It’s time for a European Grand Bargain

Entrenched economic positioning can only hurt the region’s economy and embolden the growing Eurosceptic movements

 

The power paradigm in Europe is rapidly changing, and Germany isn’t happy. The days when the Nicolas Sarkozy – Angela Merkel axis both dictated and drove European policy are behind us and have given way to an unlikely new pair: the dynamic Italian Prime Minister Matteo Renzi and the affable, but highly unpopular, French President Francois Hollande. Although independently, neither of them had the political capital to loosen the grip of the German chancellor, their cooperation is an unquestionable force that is likely to upend the prevailing austerity rhetoric in Europe.

As the second and third biggest countries respectively, France and Italy hold considerable influence in European affairs. Their combined economies account for roughly 40% of the total GDP of the Eurozone. Their coupling in EU matters should not be overlooked and should certainly not be dismissed, as is too often the case when confronted with Germany.

Rome and Paris have pushed the envelope in European politics last month by submitting controversial budgets that violate the famous 3% deficit and 60% debt limitations set forth by the stability and growth pact. From the perspective of Renzi and Hollande, deficit reduction without growth will perpetuate the cycle of stagnation that has gripped the Eurozone. They propose instead a short-term fiscal stimulus that will boost growth and increase tax revenue.

Although this argument is compelling, it goes against the very nature of the rules established in the EU post-crisis. Thrusting them aside so soon after they were implemented is an obvious affront to economic unity and runs the risk of further undermining the bloc’s credibility. What’s more, any mention of expansionary demand-side policies draws a visceral reaction from Berlin and naturally upsets other Eurozone countries who implemented the tough reforms needed to harmonize their budgets.

From a political standpoint, this new rift between Brussels and two major member states will fan the flames of Eurosceptic extremism. As is too often the case with European affairs, the budgetary restrictions (which, it’s worth noting, were agreed to by all Eurozone states) are instrumentalized to justify politically tenuous decisions. This narrative plays into the hands of Eurosceptics who are quick to bemoan the erosion of sovereignty and the bureaucratic wizardry of Brussels. Nowhere is it mentioned that member states are only implementing decisions they themselves took!

Regardless, as this debate rages and both sides retreat into their entrenched positions, the perception of Brussels as a weak and overly technocratic institution is perpetuated. Such a view not only degrades the EU, but destabilizes the region’s economy by highlighting the deep divisions and childish stubbornness of the continents supposed leaders. Although both sides make good arguments, no winner can emerge from the current squabbling. It is time for the EU and its member states to embrace its credo of “unity in diversity” and come to an agreement that can boost growth in the short term while addressing budgetary and structural issues in the long term. The EU needs, in short, a grand bargain that will not only address the vital economic questions but also cement the unity of the Eurozone and reaffirm the relevance of Brussels in the lives of all Europeans.

Between Keynes and Friedman: Debunking the myth of a singular approach to fiscal policy

 

The current debate in the Eurozone has long been interpreted as an ideological clash between demand-side and supply-side fiscal policies. Although Germany is quick to rule out the merits of a stimulus package, budgetary considerations alone do not justify austerity politics. The markets remain willing to let France and Italy borrow at particularly low rates with ten year bond yields at 1.28% and 2.55% respectively. Despite the alarmingly slow pace of reforms in these countries, the protective and aggressive actions of the European Central Bank (ECB) continue to guide the investment decisions of markets. As the ECB continues to ramp up its asset buying program, with the potential of a full blown quantitative easing scheme looming, the markets are unlikely to suddenly worry about the stunning ineffectiveness of the Hollande government or the slow pace of reforms in Italy.

Yet low borrowing costs should evidently not be an invitation to perform an unrestricted stimulus that would further balloon deficits. Instead of focusing exclusively on implementing Keynesian or Friedmanite policies, a grand bargain should balance the two: incentivizing structural changes that liberate the economy while boosting growth and decreasing unemployment. The first step in this process has to be a recognition by both sides of the limitations of their respective policies. In France for instance, further government spending is not a panacea, in fact reducing the role of the state in the economy is central to long-term recovery.

Government spending in France currently accounts for roughly 57% of GDP. For the sake of comparison, this figure puts France at the eighth rank worldwide for spending as a proportion of GDP. As shown below, the only countries with a greater percent of government spending include small countries (Kiribati, Micronesia, Lesotho) or largely failed or closed states (Libya, Cuba). Denmark is the only developed country with a higher ratio and even then, their public finances are very healthy with a deficit hovering around the 1% of GDP mark and debt at around 40% of GDP.

Chart 1 TC 2311

When comparing France to its EU and Eurozone partners, the results are similarly dismal. France is the leader in government spending to GDP in the Eurozone. Both France and Italy are far above the EU and Eurozone averages and it is likely that further unchecked spending will exacerbate this figure. When government spending is an inordinately large share of GDP, it crowds out opportunities for investment and growth in the private sector. What’s more, unlike Denmark, the huge government bill in France and Italy are not exclusively the source of a social contract that values government provision of services in return for high taxes. Rather, government spending is financed through unchecked deficits that have translated into an untenable debt for both countries.

Chart 2 TC 2311

Screen Shot 2014-11-23 at 21.22.41

This situation may seem like a paradox, and in many ways it is. From one side, low borrowing costs should incentivize an increase in spending to boost growth, yet from the other further government spending will crowd out investment and exacerbate the deficit problem in both countries. This paradox is only valid if fiscal policy is interpreted through a purely demand-side or supply-side model. In reality there are many ways to leverage cheap capital to boost the economy while fixing the structural issues in both countries – such is the purpose of a grand bargain.

Looser capital restrictions tied to a reform schedule

 

Any potential deal will be met by resistance on both sides, it is therefore important to give major concessions to both sides that can be used, both politically and pragmatically, to sell the deals in their respective countries. Before any negotiations are to start, both sides should delineate their precise concerns and expectations. From the German perspective, France and Italy need to reform their labor markets and rethink their welfare systems. Rome and Paris argue that the ability to conduct a stimulus to boost growth will lower unemployment and increase government tax revenue.

With those goals in mind, one possibility for the accord would be to grant extensions in meeting the EU-mandated 3% deficit-GDP ratio on reforms. In other words, France and Italy would have access to a stimulus of a certain size depending on the economic reforms, in line with the opinions of Brussels that they are able to implement. Such a schedule would presumably incentivize French and Italian leaders to accelerate the pace of reforms to a get access to larger stimuli.

Although it’s possible for such a scenario to work, it has evident drawbacks. To begin with, Rome and Paris would likely argue (as they have been) that reforms without stimulus would plunge the two countries into (or deeper into) recession. This agreement would also place a great deal of trust in the willingness, and perhaps even the ability, of both countries to enact changes. As President Hollande has shown time and again, talking about reforms is one thing, but actually going about implementing them is another entirely. If his approval rating in the low-teens isn’t enough to compel action, it’s hard to see why the promise of somewhat looser finances would.

A bargain under this form would follow the mold of traditional EU deals: very ambitious with the potential for high results, but ultimately killed by dubious political will. This model is certainly doable, but a stronger deal would focus on compelling action rather than hoping for it. Overall, a reforms schedule linked to a stimulus could be a part of a functioning agreement, but it would need to do more to entice spending and investment to boost something other than government spending.

Free tax cuts, a supply solution to a demand problem

 

The strongest form that a potential deal could take would be if Brussels agreed to remove any additional borrowing used for the sole purpose of funding tax cuts from the calculation of a country’s deficit. Obviously, this would contribute to higher deficits, but if the EU agreed that any tax reduction would not count against the 3% deficit rule, France and Italy would be foolish not to lower taxes.

To assuage German fears, the tax reductions can only be counted for 50% of their value or some other percentage so as to not give a free pass to France and Italy. Perhaps the total break can even be capped so as to ensure that real deficits do not exceed a certain level. If these taxes were to be targeted in an intelligent way (IE in capital gains or in business income tax) this would create a massive jump in investment, with further incentives for foreign investment in France. What’s more, any tax cuts for households would increase consumption, even if savings increase at a higher proportion. Even if a majority go into savings, this would free up liquidity for banks to lend more and hopefully have a ripple effect on investment. Either way, this policy is both politically popular and economically reasonable.
Another way to make this policy work is to attach it to decreases in government spending. Perhaps for every euro cut from the state’s budget, two euros could be decounted from the deficit for the purpose of tax cuts. There are many ways to go about implementing such a policy, and surely some of them would be acceptable to both the Germans and the French/Italian.

Conclusions

 

An uncounted decrease in taxes, coupled with a stimulus/reform schedule is a bold and aggressive plan to put Europe’s stray members back in line and continue its vital political and economic mission. Europe and the EU is at a key time in its history. In a speech before the European commission, Jean-Claude Juncker stressed that his commission represented what might well be the last chance for the success of Europe. Indeed, as Eurosceptics rise, the monetary union is still vulnerable, and the very idea of the European experiment is being tested. The argument for a grand economic bargain to both address structural issues but also give way for growth is vital.

For too long, the EU has been used as a scapegoat to justify tough economic decisions. If this grand bargain were to go through it could not only increase growth and decrease unemployment, but also remove the impression that the EU stands in the way of development.

It will be no small task to convince the entrenched positions to change, but doing so is vital not only for their own good, but also for that of the Union as a whole. The day will probably never come when Hollenzi rules with the same force as Merkozy, but showing that the EU can develop positive, pragmatic, and bold new policies would show that it is indeed a Union of 28 and not a cacophony of 28 views. Unity in prosperity should be the guiding mission for the EU, and with a grand economic bargain building a bridge between France, Italy, and Germany, the EU will find a new gust of wind in its sails.