Eurozone - Heading towards Animal Farm?

The latest announcements have shown that the Eurozone is heading towards another showdown on the right balance between austerity and growth.

The Eurozone is preparing for yet another showdown on the right balance between austerity and growth. Italy, but even more so France, laid down the gauntlet to EU partners in recent days, presenting fiscal plans which would clearly be in strong contrast with the Eurozone’s fiscal framework. In addition, the latest comments by the IMF, the ECB and the OECD, all basically calling for more active fiscal stimulus, have also heated up the debate. A new showdown between Italy and France on the one side and Germany plus some fiscal hardliners on the other side is clearly in the making.

The discussion on growth versus austerity has become an almost religious debate. Without choosing sides, let’s have a quick look at what wiggle room the strengthened fiscal framework is offering. For countries with a fiscal deficit below 3% of GDP, read Italy, the fiscal rules offer a decent portion of flexibility. Countries still have to reach balanced budgets in the medium-term and have to stick to their own national debt brakes (if they have implemented them already) but the adjustment pace can be flexible. The flexibility allows for government investments. At least if these are investments in projects co-financed by the EU under regional development policies for poorer regions, European networks, or the connecting Europe facility. Moreover, there is room for major structural reforms that have "direct long-term positive budgetary effects, including by raising potential sustainable growth”. However, the problem is that these reforms actually have to be implemented already.

As regards countries with a fiscal deficit above 3%, read France, the flexibility of the fiscal rules is very limited. As long as countries are still in the so-called excessive deficit procedure, flexibility is limited to extending the deadline to reach the 3%-deficit target. In the case of France, however, the deadline has already been extended twice; in 2009 and in 2013. According to the fiscal rules, such a deadline can only be extended in the case of unexpected adverse economic events. While the financial crisis qualified as such an event, it is hard to see that the failure to implement structural reforms or stagnating growth can be considered unexpected.

Today, everyone seems to talk about flexibility again. Obviously, some economic common sense should be welcome but at the same time let’s not forget that bending the rules in the early 2000s had laid the grounds for unsustainable and uncontrollable public finances almost ten years later. Of course, there is wiggle room in the new fiscal surveillance framework and it looks as if there is new momentum in the Eurozone to also support the demand side of the economy. However, it will not be an easy balancing act. In this context, the biggest challenge will be to treat Italy and France differently. Treating France differently than other countries in the so-called excessive deficit procedure could damage the long-term credibility of the fiscal framework and would clearly have the scent of Animal Farm: all (pigs) are equal, only some are more equal than the others.

In our view, the situation is more delicate than it looks like. However, the most probable outcome of the current controversy is still a bit of more accommodative fiscal policies, without letting austerity disappear, a bit of German goodwill topped with a bit of European investment (eventually maybe even supported by some ECB QE).