Contrdictions in the Fiscal Sustainability

The Fiscal Sustainability Report 2015 of the European Commission (Institutional Paper no. 18, January 2016), presented to the Council and the European Parliament, is a document of more than two hundred pages, with a mass of data, tables and graphs. The goal is to present an overall picture of public debt sustainability in short term (essentially the current year), medium-term (a ten-year period), and finally the long term (from 2027 on). Cyprus and Greece, submitted to the programs of the troika, are not considered. Countries are classified into three levels of risk: low, medium and high. While in the medium term the main factors consist of the debt ratio and the dynamics of the deficit, in the long-term demography, especially the aging population (and therefore pensions and long-term care) plays the most important role.

While in the short term and all twenty-six countries are considered at low risk, 11 countries are considered at high risk and 5 at medium risk in the medium term; one country is considered at high risk in the long term, and 14 at medium risk. Slovenia is therefore at high risk both in the medium and in the long term, while Belgium, Finland, Romania and the United Kingdom are at high risk in the medium and at medium risk in the long run. All countries, except Hungary, which have a medium risk in the medium term, have a medium risk also in the long term.

Countries in italics are present in two boxes. As you can see Ireland, Spain, France, Croatia, Italy, Portugal, who are considered high risk in the medium term, go down at low risk in the long run. Only four countries are considered at low risk both in the medium and in the long term (Germany, Denmark, Estonia, Latvia), as well as, of course, in the short. This classification of the Commission is surprising. Suppose that in Germany the government decide that only low-risk countries, in the short, medium and long term, be worthy to have a common currency; in this case they would find themselves with only Denmark and two Baltic countries. Suppose instead that you want to focus on long-term and low-risk countries: well, in this case Germany finds itself with France, but also with Italy, Spain and Portugal, but not with Austria, Belgium, Finland and Netherlands.

There are many observations that one could made to the Commission’s report; just think of how to assess the effects of immigration on the aging trends of European countries in the long run. But here we can limit to indicate two points in particular. The first is a statement that can be found in the introduction:

Whilst high public debt was not at the origin of the crisis in most euro area countries, lack of fiscal space at the outset prevented proper use of fiscal policies and we have to face now higher public debt levels due to the effects of the crisis.

So the reasoning is as follows: it was not the public debt that caused the crisis, in most European countries (in fact in no one except Greece); But the countries have not been able to make expansionary policies because deficits were too high (lack of fiscal space), and we now have the highest public debts, and then we have to make restrictive policies to reduce the debt and establish a sound budget (that is, bring in balance public budgets), so that we will have more fiscal space to utilize when the next crisis comes:

Sustainable public finances, and smaller public debt burdens in particular, remain important elements to ensure that EU countries have sufficient fiscal space to cope with adverse macroeconomic developments over the economic cycle. The conduct of fiscal policy should therefore importantly ensure that buffers are built in good times to be ready to be used to support the economy in bad times.

The second point concerns the relationship between public debt and growth (par. 5.5 Public debt, fiscal consolidation and growth); it is assumed that in the short term the Keynesian effects dominate (an increase in the deficit increases the GDP, a decrease decreases it) but it is assumed that in the long run the relationship is negative:

Overall, this new set of empirical evidence appears broadly in line with the neoclassical view that in an economic environment, such as the one prompted by a crisis or zero lower bound conditions for monetary policy, government spending (an increase in debt) can stimulate aggregate demand and GDP in the short run in a Keynesian manner, while crowding out capital and reducing output in the long run.

The Report cites two articles[1] [2] that argue that fiscal expansion can have a positive effect in the long run, but considers the analysis unreliable. This theme could give rise to many considerations, but it is interesting to note that, having admitted that in the short term a restrictive fiscal policy decreases production, the Report indicates an average value of the multiplier of 0.75. So one percentage point increase in the primary surplus reduces the GDP of 0.75. It is not worth very encouraging; in the Italian case this would mean that a cut of a point of GDP would reduce the debt-to-GDP from 133% to 132,8 or 132,9% (depending on the rate of inflation assumed).

But apart from that, the interesting thing is that the value of the multiplier is taken from a recent article[2] [3] by two Commission officials. Now when a Commission’s economist writes an article, preliminary there is the usual disclaimer: “the paper do not involve the Commission”. Which adopts, however, the value of the multiplier; but according to what the same Report (Table 5.10) refers, the two authors indicate values between 0.8 and 0.9  (good times), and between 0.9 and 1 (bad times). To return to the Italian case, a multiplier of 0.9 means that a tightening would increase, not decrease, the debt-to-GDP.

Not only that, but the authors oppose to the method of calculation of the structural surplus their own method (discretionary fiscal effort), concluding that:

the discretionary fiscal effort suggests that, with exceptions, fiscal policy in the EU has been conducted in a more stop and go and pro-cyclical fashion over the past ten years than suggested by traditional indicators. In recent years, in a context when most EU countries are tightening fiscal policy, the actual consolidation effort appears to be underestimated in many countries when assessed on the sole basis of the structural balance.

In conclusion, the ordo-liberalism is alive and well, but some glimmer of awareness is beginning to emerge in some papers, and, in a small extent, also in the official reports of the Commission.