There is much debate today on the direction that fiscal policy should take in Europe. On one hand, stocks of public debt are higher than ever, calling for long-run fiscal adjustment. On the other, doubts about the subdued recovery push for slowing fiscal consolidation and providing short-term stimulus. There doesn't exist a clear compass to balance these considerations. And the balance of course may differ with specific country situations.
The European Commission has adopted 'fiscal responsibility' as a key pillar of its growth strategy, together with boosting investment and a renewed commitment to structural reforms (European Commission 2014a). Fiscal responsibility has to do with appropriately confronting the current dilemmas, since the Commission at the same time stresses that Member States "still need to secure long term control over deficit and debt levels" while underscoring that consolidation should be "growth-friendly". The Commission has also judged that concerning the euro area as a whole, a broadly neutral stance emerges from the analysis of country budgetary plans for 2015 (European Commission 2014b). Moreover, while this is deemed to strike an appropriate balance for the overall zone, the country distribution of fiscal policies is judged to be sub-optimal, as "some Member States are called to increase their efforts to comply with the SGP, [which] implies a degree of fiscal support coming from the exploitation of the fiscal space available elsewhere".
These judgments beg a number of analytical questions.
- How to characterise the notion of fiscal responsibility?
- Can the conclusion of appropriateness of a broadly neutral fiscal stance for the Eurozone at the current juncture be substantiated?
- How to make consistent assessments between the area taken in its entirety and the needed country differentiation?
The theoretical background to this discussion is being shaken by the debate over the possibility of secular stagnation (Summers 2014). Economists have generally agreed that keeping debt at prudent levels is a sensible long-term objective, if only to preserve space for firing countercyclical ammunition in downturns. Secular stagnation in a deep sense has the potential to unravel this wisdom (Eggertson and Mehrotra 2014). A permanent (or at least persistent) shortfall in desired private investment relative to saving can – and arguably should – be countered by permanent fiscal support. This may in turn imply a growing stock of public debt – but without much concern for financing as there is a large pool of savers craving safe assets. However, the implications of low interest rates for policy depend on the underlying causes. Chronic private underspending is one explanation, yet another one is an increasingly feeble supply side (Gordon 2014).
Navigating in a grey reality
Models offer stylised descriptions within particular paradigms, but reality combines features of different models. This 'grey reality' has crucial implications. For one, we are unlikely to receive unambiguous signals as to which kind of world we live in. At best, we modify with new information the subjective plausibility that we attach to each of the 'visions'. But fundamental uncertainty about key features of the economy is bound to remain. This applies to the current European predicament, which combines an interaction of supply and demand weaknesses.
From a policy perspective, uncertainty has deep implications that are not always sufficiently acknowledged (Aikman et al. 2014). An important one is the need for robust policy strategies – strategies that are not optimal under a given state of the world, but which perform acceptably well across a broad range of plausible worlds.
In the fiscal field, the premium on robust strategies is increased by the political economy complexities of budgetary policy-making. Today, running fiscal policy is a bit like steering a big tanker that is lost at sea under changing weather conditions. One needs to maintain a steady course while acknowledging the uncertainties. One also needs to think deep about coordinating the short-term with the long-term (Borg 2014). To this end it is useful to keep an eye on a 'fiscal compass' that can act as a consistent guiding principle.
Carnot (2014) explores a rule of thumb that puts at its core a balancing act between fiscal sustainability and macroeconomic stabilisation. Fiscal sustainability is anchored in a long-run debt objective. For each budgetary period, the rule suggests a fiscal impulse that trades off the fiscal gap with a summary measure of economic conditions. This 'rule of thumb' is both temporally consistent and geographically consistent. Moreover – and crucially in the context of European discussions – it delivers a consistent prescription for both the aggregate stance of a group of countries (e.g. the Eurozone) and each participating country of the group.
Heading north or south?
The current fiscal map (Figure 1) shows that overall, the Eurozone still retains a fiscal gap of about 2% of GDP compared with what would be needed for a smooth reduction of debt in the long run (although this gap has been already significantly reduced in past years). On the other hand, while not as acutely dramatic as in the Great Recession of 2009, economic conditions clearly remain depressed, albeit with signs of improvements (European Commission 2015). There is also significant country differentiation around this average picture. In particular, Germany has 'fiscal space' in the sense that its primary surplus overachieves what is needed for gradual debt reduction, while other large countries have sizeable fiscal gaps, though to varying extents.
Figure 1. The fiscal map: primary gaps and economic conditions in 2015
Note: The primary gap (in percent of GDP) summarises the long-run sustainability challenge. It is the distance between the actual primary balance and one that would put debt on a gently declining path. A negative sign indicates the existence of 'fiscal space'. The score on economic conditions summarises business cycle conditions based on the output gap and the change thereof. A null score corresponds to broadly neutral conditions. See Carnot (2014) for details.
Source: European Commission winter forecast 2015, author's calculations.
What guidance does this imply for current budgets? The rule of thumb combines the primary gap and the summary of cyclical conditions to determine the desirable fiscal stance – like how a Taylor rule blends the inflation and output gaps for gauging policy interest rates. Our specific formulation gives equal weights to the primary gap and the economic score.
We find the following (see Figure 2).
- As a whole, the Eurozone should conduct a close-to-neutral fiscal stance. This reflects the fact that, at the current juncture, the contributions from the fiscal gap and from the economic outlook broadly cancel out. (This was absolutely not a forgone conclusion enshrined in the nature of the rule. Over the past decade, the same rule of thumb would have prescribed both expansion and retrenchment, depending on circumstances.)
- Confirming a common insight, this overall stance should be differentiated across the zone. Pursing moderate consolidation appears warranted in both France and Spain (reflecting the still very large primary gaps). The case of Italy is more in-between, given the relatively smaller fiscal gap and the still very depressed environment (in contrast to better momentum in Spain).
- Meanwhile, the rule of thumb is consistent with a moderate fiscal stimulus in Germany. This, it should be stressed, reflects the conditions of Germany only, and should thus not be done 'for the sake of others' but primarily as a result of a balanced judgment of Germany's situation.
Figure 2. Fiscal stance according to the rule of thumb for 2015 (in % of GDP)
Note: The desirable fiscal stance is determined as Ft = ¼(Pt + St), where P is the primary gap and S the economic score. The rule of thumb is used in the version giving equal weights to the primary gap and economic conditions in terms of their possible contributions to the desired fiscal stance.
Source: European Commission winter forecast 2015, author's calculations.
These messages are in line with the Commission's conclusions over the 2015 round of budgets. Indeed, as formalised in the rule of thumb, the advice from the Commission on an appropriate fiscal stance takes into account the cyclical conditions of a fairly fragile recovery and sustainability concerns from high debt levels.
When the recovery gains strength, the rule of thumb will point towards resuming differentiated consolidation for the Eurozone and most countries until the remaining primary gaps are eliminated and positions are on par with steady debt reductions. This reflects the premise that public debt should be contained at prudent levels in the long-run for individual sovereigns, in line with the EU fiscal framework.
In the deeply uncertain current environment, the fiscal policy debate would benefit from simple benchmarks that help steer a responsible and time-consistent course, explicitly acknowledging conflicting considerations. This is especially the case in a Europe which faces the additional challenge of coordinating decentralised fiscal policies. Indeed, as also underlined by the ECB President, there is a need and scope within the Stability and Growth Pact for "stronger coordination among the different national stances … to achieve a more growth-friendly overall fiscal stance for the euro area" (Draghi 2014).
Our fiscal compass offers a tool to explore these considerations. At the current juncture it suggests differentiating fiscal policies around a broadly neutral overall stance in the Eurozone. The results are partly parameter-sensitive but nevertheless suggestive. They bring analytical support to the recent judgement over the aggregate stance carried out by the European Commission as part of its assessment of budgetary plans (European Commission 2014b). In addition, the composition of fiscal policies also needs to be considered, as fiscal changes offer the opportunity to improve the quality of public spending and of the tax structure.
Aikman D, M Galesic, G Gigerenzer, S Kapadia, K Katsikopoulos, A Kothiyal, E Murphy and T Neumann (2014), Taking uncertainty seriously: simpicity versus complexity in financial regulation, Bank of England Financial stability paper, N°28, May.
Borg A (2014), Fiscal policy in the shadow of debt: surplus keynesianism still works, in Akerlof G., Blanchard O., Romer D. and J. Stiglitz (eds.): What have we learned? Macroeconomic policy after the crisis, MIT Press, Cambridge Massachussets.
Carnot N (2014), "Evaluating fiscal policy: a rule of thumb", European economy economic paper, N°526, August.
Draghi M (2014), "Unemployment in the euro area", Speech at the annual central bank symposium in Jackson Hole, 22 August.
Eggertsson, G B and N R Mehrotra (2014), "A model of secular stagnation", NBER working paper, No. 20574.
European Commission (2014a), "Annual growth survey 2015, Communication from the Commission", COM(2014) 902, 28 November.
European Commission (2014b), "2015 draft budgetary plans: overall assessment, Communication from the Commission", COM(2014) 907, 28 November.
European Commission (2015), "European Economic Forecast Winter 2015", European Economy, N°1/2015.
Gordon, R J (2014), "The turtle’s progress: Secular stagnation meets the headwinds", in: Teulings, C and R Baldwin (eds.): Secular stagnation: facts, causes and cures, A VoxEU.org eBook.
Summers L H (2014), "Reflections on the new 'Secular Stagnation' hypothesis", VoxEU.org, 30 October 2014.