In my previous two columns I have argued that lack of aggregate demand is reducing potential growth and long-term employment, and that policies of cutting public expenditure and reducing disposable income for households will re-enforce the negative dynamics. Aggregate demand can be stimulated by private investment, consumption and debt-financed public spending. However, there are trade-offs. Higher public spending is needed when private demand is lacking. But even if monetary policy is very loose, as today in the Euro Area, large budget deficits and low-interest rates will not stimulate investment when government debt is considered not to be safe. Lending rates will then rise, despite a single unique money rate set by the ECB. This is a major cause for the output decline in the southern crisis states. Hence, fiscal policy could be a factor of growth, but it is constrained by debt sustainability. Europe’s problem is that it has reduced the stimulus prematurely and now it has few margins for action.
Europe’s premature fiscal exit
In the immediate aftermath of the Global Financial Crisis, all G20 governments agreed to stimulate effective demand by public borrowing. It worked. A sustained depression was avoided and economic growth returned, although it did so at lower rates than before. Yet, as soon as the world pulled out of the global financial crisis, Europe was shaken by the Greek debt crisis, which revealed the failure of Europe’s fiscal governance. Bad institutions, bad politics and bad communication turned a bad local event into a deep systemic crisis for everyone. The succession of two major crises pushed Europe into repeated recessions and stagnation with dramatic consequences for employment.
The problems were made worse by the premature exit from fiscal stimulus. America and Japan had kept their loose fiscal stance steady while output gaps were still negative in order to bring demand up to potential; but Europe tightened its fiscal regime as soon as economic growth had returned – except in Germany, where this was delayed by one year with positive growth effects. Hence, budget consolidation was imposed well before the output gaps had closed. Not surprisingly, Europe fell into a second recession. Again, this was bad politics, for Europe’s fiscal rules would have allowed postponing the consolidation. The Stability and Growth Pact stipulates that the Excessive Deficit Procedure is suspended in case of a severe economic downturn “if the excess over the reference value results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth relative to its potential”. When GDP growth bounced back into positive territory, the suspension was revoked despite persistent negative output gaps. As a consequence, 12 Euro Area member states were declared to have “excessive deficits” already by the end of 2009 and early fiscal austerity was imposed. Yet, this was not unavoidable; the Pact was applied in an overly restrictive way for political reasons by Europe’s conservative ruling alliance.
The diverging policy orientations in the USA and Europe have generated important differences in their economic performances. They teach a simple lesson: a loose combined fiscal and monetary policy stance is useful for reducing a demand gap and should be maintained until the output gap is closed; thereafter structural deficits must be consolidated. This should become the rule for a new, reformulated fiscal policy pact in Europe.
The debt sustainability constraint
When demand is insufficient to absorb the output capacity, austerity is self-defeating, because the lack of demand for products pushes firms to reduce investment and employment, and lower growth will reduce government revenue. Yet, if public debt is unsustainable, this will further destabilise financial markets and hamper the return to economic growth. There is, therefore, a delicate balance between excessive consolidation and excessive stimulus, while respecting the debt consolidation constraint.
Rigid austerity imposes rapid and excessive increases in primary budget balances in order to close deficits. But if such policies reduce economic growth, they become counterproductive. What matters for financial markets is the sustainability of debt, which means that over time the debt ratio will converge to stable long run equilibrium and does not explode. It can be shown that the fiscal rules under Europe’s Excessive Deficit Procedure yield a simple condition for keeping the debt ratio from becoming explosive: ignoring the 60% debt target and just focusing on the deficit target, the gap between an excessive deficit and the 3%-ceiling should be adjusted by not less than the growth-adjusted interest rate. In this case, the debt ratio will converge to a long run equilibrium that is determined by the ratio of the 3% deficit target divided by the nominal growth rate of GDP. If real growth is 2% and inflation 2%, the long term equilibrium is 75%. But if the adjustment rule is violated, the debt ratio will increase without bounds. The intuition is clear: when the interest rate is larger than the growth rate, the primary budget surplus must be increased in order to service the debt. On the other hand, the lower the interest rates and the larger the growth rates, the less fiscal consolidation is needed, because economic growth generates the income necessary to repay debt.
In principle, this adjustment rule is not very harsh, because in the long run growth and interest rates should converge. However, in the present crisis many economies are hampered by low or negative growth. Table 1 presents the consolidation efforts required to ensure dynamic sustainability in accordance with European fiscal rules. In order to compare European policies with the other major economies in the world, we apply these rules also to the United States and Japan. The first two columns show the actual deficit and the excess over the 3%. No consolidation is needed, when the public deficit is below 3 percent. Consolidation requires an increase in the primary structural balance. The difference between the interest rate and the nominal growth rate determines the minimum consolidation response required for debt convergence. The calculations are based on implicit interest rates, i.e. the ratio of actual interest payments to gross debt, as this is a more realistic measure than 10-year government bonds.
In five northern countries of the Euro Area and in most of the new member states in Central and Eastern Europe (except Lithuania, Poland and Czech Republic), there is no need for consolidation because deficits are below 3%. In principle, a fiscal stimulus would be possible here. In four states consolidation efforts have stabilised public debt. Under Monti, Italy has tightened its fiscal stance more than the minimum requirement. Hence, its public debt has become sustainable, but the margins for fiscal stimulus are still extremely narrow. The situation is similar in Slovakia, and in Lithuania and Denmark outside the Euro Area. In the other crisis countries, the situation is worse. 12 EU member states with excessive deficits are not meeting the sustainability condition. In Belgium and France, the required additional consolidation effort is less than 2% of GDP, and in the Netherlands and Ireland less than 3%. With an inflation rate of 2% this could easily be achieved by a return to historic growth rates. The situation is, however, much harder in Greece, Spain, Cyprus, and Portugal. Slovenia is also in trouble. In the United Kingdom and the Czech Republic, public debt is not sustainable either. In these last four countries, the problem is the loose fiscal policy stance, which would require fiscal tightening. But in most southern crisis countries, the dominant problem is the recession, because implicit interest rates are already relatively low. With negative growth of -3.4 or -7.4 stabilising public debt is simply impossible. Finally, Japan and the United States would also have to make big consolidation efforts, if they were following a policy regime similar to Europe’s fiscal rules. Of course, this is not the case. The point here is to show that the system of European budget rules is clearly more constraining than in other parts of the world.
The sustainability of public debt is, therefore, a real issue in Europe. Borrowing in order to stimulate demand can be justified more easily in member states without excessive deficits and without explosive debt dynamics. Given its size, Germany is the prime candidate for a fiscal stimulus. However, as I have shown in the first paper of this series, Germany is already close to a zero output gap, which means a stimulus would become inflationary. Thus, Germany’s capacity to stimulate Europe is also constrained. The other two large Euro economies have no room to manoeuvre either. France needs to avoid being too closely associated with southern crisis countries, because that would push up interest rates, and it must avoid a fiscally induced recession. Italy is the corner country between sustainable and unsustainable public debt. Given that it has one of the highest debt ratios in the Union, sliding into unsustainable debt positions could be fatal for the whole edifice of European integration. Hence, a fiscal loosening, which has been proposed repeatedly by Berlusconi and could be perceived as increasing the risks of insolvency, is counterproductive, but so is further fiscal tightening. The sad truth is that Europe’s debt situation does not allow ending austerity by implementing a strong fiscal stimulus. Debt sustainability requires adopting a neutral fiscal policy stance: no stimulus, no austerity.
The question arises nevertheless whether marginally loosening the policy stance could make public debt more sustainable by increasing the growth rate. The Keynesian answer is “yes”. By contrast, the neoclassical reply is that additional borrowing by governments will push up interest rates and lower growth. The empirical evidence leans slightly in favour of the Keynesian multiplier story as long as output gaps are negative. However, given the debt constraints on fiscal policy, an alternative policy may aim at strengthening regional growth by proactive investment policies. I will deal with that in my next column.
 Council Regulation (EC) No 1056/2005of 27 June 2005 amending Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit procedure, Article 1.
 For the full explanation of the concept of debt sustainability in the European context, see: S. Collignon, Fiscal Policy Rules and the Sustainability of Public Debt in Europe; International Economic Review, Vol. 53, No. 2, May 2012
 If the growth rate exceeds the interest rate, the stability condition is not α>(r-g), but . I used this formula for calculating the consolidation efforts in Lithuania and Japan.
 Due to bailout money and haircuts, Greece has now fairly low implicit interest rates.
 See Corsetti G., Meier A., Müller G.J., (2012), “What Determines Government Spending Multipliers?”, IMF Working paper 12/150; Blanchard O., Leigh D., (2013) “Growth Forecast Errors and Fiscal Multipliers”, IMF Working Paper, 13/1; Auerbach A.J., Gorodnichenko Y., (2011) “Fiscal Multipliers in Recessions and expansions” NBER Working Paper, 17447; Auerbach A.J.,Gorodnichenko,Y., (2012) “Measuring the output responses to fiscal policy”, American Economic Journal: Economic Policy 4(1), pp: 1–27; Barrel R., Holland D., Hurst I., (2012) “Fiscal multipliers and prospects for consolidation”, OECD Journal: Economic Studies, 2012(1), pp: 71-102; Mittnik S., Semmler W., (2012) “Regime dependence of the fiscal multiplier”, Journal of Economic Behavior & Organization, 83(3), pp: 502–22; Seidman L. S., (2012) “Keynesian Fiscal Stimulus: What Have We Learned from the Great Recession?”, Business Economics 47(4), pp: 273-84;