The End of European Austerity?

Since 2009, Europe’s peripheral economies – Greece, Ireland, Italy, Portugal, and Spain – have tried to dig their way out of a debt crisis by cutting public spending and raising taxes. This year, however, will be different. Fiscal policy in the euro zone is expected to ease for the first time since 2010.   The European economists in Credit Suisse’s Global Markets division say it’s high time fiscal policy loosened in the Eurozone. Had it done so earlier, the region might now be experiencing stronger economic growth than it is today. Consider that the output gap, the difference between actual economic growth and what it could produce if it were running at full throttle, was still 1.8 percent of potential GDP at the end of 2015, according to the European Commission. That’s better than 2009, when the gap hit a peak of 3.4 percent, but it’s still larger than at any point between when the European Commission began collecting data in 1996 and the onset of the global financial crisis.   The Eurozone’s overall budget deficit is expected to improve from -2 percent to -1.8 percent in 2016, but not because governments are cutting spending on programs. Instead, lower interest rates will reduce debt payments and improving domestic demand should boost government revenues. Meanwhile, the Eurozone’s structural primary balance – the difference between revenues and spending, minus government debt service and adjusted for the stage of the business cycle – will decline from 1.4 percent to 1.2 percent. This indicator is more telling about the current direction of fiscal policy than the overall deficit number for a couple of reasons. First, interest payments only tell observers about historical borrowing, not current fiscal policy. Second, governments naturally take in more revenues in good times and less in bad ones, so at least some of the growth or shrinkage of any deficit is simply an artifact of how well the overall economy is doing. Removing these two variables gives a better sense of current fiscal policy.   Few countries in the euro zone are planning new austerity measures this year, with the majority either keeping budgets flat or increasing them. Germany’s states plan to spend an additional €17 billion – an amount that exceeds the budget of the Ministry of Education and Research – to accommodate an influx of migrants from Africa and the Middle East. Meanwhile, Italy’s latest budget abolishes property taxes on primary residences, cuts business taxes for companies that purchase equipment, awards pay increases to police officers and soldiers, and gives every 18-year-old €500 to spend on cultural activities. Ireland, too, has pledged to cut taxes and increase spending in a number of ways, including raising the minimum wage, introducing free childcare for children between the ages of 3½ and 5, and boosting education spending. While France’s proposed 2016 budget cuts public spending, it also reduces corporate and income taxes.   The budget situations in Spain and Portugal are less clear-cut. Spanish Prime Minister Mariano Rajoy introduced a preliminary budget in September 2015, but Spain has yet to form a new government following inconclusive elections on December 20. The European Commission was skeptical about the budget when it was introduced, predicting that it would cause Spain to miss its 4.2 percent deficit target in 2016. Meanwhile, European authorities recently issued a letter warning Portugal that its anticipated spending cuts were insufficient.   European authorities are also planning regional fiscal stimulus programs of their own. Under the so-called Juncker plan, European member states are planning to raise €315 billion to invest in large infrastructure projects, youth unemployment measures, funding for small- and medium-sized businesses, and research and development.   Even in Germany, the most famous proponent of austerity policies, the likelihood of fiscal stimulus is increasing. While Germany’s model of running huge, export-driven current account surpluses shielded the country from the debt crisis, it’s not holding up as well as demand slows in emerging markets, which Germany relies on for 25 percent of its exports. Though Credit Suisse economists still expect Germany’s economy to grow just under 2 percent in 2016, they don’t expect it to outperform the Eurozone, as it has in every other year since the crisis began. That’s partly because the hardest-hit peripheral economies are experiencing sharp rebounds, but German policy bears some responsibility, too. “It has been clear for some time that the German growth model needs to change and that the country should revert to more sustained levels of domestically driven economic growth,” Credit Suisse’s European economists wrote in a recent note.   Consumption has been playing an increasingly important role in the Germany economy in recent years, accounting for more than half of GDP growth between 2013 and 2015 compared to just one-third in the preceding decade. Still, with a 9 percent current account surplus, negative real interest rates, and historically low public investment rates, Europe’s largest economy certainly has room to do more to encourage domestic consumption. The call for Germany to do so used to be framed in altruistic terms of helping the regional economy, but now it looks more like a matter of self-preservation.