On Wednesday October 21st, the European Fiscal Board, an independent body that advises the European Commission, urged policymakers to take advantage of the opportunity for much-needed fiscal policy reform. The Stability and Growth Pact’s current temporary suspension has led for calls to rethink whether the pact’s target of a 60% debt to GDP ratio and 3% deficit limit are still suitable in the long-term for a Eurozone economy impacted by COVID-19, and facing the increasingly likely risk of a double-dip recession as COVID-19 infections continue to rise across the continent. If policy fails to adapt, whilst delays of the €750bn recovery fund persist, the region risks facing a perilous fourth quarter and long-term difficulties.
Rising infections and restrictions
The Eurozone faces a number of threats to the economic recovery and stability that it enjoyed towards the end of the summer. Third quarter economic growth in the region is forecast by Consensus Economics to be close to 10% greater than the second quarter of this year, as businesses were able to reopen and consumption recovered. However, the recent rise in COVID-19 infections across the continent threaten to undo much of the recovery as nations are forced to reimpose restrictions.
In the week to October 11th, Europe registered its highest weekly number of COVID-19 infections of almost 700,000 new cases, according to the WHO. Nations across the continent continue to restrict economic freedom and activity in response to record new infection numbers. This rapid escalation and dramatic change to the summer is captured by a senior economist at Allianz, Katharina Utermohol, who said, “I can’t believe how fast the second wave has hit. We now see growth turning negative in several countries in the fourth quarter” as French and Spanish fourth quarter growth forecasts have been slashed to negative 1.3% and 1.1% respectively by Allianz.
Further weakness across the continent was evidenced by September’s IHS Markit survey of purchasing managers, which showed that for the first time since May businesses were reporting a contraction in activity compared to the previous month. Eurozone unemployment increased in August by 251,000. As a result, many new predictions forecast negative growth for the Eurozone’s fourth quarter, only one month after the ECB forecast growth of more than 3%. Even if governments have learnt from the first wave and are able to manage the second wave less restrictively and keep parts of the economy open, the fact that infection rates are increasing at such a rate is likely to haemorrhage consumer activity. In the words of one ECB governing council member, “A double-dip is possible”.
The need for fiscal help
The challenging situation in which EU members now find themselves calls for impactful and decisive fiscal action. Although the region’s €750bn recovery fund was agreed upon in July, its distribution is likely to be significantly delayed as nations continue to clash over how the fund should be spent, with talks on October 8th breaking down after less than an hour. Even more concerning for the region is the fact that many European nations are betting on a sharp 2021 recovery and planning fiscal policy to match it. Budgetary plans submitted by nations at the start of October showed that Germany plans to reduce its deficit as a percentage of GDP by 2% next year, whilst France also plans to cut its deficit. As EU fiscal contribution through the recovery fund may be delayed beyond January, and the fact that it will not be able to address all needs for stimulus, means that premature fiscal tightening may increase the likelihood of a double-dip recession, as in 2011. Additional fiscal help is required across Europe to help fight off another recession. Nations must avoid premature fiscal tightening and reform and change are required to ensure that this is in line with European fiscal rules in the long-term.
Fiscal rule reform
Beyond the need for current fiscal action, the EU needs to review and reform its fiscal rule book, the Stability and Growth Pact, in order to accommodate for the aggregate fiscal deficit of €976bn by the end of the year for the Eurozone. Budget deficits this year stand close to 10 times higher than last year’s levels. A sustained recovery has been shown, by recent increases in economic restrictions following a rise in COVID-19 infections, to be highly unlikely. Therefore, the European Fiscal Board has called for the currently suspended fiscal rules to be amended. Levels of debt will likely remain high for the near future and with the IMF forecasting that the debt to GDP ratio for the Euro area will top 100% this year and next, the previous provisions for EU fiscal rules (which includes a 60% debt to GDP target) are now highly inappropriate. The EFB’s chair has warned that the EU ought to take advantage of the suspension now rather than later given that, “it seems likely that trying to revise the rules after deactivation could prove even more contentious”. Further to this, it is well known that fiscal policy formulation for the EU is not without its difficulties, given the time that it took to reach an agreement on the recovery fund and the subsequent continuing disagreements that look likely to delay the fund’s implementation.
However, immediate reform is unlikely. Ministers will want to avoid a public discussion on fiscal rules as the uncertainty it will create over the outcome of the EU’s stance on public debt may create further instability in the markets. Moreover, the commission will want to ensure that the €750bn recovery fund is pushed through before entering into even more divisive talks on fiscal rules.
The need for fiscal rule reform of the EU is imperative. However for the time being, with other matters at hand, leaders will likely shelve the topic. Instead, European governments need to guarantee further fiscal stimulus and avoid premature fiscal tightening. The rise in cases and resultant economic impact, which may even turn growth negative, poses the risk of a double-dip recession reminiscent of 2011, if governments repeat their fiscal errors.