European monetary policy has now reached the limits of the possible in its economic intervention. Although the European Central Bank, or ECB, is following a more expansionary monetary policy than ever before, pushing interest rates into negative territory, bank lending has barely recovered. The policy has also failed to generate significant inflation, still at extremely low levels.
But the ECB’s loose monetary policy has at least achieved one thing: it has made viable an increased state debt load, even for the euro zone’s more economically weak countries. In the fall of 2015, average state indebtedness in the euro zone reached 92 percent of gross domestic product, or GDP: this is 27 percentage points higher than in 2007, before the onset of the financial and economic crises.
The euro debt crisis has been alleviated, aside from occasional commotion in Greece. And so an increasing number of economists and politicians are demanding a change in European fiscal policy. They think governments should take advantage of favorable conditions to take on new debt at almost no cost, and then pump that money into the economic cycle.
Debt-financed spending is no basis for growth policy, even if it helps to close a negative output gap.
But debt-financed spending is no basis for growth policy, even if it helps to close a negative output gap. Growth policy should do more than just eliminate the underuse of productive capacity. It should aim to increase potential output, and thus the trend growth rate in the economy. This will not be achieved by debt-financed stimulus alone.
In order to increase potential output, it is necessary to stimulate private investment. A short-term, debt-financed boost in demand will only induce companies to invest as long as there is also a long-term political and economic environment which encourages employment and growth.
And this is where the problem lies. Spending programs based on cheap debt will not help the countries of the euro zone to catapult their GDP growth from levels of 1-2 percent up to a steady 3 percent.
If it were all that simple, the European growth champions would be those euro-zone countries with high budget deficits and significant output gaps. But that is simply not the case, something confirmed by a glance at the four most important euro-zone economies.
Since 2010, France has run budget deficits of between 4 and 5 percept of GDP, increasing its national debt by €470 billion, around $528 billion. At first, the French output gap fell during this time, but in the last two years, it has begun to increase again. In the same period, French GDP growth at first outpaced the euro-zone average, but it was almost 2 percentage points lower in 2014 and 2015. Expansive fiscal policy, it seems, only helped in the short term.
In the same period, Italy regularly ran deficits of around 3 percent of GDP, and saw its government debt rise by €340 billion. But the Italian economic output gap has more than doubled, and annual GDP growth lies below the euro-zone average. From 2012 to 2014, Italy even went into recession. In Italy, expansive fiscal policy has failed to provide even short-term economic stimulus.
While almost complete eliminating its budget deficit, Germany has also been the growth champion of the euro zone.
In 2010, Spain was confronted with the highest budget deficit in the euro zone, at almost 10 percent of GDP. Since 2012, this figure has been cut almost in half. In the years to 2013, Spanish output gap increased fourfold. But since then, in parallel with the country’s deficit reduction, it has fallen by about half. Spain went into recession between 2011 and 2013, but since then has seen economic production increasing at about twice the euro-zone average. The more the government has tightened fiscal policy, the greater the increase in Spanish GDP.
Finally, let’s turn to Germany, which since 2010 has turned a 4 percent budget deficit into a surplus. In parallel to this fiscal consolidation—which took the opportunity of low interest rates to pay off debt and reduce the debt-to-GDP ratio—the German output gap has shrunk to almost nothing. GDP growth is significantly higher than the euro-zone average. In other words, while almost complete eliminating its budget deficit, Germany has also been the growth champion of the euro zone.
To sum up, expansive fiscal policy in euro-zone countries with large output gaps is unlikely to bring about a broad-based economic upturn. Therefore, euro-zone governments and the E.U. Commission should remain skeptical towards suggestions that they turn to fiscal expansion because of low interest rates.
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