Europe’s slow growth and wobbly commitment to fiscal stability

Date: 17/10/02

By Daniel Gros

When it comes to preparing for leaner times ahead, larger EU countries can learn lessons from their smaller neighbours.

TOUGH economic times expose weakness in economic policymaking. This axiom is being demonstrated by the recent faltering by key eurozone members in their commitments to the Stability and Growth Pact.

When did this problem begin? The real starting point must have been the failure or lack of foresight on the part of the economic authorities to use the good times of 1999-2000 to bring down structural deficits. But bygones are bygones.

The question we face today is what can and should be done now? Should the 3 upper limit on deficits be discarded? Should France be allowed to increase its spending and disregard the commitment to cut at least the cyclically adjusted deficit?

The Stability and Growth Pact was invented to make fiscal policy sustainable, which was clearly needed in view of the rising share of public debt as a proportion of GDP year after year. There is little disagreement over the need to stabilise debt/GDP ratios at reasonable levels.

This is also the reason why the 3 upper limit on deficits makes sense and is not really disputed at the political level. This part of the Stability Pact is thus safe.

But what about all the rest? The commitment to a balanced budget over the cycle resulted from the desire to create some room for manoeuvre in response to cyclical variations in growth.

A number of observers have correctly pointed out that this commitment to a rough balance over the cycle implies that the debt/GDP ratio should tend towards zero.

This is certainly more than is needed to make fiscal policy sustainable. But even if not strictly necessary, it still makes economic sense in view of the rapid ageing of the European population and the concomitant increasing burden on public pension systems.

This is not just a problem for some distant future. Ageing is already influencing social security budgets and will have very strong impact by the year 2010, when a large number of the present workforce will be in the 55-65 age group.

In most eurozone countries, employment rates in this age class are extremely low. This implies that over the coming years an important percentage of the workforce will retire early, thus reducing the tax base and increasing the pressure on expenditure.

Against this background, it makes a lot of sense to prepare public finances for the even leaner years ahead. The medium-to-long-term fiscal problems resulting from ageing are widely acknowledged. But could one not argue that a large part of the fiscal problems today are related to an unfavourable business cycle?

This might actually be an optimistic view. Recent work at the Centre for European Policy Studies (Fiscal and Monetary Policy for a Low-Speed Europe, 4th CEPS Macroeconomic Policy Group Report, June 2002) has shown that the potential growth rate of the eurozone is declining, due primarily to the fact that productivity growth has slowed to a snail's pace in Europe (while it has accelerated in the US).

Productivity is a slow-moving variable and the exact numbers are available only after a delay of several years. There can nevertheless be little doubt that productivity growth is now significantly lower than it was ten years ago, when the Maastricht Treaty was signed. During the 15 years leading up to 1990, labour productivity growth had been increasing at 2.3 per year.

During the 1990s, this measure of productivity decelerated and is now running at 1.3-1.4, a decline of almost a full percentage point. Moreover, there is no reason to hope for a quick rebound (as happened in the US over the same period).

That potential growth might have declined is not admitted by most policymakers. Their view, clouded perhaps by a professional optimism, is that the problem today is that growth is below potential and the task of monetary and fiscal policy is to get it back to its full potential. This view implies that fiscal (and monetary) policy should be actively used now to correct a cyclical weakness in demand.

But the data on productivity suggest that the reality might be more sombre. If Europe's problems are not cyclical in nature, but rather have arisen as a result of a fall in potential growth, the policy prescription has to be different.

If long-term growth prospects have diminished, fiscal and monetary policy has to adjust to this fact. Demand management can then do very little (but supply policies should be activated).

The decline in potential growth has two immediate implications for how one judges fiscal policy: a first implication is that current estimates of structural balances are too low. Given that the share of general government in GDP is around 50, every percentage point of lower potential growth implies an overestimate of structural balances by 0.5 of GDP.

For example, if potential growth is in reality 1, one percentage point lower than the officially assumed 2.5 per year, then the deficit of 2001 might have actually been almost totally structural and not cyclical as often assumed.

A second implication of lower potential growth pertains to the sustainability of debt levels. If potential growth is as low as 1.5 and if the European Central Bank achieves an average inflation rate of 1.5, the maximum allowable deficit to keep public debt at 60 of GDP is only 1.8 of GDP (not the 3 as assumed under Maastricht parameters). The ongoing productivity slowdown in Europe thus imposes some hard constraints on fiscal policy that have not been sufficiently recognised so far.

It is interesting to note that it is mainly the large countries that have a problem with fiscal policy. All the big eurozone countries (France, Germany and Italy) are currently violating or close to violating their commitments, whereas most of the small countries (with the notable exception of Portugal) have been able to stick to their commitments.

The reason for this is quite clear. Eight 'virtuous' small eurozone countries were able to cut expenditure on average by around 1.5 of GDP over the past three years (more than would have been required by the new approach), whereas the three large members and the sinner Portugal were not able to manage even one-third of this.

It is thus not surprising that the deficits are under control in the smaller eurozone countries. It seems that the body politic of the smaller countries has been quicker to realise that leaner times are ahead.

What is the most likely outcome at his point? The row over the narrowly averted early warning to Germany neatly illustrates the first rule in EU affairs: never collide with the vital interests of a large member country.

And ensuring one's re-election always counts as a vital interest. This rule was evident in the agreement reached over the unpleasantness between the Commission and Germany concerning the latter's plan to send Germany an early warning that the country was getting too close to the 3 limit on public-sector deficits.

In the end Germany was let off the hook, but not before agreeing to a tough convergence programme in which it promised, pretty much unconditionally, to achieve a budget 'close to balance' within only two years.

The elections are now over, the gloves are off and there is hope that the majority of small countries, which have made good progress, will succeed in bringing the larger countries back to reality.

• Daniel Gros is the director of the Centre for European Policy Studies, Brussels (www.ceps.be).

Major analysis feature. Author is director of the Centre for European Policy Studies.

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