European fiscal complacency

Yesterday, Martin Sandbu was banging the drum for more fiscal policy action in Europe: “[The] US stimulus package leaves Europe standing in the dust […] This will hasten Europe’s and the UK’s relative economic decline, especially compared with China.“ Adam Tooze has also been arguing for a bigger fiscal and monetary effort in Europe to counteract the COVID-19 crisis. Another recent piece in the Financial Times argues that faster vaccination and the larger size of fiscal support packages in the US explains the divergent recovery path in comparison with Europe.

The most recent OECD forecast suggests that China’s economy will power ahead; real GDP in 2022 is forecast to stand more than 15% above the pre-COVID-19 level. The US economy will also recover relatively fast from the COVID-19 shock, with GDP in 2022 about 7% above the 2019 level. The recovery is, however, forecast to be much weaker in the Eurozone, where GDP in 2022 will barely surpass the pre-crisis level. Even more worrying is that we’ll see divergence between Eurozone countries, as Germany is set to do significantly better than Italy and Spain.

Source: OECD March Interim Report.

Differences in the discretionary fiscal response to the crisis play an essential role in explaining this divergence in recovery patterns between the US and European countries. IMF data from the IMF fiscal monitor (last update in January 2021) suggest that additional government spending and foregone revenues in response to COVID-19 amounted to about 16.7% of GDP in the US. And these numbers do not yet include the massive $1.9 trillion Biden fiscal support package, which has been approved last week. The IMF data show a discretionary fiscal impulse of 11% of GDP for Germany. Especially if we take into account that the recession in Southern Europe has been more severe than in Germany, the fiscal impulse of 6.8% in Italy and 4.1% in Spain can only be considered to be very small in international comparison.

Source: IMF Fiscal Monitor January 2021 update.

I fully share the Sandbu/Tooze argument that fiscal policy support in Europe - especially in hard-hit Eurozone countries such as Italy and Spain - has been too timid. Yes, the EU will borrow up to €750 billion for “Next Generation EU” to finance spending in EU countries (where €390 billion are in grants, which could start flowing in the second half of the year). This will provide a positive macroeconomic impulse. But it’s still to small to really turn things around and avoid a European economic decline vis-a-vis other major economic blocs.

Italy will receive grants of about 3.7% of GDP from the Recovery and Resilience Facility (RRF, the key component of “Next Generation EU”) over the period 2021-2026; Spain will get 4.8% of GDP. These numbers indicate that annual spending based on the grants will be less than 1% of GDP for large and hard-hit Eurozone countries such as Italy and Spain. We also need to take into account that partly the EU funds from “Next Generation EU” will substitute for spending that might otherwise have been financed by national government borrowing. Furthermore, it is still not clear whether every country will be able to draw on all the available funds, because the payments are attached to conditionality - countries need to submit national recovery plans until April 31st 2021 to justify how they want to use the money, where 37% need to be spent on climate and 20% on the digitalisation agenda.

Source: European Commission.

“Next Generation EU” was certainly a major political step; it would have been unthinkable before the crisis. But it remains a temporary instrument, and while its macroeconomic impact is certainly not negligible, it is way too small to support a strong recovery in all countries and to halt Europe’s relative economic decline vis-a-vis China and the US. Europe would need a second big fiscal push in terms of a large investment project that also raises potential growth and tackles climate change concerns.

In the absence of another major European effort in addition to “Next Generation EU”, national fiscal policy will need to do most of the work in supporting economic recovery. In this regard, the Damocles sword of reapplying the EU’s fiscal rules is hanging over all governments; but the problem of going back to the fiscal rules would be most acute for those countries with higher public-debt-to-GDP ratios (such as Italy and Spain), which would need to implement harsh fiscal consolidation measures that would undermine economic recovery, which is likely to also pose problems for debt sustainability.

A communication published by the European Commission implies that the suspension of the EU's fiscal rules will be extended for 2022, but the rules may be reintroduced in 2023 if GDP recovers to pre-2019 levels. Europe must urgently avoid repeating the mistakes after the financial crisis, when fiscal austerity from 2010 onwards led to a double-dip recession that made the Eurozone economy fall well behind the US. This underperformance was mostly a fiscal story, i.e. it was a policy choice. Currently, Europe is on track to repeating choices that will lead to underperformance. If policy-makers still want to avoid it, they should think about a second big fiscal push, and they must urgently come up with a meaningful reform of the EU’s fiscal rules to avoid counterproductive fiscal austerity in the years after the COVID-19 crisis at the national level. But that’s a matter for another post.

Source: AMECO (Autumn 2020); own calculations).