The ongoing discussion around the effectiveness of the ECB’s monetary stimulus highlighted fiscal policy as an important driver for economic growth. By setting targets for government revenues and spending, each country directly influences its economic expansion and creditworthiness. In an environment of slowing economic growth, appropriate fiscal governance can be crucial in avoiding a European recession.
Within the eurozone, budget plans are determined by the local governments, while monetary policy is set by the European Central Bank (ECB). The ECB is concerned about the prevailing risks from the US-China trade war, Brexit and global economic slowdown and has already introduced an extensive easing package to help the European economy. However, many members of the ECB's Governing Council have admitted that the current loose monetary policy has adverse secondary effects. Investors started to question whether the ECB tools are effective and what the side effects are. To address the potential negative impact and to strengthen the support which is already provided to the economy, the monetary supervisor became vocal in calling for action from fiscal policymakers.
In her first speech as the new ECB president, Christine Lagarde appealed to the countries with a strong budget surplus to intensify fiscal spending. Specifically, she mentioned the Netherlands and Germany, countries with a budget surplus of 1.5% and 1.9%, respectively. There is a limited amount of countries in the European Union that have a structural budget surplus. In the Eurozone, only small economies like Malta and Luxemburg have a higher surplus than Germany and the Netherlands. According to the Maastricht Treaty, a government deficit is considered excessive when a budget deficit is above 3% and debt as a percentage of GDP is above 60% (with some exemptions). In 2018, the only country in the eurozone which breached both limits was Cyprus, with a deficit of 4.4% and debt at 100.6% of GDP, while at least half of the euro area countries do not comply with the 60% debt rule.
Figure 1: The bars represent the government deficit/surplus within the euro area as % of GDP for 2018. Source: Eurostat.
Despite the lack of central fiscal legislation, all members of the eurozone have to draft their budget plans in accordance with the guidelines of the EU Fiscal Stability Treaty which are supervised by the European Commission (EC). Currently, the discussion of the 2020 budget plans is taking place. Countries have submitted their proposals which were approved at local level, and now the EC reviews whether these budgets are in compliance with European economic governance rules. News headlines were made by the draft plans from Germany and Italy due, however, to completely different reasons.
In the case of Germany, the budget plan so far does not provide for extra stimulus which could boost economic growth. For many years, Germany has been targeting a balanced budget which entails hard restrictions on the allowed deficit. As it is the largest economy in Europe by GDP and population, the stalling German economy will impact other European countries. The German government indicated that it has capacity for fiscal expansion but is determined to use it only in case of a severe downturn. As for Italy, investors monitor its budget plans with caution because the country is dealing with high sovereign debt levels and low economic growth and important structural reforms are not taking place. In the initial budget proposal from Italy, the target for budget balance is at 2.2% of GDP (unchanged from 2019) and the government expenditures would grow by 1.9% while the EC recommended to reduce it by at least 0.1%. The current debt-to-GDP ratio is already above 130% so there is a mounting pressure on Italy to show improvements in macroeconomic indicators and to narrow the budget deficit. However, the government still intends to make use of their fiscal space even if they have to worsen the budget deficit because the economy is vulnerable and might fall into recession if not supported.
Figure 2: Government debt as % of GDP for eurozone countries in 2018 and the respective credit rating by Fitch as of November 2019. Orange dashed line represents the 60% limit on government debt as % of GDP stated in the Maastricht Treaty. Source: Eurostat, Bloomberg
The existing fragmentation in Europe makes it difficult to align fiscal policies among different member states. Countries that would like to boost government investments have no room for fiscal easing, while countries with a budget surplus are not willing to increase spending. Currently, European fiscal legislations imply only penalties for having a too high budget deficit but have no requirements to spend an excessive surplus. Additional fiscal unification within the eurozone may be needed for fiscal space between the countries to converge. For example, setting a target for a budget deficit within specific upper and lower boundaries would impose symmetrical measures to limit the buildup of an excessive budget surplus. This would allow the euro area to benefit from the additional spending by "budget rich" countries while still restricting the amount of outstanding debt.
Despite the constraints from the budgetary rules and lack of political will to take proactive fiscal steps, there are some important trends that can encourage fiscal expansion within the euro area:
- Low interest rates. The record low deposit rate of -0.5% accompanied with the generous asset purchasing program by the ECB give governments the opportunity to borrow at historically low rates.
- Green initiatives. Climate change is a high priority for the European Union and consequently green projects have strong support and need for financing. By increasing expenses in this area, the government could contend with both climate change and slow economic growth. For instance, in Germany, subsidies for electric car producers can play a crucial role in transforming a stagnant auto industry into a more environment-friendly sector with a positive growth outlook.
According to the draft budget plans 2020 which were submitted to the EC, most countries aim at only moderate fiscal expansion so there will be no substantial increase in government spending in the eurozone compared to 2019. Countries with a budget surplus are not keen on increasing their debt burden, while some periphery countries are not allowed to grow their debt-to-GDP ratios further. This creates an additional challenge for the euro area economy which is facing downside external risks and slowing internal growth.