Overview: A Change Of Focus

France, Spain and Portugal are soon likely to be granted additional time to bring their budget deficits back below 3% of GDP. A return to within the limits set by the Maastricht Treaty will probably be postponed by one year from the original deadlines of 2013 for France and 2014 for Spain and Portugal.

The likely relaxation of the deadline, proposed by the European Commission and approved by heads of State and government, forms part of the shift in emphasis seen in Europe over recent months: the policy of austerity at all costs, adopted at the beginning of the sovereign debt crisis as the ultimate remedy, has foundered on its rejection by voters and its relative failure to reduce deficits. Is this a surprise? Well, yes and no. Although voters will sometimes vote in favour of austerity, it is rare for them to put up with it too long. However, the scale of the backlash is due largely to the scale of the recession. As the IMF has recently recognised, fiscal multipliers (i.e. the effect on economic activity of fiscal consolidation) have been underestimated, resulting in deeper recessions and higher unemployment than expected.

This last point also helps explain the relative failure of fiscal adjustments. Greece provides a particularly good example. The European Commission estimates that between 2010 and 2012, the country cut its structural budget deficit by 14.3 points of GDP to 0.5% of GDP, the target set under the Stability, Coordination and Governance Treaty. Over the same time however, the overall government deficit was reduced by only 9 points of GDP. Despite colossal efforts and a huge social cost, the public sector deficit was still 6.6% of GDP in 2012.

The rapid pace of consolidation has pushed down the potential of the economy, which, all other things being equal, push up the structural deficit. In Greece, austerity has resulted in a collapse in productive investment and in potential GDP. In 2012 the latter was 7% below its 2008 level (GDP itself fell by 20% over the same period) with the result that the permanent loss of output has fuelled, all other things being equal, a structural deficit. If potential GDP in 2012 had been the same as in 2008, then the structural budget would have been in surplus, assuming the same level of total deficit, to the tune of 2.7% of GDP.

However, these efforts are not completely in vain. Public sector deficits have been cut. Most importantly, the relaxation of the calendars for fiscal consolidation is now possible because the southern European countries have re-established their fiscal credibility at the cost of a collapse in economic activity and employment. The markets may doubt their ability to reach their budget targets, but no one is questioning their determination. This is the meaning of the distinction between the overall budget balance and the structural balance. The latter is increasingly becoming the focus of government communication and of assessments of policies published by the European Commission.

From now on, discipline will be focused less on slashing public spending than on the introduction of structural reforms. Spain may be allowed up until 2015 to cut its deficit to 3% of GDP, but it needs to accelerate the reform of its pensions system, push labour market reforms further and increase the openness to competition of the business services sector. The rebalancing of public policy away from fiscal consolidation and towards structural reforms also responds to the current contradiction between the reduction of public sector deficits and internal devaluation within the euro zone.

Without the option of devaluing, the countries of southern Europe have had to adopt policies of wage deflation in order to rebuild competitiveness. The resulting loss of purchasing power has caused domestic demand and fiscal receipts in these countries to plummet. Lasting reductions in public sector and trade deficits will require the markets in goods and services to achieve the same degree of flexibility as the labour market.

What can we expect from this new strategy? The adoption of a slower pace of fiscal consolidation and the accelerated implementation of structural reforms could open the way for a return to growth in late 2013 or early 2014. If we assume that reforms will gradually boost medium-term growth and that economic activity will converge towards its potential from 2015, then the reduction of public sector deficits should become easier. On average the reduction of the output gap (the difference between actual and potential economic activity) by one point per year reduces the public sector deficit by half a point with no effort at all. The opposite mechanism to that currently in effect comes into play: the unemployment rate trends back towards its natural level, increasing tax revenues and decreasing unemployment benefit costs. Once the output gap is closed, the total deficit is equal to the structural deficit. According to the European Commission, structural deficits for 2013 will be 2% of GDP for France, 0.1% for Italy, 4.7% for Spain and 3.1% for Portugal. Clearly significant fiscal efforts are still required (except in Italy) but they will be more effective, and politically more acceptable, if the pace of consolidation leaves some room for a return to growth.

BY Thibault MERCIER