Can fiscal policy fill the gap?

Both fiscal and monetary policy can serve as stabilizers during an economic downturn. With emerging markets under stress, rising trade tensions and concerns about debt sustainability in for example Italy, the risks of a new downturn may be building up. Major central banks have started to talk about ‘normalizing’ monetary policy, but most are still far from having a neutral monetary policy stance. There is divergence in the monetary policy stances across currency areas. The Federal Reserve is relatively far in the process of normalization and has continued its very gradual tightening pace. The Bank of Japan is keeping its ultra-loose monetary policy stance unchanged. The ECB’s balance sheet is unlikely to shrink any time soon and the deposit rate will likely stay at its current low of -0,4% until the summer of 2019 at least. With the ECB (largely[1]) out of ammunition, fiscal policy may have to step in to fill the monetary policy gap to fight a new downturn and dampen the impact of a new recession. The important question therefore is how much fiscal space Eurozone countries currently have to stabilize the economy when the next downturn hits.

[1] The current case of Japan shows there are more instruments than the interest rate and QE, such as yield curve targeting and buying different asset classes.

The speed at which countries recover from crises varies greatly, demonstrated for example by the strength of the recovery of the financial crisis that started in 2008 (figure 1). France and Germany already recovered the GDP lost during the crisis in 2011. The Netherlands returned to the pre-crisis GDP level in 2015. Spain and notably Italy had slower recoveries. Several explanations can be given for the divergence in recovery after a crisis, such as the doom-loop between banks and sovereigns or the impact of a housing bubble that crashed. Another explanation can be found in the ability to use fiscal policy to stabilize the economy.

In a recent paper Romer and Romer (2018) analyse whether fiscal policy space[2] at the beginning of a financial crisis affects the aftermath of such a crisis. Based on a sample of 24 advanced economies they find that when a country has both monetary and fiscal policy space the decline in output following a crisis is less than 1%, but almost 10% when a country has neither. Focusing solely on fiscal policy they find that the average decline in GDP reaches 8.8% without fiscal space but only 1.6% with fiscal space. The mechanism via which fiscal policy space affects this outcome is that countries with fiscal space seem to use this room much more aggressively in response to financial distress than countries who don’t have this fiscal space.

With this in mind we plot the relationship between the debt-to-GDP ratio in 2007 and the effect of the crisis in the following years in the Eurozone countries (figure 2). We observe a negative relationship between the pre-crisis debt levels and the GDP growth during the crisis years[3]. The countries with high levels of debt in the pre-crisis period experienced a deeper crisis, which could be caused by the fact that they had less room to stabilise the economy via fiscal policy. This result is also found by Jorda et al (2017), who use long-run data and conclude that countries with elevated public debt levels have a worse path of recovery after a crisis.

The importance of fiscal policy space for the aftermath of a crisis seems to be clear-cut. Important to note is that the focus is not on the cause of the crisis, but to what extent differences in fiscal space have affected the impact of the crisis and could aggravate a possible next downturn.

[2] The paper uses several versions of debt-to-GDP as a measure for fiscal policy space. The no-fiscal policy space effect is based on a debt-to-GDP ratio of 96%, which is one standard deviation above the sample mean.

[3] We excluded some outliers, such as Greece, Malta and Ireland. The negative relationship persists under any sample choice, however, and is more negative when including Greece.

At first sight, fiscal space is a relatively simple concept. It can be described as the room a government has to increase its spending without causing its financial position to become unsustainable. While the concept may be relatively easy, measuring how much fiscal space a country has, is not straightforward. There is no clear cross country debt threshold above which public finances become unsustainable, which a government does not want to breach[4]. That said, for EU countries there are some ‘additional’ fiscal limits, not dictated by the markets, but by self-imposed fiscal rules.

European budget rules bundled in the Stability and Growth Pact (SGP) provide public debt and deficit limits (see box 1). Figure 3 shows the debt-to-GDP ratio for the Eurozone countries. At present 12 out of 19 countries are above the 60% debt limit. This means that according to the SGP-rules they should lower their debt-to-GDP ratio at a sufficient pace (1/20th of the excess over the 60% ceiling per year), and are not allowed to increase their debt-to-GDP ratio. When these countries do not reduce their debt they can be placed in an excessive debt procedure, resulting in possible sanctions. A large share of the EU is therefore constrained by the rules of the SGP to use fiscal policy in a possible recession.

[4] Ostry et al (2010) estimate a country-specific debt limit. These are highly dependent on assumptions made, historical data and therefore not very reliable.

Another measure of fiscal policy space within the SGP is the distance of a country’s structural budget balance from its medium-term budgetary objectives (MTOs[5]). Structural balances are used because actual fiscal balances can give a misleading picture of the underlying fiscal situation. Governments can report fiscal surpluses of 2+ percent of GDP during an economic boom, when the business cycle turns the fiscal balance can shift rapidly into negative territory. In 2017, 10 countries did not meet their MTO, implying they do not have fiscal space for future macroeconomic stabilization according to the rules in the preventive arm. Important to note is that the countries with high debt levels are often also the countries with large structural deficits. Italy, Spain, Belgium, France and Portugal all have debt levels above the 60% limit and have lower structural balances than their MTO prescribes. This means a large part of the Eurozone has very little to no space to stabilize the economy in a possible future economic downturn, if European budget rules are to be fully complied with. The most recent Debt Sustainability Monitor of the European Commission also deems these countries as having a high fiscal sustainability risk in the medium term. They are said to be sensitive to unfavourable shocks, mainly as a result of inherited post-crisis debt burdens.

[5] The medium-term budgetary objectives are country-specific and ensure sound fiscal health with a safety margin against breaching the EU’s fiscal rules.

Since many countries have been breaching the rules on a regular basis, one could argue that the limits of the SGP are not a reliable indicator of a country’s fiscal space. Even though this is true, countries might feel and behave as if they are constrained in letting their debt and deficit levels increase a lot above the threshold and will therefore use less fiscal stimulus than without these rules. In any case, in our view the rules can be used to get a conservative estimate of the fiscal space governments have to stabilize the economy during a possible downturn.

Relative to the situation in 2007, the pre-crisis year, the fiscal position of the Eurozone countries has not materially improved and for the most it has even worsened. Debt ratios in most countries are higher than they were prior to the outbreak of the financial crisis (figure 5). Even if European budget rules were neglected, high debt countries will face market pressure to restrain budget deficits and might not be able to stabilize the economy with fiscal policy. Figure 6 shows that the budget balances of the Eurozone countries are not in a better shape than in 2007; the same countries still have relatively high deficits. The 3%-deficit rule can also restrict the space the countries have to increase their expenditures. Especially Spain, France and Italy are still very close to breaching the 3%-rule and will face pressure from the Commission when reporting deficits higher than 3%.

10 years after the crisis the majority of the countries seems to have less fiscal space relative to the pre-crisis year 2007. Using the results of Romer and Romer (2018) it is possible to estimate the impact of a moderate crisis[6] given the current debt levels. When countries comply with the EU debt rule of 60% a moderate crisis would, according to the model of Romer and Romer (2018) reduce GDP by 4.7%-points of GDP. Would, for example, Spain be compliant with the EU-rules and start the moderate crisis with a debt level of 60%, the impact is estimated to be 4.7%. Currently Spain’s debt level is 98.3%, which raises the impact of a moderate crisis on the economy to roughly 8.5%-points.

[6] Using the scale (0-15) of Romer and Romer (2018) we use a 7, which is a moderate crisis with a fall in GDP of roughly 6%.

To ensure that countries have a cushion to deal with business cycle fluctuations, EU policy makers designed the preventive arm of the SGP-pact. These fiscal rules aim to force governments to save during good times[7], so that they are able to execute anti-cyclical fiscal policy during downturns.

The commission estimates that the majority of the Eurozone countries will be closing their output gaps in 2018. This means that now is the time to improve the structural balances. This is overwhelmingly not the case so far, with almost every country seeing its structural deficit increase in 2018 while having a positive output gap. Figure 7 gives an overview of the fiscal policy stances of the Euro area countries in 2018 according to the European Commission. Important to note is that estimates and forecasts of the output gap are unstable and have been prone to significant revisions. More uncertainty stems from the structural balance estimates which are also subject to major revisions. The uncertainty can be illustrated by looking at the output gap estimates of the IMF, using these output gaps only 9 countries would have a pro-cyclical fiscal policy stance. This is mainly because the IMF estimates negative output gaps for several countries, while the Commission already reports positive output gaps.

[7] Good economic times are often defined as the period during which the output gap is positive. The output gap is measured as the gap between actual and potential output. Potential output is a measure of production if all resources were employed at their long-term sustainable rate.

The rules in the preventive arm regarding the structural balance do not seem to have the desired effect on the fiscal policy stance of the Eurozone countries. The reason for the ineffectiveness can be found when we dig a bit deeper into the rules of the preventive arm of the Stability and Growth Pact.

The regulation allows for a relatively large margin of deviation from the benchmark before a member state is considered non-compliant. In a certain year the permitted deviation from the required adjustment towards the MTO can be 0.5%. On average over two years it is allowed to be 0.5% resulting in an average allowed deviation of 0.25% in each year. This significantly lengthens the time a country can take to reach its MTO. In addition to this, several flexibility clauses have been introduced, most notably the investment clause and structural reform clause. These allow countries to deviate from the target, because of costs related to structural reforms or investments. The most recent weakening of the framework was introduced in May 2017. A margin of appreciation is used in cases where the impact of a large fiscal adjustment on growth and employment would be significant. Figure 8 gives an overview of the number of flexibility clauses granted, which has been rising fast the last two years.

Figure 9 illustrates that applying a subset of these different clauses and margins can theoretically lead to an extension of the time to reach the MTO to 15 years (with a structural deficit of 2.5%-points as a starting point). Non-compliance of the member states further weakens impact of the preventive arm towards balanced budgets.

In an effort to increase the flexibility of the SGP rules, in itself a justified objective, the main objective of the rules in the preventive arm seems to have been lost out of sight: convergence towards the MTO in a reasonable period of time. Especially the lack of progress towards the MTO in several highly indebted countries, such as Spain, Italy and France, is a matter of concern. The clauses and margins relative to the benchmark adjustment rate allow for long delays in reaching the MTO. This could be avoided by requiring countries to increase the rate of adjustment in the years after they are granted one of the clauses. A further improvement could come from increasing the adjustment requirement for countries with debt ratio’s above 60% and even higher for countries with higher debt ratios. Additional fiscal restraint could have negative consequences for growth, therefore this should especially be used during good economic times in order to create room for growth in lesser times.

The ECB will not have a lot of room to stabilize the economy in case a new recession strikes in the coming years, at least not with the tools it has used in the previous decade. Therefore it is of great importance that the Eurozone countries have fiscal policy space to stabilize the economy. Relative to 2007 the majority of the countries now have higher debt-to-GDP ratios and will therefore have less room to increase expenditures during a possible recession. They might be restricted because of the fiscal rules of the EU or restricted by the financial markets. A coming recession will hopefully not be as deep as the most recent one, but lack of possibilities to stabilize the economy with fiscal policy could make the impact worse than necessary. The rules of the SGP are designed to move countries towards anti-cyclical fiscal policy and to build buffers during economic good times. Obviously, regular monitoring and pressure by the European Commission in the form of ‘naming and shaming’ can still be effective in coercing countries not to seek the boundaries of the SGP, but the rules themselves are no longer effective in guiding member states towards anti-cyclical fiscal policy.

The rules could be improved by requiring countries to increase the rate of adjustment towards the MTO in the years after they are granted a clause. A further improvement could be to increase the required adjustment for countries with debt ratios above 60% and possibly gradually increasing further with the debt level.

Romer, C. D., & Romer, D. H. (2017). Why some times are different: Macroeconomic policy and the aftermath of financial crises (No. w23931). National Bureau of Economic Research.

European Court of Auditors (2018). Special report no 18/2018: Is the main objective of the preventive arm of the Stability and Growth Pact delivered?

Ostry, J. D., Ghosh, A. R., Kim, J. I., & Qureshi, M. S. (2010). Fiscal space. International Monetary Fund, Research Department.