The fiscal stance in Europe in a period of economic slowdown (29 August 2001)

The budget targets of the Stability and Growth Pact (SGP) set a narrow and precisely defined framework for fiscal policy. The question is whether cyclically caused budgetary over- and undershooting of the predesigned medium term path to balanced budgets should be accepted or whether they necessitate correction.

Cyclical fluctuations can be defined as fluctuations in the utilisation of the production potential. Questions regarding the business cycle therefore relate to the demand side of an economy. They must be clearly distinguished from the (structural) factors that affect the supply side. Supply-side conditions determine the long-term growth path whereas demand-side conditions cause short-term fluctuations around this growth path. This distinction is fundamental for the specifics of fiscal policy.

The objective of the SGP is to ensure a stable and sustainable fiscal policy, i.e. a policy oriented towards prosperity and stability, designed to enhance supply-side conditions in Euroland. Low government debt and correspondingly low interest commitments result in a low burden on the capital markets and on taxpayers, it frees saving for more productive private sector use. Solid fiscal policy is thus a precondition for economic dynamic and growth. This approach is sound and the policy of budget consolidation should therefore be continued.

If macroeconomic demand expands sustainably stronger than capacity grows and fiscal policy would not act to correct, the result will be inflation; if demand growth falls sustainably short of the potential growth rate and fiscal policy would be neutral, unemployment would result. Governments can respond with a pro-active anticyclical fiscal policy or simply allow the automatic stabilisers to take effect. The term ‘automatic stabilisers’ is used to describe the stabilising mechanisms triggered automatically by changing revenues from income tax and cyclically dependent expenditures in unemployment benefits. They reduce cyclical fluctuations. When the economy is booming, tax revenues are high because of rising employment and disproportionally increasing personal incomes. This implies that income is withdrawn from the private sector, which means that demand expansion is reduced and prices are stabilised. Just the opposite happens in an economic slowdown: unemployment benefits increase and tax revenues decrease. Both of these effects support private consumption, thereby smoothening the business cycle.

If the automatic stabilisers were not allowed to take effect, this would amount to a pro-cyclical fiscal policy as, in a recession, public expenditures would be reduced in line with the fall in tax revenues. In a booming economy, spending would be increased to avoid budget surpluses. In order to prevent this, the automatic stabilisers must be allowed to take effect. This implies in 2001/2002 that the resultant budget deficit widening must be tolerated.

Allowing the automatic stabilisers to work does not lead to a deviation of the trend toward balanced budgets (over the cycle), because it also implies that during an economic boom state spending will be reduced (additional tax revenues should lead to a reduction of public debt and lower unemployment deficits). This symmetry must be maintained. Experience shows, however, that it is politically more difficult to reduce deficits: in economic good times there is no pressure for reforms and the general public sees no reason for belt-tightening. During the last boom the governments failed to use the opportunity to improve the public finances.

Factually the intention of a pro-active anticyclical policy often ends up having a pro-cyclical effect since in most cases it takes effect too late. It also reduces the compulsion to undertake structural reforms and it imposes a lasting burden on the public finances. The growth effects of an intended anticyclical fiscal policy are therefore n egative in most cases.

The automatic-stabiliser mechanism logically implies a deviation from the planned path of budget consolidation. The headline budget balances targeted in the national stability programmes submitted each year should therefore be super imposed by a cyclical component. The consolidation efforts of all member states could then be controlled in a more meaningful way. Unfortunately, there are several problems in defining the cyclical effects with scientific precision, and it would be more difficult to communicate such a cyclically adjusted rule. The scope provided by target corridors is used only too often for purposes other than those for which it was originally intended. The distinction between automatic stabilisers and anticyclical fiscal policy may not be easily drawn. In fiscal policy, as elsewhere, the principle of strict adherence to commitments (regarding discretionary measures) is an important factor to ensure credibility, in itself an important factor for guaranteeing good economic outcomes.

A loosening of the stability targets of individual countries must be avoided. Permanent public deficits and government debt would push up interest rates, and hamper investment by crowding out private demand for capital. In addition, fiscal flexibility is reduced. The automatic stabilisers, on the other hand, increase budget deficits only temporarily and can therefore be permitted. It would be very helpful if the calculation of cyclically adjusted budgets would be done by somebody else but the national governments. Perhaps the work done at the OECD could be made use of as an important observer. Allowing somewhat higher deficits in 2001/2002 in countries with stick to high deficits and debts and to a high government share in GDP (like Italy, France, Germany i.a.) would cause little trouble if combined with reforms that will help to reduce deficits over the medium term. Efforts must concentrate on reducing subsidies, increasing the efficiency of social expenditures, and continuing the reform of pension systems. The next economic recovery must be used for basic reforms that strengthen the supply side of the national economies and consequently enhance the conditions for growth.