Euro zone public finances: an increasingly complex exercice

Growth and deficit forecasts are provisional for the time being. Where necessary, updates will be issued, along with brief comments, after the next Global Outlook meeting.

Coming out of 2007, public finances in the euro zone were in a relatively healthy state. Expressed as a percentage of GDP, the overall public sector deficit shrank from 1.3% in 2006 to 0.6%, its lowest level since 2000, when the sale of UMTS licence gave fiscal receipts a temporary boost. This situation is the result of several years of relatively strong growth. In addition, certain countries have continued to push through structural measures.  As a result, Germany balanced its budget for the first time since reunification. Portugal and Italy have also made changes and though still some way off balanced budgets have now taken the steps that will allow them, at last, to come out of the excessive deficit procedure. For a number of years now, all member states have undertaken to have reached balance in their public finances by 2010. Given current conditions, it is unlikely that all of them will meet their target, but the targets are clearly already providing a major source of motivation. At 0.7% of GDP in 2007, the euro zone deficit corrected for cyclical variations is at its lowest since the zone was created, and indeed for some time before that. The positions of the euro zone countries are rather spread out as they face the current economic slowdown. This is a positive factor both for growth prospects and fiscal management. Thus Germany could see growth at or even above long-term potential over the whole of 2008, whilst Italy is likely to see virtually no growth at all. Spain and Finland have substantial budgetary surpluses, whilst France, Greece and Portugal have no room for manoeuvre if they are to meet the European criteria. When these differences are aggregated, however, they could result in a slight worsening of the euro zone’s budgetary balance, with fiscal loosening in a few countries being partly offset by robust growth in some countries and the desire to control worrying levels of deficit in others. If the current slowdown proves particularly deep and long-lasting, it could result in a greater number of member states introducing economic stimulus policies in 2009. Graph 1 euro zone budget balance corrected for cyclical variations. 1991-2007 Source: OECD.  2007 in review The 2007 budget year was probably the last of the current cycle in which growth provided a natural source of reduction in budget deficits. As a result, the budget positions achieved last year probably mark a high point on which the current slowdown will now have its effects. According to Eurostat’s initial estimate, the euro zone’s public sector deficit narrowed by 0.7 of a point of GDP last year. Although this is a substantial improvement it failed to match the 1.2-point narrowing recorded in 2006, despite the fact that economic conditions were only barely less favourable. On a country-by-country basis, there was a wider range of performances in 2007 than in 2006, when budget balances improved in nearly all member states. In 2007 the majority of member states saw significant improvements in their public finances, which in many cases were more than 1 point of GDP. Conversely, budget balances worsened, albeit to a relatively limited degree (half a point of GDP or less), in Belgium, France, Greece and the Netherlands. There was a significant decline in Ireland, of 2.7 points of GDP. With favourable overall economic conditions across the board, these differences were in part due to specific situations (institutional crisis in Belgium, the strong dependence of Irish tax receipts on real estate revenue) and in part to differences in economic policies (notably in France). Four countries find themselves in a delicate position, where a slowdown in growth could quite easily take them very close to the 3% deficit threshold. Portugal, France and Greece ran deficits of 2.6%, 2.7% and 2.8% of GDP respectively in 2007. Although much less likely, it is by no means certain that Italy, with a deficit of 1.9% of GDP, will escape the same fate, given the particularly weak growth prospects there. A high-risk economic climate Early 2008 brought economic conditions that differed significantly from those that might have been expected when budgets were prepared in the second half of 2007. On top of the risk of a US recession, which is considered ever more likely, there has been a deepening of the financial crisis (although clearly the two developments are not independent of each other). Although it looks less likely now, the risk of systemic collapse appeared, at one point, particularly high. Moreover, the slowdown in the global economy, whilst remaining limited for the time being, is still taking place against a background of extremely strong increases in energy and food prices, pushing inflation to levels not seen — or at least not in the euro zone — since 1993. Lastly, a number of structural factors in the US economy have exacerbated the dollar’s slide, pushing the euro to record highs against the greenback. A range of suggested remedies One result has been a stepping up in recent months of the debate over the best economic, fiscal and monetary policies to adopt in such circumstances, and the arguments are likely to intensify still further in the coming months. Arguing for an easing of fiscal policy The IMF took a particularly clear position in this camp at a time when growth prospects seemed to have worsened particularly sharply (see Box 1). In their latest forecasts the Fund’s experts call for the use of economic, monetary and fiscal policies to tackle global economic and financial conditions that they believe are particularly threatening. Regarding fiscal policy in the euro zone, the Fund’s analysis is careful to stress that the free operation of automatic stabilisers does not compromise medium-term budgetary adjustment (in other words, the stabilisers do not have an impact on trends in structural budgetary positions). As a result, they should be used as much as possible this year and next. In countries where the budget position is fragile (France, Italy and Portugal are mentioned) the continuation of structural adjustments is nevertheless encouraged. The fund also notes that in these countries, where the ability to control deficits remains unproven, doubts raised by a worsening of the public finances are likely to reduce the effectiveness of public spending more than they might elsewhere (via an increase in long-term rates and the eviction effect of public spending). However, in those countries where the economic situation warrants it, the IMF recommends that discretionary stimulus policies should also be pursued. This could be all the more useful given that the financial crisis has reduced the effectiveness of the usual mechanisms by which monetary policy is transmitted. “Prudence” from European institutions European financial institutions take a very different view. Indeed the ECB’s argument is almost exactly opposite, as can be seen in the excerpt from a statement reproduced in Box 1. In addition to having maintained a very firm stance with regard to inflation, well before this reached its current highs, the bank has also expressed its concerns about the “pressures” that the worsening of economic conditions are likely to place on fiscal policies, noting that “prudent and stability-oriented fiscal policies would also contribute to containing inflationary pressures”. For its part, the European Commission can make only a very limited contribution to the debate. It traditionally avoids making any normative comment when it releases its spring and autumn forecasts, and is limited to judging member states’ budget policies only with regard to whether or not they meet the rules of conduct set out in the Stability and Growth Pact. This year, its assessments of the stability pact updates (or “macro fiscal assessment”) seemed to be relatively benevolent, not only with respect to those members having a relatively solid initial (i.e. 2007) budget position, but also for Greece and Portugal for instance, which despite having run deficits dangerously close to the 3% mark last year still expected, at the end of 2007, to see continued improvement in their public finances. It is unlikely that such a divergence of views between the IMF, ECB and EC can be explained solely by their differing analysis of the scale of the economic slowdown now under way. At a deeper level, the Commission is probably attempting to evaluate the underlying desire of member states, or at least those who have not yet done so, to bring their public finances back into balance over the medium term, thus meeting the Commission’s central position. This is why it decided against issuing warnings to some countries, which it believes are engaged in this process, even though the action of automatic stabilisers alone could push their budgets through the 3% limit in the event of too severe an economic slowdown. In the end, only France was singled out, receiving a “policy recommendation” as a result of its premature decision to interrupt this adjustment in 2008, irrespective of growth prospects.

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Box 1 Extract from Regional Economic Outlook: Europe, April 2008, IMF While current inflation is uncomfortably high, prospects point to its falling back below 2 percent during 2009 in the context of an increasingly negative outlook for activity. Accordingly, the ECB can afford some easing of the policy stance. […] Under the baseline forecast, policymakers should allow automatic stabilizers to cushion the downturn. Most advanced European economies have larger automatic stabilizers and more extensive social safety nets than the United States. A number of countries have reined in their fiscal deficits during the recent economic upswing, freeing space for stabilizers to operate fully in the downturn. However, in economies that are close to the boundaries set by their fiscal rules (France, Italy, and Portugal), stabilizers should be allowed to operate only as long as adjustment toward medium-term objectives continues. It will be important not to jeopardize the process of improving public balance sheets in preparation for the coming rise in population aging-related expenditure. If downside risks materialize and growth contracts to near-recession levels, discretionary fiscal stimuli would be warranted in countries where medium-term objectives are well in hand. Extract from the ECB Chairman’s press conference following the monetary policy committee meeting in April 2008 “Regarding fiscal policies, the intentions reflected in the latest round of stability programmes imply a rise in the euro area general government deficit ratio in 2008. Further fiscal pressures are likely to arise as overly optimistic macroeconomic assumptions are already being revised downwards and political demands for fiscal loosening are increasing. In this situation, countries with fiscal imbalances are urged to make further progress with structural consolidation, in line with the requirements of the Stability and Growth Pact. At the current juncture, particularly prudent and stability-oriented fiscal policies would also contribute to containing inflationary pressures.”

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Outlook Since the confirmation of continued good growth trends in several euro zone countries in the first quarter of 2008, our own forecasts of prospects for public finances in the euro zone this year and next are based on growth assumptions, for 2008 at least, that are significantly above those used by the IMF. In most member states, growth this year is likely to be close to, but below long-term potential: its impact on public sector budgets will therefore be neutral overall in these countries. The economic slowdown will, however, make itself felt much more acutely in a few countries, namely Italy, Ireland and Spain. Affected, with a degree of lag, by the stagnation of the US economy and the financial crisis, euro zone activity will remain very weak in the first half of 2009. For the year as a whole we expect GDP growth of just 1.1%, from 1.7% in 2008, with the result that it will have a much more significant effect on public sector budgets. As has already been mentioned, these forecasts carry a much greater degree of uncertainty than usual. What will be most important in determining the state of public finances, for the next two years at least, is primarily, though not solely, the “mechanical” effect of automatic stabilisers. In most member states, proposed budgets and the latest updates to stability programmes were drawn up against a background of relatively strong growth, which many believe would be lasting. Thus the assumptions used in the updates implied average growth across the euro zone of 2.3% in 2008 and 2.2% in 2009. Of those countries still engaged in significant deficit reduction processes, most notably in response to the European Commission, only Greece and Portugal at this time set time ambitious deficit reduction targets for 2008, at 1 point and 0.5 of a point of GDP respectively. The others, most notably France and Italy, opted to delay the bulk of the adjustment requested of them until later years. Elsewhere, significant reductions in budget surpluses had already been planned in Ireland (1.4 points of GDP) and, to a lesser degree in absolute terms but with a greater impact across the euro zone as a whole, in Germany (half a point) and Spain (0.6 of a point). Taking all the updates together, the European Commission recently indicated that fiscal policies in the euro zone could produce an effect of around 0.3 of a point of GDP, primarily through a reduction in the tax take in some countries. To what extent will the subsequent significant shift in economic conditions change these plans? The direction of fiscal policy could be reviewed in a number of places, in the light of the possible need to stimulate growth in some member states, or to (attempt to) remain within the framework of the European Growth and Stability pact in others. To achieve this, the policies planned in updates to the stability programme could be adjusted, frozen or strengthened. If this happens it will come with a degree of inertia, resulting from the natural delayed responses of government and the impact on public opinion of going back on undertakings that have been clearly made. For all these reasons, 2008 is likely to be a transitional year for public finances and will reveal highly divergent trends between member states where control is, in many cases, poor. From this point of view, the preparation of 2009 budgets, which is now beginning in most member states will give a clearer picture of the direction that the various member states, intend to take in the current climate and the room for manoeuvre that they do, or do not, have. The budget deficit for the euro zone as a whole is likely to worsen only slightly this year, to 0.9% of GDP. This will reflect both budgetary measures introduced some time ago in certain countries, Germany and France chief amongst them, and economic stimulus measures taken, primarily in Spain. The economic slowdown is likely to mean that Italy and Portugal will fail to improve their budget position. The sharper economic slowdown in the second half of 2008 will cause these countries also to plan a pause in their deficit reduction programmes in 2009. In contrast to what could happen in France, however, they will be able to hold deficits below the 3% threshold. Amongst the countries in the strongest positions, those where economic growth slows most sharply will have no hesitation in using the room for manoeuvre they have built up in recent years. The euro zone’s budget deficit is likely to widen to 1.3% of GDP in 2009, with growth slipping to 1.1%.
An easing of fiscal policy in the biggest economies, albeit to varying degrees

Spain: adjustments to the growth model will require major stimulus measures

 

 

 

For Spain the time has clearly come to make use of the room for manoeuvre in fiscal policy built up over more than a decade of continuous improvements in its budget. The Spanish economy is likely to suffer most, with growth slowing by more than two points, to 1.5%, in 2008 and to 0.0% in 2009 (compared to a long-term potential figure that the OECD has estimated at 3.5% in recent years). In response, the government recently announced a support package for 2008 worth €10bn (or nearly 1% of GDP), followed by nearly €8bn in 2009 (0.8%). The programme aims in particular to help households and the construction sector (around 13% of all jobs), which have been particularly hard hit by the downturn in the real estate market. As well as a removal of the wealth tax (€1.8bn), the measures introduced in this plan are temporary, and do not, therefore, undermine the long-term position of Spain’s public finances. For consumers, each taxpayer will receive a €400 tax cut this year, at a total cost of €6bn. Next year, the shift to a monthly schedule of VAT repayments to companies will produce “exceptional income” for them totalling a further €6bn. These factors, coupled with the operation of automatic stabilisers, could take the budget surplus, which peaked at 2.2% of GDP in 2007, below 1.0% of GDP this year, and a deficit is likely in 2009. The support package will no longer affect the fiscal balance in 2010, but in the medium term, it remains the case that rapid growth seen in the real estate and construction sectors in Spain, as in Ireland indeed, made a substantial contribution to the country’s growth and to the exceptionally high level of tax revenues. As a result, the downturn in these sectors has a structural impact on public finances that will need to be watched closely. To maintain a favourable budget position, these countries could find themselves having to make relatively substantial adjustments to their tax or spending policies in future years.
Germany: a well-earned break In early 2007, feeling reasonably confident in Germany’s growth prospects given the scale of the success of its deficit reduction policy (see Box 2), the German government decided to move to a second phase of economic policy in 2008 that would bring a reduction in the tax and social security burden even if this resulted in a temporary and moderate worsening of its budget balance. A cut of nearly one point in unemployment insurance contributions was introduced at the beginning of the year (from 4.2% to 3.3% of gross salary), accompanied by a substantial reduction in company tax rates. These flagship measures were joined later by decisions to increase spending, such as an increase in the period over which unemployment benefits would be paid to the older unemployed, and more recently the help provided to pensions schemes. In addition, a section of public sector employees received relatively substantial pay rises, averaging around 4.5%, at the beginning of 2008. Lastly, it is not yet possible to know just what the cost will be for the rest of the year to local authorities that have been involved in measures to support the Landesbanken. Overall, these measures are likely to have an impact of over half a point of GDP on the general budget balance. However, the German economy is one of the few in the euro zone that might maintain growth substantially above its potential rate this year (2.3%), although this will be for the most part built on the achievements of the first quarter of 2008. Barring a much sharper economic slowdown, the government will nevertheless be careful not to risk a budget balance that has been so hard-won and will thus keep up a degree of pressure on other areas of spending. In fact, it is not so much the economic slowdown as the prospect of general elections in autumn 2009 that is currently weighing on German public finances. Indeed, after several years of wage restraint and of budgetary consolidation based around control of spending, particularly on social security, the current electoral campaign is providing a forum for vigorous debates about the distribution of added value and the social costs of reforms of the labour market and the budgetary adjustment. Overall, the fiscal impulse delivered this year will remain reasonable, unlikely to threaten the long drawn-out cleaning up carried out over recent years. Given the strong performance of growth in 2008, German public accounts could remain balanced this year, with a small surplus of 0.3% of GDP.
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Box 2: French and German budget balances: a recent divergence Germany is now often cited as an example of successful, rapid and purposeful budgetary consolidation. Conversely, France is often singled out as one of the countries that has clearly avoided or delayed such adjustments. In this box we will take a quick look at the two countries’ public finances and their constituent factors over recent years. The comparison highlights the costs and advantages of the adjustment policy undertaken in Germany, which are factors to be borne in mind in France, where the bulk of the budgetary consolidation process has yet to take place. Up until 2003, the public finances of France and Germany moved more or less in parallel. After a period of consolidation to allow for the adoption of the euro and the Stability and Growth Pact, public finances worsened rapidly in both countries in response to the economic slowdown that began in 2001. Public sector borrowing levels began to rise rapidly. The two economies faced the same difficulties: weak growth, or zero growth in the case of Germany, rapidly rising unemployment, low fiscal receipts and substantial growth in social security payments. In 2003, the overall public sector deficit was around 4.0% in both countries (4.1% in France), with growth dropping to 1.1% in France and Germany slipping into recession with GDP down 0.2%. The recovery in public sector finances from this point was continuous in Germany and accelerated through to 2007, a year in which it balanced its budget for the first time since reunification (if we ignore the exceptional impact of UMTS licence sales in 2007). Although France carried out significant consolidation of its public finances in 2004 and 2005, this process ran out of steam in 2006. Looking at trends in expenditure and income shows that the two countries started to go their separate ways in 2004. Since then, Germany has opted for a policy of deep cuts in public spending, which have delivered the budgetary adjustment in its entirety. Between 2003 and 2007, German public spending was cut by 4.5 points of GDP. In France, improvement came from rising receipts up until 2005, a year when, with a deficit of 2.9% of GDP, the country could finally hope to come out of the excessive deficit procedure. No clear trend emerges thereafter and in 2007 the country ran a deficit of 2.7% of GDP.
The anatomy of spending cuts Table 1 shows trends in the main areas of public spending and fiscal receipts in France and Germany. The period of comparison used (2003 to 2007) corresponds to that during which the reforms were implemented. Clearly this skews the comparison between rates of growth in spending and receipts due to the sharp upswing in growth, particularly since 2006 in Germany. However, the comparison between the two countries, which enjoyed very similar average rates of growth over the period, is relevant. The policies responsible for the improvements in Germany were, on the whole, introduced in 2003, first by the Schröder government under its Agenda 2010 programme, then by Angela Merkel’s coalition. Spending control goes across the board and affects all items. The reduction in the public sector wage bill was the result both of reduction in the number of civil servants, which began after reunification and has been a constant feature of the last 15 years, and of tight control over wage levels in the public sector, something clearly made easier by the fact that private sector wages were also tightly controlled over this period. Overall, however, it would appear that the biggest contribution to the total adjustment came from the virtual stabilisation of social security spending, in value terms at 2.8 points of GDP between 2003 and 2007. This was the result of major reforms of all social security systems, which squeezed spending and sometimes included higher contributions. Whilst by no means limited to these measures, the reforms included an increase in the contribution made by patients to healthcare costs (health insurance excess,  a narrowing of the list of reimbursable products and services, increase in patients’ share of costs), coupled with limited growth in retirement pension payments. The measures introduced in the area of unemployment insurance formed part of a larger programme of reforming and improving the flexibility of the labour market (Hartz Acts I to IV, 2003 to 2005). The goal of controlling public sector spending did not run counter to these reforms – far from it, as their purpose was to stimulate job creation, make it tougher to claim unemployment benefits and reduce the level of benefits and the period over which they were payable. Meanwhile, on the revenue side, fiscal pressure remained strong, with taxes growing by around 4.5% per year, although social security contributions remained virtually unchanged. This phenomenon owed much to labour market reform which substantially encouraged the creation of low-paid jobs and others which did not qualify for social security contributions. But transfers to the fiscal domain of the financing of social security services have also taken a more explicit form, such as the government’s decision to take responsibility for all expenditure relating to pregnancy and child health care. Meanwhile in France, some of the trends seen in Germany, such as moderation in wage growth and the stronger performances of fiscal and social security receipts, are observable but much less marked. Overall, however, growth in both receipts and spending was much stronger than in Germany, and only about a single point of this gap can be explained by inflation. In particular, the goal of stabilising government spending, in volume terms, which had been the stated aim of the French government for many years, was not achieved, with spending growth only barely slower than that in GDP. The major difficulty created by the policies followed has of course been that they have been extremely costly in terms of purchasing power, and this explains a significant part of the average half-point annual growth differential between France and Germany from 2003 to 2007. Thus disposable income increased by only 0.3% on average between 2003 and 2007, and by just 0.5% per year in 2006 and 2007, despite the fact that unemployment fell by more than 2.5 points over the same period. However, it did allow France to rebalance its public finances without increasing tax rates or the tax wedge, which, in 2006, remained amongst the highest in Europe.
Table 1: Comparison of public sector revenue and expenditure in France and Germany
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France: on a tightrope France’s overall public sector deficit came out at 2.7% of GDP in 2007, compared to the initial estimate of 2.4% in December. This made France one of the few countries in the euro zone (the others being Ireland and Belgium) to have underestimated its deficit at the end of 2007, with the majority of other member states repeating the pattern of 2006 and reporting better than estimated budget figures due to persistently strong fiscal revenue. It was not so much the measures approved in the summer of 2007 as the tax cuts introduced by the previous government that explained the 0.3 point increase compared to 2006. However, the much heralded “tax package” introduced in the TEPA Act, though yet to reach its full effect, will be the main driving force behind changes this year.  At present the European Commission places the cost of the package at around €6bn (0.3 of a point of GDP), a figure that will depend largely on the success or otherwise of tax exemption and reduced social security contributions on overtime hours worked. The shortfall in social security contributions that these will produce represents the bulk of the cost of the package. Apart from this measure, the main features of the Act are a reduction in tax on bequests and gifts, the tax deductibility of mortgage interest, the introduction of a tax shield capping the tax rate and a reform of the wealth tax. All these measures will lead to a lasting reduction in tax rates and their cost will continue to increase for some years to come. Meanwhile, very few long-lasting measures to reduce spending have been introduced. The government is counting mainly on natural wastage in civil service employment and, more generally, on tight control of spending (flat central government spending and 1.2% growth in social security spending by volume) to contain the deficit. The European Commission recently estimated that, even if these targets are achieved, which would require an unprecedented effort, the government deficit in France will be 2.9% of GDP in 2008. In general terms, we believe that without any corrective action, the effect of the measures introduced this summer on public accounts that are already looking ragged by European standards (deficit at 2.7% of GDP) and in a climate of weak growth (around 1.7% this year and 1.4% in 2009) will be to push the French deficit beyond the 3% mark both this year and next. Thereafter, future developments will depend ultimately on the government’s desire to stay within European rules and its ability to take the necessary action.  It is thus highly likely that French fiscal policy will re-adopt a restrictive stance next year, going against the grain of the economic cycle. Such a step will be needed to contain the evolution of the deficit, that could however reach 3.2% of GDP.
Italy: a tricky start for the new government Last year, Italian finances enjoyed a substantial improvement, with the deficit cut to 1.9% of GDP, from 3.4% in 2006 and 4.2% in 2005. This was the first time it had been brought below the 3% mark since 2002. Just as it had for Portugal, the European Commission recommended closure of the excessive deficit procedure in which Italy was still engaged. The Commission also estimated that the structural deficit had been cut by 3 points of GDP over these two years. As expected, the only negative aspect of this improvement was that it came solely from higher receipts (up by 2.8 points of GDP between 2005 and 2007). Meanwhile, spending levels remain amongst the highest in the euro zone; at 48.5% of GDP in 2007, they trailed only Belgium and France. After two relatively positive years, Italian growth is likely to pretty much stagnate this year, with GDP rising by just 0.1%. The previous government, expecting altogether stronger growth (1.5% in its Stability and Growth Pact update), introduced a series of discretionary measures which, all other things being equal, would probably increase the deficit by around 0.4 of a point of GDP. In particular these included a cut in the tax burden on individuals (particularly to encourage first-time house buyers) and a reform of company taxation similar to that introduced in Germany. The maximum tax rate on profits was cut by 5 points to 31.4%. By the end of March, the government’s forecast for 2008 had been scaled back and now suggested 0.6% growth and a 2.4% deficit. On the basis of the government’s programme, the Commission accepted these projections as relatively credible. It is still too early to confirm that the new government will accept these measures as an adequate way of supporting growth during this year, and will thus focus any measures of its own on 2009, or whether it will decide to do more. The recent recovery in public finances gives it some room to manoeuvre, and the weakness of current growth prospects suggests that support is needed. It is also worth noting that the reform of the Stability and Growth Pact in 2005 significantly relaxed the definition of the “severe economic downturn” required before European rules can be temporarily set aside. However, Italy’s finances remain fragile, with high levels of public spending, huge borrowings, at 104% of GDP despite the figure beginning to fall again in 2007, and interest costs which ran at 5% of GDP last year. As a result, if any economic stimulus measures are taken, it would seem essential that, in keeping with the measures taken in Spain, they are very clearly identified as one-off spending rather than a fresh cut in tax rates, which tend to be more long-lived, to add to those already included in the 2008 budget.
Conclusion Current economic conditions are extremely uncertain. In early 2008 the scale of the financial crisis and the growing consensus that the US economy would slip into recession led the IMF, among others, to conclude that the prospects for the world economy had become considerably worse and to recommend that fiscal policies to support growth be adopted as widely as possible, including in Europe. At the time of writing (late May 2008), recent developments tend to suggest that the ECB’s counter argument was correct. Most of the euro zone countries recorded growth in the first quarter, which in some cases was quite strong, and in nearly all cases was better than expected. Meanwhile, with oil prices exceeding $130/barrel, and showing no signs of easing, any move in inflation back below the 3% mark will come at the end of the year if at all. As a result, the possibility that expansionist fiscal policies will further stimulate inflation expectations, which are already hard enough to control, must be taken very seriously. Not only will this attenuate their effectiveness in stimulating growth, but it could also have an effect on inflation prospects and thus strengthen the need for a restrictive monetary policy. Nor can we exclude the possibility that the balance of risks might shift again, perhaps several times, in the coming months, with the emphasis moving from growth to inflation and back again. In such circumstances, it is highly difficult to assess the prospects of the fiscal policies currently being put into practice, particularly when one considers the time required for them to be drafted and implemented and for their effects to feed through. Naturally, we will at some point be able to look back and judge which risk would have been better to take: whether the best solution was to seek joint action to ensure the greatest effectiveness, as the IMF argued with its stimulus proposals, or if, conversely, it was better to take a case-by-case approach to each economy, assessing the scale of the slowdown, the health of public finances and any adverse movements in inflation expectations. For the time being, the ECB has just redirected monetary policy expectations, when declaring that a 25bp-increase in the refi rate in July was not excluded. As far as fiscal policy is concerned, most countries are unlikely to make changes to the budgets introduced in late 2007 during the course of this year, and will instead rely on the fact that their growth prospects and budgetary positions are such that they can give the automatic stabilisers free rein. This said, Spain has opted to dig deep into its surpluses to soften the landing of its economy, which otherwise could be abrupt, whilst France and Portugal will have to find savings somewhere if they are going to hold their deficits at below 3% of GDP this year. If, however, the economic slowdown tightens its grip quite sharply in the next few months, and signs of an easing of inflation are slow in coming, the preparation and implementation of 2009 budgets could be a very delicate balancing act for Europe’s economies and its institutions, representing as it would a full-scale test of the reforms of the Stability and Growth Pact carried out in 2005.