Europe’s Impending Fiscal Volte-Face
Treasury Secretary Jack Lew recently declared victory for the US position in the debate over stimulus versus austerity within the G-20. “Today the G-20 is no longer debating growth versus austerity, but rather how to best employ fiscal policy to support our economies,” he said at the end of August, before the G-20 meeting in China. He was even more correct than he may have imagined. Germany, which has led the pro-austerity camp in Europe, is about to shift towards fiscal stimulus.
Several factors have led to the fiscal turnabout in Europe. The British electorate’s decision to leave the European Union caused the Conservative government in London to abandon its previous pro-austerity stance in order to counter the downturn caused by the vote. The UK government's upcoming Autumn Statement is expected to reset fiscal policy toward a more stimulative stance. How much more remains to be seen, but the unmistakable direction is underpinned by the Bank of England’s commitment to restart its quantitative easing (QE) program and purchase up to £60 billion in additional government debt.
Germany, which has led the pro-austerity camp in Europe, is about to shift towards fiscal stimulus.
In addition, Europe unceremoniously buried the recently strengthened Stability and Growth Pact (SGP) over the summer. In a process reminiscent of the 2003–04 gutting of the original SGP by Germany and France, the College of European Commissioners refrained from recommending financial sanctions against Spain and Portugal, despite the two countries’ bursting of their SGP deficit limits. More surprising, German Finance Minister Wolfgang Schauble lobbied for lenience, thereby avoiding the political responsibility for levying huge fines on two struggling economies at a time of rising public skepticism about the European Union across Europe. Schauble also did a favor for a fellow center-right leader, Prime Minister Mariano Rajoy, to prevent Spain from going center-left, as France and Italy have done as a result of the economic crisis of recent years. For Germany, such political concerns have trumped any commitment to long-term SGP fiscal targets. As a result, no euro area member will likely face financial sanctions under the SGP for an overly loose fiscal policy. For a currency area that has spent the last six years painstakingly trying to strengthen its fiscal rules, these developments represent a remarkably underappreciated shift in policy.
Germany has its own domestic reasons for relenting on austerity as its government indulges in increasing tax breaks before the September 2017 federal elections. Schauble fired the first shot in a likely bidding war this week by proposing €2 billion in almost immediate tax breaks, and then another €15 billion (0.5 percent of GDP) to be phased in after the election. For a country with a projected +1 percent fiscal surplus in 2016, this proposal does not amount to much, perhaps. It allows the German government to adhere to its balanced budget commitment (die schwartze Null, or black zero), which is more stringent than the German constitutional requirement.
The election, however, is still far away, and Chancellor Angela Merkel is slipping in the polls and needs to keep her more conservative governing partners happy. Unwilling to change her immigration policies, she needs the tax cuts to placate restive colleagues, especially since the country can afford them. With massively increased spending on refugees, general tax cuts are also a good way to distribute money to average Germans, who are increasingly concerned about immigration. And somewhat ironically, given how much of Germany's recent strong fiscal performance can be attributed to the large interest cost savings coming from the European Central Bank’s monetary stimulus (the German government now issues 10-year debt at negative nominal interest rates), tax cuts should go at least some way toward placating German savers concerned about the reduced returns on their assets. There are hence a host of reasons why Schauble’s offer may be only the beginning of still more to come.
Germany is hardly the only major euro area economy under political pressure. Both France and Germany go to the polls next year, a coincidence that occurs only once every 20 years. They are to be joined by the Netherlands. On top of that, Prime Minister Matteo Renzi of Italy may have to call an early election next year, on the heels of a likely election in Spain in late 2016. Populist threats abound throughout Europe, spurring the old election year tradition of European budgets loosening up in 2017.
Finally, these pressures occur as the monetary stimulus policies of the European Central Bank (ECB) appear at their financial and political limit. Additional new stimulus measures, such as lower or even negative interest rates, may in fact provoke political anger. In other words, as a result, European politicians can no longer count on ECB President Mario Draghi’s largesse to bail them out. Instead they must increasingly rely on fiscal action to sustain Europe’s recovery. Fortunately for them and especially Germany, the ECB’s easy monetary policy has reduced debt service costs by 1 to 2 percent of GDP, giving them room to spend or cut taxes.
Thus the era of transatlantic sniping over stimulus versus austerity is about to end, and better macroeconomic coordination—at least in Europe—is in the offing.