By Christine Rifflart

With a deficit of 3.1% of GDP in 2017, Spain has cut its deficit by 1.4 points from 2016 and has been meeting its commitments to the European Commission. It should cross the 3% threshold in 2018 without difficulty, making it the latest country to leave the excessive deficit procedure (EDP), after France in 2017. The 2018 budget was first presented to the European Commission on April 30 and then approved by Spain’s Congress of Deputies on May 23 amidst a highly tense political situation, which on June 1 led to the dismissal of Spain’s President Mariano Rajoy (supported by the Basque nationalist representatives of the PNV Party who had approved the 2018 budget a few days earlier). It should be passed in the Senate soon by another majority vote. The expansionary orientation of the 2018 budget, backed by the government of the new Socialist President Pedro Sanchez, does not satisfy the Commission, which considers the adjustment of public finances insufficient to meet the target of 2.2% of GDP included in the 2018-2021 Stability and Growth Pact (SGP). According to the hypotheses of the previous government, not only would the deficit fall below 3% but the nominal target would be respected.

Admittedly, while, given the strong growth expected in Spain in 2018, the public deficit will easily be below 3% in 2018 and therefore meet the requirements set in the EDP, the new budget act is not in line with the fiscal orthodoxy expected by Brussels. The lack of a People’s Party majority in Congress led ex-President Mariano Rajoy into strategic alliances with Ciudadanos and the PNV to get the 2018 budget adopted (with the hope, in particular, of avoiding early parliamentary elections), at the price of significant concessions:

– An increase in civil servants’ salaries of 1.75%[1] in 2018 and at least 2.5% in 2019, with a larger increase if GDP grows by more than 2.5% (estimated cost of 2.7 billion euros in 2018 and 3.5 billion in 2019 according to the outgoing government);

– Lower taxes for low-income households (via the increase in the minimum tax threshold from 12,000 to 14,000 euros income per year, tax credits for childcare expenses, assistance for disabled people and large families, and a reduction in tax on gross wages between 14,000 and 18,000 euros) (cost 835 million in 2018 and 1.4 billion in 2019);

– The revaluation of pensions by 1.6% in 2018 and by 1.5% in 2019 (cost of 1.5 and 2.2 billion), in addition to a rise of up to 3% in the old age and non-taxpayer minimum, and between 1% and 1.5% for the lowest pensions (cost 1.1 billion in 2018).

According to the former government, these measures will cost a little more than 6 billion euros in 2018 (0.5% of GDP) and nearly 7 billion in 2019 (0.6% of GDP). The revaluation of pensions should be partly covered by the introduction of a tax on digital activities (Google tax) in 2018 and 2019, with revenues of 2.1 billion euros expected. In the end, spending, which was expected to fall by 0.9 GDP point in 2018 based on the undertakings made in the previous 2017-2020 SGP, would fall by only 0.5 GDP point in the 2018-2021 SGP (to 40.5% of GDP) (Table). But above all, despite the tax cuts just introduced, the extra revenue expected from the additional growth should represent 0.1 GDP point (to 38.3% of GDP). In fact, the budget’s redistributive character, combined with the downward revision of the impact of the Catalan crisis on the economy (0.1% of GDP according to the AIReF [2]) led all the institutes (Bank of Spain, the Government, the European Commission) to raise their 2018 growth forecasts from last winter by 0.2 or 0.3 GDP point to bring it slightly below 3% (2.6% for the OFCE according to our April forecasts [3]).

Nevertheless, beyond the shared optimism about Spanish growth, the calculations of the cost of the new measures differ between the Spanish authorities and the Commission. According to the government, the increase in growth should, as we have said, boost tax revenues and neutralize the expected cost of new spending. In 2018, the 0.9 percentage point reduction in the deficit (from 3.1% to 2.2%) would therefore be achieved by the 0.8 GDP point growth in the cyclical balance, combined with the 0.2 point fall in debt charges, with the structural balance remaining stable (fiscal policy would become neutral rather than restrictive as set out in the earlier version of the Pact). But this scenario is not shared by Brussels[4], for whom the cost of the measures, and in particular of the increase in civil servants’ salaries, is underestimated. Expenditures are expected to be 0.2 GDP point higher and revenue 0.2 GDP point higher than the government has announced. According to the Commission, the cyclical balance is expected to improve by 0.9 GDP point, but the fiscal impulse would worsen the structural balance by 0.6 GDP point. In these conditions, the deficit would bypass the 3% mark, but fiscal policy would clearly become expansionary and the 2.2% target would not be hit. The public deficit stood at 2.6% in 2018 (Figure 1).

This more expansionary orientation of the 2018 budget results above all from the political considerations of the former Rajoy government and its effort to deal with the impossibility of governing (facts have demonstrated the fragility of this position). Nevertheless, the timing is ideal – because the only budget commitment required in 2018 is to cross the 3% deficit threshold in order to get out of the corrective arm of the SGP. The year 2018 therefore makes it possible to implement a generous fiscal policy, while crossing the 3% mark, without exposing the country to sanctions. The situation will be more delicate in 2019, when EU rules aimed at reducing a debt that is still well above 60% of GDP will be applied, notably by adjusting the structural balance (Figure 2).

[1] https://www.boe.es/boe/dias/2018/03/26/pdfs/BOE-A-2018-4222.pdf

[2] https://elpais.com/economia/2018/04/17/actualidad/1523949570_477094.html?rel=str_articulo#1526464987471

[3] See the Spain part of the dossier:  https://www.ofce.sciences-po.fr/pdf/revue/11-155OFCE.pdf , pp 137-141.

[4] Nor by the AIReF.

By Bruno Ducoudré, Xavier Timbeau and Sébastien Villemot

Current account imbalances are at the heart of the process that led to the crisis in the euro zone starting in 2009. The initial years of the euro, up to the crisis of 2007-2008, were a period that saw widening imbalances between the countries of the so-called North (or the core) and those of the South (or the periphery) of Europe, as can be seen in Figure 1.

The trend towards diverging current account balances slowed sharply after 2009, and external deficits disappeared in almost all the euro zone countries. Despite this, there is still a significant gap between the northern and southern countries, so there cannot yet be any talk about reconvergence. Moreover, the fact that the deficits have fallen (Italian and Spanish) but not the surpluses (German and Dutch) has radically changed the ratio of the euro zone to the rest of the world: while the zone’s current account was close to balanced between 2001 and 2008, a significant surplus has formed since 2010, reaching 3.3% of GDP in 2016. In other words, the imbalance that was internal to the euro zone has shifted into an external imbalance between the euro zone and the rest of the world, in particular the United States and the United Kingdom. This imbalance is feeding Donald Trump’s protectionism and putting pressure on exchange rates. While the nominal exchange rate internal to the euro zone is not an adjustment variable, the exchange rate between the euro and the dollar can adjust.

It seems unlikely that the euro zone can maintain a surplus like this over the long run. Admittedly, the pressures for the appreciation of the euro are now being contained by the particularly accommodative monetary policy of the European Central Bank (ECB), but when the time comes for the normalization of monetary policies, it is likely that the euro will appreciate significantly. In addition to having a deflationary impact, this could rekindle the crisis in the zone by once again deepening the Southern countries’ external deficits due to their loss in competitiveness. This will in turn give new grounds for leaving the euro zone.

In a recent study [1], we seek to quantify the adjustments that remain to be made in order to resolve these various current account imbalances, both within the euro zone and vis-à-vis the rest of the world. To do this, we estimate equilibrium real exchange rates at two levels. First, from the point of view of the euro zone as a whole, with the idea that the adjustment of the real exchange rate will pass through an adjustment of the nominal exchange rate, notably the euro vis-à-vis the dollar: we estimate the long-term target of euro / dollar parity at USD 1.35 per euro. Next, we calculate equilibrium real exchange rates within the euro zone, because while the nominal exchange rate between the member countries does not change because of the monetary union, relative price levels allow adjustments in the real exchange rate. Our estimates indicate that substantial misalignments remain (see Figure 2), with the average (in absolute terms) misalignment relative to the level of the euro being 11% in 2016. The relative nominal differential between Germany and France comes to 25%.

In the current situation, claims by some euro zone countries are not accumulating on others in the zone, but there is accumulation by some euro zone countries on other countries around the world. This time the exchange rate (actual, weighted by accumulated gross assets) can serve as an adjustment variable. The appreciation of the euro would therefore reduce the euro zone’s current account surplus and depreciate the value of assets, which are probably accumulated in foreign currency. France however now appears as the last country in the euro zone running a significant deficit. Relative to the zone’s other countries, it is France that is contributing most (negatively) to the imbalances with Germany (positively). If the euro appreciates, it is likely that France’s situation would further deteriorate and that we would see a situation where the net internal position accumulates, but this time between France (on the debtor side) and Germany (creditor). This would not be comparable to the situation prior to 2012, since France is a bigger country than Greece or Portugal, and therefore the question of sustainability would be posed in very different terms. On the other hand, reabsorbing this imbalance by an adjustment of prices would require an order of magnitude such that, given the relative price differentials that would likely be needed between France and Germany, it would take several decades to achieve. It is also striking that, all things considered, since 2012, when France undertook a costly reduction in wages through the CICE tax credit and the Responsibility Pact, and Germany introduced a minimum wage and has been experiencing more wage growth in a labour market that is close to full employment, the relative imbalance between France and Germany, expressed in the adjustment of relative prices, has not budged.

Three consequences can be drawn from this analysis:

1. The disequilibrium that has set in today will be difficult to reverse, and any move to speed this up is welcome. Ongoing moderation in rises in nominal wages in France, stimulating the growth of nominal wages in Germany, restoring the share of German added value going to wages, and continuing to boost the minimum wage are all paths that have been mentioned in the various iAGS reports. A reverse social VAT, or at least a reduction in VAT in Germany, would also be a way to reduce Germany’s national savings and, together with an increase in German social security contributions, would boost the competitiveness of other countries in the euro zone;
2. The pre-crisis internal imbalance has become an external imbalance in the euro zone, which is leading to pressure for a real appreciation of the euro. The order of magnitude is significant: it will weigh on the competitiveness of the different countries in the euro zone and will lead to the problems familiar prior to 2012 resurfacing in a different form;
3. The appreciation of the euro caused by the current account surpluses in certain euro zone countries is generating an externality for the euro zone countries. Because their current accounts respond differently to a change in relative prices, Italy and Spain will see their current account balance react the most, while Germany’s will react the least. In other words, the appreciation of the euro, relatively, will hit the current accounts of Italy and Spain harder than Germany’s and will lead to a situation of internal imbalance much like what existed prior to 2012. This externality together with the reduced sensitivity of Germany’s current account to relative prices argues for a reduction in imbalances by boosting Germany’s internal demand, i.e. by a reduction in its national savings. The tools to do this could include boosting public investment, lowering direct personal taxes, or raising the minimum wage more quickly relative to productivity and inflation.

[1] Sébastien Villemot, Bruno Ducoudré, Xavier Timbeau: “Taux de change d’équilibre et ampleur des désajustements internes à la zone euro“ [Equilibrium exchange rate and scale of internal misalignments in the euro zone], Revue de l’OFCE, 156 (2018).

By Bruno Ducoudré and Pierre Madec

In the course of the crisis, most European countries reduced actual working hours to a greater or lesser extent through partial unemployment schemes, the reduction of overtime or the use of time savings accounts, but also through the expansion of part-time work (particularly in Italy and Spain), including on an involuntary basis. In contrast, the favourable trend in US unemployment has been due in part to a significant fall in the labour force participation rate.

Assuming that a one-point increase in the participation rate leads, holding employment constant, to a rise in the unemployment rate, it is possible to measure the impact of these adjustments (working hours and participation rates) on unemployment by calculating an unemployment rate at constant employment and checking these adjustments. Except in the United States, the countries studied experienced an increase in their active population (employed + unemployed) that was larger than that observed in the general population, due among other things to the implementation of pension reforms. Mechanically, without job creation, this demographic growth would have the effect of pushing up the unemployment rate in the countries concerned.

If the participation rate had remained at its 2007 level, the unemployment rate would be lower by 2.3 points in France, 3.1 points in Italy and 2 points in the United Kingdom (see figure). On the other hand, without the sharp contraction in the US labour force, the unemployment rate would have been more than 3.2 percentage points higher than that observed at the end of 2017. It also seems that Germany has experienced a significant reduction in its unemployment rate since the crisis, even as its participation rate rose. Given the same participation rate, Germany’s unemployment rate would be … 0.9%. However, changes in participation rates are also the result of structural demographic factors, to such an extent that the hypothesis of a return to 2007 rates can be considered arbitrary. For the United States, part of the fall in the participation rate can be explained by changes in the structure of the population. The figure for under-employment can also be considered too high.

The lessons are very different with respect to the duration of work. It seems that if working hours had stayed at their pre-crisis levels in all the countries, the unemployment rate would have been 3.7 points higher in Germany and 2.9 points higher in Italy. In France, Spain, the United Kingdom and the United States, working time has fallen only slightly since the crisis. If working hours had remained the same as in 2007, the unemployment rate would have been slightly higher in all of these countries.

Note that the trend for working time to fall largely preceded the 2007 economic crisis (table). While this pre-crisis trend has continued in Germany and even been accentuated in Italy, working time has fallen to a lesser extent in France, Spain and the United States. In the United Kingdom, the reduction in working hours that was underway before 2007 has been cut short.

By Eric Heyer

In May, inflation in the euro area moved closer to the ECB target. The sharp rise in inflation, from 1.2% to 1.9% per annum in the space of one month, did not nevertheless provoke a reaction, since the main reason for it was well known and common to all the countries: the surge in oil prices. After having plummeted to 30 dollars a barrel at the beginning of 2016, the price per barrel now stands at around 77 dollars, the highest level since 2014. Even after adjusting for the exchange rate – the euro has appreciated against the dollar – the price of a barrel has increased by almost 40% (18 euros) over the last 12 months, directly causing prices in the net oil importing countries to rise at an accelerating pace. In addition to this common effect, for France the impact of the hike in indirect taxes on tobacco and fuels, which came into force at the beginning of the year, will, according to our estimates, add 0.4 point to the price index.

At the same time, the underlying inflation (or core inflation) index, excluding products with volatile prices (such as oil and fresh produce) as well as prices subject to state intervention (electricity, gas, tobacco, etc.), is still not picking up pace and is staying below 1%. The second-round effect of an oil shock, which passes through a rise in wages, does not seem to be very significant, since consumers are absorbing most of the shock by reducing their purchasing power. This explains part of the observed slowdown in household consumption at the beginning of the year as well as the general lack of reaction of the monetary authorities to the announcement of the inflation figures.

There remains the question of the weakness of trend inflation and its link with the state of the economy. Have we already caught up with the output gap that arose since the Great Depression of 2008 (an output gap of close to zero), or are there still production capacities that can be mobilized in the event of additional demand (positive output gap)? In the first case, this would mean that the link between growth and inflation has been significantly broken; in the second case, this would indicate that the low level of inflation is not surprising and that the normalization of monetary policy needs to be gradual.

In 2017, even though the process of recovery was consolidating and spreading, most developed economies were still lagging behind their pre-crisis trajectory. Only a few seem to have already overcome the lag in growth. Thus, two categories of countries seem to be emerging: the first – in particular Germany, the United States and the United Kingdom – includes countries that have caught up with their potential level of production and are at the top of the cycle; the second – which includes France, Italy and Spain, for example – includes countries that are still experiencing a lag in production which, according to the economic analysis institutes, lies between 1 and 2 points of GDP for France and Italy and 3 points of GDP for Spain (Figure 1).

The presence of developed countries in both categories should logically result in the appearance of inflationary pressures in the countries listed in the first group and an inflation gap in those in the latter. However, these two phenomena were not apparent in 2017: as shown in Figure 2, the link between the level of the output gap and the underlying inflation rate is far from clear, casting doubt on the interpretation to be made with respect to the level of the output gap: to uncertainties relating to this notion is added that associated with the level of this gap in the past, in 2007 for example.

Given this high level of uncertainty, it seems appropriate to make a diagnosis based on how this output gap has varied since 2007. Such an analysis leads to a clearer consensus between the different institutes and to the disappearance of the first category of countries, those with no additional growth margin beyond their own potential growth. Indeed, according to these, in 2017 none of the major developed countries would have come back to its output gap level of 2007, including Germany. This gap would be around 1 GDP point for Germany, 2 GDP points for the United Kingdom and the United States, more than 3 GDP points for France and Italy and around 5 GDP points for Spain (Figure 3).

This analysis is more in line with the diagnosis of the renewal of inflation based on the concept of underlying inflation: the fact that the economies of the developed countries had not in 2017 recovered their cyclical level of 2007 explains that inflation rates were lower than those observed during the pre-crisis period (Figure 4). This finding is corroborated by an analysis based on criteria other than the output gap, notably the variation in the unemployment rate and the employment rate since the beginning of the crisis and in the rate of increase in working hours during this same period. Figure 5 illustrates these different criteria. On the basis of these latter criteria, the qualitative diagnosis of the cyclical situation of the different economies points to the existence of relatively high margins for a rebound in Spain, Italy and France. This rebound potential is low in Germany, the United States and the United Kingdom: only an increase in working time in the former or in the employment rate for the latter two could make this possible.

By Céline Antonin

The question of how disposable income is shared between savings and consumption involves trade-offs that take place at the household level and has direct implications at the aggregate level. For example, if the propensity to save is higher among wealthy households, a consumer stimulus will be more effective if it targets low incomes. Another example concerns how progressive the income tax system is: if the savings rate rises with income, then making income tax more progressive will have a more than proportional effect on the decline in national savings, with consequences for investment. Other issues such as tax incentive schemes to encourage savings (life insurance, Livret A accounts) or the question of the relevant tax base (work versus consumption, income versus wealth) depend on this trade-off. The measurement of precautionary savings is essential, especially to understand the implications of rising unemployment during a shock such as the 2008 crisis. So if the increase in unemployment affects all households equally, and if rich households have a stronger precautionary motive than others, then the recession will be more violent.

Historically, the models of the life cycle and permanent income, which originated with Modigliani and Brumberg (1954) and Friedman (1957), provided one of the first theoretical frameworks for thinking about savings behaviours. Friedman (1957) introduced the notion of permanent income, defined as the constant income over time that gives the household the same discounted income as its future income, and showed that the permanent consumption (and thus the savings) is proportional to the permanent income over the lifetime. Thus, households should save during their working lives and start dis-saving upon retirement. These models have been enriched by the precautionary savings theory, which shows that savings also serves as insurance against contingencies that might affect the household, particularly with respect to income (unemployment, loss of wages, etc.). As a result, households are saving not only to offset lower future income, but also to insure against all kinds of risks, including risk to income. The main difficulty when trying to evaluate this precautionary behaviour is to find an accurate measure of the risk to income. The most convincing approach involves the use of subjective household survey data about trends in income and in the likelihood of unemployment (Guiso et al., 1992; Lusardi, 1997; Lusardi, 1998; Arrondel, 2002; Carroll et al., 2003; Arrondel and Calvo-Pardo, 2008). This approach quantifies the share of wealth accumulation that is related to the precautionary motive.

What is the amplitude of the precautionary motive? Do all households exhibit precautionary behaviour, or does it depend on their income? The working paper on The Linkages between Savings Rates, Income and Uncertainty. An illustration based on French data [“Les liens entre taux d’épargne, revenu et incertitude. Une illustration sur données françaises”] first seeks to test the homogeneity of savings rates empirically according to the level of income. It is also interested in the existence of precautionary savings behaviour related to income and tries to quantify this, based on the French INSEE 2010-2011 Family Budget survey. The precautionary motive is assessed by means of the subjective measure of the likelihood of unemployment that is expected by household members over the next five years.

The precautionary motive exists for all French households: the extra savings linked to the risk of unemployment is around 6-7%, and the proportion of precautionary holdings attributable to the risk of unemployment comes to around 7% of total wealth. The precautionary motive can be differentiated according to the level of income: middle-income households accumulate the most precautionary savings. Their savings represents 11-12% of the total household wealth of the second, third and fourth income quintiles, compared with about 5% for households in the income quintiles at the extremes.