Eurozone Fiscal Stimulus: Mirage or Game Changer?

Global Fixed Income Update

October 11, 2019

There are plenty of reasons to expect a repricing of eurozone government bonds, after their stellar performance and since now a large part of that universe trades in negative yield territory. But expansionary fiscal policy should probably not be one of these reasons. As discussed in this note, the obstacles to comprehensive fiscal expansion in the eurozone should not be underestimated. To be sure, the importance of a shift from monetary to fiscal stimulus is on everybody’s radar. It is now widely known that during the September ECB meeting, the only thing that all board members could agree on was that time was ripe for a transition toward fiscal stimulus. Expectations are high that newly appointed ECB president Christine Lagarde will help facilitate discussions among the various national finance ministries and eurozone fiscal watchdogs.

We see this shift in focus from monetary to fiscal policy as timely and potentially very consequential; however, we identify three main obstacles ahead. One is the asymmetry in “fiscal space” across different eurozone economies. The second is the fact that in economies with fiscal space, like Germany, there is not a lot of political/popular support for debt financed spending. The third factor is the lack of a broad framework to share this fiscal space while keeping heavily indebted economies on track to deleverage in the medium to long term. Our concern is that this healthy attention shift will be wasted in endless discussions and on ad hoc mini fiscal packages with little growth enhancing consequences.

A Brief Recap of Eurozone Fiscal Framework and Performance

During the last decade, macroeconomic policy in the eurozone was characterized by a mix of fiscal austerity and counter-cyclical expansionary monetary policy. Only very recently has the overall eurozone fiscal stance turned from restrictive to neutral, according to EU Commission estimates. In very few countries (Spain and France being examples) fiscal policy can be currently characterized as (mildly) expansionary.

The EU’s Stability and Convergence framework was tweaked after 2011 in order to make rules more flexible and avoid pro-cyclical budget cutting. Currently, it has a “preventive arm” defined by medium term budgetary objectives (MTOs). These medium term goals, in principle, allow some short term flexibility in the design of national budgets. But “flexibility” in this context basically means wiggle room in a path still defined by fiscal consolidation. The framework has a “corrective arm” designed to ensure eurozone economies stay on a steady path consistent with reduction of public debt to GDP to 60%, and with deficits never exceeding 3% of GDP. Countries that stray from these commitments are potentially subject to the so-called Excessive Deficit Procedure – with consequences ranging from higher surveillance and fiscal disclosure, to fines and restricted access to EU budget funds. Combined, these rules have kept eurozone fiscal policy in an austerity path.1

Years of fiscal austerity have delivered mixed results. The aggregate numbers are positive, but the problem lies in country-specific performance. Eurozone-wide general government gross debt to GDP peaked at 91.8% in 2014. The IMF forecasts that it will decline to 82% of GDP by 2020. The chart below shows how different countries performed since debt peaked in 2014.

Ireland is the most impressive case, being the only economy that crossed the 100% public debt to GDP threshold but has since been able to outperform the fiscal goals by a wide margin. Post crisis fiscal consolidation ranges from excellent (Ireland, Germany, Netherlands), to underwhelming (Spain, France) and very disappointing (Italy). Years of fairly sizable primary surpluses in Italy were just enough to disarm, for now, a time bomb of spiraling debt growth. Greece is showing steady progress, but the starting point, even after debt restructuring, was so adverse that it remains to be seen if further fiscal consolidation will be consistent with a sustainable growth path.

Government Debt to GDP (%)

Source: IMF

Who Has “Fiscal Room”, and Why?

After years of debt consolidation measures, success in deleveraging efforts was heavily influenced by initial growth fundamentals and debt conditions (i.e. deleveraging was much easier for more competitive economies with lower debt burden). Intuitively, economies with more “breathing room” could implement less draconian belt-tightening. Think, for example, about being able to support (or at least not hurt) household spending and to provide comprehensive unemployment insurance and job market retraining during a job market downturn, with region-wide unemployment climbing for five long years (2008 to 2013). Those countries capable of doing so now have healthier job markets, and exhibit broad based improvement in labor force participation (across gender, age and education levels), a variable that influences growth potential. For example, in Germany, the labor force participation of individuals with low educational level (usually vulnerable to long term unemployment/underemployment risks) evolved from 50% pre-crisis to currently 60%.

As a result, recent fiscal performance can be characterized in two broad groups: those economies that are outperforming the fiscal goals and those that, with the passage of time, are further distancing themselves from the goals because they are not making any progress towards the medium term objectives. The current “fiscal room” is influenced not only by the overall debt level, but also by the pace with which an economy has been making progress towards its medium term objective. This is why Greece currently has significantly more fiscal room than Italy, even though it is more heavily indebted.

Medium Term Objective (MTO – 2020 to 2023)

Source: European Comission, Deutsche Bank
*The structural budget is a cyclically adjusted measure that represents the estimated fiscal performance once cyclical factors that impact expenditures and revenues are removed.

Fiscal Room* (% GDP)

*Difference between where the budget can be (medium term objective consistent with the stability and convergence program) and where the cyclically adjusted budget actually is.
Source: Calculations based on European Commission data

The Need to Think Outside the “Fiscal Box”

ECB officials have been advocating for those economies with fiscal room to implement fiscal expansion. Even the European Commission in its latest assessment of euro area fiscal stance made a similar point.2 So far, fiscal expansion announcements have come from the Netherlands, Germany, and France, but in steps that are quite timid. Germany announced in September that it plans to spend EUR 40 bn on climate change initiatives, but in a budget-neutral way. Critics argue that this was just a repackaging of expenditure items that would sooner or later be disbursed in order to mitigate the economic impact on regions that have more fossil fuel related industries. Overall, we are not seeing fiscal expansion announcements that go beyond putting to work the savings created from the declining costs of outstanding debt.

More needs to be done. We do not mean discarding hard earned dividends after years of fiscal austerity. In 2018, Italy learned the hard way that continued access to funding markets, at spreads not excessively punitive, requires unwavering commitment to fiscal sustainability. But there has been one fundamental change in public debt dynamic in the eurozone (historically low real yields) that should prompt a rethinking of the cost and benefit of adhering to the current targets (or to the pace with which to get to these targets).3 There has also been a policy failure (or perhaps a policy coordination failure) with unprecedented levels of monetary easing not being able to deliver the ECB inflation objective.

We see two conditions for successful fiscal policy expansion (and framework revision) in the eurozone and in the single market in general.

First, it has to be broad in scope (beyond fiscal savings with lower interest rates expenses), it should be inclusive-growth enhancing, environmentally friendly and ideally tailored to reduce Europe’s export dependent growth model.

Secondly, while the bulk of fiscal expansion obviously has to come from fiscally sound economies, it is perhaps unrealistic to expect that countries like Italy will stay on an austerity path if the fiscal space is not “shared.” Obviously, Italy and other low growth, heavily indebted countries would indirectly benefit from fiscal expansion in other parts of the eurozone. But we suspect that indirect benefits are not enough, and that this asymmetric fiscal stance would only deepen the performance gap between high growth European economies and low growth ones.

So what’s the alternative? Steps toward higher fiscal integration seem crucial, even if one is not ready to believe complete fiscal integration in the eurozone will ever be possible. A eurozone budget, eurozone bonds, some level of fiscal transfers in exchange for reforms and other growth enhancing initiatives, these are all feasible as long as politics does not get in the way of creative budget diplomacy. But even that may be too much to ask at this stage.

Summing Up

We do not see a game changing shift in eurozone fiscal policy any time soon, fundamentally because of the asymmetric “fire power” of different economies and the absence of a framework to share this fiscal room. To be sure, we would welcome more limited steps, such as Germany making more decisive use of the fact that it can basically borrow for free. However, it is more likely that the economic downturn needs to get worse in order to spark action. We are not there yet.

1 The European Commission assesses where an individual country fiscal performance should be, on a given year, based on various parameters such as estimates of potential GDP growth. If a country’s potential GDP was revised down after the financial crisis, then the commission recommendations will be more conservative. The reason is that, with lower potential GDP, estimates of structural (or cycle-adjusted) government revenues will be more conservative as well. Another element of the Commission approach that limits fiscal spending is the broad definition of “normal times”. An economy operating 1.5% below potential GDP is still considered within a normal business cycle variation from potential; in this case, medium term fiscal consolidation objectives are still expected to drive the government budget draft and execution.

2 European Commission, The 2019 Stability & Convergence Programmes – An Overview and Assessment of the Euro Area Fiscal Stance – Institutional Paper 110 – July 2019.

3 Olivier Blanchard discusses how a low interest rate environment changes the optimal levels and adequate management of public debt. Olivier Blanchard (2019), “Public Debt and Low Interest Rates”, American Economic Association Presidential Lecture, January 2019.


Media Attachments

Legal Disclosures

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW