Jorge Uxó, Nacho Álvarez – Can We Resuscitate Fiscal Policy in Europe?

The EU economy is going nowhere (nor the EU for that matter), which is the essence of reactionary politics – and Germany is certainly providing the EU with enough of that. On the other hand we have so many good ideas coursing through Europe and increasing activism. Maybe that is why Ms Merkel is shaking.

Jorge Uxó is associate professor at the University of Castilla la Mancha

Nacho Álvarez is associate professor at the Autonomous University of Madrid

Let us be clear, from the outset: the construction of European fiscal rules, the strong limitations on the use of budgetary policies, and the extreme interventionism of Brussels in the fiscal decisions of national governments and parliaments do not derive from a solid and uncontroversial economic theory. The certainty with which it is demanded the fulfilment of all the tangle of requirements that limit what governments can or cannot do, on pain of supposedly subjecting European economies to serious catastrophes, reflect to a large extent political positions with a strong ideological content, and prejudices against public intervention. The limits imposed on debt and deficit (60% and 3% of GDP) are completely arbitrary, as is the requirement for all countries to reduce their structural deficits, which cannot even be measured without a great deal of uncertainty, at preset rates.

The experience of past years teaches us that remaining within this framework does not ensure that economic results improve (on the contrary, the austerity policies applied in the middle of the recession on the basis of these ideas only worsened the situation, as Draghi himself has just acknowledged, here). Nor is it true that getting out of it is tantamount to endangering the sustainability of public finances.

Many heterodox economists have been saying this for some time – with “relative success” in achieving real change, let’s be honest – although recently there are more and more mainstream economists who are also beginning to call for a more active role for budgetary policy, even going beyond the current fiscal framework. As they will surely end up being more convincing – they are “serious people” – it is advisable to be attentive to what they say and, if possible, to use it to achieve a greater political consensus around this objective of “reviving” fiscal policy.

Although there are other examples, the case that has received the most attention is that of Olivier Blanchard, the former chief economist of the IMF who initiated the review of fiscal multipliers at the time, recognizing that the institution had underestimated the restrictive effects of the austerity policies that it had been recommending. Last January he delivered the presidential speech at the annual meeting of the American Economic Association, pointing out that the fiscal and social costs of public debt are, in a context of low interest rates such as the current one, much lower than is usually claimed, and that therefore the reduction of current debt levels is less urgent than the promotion of certain investments that may now be crucial (a summary can be found here).

Blanchard has recently insisted on this idea (here and here) and has explicitly called for a change in the European fiscal framework that will enable us to implement the fiscal stimuli that our economies need. And he is not wrong.

To begin with, growth forecasts for the euro zone are limited and inflation is far from the 2% target and there are downside risks: everything indicates that measures are needed to stimulate demand. Mario Draghi has announced (here) that he is ready to implement further exceptional monetary policy measures if the situation does not improve, including negative interest rates. But without the support of fiscal policy it is difficult for this to have a sufficient impact on the economy.

Moreover, as we said, if the context of low interest rates makes it difficult to implement new monetary stimuli, it clearly is in favour of the use of fiscal stimuli, especially when this situation is expected to persist for a sufficient period of time. According to Blanchard himself, the probability attributed by the market itself to the Euribor exceeding 1% in the next three years is less than 0.3%. In this context, there are many investments that are socially profitable and that will help the European economy to stop squandering resources in the form of unemployment, without public debt having to pose a risk to the sustainability of public finances or an excessive cost.

For this completely sensible use of fiscal policy to be possible, it is necessary to substantially modify the current European rules which, let us remember, are merely the result of a political agreement, not a Revealed Truth. Political will is therefore enough to do what Blanchard himself proposes: 1) raise the current debt limit and make the requirement that members exceeding it adjust to it at a certain speed more flexible; 2) give countries more freedom to stimulate demand through fiscal policy, even if the 3% debt limit is exceeded; 3) the Commission should stop monitoring national budgetary policies so exhaustively, merely reporting on each country’s economic situation and the likely evolution of its debt ratio; 4) in particular, protect public investment, which has been one of the components of expenditure most affected by the policy of cuts, by introducing what is known as the “golden rule” (not counting public investment within the limits set for the total deficit).

The latter connects Blanchard’s defence of fiscal policy to the need to stimulate the economy with another reason no less important: to launch an ambitious plan of green investments that address the climate emergency, while driving the transformation of the economy. Simon Wren-Lewis (here) and Paul de Grauwe (here) are two other examples of economists who, from the mainstream, are defending the convenience of using public debt to finance these investments. But De Grauwe also points out the limitations of the European fiscal framework to make this possible: “Unfortunately the European authorities have put sticks in the wheels. The budgetary rules imposed today by the European Commission prevent the costs of public investment from being spread over time. The rule that the government budget must be (structurally) in balance makes it impossible for public investment to be financed through the issuance of bonds. (…) The solution to this problem is actually very simple and is sometimes called the ‘golden rule’. (…) The only thing that stands in the way of this solution is the dogma that government debt is always bad. (…) We have to shed this dogma to make it possible to massively invest in projects that will prevent climate change from destroying the planet.”

And how does the situation in Spain fit into this discourse?

In our opinion, these same two reasons justify that, once out of the Excessive Deficit Procedure, the new government also abandons its obsession with deficit reduction at all costs and concentrates fiscal policy on contributing to the real objectives of the Spanish economy.

The first must be the creation of (good) employment. All forecasts indicate that the rate of growth of the Spanish economy is going to decrease, which will make it difficult to reduce current unemployment. According to the Bank of Spain, the average rate of growth of 3.1% in 2015-2018 will sink to 1.9% in 2019-2021. The European Commission or the Bank of Spain itself are saying that this is really nothing more than the soft landing of the Spanish economy towards its equilibrium growth rate, and that we would even be above potential GDP in 2019 (i.e. the output gap is positive, despite the fact that the unemployment rate still stands at 14%). However, this is a completely abstract concept, the measurement of which is subject to great uncertainty, and other indicators, such as a very low inflation rate (around 1%) that shows no signs of acceleration, seem to indicate rather that Spain has problems with lack of demand that fiscal policy could alleviate, ensuring job creation. This is also the opinion of economists who have started a campaign against the “Nonsense Output Gaps” calculated by international bodies (here) and who cite Spain as an example of an unlikely estimate of its cyclical position. In his opinion, Spain clearly has room to grow without generating macroeconomic imbalances. We share it.

In addition, and taking up the second reason we mentioned earlier for substantially relaxing fiscal rules, these fiscal stimulus measures should preferably concentrate on “investments for the future” that Spain has pending: the climate emergency, the development of sustainable mobility, digitisation or care services, for example. In this way, not only would it contribute to creating good jobs, but it would also contribute to the transformation of the productive system in a direction that the “structural reforms” have not been able to promote.

It is well known that Spain has a “deficit of public revenues” with respect to its European partners, which it should correct with measures that also increase fiscal progresivity. But these revenues should be used to finance these policies, and not to reduce the deficit. This is probably going to be around 2%, which is a figure that does not threaten the sustainability of public finances and is compatible with a progressive reduction in the debt-to-GDP ratio. Interest rates will remain low for some time, so the cost of debt and the risk associated with it is low. As Blanchard says, the urgency of reducing it rapidly is much less pressing than the two objectives whose achievement justifies, as we see, “the resurrection of fiscal policy”. Starting with Spain.

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