18 October 2012

VP Rehn speech at ECMI Annual Conference - Rebalancing Europe, rebuilding the EMU

It is correct that fiscal consolidation can have a dampening effect on growth in the short term. Attempts to quantify this effect through the so-called "fiscal multiplier" have been much in the news in recent days. This issue merits analysis. But we should be cautious about drawing conclusions too quickly. Let me make two counter-arguments on this.

On fiscal multipliers and the quantifiable and confidence effects

First, we have to make a distinction between the directly quantifiable fiscal effect and the confidence effect. Fiscal multipliers may be larger on average in this crisis than in normal times, since households are more financially constrained and the room for monetary maneuver is limited.

But this does not mean that no consolidation should be undertaken. Can we attribute worse-than-expected economic situations in some countries just to the effects of fiscal consolidation? We should ask whether worse-than-expected recessions in certain countries can be attributed only, or even mainly, to the effects of fiscal consolidation. Other factors have played a role in each slowdown. In some countries, it has been due to a fall in consumer and investor confidence. In other countries, it has been due to a complete loss of market access of a country. In these cases, the multipliers should not be measured against a business-as-usual scenario, but one in which drastic market reaction would not allow a managed unwinding of the unsustainable policies of the past.

Second, the EU's reformed Stability and Growth pact is not stupid. A casual reader of much recent commentary could be forgiven for believing that EU governments are blindly enacting harsh policies of austerity, under the watchful eye of a European Commission obsessed with enforcing arbitrarily chosen nominal deficit targets. It is time to debunk this damaging myth. In fact, the Stability and Growth Pact can adapt a country's path of fiscal adjustment, if the economic situation calls for it.

Alongside the nominal targets for deficit reduction, each new recommendation issued to a Member State specifies the structural fiscal effort to be achieved each year until the excessive deficit is corrected. While the nominal targets may continue to dominate the headlines, the Commission focuses its assessments of Member States' actions first and foremost on their compliance with the agreed structural effort.

This takes into account the fiscal space and macro-economic conditions of a Member State.  Accordingly, a Member State may receive extra time to correct its excessive deficit. This has occurred twice this year already: in July for Spain, and in October for Portugal. Both now have until 2014 to bring their government deficits back below 3 per cent of GDP.

Of course, there are those who argue that pursuing fiscal consolidation in times of weak or negative growth is counterproductive and that, instead, what is needed is fiscal stimulus. But investors and consumers do not need to be convinced that a country can boost growth by a few decimal points in a given year through higher spending. They need to be reassured that the country's public finances will be sound in the long-term, which means pursuing prudent fiscal policies, ensuring the sustainability of welfare states, and enacting structural reforms that can deliver a lasting improvement in growth and employment.

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