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Silvia Quandt & Cie. AG, Brokerage & Investment Banking: In-between the lines – Bernhard Eschweiler
Silvia Quandt & Cie. AG, Merchant & Investment Banking / Key word(s): Miscellaneous – Euro-area fiscal adjustment has progressed more than is perceived – Overall Euro-area debt and deficit figures better than US, UK and Japan – Still, debt sustainability is not assured for some Euro members The Euro-area debt crisis has sparked a fierce debate about the right pace of fiscal adjustment. For some, the crisis countries are not doing enough. Others believe that fiscal tightening is squeezing growth too much. Missing in the debate are often the facts. Have the Greeks really done nothing? What exactly is the impact of tightening on growth? This is not the place for detailed answers, but a look at the latest IMF Fiscal Monitor provides some interesting insights. Headline versus structural deficit First, headline deficits often disguise the true fiscal adjustment, which is better seen in the structural deficit (excluding cyclical effects). Since the end of the recession in 2009, headline deficits have generally declined. However, some countries enjoyed positive cyclical effects (notably Germany and also France) and tightened relatively little, while others tightened drastically (most PIIGS, especially Greece) and yet their deficits fell less due to unfavorable economic effects. The same is also true for countries outside the Euro area. The UK has tightened more than the headline deficit suggests, while the US has tightened much less and Japan actually eased. Interestingly, all three countries as well as the Euro area have similarly easy monetary policy. Gradualism versus cold turkey Second, fiscal tightening has an immediate negative impact on the recovery. Plotting the changes in structural fiscal balances between 2009 and 2012 versus the corresponding changes in output gaps reveals a surprisingly robust relationship. Fiscal tightening in the Euro area and elsewhere since 2009 has dampened the pace of recovery relative to potential and in some cases led to recession. To be sure, this does not imply that fiscal tightening has negative long-term effects on growth. In fact, the opposite may be true. Interesting is the impact of different degrees of tightening on growth. If the tightening is modest (up to 1% of GDP per year) the pace of recovery moderates, but not below the potential growth rate. Thus, the output gap still narrows (‘Sweet Spot’ area). This is the case for the Euro area as a whole (notably Germany and France) as well as the US. Annual fiscal tightening of 1%-to-2% of GDP pushes actual growth below its potential. Economic activity essentially stagnates, but outright recession is avoided. This applies to the PIIGS as a group as well as the UK. Further tightening leads to recession, which is most evident in the case of Greece and probably also applies to Portugal. The whole is much better . Third, overall Euro-area fiscal figures are better than it is often perceived. – As a whole, the Euro area has significantly lower headline and structural budget deficits than the UK, US and Japan. – The trade-off between fiscal tightening and economic performance is well balanced (‘Sweet Spot’ area) similar to the US. – Finally, the debt/GDP ratio is not higher. The Euro-area debt/GDP ratio is on par with the UK, below the US and much below Japan. Moreover, the debt buildup in the Euro area since the start of the financial crisis has been significantly smaller than in the US, UK and Japan (below trend line). Indeed, the fiscal adjustment of the Euro area as a whole is on a better path than the UK, US and Japan. As outlined in the box, the effort needed to stop and reverse the debt build-up depends on the gap between the real interest paid on government debt and real growth as well as the current debt/GDP ratio. Unlike the US, the Euro area gets no help from the gap between real interest rates and growth. However, its primary balance is already on the verge of moving into surplus and the starting debt/GDP ratio is not too high to undermine the tightening efforts. Thus, based on the latest IMF figures, the Euro area should be able to stabilize its debt/GDP ratio within the next few years with only modest additional tightening. In contrast, the UK, the US and Japan would have to apply significantly more fiscal tightening to achieve the same result. . than some of the parts The problem of the Euro area is that some parts are much worse than the whole. Based on current real interest rate, growth, deficit and debt conditions, the crisis countries will struggle to escape the debt trap. Yet, judging by the evidence so far, a cold-turkey approach will probably back fire. Instead, needed is a multi-pronged strategy that reduces the gap between real interest rates and growth and simultaneously improves the fiscal position. Structural reforms and adherence to a medium-term deficit reduction plan are necessary conditions for success. If that is assured then other Euro members and the ECB can help reduce interest rates and restructure the debt burden. We believe the Euro area is moving in this direction, but the process is politically complicated and will take a long time. Spain has made good progress and is likely to get help, but some others, most notably Italy, have more homework to do. Disclaimer This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 17 August 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. 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