The worsening of the economic situation in the euro area raises serious questions about the capacity of policymakers to get the situation under control. Member States have limited room of manoeuvre to implement a counter-cyclical budgetary policy under the Stability and Growth Pact (SGP). The European Central Bank (ECB) is confronted the zero bound interest rate and the political challenge of engaging into an ambitious program of quantitative easing. Structural policies to liberalize the good, services and labor markets are unlikely to accelerate economic growth in the short term.
A limited fiscal capacity for the euro area
The challenge would be less severe if the euro area had a fiscal capacity to adjust to economic shocks. However, there is very limited appetite among member states to create a European fiscal union. In the name of realism, a growing number of economists are trying to develop mild forms of common fiscal policy mechanism that could improve the functioning of the euro area (see in particular Wolff 2012 and IMF 2013). One example of such mechanism is described in Delbecque (2013). Under this proposal, the net contributions to a euro area stabilization fund (ESF) would be based on the country’s position in the economic cycle and the relative size of the economy. Euro-area countries would benefit from a disbursement from the ESF during economic downturns, and they would make a contribution to the ESF when they are in a strong cyclical position. Thanks to payments received from the ESF, a country could take fewer austerity measures in the face of a negative economic shock.
Depending on the overall economic situation, the ESF would accumulate reserves if the contributions received from high-growth countries exceed the payments made to low-growth countries. And it would borrow from financial markets during hard economic hard times if the reserves accumulated during times of economic boom are not sufficient to transfer resources to member countries. At the institutional level, the ESF could be managed by the European Stability Mechanism (ESM).
An empirical illustration
Chart 1 illustrates how the ESF would work using the following equation to calculate each member country’s annual net contributions to the ESF: d = α (y – y*), where d is the net contribution expressed as a percentage of GDP, α = 0.5, (y – y*) is the output gap, i.e. the difference between the output of an economy (y) and its potential output (y*). The output gap data used are from the International Monetary Fund (IMF) World Economic Outlook October 2014 database.
We can see how the total net contributions would have varied with the ups and downs of the euro area economy. Overall, all other things equal, the EFS would have accumulated a total debt of EUR 283 billion or 2.8% of the euro area GDP. It should be recognized, however, that this amount corresponds exactly to the ESF disbursements in 2014-2015. This finding highlights the severity of the current economic downturn, and the need to take action.
The calculated net ESF disbursements for 2015 are shown, by country, in the table below. It can be seen that all countries would benefit from ESF support. Greecewould be the biggest receiver of funds (3.4% of GDP in 2015, or EUR 6.4 billion), whereasGermany,LuxembourgandMaltawould receive the smallest relative amount (less than 0.5% of GDP).
At first glance, the disbursements in favor ofGreeceseem high. However, they have to be compared with the overall evolution of the net contributions ofGreecesince 1999. Overall, all things being equal,Greecewould have been a net contributor to the EFS, for a total amount of EUR 5.4 billion (2.9% of GDP). In contrast,Germanywould have benefited from an overall net contribution of EUR 52 billion (1.8% of GDP). These different outcomes mostly reflect the different average output gaps in 1999-2008, i.e. 0.2% forGermanycompared to 2.3% forGreece. It should be noted, however, that the existence of the ESF would have allowed smoothing both positive and negative shocks, and therefore reduce the size of the net contributions to the ESF.
It is also interesting to note the modest size of the ESF disbursements to Germany. This result indicates that the room for manoeuvre to support the euro area’s economy is relatively small when measured against its current output gap. This finding is at odds with the numerous calls for Germanyto increase government spending. These calls refer to the low budgetary deficit ofGermany, which makes it possible to relax its budgetary policy in a significant way without breaching the 3% deficit rule of the SGP. From an output gap perspective, however, Germany has a more limited space to act.
It should also be noted that the euro area countries with a rather high negative output gap tend to have no room of manoeuvre because of their budgetary deficits and the rules of the SGP. Indeed, ten of the eleven euro-area countries with a negative output gap greater than 2% are expected to have a budget deficit greater than 2.5% of GDP in 2014; Finland is the only exception, with a budget deficit very close to 2.5% (see Chart 2). These countries represent 64% of the GDP of the euro area. Clearly, if they continue to take austerity measures in 2015, and if the other countries are doing the same thing because their deficit is too close to 3% of GDP (this is the case for Austria, Belgium and Malta) or if they give preference to maintaining a deficit close to zero as is the case for Germany, it is not surprising that real GDP growth in the euro area will be barely above 1% in 2015, in the best case scenario.
The case for action
The creation of a mechanism similar to the ESF would create the conditions for stronger growth in Europe. Beyond this general observation, the ESF would have the following advantages:
- It would allow keeping the rules of the SGP. The principle of budgetary discipline would remain as a corner stone of the euro area. The member countries which have included the principle of balanced budget in their constitutions could continue to target this objective. The support given by the ESF in adverse economic conditions such as the ones we are experiencing at present would help these countries to achieve their objectives more easily.
- The ESF would give the means to euro area countries to coordinate a coordinated fiscal response to the current economic downturn. This could be implemented without triggering negative movements in the financial markets against some high-debt countries because the ESF disbursement would be funded by ESM borrowing under very favorable financing conditions.
- The entry into force of the ESF would not be a free lunch for member countries. They would receive support during difficult economic times in exchange for paying an “insurance premium” when their output gap becomes positive. They would therefore enter into a contractual agreement with other member countries and the ESF, based on shared responsibility and mutual accountability. This framework would ensure that the overall potential increase in the euro area common debt would be capped at a very low level.
- In the absence of a mechanism like the ESF, the euro area will have to rely almost entirely on the European Central Bank (ECB) to return to growth. However, the zero-interest bound and the ban on monetary financing of budget deficits reduce very much the scope for further action by the ECB. The ESF would therefore contribute to reduce the pressure on the ECB.
- The creation of the ESF would also strengthen the credibility of the commitment made by the new President of the European Commission, Jean-Claude Juncker, to implement a EUR 300 billion investment package to boost growth and employment. Indeed, it could be agreed that the ESF disbursements should be used for the financing of long-term investments. According to recent IMF research, during periods of low growth, a 1 percent of GDP permanent increase in public investment in advanced economies increases output by about 1.5 percent in the same year and by 3 percent in the medium term (see IMF 2014). Public investment increases also bring about a reduction in the public-debt-to-GDP ratio during periods of low growth in countries with high public investment efficiency. Under the proposed mechanism, the reduction in the debt ratios would be all the more significant as the investments would be financed by ESF disbursements.
Unconventional fiscal stimulus against deflation
When the economy is stuck in a liquidity trap, there may be an argument for relying on fiscal policy intervention to avoid any serious threat of deflation. Werning (2012) confirms that there is a role for government spending during a liquidity trap.
Following this approach, it could be considered to increase the level of ESF transfers to the countries where the inflation rate would smaller than a certain level. For instance, it could be considered that the transfers could be increased by an amount equal to 0.5 (1.5% – π) when the inflation rate π is less than 1.5%. The chart below compares the total net contributions to the ESF that would result from this approach with those presented in Chart 1. In 2015, the ESF would disburse EUR 151 billion (1.5% of GDP) rather than EUR 122 billion (1.2% of GDP), if the disbursements were linked to both the output gap and the inflation gap.
The euro area economy can be compared to a car that has come to a standstill. Its tank is full of gas. The problem is with the brakes which prevent the car from moving off. In other words, it is not the fault of monetary policy that the economy is in contraction mode at this juncture. To paraphrase President Clinton, one could say “It’s the fiscal policy, stupid”! There is today a real risk that some passengers will decide to leave the car. The expected general election in Greece in February could be a trigger. Rather than waiting to see whether the ECB be able to do whatever it takes to save Greece and the euro, it would be wise to explore available alternatives to revive growth in the euro area, including through the establishment of a limited fiscal capacity such as the ESF.
Delbecque, B. (2013), “Proposal for a Stabilisation Fund for the EMU”, CEPS Working Document, N°385, October 2013.
IMF (2014), “Is it time for an Infrastructure Push? The Macroeconomic Effect of Public Investment”, Chapter 3, IMF World Economic Outlook, October 2014.
IMF (2013), “Toward a Fiscal Union for the Euro”, IMF Staff Discussion Note 13/09, September 2013.
Werning, I. (2012), “Managing a Liquidity Trap: Monetary and Fiscal Policy”, MIT, March 2012.
Wolff, G. (2012), “A Budget for Europe’s Monetary Union”, Bruegel Policy contribution, Issue 2012/22, Bruegel, Brussels, December.
 In principle, it could be proposed to implement a symmetric mechanism to collect payments from high inflation countries. However, this would require taking into account the fact that the equilibrium inflation rates in less advanced euro area countries tend to be somewhat higher than 2%. Moreover, it should remain the task of the central bank to preserve inflation stability when inflation is above target.