Fiscal Lessons from the US

While most reporting on the US at the moment focuses on President George W. Bush’s plans of a surge in troop presence in Iraq, a number of other interesting political developments are happening in Washington, DC – developments from which the Eurozone could draw some important lessons for its own governance.

One field in which Europe could learn is fiscal policy, more specific the so called “paygo” rule which the American Congress has voted on in early January, even before it began its core legislative agenda. According to this rule, any legislation of discretionary spending increases or tax cuts has to be financed by cuts in other spending or increases in other taxes. (Only military spending is exempted from this rule.)

The United States has experienced a rather impressive reduction of its public deficit with a similar rule before: eminent economists such as former Fed chairman Alan Greenspan have (at least partially) given credit for the reduction of deficits during the Clinton administration to that rule. In 1992, just before the Clinton administration took over, the US budget deficit reached 5.8 percent of GDP (according to OECD figures). This is more than twice as much as the current deficit, even though the US budget is now burdened with the immense costs of the war in Iraq. The state of public finances in the early 1990s was so dire that many commentators were sceptical whether the US would ever be able to stop the raise in public debt. Only six years later, the US budget was in surplus.

Looking more in depth at the data, it seems that this reduction came about mostly by spending restraint. While public spending outside social security and defense rose on average by 4.7 percent per year between 1993 and 2002, it jumped by almost 8 percent annually since the expiry of the paygo provision in 2002. And even while a very fiscally conservative Republican Congress in 1996 and the peace dividend might have contributed to the rapid reduction in deficits, the long period of low spending growth has most likely also its roots in the paygo rule.

What is really attractive about the rule is that it guarantees a medium and long-term spending restraint (and thus budget consolidation) without jeopardizing automatic stabilizers in the short run. If spending for unemployment compensation jumps in a downturn, paygo does not prescribe any budget cuts, as the increase in spending has not been discretionary. A similar argument applies if tax revenue falls short in a recession: Since the fall in revenue was not legislated, there is no need to increase tax rates or cut spending.

At the same time, the rule prevents policy-makers to use windfall tax revenue in an upswing (as the Eurozone is experiencing at the moment – see the interesting post on Italy’s finances on Wolfgang Munchau’s website) for their pet spending projects or irresponsible tax cuts. If such a rule had been in place, the German government for example would not have been able to pass a large tax cut in the boom year 2000, just to find its deficit above the three-percent treshold only a little later.

In short, the paygo-rule helps distinguishing between cyclical and structural deficits in a very easy and understandable way, without requiring legislators to understand technical issues such as output gaps or econometric filters (not to mention the problems that the large ex-post revisions to structural deficits pose for the actual policy making process).

Compared to the way the European Stability and Growth Pact (SGP) has been applied over the past years, the paygo rule thus prevents pro-cyclical fiscal policy, a problem that has contributed to prolonging the period of weak growth in EMU after 2000. European policy makers should thus think about including a similar paygo-rule into their own policy making. Even if the SGP will not be reformed anytime soon, single governments could contribute to long-term healthy public finances by passing national paygo rules.

At the moment, I have myself the opportunity to watch US policy making from a very short distance, being on sabbatical leave from the Financial Times Deutschland and working as a visiting research fellow at the American Institute for Contemporary German Studies at the Johns Hopkins University, in the building of the Brookings Institution and just across the street from the Institute for International Economics in Washington, DC.

The euro economy in 2007

With business and political life slowly returning to normal after the holidays, focus has shifted again towards political and economic developments to come in 2007. The founders of Eurozone Watch have taken a deep look into their crystal ball and present their findings in two posts, one on economic developments in EMU (this post) and one on political developments (to be published later this week).

Will the upswing in the eurozone continue?

Yes, albeit at a slightly lower pace. Restrictive fiscal policies in Germany and Italy will dampen economic growth from the very strong (Germany) and robust (Italy) pace in 2006. The rest of the euro-area is not in a position to make up for this growth slowdown. In France, problems in the manufacturing sector will continue and French fixed investment will continue to be comparably weak. Moreover, the interest rate hikes of the ECB will dampen economic activity all over the eurozone. Overall, an EMU GDP growth rate of slightly above 2 percent seems like a sensible forecast for 2007, after slightly less than 3 percent in 2006. As long as the US economy avoids an outright recession and the dollar does not crash, spill-overs to the EMU economy can be expected to be limited.

Is the ECB going to raise interest rates towards 4 percent?

Yes. The strong growth outlook will push the ECB to raise its interest rates to 3.75 percent in the first half of the year and by a further 25 basis points later on. As inflationary pressure is still limited, the ECB will refrain from tightening much faster. Risks to this call are, however, a stronger than expected US downturn or a strong appreciation of the euro. In these cases, the ECB might delay a further hike beyond 3.75 percent.

Will the euro further gain value in 2007? If so, what are the consequences? Who will suffer most?

The euro will most likely further gain in value. There is a significant risk that it rises above 1.40 $ in 2007. Two factors are supporting the young currency: With further interest rate hikes by the ECB, investment in the Eurozone will become more attractive. Moreover, the possibility of a rate cut by the US Federal reserve still remains. Finally, there is a risk that central banks in Asia and from OPEC countries continue to diversify their portfolios and buy euros.

As long as the euro appreciates only gradually and does not overshoot strongly over 1.40 $, the euro economy seems well prepared to weather a stronger currency. However, if the appreciation comes amid news of a strongly decelerating US economy, the tripple shock (together with fiscal tightening) might become a danger for the upswing in the euro-zone.

Country-wise, a further appreciation of the euro is set to hurt those countries most which compete mainly with Asia, such as Italy or Portugal. Countries which have weak domestic demand will also be hurt, as in those cases, internal demand cannot make up for the shortfall in external demand.

Will economic divergences in EMU continue to grow bigger?

Yes, albeit they will not be noticed much in 2007. Dispersion in headline GDP growth will be lower than in the past years. Especially Germany will not be a stark outliner anymore. Growth in high-flyers like Finland and Ireland is set to moderate. However, below the surface, the diverging trends in unit labour costs are set to continue. Italian, Portuguese and Spanish unit labour costs will continue to increase much more quickly than is compatible with a sustainable competitiveness position. Germany will continue its beggar-thy-neighbour policy not only with a continuing low (albeit slightly accelerating) wage increase, but has also lowered employers’ contribution (payroll taxes) on January 1, further depreciating in real terms relative to its partners in EMU. The debate on divergences is thus set to re-emerge.

Will Italy and Portugal, the EMU’s problem cases, finally do better in 2007?

No. Italy’s growth is dampened by massive fiscal consolidation which mainly relies on increasing revenues. Both countries are still losing competitiveness relative to the rest of the euro-area. In contrast to Spain or Greece, Portugal is not in a position of the business cycle in which domestic demand could compensate for the continuing problems of the export sector. None of the two countries is thus set to come anywhere close to the region’s average growth rate of about 2 percent in 2007.

P.S.: Happy New Year to all our readers!