The recent slowdown in growth in the eurozone is raising difficult questions for policymakers. If the current policy mix of modest fiscal stimulus and accommodative policies from the European Central Bank proves insufficient to boost growth, more radical measures may be needed.
In theory, the euro area has ample room to increase government spending and/or to cut taxes. With a fiscal deficit of just 0.5 per cent of gross domestic product and a public debt/GDP ratio of about 85 per cent, the euro area in aggregate has a sounder fiscal position than the US, the UK or Japan. It also faces a very low probability of incurring a situation of fiscal stress in which financial markets stop funding governments, or do so only at very high yields.
But the problem facing policymakers is that the aggregate position across the euro area conceals a great deal of variation across the bloc. A number of eurozone countries run structural government surpluses, while others run structural deficits. Public debt/GDP ratios also diverge significantly. Both points imply that “fiscal space”, or capacity to spend and/or to lower taxes without risking a period of fiscal distress, is distributed unevenly.
There is a good amount of space in countries that have already returned to full employment, but little or no room for fiscal expansion in countries that we believe need it most. Investors are well aware of this and are therefore pricing Austrian or Finnish government bonds differently from, say, Spanish or Portuguese ones. Across the eurozone spreads over German Bunds are wider and more dispersed than before the European sovereign crisis — a sign that the “bond vigilantes” are pricing fiscal risks in the monetary union more adequately.
With respect to fiscal space, our research shows that euro-area countries fall into three groups. Germany and many small euro-area countries have strong public finances and can boost spending without risking a period of distress. At the other end of the spectrum, Italy has little or no room for manoeuvre, as demonstrated by the economic and financial markets’ fierce reaction to the measures announced with the 2019 government budget. France, Spain and Portugal are in between; additional fiscal easing would probably come with increased borrowing costs that partially crowd out the positive impact on aggregate demand. What is less well understood by the market is how quickly a fiscal expansion can turn from a drizzle into a downpour by exhausting fiscal space in member states with high debt and low credit ratings.
All else being equal, we estimate that a fiscal expansion of, say, 2 per cent of GDP would increase our index of fiscal stress by very little in France, by a more sizeable but still not much more dangerous amount in Spain, but by a magnitude that would make the index jump to its highest level since 2012 in Italy.
If credit rating agencies were to respond by downgrading Italian sovereign bonds, it would probably lead to a period of fiscal stress for Rome. By contrast, in Spain and France, given the more favourable initial level of ratings, a downgrade would have less severe consequences. As such, a fiscal expansion of the same size could stimulate growth and be bullish for the equity and debt markets of countries with fiscal space — but could have exactly the opposite effect in countries with high debt and low ratings.
For countries with limited fiscal space that nevertheless want to boost growth via the use of fiscal policy, the only viable option is to use the kind of policy package that the ECB has consistently advocated: cuts in current government spending and income taxes, combined with increases in public investment.
If this still proves insufficient for euro area countries to avert a renewed downturn, bolder policy options might be necessary, especially in light of the likely escalation of anti-European sentiment that a recession would bring. The ECB would probably provide the first line of defence: its options include extending forward guidance, cutting interest rates further and re-initiating asset purchases. In the end, though, euro-area policymakers may also need to consider more radical fiscal measures.
These could involve debt mutualisation — pooling the debt of the individual euro-area countries so that it becomes a joint liability of all members. Or there could be a common fiscal policy funded by pooling member-country tax revenues; a “safe asset” bought by the ECB as a part of its asset purchase programme; or even a form of “helicopter money” that explicitly finances fiscal expansion via central bank credit.
None of these options is in our current baseline forecast. But if any of them were to be granted serious consideration it could be another “whatever it takes” moment for the euro area.
Silvia Ardagna is head of the Southern Europe economics team at Goldman Sachs