Fiscal Stimulus for the European Economy: The Right Thing?

Eckhard Wurzel

University of Konstanz

Prof. Dr. Eckhard Wurzel teaches European economics at the universities of Konstanz and Göttingen. The article is based on his recent book Europäische Integration wohin? – Zu Wirtschafts-, Finanz- und Geldpolitik sowie Reformen der EU (Kohlhammer: Stuttgart, 2019).

With weaker economic growth in Europe, the idea is being resurrected that European governments, or at least those with “enough fiscal space,” should stimulate their economies by increasing government debt and spending. As monetary policy is reaching its limits to stimulate the economy—the argument goes—fiscal expansion will need to step in.

The proposition also frequently employs the narrative that in Europe “austerity policy” deepened the financial crisis of about a decade ago.[1] It is therefore worth recalling first that, over and above regulatory failure in the banking sector, public and private sector debt accumulation was pivotal in bringing about and amplifying the crisis in the European Union (EU). In some of the countries hit most by the recession, high stocks of net debt to foreign countries and persistent current account deficits, linked to large private or public sector borrowing, triggered the steep hikes in credit risk premia seen during the crisis. In addition, resource misallocation, reflected in excessive government or private sector debt levels, led to declining external competitiveness that weakened the economy. In the countries that experienced systemic banking problems, rising government debt fueled negative feedback loops between bank and government balance sheets, which turned out to be major amplifiers of the recession. Also, fiscal stimulus does not help to correct structural imbalances that require resources to be reallocated for potential output to recover. It can even impede correction.

Fiscal stimulus does not help to correct structural imbalances that require resources to be reallocated for potential output to recover.

The claim, made by some, that fiscal “austerity policy” underpinned the crisis is as flawed as it is simplistic. Without credible signals of governments’ willingness to take serious steps toward re-establishing the sustainability of their finances, market reactions might have been even more vigorous than what we have seen. It is also worth noting—something frequently ignored in the austerity narrative—that countries most affected by the crisis were helped in coping with fiscal stress and bank restructuring by massive financial aid from new European inter-governmental financial support mechanisms.

More generally, the case for discretionary fiscal expansion as a remedy against slumps is not as clear-cut as it is often presented. Empirical evidence—stretching over several decades—about the impact of fiscal expansion on GDP (fiscal multiplier) is highly mixed. For example, John B. Taylor argues that the U.S. government’s fiscal stimulus programs enacted during the recession of 2007-2009 did not stimulate the economy.[2] Indeed, several conditions and channels can reduce the counter-cyclical impact of stimulus packages. One such channel, often associated with “Ricardian Equivalence,” is that rising government deficits are countervailed to some extent by additional savings of the private sector, reducing aggregate demand. Empirical evidence suggests that the size of the countervailing private sector response is larger when government debt is high and the economy’s underlying growth potential is low.

In the current European context this raises doubts about the effectiveness of fiscal stimulus packages. First, in several countries, government debt relative to GDP is still at high levels and declining only slowly from crisis peaks. Debt will need to be reduced, both for the sake of strengthening the growth potential of the European economies and to reduce the risks of another debt-financial crisis.

Debt will need to be reduced, both for the sake of strengthening the growth potential of the European economies and to reduce the risks of another debt-financial crisis.

Second, government finances are facing serious burdens going forward. Current interest rates are extraordinarily low or even negative, owing to the unprecedented expansionary monetary policy of the European Central Bank (ECB). This is helping governments to shoulder their debt servicing obligations and to finance new debt. However, interest rates will go up once monetary policy is normalized and the ECB rewinds its large-scale purchases of government securities. Future upward pressure on interest rates is likely to be significant, even if one adheres to the (debatable) hypothesis that interest rates might not swing back to the high levels seen in some pre-crisis decades. Also, rate increases are likely to become particularly pronounced in countries with high debt levels, whose credit risk premia are currently artificially compressed by the ECB’s purchases of government bonds.

The dynamics of government debt-to-GDP ratios is governed by the differential between interest rates and GDP growth rates, together with the size of the government primary balance that nets out interest payments. For some years, interest rates have been undercutting GDP growth rates by substantial margins in almost all euro area countries. Once the favorable differential between interest rates and GDP growth rates shrinks or even turns positive, higher government primary surpluses will be required to reduce debt-to-GDP ratios or prevent them from exploding. That, in turn, is a compelling argument in favor of consolidating government finances as long as interest rates are still low.

Moreover, many European countries are facing rapidly deteriorating old-age dependency ratios, as measured by the number of persons aged 65 and older relative to the number of persons aged between 15 and 64 (working-age population). Eurostat, the statistics office of the EU, is projecting the ratio to rise on average in the EU from currently about 31 percent to 46 percent in 2040. This development will increasingly weigh on trend GDP growth and government revenue, while at the same time aging-related spending pressure on government budgets will rise. Projections by the European Commission and the OECD show that public expenditures on pensions, health care, and long-term care combined could increase over the next two decades by several percentage points of GDP in some EU countries. Upfront fiscal consolidation, together with structural reforms, is necessary to be able to cope financially with this development.

Infrastructure investment can raise the economy’s potential to grow, depending on structural characteristics of the economy and provided the investment is well designed, which will require planning for longer periods into the future.

If many European countries do not have much scope to step up debt-financed discretionary fiscal stimulus, what about countries like Germany, who are often considered to have “sufficient fiscal space”? Let us observe first that Germany is one of the countries that are projected to experience the largest deterioration, worldwide, in the old-age dependency ratio—supporting the case for containing public debt. There are nonetheless a number of good arguments in favor of increasing the rate of government investment. Infrastructure investment can raise the economy’s potential to grow, depending on structural characteristics of the economy and provided the investment is well designed, which will require planning for longer periods into the future. Financing public investment projects is to some extent a matter prioritizing government expenditures but might also involve debt financing to maintain projects over the longer term and independently from the business cycle.

It is questionable, though, whether government investment would provide significant fiscal stimulus. For example, a recent empirical study for OECD countries suggests that the fiscal multiplier for temporary increases in government investment is close to zero.[3] Thus, one euro investment spending by the government would have a near-zero effect on aggregate demand, due to corresponding postponement of private sector investment. The benefits of infrastructure investment consist in improving the productive endowment of the economy rather than in raising GDP over short horizons. Besides, potential spill-overs from German government expenditures across borders would mainly benefit a few countries, like Austria, that are coping with business cycles relatively well—if spill-overs were significant at all.

In sum, well-planned infrastructure investment by federal and regional governments can help the economy and should be embedded in a strategy of improving the quality of government spending more generally. They are often longer-term. By contrast, fiscal stimulus packages risk being myopic and having little effect in raising domestic and cross-border output. Moreover, much would be gained for economic activity at this juncture if policy uncertainties were reduced. Refraining from triggering trade wars that are jeopardizing global economic activity would be a major ingredient.


[1] For example: Paul Krugman, “The World Has a Germany Problem,” The New York Times, August 19, 2019.

[2] John B. Taylor, “Fiscal Stimulus Programs During the Great Recession,” Hoover Workshop Series on the 2008 Financial Crisis; prepared for the December 7 session (2018).

[3] Christoph E. Boehm, “Government Consumption and Investment: Does the Composition of Purchases Affect the Multiplier?” Journal of Monetary Economics (2019).

 

The views expressed are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.