predecessor were well-founded: in the absence of a lender of last resort or without debt mutualization, slowing down austerity does expose sovereign debt to the risk of rising interest rates by provoking the self-fulfilling anxiety of creditors. But the experience of the US shows that the best way to deal with this danger is to have a full-fledged central bank that can act as a lender of last resort. The Maastricht Treaty should be amended fast in that dimension. Endowing the ECB with growth as a second mandate is not essential.
4. Mrs. Merkel is right that allowing the ECB to bail out States is a sure recipe for moral hazard. You should therefore agree, as a complement of the modification of ECB statutes, with her insistence that a Fiscal Compact governs Europe but you should strive for a Smart Fiscal Compact. This Smart Fiscal Compact should aim at enforcing the sustainability of public finances in a world where the long run is not given but depends on the short-run fiscal stance. It should draw its strength from legitimate European political institutions endowed with the power to control and enforce the commitment of each country to fiscal discipline. This task will require pragmatism and evidence-based economic policy – rather than budgetary numerology and simple-minded rules.

Failing to reduce deficits in Europe may end in a debacle. However, reducing them cold turkey is a sure recipe for disaster. Believing that old tricks like deregulating job markets will bring back economic growth lost in the recession is delusional, as the ILO warned in its last report. The possibility of brutal switches in economic or social trends rules out half-measures. The creeping build-up of long-term disequilibria requires prompt and decisive action in the short run. What is true for France is even truer for our main neighbors: the whole EU needs room for maneuver, and it needs it fast for the sake of its future.

Yours faithfully.

______________________________

[1] Jérôme Creel is deputy director of the Research Department, Xavier Timbeau is director of the Analysis and Forecasting Department, and Philippe Weil is president of OFCE.

By the Department of Analysis and Forecasting, headed by X. Timbeau

This article summarizes OFCE note no.16 that gives the outlook on the global economy for 2012-2013.

The sovereign debt crisis has passed its peak. Greece’s public debt has been restructured and, at the cost of a default, will fall from 160% of GDP to 120%. This restructuring has permitted the release of financial support from the Troika to Greece, which for the time being solves the problem of financing the renewal of the country’s public debt. The contagion that hit most euro zone countries, and which was reflected in higher sovereign rates, has been stopped. Tension has eased considerably since the beginning of 2012, and the risk that the euro zone will break up has been greatly reduced, at least in the short term. Nevertheless, the process of the Great Recession that began in 2008 being transformed into a very Great Recession has not been interrupted by the temporary relief of the Greek crisis.
First, the global economy, and especially the euro zone, remains a high-risk zone where a systemic crisis is looming once again. Second, the strategy adopted by Europe, namely the rapid reduction of public debt (which involves cutting public deficits and maintaining them below the level needed to stabilize debt), is jeopardizing the stated objective. However, since the credibility of this strategy is perceived, rightly or wrongly, as a necessary step in the euro zone to reassure the financial markets and make it possible to finance the public debt at acceptable rates (between 10% and 20% of this debt is refinanced each year), the difficulty of reaching the goal is demanding ever greater rigor. The euro zone seems to be pursuing a strategy for which it does not hold the reins, which can only fuel speculation and uncertainty.
Our forecast for the euro zone points to a recession of 0.4 percentage point in 2012 and growth of 0.3 point in 2013 (Table 1). GDP per capita in the euro zone should decline in 2012 and stabilize in 2013. The UK will escape recession in 2012, but in 2012 and 2013 annual GDP growth will remain below 1%. In the US, GDP growth will accelerate from 1.7% per year in 2011 to 2.3% in 2012. Although this growth rate is higher than in the euro zone, it is barely enough to trigger an increase in GDP per capita and will not lead to any significant fall in unemployment.
The epicenter of the crisis is thus shifting to the Old Continent and undermining the recovery in the developed countries. The United States and United Kingdom, which are faced even more than the euro zone with deteriorating fiscal positions, and thus mounting debt, are worried about the sustainability of their public debts. But because growth is just as important for the stability of the debt, the budget cuts in the euro zone that are weighing on their activity are only adding to difficulties of the US and UK.
By emphasizing the rapid reduction of deficits and public debt, euro zone policymakers are showing that they are anticipating a worst case scenario for the future. Relying on so-called market discipline to rein in countries whose public finances have deteriorated only aggravates the problem of sustainability by pushing interest rates up. Through the interplay of the fiscal multiplier, which is always underestimated in the development of strategies and forecasts, fiscal adjustment policies are leading to a reduction in activity, which validates the resignation to a worse “new normal”. Ultimately, this is simply a self-fulfilling process.

By André Grjebine and Francesco Saraceno

It is certainly possible to question whether the role acquired by the rating agencies in the international economy is legitimate. But if in the end their message must be taken into account, then this should be done based on what they are really saying and not on the economic orthodoxy attributed to them, sometimes wrongly. This orthodoxy is so prevalent that many commentators are continuing to talk about the decision by Standard & Poor’s (S&P) to downgrade the rating of France and other European countries as if this could be attributed to an insufficiently strong austerity policy.

In reality, the rating agency justifies the downgrade that it has decided with arguments opposed to this orthodoxy. For instance, the agency criticises the agreement between European leaders that emerged from the EU summit on 9 December 2011 and the statements that followed it, making the reproach that the agreement takes into account only one aspect of the crisis, as if it “… stems primarily from fiscal profligacy at the periphery of the euro zone. In our view, however, the financial problems facing the euro zone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called ‘periphery’. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”

Based on this, S&P believes that the main risk facing the European states could come from a deterioration in the fiscal positions of certain among them “in the wake of a more recessionary macroeconomic environment.” As a result, S&P does not exclude a further deterioration in the coming year of the rating of euro zone countries.

So if the European countries do indeed take into account the explanations of the rating agency, they should implement economic policies that are capable of both supporting growth and thereby facilitating the repayment of public debts while at the same time rebalancing the current account balances between the euro zone countries. This dual objective could be achieved only by a stimulus in the countries running a surplus, primarily Germany.

Unsustainable debt

The budget adjustments being imposed on the countries of the periphery should also be spread over a period that is long enough for its recessionary effects to be minimised. Such a strategy would accord with the principle that in a group as heterogeneous as the euro zone, the national policies of member countries must be synchronised but certainly not convergent, as is being proposed in some quarters. Such a policy would boost the growth of the zone as a whole, it would make debt sustainable and it would reduce the current account surpluses of some countries and the deficits of others. The least we can say is that the German government is far from this approach.

Didn’t Angela Merkel respond to the S&P statement by calling once again for strengthening fiscal discipline in the countries that were downgraded, that is to say, adopting an analysis opposed to that of the rating agency? Given its argumentation, one begins to wonder whether the agency wouldn’t have been better advised to downgrade the country that wants to impose austerity throughout the euro zone rather than wrongly to give it a feeling of being a paragon of virtue by making it one of the few to retain its AAA rating.

by Jérôme Creel, Xavier Timbeau and Philippe Weil [archivage et redirection]

[version française ; english version]

By Sabine Le Bayon

Should deficit reduction be the priority of governments today?

The constraints imposed by the Stability Pact and especially by the financial markets on Europe’s governments do not leave them much leeway. But while there is no avoiding the issue of the sustainability of public debt, we also need to take into account the recessionary impact of austerity programs on economic activity, particularly during a period of recovery. The great majority of studies point to a positive multiplier effect, that is to say, a one point cut (expansion) in the budget results in a decrease (increase) in activity. Furthermore, studies have highlighted that in order to maximize a policy’s impact, its timing is crucial: the impact on growth and on the public deficit (via its cyclical component) depends on whether or not it is supported by monetary policy, on the fiscal policy conducted by other countries, on the phase of the cycle, and so forth.

Fiscal consolidation, for example, has less impact on activity when it is accompanied by a relaxation in monetary policy and by a currency depreciation. But when interest rates are already close to zero (or in the case of a liquidity trap), the impact of fiscal restraint is not cushioned by a fall in base rates. As the central bank cannot counter disinflation, real interest rates rise, which amplifies the fall in activity. Moreover, in a context of generalized tightening, the exchange rate cannot be a means of supporting activity in every area. This is also true when a policy of fiscal restraint is being implemented within a monetary union where the countries trade mainly among themselves. Thus, according to the IMF, the impact on growth of a budget cut of 1 GDP point can vary between 0.5% and 2%, depending on whether or not an austerity program is synchronized with the response of monetary policy (Table 1).

Ultimately, the impact on growth feeds back into the state of public finances. When monetary policy can counteract the recessionary effects of fiscal policy, a one-off budget cut of a single GDP point reduces activity by 0.5% after two years. The deterioration in the cyclical deficit then comes to 0.25 GDP point, and the balance ultimately improves by 0.75 point. When interest rates are near zero, a one point negative fiscal stimulus in a country reduces growth by one point and worsens the cyclical deficit by 0.5 point, leading ultimately to an improvement in the deficit of only 0.5 GDP point. Finally, when a liquidity trap (or rates of zero) is combined with generalized budget cuts, a one GDP point negative fiscal stimulus reduces growth by 2 points, because neither monetary policy nor exchange rates can offset the impact of the cuts. This widens the cyclical deficit by one point, and there is therefore no improvement in the public deficit despite the one point structural effort.

Furthermore, the economy’s position in the cycle influences the multipliers. At the bottom of the cycle, for instance, they are amplified: an austerity policy accentuates any deflationary tendencies at work, which intensifies the fall in demand and therefore the impact on activity. However, at the top of the cycle, the disinflationary effects of the austerity measures counteract the inflationary trend usually seen in this phase, thus reducing the multiplier. According to Creel, Heyer and Plane, after one year, and depending on the policy instruments used, the multiplier lies between 1 and 1.3 points when the economy is in the bottom of the cycle (assuming an output gap of -2%) and between 0.8 and 1.2 points in mid-cycle (an output gap of zero) and the top of the cycle (for an output gap of 2%). At 5 years, the effect is even stronger: between 1 and 1.6 points at the bottom of the cycle, between 0.6 and 1.3 in mid-cycle and between 0 and 1.2 at the top of the cycle. Thus, when the output gap is negative, fiscal consolidation policies are not very effective because they lead to a significant decline in GDP compared to a scenario with no restraint, which limits any fiscal gains to be expected from the austerity policies.

Today everything has come together for the austerity policies to lead to a significant slowdown in growth with little reduction in the deficit, especially in the euro zone. This is why we tried to assess the indirect impact, for France and the major developed countries, of the austerity measures being implemented by their trading partners, in addition to the direct impact of the various national plans. The impact of fiscal restraint (in country A) on demand from its partners (B) depends on the elasticity of imports with respect to the GDP of country A but also on the degree of openness and geographical orientation of exports of the B countries. In the case of France, for a national multiplier of 0.5, the total multiplier is 0.7, once the fiscal restraint policies of the partners are taken into account via foreign trade; for a national multiplier of 1, the total multiplier is 1.5.

Based on the fiscal packages planned in the various countries, we obtain an impact of foreign plans on national activity of between -0.1 and -0.7 point in 2012, depending on the degree of openness of the countries and the orientation of their trade (Table 2). For France, the restraint planned by its trading partners will cut growth by 0.7 point in 2012, which is almost equal to the savings plan set up by the government (1 point). In Germany, the impact of foreign austerity plans on GDP is close to that calculated for France: even if Germany is more open, it trades less than France does with the rest of the euro zone, and will benefit more from the US stimulus package in 2012. In the other euro zone countries, foreign fiscal cuts will have an impact of the same magnitude (0.6). In the US, the effects of the stimulus package will be undercut by the austerity measures being implemented elsewhere; while the direct effect of the stimulus package on GDP will be 0.7 point, the lower demand addressed to it will cut growth by 0.2 point, limiting the impact of the expansionary fiscal policy. The slower than expected growth could render the deficit reduction goals obsolete. Using our assumptions of national multipliers of between 0.6 and 0.9, a one GDP point negative fiscal stimulus in all the EU countries actually reduces the deficit by only 0.4 to 0.6 GDP point in each country, once the fiscal restraint of the trade partners is taken into account.

This text refers to the study of fiscal policy (in French) that accompanies the analysis of the economic situation and the forecast for 2011-2012, available on the OFCE web site.

par Jean-Paul Fitoussi, Gabriele Galateri di Genola et Philippe Weil

Il est grand temps, pour rappeler les marchés à la réalité, de ressortir l’emprunt forcé de l’arsenal budgétaire/ Time is ripe for governments to take out of their fiscal armoury the weapon that has served them so well in war and peace alike: forced borrowing

A spectre is haunting Europe – the spectre of sovereign default. All the powers of old Europe have entered into a holy alliance to exorcise this spectre: Brussels and Frankfurt, Angela Merkel and Nicolas Sarkozy, French socialists and German Christian Democrats. Churchillian doctors, they prescribe blood, sweat and tears – fiscal consolidation, tax increases and spending cuts. They swear, for the umpteenth time, that they will never surrender: Greece will be saved, Italy and Spain will not be abandoned and the rating of France will not be downgraded. In the face of adversity, they assure us that what cannot be achieved by austerity can be achieved by more austerity. An epidemic of holier-than-thou fiscal virtue is spreading throughout Europe and is fast transforming a series of uncoordinated fiscal retrenchments into a euro-wide contraction with dire implications for growth and employment.

To be sure, eurozone policymakers are in a maddening situation. The threat to monetise public debt, which in the old days could be waved by each country to remind investors it need not ever default outright, has been removed from national arsenals. No one knows for sure whether it will ever be brandished from Frankfurt or if European treaties even allow it. Eurobonds would have every economic merit but they hurt Germany which, having been left on its own to finance reunification, is understandably cold towards die Transfer-Union. Creating separate northern and southern euro areas would probably precipitate the end of the single market – and where would France fit? Wide-ranging fiscal reform designed to increase tax revenue equitably, while sorely needed, is a pipe dream: it requires elusive European co-ordination in an area in which the temptation to compete is strong and it is best done at its own pace – not under the pressure of fickle market sentiment or rising sovereign spreads.

Add to this powerlessness the terrifying failure of the old engine of European policymaking (putting the cart before the horse in the hope that the cart will conjure up the horse) and you will understand the ghoulish visions gripping our leaders. Monetary union has not begotten the expected fiscal union. Imposing, as a substitute, austerity plans from Brussels or Frankfurt, or racing to be first to impose “golden rule” constitutional strictures on parliaments that should remain sovereign in fiscal matters is stoking the fire of civil unrest. The English Civil War and American Revolution were ignited by much less. It would be wise to recall, as John Hampden did in contesting the Ship Money tax levied by Charles I, that what leaders have no right to demand, a citizen has a right to refuse.

Yet Europe’s fate is not sealed. The spectre of sovereign default and rising spreads in Italy, Spain, Belgium and other countries can be chased away in one fell swoop and the panic of contractionary fiscal policies can be stopped. National governments must simply take out of their fiscal armoury the weapon that has served them so well in war and peace alike: forced borrowing.

It consists in coercing taxpayers to lend to their government. California did this in 2009 when it added a premium to the income tax withheld from paychecks, to be repaid the following year. In France, the first Mitterand government forced rich taxpayers to fund a two-year bond issue – and both the US and UK have used moral suasion in patriotic sales of war bonds. Compulsory lending is an unconventional weapon but it is high time it be used, even on a small scale, to remind investors that sovereigns are not private borrowers: they need never default because they can always force-feed debt issues to their own residents.

Central banks have been bold and dared resort to unconventional policies to respond to the exceptional circumstances of this crisis. Large sovereign borrowers should be as defiant and intrepid. The invaluable asset of fiscal sovereignty guarantees that their public debt is completely risk-free in nominal terms. Investors who buy sovereign credit default swaps against the spectre of French or Italian default are wasting their money. Policymakers rushing to austerity should wake up from their nightmare and save growth and employment before it is too late.

Jean-Paul Fitoussi is former president and Philippe Weil is president of OFCE, the Observatoire français des conjonctures économiques in Paris. Gabriele Galateri di Genola is president of Generali. The views expressed are their own.

Copyright The Financial Times Limited 2011

By Jean-Paul Fitoussi, Gabriele Galateri di Genola and Philippe Weil

A spectre is haunting Europe – the spectre of sovereign default. All the powers of old Europe have entered into a holy alliance to exorcise this spectre: Brussels and Frankfurt, Angela Merkel and Nicolas Sarkozy, French socialists and German Christian Democrats. Churchillian doctors, they prescribe blood, sweat and tears – fiscal consolidation, tax increases and spending cuts. They swear, for the umpteenth time, that they will never surrender: Greece will be saved, Italy and Spain will not be abandoned and the rating of France will not be downgraded. In the face of adversity, they assure us that what cannot be achieved by austerity can be achieved by more austerity. An epidemic of holier-than-thou fiscal virtue is spreading throughout Europe and is fast transforming a series of uncoordinated fiscal retrenchments into a euro-wide contraction with dire implications for growth and employment.

To be sure, eurozone policymakers are in a maddening situation. The threat to monetise public debt, which in the old days could be waved by each country to remind investors it need not ever default outright, has been removed from national arsenals. No one knows for sure whether it will ever be brandished from Frankfurt or if European treaties even allow it. Eurobonds would have every economic merit but they hurt Germany which, having been left on its own to finance reunification, is understandably cold towards die Transfer-Union. Creating separate northern and southern euro areas would probably precipitate the end of the single market – and where would France fit? Wide-ranging fiscal reform designed to increase tax revenue equitably, while sorely needed, is a pipe dream: it requires elusive European co-ordination in an area in which the temptation to compete is strong and it is best done at its own pace – not under the pressure of fickle market sentiment or rising sovereign spreads.

Add to this powerlessness the terrifying failure of the old engine of European policymaking (putting the cart before the horse in the hope that the cart will conjure up the horse) and you will understand the ghoulish visions gripping our leaders. Monetary union has not begotten the expected fiscal union. Imposing, as a substitute, austerity plans from Brussels or Frankfurt, or racing to be first to impose “golden rule” constitutional strictures on parliaments that should remain sovereign in fiscal matters is stoking the fire of civil unrest. The English Civil War and American Revolution were ignited by much less. It would be wise to recall, as John Hampden did in contesting the Ship Money tax levied by Charles I, that what leaders have no right to demand, a citizen has a right to refuse.

Yet Europe’s fate is not sealed. The spectre of sovereign default and rising spreads in Italy, Spain, Belgium and other countries can be chased away in one fell swoop and the panic of contractionary fiscal policies can be stopped. National governments must simply take out of their fiscal armoury the weapon that has served them so well in war and peace alike: forced borrowing.

It consists in coercing taxpayers to lend to their government. California did this in 2009 when it added a premium to the income tax withheld from paychecks, to be repaid the following year. In France, the first Mitterand government forced rich taxpayers to fund a two-year bond issue – and both the US and UK have used moral suasion in patriotic sales of war bonds. Compulsory lending is an unconventional weapon but it is high time it be used, even on a small scale, to remind investors that sovereigns are not private borrowers: they need never default because they can always force-feed debt issues to their own residents.

Central banks have been bold and dared resort to unconventional policies to respond to the exceptional circumstances of this crisis. Large sovereign borrowers should be as defiant and intrepid. The invaluable asset of fiscal sovereignty guarantees that their public debt is completely risk-free in nominal terms. Investors who buy sovereign credit default swaps against the spectre of French or Italian default are wasting their money. Policymakers rushing to austerity should wake up from their nightmare and save growth and employment before it is too late.

Jean-Paul Fitoussi is former president and Philippe Weil is president of OFCE, the Observatoire français des conjonctures économiques in Paris. Gabriele Galateri di Genola is president of Generali. The views expressed are their own.

Copyright The Financial Times Limited 2011