Fiscal policies in a monetary union: the eurozone case

Zezza, Gennaro Article Fiscal policies in a monetary union: the eurozone case European Journal of Economics and Economic Policies: Intervention (EJEEP) Provided in Cooperation with: Edward Elgar Publishing Suggested Citation: Zezza, Gennaro (2020) : Fiscal policies in a monetary union: the eurozone case, European Journal of Economics and Economic Policies: Intervention (EJEEP), ISSN 2052-7772, Edward Elgar Publishing, Cheltenham, Vol. 17, Iss. 2, pp. 156-170, https://doi.org/10.4337/ejeep.2020.02.05 This Version is available at: https://hdl.handle.net/10419/277474 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Fiscal policies in a monetary union: the eurozone case Gennaro Zezza* Università di Cassino e del Lazio Meridionale, Italy and Levy Economics Institute of Bard College, Annandale-on-Hudson, NY, USA * We argue that the institutional framework of the eurozone was designed to deny a role for fiscal policy. However, the Great Recession of 2008–2009 forced governments to intervene, mainly to avoid the collapse of their financial systems. At the same time, the severe recession implied a decrease in tax revenues, and an increase in some components of public expenditure –such as unemployment benefits, which implied an increase in public deficits. When the crisis seemed to be over, the Maastricht rules gave priority to restoring fiscal targets, even at the cost of prolonged unemployment and stagnation in countries like Greece and Italy. Using the three-balances approach pioneered by Godley, we argue that such policies require the achievement of an external surplus, or else fiscal austerity will worsen the financial position of the private sector. We show that this is indeed how most eurozone countries moved, and argue that such policies are fragile, and possibly not sustainable in the medium term. We suggest the introduction of fiscal currencies as one way of introducing a degree of freedom in the sustainability of the eurozone. Keywords: fiscal policy, monetary union, eurozone, austerity, sectoral balances JEL codes: E62, F41, F45 1 INTRODUCTION The Maastricht Treaty, which established the rules of the game for the institutions of the European Union, devoted considerable attention to the new institution which would govern monetary policy –the European Central Bank (ECB) –but did not envision any new institution for fiscal policy, which was implicitly left at the discretion of each member state. On the contrary, the Treaty introduced binding limitations to the conduct of discretionary fiscal policies, whenever the public sector deficit was exceeding a given threshold (of 3 per cent of GDP) or public debt was higher than 60 per cent of GDP, on the presumption that an expansionary fiscal policy in such cases would harm the stability of the new currency. Godley (1992: 3) noted presciently that [t]he central idea of the Maastricht Treaty is that the EC countries should move towards an economic and monetary union, with a single currency managed by an independent central bank. But how is the rest of economic policy to be run? As the treaty proposes no new institutions * Dipartimento di Economia e Giurisprudenza, Via S. Angelo Loc. Folcara, 03043 Cassino (FR), Italy; email: [email protected]. We wish to thank Francesco Zezza, two reviewers from the journal, and the participants to the 2019 FMM conference for useful comments. The usual disclaimer applies. Received 18 January 2020, accepted 28 May 2020 European Journal of Economics and Economic Policies: Intervention, Vol. 17 No. 2, 2020, pp. 156–170 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd The Lypiatts, 15 Lansdown Road, Cheltenham, Glos GL50 2JA, UK and The William Pratt House, 9 Dewey Court, Northampton MA 01060-3815, USA other than a European bank, its sponsors must suppose that nothing more is needed. But this could only be correct if modern economies were self-adjusting systems that didn’t need any management at all. The theoretical approach behind the Treaty therefore ran contrary to the standard Keynesian view, which maintains that without active economic policy the system will not achieve full employment, to embrace a form 1 of the ordoliberal, monetarist approach which claims that the government should not interfere with market mechanisms. This approach is coherent with the New Consensus in mainstream macroeconomics, where the non-accelerating wagerateofunemployment(NAWRU)is eventually reached thanks to the optimizing behaviour of agents, and a central bank as the only institution conducting economic policy by fixing the interest rate according to the Taylor rule. Although this approach had been discredited by the 2008–2009 global financial crisis, its influence had been pervasive, so much so that the measurement of potential output, and of the output gap, had beenintroducedintothelegislationofthe European Union with the revisions to the Stability and Growth Pact (SGP). The 2012 ‘Fiscal Compact’Treaty 2 states in Article 3 that ‘the budgetary position of the general government of a Contracting Party shall be balanced or in surplus’, translating this strict rule in a maximum ‘structural deficit’of 0.5 per cent of GDP, where the estimate of the structural deficit requires the evaluation of the current level of the output gap, based on the mainstream assumption of an aggregate production function. 3 The fear that government deficits could translate into requests for financial means from the ECB implied the strict prohibition to the ECB to purchase Treasuries in the primary market for any country: the possible role of the ECB as lender-of-last-resort for governments in trouble was completely ruled out. Summing up, in the institutional framework of the institutions of the European Union there was no space for a common fiscal policy, and there was a large number of restrictions to the ability of individual countries to run a budget deficit to increase aggregate demand and employment. In Section 2 we will provide a short overview of the different phases of the economies which adopted the euro, focusing in particular on how fiscal policy was mainly targeted at reducing ‘excessive’levels of public debt, but had to change its course with the Great Recession first, and the sovereign debt crisis later. In Section 3 we will frame the discussion of the targets for public deficits in the macroeconomic approach provided by the analysis of financial balances, showing that the only way to achieve the desired goals for public debts and deficits requires the achievement of surpluses in the current-account balances, or else will imply a deterioration in the financial position of the private sector in each economy. In Section 4 we briefly discuss an authoritative proposal for a ‘budget neutral’fiscal policy based on the reduction of public expenditure and taxation, arguing that it will not be effective, and in Section 5 we will briefly suggest an alternative proposal to introduce degrees of freedom in the conduct of fiscal policies in the monetary union. Section 6 concludes, and provides some preliminary suggestions arising from the COVID-19 health (and economic) crisis. 1. Feld et al. (2015) claim that a stricter adherence to ordoliberalism would have implied a different institutional set-up for the ECB. 2. See https://www.consilium.europa.eu/media/20399/st00tscg26_en12.pdf. 3. See Ciucci/Zoppè (2017), who also cover the criticism to the procedures adopted to estimate potential output, and document how the official measures of structural balances have been heavily revised over time for some countries, notably Italy. Fiscal policies in a monetary union: the eurozone case 157 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd 2 A SHORT HISTORY OF FISCAL POLICY IN THE EUROZONE The period following the introduction of the euro, up to 2008, may be labelled –in retrospect – as the ‘glory years of the euro’in terms of economic growth for most participating countries. The average growth rate for the 12 countries forming the eurozone (EZ from now on) was 2.0 per cent in the 2000–2007 period (Table 1), and unemployment rates were somewhat lower than in the previous period, and stabilized (Figure 1). Some countries in the periphery, notably Greece and Spain, experienced a period of rapid growth, with real GDP increasing by 4.6 per cent and 3.8 per cent, respectively. Germany was instead the ‘sick man of the euro’, as an article from The Economist (1999) labelled it, given its troubles in coping with the reunification, and the introduction of labour market reforms, which resulted in a growth rate of only 1.4 per cent in the 2000–2007 period. It later became clear that many EZ countries which enjoyed faster growth rates were driven by an unsustainable accumulation process. 4 With the adoption of the common currency, banks in each EZ country could refinance at the ECB at the same interest rate. This implied a substantial reduction in the cost of borrowing for countries –like Greece –where interest rates were much higher, and access to credit was sometimes rationed. Besides, inflation rates had converged before the adoption of the common currency, but not completely: countries with a higher inflation rate –again like Greece –were therefore enjoying a lower real interest rate than countries at the core. Easier access to cheap credit fuelled a credit-led boom of domestic demand in the EZ periphery. At the same time, the adoption of the common currency implied that EZ Belgium 30% 25% 20% 15% 10% 5% 0% 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Ireland Spain Italy Austria Germany Greece France Netherlands Portugal Source: Eurostat. Figure 1 Unemployment rates 4. There is a rich post-Keynesian literature on the polarization in the eurozone between exportled growth regimes in the core and the debt-led regimes in the periphery, and the connection of such growth models to neoliberalism. See Hein (2013), Stockhammer (2016), Stockhammer et al. (2020) and Zezza (2012), among many others. 158 European Journal of Economics and Economic Policies: Intervention, Vol. 17 No. 2 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd countries could no longer realign their exchange rates to restore price competitiveness. Small differentials in the inflation rates of the EZ periphery started to deteriorate its competitiveness against the EZ core, while the exchange rate of the euro against other currencies would not move enough to support the competitiveness of higher-inflation EZ countries against the US and other economies: the euro was therefore a strong currency for the EZ periphery, and a weak currency for the EZ core. The intrinsic instabilities resulting fromtheadoptionofacommonmonetaryand exchange policy for the EZ translated into growing trade imbalances between the periphery and the core: such imbalances were not considered to be a cause of concern as long as EZ financial markets were willing to lend to those countries experiencing the credit-led boom. In the years before monetary unification, and until the Great Recession (GR from now on), fiscal policy in EZ countries was apparently not aimed towards macroeconomic targets as before, when it was a crucial tool for pursuing full employment. Indeed, the required process of convergence to the target deficit and debt ratios defined by the Maastricht Treaty meant all countries struggled to reduce larger government deficits and debt. In Figure 2 we report the average government deficit over different sub-periods: notice that the bars are drawn relative to the Maastricht limit of 3 per cent of GDP, so that the bars on the top show deficits exceeding the threshold. The chart clearly shows how deficits shrank from a still-high level in 1995 to what was required before 2000 to join the eurozone, and remained on target during the ‘glory years’of the euro. Lower deficits implied, for many countries, a reduction in the stock of public debt relative to GDP (Figure 3). Again, the bars in Figure 3 have been drawn with respect to the Maastricht limit of 60 per cent of GDP, so that the bars above the line highlight countries which need to reduce their debt. While the deficit limit was enforced from the beginning of the common currency, there was no pressure on countries exceeding the debt limit to comply with the requirements in a short time period –as it was clear that for some countries, like Italy, this would have required very restrictive fiscal policies –but a tendency to reduce the debt-to-GDP ratio over time was considered to be sufficient. Indeed, countries Table 1 Eurozone countries, average growth rates in real GDP 2000–2007 2007–2009 2009–2014 2014–2018 Euro area 2.0% −2.1% 0.8% 2.1% Austria 2.4% −1.2% 1.2% 2.1% Belgium 2.3% −0.8% 1.3% 1.6% Cyprus 4.9% 0.8% −1.9% 4.9% Finland 3.5% −3.7% 0.6% 2.1% France 2.0% −1.3% 1.2% 1.6% Germany 1.4% −2.4% 2.3% 2.1% Greece 4.6% −2.3% −4.5% 0.7% Ireland 6.2% −4.7% 2.5% 12.9% Italy 1.2% −3.1% −0.5% 1.1% Luxembourg 4.6% −2.8% 3.2% 3.6% Malta 2.5% 0.4% 4.5% 8.4% Netherlands 2.1% −0.8% 0.6% 2.5% Portugal 1.2% −1.4% −0.8% 2.5% Slovenia 5.0% −2.1% 0.2% 3.8% Spain 3.8% −1.5% −0.7% 3.2% Source: Eurostat. Fiscal policies in a monetary union: the eurozone case 159 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd with a high level of public debt, such as Belgium and Italy, managed to reduce its size in the period up to the GR. At the end of 2006 the bubble in US housing prices ended, and house prices started to drop in 2007, leading to foreclosures, and the exposure of a very opaque mechanism for 1995 1996–1999 2000–2004 2005–2009 2010–2014 2015–2018 –14 –12 –10 –8 –6 –4 –2 0 2 4 Germany France Italy Spain Netherlands Belgium Austria Ireland Portugal Greece Source: Eurostat. Figure 2 Government deficit (percentage of GDP) Germany France Italy Spain Netherlands Belgium Austria Ireland Portugal Greece 200 180 160 140 120 100 80 60 40 20 1995 2000 2005 2010 2015 2018 Source: Eurostat. Figure 3 Gross government debt (percentage of GDP) 160 European Journal of Economics and Economic Policies: Intervention, Vol. 17 No. 2 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd pricing mortgage-backed securities (MBSs). When the market evaluation of securities linked to mortgages collapsed, financial turmoil started, which eventually led to the bankruptcy of Lehman Brothers in September of 2008, and of other financial institutions, starting what has been called the GR, which officially began in December of that year. EZ countries were hit in a different way by the crisis, and therefore their policy responses varied. In some cases, notably in Ireland, financial institutions suffered heavy losses from the collapse in the market value of the US securities among their assets. Countries like Spain and Greece had seen a housing bubble similar to that experienced in the US, and possibly financed by foreign capital, and experienced a similar destiny with a fall in the market prices of homes, and an increase in non-performing loans (NPLs) which hit the balance sheet of the financial sector. Financial institutions in other countries, like Italy, were not as exposed on US MBSs, but the recession hit through the fall in US imports. When the GR hit, deficits soared, as the data in Figure 2 show. It is well known that government deficits will automatically increase during a recession, with no change in policy. This is because the tax base is shrinking, and some components of expenditure, like unemployment benefits, increase. On top of these effects, it became clear to governments in Europe and the US that monetary policy would not have been effective by itself to offset the damages of the financial crisis. The discount rate was brought to 0.5 per cent at the beginning of 2009 in the US, down from 5 per cent at the beginning of the recession (November 2007), while the ECB reacted more slowly, even increasing the discount rate by 25 basis points in 2008 to 5.25 per cent, and lowering to 1.75 per cent only in May of 2009. 5 The Federal Reserve recognized the lack of efficacy of a conventional monetary policy, and started a quantitative easing (QE) programme of purchases of MBSs at the end of 2008. The ECB again followed later, starting its QE programme only in May of 2009. With monetary policy struggling to cope with the impact of the financial crisis, fiscal policy was rehabilitated, but in the EZ it was not implemented following the Keynesian suggestion of creating jobs to counter the fall in employment. Rather, many countries saw it as a priority to save their financial system which had a substantial amount of US securities among their assets, or had financed an unsustainable housing bubble and were experiencing an increase in NPLs. Given the different abilities of interest groups in lobbying their governments, policies were aimed mainly at repairing the damage suffered by creditors, rather than helping debtors get back to solvency, and this myopic approach did not eliminate the underlying financial fragility. The data from the capital account on the non-financial statistics of the government sector can be compared to the same data for the financial sector to evaluate the magnitude of what each country transferred to banks and other financial institutions. 6 Main results from this exercise are displayed in Table 2. The largest interventions between 2009 and 2012, in terms of GDP, were made by Ireland and Spain, but Germany also intervened substantially. Although the Maastricht Treaty prohibited the ECB from intervening in the primary market for Treasuries, up to 2009 there must have been a presumption that the ECB would have backed up governments in case of troubles, and therefore that the risk on government bonds for all EZ countries would be negligible. This is confirmed by the spread between the government bonds of countries with a high public debt, like Italy and Greece, against Germany. At 5. Data from https://fred.stlouisfed.org on the basis of IMF, International Financial Statistics data. 6. One way in which such transfers are realized is when the government purchases financial assets from a bank at a value higher than the current market price. Fiscal policies in a monetary union: the eurozone case 161 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd the end of 1995 the spread was more than 9 per cent for Greece and 5 per cent for Italy, and went down to less than 0.5 per cent between 2001 and 2008. Since the shock from the GR was asymmetric, the spread increasedsomewhat from 2008, but interest rates started to diverge dramatically with the Greek crisis, when EZ institutions refused to bail out the Greek government, and the prospect of defaults on sovereign debts could no longer be avoided. The spread on Greek debt soared to more than 27 per cent in 2012, and that of Italy and Portugal also increased substantially. A new phase in the life of the EZ had started, with austerity and ‘structural reforms’being forced on all governments with a high level of public debt. Since markets were now placing a risk premium on sovereign debts, this implied larger interest payments, and therefore larger deficits, for countries like Italy, Portugal and Spain, which were partly avoided by running larger government primary surpluses (Figure 4). As Godley (1997) noted presciently, ‘[t]he danger, then, is that the budgetary restraint to which governments are individually committed will impart a dis-inflationary bias that locks Europe as a whole into a depression it is powerless to lift’.Thisprediction materialized, in particular for EZ periphery countries which followed austerity policies, like Greece, Italy, Portugal and Spain, bringing the EZ average GDP growth rate below 1 per cent in the 2009–2014period(Table1),muchlowerthanthatoftheUSoverthe same period (2.2 per cent). With the exception of Spain, the growth rate in the EZ periphery remained lower than that in the core in the following period (Table 1), especially for countries like Italy and Greece where fiscal primary surpluses were not achieving a reduction in the publicdebt-to-GDP ratio. As Kregel (2018: 40) pointed out, ‘[t]he necessity of an EU level response to the crisis should have made it obvious that the existing framework of fiscal policy management at the national level was incompatible with the new system’. But rather than admitting the recessionary architecture of the common currency, EZ institutions and governments opted for making the rules even more stringent, with the introduction of the European System of Financial Supervision (ESFS) in 2010, the ‘Six Pack’in 2011, and the European Stability Mechanism (ESM) in 2012, along with the ‘Fiscal Compact’which required countries with a public debt in excess of the 60 per cent limit to reduce it progressively over time, obviously through the implementation of ‘structural reforms’and more austerity. Structural reforms were mainly aimed at increasing the flexibility of labour markets and increasing competition: the former, when implemented, increased the precariousness of jobs and reduced real wages Table 2 Capital transfers to the financial sector Million euro (averages) % of 2008 GDP 2000–2008 2009–2012 2013–2017 2000–2008 2009–2012 2013–2017 Germany 1 419 10 730 2 240 0.06% 0.42% 0.09% France 1 798 1 699 3 205 0.09% 0.09% 0.16% Italy 287 1 168 6 504 0.02% 0.07% 0.40% Spain 611 13 577 3 691 0.06% 1.22% 0.33% Netherlands 80 876 348 0.01% 0.14% 0.05% Belgium 310 2 113 157 0.09% 0.60% 0.04% Austria 126 1 872 1 620 0.04% 0.64% 0.55% Ireland 37 11 906 459 0.02% 6.34% 0.24% Portugal 8 945 2 481 0.00% 0.53% 1.39% Greece 0 1 270 4 814 0.00% 0.52% 1.99% Source: Eurostat. 162 European Journal of Economics and Economic Policies: Intervention, Vol. 17 No. 2 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd substantially, with positive consequences on price competitiveness but adverse effects on domestic demand, while the latter increased the market penetration of multinationals and foreign companies in the EZ peripheral markets, possibly putting additional pressure on real wages. 3 FISCAL POLICY AND FINANCIAL BALANCES EZ countries with a high level of public debt are required to run primary surpluses, and possibly overall surpluses, in order to reduce their public-debt-to-GDP ratio. We can frame a discussion of the consequences of such policy with an analysis of financial balances of the three main sectors of the economy: the private, public and foreign sectors. 7 Starting from the GDP identity Y¼CþIþGþE−M(1) and subtracting from both sides taxes and net transfers from the private sector to the government (T) and net transfers from the private sector to the rest of the world (TR), we obtain: Y−T−TR ¼CþIþðG−TÞþðE−M−TRÞ:(2) Using the definition of saving of the private sector (S¼Y−T−TR −C), government deficit (GD ¼G−T) and the current-account balance (CAB ¼E−M−TR), and rearranging, we get the measure of the net acquisition of financial assets (NAFA) by the private sector: NAFA¼S−I¼GD þCAB:(3) 8 6 4 2 0 –2 –4 –6 –8 –10 Germany France Italy Spain Netherlands Belgium Austria Ireland Portugal Greece 1995 1996–1999 2000–2004 2005–2009 2010–2004 2015–2008 Source: Eurostat. Figure 4 Government primary surplus (percentage of GDP) 7. This section builds on the inspiring contribution by Kregel (2018). Fiscal policies in a monetary union: the eurozone case 163 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd Stockhammer, E., Constantine, C., Reissl, S. (2020): Explaining the euro crisis: current account imbalances, credit booms and economic policy in different economic paradigms, in: Journal of Post Keynesian Economics, 43(2), 231–266. Zezza, G. (2009): Fiscal policy and the economics of financial balances, in: Intervention. European Journal of Economics and Economic Policies, 6(2), 289–310. Zezza, G. (2011): Income distribution and borrowing. tracking the U.S. economy with a ‘New Cambridge’model, in: Brancaccio, G.F.E. (ed.), The Global Economic Crisis: New Perspectives on the Critique of Economic Theory and Policy, London: Routledge, 99–120. Zezza, G. (2012): The impact of fiscal austerity in the Eurozone, in: Review of Keynesian Economics, 0(1), 37–54. 170 European Journal of Economics and Economic Policies: Intervention, Vol. 17 No. 2 © 2020 The Author Journal compilation © 2020 Edward Elgar Publishing Ltd