The long-awaited start of the European Central Bank's (ECB) program of quantitative easing (the purchase of bonds) and the ensuing collapse of government bond yields throughout the euro area and beyond have given finance and budget ministers flexibility this fiscal year and the next. Since last summer, when budgets were being prepared, bond yields have declined by 100 basis points. The resulting budgetary savings are substantial, given that most euro area economies have public debts in excess of 75 percent of GDP. The savings will be especially large for countries that must refinance sizable amounts of debt over the next couple of years or that have a significant share of floating rate bonds. Italy, for example, could save as much as half a percent of annual GDP in debt service costs, and even more if low interest rates persist, as seems likely.
How should finance ministers use this windfall—and is there a danger of squandering this opportunity? How justified are the concerns of some members of the ECB's governing board that reduced market pressure will let governments postpone reforms?
The ECB's actions are aimed at bringing Europe back from the brink of deflation and gradually returning inflation to its target level of 2 percent. The main benefits to the fiscal accounts will eventually come from stronger economic growth. Low interest rates will facilitate a recovery of private investment and a portfolio shift toward riskier assets. A higher nominal GDP growth rate will tend to reduce the government debt-to-GDP ratio. As economies regain strength, so will tax revenues, reducing fiscal deficits. But higher growth remains uncertain and may take a few quarters to materialize. By contrast, the savings resulting from the decline in interest rates are already being felt.
Both the Stability and Growth Pact (SGP, which envisages a 3 percent fiscal deficit-to-GDP ceiling) and individual countries' domestic fiscal rules (such as constitutional rules for a structural fiscal balance over the economic cycle) are based upon the overall fiscal balance, not the primary balance (which excludes the interest bill). Thus, most finance ministers must decide whether to use the windfall gains to reduce the debt or permit additional spending or tax cuts. The decision will be dictated by circumstances in each country. France and Spain are under the SGP's excessive deficit procedure, and in such cases most of the windfall should be devoted to deficit reduction. Italy and Germany have more latitude.
Italy, which continues to lag in growth, is highly indebted and is using the limited flexibility permitted by the SGP to avoid excessive fiscal consolidation that would impede its recovery. Its large projected savings must seem like manna from heaven to Finance Minister Pier Carlo Padoan. He will need to resist pressures for generalized spending. He should instead allocate the gains to (i) debt reduction; (ii) cuts in social security contributions for young people, aimed at curbing youth unemployment, Italy's most pressing social and economic challenge; and (iii) support for workers who may lose their jobs as a result of labor market or other reforms. The government should also specify its various structural reforms, starting with closing or privatizing state-owned entities deemed not in the public interest by the spending review. In this way, Italy would demonstrate that the reprieve from quantitative easing is being used wisely to undertake structural reforms.
Germany, in contrast, is in an enviable fiscal position, with a balanced budget and a declining debt-to-GDP ratio. Although its fiscal savings from lower interest rates are more limited because its refinancing flows are small, Germany already had budgetary room for fiscal stimulus before quantitative easing. Despite weak growth (and calls for additional public investment from the United States, among others) Germany has adhered to its balanced budget objective, citing the need to prepare for an aging population. In view of the interest savings, Germany might well end up with a fiscal surplus, which may be difficult to defend to the German public. Germany should respond by considering increases in public investment and fiscal measures to stimulate private investment, whose decline in recent years has contributed to Germany's current account surplus.
The underlying principle is the same for all countries: The windfall from the ECB should be put to sensible use. For Italy, that means reducing public debt, limiting the losses in human capital, and improving the structure of the state. For Germany, it means increasing physical capital accumulation. Seizing the window of opportunity would show that the ECB's gift has been used wisely.