by Raul Sampognaro

On November the 26^th, the ECFIN launched the European Semester and published the 2016 Annual Growth Survey and the Euro Area policy recommendation. The ECFIN states that the large spillovers from fiscal policy decisions and the current constraints on the single monetary policy call for strengthened attention to the aggregate fiscal stance at the euro area level. The recommended aggregate fiscal stance should take into account the cyclical position of the euro area. Moreover, a broadly neutral aggregate fiscal stance for the next years in the euro area appears appropriate to ECFIN in light of downside risks to growth and the persistent economic slack.

Opening the debate about the aggregate fiscal stance constitutes an important step in the improvement of the macroeconomic policy framework in the EA. In fact, the crisis that Euro zone has been facing since 2012 can be explained to a large extent by the fragilities in the monetary union. The lack of economic policy coordination emerged as one of the most important weaknesses. Before the crisis, the ECB was left alone to deal with common shocks while the fiscal policy was supposed to manage asymmetric shocks. Furthermore, the fiscal policy was supposed to safeguard public debt sustainability. This double objective was supposed to be assured by the compliance with the Stability and Growth Pact (SGP) rules. This framework failed during the crisis. First, the rules of the SGP were focused only on public debt sustainability and neglected the impact of fiscal policy on macroeconomic stabilization. Second, the decentralization of the procedures resulted in a bad aggregate outcome. The asymmetry in the rules implies ill-calibrated adjustments in deficit countries while anything forces countries with fiscal space to implement growth supportive policies.

In order to assess about the global orientation of fiscal policy the weighted sum of changes in structural balances is the traditional indicator used in the European Semester. This figure evaluates the evolution of deficits in the long run, once the cyclical effects are purged. This figure depends crucially on the way structural deficits are calculated and hence on the assumptions about the potential output used: even under common budgetary assumptions, the evolution of structural balance can evolve in different ways (see lines 2 and 3 of the table 1, which are computed using the same assumptions in terms of fiscal policy). On the basis of this indicator, the aggregate fiscal stance in the euro area is neutral or slightly expansionary in 2015 and 2016. This assessment is shared by the 2016 independent Annual Growth Survey (iAGS).  On the basis of the announcements of the Member States in their Stability Programmes, the iAGS team forecast that the fiscal consolidation will start again in 2017. This result differs with ECFIN forecasts, based on a no-policy change scenario that only takes into account the measures already implemented.

If the change of the structural balance shows that fiscal policy is broadly neutral in the euro area as a whole, the assessment of its economic impact needs to be completed. In the 2016 independent Annual Growth Report, we propose a new way to compute the aggregate fiscal stance that takes into account the most recent advances in the literature. According to several authors the multipliers of public expenses – which are decreasing in most of the bigger euro area economies– are higher than those associated with tax changes –which are decreasing and should have an expansionary impact. This is particularly true when output gaps are negative. Hence, the proposed indicator of the aggregate fiscal stance proposed is based on a weight that takes into account the macroeconomic impact of fiscal policy.

When the composition and the localisation of the fiscal impulses are taken into account, the assessment of the aggregate fiscal stance is modified. According to our calculation, fiscal policy will be slightly contractionary in 2016 (-0.1 point of GDP, table 2) in spite of the decrease in the aggregate structural balance. This paradox can be explained by the localisation of the impulsion, which has low impact in Germany and the composition of the expansion in Italy and in Spain (based on large tax cuts with a low multiplier partially compensated by an effort in expenses with a high multiplier).

The apparent paradox of a fiscal loosening with recessionary effects raises the matter of the fiscal space –expansionary policies should be larger in unconstrained countries– and the flexibilities in the application of SGP –expansion should be done in countries with high multipliers. Analyzing the situation of each Member State vis-à-vis the SGP, it appears that very few countries have fiscal space with respect to the rules of the SGP. According to the ECFIN analysis of Draft Budgetary Plans, only Germany would have some fiscal space but the efficiency of a timid German based stimulus would be limited, at least from a GDP point of view. This raises new questions and particularly about the creation of a common fiscal capacity that would enable implementation of a counter-cyclical budgetary policy, especially when there is no scope for monetary policy like a situation of liquidity trap and deflation. This is the rational of the Juncker Plan that aims to increase investment in the euro zone. However, the plan relies on unrealistic leverage assumptions and the selection of investment projects, based on the profitability of the project, may lead to a pro-cyclical bias. This plan may not be sufficient to generate the demand shock needed to escape from the Zero Lower Bound, suggesting that a permanent is needed.Taking into account the very high levels of unemployment and underemployment, even the highest value of the fiscal impulse (+0.1% GDP) is far too low to deliver significant stimulus. A coordinated increase of public investment with a focus on the Europe 2020 targets would be a proper policy change for a more balanced economic policy. With the implementation of the golden rule of public investment, such a stimulus could be achieved in line with the European fiscal rules.

This post summarizes a paper written by Mahito Uchida, in Revue de l’OFCE, n° 135.

With the arrival of Shinzo Abe at the end of 2012, Japan’s economic policy started clearly focusing on the risk of deflation. This new policy combines a highly accommodative monetary policy with a fiscal stimulus based on public investment. In an article published by the OFCE, Mahito Uchida of SEIJO University, analyses the first stage of implementation of the new Japanese monetary policy. In that paper, Mahito Uchida investigates the Bank of Japan’s (BOJ) monetary policy effects under Abenomics at the initial stage. First, he describes briefly what is “Abenomics” and “New monetary policy under Abenomics” since April 2013. He also examines the causes of the sharp response of the yen and Japanese stock prices, the increase in consumer price index and the change in public’s expectations of the economic activity and prices from surveys. In the second part he explains why the new monetary policy was effective in 2013, comparing the previous policy until 2012. Although there is not much difference between monetary policies before and after 2012 theoretically, he points out the importance of the strong commitment by central bank, the cooperation with the government and “psychological impact” on public. The third part discusses the durability of the new monetary policy. The policy effects will be sustainable if a price becomes lastingly positive, which needs a durably positive output gap. Therefore, Abenomics’ growth strategy plays an important role. He also points out that the BOJ has to perform the policy over side effects such as the impact on the government bond markets, the impact on other financial markets and on capital flows  overseas.

By Catherine Mathieu and Henri Sterdyniak

The 9th EUROFRAME conference [1] was held on 8 June 2012 in Kiel on issues concerning the economic policy of the European Union. The topic was: “The euro zone in crisis: challenges for monetary and fiscal policies”. The conference was, of course, dominated by the issue of the sovereign debt crisis in the euro zone. How did it come to this? Should the blame be put on mistakes in national economic policies? Must the way the euro zone is organized be changed?

A number of fault lines appeared (cf. also the related Note in French):

• Some believe that it is irresponsible domestic policies that are the cause of the imbalances: the southern countries were allowed to develop real estate and wage bubbles, while the northern countries carried out virtuous policies of wage moderation and structural reform. The southern countries must adopt the strategy of the northern countries and accept a prolonged dose of austerity. For others, the single currency has allowed the development of mirror opposite imbalances: too much austerity in the North, and too many wage increases in the South; what is needed is a convergence where stimulus in the North facilitates the absorption of the external imbalances in the South.
• For some, every country must implement policies that combine fiscal consolidation and structural reform. For others, what is needed is an EU-wide growth strategy (in particular by financing an ecological transition) and a guarantee of public debt so as to promote a convergence of national interest rates at lower levels.
• Some believe that any new solidarity measures involve developing a Union budget, which means the inclusion of binding rules in the Fiscal Compact; for others, what is needed is the open coordination of economic policies, without pre-established standards.

We provide a report that includes brief comments [2] in a lengthy Note.

[1] EUROFRAME is a network of European economic institutes that includes: DIW and IFW (Germany), WIFO (Austria), ETLA (Finland), OFCE (France), ESRI (Ireland), PROMETEIA (Italy), CPB (Netherlands), CASE (Poland), NIESR (United Kingdom).

[2] Most of the articles are available at: http://www.euroframe.org/index.php?id=7. Selected articles will be published in an issue of the Revue de l’OFCE, in the “Débats et Politiques” collection, at the end of 2012. The report reflects the views of the authors alone.

By Jérôme Creel

“The size of many multipliers is large, particularly for spending and targeted transfers.” Who today would dare to write such a thing?

The answer is: 17 economists from the European Central Bank, the US Federal Reserve, the Bank of Canada, the European Commission, the International Monetary Fund, and the Organization for Economic Cooperation and Development, in an article published in January 2012 in the American Economic Journal: Macroeconomics.

They continue in the abstract: “Fiscal policy is most effective if it has moderate persistence and if monetary policy is accommodative. Permanently higher spending or deficits imply significantly lower initial multipliers.”

What are the values ​​of these multiplier effects, and what about the significant reduction in such effects if fiscal policy is expansionary over the long term? According to these 17 economists, based on eight different macroeconometric models for the US and four different models for the euro zone, the conclusion is clear: a fiscal stimulus that is in effect for 2 years, accompanied by an accommodative monetary policy (the interest rate is kept low by the central bank) produces multiplier effects that are well above one both in the United States and in the euro zone (between 1.12 and 1.59) if the stimulus plan targets public consumption, public investment or targeted transfers. For other instruments available to government, such as VAT, the effects are smaller, on the order of 0.6, but still decidedly positive.

What if the stimulus is continued? The multiplier effects of a permanent increase in public consumption dwindles, of course, but they remain positive in the euro zone, regardless of the model used and regardless of the assumption made about the monetary policy pursued. Rare cases of negative multiplier effects are reported for the United States, but these depend on the model used or on assumptions about monetary policy.

Finally, a comment and a question raised by this recent article.

The comment: the choice of an optimal fiscal policy in the euro zone is well worth a few moments of reflection, reading and analysis of current work, rather than a truncated and distorted vision of fiscal policy that is judged without fair consideration as harmful to economic activity.

The question: an expansionary fiscal policy has … expansionary effects on gross domestic product; must we really deprive ourselves of an instrument that is, after all, effective?

By Jean-Luc Gaffard

The simultaneous increase of inflation and unemployment in the 1970s indicated that Keynesian theory and policy had run into a wall. No longer was it simply possible to arbitrate between the two evils and fine-tune economic activity by acting solely on aggregate demand through the budget channel. This failure together with the persistence of high inflation eventually convinced policymakers of the need and urgency of prioritising the fight against inflation.

The economic theory devised by the new classical school came in support of this policy decision with the claim that inflation and unemployment were distinct phenomena that should be handled with distinct methods. If inflation takes off, it is because of a lack of monetary discipline. If unemployment rises, it is due to increased rigidities in the functioning of the markets. The famous Phillips curve, the basis for arbitrating between the two, theoretically becomes vertical, at least in the long run. Macroeconomic policies thus become dissociated from structural policies: the first are intended to stem inflation, the second to curb unemployment. The only relationship that they have with each other is that cyclical policy does not allow the economy to escape for long from the position determined by structural policy, a position that reflects the so-called natural unemployment rate. One attraction of this theory is the simplicity of its recommendations to government. Policymakers can (and should) meet a single target, inflation, by using a single instrument wielded by a central bank that is now independent, especially as hitting this target also ensures that the natural employment level will be achieved at the lowest cost in terms of inflation. If by chance the unemployment rate is considered too high, policymakers should take the view that this reflects dysfunctions in the markets for goods and labour, and they can then decide to introduce a well-organised set of structural reforms designed for market liberalisation. In this wonderful world, reducing the budget deficit is always profitable. The basic model teaches that, after such a reduction, income and employment decrease initially, but then, thanks to a reduction in interest rates, private investment quickly increases and with it income and employment. The new medium-term equilibrium may even correspond to a higher level of income and employment, as private investment expenditure is considered to be more efficient than government expenditure. An independent central bank and financial markets that are deemed efficient play the role of disciplining the government by punishing any inappropriate budget deficits.

Europe has been a prime testing ground for this theory. Monetary policy is in the hands of a central bank, and its governing treaties ensure that it is independent and that its sole objective is price stability. Structural policies and reforms are a matter for the states, which are responsible for choosing the natural unemployment rate that they consider acceptable or, if they consider unemployment to be too high, they can impose reforms. If unemployment is higher in one country than in another, in the medium term, this can only be due to structural differences, in other words, to the existence of greater rigidities in the way the markets in this country operate. Once the recommended reforms are implemented, things will get back to normal. The theory thus formulated is expected to survive the crisis: for Europe to regain its lost coherence is a simple matter of policy choices. Excessively indebted countries need to reduce their budget deficits and make the structural reforms that they have put off for too long in order to restore growth, full employment and price stability. At most, some are proposing that debts be pooled in return for a commitment to implement structural reform. Germany, which has preceded the others down this particular path to virtue, has nothing to fear from this scenario, since the renewed growth of its partners will ensure the long-term viability of its commercial outlets. Furthermore, the European Central Bank does not need to concern itself with financial stability, as markets punish impecunious States and force them into fiscal austerity by driving up the interest rates paid on their borrowings.

This entire beautiful structure rests on assumptions that are not very robust, in particular that any increase in market rigidities, particularly on the labour market, e.g. due to an increase in unemployment benefits, redundancy costs or employee bargaining power, shifts the long-term equilibrium position of the economy and inevitably produces an increase in the “natural” unemployment rate. It is, of course, always possible to compare long-run equilibria that are distinguished only by the value of certain structural data. It is riskier to deduce the path that leads from one to another. We should have learned from the experience of the 1930s that rigidities in prices and wages are a way to stem rising unemployment in a depressed economy, that is to say, when it becomes important to block reductions in prices and wages that are increasing the burden of private debt and putting downward pressure on aggregate demand. It should also be clear that structural reforms intended to reduce the natural rate of unemployment often lead immediately to a redistribution and reduction in income, which leads in turn to higher unemployment. But nothing says that this increase will only be temporary and will not trigger a chain reaction through the channel of aggregate demand. Rigidities remain a factor in reducing the risk of instability inherent in any structural change, whether this involves reforms in market organisation, the emergence of new competitors on the market or technological breakthroughs. A better allocation of resources may justify calling these rigidities into question, but care must be taken to avoid the inherent risk of instability. Certainly, when structural reforms aimed at introducing more flexibility undermine domestic demand, the latter can then be boosted by stimulating external demand with lower prices. The unemployment rate may then fall. But it is actually exported to countries that might well not yet have undertaken such reforms, where unemployment thus inevitably exceeds the level deemed natural. “Every man for himself” begins to prevail over solidarity.

Europe is currently going through this scenario. Germany, in particular, carried out the structural reforms required by the prevailing theory, but at the cost of the segmentation of its labour market and the growth of low-paid insecure jobs, which resulted in turn in a slowdown in domestic demand. The improvement in Germany’s export performance, based on the quality of its goods as well as on the international fragmentation of the production process, has been offsetting the slowdown and helping to contain or even reduce the budget deficit. The unemployment rate has been rising in many other European countries in parallel to their budget deficits. The correction required by the experts (and in fact imposed by the financial markets), which involves simultaneously reducing public spending, raising taxes and making structural reforms, will very likely further reduce domestic demand in these countries, increase their budget deficits and ultimately hit German exports. Recession, if not a general depression, lies at the end of this path. The cause is a series of internal and external imbalances. And things could get even more complicated if performance gaps in the countries concerned widen even further and lead to divergences in their goals and interests.

Economic policy is unfortunately more complex than modern macroeconomics would have it. The long term is not independent of the short term; and the goals pursued are not independent of each other, and not always inter-compatible. Policies that are categorised as cyclical and structural are not really independent of each other, nor can they be targeted exclusively at a single goal. If there must be structural reforms, they need to be accompanied by expansionary cyclical policies to counteract the immediate recessionary effects that they may amplify. Even so, cyclical policies are not sufficient in themselves to ensure strong, steady growth.

It is unrealistic and dangerous to expect to break free of the current impasse through generalised fiscal austerity in Europe. Compromises are needed that involve the acceptance of some disequilibria in order to alleviate others. The only way out is to accept budget deficits for a while longer. Without a recovery in the balance sheets of both firms and households, there will be no positive outcome from the rebalancing of public accounts, if indeed that even occurs.

There is of course no doubt that we must achieve greater harmony in the fiscal positions of countries belonging to the same monetary zone. Fiscal federalism is necessary to deal with monetary federalism. But federalism does not stop with the actions of a central bank that has been stripped of its basic functions and is unable to carry out common national fiscal contractions. It demands genuine budget solidarity, including to intervene to prevent the insolvency of States that are facing exorbitant interest rates. It also involves structural policies that not only refrain from reforms that could exacerbate fiscal and social competition, but also promote industrial and technological projects funded by a common European budget that has been strengthened through the establishment of a federal tax. State budget deficits will not be contained and the objectives and interests of states will not converge without the implementation of the cyclical and structural policies needed for a general recovery of growth.