Op-Ed: ECB is expected to offset euro area’s fiscal tightening

  • The monetary union faces a long process of fiscal consolidation
  • The ECB will lend support consistent with its policy mandate
  • Investors now have an irrevocable political commitment to the euro
Hannelore Foerster | Getty Images

If the euro area countries continue to insist on balancing the books and cutting in half their current public debt to GDP ratio, it simply follows that the ECB has to provide an appropriate amount of monetary accommodation to offset the fiscal tightening and keep the economy on a steady and sustainable growth path.

Here are some numbers to illustrate that fiscal-monetary alignment.

Last year, the euro area got its budget deficit down to 1.8 percent of GDP from 2.1 percent in 2015. That was a stellar performance compared with 5 percent in the U.S. and 5.2 percent in Japan.

But there are still big intra-area differences: The monetary union's fiscal balances span a range of a 4.6 percent of GDP deficit in Spain and a 0.5 percent of GDP surplus in Germany. France is somewhere in the middle with a deficit of 3.3 percent of GDP, slightly above the euro area budget rule of 3 percent.

Spain and France have to bring their budget deficits to 3 percent of GDP by the end of this year. If they did that, they would cut 2 percent of the deficit-financed purchasing power from one-third of the euro area economy -- a significant hit to their domestic demand.

Cut public debt to 60 percent of GDP

Italy's budget deficit of 2.4 percent of GDP is within the euro area rules, but that is still much too high if the country wants to get a grip on its huge public debt of 159.3 percent of GDP. Rome will now most probably refrain from any fiscal tightening because it is facing a possible general election in a few months.

Markets, however, may still force Italy's hand: Creditors are asking for higher interest rates, and the rising costs of debt service could lead to spending cuts to keep Italy's budget deficit below 3 percent of GDP.

Adding all this up, the ECB is looking at discretionary budget cuts (France and Spain) and similar market-imposed measures (Italy) in one-half of the euro area economy. A fiscal tightening on such a scale clearly calls for an offsetting monetary policy.

Investors should expect that this sort of policy mix alignment will be in place for quite some time -- if the euro area's public debt of 109 percent of GDP is to be brought down to the mandated limit of 60 percent.

The reason is very simple: Declining public debt can only be achieved with substantial and sustained primary budget surpluses (budget balance before interest charges on public debt).

And we are very far from that at the moment.

Last year, for example, the euro area budget had a primary surplus of about 1 percent of GDP, and the total budget deficit was cut by 0.3 percent. In spite of that, there was virtually no change in the public debt to GDP ratio. The message here is: It will take a much bigger fiscal restraint to keep the stock of public sector liabilities on a steady downward trend.

And the corollary is this: A substantial euro area budget tightening will leave the ECB to carry the burden of economic stabilization for the foreseeable future.

Irrevocable monetary union

That won't be easy because serious socio-political issues will be raised as tighter budgets continue to erode Europe's unaffordable welfare states. These issues are called (painful) structural reforms. Countries like France and Italy find them politically flammable.

Striking down elaborate labor protection laws is strongly resisted; it is part of the class warfare, and its short-run impact leads to losses of jobs and incomes.

But windows of opportunity may be opening up.

The new government in France seems likely to have a comfortable parliamentary majority. That could help a quick passage of labor market reforms, especially if the rising business confidence and low credit costs were to lead to stronger investments and a new wave of job creation.

A similar scenario could happen in Italy, based on perhaps overly optimistic estimates that a reviving Democratic Party might benefit from political support of its earlier right-wing opponents. Regional elections today (Sunday, June 11) will tell us something about that. Either way, Italy's anti-EU and anti-euro forces seem now much more subdued than a few months ago.

That leads us back to the ECB and a key question: Can the Europe's central bankers deliver?

As things now stand, the ECB should have no problem maintaining an accommodative policy stance in an economic system where 9.3 percent of the labor force is out of work, and where the core price inflation was declining to 0.9 percent last April.

The latest data indicate that most of the ECB lending goes to public sector borrowers. That credit aggregate has been growing at an average annual rate of about 10 percent in recent months, while lending to the private sector was increasing by less than 3 percent.

Lending to households and non-financial corporations is still weak. Credit extended to these two key sectors of the economy grew only 2.4 percent in the year to April, indicating a slow recovery of private consumption and business investments.

But that could soon change for the better. Household and business confidence in the euro area is rising after anti-EU and anti-euro political forces were trounced in recent French and Dutch elections. These new developments are reinforcing the commitment to the monetary union and to further integration steps to strengthen the euro area management.

A demand for euro area assets is growing. The euro has gone up 3.6 percent against the dollar and 1.5 percent in trade-weighted terms since the French elections on May 7. The ECB should like this, because a strong euro is a powerful inflation dampener in a highly open euro area economy, where the external sector represents about two-thirds of its GDP.

Investment thoughts

Balancing the public sector accounts in the monetary union is a good idea, provided it is done at a reasonable pace during the business cycle upturn. The public debt of 109 percent of GDP is a big danger for the union's economic stability. The sooner that debt is brought down to 60 percent of GDP, the more savings will be available to finance growth-enhancing investments in dwindling human and physical capital stocks.

This huge fiscal consolidation will take a long time, and it will require large and sustained primary budget surpluses. Only six (very small) euro area economies – out of 19 -- are currently running public debt to GDP ratios at or below 60 percent of GDP.

The ECB will have to support this difficult adjustment process. Tight fiscal policies will require a degree of monetary accommodation consistent with the price stability mandate, defined by the ECB as a core price inflation of 0-2 percent. Given a large labor market slack and the euro's strong trade-weighted value, staying within that policy objective is unlikely to pose serious problems to the ECB in the foreseeable future.

And here is the bottom line: For the first time since the euro appeared as a global transactions currency and a store of value, investors now have a credible political commitment to the monetary union and to further integration steps toward common management of public finances.

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