Francois Hollande is right – Why Fiscal Stimulus would reduce Debt

Francois Hollande has emerged as the new leader of Europe. Like the biblical young David, he has dared to challenge the Goliath-like consensus imposed by German conservatives, according to which only cutting budgets can get us out of the crisis. If he wins the battle, he may well become the King of the European Promised Land.

Consensus is a tricky thing. It is useful to coordinate policies among different actors; otherwise no results can be achieved. But consensus can also turn into a straight-jacket of repressive conformism. Political correctness has prevented policy-makers from changing course and stimulating the economy. Consensus may also cover up real differences. For example, ECB President Mario Draghi has now also called for a Growth Compact, and Angela Merkel has once again made a verbal U-turn in order to accommodate the idea. Yet, as Hollande has pointed out, he wants a different policy.

The conservative growth agenda emphasizes “structural reforms” to increase the long-run economic growth potential: hire-and-fire reforms of the labour market, longer retirement age for pensioners, less bureaucracy to start businesses, and lower non-wage labour costs. A former President of the Bundesbank once told me: “We need to make use of the recession in order to cut into the social safety net, for otherwise we will never get the policy consensus to do this”. This is the conservative growth agenda. And it is dressed in the claim that one must stop public debt from rising in the interest of future generations.

Progressives and social democrats are not fundamentally opposed to structural reforms, as long as they increase the economic growth potential, for that would help to finance the welfare system. Productive private and public investment in infrastructure, housing, education, training, research and ecological innovation are the key to a better future. But social democrats are also painfully aware that none of these reforms will improve people’s lives unless money is spent to make use of the already existing capacities. In today’s situation of high unemployment, idle factories, jobless school leavers and rising poverty, Europe needs a stimulus of demand. Austerity does not help bringing down debt levels.

Sometimes clarity is the best way to ensure that people get what they want. Austerity programs, which have become the policy consensus among the technocrats that guide our politicians, are not what people want. Even the most self-righteous of Europe’s conservative Prime Ministers, the Dutch Mark Rutte, had to resign because his parliamentary majority would no longer let him implement them. Hardest hit are, of course, Greece, Ireland, Portugal and Spain where popular discontent is boiling. Francois Holland was right to insist that the Euro Area will not survive as a persistent “negative growth zone”.

Only two years after the great crisis, Europe is now falling into a double-dip recession. The UK, Slovenia, Belgium, the Netherlands and Spain are already technically there and growth was negative in Greece, Ireland, Portugal, and Italy in the last quarter of 2011. For the Euro Area as a whole we expect new data in a few days. These trends contrast with the United States, where President Obama has paved the way out of the recession by tailoring responsible stimulus packages combined with long term innovation.

At the height of the Global Financial Crisis, all major economies stimulated growth by opening the public purse. The EU agreed to spend €129.6bn (1.0% of GDP), and the USA €186.0bn (1.7% of GDP). However within the EU, Germany, then governed by a social democratic finance minister, took on as much as the USA (in terms of GDP), while with 0.7% of GDP Greece did not even make half of Germany’s effort, and Italy was even tightening its fiscal policy during the crisis.[1] The UK under Gordon Brown closely followed Germany and the USA, but this effort was lost after the election of Cameron/Osborne with dramatic consequences for jobs and poverty. Today, the least stimulated economies are in worse shape than those who took the lead. Could it be that in the middle of the debt crisis Europe needs a new budget stimulus?

Conservatives favour tighter fiscal policies. A good way to assess the budget policy stance is the level and change of the structural (i.e. cyclical adjusted) primary budget position. The primary budget indicates the position of public revenue over expenditure net of debt service. Economic theory says that in the long run this position should be positive so that governments are able to pay their debt. However, in a deep recession, the budget position deteriorates because tax revenue will dwindle. As higher borrowing by the government will close at least some of the demand gap from the private sector, such deficits automatically contribute to the stability of the economy. The cyclically adjusted primary deficit, on the other hand, shows how much “extra” effort a government makes in stimulating the economy over and above the automatic stabiliser. An increase in this budget position reflects a tightening, and a reduction a softening in fiscal policy.

The Chart below shows the negative correlation between a tighter fiscal stance and economic growth over the last 3 years. The stronger the increase in the structural primary budget position, the more negative is the growth rate. This is particularly dramatic for the problem member states Ireland, Greece, Portugal, Italy and Spain.


The regression line in our chart shows that a fiscal stimulus would (on average) stimulate economic growth, but the effect is not fantastically large: a one percentage point reduction in the structural (i.e. cyclical adjusted) primary budget position would push GDP up on average by 0.09%. However, one would expect this initial stimulus to be followed by private investment and further growth. This is, in effect, the meaning of “stimulus”.

The good news is that such a stimulus would actually slow down public debt dynamics. By increasing growth, it would generate additional revenue and higher GDP brings the debt ratio down. Table 1 shows the impact of a 1-percentage point reduction in the structural (i.e. cyclical adjusted) primary budget position on this ratio.[2] The first column indicates the debt levels as estimated by the European Commission for 2012, the second the change in debt levels over the last three years, and the third column shows the amount of fiscal tightening that took place over this period. There is a clear correlation between fiscal tightening and higher public debt levels.[3] The last three columns show the average impact of a fiscal loosening equivalent to a reduction in the structural primary budget position by 1 percentage point of GDP. Under present circumstances, a fiscal loosening would reduce public debt levels in all EU member states. It would lower the debt-to-GDP ratio by -0.8 to -1 points (see column 4). In relative terms, the impact is obviously larger if a country has a low debt burden when it starts the stimulus (column 5). The final column shows that if debt increases have been large over the 2009-2012 period, it would take a larger fiscal stimulus to revert this course.

These calculations confirm that in today’s double-dip recession a growth stimulus would be good, not only for growth and jobs, but also for controlling public debt. Someone needs to explain this to the German Chancellor. However, it is important to consider how to structure such stimulus. Rather than just spending money or cutting taxes, it should be used to modernize Europe’s economic growth potential, improve ecological efficiency and restore social justice. This is why Francois Hollande was right to insist that growth needs to be durable and shared. European solidarity requires today that previous drops in real wages are reversed and that the North lends support to the South. Although a major stimulus would no doubt at first benefit industry in the North, it must soon spill over into the South. But such new policies would need a coherent approach to develop modern growth industries across the continent. Making use of the continental gains from scale, investing in large border-transcending research, exploiting sun energy in Europe’s South and bringing it up North – these are some of the untapped opportunities the European Union can offer to its citizens. If social democrats could build a new policy consensus around these issues, then Francois Holland would have proven another of his daring claims, [4]namely that democracy can be a factor of economic growth.

[1] See: Saha , D and J. Von Weizsäcker, 2009. EU Stimulus Packages Estimating the Size of the European Stimulus Packages for 2009: An Update. Bruegel Policy  Contribution, Issue 2009/02 (April).

[2] The calculation is made by inserting the estimated linear relation between growth  acceleration (?y) and fiscal tightening (?s) into the well-known equation for public debt dynamics: ?d=(r-y)d-s and then taking the partial derivative with respect to the primary budget.

[3] The coefficient of correlation is 0.7293


  1. Barry Cannon says

    The problem is that the Conservatives know this but they don’t want to implement it, because implementing their structural reforms is of more importance. As long as the crisis endures their political cover for this strategy remains. Once growth returns that political cover is lost. That is why they won’t agree to this, unless they are guaranteed their reforms. But a social democratic government will find this difficult due to popular pressure which could risk derailing the whole strategy. Catch 22. Either you are for structural adjustment or you are for growth, you can’t have both.

  2. john says

    Really? are you saying that the way to lower debt is not to cut spending. Government is just a large household, when households are in debt they don’t spend more money or spend money on luxuries they cut back and get out of debt. it is that simple.

    • Daniel C. says

      No it isn’t a large household – households typically have fixed income, while government revenues vary according to economic growth or decline. Short-term deficit spending during recession can generate long-term growth, improving revenue in the long run and eventually reducing the debt – assuming the government is disciplined enough to modify fiscal policy once the recession ends.