12 October 2012

VP Rehn: The foundations for growth in Europe

A casual reader of much recent commentary could be forgiven for believing that European governments are blindly enacting harsh policies of austerity, under the watchful eye of a European Commission obsessed with the enforcement of arbitrarily chosen nominal deficit targets. It is time to debunk this damaging myth.

The European Union's Stability and Growth Pact can adapt a country's agreed fiscal adjustment path if called for by the economic situation.

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, it is first and foremost on compliance with the agreed structural effort that the Commission focuses when assessing whether effective action has been taken.

This is consistent with another little-known, yet key element of the Pact: the medium-term objective of a balanced budget in structural terms. The appropriate pace of progress towards this medium-term objective is agreed taking into account the specific economic circumstances of each EU 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. Yet what if these are countries that have lost market access, or are struggling to contain rising spreads, precisely because of fears for the sustainability of their debt? What impact would an abandonment or reversal of fiscal consolidation policies have on their efforts to restore the confidence of investors? Countries in these positions should be deeply wary of such illusory temptations. Markets 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 that 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.

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.

Fiscal multipliers may indeed be larger on average in this crisis than in normal times, since households are more financially constrained and the room for monetary manoeuvre is limited. That is not to say they are larger in every case. And 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 cases, it has been rather due to a complete loss of market access of a country, or a drop in consumer and investor confidence. The countries whose growth was revised most sharply down at a time when they were tightening fiscal policy were also those experiencing large rises in spreads and suffering the effects of the breakdown in monetary policy transmission in the euro area – a problem the European Central Bank has recognised and which its announcement of Outright Monetary Transactions aims to address.

Moreover, when it comes to the case of countries that have lost or are at risk of losing market access, the multipliers should not be measured against an implicit business-as-usual scenario, but one in which the unsustainable policies revealed by the crisis were allowed to continue. It is not too difficult to imagine that capital outflows and higher risk premia would quickly negate the putative benefits of a fiscal relaxation in such circumstances. Somewhat paradoxically then, if measured against the appropriate baseline, the multiplier may turn out to be not only smaller but even negative.

Fiscal consolidation, at a pace appropriate for each country, must remain a core element of economic policy in Europe. It should be borne in mind that the sovereign debt ratio has increased in the European Union from 60 to 90 per cent of GDP in only four years. However, deficits in the euro area have fallen from an average of over 6 per cent in 2010 to just over 3 per cent this year. As a consequence of fiscal consolidation efforts, public debt is expected to peak next year, and then to start to decline as a proportion of GDP.

Now is not the time to turn away from the policies that have led to this improvement and are contributing to a gradual return of confidence in the euro area.

To accelerate that return, we know what we have to do. In step with this differentiated but determined fiscal consolidation, governments must maintain the momentum of structural reforms that have, over the past two years, begun to clear the backlog of long-standing obstacles to growth and employment in some of Europe’s most vulnerable countries. Where necessary, market stabilisation tools of the euro area can give countries under intense market pressure the time to pursue these reforms.

Full statement

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