Monday, February 18, 2013

Fiscal storm ahead?

The European Commission’s latest economic forecasts will be presented on Friday. They should be the prelude to the first test case of the Eurozone’s ever-stricter fiscal rules.

Normally, releases of the European Commission’s economic forecasts pass by almost unnoticed and often lack financial markets’ interest. This time around, it should be different. When the European Commission presents its economic forecasts on Friday, market participants are well advised to have a closer look and pay particular attention to the fiscal forecasts. For the first time, the Commission will present a fully-fledged forecast in February. The forecasts for government budgets will form the basis for the next steps in the Eurozone’s fiscal surveillance.

Of course, fiscal surveillance in the Eurozone has become a rather complex mixture of prevention, correction, early warnings and ultimately even financial sanctions. The most straightforward surveillance is still the so-called Excessive Deficit Procedure (EDP). Enshrined in the Treaty, the EDP is the sanctionary or dissuasive arm of the Eurozone’s fiscal surveillance framework, stipulating a trajectory to correct excessive fiscal deficits and bring fiscal balances back in line with the threshold of 3% of GDP.

Currently, 12 out of 17 Eurozone countries are in an EDP. While the four bailed out countries (GR, SP, IR and PT) still have some time to bring their fiscal deficits back to 3% of GDP, the other eight countries had received 2012 or 2013 as a deadline to, as it is called, “correct the excessive deficit” (see Figure 1). For the countries with the 2012 deadline (IT, CY and BE), it will be thumbs up or thumbs down already before the summer. Normally, the Ecofin should decide on next steps in May. The European Council in June could take final decisions. For the countries with the 2013 deadline (FR, NL, AT, SL and SK), the Commission forecasts should send a clear signal of whether the countries are on the right track for fiscal consolidation or whether more austerity measures have to be taken.

The European Commission’s forecasts of last November suggest that the coming months could be the first big test case for the (once again) overhauled fiscal rules of the Eurozone. Back in November, only Belgium, Italy, Austria and the Netherlands were on track to meet their respective deadlines. Given the worse-than-expected growth environment in 2012 but also prospects for 2013, new fiscal slippages could be expected.

So what if a country fails or looks set to meet the required deadline? Eventually, not sticking to the official deadline could lead to a financial fine. Before this happens, however, the country in question will be given a last chance to take additional austerity measures. Or, following good European traditions, the deadline could be extended.

The option of an extended deadline is seen in the official fiscal rules. To qualify for an extended deadline, two criteria have to be fulfilled: 1) the country has to have implemented the required structural adjustment; and 2) fiscal slippages must have been caused by “unexpected adverse economic events”. An exact definition of these “unexpected adverse economic events” does not exist. In recent years, the severe 2009 recession led to an extension of EDP deadlines.

Given the above, at least three Eurozone countries will anxiously study the new European Commission forecasts on Friday. Cyprus and Slovenia seem to be off track in terms of both meeting the required deadline and fulfilling the structural adjustment. Clear evidence that Cyprus probably needs a fully-fledged bailout, rather than a bailout light only for its financial sector. France is a borderline case and could become the big challenge for the Eurozone’s fiscal framework. Last week, a French government official announced that the deficit target for this year will not be reached. This means that the deadline to bring the deficit back to 3% will be missed and, at the same time, the structural fiscal adjustment so far has anything but outperformed the requirements. Here, the deadline could be extended although sluggish growth, mainly due to home-made structural weaknesses, would obviously not be the most elegant way to define “unexpected adverse economic events”. The same holds for the fact that the economy falls clearly short of returning to the government’s assumed trend growth of 2.5% from 2011 onwards.

For the European Commission and eventually all Eurozone governments the question will be “sink or swim”. Strict application of the rules to regain credibility or softer (and for some smarter) application not to overburden the battered economies with additional austerity? Obviously, there are pros and cons for both options. An interesting side track will be the discussion on the methodology of structural adjustment. The structural adjustment is measured as the change of the cyclically-adjusted fiscal balance; a methodology that recently received some criticism in the context of the fiscal multiplier discussion.

The way forward will be a walk on a tightrope. The decisions of the coming months will not only have an impact on near-term economic prospects but will also more fundamentally pave the way for fiscal surveillance in the Eurozone.

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