Eurozone: Fiscal Consolidation under Review

Transcription

1 Eurozone: Fiscal Consolidation under Review Frédérique Cerisier In early 2013, growth prospects remain extremely dim in the eurozone. Its GDP will likely contract for a second straight year, falling 0.5% according to our latest forecasts, as in Nonetheless, Heads of State and central bankers did not sit on their thumbs last year, and several developments suggest that some of their decisions have radically changed the situation for several months already. Accordingly, are there grounds to be surprised that the recovery is so slow to take shape, and the improvement in financial conditions is struggling to extend to the real sphere in Mario Draghi s own words? One needs to bear in mind that the fiscal consolidation policy is being implemented at a fast pace and it is hurting growth every year. Three years after the crisis started, a debate persists about the pace at which such a policy should be conducted, all the more so as the prospect of a recovery is fading. Europe has set itself objectives. To what extent is it drawing closer to meeting them? 2013 is this the way out (from the crisis)? In the last few months of 2012, the eurozone benefited from a respite. In fact, many observers have been even more bullish, suggesting that the sovereign debt crisis had entered a second phase, pointing at last to the prospect that the eurozone would pull out from the crisis. Since the end of the summer, strains have markedly abated indeed and the financial deconstruction under way between mid-2011 and mid has been interrupted. Several developments reflect this improvement. First of all, governments borrowing conditions have significantly improved in many eurozone countries. Despite some volatility related to uncertainty at the political level, Spanish and Italian 5-year sovereign rates are around 200 basis points lower than in early summer 2012 (Chart 1). For their part, Portugal and Ireland have started, so far successfully, a process aimed at recovering full access to market funding. Another symptom of the crisis, i.e. Target2 balances, i.e. the positions of the payment systems of all States at the European Central Bank, are no longer ballooning (Chart 2). In January, the German surplus, was still above 615 billion, had contracted by close to 135 billion, or 18% in comparison with its peak in August Symmetrically, the deficits of troubled countries have been slashed, down to circa 337 billion in Spain at 31 December, i.e. 22% lower than in August 2012, and to less than 230 billion, down 21%, in Italy at 31 January. While those imbalances remain huge, the fact that they are ebbing reflects the fact that confidence has returned. This calming down has resulted from three major decisions taken in H By launching a new programme of purchases of government bonds, called OMT or Outright Monetary Transactions, the European Central Bank visibly convinced investors that eurozone governments benefited from a last-resort lender. In addition, Heads of State and of Governments have agreed to form a Banking Union. Within a year, single supervision of the largest banks of the eurozone will be set up under the aegis of the ECB, which could authorise the direct recapitalisation of certain banks by the European Stability Mechanism. Lastly, by eventually completing its talks with the Greek government that led to a new restructuring of its debt and an extension of the European financing plan, the Troika has shown that the possibility that Greece might be forced out of the eurozone had been definitively ruled out. March 2013 Conjoncture 9

2 5Y sovereign yields % Italy Chart 1 Source: Datastream Target2 balances With these decisions, the progress achieved in terms of solving the crisis has clearly reached the critical mass needed to dispel uncertainties about the single currency s likelihood of surviving. Once fears that the eurozone might collapse had been dispelled, a positive scenario has taken shape, in which the return of investor confidence, the easing in financial conditions, the recovery in activity, and the reduction of fiscal imbalances are likely to follow one another in what would now be a virtuous circle. Even though it hardly depicts a noticeably dynamic situation, our own growth forecast is nevertheless based on this positive scenario. After declining further in Q1 2013, for the fourth successive quarter, activity could gradually pick up during the year and this incipient recovery would slightly gain momentum next year, with 0.8% growth in Many pitfalls remain Spain 1050 bn euros 750 Germany, Netherlands, Luxembourg, Finland Greece, Italy, Ireland, Portugal, Spain * Institute of Empirical Economic Research Osnabrück University Chart 2 Source: Euro Crisis Monitor* Many risks subsist, however, and could derail this scenario. The most obvious are related to changes under way in institutions. Admittedly, the general principles for the single surveillance process of European banking sectors (automatic supervision of the ECB for the largest banks of each country, in principle supervision by national regulators maintained for the other ones) and the direct recapitalisation of struggling institutions by the ESM (with national deposit insurance in order to keep risks of moral hazard in check) have been set out. Notwithstanding, there is a long way to go between defining such principles and effectively implementing these processes (cf. The challenges of Banking Union, L. Quignon, Conjoncture, February 2013). Throughout this year, the eurozone s Heads of States and of Governments will keep on negotiating, while the latest European summits (on the future of the EMU in late 2012 and on the EU budget in early 2013) have shown that their determination or their capacity to forge compromises was limited. Currently, it is still not known what part will be played by the ESM in banking recapitalisations, notably in Spain. The need to finalise in the next few weeks the bailout package for the Cypriot economy (and banking system), and, perhaps, in a few months, to readjust the financing plans granted to Portugal or Ireland, will provide, inter alia, other opportunities for the Europeans to showcase their divisions. In addition to these institutional uncertainties there are political risks, clearly stemming from the rejection of austerity policies ( consolidation fatigue ), in countries where mediocre growth prospects mean that unemployment will inevitably rise further, and it already exceeds 12% on average in the eurozone, and where electoral cycles continue. At the same time, this policy remains crucial from the viewpoint of creditor States. So far, it has always been possible to overcome these hurdles, but we believe that one of the main issues in 2013 consists in the assessment that might be made about the efficiency of this strategy of rapid fiscal adjustment, launched in a few countries in 2010, before becoming widespread in Even though Europe s reaction to the crisis is currently based on three pillars, i.e. fiscal adjustment, economic rebalancing and deepening of the economic and monetary union, its fiscal component was the first to be implemented, in particular because deficiencies in this field have been identified for a long time as a major cause of the crisis. This is no longer the case currently, but nonetheless many Member States are beginning their third, or even their fourth straight year, of restrictive fiscal policy. The European Commission had March 2013 Conjoncture 10

3 initially supposed that such a period would give time enough for most of them to get back in line with the Stability and Growth Pact; i.e. a deficit lower than 3% of GDP. Endless debates about a suboptimal strategy Since then, every year, growth as well as deficit reduction projections have been revised downwards. The economic debate about the impact of fiscal austerity on activity has been rekindled as a result. In fact, even as this issue has become crucial with regard to conducting economic policy, the conventional analytical tools have seemed inappropriate, and the messages sent by economists have been confusing. The analysis recently conducted by the IMF (cf. Inset 1) is a striking example. It does not lead to the conclusion that European fiscal consolidation must be interrupted, even though austerity opponents have been able to believe that it added credence to their arguments. Conversely, it sought to emphasise the cost of such a policy. It also had a major impact because, implicitly, it called into question the size and duration of austerity programmes and funding plans in troubled countries, by suggesting that the impact of consolidation programmes on economic activity had been systematically underestimated. This would entail that the fiscal overruns witnessed until now were partly inevitable, that adjustment trajectories will have to be recalculated, and funding increased. Unsurprisingly, it triggered rapid responses from the ECB and the European Commission, its partners within the Troika, as they were hardly inclined to admit the idea that European support packages suffer from a flawed design. Fundamentally, all studies, whether theoretical or empirical, agree on the fact that the impact of fiscal austerity on activity depends on a high number of factors. They include the characteristics of fiscal savings implemented and the previous situation of the country concerned but also the international environment. Drawing on an average value of the multiplier frequently occurred in the forecasting process and this was useful before the crisis, when economies were close to a standard situation, i.e. with a small Inset 1: Battle of the multipliers The debate on the size of multipliers, in other words on the impact of fiscal consolidation policies on activity, was revived in the autumn of 2012 by the International Monetary Fund. Already, in 2010, and even as certain authors were wondering about the possible expansionary effects of fiscal consolidation, the IMF s economists had pointed out that, according to their assessments, fiscal restriction in the vast majority of case has a negative impact on economic activity in the short term 1. This point has been proven to a large extent by how economies have fared in eurozone peripheral countries during the last three years. The debate has subsequently switched to the magnitude of this effect, or the size of multipliers. In the latest report on the situation of the global economy (World Economic Outlook dated November 2012), the chef economists of the IMF propounded the idea that the value of these multipliers was systematically underestimated at the beginning of the European sovereign debt crisis. To do so they show 2 that the forecasting errors made in early 2010 for 2010 and 2011, as 2012 was not over when the report was published, were positively related to the fiscal consolidation drive expected in each country. However, if the forecasters had correctly assessed the multipliers, or alternatively used a good forecasting model, these errors in growth prospects would not have been correlated to the magnitude of fiscal austerity programmes. All in all, the authors defend the idea that one percentage point of GDP of fiscal consolidation reduces growth in activity by 0.9% to 1.7%, versus 0.5% as estimated by forecasters in The European Commission and the ECB both reacted in their recent publications to the IMF report. The Commission, in particular, underlined the role played by the massive increase in interest rates also to a large extent underestimated at the beginning of the crisis in the economic slowdown and the recession witnessed in several countries. The ECB insisted on the long-term benefits of fiscal consolidation 3. output gap, the magnitude of fiscal measures was limited and finally little information was available about the detailed features of fiscal measures. This is no longer the case currently. Next, it is now widely accepted that the strategy chosen to pull out from the European debt crisis has proven far more expensive than was generally expected. Among the major factors, which were admittedly already identified at the time but clearly underestimated, the following stand out: March 2013 Conjoncture 11

4 Adjustment policies were not coordinated within the eurozone. That could have consisted, for instance, in getting the countries enjoying the most solid fiscal positions at the end of the recession of 2008, to bolster their domestic demand while countries weakened by the crisis were implementing restrictive policies. Instead, fiscal consolidation programmes were implemented simultaneously in most eurozone countries, resulting in a situation where every country had to face a slowdown in its domestic demand and its exports at the same time. Note that the reason why there was no such coordination was not because Member States were not aware of its advantages, but because it implied deep confidence among them, and was another form of risk pooling that Europe is still not ready to accept. In the most fragile Member States, these fiscal austerity programmes were implemented at the time of huge strains on interest rates, and more generally speaking, a pronounced tightening in monetary conditions: increase in sovereign interest rates and problems met in terms of banks gaining access to financing. Both developments had a knockon effect on costs and lending to private agents. The ECB s unconventional measures LTRO, measures related to collateral, and finally OMT, etc. were aimed in a way at fighting this tightening and ensuring that the very accommodative monetary conducted in Frankfurt was transmitted to all the economies of the eurozone. Lastly, recent academic literature 4 seeks to show that the impact of fiscal policy on activity is not similar depending on the economy s position in the business cycle, and multipliers are significantly higher in a phase of declining activity, when excess capacity is particularly substantial and unemployment is high. European fiscal adjustment on the test bench Under the reform of the European Semester, presented in detail in Inset 2, the European Commission published, in late February, an update of its economic forecasts. The main reason for being of this process is to provide Heads of States and of Governments, at the beginning of the semester, the most precise possible assessment of the current economic and fiscal situation and changes expected in To draw up an overview of the progress already achieved, and what has yet to be done, we calculate a series of simple indicators of the fiscal position of economies in the eurozone. For each Member State, we show: i. The improvement in the budget balance carried out by each State, between the trough of 2009 and 2012, of a cyclical origin and of a structural origin 5. ii. The improvement yet to be carried out, from the level reached in 2012, to lower the budget balance to -3% of GDP in nominal terms, i.e. not corrected for the part of the deficit linked to the cyclical situation. iii. The consolidation effort required to bring the structural balance back to -0.5% of GDP. iv. The gap between the current position and the primary deficit required in each country in order to stabilise the public debt ratio, under current growth conditions, and under more favourable medium-term hypotheses. v. The gap between the current position and the deficit required to reduce the excessive public debt, i.e. the part above 60% of GDP, at the pace of 1/20th per year (under the same hypotheses). Measure i) gives an idea of the progress achieved in three years, in a tough environment, and it is interesting to compare it with the progress yet to be achieved provided in the rest of the Table. Measures ii) and iii) referrer to the target values of European legislation (Stability Pact and fiscal pact or TSCG) for the nominal and structural deficits. The last two measures take into account the stock of debt accumulated and its probable dynamics, and are therefore more representative of the sustainability of public debts. Measure (iv) seeks to assess the capacity of a State to stabilise the debt ratio in the long term, and therefore finance the payment of related interest expenses thanks to growth. Measure (v) also refers to a European regulation (found in both the Six-Pack and the TSCG) that is aimed at inducing Member States to gradually lower their debt ratio towards 60% of GDP 6. March 2013 Conjoncture 12

5 Inset 2: The European Semester The so-called European semester is a six-month period each year when Member States' budgetary, macro-economic and structural policies are coordinated effectively so as to allow Member States to take EU considerations into account at an early stage of their national budgetary processes and in other aspects of economic policymaking 7. In the past, EU Member States would debate economic policies in the spring, and reported back on their fiscal policy to the European Commission (EC) and the Council in the autumn. Apart from the fact that this made it difficult to coordinate their different policies, or better take into account their impact on one another, the major weakness of this procedure was that it led the Council of the EU to give its opinion about fiscal trajectories and policies planned to implement them at a time when said measures had already been voted or virtually voted by national parliaments. Since 2011, the reform of these procedures now enables the Commission to assess jointly the economic and fiscal policies of Member States, and release its recommendations early enough for them to be fully taken into consideration while drafting national Finance Bills, usually in the autumn. This reform, by consequence, is clearly part of a process aimed at coordinating and monitoring far more closely the economic and fiscal policies of Member States than before. The main stages (and the main documents) of the 2013 European Semester: To open the semester, the Commission published in late 2012 its 2013 Annual Growth Survey and its 2013 Alert Mechanism Report on macroeconomic imbalances. The first defined priorities for the Member States in terms of economic, fiscal and employment policies: continue structural fiscal consolidation, boost lending to the economy, improve competitiveness and reform further the labour markets. The second, after an assessment of the Dashboard of macroeconomic imbalances, drew the conclusion that an in-depth review of the situation of 14 EU Member States, including 9 eurozone members was necessary. With respect to the eurozone, they are Belgium, Spain, France, Italy, Cyprus, Malta, the Netherlands, Slovenia and Finland. Note that quarterly reports are already available for Greece, Ireland and Portugal under their financial support programme. In February, Ecofin (meeting of EU finance ministers) already began to debate these guidelines during its monthly meeting. At the end of the month, the European Commission released its 2013 Winter Forecast. Published for the first time at this date, in addition to the traditional autumn and spring forecasts, the purpose of this forecast is to provide the European Council at the start of the semester with the most recent possible update of the growth prospects and fiscal trajectory of each Member State that will be used as a reference for the entire semestrial procedure. Projections cover the current year, i.e. this year taking into account Finance Acts voted for 2013 in late 2012, as well as the following fiscal year. Forecasts covering 2014 give an idea of changes in economic and fiscal aggregates at an unchanged policy, in other words taking into account only fiscal measures that have already been voted. They therefore also give an estimate of the magnitude of the additional measures a Member State will have to plan for the following year to meet its fiscal consolidation objectives, if relevant. By late March, the EC will publish the 2013 In-Depth Reviews of the 14 States mentioned hereabove. Last year, it merely drew the conclusion, for each reviewed State, that there were serious macroeconomic imbalances, and recommended implementing corrective measures, sometimes urgently. If it were to deem this March 2013 Conjoncture 13

6 necessary, however, it could recommend in one of these reports the opening of an excessive imbalance procedure against a Member State. In March as well, and on the basis of all this information, the European Council (meeting of Heads of States and of Governments) will adopt EU guidelines for national policies at its spring meeting. In April, the Member States will jointly present their stability programme ( Stability Programme, socalled convergence programmes for non-members of the eurozone) and their 2013 National Reform Programme, which sets out in detail their fiscal and economic reform strategy. These programmes are supposed to take into account the priorities set by the Council in March and, if relevant, the recommendations made by the Commission after its in-depth reviews. In May, the European Commission will draw up its Country-Specific Recommendations. They will result from its review of stability and reform programmes. The purpose here is to assess to what extent these programmes comply with European rules, such as the Stability and Growth Pact, Six-Pack, etc., in particular fiscal rules, and meet the economic and fiscal situation of the State under consideration. Some of these recommendations may be binding, when disciplinary procedures have been opened against a State, such as the excessive fiscal deficit procedure or excessive imbalance procedure. In the same month, the Commission will make its proposals with respect to the unfolding of procedures. Currently, an excessive deficit procedure is under way against 20 EU countries, including 12 eurozone countries, i.e. all of them except Germany, Luxembourg, Finland, Malta and Estonia. The EC could then recommend closing this procedure against a Member State, on the basis of the budget balances recorded in the previous year, the estimate of which will have been released by Eurostat in late April For the other economies, the EC will say whether the corrective measures, either launched or planned, will be sufficient to meet fiscal objectives. In the case of probable overruns, it will have to report whether the structural measures implemented are sufficient and, when relevant, postpone the nominal objectives set for the relevant State. Conversely, it can be led to call for additional measures, failing which it might recommend applying sanctions under the procedure. In practice of course, talks between Member States and the Commission will already be under way and will last several weeks, as the objective is definitely to reach an agreement before stability programmes are sent. All in all, accordingly, after lengthy talks, although the possibility that they might, in principle, fail to lead to an agreement cannot be ruled out, in, late June or early July, the European Council will approve a definitive version of these country-specific recommendations, before the EU Council (ministers) adopts it formally. This will close the European Semester. Subsequently, the National Semester will open, during which Member States will have to, in view of aforesaid recommendations, finalise their Finance Bill and have it approved by their national parliament. Expected by the summer of 2013, the entry into force of the so-called Two-Pack 8 will for the first time this year give the European Commission the right to some extent to review these Finance Bills. Some of them will have to be presented to the EC before they are studied by national parliaments, no later than 15 October. The EC will have the right, if it deems they are not consistent with the policies announced at the beginning of the year, to release public recommendations. March 2013 Conjoncture 14

7 The European Semester Policy guidance to EU and euro area Country-specific surveillance Janurary February March April May June July European commission Council of Ministers Annual growth survey and alert mechanism report Debate and orientations In-depth reviews (imbalance procedure) Proposals for country-specific recommendations Discussion in Council formations Adoption of recommandations Autumn: monitoring and peer review at European level European Parliament Dialogue on orientations Dialogue on European council conclusions Dialogue on recommandations European Council Spring EU summit: overall guidance on EU priorities Endorsement of country-specific recommendations Member States Submission of National Reform Programme (NRPs) & Stability and Convergence Programme Autumn: implementation at national level Diagram Source: European Commission March 2013 Conjoncture 15

8 The results are presented in Table 1 page 17. Charts 5 to 10 illustrate these findings for a selection of Member States. Data covering 2012, nominal, cyclical and structural deficits and debt ratios, are not definitive, and are those estimated by the European Commission. To calculate measures iv and v, furthermore assumptions about growth prospects in the medium term in various economies of the eurozone have to be made. These forecasts are obviously tricky, while they have a decisive impact on the picture given by criteria iv and v of the solvency of a State, and therefore have to be used cautiously. Bear in mind that the purpose of this Table does not consist in providing a detailed analysis of the solvency of each Member State: as that would require in particular carrying out projections under various sets of hypotheses, and widening the scope of our analysis. Instead we try to give an overall picture of the eurozone s situation by focusing on the objectives Europe has set itself in the fiscal field. The hypotheses drawn upon, as well as the detailed description of the calculations made are presented in the Appendix. Update What lessons can be drawn from these data? Since 2009, the improvement in the structural deficit has exceeded 2.5 pp of GDP in France, Italy, Slovenia, Spain and Ireland, exceeded 4 pp in Portugal, and more than 14 percentage points of GDP in Greece. This improvement has not been counterproductive, in the sense that it would have resulted in larger deficits. Among peripheral countries, however, Greece seems to be a unique case and has recorded, during the last three years, a marked deterioration in the cyclical component of its fiscal deficit, pointing to a real crowding-out effect of fiscal consolidation measures through the meltdown of activity. In Spain and Portugal, this deterioration has been relatively weak. The contrast is nevertheless striking with the core countries (Austria, Belgium, Finland, Germany), where the improvement in the fiscal deficit is ultimately mostly of a cyclical origin. In the Netherlands, an economy belatedly hit by the bursting of its property bubble, the improvement is entirely of a structural origin, as in France and Italy. That said, filling the shortfall in growth would lead to an improvement in the budget balance of more than 1 pp of GDP in France and Slovenia 9, 1.5 percentage points in Italy, Portugal and the Netherlands, 2 percentage points in Spain and 6 percentage points of GDP in Greece. These gains, which might be recorded in a few years when the fiscal adjustment policies have run their course, are far from negligible in view of the structural efforts already under way as well as, in some cases, in view of the improvement in the budget balances needed to meet European criteria. With regard to these criteria, 8 Member States out of 17 (including Italy), had lowered their fiscal deficit under 3% of GDP already in As Chart 3 shows, the mere return of growth would enable the Netherlands to join them and would make their task far easier for the French, Portuguese and Slovenian governments. Cyclical part of the deficit & the fiscal improvement required to bring deficit back to 3% of GDP 6% Back to 3% inverted scale -6% 4% Cyclical deficit -4% 2% 0% -2% -4% Germany Estonia Luxembourg Finland Malta Italy Belgium Austria Euro area Netherlands Slovenia France Slovakia Portugal Cyprus Greece Spain Ireland Chart 3 Source: Table 1-2% Meeting the other targets, and in particular those recently added to the European arsenal, will take more time. In the Table, we have greyed out the cells for which the required improvement in the deficit is negative (target met under our hypotheses) or lower than 0.5 pp of GDP. We have used a bold type in the cells where challenges remain substantial, requiring an improvement in the deficit of more than 3 percentage points of GDP. Stabilising the public debt ratio is probably the first objective Member States should set themselves in the fiscal field. Few of them are already able to do so: Germany, Estonia and Malta. Nevertheless, the deadline is drawing closer for several others, for which the required improvement is lower than 2pp of GDP, and could be partly covered by a return of growth: Austria, Belgium, Italy clearly; France and the Netherlands as well. 0% 2% 4% March 2013 Conjoncture 16

9 Situation reached in late 2012 Fiscal deficit Debt ratio Improvement, from 2009 to 2012, of the [ ] part of the deficit % of GDP nominal structural cyclical cyclical structural Austria Cyprus* Estonia Finland France* Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain* Eurozone Gap between current position and the deficit required to Lower Stabilise the debt ratio Comply with the 1/20 th rule % of GDP the nominal deficit to -3% the structural balance to.-5% in the medium term as early as 2013 in the medium term as early as 2013 Autria Belgium* Cyprus* Estonia Finland France* Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain* Eurozone Table 1 Sources: European Commission and BNP Paribas calculations The nominal deficit differs from the sum of the structural deficit and of the cyclical deficit. See Note at the end of the document (4). Greyed-out cells indicate that an objective has been met, or virtually met. Figures in bold indicate that a substantial improvement is still necessary. (*) Excluding the impact of bank recapitalisations on the deficit of In Spain, this amounts to 3.2 pp of GDP. Belgium (0.8 pp) and France (0.1pp) are waiting for a decision from Eurostat with respect to Dexia. For Cyprus, the amounts are still uncertain. March 2013 Conjoncture 17

10 Undoubtedly, the European objectives with regard to a structural balancing of public finances (less than 0.5% of GDP) and of a significant reduction in debt ratios (1/20th) will need more time, in particular for the most heavily indebted countries. For these criteria are particularly demanding for said countries, as they have to generate a huge primary, more or less equivalent to their interest expenses for the first objective. As the data in the last columns of the Table show, reducing in the long term the public debt ratios of certain troubled States (without even mentioning Greece) is unrealistic if their economies do not renew with sustained and lasting growth. Cyclical part of the deficit & the fiscal improvement required to stabilize/reduce the debt ratio in medium term 8% stab. debt inverted scale -8% 1/20 th rule 6% cyclical deficit -6% 4% 2% 0% -2% Estonia Germany Luxembourg Finland Malta Austria Slovakia Slovenia Belgium Euro area Netherlands France Italy -4% *out of scale 4% Chart 4 Source: Table 1 A few specific points of interest Cyprus Portugal Ireland Spain Greece* -4% -2% Once more, our study does not aim to draw a conclusion about the solvency of eurozone governments taken one by one and lacks the scope to do so. Nevertheless, in our opinion, a few points should be highlighted. The data confirm the robust health of public finances in Germany, as well as in Finland and Luxembourg. These countries meet all, or virtually all, the criteria that have been set. Thus, there is an imperative need that fiscal policy should no longer be restrictive in these economies. Fortunately, this will likely be the case in 2013 in Germany. According to these criteria, the situation of Italian public finances seems fundamentally healthy, and finally quite comparable to that prevailing in the Netherlands and France, with each one of these economies displaying different strong and weak points. For instance, with a deficit already lower than 3%, Italy could easily stabilise its debt ratio in a more positive 0% 2% growth environment: by 0.8% in our medium-term hypotheses, versus the 1.0% deterioration expected in In France and the Netherlands, despite a smaller debt and more upbeat growth prospects (cf. Appendix), structural efforts are still needed. From a strictly fiscal viewpoint, the challenges facing Ireland remain about as daunting as in the other countries that are struggling badly. Obviously, the greater confidence now enjoyed by the Irish economy, both in the markets as well as among rating agencies, mostly results from the fact that growth has made a comeback in Ireland for two years now, and is set to last. Nevertheless, some of our criteria (those relative to the dynamics of the debt) include these differences, both in the near and the medium term. We believe that another explanatory factor may consist in the fact that the adjustment strategy chosen in Ireland, with the Troika s approval, was different. Probably because Ireland was already an extremely flexible and small economy, the strategy began with a macroeconomic adjustment and an internal devaluation that enabled it to renew with growth. Until now, the fiscal adjustment has been limited. The greater confidence in Ireland s prospects, in our opinion, may also be based on the idea that this adjustment will be easier to implement in an economy enjoying growth. Lastly, Greece s situation deserves a word. According to the European Commission s estimates, Greece s structural deficit probably did not exceed 0.5% of GDP last year despite interest expenses of more than 5 percentage points of GDP versus a cyclical deficit of 5.9% of GDP. Absorbing this growth shortfall should therefore immediately become the priority of any policy conducted in Greece. By contrast, our calculations clearly show that reining in the public debt will in any event require new efforts from public creditors, as the Europeans have already pledged at the end of last year. Outlook According to the European Commission, 2012 will have been the year in which structural efforts aimed at reducing deficits will have been the most significant, at the scale of the eurozone. After improving by 1.5pp in 2012, from -3.6% to -2.1%, structural balance will likely contract by no more than 0.8pp this year, to -1.3%. This respite will likely lead to something of a recovery in activity during It will mostly result from the interruption of consolidation measures in Germany and March 2013 Conjoncture 18

11 Overview of fiscal positions... cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% Chart 5 NETHERLANDS from 2009 to structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule 0% 1% 2% 3% 4% 5% 6% 7% BELGIUM 0% 1% 2% 3% 4% 5% 6% 7% cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% Chart 8 from 2009 to structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule FRANCE 0% 1% 2% 3% 4% 5% 6% 7% cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% Chart 6 from 2009 to structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule ITALY 0% 1% 2% 3% 4% 5% 6% 7% cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% Chart 9 from 2009 to structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule IRELAND 0% 1% 2% 3% 4% 5% 6% 7% cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% Chart 7 from 2009 to structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule SPAIN 0% 1% 2% 3% 4% 5% 6% 7% from 2009 to 2012 cyclical structural potential cyclical improvement Fiscal improvement required to: -fiscal deficit at 3% -structural deficit at 0.5% -stab.debt ratio -stab.debt ratio in 2013 th -respect 1/20 rule Chart 10 Source: Table 1 March 2013 Conjoncture 19

12 their slowdown in Italy: structural balance up 1.3pp in 2013, after +2.3pp. Conversely, the pace of consolidation should remain unchanged in France (+1.3pp after +1.2pp), Spain (+1.2pp after +1.4pp) and the Netherlands (+0.9pp after +1.1pp). Overall, the consolidation drive is set to remain significant in many countries. Nearly everywhere, they should be partly countered by a further increase in cyclical deficits (Chart 11). Fiscal improvement expected in % 3% 2% 1% 0% -1% Chart 11 Slovenia Malta Germany cyclical others Belgium Portugal Estonia structural total Finland Ireland Austria Netherlands Luxembourg Euro area (17) Italy France Cyprus Slovakia Greece Spain Source: European Comm. (Winter 2013 forecast) Under the European Semester (cf. Inset 2), the European Commission will have to say, by late May, whether it believes these policies comply with European commitments. This year it should announce the closing of the excessive deficit procedure against Italy. If current forecasts are confirmed, Austria and Belgium might also be concerned. In Belgium, where complying with the debt ratio reduction (1/20 th ) rule will be a huge challenge, requiring to free up initially around 2.5 additional pp of GDP according to our calculations, (cf. Note n o 6 at the end of the document). Reportedly, the EC has already indicated that the consolidation pace forecast in 2013 (+0.5pp) was not fast enough. Among the members of the eurozone still facing an excessive deficit procedure, only Spain, Portugal, Ireland (2015) and Greece (2016) have until 2014 or later to lower their fiscal deficit under 3% of GDP. The issue of whether this objective should be postponed until after 2013 clearly arises for France and Slovenia, the Netherlands and Slovakia. To approve, or not, these overruns, the Commission will take into consideration the corrective measures implemented in 2013 and 2014, such as they will be presented to it in the stability programmes Member States are currently drafting. Cyprus should, for its part, be set a new target adjustment trajectory when its financial support plan is finalised, and this is expected to occur during H Fiscal consolidation was the eurozone s initial response to the sovereign debt crisis. The fact that it cannot be a solution of the crisis on its own is now accepted to a large extent. Nevertheless, the objective of carrying out a massive reduction in fiscal deficits throughout the eurozone, all the more rapidly when countries suffer from market mistrust, remains a key component of the strategy approved by the Europeans (Heads of State and central bankers). As the eurozone has been mired in recession for more than a year, the desirable pace and magnitude of fiscal consolidation remains a controversial issue and opinions voiced in this debate have remained virtually unchanged for three years. The value of the multiplier, which measures the impact of this policy on activity, is uncertain and depends on numerous factors: monetary policy constraint, phase of the cycle, type of measures implemented and whether they are temporary or permanent, etc. This is the first reason why deficit reduction targets in nominal terms have to be discarded. Precisely, this year the European Commission, after having adjusted its approach on a case-by-case basis for Portugal or Spain last year, will have to stop being ambiguous and acknowledge that the objective of cutting the deficits to 3% in 2013 for all is hardly sensible. The EC must set for each country an appropriate pace of structural consolidation, and avoid accepting the setting of endlessly moving targets. Furthermore, it is well known that changing over to assessments in structural terms is hardly problemfree either. Debates between economists might be heated and the effect on government budgets significant. In this regard, the European Commission s capacity to justify and impose its own assessment will also be decisive. 4 March 2013 frederique.cerisier@bnpparibas.com March 2013 Conjoncture 20

13 Appendix: medium-term hypotheses and dynamics of public debt ratios Debt in year t is equal to the debt already accumulated in the previous year, increased by interest expenses due, from which redemptions or the share of interest expenses that can be paid by a possible primary surplus are deducted. In other words, at date t, the stock of a State s public debt verifies the following relation: D D i D SP S t t 1 t t 1 t t 1 t with D standing for the nominal stock of debt, i the nominal interest rate and SP the primary budget balance, i.e. current expenditure current revenues, and S the total budget balance (primary balance interest expenses). By denoting d and s the variables expressed as a percentage of GDP, and g the economy s nominal growth rate, we rewrite this equation: 1 d d s t t 1 t 1 gt We can then calculate the increase in the public debt ratio from just the nominal growth rate of the economy and the deficit: g t dd d d d s g d t t t 1 t 1 t t t 1 g ( t t 1 t t t 1 t t The balance that would stabilise the debt ratio d d ) is therefore equal to: s g t t d g d t (1 ) t t 1 t And the balance that would comply with the 1/20 th rule: (60% dt 1) s gg t t dt 1 20 In Table 1, these indicators are calculated both with the nominal growth rate expected in 2013 (European Commission s winter forecasts), and under a hypothesis of medium-term nominal growth, which we expect to be close to the nominal growth rate eurozone countries might record in the next few years, once the current episode of drastic fiscal consolidation is over. To define these hypotheses, we draw on the average, over the period of the projections of the IMF s World Economic Outlook dated October The Table below presents these hypotheses: s Set of hypotheses drawn upon for the calculations of Table 1 IMF prospects, average 2013 forecasts of the European Commission As % Real growth GDP deflator Nominal growth Real growth GDP deflator Nominal growth Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain Eurozone Table 2 Sources: IMF, WEO October 2012, European Commission 2013 Winter European Economic Forecast March 2013 Conjoncture 21

14 NOTES 1 Will it hurt? Macroeconomic effects of fiscal consolidation, World Economic Outlook, October 2010, Chapter 3. For a summary of the debates at that period in time about the size, and even on the sign, of the multiplier of public finances, see the following article in the ECB s July 2010 Monthly Bulletin: "Efficiency of fiscal policies in the euro zone". 2 See box 1.1 Are we underestimating short-term fiscal multipliers? by Olivier Blanchard and Daniel Leigh, p41, WEO October 2012, IMF. For a more in-depth analysis, see Blanchard, O. & D. Leigh Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper 13/1. 3 See The role of fiscal multipliers in the current consolidation debate, Box 6, ECB Monthly Bulletin December 2012, pp82-85 and Forecast errors and multiplier uncertainty, Box 1.5, European Commission, European Economic Forecast, Autumn See «Une revue récente de la littérature sur les multiplicateurs budgétaires : la taille compte!», ( A recent review of the literature on fiscal multipliers, size matters! ), Heyer E. p p. 5 The structural deficit published by the European Commission differs from the traditional deficit corrected for cyclical changes, because it does not take into consideration one-off developments weighing on the deficit. This concerns the cost of bank recapitalisations, but also any measure that has only a temporary impact temporary on the deficit. This is the reason why the nominal deficit estimated for 2012 is not equal to the sum of the structural deficit and of the cyclical deficit. Likewise, the change in ces two deficits, from 2009 to 20012, differs from that in the total deficit The Two-Pack is a regulatory package that applies only to Member States of the eurozone. The first regulation deals with enhanced surveillance and the assessment of draft plans. It should make it compulsory for Member States to base their fiscal planning on independent growth forecasts. Every year, Member States would have to present to the Council and the Commission, no later than on 15 October, their draft fiscal plan for the following fiscal year. Tighter control would be applied to Member States against which excessive deficit procedures have been opened, in order to enable the Commission to better ascertain whether there is a risk of non-compliance with the deadline set to correct the excessive deficit. The EC could release an opinion and, in serious case, request changes. A second regulation will organise the enhanced surveillance of Member States receiving financial aid (EFSF/ESM). After very long negotiations, an agreement was reached in February between the European Parliament and the Council as to when these regulations will enter into force. 8 This rule forces a Member State to reduce its public debt all the more rapidly the higher the debt ratio is. For instance, a State with a debt ratio of 100% of GDP will have to cut its debt by 2pp of GDP per year. As its debt shrinks, the constraint loosens and the deficit required to meet this criterion gradually declines. 9 As in Finland, but the country is not concerned by the need to adjust its public finances. March 2013 Conjoncture 22

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