Expansionary Fiscal Policy in Times of Covid-19: a Crisis Measure or a Long-Term Shift?
A Shift in Macroeconomics?
From the onset of the pandemic, there has been a widespread acceptance among economists and governments that to protect households and firms and boost demand in response to the Covid-19 crisis, governments must temporarily accept a large increase in public debt.
The OECD argues that in case the recovery lacks vigor, it might be necessary to continue expansionary fiscal policy for a sustained period to stimulate broader household consumption and business investment. This willingness to increase government spending, with government debt reaching up to 89.8% of GDP in the EU in Q3 2020 (up from 79.3% in the same period the year before), represents a new way of thinking in macroeconomics for some, while being strictly a crisis measure for others. In this edition of showCASE, I will shed light on the ongoing debate on fiscal policy and debt sustainability and will discuss its potential impact on the future of fiscal policy.
Debt Sustainability in the EU
Following the 2008 crisis, the European Commission introduced changes in the EU fiscal policy that strengthened the monitoring of Member States’ budgetary position and aimed to encourage more responsible budgeting. The crisis showed a weakness in the EU’s economic governance and demonstrated a need for increased policy coordination to prevent the rise of imbalances and to ensure stability. There is now a greater emphasis on improving public finances in structural terms including more guidance on how to achieve this, combined with a better warning system of unsustainable debt and wider sanctioning options.
Nevertheless, one could argue that two reference values remain central. While routinely surpassed by a portion of the Member States — for e.g., reaching close to 180% in Greece, exceeding 120% in Italy, and nearing 100% in France and Spain in 2018/2019 — the 60% gross debt-to-GDP ratio and the 3% of GDP overall deficit limit arguably retain an important role in the eyes of the public as an insurance that Member States would not take on excessive, or in other words, unsustainable, debt.
According to some economists, with the leading voice of Olivier Blanchard, current debt limits are too low and the economic situation both before and after the onset of the pandemic warrants higher government spending, i.e., higher deficit and debt-to-GDP ratio.
Already before the outbreak of the Covid-19 pandemic, Blanchard has repeatedly argued that in an environment of low interest rates, public debt can be increased without significant fiscal costs if the growth rate exceeds the interest rate — a major intellectual shift in macroeconomics. According to Blanchard, increased government spending can be vital for securing the livelihoods of workers or the survival of businesses. Inversely, the economic costs of not doing so could be substantial. Choosing fiscal prudence out of a desire to remain below the debt limit of 60% would — in Blanchard’s mind — be unwise, as the benchmark is highly context-specific and there is a room to increase public debt throughout the EU without running unmanageable risks.
Not all Member States agree with that logic. In the Netherlands, the Studiegroep Begrotingsruimte (SBR), a nonpartisan national advisory group on budgetary principles, which has made recommendations on budgetary policy since 1971, recently issued their recommendations for the coming government term. The SBR claims that, while low interest rates make borrowing cheap, they certainly do not make it low risk.
The current low interest rates create a highly favorable situation for the Netherlands to borrow money, but this does not mean that extra public debt can be taken on without significant costs. Borrowing works as long as lenders believe the debt will be repaid.
Currently, indeed, the difference between the interest rate and the growth rate is negative, which creates an ever-low debt quote. However, the SBR stresses that one cannot rely on this differential to remain negative. In the past, both the Netherlands and other countries have known as many periods of negative interest-growth differentials as periods of positive ratios. In case of a positive interest-growth differential, the deficit and debt will get bigger and bigger. On the other hand, even with a negative interest-growth rates differential, debt sustainability is not a given as interest rates could increase over time or once the European Central Bank (ECB) halts its loose monetary policy.
Fiscal Rules vs Fiscal Standards
‘There is no single, time-country-invariant, magic debt or deficit number’. This is the key point made in a paper by Blanchard, Leandro, and Zettelmeyer. In the eyes of Blanchard et al., this conclusion has major consequences for the way debt sustainability should be assessed and enforced in the context of the EU and beyond. They argue that in the EU, fiscal rules based on the 60% gross debt ratio and the 3% overall deficit limit should make way for fiscal standards based on principles accompanied by guidelines.
Let us turn to the downsides and benefits of fiscal standards versus rules. To start, why is there a need for EU fiscal rules? Fiscal rules were designed to mitigate debt externalities in the course of the transition and formation period of the euro. The desire for transparent and simple rules was driven by the fact that national fiscal rules do not provide adequate constraints and a suspicion that some governments might, for opportunistic reasons and a short-term focus, take on unsustainable amounts of debt. The transparent and simple nature of the rules such as the 60% debt-to-GDP ratio and the 3% of GDP deficit limit was seen as essential for their credibility.
Blanchard et al. argue that, while in the formation period of the euro such rules might have been justifiable, over time they proved to be too restrictive and call for a major rethink. More importantly, in their opinion, the sheer complexity of the issue of debt sustainability, being highly time- and country-specific, makes it impossible to be captured ex ante using fit-all rules. Therefore, they argue that rules should be abandoned altogether in favour of standards which are based on principles accompanied by guidelines. These fiscal standards could be based on the current EU’s fiscal principle that ‘Member States shall avoid excessive government deficits’ (Article 126 TFEU) and would be followed by guidelines on how to apply the standards and methods on how to assess whether debt is excessive, or in other words, unsustainable.
In the panel discussion of Blanchard’s paper on October 22, 2020, Davide Debortoli, Micheal McMahon and Jakob von Weizsäcker brought forward several challenges related to the proposal, touching upon communication, credibility, and urgency. According to von Weizsäcker, the possibility and application of escape clauses in the EU’s fiscal rules already provides a level of flexibility sufficient to deal with the current crisis. Second, as mentioned by Debortoli, the application of standards can pose a threat to credibility. The use of complex econometric tools to assess debt sustainability without set limits creates a situation where even a more technical audience may be feeling left in the dark about the methodology of calculations. There is a risk that, just as the current 60% debt level is seen as arbitrary by opponents, so will be perceived the country-specific calculations of debt limit.
On this note, recent research highlights how politicised statistics are, with statisticians and politicians having a level of discretion in dealing with data. Mügge describes the way economic data is frequently used selectively and strategically, with the statistical practices of many countries falling into a grey area between full compliance and data manipulation.
Relating to communication, a point highlighted by McMahon, standards and particularly the methods used to asses whether standards are met are very difficult to communicate clearly to the public. This is not to be taken lightly, as it is essential to the functioning of the EU that its citizens believe that there are clear rules in place which are uniformly applied and that, therefore, all countries are treated fairly.
Against the background of ever-spiking budget deficits in 2020 and rather hazy outlook for 2021, many governments and economists agree on the short-term need for fiscal stimulus in response to the Covid-19. Some economists see the current willingness to expand public spending as a welcome indication of a long-term shift in government’s approaches to fiscal policy.
For the long-term, however, expansionary fiscal policy should be approached with caution, as we cannot rely on interest rates remaining low. If the ECB was to halt its loose monetary policy, interest rates could go up.
While acknowledging that the reference values for the gross debt-to-GDP ratio and the GDP overall deficit are routinely exceeded, for the EU to leave out these limits altogether would mean letting go of a certain form of safeguarding. To abandon the limits now included in its fiscal rules, and to make the shift from rules to standards, several things would be needed: a wider consensus among countries on the long-term benefits of taking on larger public debt as well as a higher degree of trust among member states to not take on an unsustainable amount of public debt. I would argue both of these elements are currently lacking.
For the near future this, in my view, will most likely lead to the continuation of the use of the escape clauses combined with minor adjustments of the EU’s fiscal rules. Yet, while this analysis focused mainly on the EU’s fiscal rules, in the absence of a fiscal union, domestic frameworks continue to play a major role in how budgetary policy is developed and implemented throughout the Member States. Within the boundaries of the EU’s fiscal rules, Member States may seek to adjust their national fiscal governance with a leaning towards higher public spending.