A wider perspective

At present there is much debate on the shape and direction of fiscal policy. The governments of the three biggest European countries have recently presented their draft budgets, while Parliamentary debate has started and will lead, with different degrees of difficulty and speed, to the final approval. Just to give a snapshot on timing, draft budgets were issued on 4th July by the German government, 29th September by the Italian government, and 26th September by the French government. Final approval should be given before the end of November in Germany, and before the end of the year in the other two countries. All three have been subject to excessive deficit procedures in the recent past. ED procedure was launched in January 2003 and cancelled in early summer 2007 in Germany, while in France it began in June 2003, and was cancelled in January 2007. In Italy the procedure began in July 2005, although it would have been launched earlier had the actual data been known in due time (there was a significant upward revision of deficit data in 2006). The ED procedure here is likely to be cancelled towards mid-2008, if everything goes well. The graph below shows the three countries’ current situation and the prospects envisaged by their draft budgets. A quick look at the picture below suggests that Germany is proceeding much more decisively towards balancing its budget (within reach already in 2007), while Italy and France have taken a more relaxed stance. However, the trends are similar on the whole. Nonetheless, if we scrape the surface, a lot of questions emerge.

graph_400.jpg

Obviously, recent economic performance has a lot to do with 2006-2007 results in Germany: higher than expected growth with healthy corporate profits and a huge reduction in unemployment played a big role in easing pressure on public accounts. Also there some observers are concerned that fiscal policy is turning pro-cyclical again (expanding in good times and restricting in bad times). In general, the elasticity of revenues to GDP growth has been remarkably high in all these countries in recent years, but particularly in Germany, thanks to the huge increase in revenues from corporate taxes, and in Italy thanks (probably) to the increase in tax compliance following government efforts to combat the country’s historically huge degree of tax evasion.

While an external observer would tend to consider the German budget as an orthodox one (banking on good times to balance the budget), the main criticism of the Italian budget is that it does not introduce enough measures to reduce current spending, and that it could have been more aggressive on reducing the deficit, given higher than expected tax revenues. Some observers have also said that the French budget is not rigorous enough. Looking at the macroeconomic forecasts behind these public targets, we see that Germany’s draft budget is based on a 1.75% per year growth projection, Italy’s on a cautious 1.5% in 2008, slightly improving thereafter, and France’s on a regular path of growth in the 2-2.5% range.

We can summarize the three countries’ different approaches as follows: Germany: stick to the target whatever happens Italy: stick to the path towards the target whatever happens France: stick to the path towards the target provided that …

Looking at details there are considerable similarities, for example in the reform of corporate tax in Germany and Italy, both effective from 2008. Nominal tax rates have been sharply reduced (especially in Germany) in exchange for a widening of the tax base, including a reduction in the deductibility of interest payments. Obviously there is a relevant issue here in terms of harmonization of taxation at European level.

Nonetheless, and despite the first impression from the graph, the relative positions in late 2008 when deciding the budget for 2009 will be fairly different. Italy and France will have to look for other resources, given some political constraints on available measures in terms of the breakdown of expenditure cuts or tax hikes.

Let’s make a purely hypothetical scenario in which an unexpected crisis occurs and world growth slows heavily. Let’s say that each of the three countries’ growth rate in 2008 is one full percentage point below the consensus forecasts. The final outcome will be that Italy and France, given the elasticity of their budgets to growth (see OECD WP 434) and the distance from growth level projected for planning purposes, will likely post deficit/GDP ratios of around (the former) or above (the latter) the 3% limit, while Germany could well stay on course. And policy reactions will be different once again, contradicting the idea that in a monetary union fiscal policy should be used to counteract local one-off shocks and should become more regional than national. There is an interesting EU Commission paper (economicpapers287) which suggests that synchronization in the Euro area has increased, but that it still tends to diminish after the business cycle has hit a trough. Varying fiscal policy approaches will therefore emphasize this tendency in such a situation, making the ECB’s job more difficult.

Conversely, let’s assume that the turmoil in the financial markets disappears without any major consequences, and let’s adopt a wider perspective. At the end of the process each of the three biggest countries in Europe would have a balanced budget, while their bond issuances would be lower than in 2006 by a total amount of around 140 bln Euros. And let’s think again about what happened to the financial system in late summer. One interpretation is that the turmoil was due to the fact that there is too much liquidity with too few real assets to support, causing an almost-rational non-smooth transition from one bubble to another. If this is true, why can’t we imagine a European agency taking care of supranational problems (the most obvious being environmental issues such as Kyoto compliance-related expenditures), and coordinating efforts at European level for which each member state would provide funding, issuing bonds for the purpose?

2 Responses to "A wider perspective"

  1. Guest   October 19, 2007 at 6:05 am

    A very good analysis. But i am not sure that issuing EU-wide bonds just for the sake of creating a supply of bonds given the liquidity sloshing around is a good idea. If that issuance of bonds can be justified based on fiscal spending needs at the EU level it would be another story.

  2. Lyle   October 19, 2007 at 4:59 pm

    “We can summarize the three countries’ different approaches as follows:
    Germany: stick to the target whatever happens
    Italy: stick to the path towards the target whatever happens
    France: stick to the path towards the target provided that …”

    That is a brilliant statement. But which political or fiscal institutions explain this differential fiscal policy approach?