The Future of Europe

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The European growth prospects what are we
expecting? Prof. Carluccio Bianchi Università
di Pavia
La crisi dei debiti sovrani e le prospettive
dell'Italia
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A deep and long recession

• The European Union (EU) as a whole and the
  Eurozone in particular experienced a period of
  heavy downturn and prolonged economic slowdown
  after the Great Crisis first and the European
  sovereign debt crisis afterwards.
• Next graphs show the dynamics of GDP growth, of
  the unemployment rate and of the investment ratio
  in the USA, the EU28, the Eurozone and the UK,
  whose performance was definitely better than the
  average of EU countries.

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The growth performance
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The unemployment rates
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The investment rates
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A two-speed Eurozone

• Within the EMU, however, a divergent performance
  characterizes core central countries (mainly
  Germany, and excluding France) with regards to
  peripheral (GIPSI) countries.
• Next graphs show the recent dynamics of GDP
  growth and of the unemployment rate in Germany
  versus the GIPSI countries.

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A two-speed EZ
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A two-speed EZ
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Fiscal policy and growth

• The different economic performance between
  countries after the Great Crisis and within EZ
  member States after the European sovereign debt
  crisis is of course mainly due to the different
  stance of fiscal policy.
• In the USA and in the UK Government deficits
  were allowed to widen greatly immediately after
  the Great Crisis and then fiscal retrenchment was
  a slow still-ongoing process.
• In the EU, but especially in the Eurozone,
  fiscal policy was at first weakly expansionary,
  because of the EU Treaties constraints, but then
  pro-cyclical fiscal consolidations were required
  to peripheral countries during the sovereign debt
  crisis.
• The process is still continuing, albeit at a
  slower pace.

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The Government deficits
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Austerity vs growth

• The EMU situation has been, and still is,
  conditioned by the European orthodox attitude
  towards economic policy, according to which
  monetary policy should aim to price stability
  only and fiscal policy to balanced budgets.
• The austerity measures taken had a strong
  negative impact on growth and unemployment. The
  triggered recession, then, increased Government
  spending, decreased taxation revenues and thus
  increased the deficit/GDP and the debt/GDP
  ratios.
• Therefore austerity led to pro-cyclical fiscal
  policies, which reduced growth rates and required
  new austerity measures.
• The simultaneous reduction in deficits of all
  countries amplified the negative effects of
  austerity on member countries.

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The crisis spiral
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The contradictions of austerity

• When the output gap worsens, the Government
  deficit (or borrowing requirement) increases
  (because expenditures rise and taxes fall).
• Let us label e as the responsiveness (sometimes
  also called elasticity) of the public budget to
  the output gap (og). Then it will be Dbre ?og,
  where br is the deficit/GDP ratio.
• e will depend on the type and burden of the
  taxation system and on the type and extension of
  the Social Welfare system.
• In the case of Italy it is believed that e is
  approximately equal to 0.5. Obviously e is higher
  in Nordic-Scandinavian countries, a bit higher in
  core Continental Europe and lower in the UK and
  in the Mediterranean countries.
• In the case of Italy, then, if ceteris paribus
  the growth rate of GDP, and thus the output gap,
  falls by 2, then the public deficit will worsen
  by 1.

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The contradictions of austerity

• To evaluate the possible effects of a fiscal
  restraint on income, it is useful to refer to the
  income multiplier (m), whereby
• Dym ?DBR.
• The multiplier is equal to
  with regards to direct Gvt. expenditure and to
  with regards to taxation or
  transfers (with a positive sign).
• In Italy approximately we have c0.8, t0.4 and
  m0.4. This means that the expenditure multiplier
  is about 1.1 and the tax multiplier 0.9, i.e. not
  very different from 1.
• Multipliers not very different from 1 seem to
  characterize the average EU situation.

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The contradictions of austerity

• Hence, since Dym ?DBR, we may write that
  DyDBR, and
• It follows that a budget restraint of 2.5 will
  determine a fall in the growth rate of GDP
  substantially by the same amount.
• But then, since Dbre ?og, the fall in g (and
  thus the increase in the output gap) of 2.5 will
  determine a worsening of the budget by half, i.e.
  1.25
• This in turn will require new austerity measures
  of the same amount (1.25), which in turn will
  imply a further fall in the growth rate by half
  (.625) and a new worsening of the public budget,
  requiring new restrictive measures.

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The contradictions of austerity

• The just described process implies smaller and
  smaller reductions in the growth rate until a new
  equilibrium is reached with a stable GDP
  (actually a GDP rise in line with potential GDP
  growth).
• Summing up all GDP declines, starting from an
  initial reduction of 2.5, one gets an overall
  loss of 5, possibly distributed over several
  years.
• Thus, a fiscal restraint implies a feed-back
  effect through GDP reduction on the Government
  budget, that hampers the assumed recovery of the
  economic system, which might never take place,
  especially if restrictive measures are taken by
  several countries together.

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The contradictions of austerity

• Indeed experience shows that the EZ fiscal
  restraints had the expected effects on GDP, but
  the opposite, unintended effects on the dynamics
  of the public debt/GDP ratios.

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The EU growth prospects

• As we saw before, after the disappointing 2014
  results (0.8 in the EZ and 1.2 in the EU), GDP
  growth is supposed to regain momentum this year
  (1.1-1.5 in the EZ and 1.7-2 in the EU) and
  improve further in 2016 (2.1 in the EZ and 2.6
  in the EU).
• This more favourable growth dynamics rests on 4
  main factors
• 1) the reduced price of oil and energy
• 2) the ECB QE effects
• 3) the depreciation of the euro
• 4) more accommodative fiscal policies in member
  countries.

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The EU growth prospects

• There are however downside risks due
• 1) political conflicts (Russia/Ukraine and IS
  threat in the Middle-East)
• 2) financial instability connected to the
  solution of the Greek bailout
• 3) less favourable effects of the QE (there is
  evidence, for instance, that the Italian banks
  are using the liquidity granted by the ECB to buy
  German bonds rather than make loans)
• 4) a more pronounced and possibly longer period
  of price deflation, leading to a change in
  inflationary expectations
• 5) slowdown in the growth process of emerging
  economies
• 6) a new stock market downturn after the
  relatively high P/E ratios recently reached
• 7) slowly-proceeding effects of the recent
  structural reforms in many EU countries
• 8) the sword of Damocles of the Fiscal Compact.

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The EU growth prospects

• Anyway the current growth forecasts are
  insufficient to eliminate the negative output gap
  inherited from the past.

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The problem of the Fiscal Compact

• According to the agreements made, the FC rules
  should have started in 2015. However it was also
  established that for countries that incurred in
  the EDP, compliance to the Pact should begin 2
  years after the closure of the EDP for instance,
  in the case of Italy, the FC should start in
  2016.
• According to the recent Italian DEF, compliance
  to the Pact is postponed to 2018, when the
  overall Government budget would be balanced, more
  or less in line with the structural budget.
• The dynamics of the Government primary and
  overall financial balances implied by the most
  recent DEF and compliance to the Pact are shown
  in the next graph.

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Italys problems with the Fiscal Compact
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The problem of the Fiscal Compact

• Since in 2014 the deficit is at 3 and the
  primary surplus at 1.6, and in 2015 the figures
  would not change for the primary surplus, but
  only slightly for the overall balance, thanks to
  the reduction in interest payments, one can
  wonder how the required primary surplus of 3.8
  can be reached in 2018 (2.2 percentage points
  higher), with no effect on the growth rate,
  assumed to remain constant around 1.1-1.2.
• Furthermore the graph shows that in the path
  towards the 60 target of the public debt/GDP
  ratio, the decline in interest payments would
  lead to the transformation of the current deficit
  in a surplus that would finally reach 2 of GDP.
  This dynamics, still required by the FC rule in
  order to reduce the debt/GDP ratio to the
  reference value of 60, would imply a budget
  surplus even excessive in relation to what is
  required by the Treaty itself (balanced
  structural budget or deficit equal to 0.5).

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A new framework for Europe

• If EMU countries can return to a stable
  satisfactory growth path, the architecture of the
  Eurozone must be changed, introducing the
  following novelties
• ECB mandate to care both about unemployment and
  price stability and to attribute her the function
  of lender of last resort with no constraints
• Centralized fiscal policy, with a federal budget
  of an adequate size, federal transfers,
  discretionary counter-cyclical fiscal policy
  aimed to increase public investments financed
  with the issue of Eurobonds (EIB)
• Risk-sharing authority to guarantee bank
  depositors and creditors
• Pooling of national debts, at least at the
  Maastricht threshold level
• Use of real indicators of divergence (such as
  current account imbalances) in order to impose
  symmetric adjustments on deviating member States
  and require surplus countries to expand aggregate
  demand (as in the Six-Pack agreements).