Supporting public investments that increase economic growth
Reducing unemployment, strengthening the euro area’s growth prospects and ensuring the future resilience of the European economy require better tailored fiscal tools at euro area level. Today, the limits of the EU’s fiscal framework mean that the euro area has had to rely excessively on the monetary policy of the European Central Bank (ECB) to ensure macroeconomic stability. As these monetary policy tools are increasingly stretched, calls for a more balanced policy mix that includes more supportive fiscal policies have been voiced by the EU – including by Commission President Jean-Claude Juncker in his 2016 State of the Union ‘Letter of Intent’1 and by ECB President Mario Draghi – as well as by a very broad set of stakeholders, from international organisations to academics. Against this backdrop, the Commission presented on 16 November a ‘Towards a Positive Fiscal Stance for the Euro Area’, confirming its intention to promote a more supportive fiscal policy in the euro area. Given the challenges that lie ahead and the current economic juncture, there is a strong case for increasing public investments in areas that increase the resilience of the European economy. In short, there is both a need and a unique window of opportunity for the EU to take action on the fiscal front at this precise point in time. This increased fiscal responsibility must be implemented in combination with supportive structural reforms and investments, making sure the elements of the ‘virtuous triangle’ are mutually reinforcing.
Economic Context Calls for Fiscal Expansion
In certain circumstances, such as in prolonged periods of sub-par growth and monetary policy at the ‘zero lower bound’, there are good reasons to expand discretionary fiscal policy in order to support aggregate demand. The euro area currently meets these criteria, despite recent improvements in the economic outlook.
Low Interest Rates Favour Fiscal Expansion
Some Member States have the fiscal space to engage in an expansionary fiscal policy but they do not use it due to limitations in the Stability and Growth Pact. Yet, there is a strong case for taking advantage of today’s very low funding costs to invest in the economy. The largest beneficiary of any fiscal expansion will be the Member State that undertakes it.
Monetary Policy Needs Support
A positive fiscal stance is needed to support the accommodating monetary policy of the ECB, which currently bears the largest burden in terms of stabilising the euro area. The ECB has repeatedly warned of the increasing constraints it faces on the use of monetary tools, calling for a euro area fiscal counterpart to its monetary policy efforts.
Positive Fiscal Stance Reinforces Virtuous Triangle
In combination with reforms and public investments supported by EU-level financial instruments, a positive fiscal stance will support the modernisation of the economy, as additional investments are channelled into strategic areas, opening up new markets and further developing existing ones.
What is the ‘fiscal stance’ and what role does it play in the euro area?
The concept of ‘fiscal stance’ describes the discretionary fiscal policies in a budget
The fiscal stance is considered to be contractionary, expansionary or neutral depending on whether the government decides to decrease (contractionary), increase (expansionary) or leave discretionary expenditures unchanged (neutral). Discretionary fiscal policies exclude components of a budget that are linked to the overall business cycle – so-called ‘automatic stabilisers’, such as unemployment insurance or social security that automatically start rising/falling as the economy slows/grows – as well as the interest paid on public debt. The fiscal stance is therefore normally captured by changes in the cyclically-adjusted primary balance.
In the present architecture, a proper euro area or EU fiscal stance does not actually exist, given the absence of any real euro area or EU-level fiscal instrument to manage the overall fiscal stance of the Member States. The concept of a euro area or EU fiscal stance refers only to the simple arithmetic aggregation of individual Member States’ fiscal stances.
Furthermore, the existing euro area fiscal supervisory framework – the Stability and Growth Pact – is not really conducive to Member States engaging in discretionary fiscal actions and hence cannot deliver on a fiscal stance at EU or euro area level . This is because it is primarily designed to prevent excessive levels of debt, encourage fiscal consolidation and a budget that is close-to-balance or in surplus over the medium term.
The Stability and Growth Pact and the European Semester can only oblige Member States to undertake a fiscal adjustment if they are facing excessive deficits. There are no mechanisms to force countries that have the possibility to pursue a positive fiscal stance to actually do so, even where there is a good case, from a domestic perspective, to encourage a more expansionary fiscal policy, e.g. in countries with an unnecessarily tight – and in some cases counterproductive – budgetary policy. This constraint is also shared by the soon-to-be operational euro area European Fiscal Board.
The Stability and Growth Pact and the European Semester can only potentially and indirectly guide Member States to take euro area-wide considerations into account, for instance, via surveillance measures and country-specific recommendations. However, up till now, there has historically been limited success in prodding Member States into action in this field.
As a result, those Member States that lack any fiscal space – because their debt levels are such that their debt sustainability would be seriously questioned if they were to engage in an expansive fiscal policy – are recommended to pursue fiscal consolidation, while those Member States that do have fiscal space prefer not to use it and to ensure the medium-term sustainability of their public finances.
The only EU fiscal instrument available is the EU budget, which acts as a structural convergence tool for all EU 28 Member States and lacks any real cyclical component. However, the upcoming review of the EU budget presents itself as an opportunity to improve the counter-cyclical capacity of the budget.
Against this backdrop, the burden of ensuring the macroeconomic stabilisation of the euro area and providing economic stimulus to lift it out of the crisis has been largely left to the monetary policy of the ECB. In particular, the ECB has made wide use of its full range of instruments, from lowering interest rates and undertaking long-term refinancing operations, to the signalling effect of outright monetary transactions and asset-purchasing programmes. However, as stressed by ECB President Mario Draghi: “>Monetary policy does not exist in a vacuum. […] Other policies matter a great deal. They can buttress or dilute the effects of our policy’. In conclusion, alongside structural reforms, fiscal policy matters for the effectiveness of monetary policy. The aggregate fiscal policy of the euro area needs to work together with the ECB monetary policy.
This is all the more important when traditional and unconventional monetary policy tools have been used extensively and given that some of the factors that have helped the current modest upswing in the euro area are expected to weaken, such as the initial boost from a depreciated euro, the low oil prices and the fiscal expansion associated with the influx of refugees in 2016. It will be crucial to boost domestic sources of growth also with respect to a dramatic increase in external political uncertainty, in light of internal and global developments.
The need to forge synergies among fiscal, monetary and structural policies was also highlighted in the G20 Leaders’ Communique at the Hangzhou Summit: ‘Underscoring the essential role of structural reforms, we emphasise that our fiscal strategies are equally important to supporting our common growth
Recent trends in EU, euro area and Member States’ fiscal stance
After being contractionary during the sovereign crisis (as shown by the values above the ‘x’ horizontal axis in Figure 1), the fiscal stance has been broadly neutral in the EU and in the euro area in 2014 and 2015 (as shown by the values below the ‘x’ horizontal axis, which would refer, for instance, to reducing an existing fiscal surplus by injecting more money into
This picture is nonetheless heterogeneous among euro area Member States (Figure 1). For instance, crisis-hit Spain was forced to undergo a very contractionary fiscal stance between 2010 and 2014. On the other hand, the largest euro area economy, Germany, pursued a negative fiscal stance until 2015 in spite of significant fiscal space and much more robust economic performance. Somewhat ironically, it was Spain that shifted towards a more supportive fiscal stance in 2015 and 2016, despite facing much higher medium-term fiscal consolidation needs than Germany. Looking ahead, neither of these two countries are forecast to put in place strongly supportive stances between 2016 and 2018 – both maintaining neutral to barely positive fiscal stances.6
As regards the euro area overall – or rather the arithmetic aggregation of the individual fiscal stances of the euro Member States – the fiscal stance in 2016 is also expected to be mildly positive and counter-cyclical (i.e. a fiscal action net of the economic cycle, but moving in the opposite direction of this economic cycle).Forecasts based on the first draft budgets for 2017, as submitted by the Member States, suggest that the euro area 2017 fiscal stance will again be broadly neutral.7
The euro area would benefit from a positive fiscal stance
In its Communication of 16 November 2016, the Commission is calling for a positive fiscal stance for the euro area, in support of the economic recovery and of the monetary policy of the ECB.
From a macroeconomic stabilisation perspective, discretionary expenditure increases are, in most cases, not necessary as a response to a recession because the automatic stabilisers that come into play during an economic slowdown usually cushion the blow. Therefore, these stabilisers should always be encouraged to work fully, to the extent that they do not endanger debt sustainability. In fact, the Stability and Growth Pact, encourages a budget that is close-to-balance or in surplus over the medium term precisely to allow enough fiscal space to let automatic stabilisers function fully during a downturn, with the expectation that the resulting increase in government debt should then be reduced as the economy recovers. The result is a stabilising counter-cyclical fiscal policy.
However, a growing body of literature finds that there are good reasons to expand fiscal policy beyond the automatic stabilisers to support aggregate demand in a country if: a) interest rates are constrained at the ‘zero lower bond’, b) there is sub-par growth, creating a large output gap, and c) households are constrained by debt overhang. As it turns out, all those conditions are today observed in the euro area (Table 1). Indeed, there is still a large (albeit decreasing) output gap, interest rates have been below the zero lower bound since 2015 (and were close to zero between 2012 and 2014) and households are still in need of deleveraging after debt build-up.
These circumstances produce fiscal multipliers, i.e. direct and induced effects effects on GDP growth generated by the fiscal expenditure, that are much larger and faster than under ‘normal’ conditions (Box 1).9 The result is that an expansionary fiscal policy does not crowd out private investments but actually stimulates them, resulting in further (‘second round’) GDP growth after the initial stimulus. This enables the economy to recover, private balance sheets to be repaired and inflation expectations to rise to normal levels.
Jason Furman, who chairs US President Barack Obama’s Council of Economic Advisers, shares this assessment, stating that: ‘fiscal policy is often beneficial for effective counter-cyclical policy as a complement to monetary policy’ and that ‘discretionary fiscal stimulus can be very effective and in some circumstances can even crowd in private investment’.10
A positive fiscal stance works with – not against – monetary policy in its efforts to stabilise the economy and the financial system following the economic crisis, and to accelerate the moderate growth currently observed in the euro area.
By stimulating growth, a fiscal expansion at the current juncture would also help to counteract any ‘hysteresis effect’ that may have started to set in. This effect describes a permanent loss of growth potential that can accompany an economy’s ongoing weak performance following a crisis, degrading its production capacity and productivity. An example of this is when a workforce starts losing skills due to high and prolonged unemployment and long periods of under-investment. As pointed out by the International Monetary Fund’s (IMF) chief Christine Lagarde: ‘The longer demand weakness lasts, the more it threatens to harm long-term growth as firms reduce production capacity and unemployed workers are leaving the labour force and critical skills are eroding. Weak demand also depresses trade, which adds to disappointing productivity growth.’
An expansionary fiscal stance could help overturn such an effect, although this is not materialising today as the burden of macroeconomic stabilisation is primarily placed on monetary policy, without a matching fiscal policy.
The fact that the stock of euro area public debt is still historically high – albeit slowly decreasing – would normally imply constraints to the dimension of any positive fiscal stance, but, in fact, the very low yields on government debt arising from supportive ECB monetary policy actions limit immediate concerns about debt sustainability.
All the above evidence leads to the conclusion that the euro area would benefit from a period of increased discretionary fiscal spending. This would also enable fiscal policy to act as an effective counterpart to the ECB’s supportive monetary policies.
The need for a more accommodating fiscal stance at euro area level has also been highlighted by the IMF in its last ‘Article IV’ consultation, where its Executive Board encourages ‘the authorities to pursue a more balanced policy mix through growth friendly fiscal rebalancing, use of fiscal space where available, and an expansion of centralised investment schemes or funds for common projects.’12 The Organisation for Economic Cooperation and Development (OECD) also comes to this conclusion, saying that ‘countries with fiscal space should use fiscal stimulus to support aggregate demand’.13
Beyond international organisations and respected academics, the view that the EU needs a new take on fiscal policy is also widely shared by the business and financial community. A representative of a leading global investment banking firm concludes: ‘We remain anchored in the past, and we continue to apply today the same pre-crisis rules and heuristics about fiscal policy, ignoring the fact that we no longer live in that world. […] This call for a more active fiscal policy is not a call for fiscal irresponsibility. […] Once growth and inflation pick up in a sustainable manner, it will be the time for fiscal consolidation. But, for now, with interest rates expected to be very low for a very long period of time, fiscal policy will have to be the main economic policy to support growth in the foreseeable future.’14
How to deliver on a positive euro area fiscal stance
In the absence of a dedicated euro area instrument for fiscal stabilisation, a short-term solution could be composed of two pillars. Firstly, it should encourage expansionary fiscal policy of individual Member States. This would imply that euro area countries with sufficient fiscal space to increase fiscal expenditures in a sustained manner over the medium term would need to do so. This is essentially a matter of collective responsibility and discussion in the Eurogroup.
But promoting a more supportive fiscal stance is also about the quality of the expenditure that goes with it. Therefore, discretionary public spending should be closely aligned with the EU’s strategic objectives in areas of digitalisation, energy transition or mobility. Where possible, public investments should be supported by modern financial tools that enable the leveraging of private spending, e.g. through blending spending vehicles. An example of such an integrated approach is the European Fund for Strategic Investments (EFSI), which has proven to be an effective tool for supporting investments towards the EU’s strategic objectives. The EFSI is also flexible enough to be combined with existing EU and national financial instruments, and open to contributions from those Member States that have sufficient fiscal space in the medium term.
The starting point is therefore to look at those countries that do have sufficient fiscal space in the medium term. Table 2 shows the availability of fiscal space for the euro area Member States (except for Cyprus and Greece).15 Similarly to Figure 1, a negative value indicates available fiscal space. Fiscal space can be defined by the possibility to expand (expansionary fiscal stance) without endangering fiscal sustainability. In this paper, sustainability is defined more precisely by the capacity for public debt to attain the 60% of GDP reference value in the medium run.
While no euro area member faces short-term fiscal pressures (chiefly thanks to ECB supportive policies), seven actually also have medium-term fiscal margin of manoeuvre (indicated in % of GDP), namely: Estonia (4.2% of GDP), Germany (0.8% of GDP), Latvia (1.9% of GDP), Luxembourg (4.8% of GDP), Malta (0.6% of GDP), Slovakia (0.6% of GDP) and the Netherlands (0.9% of GDP). On the other hand, medium-term fiscal adjustment needs – which can be seen as a negative fiscal space – are close to 4% of GDP in large economies like France and Italy, even when the considerable level of flexibility allowed by the Stability and Growth Pact, already used by those countries, is taken into consideration.19
The seven above-mentioned countries with available fiscal space represent more than 37% of the combined euro area GDP, with Germany alone standing for almost 29%. Their combined available fiscal space for a stimulus would amount to 0.32% of the euro area GDP (although this is on the conservative lower bound of the estimates of the Commission Communication, which go from 0.3% to 0.8% of GDP, with a recommended 2017 fiscal stimulus of 0.5% of GDP). Germany would be responsible for the lion share of this fiscal impulse (namely 0.22% of the euro area GDP). Pursuing this available fiscal space would help growth in the euro area and recalibrate the emphasis currently placed on monetary policy, while not being a silver bullet on its own.
As for those Member States with no fiscal space, they can and should use interest savings from the accommodating monetary policy to reduce their debt stock, build up buffers and restructure their expenditure and their taxation revenues in more effective ways.
Indeed, efforts should not be limited to the expenditure side of national budgets. Taxation can change economic decisions and thereby affect economic growth. A well-managed taxation system takes account of the mobility of the tax base and provides the right incentives for economic activity to expand. For instance, research suggests that increasing the right taxes – consumption taxes, for instance – might actually increase long-term GDP, provided that the increased room for fiscal policy is used to cut labour taxation later on.
More broadly speaking, some of the key priorities for Member States as identified by the IMF in a recent publication are that ‘countries should undertake growth-friendly fiscal rebalancing, boosting public investment and reducing high marginal tax rates on labour and capital, accompanied by cuts to unproductive spending and steps to broaden the tax base’.22 Of course, the starting points of Member States differ widely and their individual situations need to be taken into account when designing a growth-friendly expenditure and taxation mix.
Towards a win-win fiscal stance
As stated earlier, any discretionary spending should be closely aligned with the EU’s strategic objectives and, where possible, oriented towards investments that can generate positive spill-over effects in other Member States in terms of enhanced growth and job creation, as well as new cross-border business opportunities. This is a fundamental criterion when considering any fiscal stimulus with euro area-wide effects.
Recent studies confirm both the positive effect of public investments on the domestic economy and the existence of cross-border spill-over effects. In’t Veld23 finds that a 1% GDP increase in public investment, simultaneously in Germany and the Netherlands, would, already in that same year, raise GDP by 0.85% in Germany and 0.7% in the Netherlands, and by 1.3% over 10 years, while GDP in France, Italy, Spain and the rest of the euro area would be around 0.3% higher. Elekdag and Muir24 also show that a two-year government investment increase of 1% of GDP in Germany in a zero lower-bound situation boosts both domestic demand in Germany (by around 1%) and in the rest of the euro area (by between 0.2% to 0.3%). Kollmann et al. and the German Ministry of Economic Affairs25 come to similar findings, highlighting a very important point: the largest beneficiary of any fiscal stimulus is always the Member State that undertakes it.
The degree in which other economies benefit from the stimulus depends on the structure and intensity of the economic links they have with the country pursuing the supportive policies. For instance, the German Bundesbank finds that, after correcting for the composition of trade with other euro area countries, the positive spill-over effects in other euro area countries are somewhat lower (and, conversely, the positive impact of the stimulus in Germany increases even further). The spill-over effect increases with the share of the fiscal expansion spent to increase and improve production capacities via, say, capital goods and machinery (as opposed to public consumption items, which are mostly sourced domestically) and with the exports share of the partner country to Germany in those goods.26
Notwithstanding this, the higher levels of growth generated by these investments also help to support fiscal sustainability, thereby improving on those estimates. Importantly, these positive results depend on certain conditions, namely that monetary policy remains supportive while the fiscal expansion is pursued.27 This also highlights the complementary roles of monetary and fiscal policies must play in supporting the euro area economy.
Beyond fiscal expansion, expenditure policies should be designed in a growth-friendly way. Expenditures that increase an economy’s endowment of production factors (labour and capital) and/or their productivity contribute the most to increasing potential growth. This kind of spending lifts all boats and should be prioritised, even when its impact needs time to unfold and hence does not lend itself to short-term political consideration. Such expenditure includes, for instance, public infrastructure investments in transport and communications, as they set favourable conditions for private investments. Investments in education and training (which, together with other spending categories such as active labour market policies, are associated with improved human capital and skills), R&D (which is associated with technological development and innovation) and healthcare (which increases both the quantity and the productivity of labour, by increasing the number of years of healthy life) also have a positive impact on potential growth.28
The Commission has identified a number of priority areas that would benefit from increased spending in its latest country-specific recommendations. For many countries, they tend to be in areas such as education and research, which are important areas, although largely related to domestic government current spending and thus with more limited immediate spill-overs to other Member States. Nonetheless, the Commission has also identified additional annual public investment requirements for Germany of 0.5 % to 1 % of GDP (15-30 billion euro) in infrastructure projects, such as transport, which have much larger positive economic effects in the other Member States.29 The Commission also points to the very significant public investment gap faced by the Federal Republic, as do the ECB and the IMF30: Public sector gross fixed capital formation in Germany as a proportion of GDP has been declining since 2008 and is significantly below the euro area average.
As today’s historically low funding costs make investments feasible that would normally be uneconomical, there is now an even broader case for investing in the modernisation of our economies to prepare for future challenges. Together with Member States, the EU has opened a number of promising channels through which investments can have a maximum impact. This includes using novel financial instruments such as the European Fund for Strategic Investment (also known as the ‘Juncker plan’), as well as ongoing initiatives to deepen the internal market in Digital, Energy and Financial Services, such as the Capital Markets Union (whose aim to create deeper and more diverse financial markets in the EU would directly support investment). The internal market has been a major growth and convergence engine for most of the EU’s existence, and can reclaim this role if the Member States are willing to lend full political support for the implementation of these initiatives.
The euro area fiscal stance has only very recently turned mildly positive after having been contractionary between 2011 and 2013, and broadly neutral since then. The bulk of recent literature points to a series of conditions under which discretionary fiscal actions would yield larger benefits than under normal circumstances. The euro area currently meets most of these conditions, suggesting it would benefit from additional supportive fiscal actions. This call has been voiced by both the EU – via the Commission and the ECB – and a by very broad set of stakeholders, from international organisations to internationally respected academics.
However, currently most Member States that do have fiscal space are not making full use of it, whereas debt sustainability concerns outweigh the benefits of an expansionary fiscal policy in others. The result is an aggregate euro area fiscal stance that is not supportive enough considering the economic environment in which the euro area finds itself today. Consequently, the burden of macroeconomic stabilisation is placed almost entirely on monetary policy, which is overstretched.
The most effective way out would be the creation of a dedicated fiscal tool that would enable the effective enforcement of a real euro area fiscal stance. However, the more feasible alternative in the short term, is to encourage a more expansionary fiscal policy in euro area countries with sufficient fiscal space, combined with greater and more coordinated public investments that contribute to the long-term resilience of the economy, supported by EU-level instruments.
Over the past two years, the Commission has called on Member States to redouble their efforts along the principles of the ‘virtuous triangle’ of boosting investment, pursuing structural reforms and ensuring responsable fiscal policies, and, in doing so, to put the focus on social fairness and delivering more inclusive growth. It has also followed the approach of making best use of the flexibility provided for in the Stability and Growth Pact to ensure that the common fiscal framework is supportive of the EU’s jobs and growth agenda, in particular as regards investment and structural reforms, while better reflecting the cyclical situations in individual Member States.31 The recommendation to deliver a more expansionary fiscal stance is a step further in this direction. It would contribute to a broader rebalancing of the policy mix of the euro area, between monetary and fiscal policy, as well as with regards to the role and responsibilities that each Member State should play in its own recovery and the recovery of the euro area.
Furthermore, the discussion on the appropriate fiscal stance for the euro area as a whole is further embedded in the efforts to complete the Economic and Monetary Union, as part of the follow-up to the Five Presidents’ Reports of June 2015, which is now in its first phase of ‘deepening by doing’. Assessing the euro area as a single entity, as if there were a finance minister for the euro area, is of key importance to ensure a stronger and more sustainable growth path. Other developments of importance include the recent establishment of the European Fiscal Board to regularly provide independent advice to the Commission on the appropriate fiscal stance and the reflection on a macroeconomic stabilisation function for the euro area.32
Adopting a more positive fiscal stance will lead to benefits both for the domestic economy of the countries concerned, as well as to spill-overs in other Member States and to a strengthened financial and fiscal stability in the euro area. Regardless of their respective fiscal space, all Member States can improve the growth-friendliness of their budgets by focusing public expenditure on areas that increase the economy’s endowment of production factors (labour and capital) or their productivity and rearrange their taxation systems in a way to minimise the negative impact on incentives for private sector activity. All of this can be done fully within the current rules of the Stability and Growth Pact.
The shift towards a more broadly positive euro area fiscal stance and more growth supporting policies can of course be gradual, but the opportunities afforded by the unique set of circumstances we are currently facing should not be missed.
Compliments of the European Political Strategy Centre