Europe – Searching for Fiscal Stimulus

Published on September 26, 2014

At the conclusion of last weekend’s G20 meeting of global finance ministers and central bankers in Australia, host Treasurer Joe Hockey proudly declared that member states had submitted over nine hundred, yes nine hundred, concrete proposals for stimulating global growth and employment, details to follow.

Markets completely ignored that declaration, and rightly so, as in reality the most memorable product of G20 meetings in recent memory has been the generation of a good deal of hot air. That usually tends to include Emerging Market leaders blaming the Federal Reserve for their own woes either for easing or now, tightening, too much, take your pick. And lest we forget, it also includes the US Treasury Secretary (his name by the way is Jack Lew) criticizing the German government for saving too much and not spending enough.

Perhaps more to the point, EU policymakers, facing a prolonged recession that is edging dangerously close to creating another lost generation of Europeans, have for their part already been mulling three alternative plans for adding badly needed fiscal stimulus to the monetary stimulus being provided by the European Central Bank.

*** First is a Franco-German (meaning German) plan that is so limited as to fall squarely into the “why bother” category. A second is a bold 700 billion Euro proposal by Poland’s former Finance Minister Jacek Rostowski that, unfortunately from what we have gathered, appears unlikely to be funded as things currently stand. The third idea, and more likely to be adopted, is an approximately 300 billion Euro “plan” floated in Brussels by incoming European Commission President Jean-Claude Juncker. ***

*** From what we hear the Commission and European Investment Bank (EIB) are also planning in October to draw up a more specific list of projects for which they could invest on an EU level. Those could include projects such as pipelines, broadband, high voltage energy lines, highways, and so on – and they could be used to back into a specific aggregate spending number rather than the other way around. Importantly, the earmarking of spending on specific projects could also help soften some domestic opposition to greater spending if needed among key constituencies (such as, say, targeting spending on infrastructure and highways in Germany) or on projects aimed at greater energy independence from Russia. ***

*** And on the national level, France and Italy, despite the respective government claims to the contrary, have been pressing the European Commission and Council this fall for greater flexibility and budgetary leeway. There is, of course, some flexibility already built into the Stability and Growth Pact for investment spending, and Italy may be able to draw on that flexibility to some extent. But France, the new sick man of Europe, appears to be headed straight into an embarrassing collision course with Brussels over its budget. ***

If France delivers a draft budget that is rejected by the Commission, and, as already threatened, refuses revisions, it could theoretically be hit with an unprecedented, and politically explosive, 0.2% of GDP, or four billion euro, fine. Most intriguingly, there is even a mechanism if the politics deteriorate enough to also censure Germany, for the first time ever, for its “excessive” surplus.

Chances are of course those extreme outcomes will be averted. But the debate over national budgets and European-wide stimulus will play out from October through the end of the year, and none too soon, given an economy and confidence channel that has been crushed by tensions with Russia, weakened demand in Asia and the Emerging Markets, and the prospect of continued weak growth in not only France and Italy, but also now Germany.

A Call to Arms

European Central Bank President Mario Draghi warned European policymakers on August 22 in Jackson Hole that monetary policy alone would be insufficient to restart the Eurozone economy without significant structural reform and fiscal stimulus.

And that stimulus he suggested should take the shape of aggregate growth in spending across the Eurozone in productive investment areas, and on a national level, when faced with fiscal constraints, in a more balanced budgetary approach focusing on tax cuts and more efficient spending as opposed to tax hikes.

That mantle was rapidly picked up by other central bankers, including in an op-ed jointly penned by French ECB Executive Board Member Benoit Coeure and his former colleague Joerg Asmussen, now Germany’s Deputy Minister of Labor, squarely aimed at the leadership of their respective home countries.

In it they urged France to cut taxes on employment and reduce barriers to labor entry, and for Germany to increase investment, warning against both strict austerity and over reliance on cheap ECB money and spending.

The good news is that there does appear to be a sense of urgency in both Brussels and the Eurozone national capitals that the ECB cannot do all the lifting alone, and in the need for some help on the fiscal side. Unfortunately, that momentum is also dampened as always by national budgetary tensions, as well as frustration at the pace of progress on the structural reform side.

Too Cold, too Hot, and Just So-so …

The most modest plan to date was presented jointly by German Finance Minister Wolfgang Schaeuble and French Finance Minister Michel Sapin at the conclusion of their bilateral meetings on July 17. Schaeuble well understands that under the SGP constraints there really is not enough money around in the Eurozone for significant fiscal stimulus without dipping into Germany’s ample purse; the German plan, if one is to call it a plan, is little more than a pre-emptive effort to head that off at the pass and protect the German taxpayer.

The general idea is to scrape around the EIB, and pan-European institutions, for already allocated money, and to deploy those in what would in effect be targeted, symbolic investments to encourage the private sector to follow. The aim is to help encourage privately securitized funds, but without any government guarantees. One cannot help but be reminded of the Kevin Costner film “Field of Dreams” – build it and they will come…

Far more aggressive and exciting is a potential 700 billion Euro stimulus plan first presented by Poland’s Rostowski in a speech at the Bruegel Institute in Brussels on September 4. That proposal, which appears to be fairly serious and well thought out, is to create a European Investment Fund that would in essence mirror the structure of the ESM (European Stability Mechanism) that was created in September 2012 as a backstop for sovereign governments.

As with the ESM, the fund would be launched with paid-in capital by member states of the European Union, and leveraged through bond issuance in the private sector. Presumably, funding would follow a roughly similar ratio: the 500 billion Euro ESM was funded with 80 billion Euros of member state capital, so a 700 billion fund might require 110 billion euros of capital or so. Contributions would be based on a percentage of GDP, and would be phased in over five years.

As things currently stand, however, there appears to be little appetite in Berlin for additional spending on top of money that has already been allocated in national budgets. Schaeubele, not surprisingly, went out of his way at the G20 meeting to warn against excessive (government) debt-fueled financial growth.

To underscore that resistance, we were since then also reminded by political sources that Chancellor Angela Merkel’s CDU/SPD Grand Coalition share one major overarching goal in their joint economic platform, and that is a balanced budget. And so while the center left SPD on balance would be amenable to a bit more spending, they are unwilling to expend too much political capital in that direction, especially with polls still showing a population firmly in favor of the balanced budget, and if anything somewhat still suspicious of the SPD on spending. At least not yet…

That leaves for now the 300 billion Euro plan that has been proposed by Juncker.

In reality, that plan for now is more a number than an actual plan, targeting roughly 100 billion Euros in spending over each of the next three years, drawing again on existing EIB funds and earmarks from the EU budget. The exact source of funds is not fully delineated, and it is expected to be topped off with some private sector leverage, the structure of which is also not yet defined. Juncker has pledged to make a concrete proposal within three months of taking office, which would pencil in January.

The broad outlines of the Commission plan are expected to be discussed at the October 6 summit, and it is expected to meet little resistance. It could get informal Council sign-off as early as the end of the month. Merkel from what we understand has already indicated support for additional stimulus that does not necessarily require too much in the way of additional budgetary allocations beyond current plans, drawing on EIB and KfW type guarantees.

National Budgets and the Old SGP

Eurozone leaders are relieved to have re-gained the confidence of markets after the deep fiscal crisis and existential threat to the Euro, but that victory has not translated into an economic recovery or meaningful pick up in employment, or with it the re-gaining of the confidence of the increasingly radicalized European electorate.

If anything, the sense of malaise and despair is as deep as ever, and nowhere is that felt as acutely as in Rome, and most of all, in Paris.

The embattled government of President Francois Hollande is expected to lose its majority in the Senate on September 28, with no turnaround in Hollande’s political fortunes in sight. And this fall is likely to be characterized by yet more open conflicts between the national capitals and EU on budgets.

On October 15, EU states are scheduled to submit their draft budgets to the European Commission. On November 1 the new Commissioners and deputies will take office, including former French Finance Minister Pierre Moscovici. By the end of November, the Commission is expected to send back its response to the national government budgets, but this is usually done by the middle of the month. If a draft budget is seen as not conforming to the rules and guidelines laid out, it could trigger a request by the Commission for amendments. By December 31, the national budgets will need final parliamentary approval.

Italian Prime Minister Mateo Renzi and Hollande have already been pressing the Commission for more flexibility on their respective budgets, and the Stability and Growth Pact of course does provide for some limited flexibility in certain cases. The SGP has been revised twice already – in 2005 it was made more flexible, while in 2011 the Commission was given more teeth and greater power of penalties.

But for all the flexibility, once a member state is deemed to be in excessive deficit procedure, there is no flexibility, and its fiscal path is in effect rigidly set. The only leeway for such profligates after that is if, one, growth comes in substantially lower than initially forecast and two – they can show genuine progress on structural reforms.

France clearly misses the structural reform bogey. And even on growth, there is not much sympathy in Brussels for Paris. The EU forecasts in 2013 for French growth in 2014 were always substantially below what they felt were deliberately unrealistic numbers presented by the Hollande government, and so in the Commission’s eye’s the collapse in French growth is not such a surprise after all.

And France has warned that it will not meet its 3.7% deficit for 2014 and is now forecasting 4.4%. While pledging still to stick to its enormously ambitious 40 billion Euro three year spending cut and 50 billion euro tax cut plan, it has ominously suggested it may also need to postpone even its 2017 3% deficit goal. And Hollande, pushed by his own party and left, has repeatedly vowed publicly he will refuse to amend his proposed budget if asked to do so by Brussels.

Merkel has lauded France for its impressive steps, but has graciously – and shrewdly – left the final evaluation to the Commission. Sources we speak to find it hard to see how France avoids further censure, for what it matters. That would mean little to no flexibility to expand its budget, and while highly unlikely, if push comes to shove even a potential 4 billion Euro fine to be put in escrow, and increased if Paris continues to fail to comply.

Less appreciated by markets always focused on European efforts at austerity, the SGP also provides for censure for budgets that are out of balance on the other side – namely an excessive surplus penalty. Our understanding is that Germany could well have technically qualified for that in the past, but for obvious reasons it was simply far too controversial politically to go down that route.

It would be interesting indeed if Franco-German relations deteriorate to the point where Germany could even be threatened with this.

Italy actually does come in below the 3% deficit target, so in theory does have some slight room for greater flexibility per Brussels and the SGP. That means Rome could use the “Investment clause” for certain types of investment spending and would not be charged that against its deficit.

But Renzi was refused the investment clause leeway in 2013 for another reason than the deficit – namely for missing an SGP debt criterion that was, worse, also moving in the wrong direction.

Italy of course at over 100% (135% and counting) of Debt to GDP is miles away from the SGP’s 60% target (who isn’t), but according to the rule book, at that level of debt it has to be on the path of reducing its debt load by 1/20th every year. Italy’s debt has in fact gone up.

If and when it gets approval, under the investment clause a country can invest in structural reforms that have verifiable impact, five years from now. Italian Finance Minister Pier Carlo Padoan has been calling for clear reform benchmarks – a list of what he can and can’t do – from EC.

Unfortunately the inclusion this year due to accounting changes of drugs, gambling, and prostitution on GDP measures will have little material impact in opening up room for more spending. At least it will continue to provide good fodder for news articles.

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