The beginning of the end for Eurozone austerity?

Fiscal austerity, a concept which German Chancellor Merkel says meant nothing to her before the crisis, may have passed its heyday in the eurozone. This week, the European Commission has published its country-specific recommendations, containing fiscal plans for member states that are subject to excessive deficit procedures. These plans, which will form the basis for political discussion at the next Summit on 27-28 June, allow for greater flexibility in reaching budget targets for several countries, including France, Spain, the Netherlands and Portugal.

Furthermore, there have been rumblings in the German press suggesting that Berlin is beginning to recognise that fiscal consolidation without economic growth could prove to be a Pyrrhic victory. If true, this could mark the beginning of a new approach in the eurozone, helping the weakest region in the global economy to recover from a recession that has already dragged on far too long. So how real is the prospect of change?

The planned path for the fiscal stance

The commission proposals on budgetary policy have been widely heralded as providing more time for the troubled economies to reduce their budget deficits to below 3 per cent of GDP, and that is certainly true. Furthermore, Italy is rewarded for good behaviour by being removed from the excessive deficit procedure altogether. But the budget arithmetic is presented by the Commission in such an opaque form that it is very difficult to see how much the stance of fiscal policy will really change in the next few years compared to the recent past.

The attached document, prepared by my Fulcrum colleague Juan Antolin-Diaz, attempts to clarify the situation for the eurozone as a whole, and for each of the major economies affected. In summary, the essential point is that countries with excessive deficits can now use the automatic fiscal stabilisers in full in response to weaker GDP growth, provided that they continue to improve their underlying structural deficits over the medium term. The result is higher deficits in the near term, implying that it will take one to three years longer to reduce the deficits to under 3 per cent of GDP.

In previous years, member states have often been forced to “chase their own tails” by immediately acting to keep deficits on track as recessions have deepened. The full use of fiscal stabilisers for countries that exhibit “good behaviour” is an important change.
Apart from that, the planned path for future fiscal tightening in the eurozone has been modified, though the tightening has not been eliminated altogether. Graph 1 shows the intended path for the structural budget deficit in the group of troubled economies (including France) in the years ahead, while Graph 2 shows the change in the underlying fiscal stance between one year and the next (note that positive numbers represent fiscal tightening).

The conclusion is that there is much less tightening planned over the next three years than the amount that has occurred since the austerity programmes started. From 2009-13, the fiscal stance for the troubled economies was tightened by a little over 1 per cent of GDP per annum. In the next three years from 2013-16, the planned tightening runs at about 0.5 per cent of GDP per annum, about half the pace that has been implemented so far. If countries implement these plans as intended, the next three years would not see the “end of austerity”, still less its reversal, but its pace would be significantly less than before.

Developments in the German attitude

This raises the question of whether Germany might be ready to go further than the latest Commission proposals in easing the path for budgetary consolidation in the troubled economies. After all, a great deal of progress has been made on reducing the fiscal deficits, while very little has been made on regenerating economic growth. Finance Minister Schauble has recently changed his narrative, at least in public, saying that without growth “our success story would not be complete”. He has also gone out of his way to promise bilateral aid to both Spain and Portugal as they implement structural reforms.

It is most unclear, however, whether the German leopard is really changing its spots. There is no sign of them favouring any generalised easing in the fiscal stance, either in Germany or other eurozone economies. The economic approach which permeates German speeches, and indeed yesterday’s Commission documents, is the same as before: only when the budgets of member states have been brought into line with the rules of the new fiscal compact can we seriously contemplate doing much else. In the past couple of weeks, the Finance Minister has gone out of his way to oppose ECB proposals for common eurozone funding for bank resolutions, and to criticise Mario Draghi‘s suggestions on funding for small business loans in the south.

This means that any changes in German thinking are happening only at the margin, rather than in the mainstream. It is hard to expect much different in the run up to the election in September. But some changes are underway. The Merkel chancellery has reportedly become exercised about the slow pace of structural reforms in the south, relating mainly to labour markets and pensions, and is thinking carefully about how to design contracts which would reward progress on this front by allowing access to additional structural funds from the common EU (or Eurozone) budget.The Commission has already published some proposals in this area, and more progress may be made before the summit.

In addition to this, there is a willingness to contemplate using the German KfW development bank to provide low interest rate loans to development agencies in Spain and Portugal, and to build on the E6 billion which has been earmarked to help address youth unemployment across the EU. Small beer, perhaps, but it is a start, and much better than nothing.

As Churchill said about El Alamein, this may not be the end of eurozone austerity, or even the beginning of the end, but it is the end of the beginning.