Euro zone can afford to keep fiscal taps running
LONDON, Jan 31 (Reuters Breakingviews) - In the past two years, European governments opened the fiscal faucets, flooding the euro zone with around 530 billion euros to combat the effects of the pandemic and Russia’s invasion of Ukraine. Now the spigots are closing. This outburst of austerity looks short-sighted. Government budgets and debt burdens are manageable. Finance ministers should use the extra funds to enhance growth, help lower-income groups and enact structural reforms. If they don’t overdo it, governments can also ease the blow of the European Central Bank’s efforts to tame inflation.
Many European citizens are still anxious about their utility bills. But euro zone leaders like Germany’s Olaf Scholz, France’s Emmanuel Macron and Italy’s Giorgia Meloni face pressure from economic policymakers to curb the handouts. ECB board member Philip Lane warned late last year that expanding budget deficits would lead to higher interest rates. Kristalina Georgieva, the International Monetary Fund’s managing director, also worries about the inflationary effects of government intervention.
Most central bankers concede that slowing growth and a spike in living costs demand public intervention. However, as ECB President Christine Lagarde likes to say, public stimulus should obey the rule of the “three Ts”: it should be temporary, targeted at specific shocks, and tailored towards society’s more vulnerable groups. Without these restraints, government spending would push up consumer prices or even lead to sovereign debt meltdown like the one the United Kingdom suffered last September.
European leaders appear to be heeding this advice. After expanding by 3.75% of GDP between 2020 and 2022, the euro area’s aggregate “fiscal stance” – a measure of the cost of discretionary policy actions taken by governments – will return to neutral this year, according to the European Commission.
Yet such stinginess looks misplaced when considering government deficits. The difference between state income and expenditures is narrowing. The Commission estimates that the euro zone aggregate deficit will be 3.7% of GDP in 2023. That’s closing in on the 3.5% level before the pandemic, and far below the 7% it reached in 2020.
Meanwhile, government debt is becoming more manageable. The bloc’s aggregate borrowings as a proportion of GDP will decline to 92% in 2023 from 99% three years earlier, helped by inflation which has pushed up the nominal value of economic output. It’s true that six countries – Belgium, Greece, Spain, Italy, France and Portugal – will still have debt exceeding one year of economic output. But of these only Belgium will see its leverage increase.
To keep public finances healthy, a government’s cost of borrowing – the average interest rate it pays on its bonds – should be lower than the increase in the resources available to service that debt, as measured by growth in nominal GDP. On this measure Germany, Spain, France and Italy are in the best position since at least 2001, according to a recent blog post by ECB staff. Even Italy experienced some of the best funding conditions in two decades in 2021 and 2022.
Granted, this benign environment will deteriorate in 2023 as inflation subsides and the ECB’s rate hikes push up bond yields. Yet funding conditions will remain favourable. Yields on 10-year Italian government bonds have trebled in the past year to more than 4%, but that rate only affects new borrowings. The average maturity of Italy’s debt is seven years, meaning that the country’s finance ministry needs to refinance only 14% of its debt each year.
As a result, finance ministers have an opportunity to prime the pump. If they simply keep discretionary spending at last year’s level, they would release around 175 billion euros. That is half of what European Commissioner Thierry Breton thinks the European Union needs to respond to the clean technology subsidies embedded in the U.S. Inflation Reduction Act. Alternatively, governments could use some of the money to help poorer people. As ECB board member Isabel Schnabel has noted, inflation in October was 2.2 percentage points higher for those in the lowest fifth of the population by income than for those in the highest quintile – the biggest gap since 2006.
Another option would be for governments to support the post-pandemic rebound in investment in Europe, which is growing faster than in the United States, according to the Organisation for Economic Co-operation and Development.
Such spending need not be inflationary. Though the ECB expects consumer prices will still be rising by 3.6% in December – above the central bank’s 2% target – government investment that boosts the economy’s productive capacity, such as structural reforms or green subsidies, should have only a limited effect on prices.
Bond investors are less predictable, especially in a bloc that experienced its own sovereign debt drama a decade ago, and watched the UK suffer a self-inflicted mini-crisis in government bonds last year. Yet ECB staff estimate that, even without fiscal tightening, the debt burdens of Italy, France and Spain would be sustainable until at least 2027.
Of course, governments must be aware of the limits of spending. If Italy’s debt-to-GDP ratio were to rise by 10 percentage points from its current level of 144%, bond yields would likely rise by 65 basis points. That would bring them uncomfortably close to the 5% level where investors might question the country’s ability to repay its debts, according to Capital Economics.
Yet these valid concerns are not a reason to reimpose austerity. As the ECB keeps a lid on growth to slay inflation, European governments can keep the fiscal taps open.
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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
The European Central Bank is putting pressure on euro zone governments to rein in fiscal spending. In speeches and interviews, senior ECB officials have criticised what they see as untargeted and excessive spending by governments. The central bank has warned that stimulus aimed at cushioning the blow of the energy price shocks on consumers and firms could stoke inflationary pressures, forcing the ECB to increase interest rates.
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