It looks like there will be a major shift in the European macroeconomic situation in the coming weeks, with Italy considering a major tax cut and the European Central Bank (ECB) possibly doing more to boost European monetary conditions. All this has important implications for the budget in October, and the type of measures the Government should adopt.
The euro crisis looks set to enter a critical new phase this autumn. The publication of the results of banking stress tests, together with the launch of a Europe-wide bank regulator, should represent an important milestone in the stabilisation of the financial system. However, there remain broader economic risk factors that need to be addressed.
The euro area is grappling with the linked problems of low growth and below-target inflation. Beyond the obvious social and political costs associated with economic stagnation, even a narrow reading of the ECB’s mandate would indicate that it is at risk of failing to meet its target of “below, but close to, 2 per cent inflation over the medium term” and that it should act forcefully to ensure that the current decline in inflation expectations is quickly reversed. Indeed, this was clearly signalled in Mario Draghi’s Jackson Hole speech recently.
Given the costliness of deflation or excessively-low inflation, the importance of addressing this problem would be widely agreed across the membership of the ECB’s governing council.
The ECB faces considerable technical challenges if it were to decide to engage in quantitative easing (outright purchases of financial assets, including sovereign bonds and private-sector debts).
Quantitative easing
Lessons can be learned from the experiences of the US, UK and Japan in operating such programmes. While the implementation of quantitative easing would also be politically controversial (since it implies that the ECB would take on substantial credit risk with any losses to be shared across the member states), it does provide a mechanism to boost inflation expectations and activity levels in the euro area.
Quantitative easing would provide stimulus by promoting depreciation of the euro and providing reassurance to firms and investors that the ECB is committed to ruling out the risks associated with below-target inflation.
Monetary expansion is more likely to be effective if matched by fiscal expansion. While Draghi’s speech pointed to the merits of co-ordinated fiscal expansion (subject to participating states having sufficient spare fiscal capacity to fund tax cuts or expenditure increases), Italy and France seem most likely to embark on such a policy in the near-term.
In each case there are risks. For Italy – its public debt level is extremely high – the new Renzi government can point to considerable progress in reforming its political system and labour market institutions, and argue that a programme of front-loaded tax cuts (with detailed expenditure cuts to follow later) is necessary to jump-start its economy.
The Hollande administration may also propose a fiscal reform that promises future spending cuts in exchange for tax cuts today, with the recent centrist shift in the cabinet make-up adding to the prospects for implementing expenditure cuts in politically-sensitive areas and complementing short-term fiscal expansion with longer-term structural reforms.
Taken together, fiscal expansion by Italy and France would represent a significant stimulus for the euro area economy (especially in combination with monetary easing by the ECB). At a minimum this can be facilitated at the EU level by an agreement that these programmes are consistent with the Fiscal Treaty, which allows short-term fiscal flexibility so long as there are credible plans to meet targets in the medium term.
More broadly, further fiscal stimulus might be provided by more extensive deployment of EU-level institutional funding schemes (such as projects funded by the European Investment Bank). While there is little prospect of an early fiscal expansion by Germany, a deepening of macroeconomic stagnation could see a revision in its fiscal strategy later.
At the European level, the responsibility for macroeconomic policy is divided across independent institutions, with the ECB independently determining monetary policy and governments fiscal decisions, albeit subject to the restrictions in the Fiscal Treaty and the various EU fiscal regulations. This means that autumn will see delicate financial diplomacy, with monetary and fiscal policymakers trying to signal how each would respond to policy actions by others.
What are the implications for Ireland, especially in the context of the budget? While the domestic fiscal debate has excessively focused on calculating what is the minimum adjustment required to meet the 3 per cent deficit limit in 2015, Ireland’s fiscal strategy should take account of the medium-term risk factors.
Fiscal measures
In one direction, if European policymakers fail to take the monetary and fiscal measures discussed above the 2011-2012 sovereign debt crisis could reignite as investors reassess the solvency of highly-indebted national governments.
In the other direction, if the monetary-fiscal expansion takes place and successfully boosts nominal growth, investors could require significantly higher medium-term yields to buy government bonds since economic recovery would also raise the odds of a medium-term tightening of monetary policy.
These risk factors reinforce the importance of Ireland reducing its very high debt-to-GDP ratio.
The prospects of future increases in bond yields also increase the urgency of Ireland successfully negotiating an agreement with its fellow European governments to prepay its costly IMF loans while still retaining the considerable benefits provided by the low-cost long-term nature of its EU debt facilities.
Philip Lane is Whately professor of political economy at Trinity College Dublin.
