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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 1/53 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. The growth performance GDP growth rates after the Great Crisis 4,0 3,0 2,0 1,0 0,0 2007 2008 2009 2010 2011 2012 2013 -1,0 -2,0 -3,0 -4,0 -5,0 United Kingdom United States Euro area EU28 2014 2015 The unemployment rates Unemployment rates after the Great Crisis 13 12 11 10 9 8 7 6 5 4 2007 2008 2009 European Union (28 countries) 2010 2011 2012 Euro area including Lithuania 2013 United Kingdom 2014 2015 United States 2016 The investment rates Investment rates after the Great Crisis 24 22 20 18 16 14 12 2007 2008 2009 Euro area 2010 2011 European Union 2012 United Kingdom 2013 2014 United States 2015 2016 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. A two-speed EZ Growth rates in Germany and GIPSI average 6 4 2 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 -2 -4 Germany -6 GIPSI A two-speed EZ Unemployment rates 20 GIPSI average Germany 18 16 14 12 10 8 6 4 2 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 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. The Government deficits 0,0 0,0 General Government financial balances General Government financial balances 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 -2,0 -2,0 -4,0 -4,0 -6,0 -6,0 -8,0 -8,0 -10,0 -10,0 -12,0 -12,0 -14,0 United UnitedKingdom Kingdom United UnitedStates States Euro area Euro area EU28 EU28 2015 2015 2016 2016 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. The crisis spiral 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: Dbr=e 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%. 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 Dy=m DBR. 1 The multiplier is equal to with regards to direct Gvt. 1 c(1 t ) m c expenditure and to with regards to taxation or 1 c(1 t ) m transfers (with a positive sign). In Italy approximately we have c=0.8, t=0.4 and m=0.4. 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. The contradictions of austerity Hence, since Dy=m DBR, we may write that Dy=DBR, and Dy DBR g Dbr y y 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 Dbr=e 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. 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. 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. 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) 2) 3) 4) the reduced price of oil and energy; the ECB QE effects; the depreciation of the euro more accommodative fiscal policies in member countries. 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. The EU growth prospects Anyway the current growth forecasts are insufficient to eliminate the negative output gap inherited from the past. Output gaps in the EU and in the EMU 4 3 2 1 0 2007 2008 2009 2010 2011 2012 -1 -2 -3 -4 Euro area EU28 2013 2014 2015 2016 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. Italy’s problems with the Fiscal Compact Time dynamics of the Government primary and financial balance to fulfill the FC requirements 5,00 pb 4,00 3,00 2,00 1,00 fb 0,00 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 -1,00 -2,00 -3,00 -4,00 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%). 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).