INTERVIEW: Fiscal Contraction To Give ECB More Room To Cut

MNI (BRUSSELS) - The implementation of the European Union’s new fiscal rules will mean a fiscal contraction of around 0.4% of GDP per year in the eurozone over the next four to seven years, giving the European Central Bank more scope for monetary easing, Zsolt Darvas, senior fellow at Brussels think tank Bruegel told MNI.

“If there is a fiscal contraction ongoing when the economy is weak … that might give the ECB a bit more room to cut rates. Interest rates are quite high and still far from any lower bound so there is still room for cutting rates if needed,” Darvas said in an interview.

“The good news is that there is lot of room still for cutting. If they have to cut a bit more because of fiscal contraction, then they can do that.” 

While a drag of 0.4% of GDP will be less than the forecast 1% drag this year, much of the current effort is due to the withdrawal of pandemic and energy crises-related measures, which is easier than implementing a genuine fiscal consolidation, Darvas said.

The 0.4% estimate is based on the assumption that eurozone member states will choose a mix of the four- or seven-year debt sustainability plans to which the new rules oblige them to commit, Darvas said, adding that the fiscal adjustment would be around 0.5% of GDP if all countries opted for the four-year plans or only 0.3% if the gentler seven-year plans were universally adopted. 

So far, Spain, Italy and Finland have said they will undertake extended fiscal-structural plans and high-debt states like France and Belgium are expected to follow suit later this year. Germany is also said to be thinking about the seven-year route. (See MNI: Germany Looks At Gentler, Extended 7Y EU Debt Plan- Source)

“We do assume that most countries which really have to do a significant fiscal adjustment would all go for a seven-year plan. That is quite likely,” Darvas said.

Bruegel has replicated the European Commission’s method of calculating countries’ reference trajectories under the plans, and assumed that little deviation from these will be permitted, which it considers to be the likely scenario.

BIG ADJUSTMENTS

For France, Italy and Spain four-year plans would require annual adjustments of 0.9% or even 1% of GDP, significantly more than the 0.5%-0.6% needed under seven-year programmes. The new rules mean that France will have to work towards a primary balance of 0.8% of GDP.

“That is not extraordinary at all. Many countries have had much higher structural primary balances surpluses. Belgium and Italy, for example, have had episodes of 3-4% structural primary balances,” noted Darvas, adding that the challenge is not so much the target itself as the starting point. (See MNI INTERVIEW: Fiscal Rules Require EU Fiscal Capacity)

“The starting position is relatively weak, in the sense that France has a 3% deficit on the structural primary balance, so it would have to make a 4% of GDP adjustment. Over seven years that is not something that is extraordinarily large.”

While considerable, such an adjustment for France would be less than those seen during the global financial crisis and the euro crisis, he said. 

The bigger problem for France is rather the “very difficult political situation, with three different political blocs, none with a majority and none of the three can agree to cooperate reliably. Tax rates in France are already super high so there is not much scope to increase taxes further.”

But shifting the focus to spending cuts will also be challenging, he added.