Author: Nicolaus Heinen (+49) 69 910-31713
May 10, 2013
The European Commission released its spring forecast on May 3. France, Italy and Portugal saw downward revisions to the forecasts for their 2013 and 2014 structural deficits in particular. Recent demands for so-called "growth-friendly consolidation" give cause for concern that Europe's policymakers will increasingly abandon austerity programmes.
The spring forecast provides an overview of the difficult economic situation in the euro area, with the recession expected to end in the second half of 2013. The prospects of structural budget consolidation are now assessed as moderate.
The Commission document is more than just a collection of numbers. On May 29, the Commission will deliver its judgements and recommendations on current excessive deficit procedures to the Council of Ministers. The figures in the spring forecast serve as the basis for related decisions. On June 21, the Council will vote on whether to abrogate the deficit procedures and will publish its assessments of other deficit procedures now in progress.
It is sensible that the assessment of fiscal consolidation progress is not geared solely to the current deficits, but also factors in the development of the structural deficits. After all, the success of consolidation is ultimately gauged by the changes in the underlying public-sector revenues and expenditures once the cyclical component has been stripped out. It would be misleading to focus solely on current deficits as a benchmark particularly in times of severe economic crises.
It holds equally, though, that in such times in particular any calculation of the structural deficit – which is already a challenging job in normal times – is fraught with extra uncertainty. Policymakers should thus exercise caution accordingly when interpreting the data, and especially when developing policy recommendations based on these data. Against this backdrop, the greater discretionary latitude enjoyed by policymakers when interpreting uncertain data on structural deficits is not unproblematic.
This holds more than ever in view of recent comments by several political leaders. Since the beginning of the year, the European Council, Ecofin and assorted representatives of the Commission have on various occasions advocated so-called "growth-friendly consolidation". However, as popular as the debate is, the way it is being conducted is just woolly. Fiscal consolidation has, by definition, a contractionary effect – the relevant issue is how negative the stimulus is.
Consolidation is anti-growth especially in areas where inflexible factor markets, generous and opaque social-security systems and inefficient administrative structures cripple private-sector activity: the share of public expenditure in GDP is falling, yet the private sector is reluctant to invest, preferring to save its spending money for a rainy day instead.
Conversely, consolidation is growth-friendly when accompanied by structural reforms. Specifically, this means increased competition in markets for labour and capital, for goods and services, and an efficient regulatory framework (public administration and judicial system). Then, investors will regain confidence in the general business environment. They will invest their money; second and third-round effects can unfold; and private business activity, ideally, will compensate for lower public expenditure via investments, higher net exports thanks to increased competitiveness, and ensuing consumption.
Such arguments are not to be found in the Commission's or the European Council's communiqués. Rather, they argue along the lines of investments that will allegedly drive growth as well as the possibility of extending the deficit correction periods.
The latest measure to extend the deficit correction period involves current excessive deficit procedures and thus the corrective arm of the Stability and Growth Pact (SGP). The Commission has already embraced the ideas of the European Council and given countries such as Spain and Portugal more time to reach their austerity targets. This would actually be possible if a country had poor growth prospects and at the same time were successfully consolidating its structural deficit. However, the very spring forecast itself shows that structural consolidation efforts remain problematic. Taking a narrow view, an extension of the deficit procedure for Portugal and France can only be justified with difficulty. However, the Commission's recommendation scope is invariably only as large as the Council's willingness to accept its recommendations. The Council can block every Commission recommendation by qualified majority vote. Therefore, at the end of June other euro member countries could also obtain extended deadlines to correct their deficits – regardless of their actual consolidation performance.
Moreover, in its March 14/15 summit conclusions, the European Council points to "the possibilities offered ... to balance productive public investment needs with fiscal discipline objectives". This addresses the preventive component of the Stability and Growth Pact that sets so-called medium-term budgetary objectives: countries are required to reduce their structural budget deficit by a certain minimum amount every year – usually by 0.5 of a percentage point. The Code of Conduct supplementing the SGP allows as an implementing rule that public-sector investments may indeed be offset when determining the preventive consolidation requirement. This has a direct impact on the national debt brakes required to be implemented by the euro members in accordance with the Fiscal Compact. The latter provides that the debt brakes must, in quantitative terms, gear their adjustment paths to said medium-term objectives. The European Council's stipulation that full use be made of this option will therefore change the austerity impact of the Fiscal Compact long before national debt brakes have entered into force.
Surely nothing can be said against public-sector investments being judged differently than consumption spending or tax hikes in the assessment of consolidation efforts. The problem of finding the right definition though – that is, which expenditures may be declared as investments and which ones may not – and the problem of valuation – which investments are productive and which ones are not – remain unchanged. In the Council, the way a situation is interpreted will invariably be subject to political influences. Regardless of this, there is also the problem that it is quite difficult to credibly convey the merits of such flexibility to an increasingly sceptical public. In the past, flexibility has been interpreted too broadly on too many occasions.
The consequences have greater implications than a simple glance at the political rhetoric and the bond market's relatively calm reaction would suggest. The changes in the assessment benchmark and time horizon harbour the potential to destroy the credibility of the already weak coordination mechanisms. As sensible as a nuanced view of fiscal consolidation and its components may be from an economic standpoint, there is a very real risk that the public at large may take a less differentiated view – this being that the policymakers are prepared to revise the targets they set at any time. This public mistrust is the payback for various past changes of fiscal tack, which range from Germany and France's relaxation of the SGP (2003) right up to the imposition of the rigorous Fiscal Compact (2012). With the qualitative and strategic underpinning of economic policy coordination having been altered several times over the past few years, it is increasingly difficult to create consistent expectations – not only on the part of consumers and investors, but also on the part of the governments themselves.
Author: Nicolaus Heinen (+49) 69 910-31713
© Copyright 2014. Deutsche Bank AG, Deutsche Bank Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite “Deutsche Bank Research”.
The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.
In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product.