Monetary measures during fiscal consolidations in the past
In the nineties, Sweden, Canada, Finland and Italy all successfully consolidated their fiscal position through rapid reductions in fiscal deficits, without negative effects on economic growth and unemployment. This was because fiscal consolidation was systematically combined with a very expansionary monetary policy that included lower interest rates and, above all, a sharp depreciation in the exchange rate to kick things off.
In these countries, the fall in government expenditure was offset by an increase in exports linked to the devaluation of the currency as well as an increase in domestic demand linked to the fall in interest rates.
In the absence of sufficient monetary measures, the fiscal consolidations in several euro-zone countries are failing
The ECB’s policy rate is actually low, but long-term interest rates in the troubled countries have risen markedly, which results in long-term interest rates for the euro zone as a whole that are far too high.
Moreover, although it has depreciated since 2008, the euro is still overvalued against the dollar. And, since euro-zone countries want to reduce their fiscal deficits as quickly as possible, the euro zone’s policy mix is on the whole too restrictive. So it is unsurprising that activity is declining in countries with restrictive fiscal policies: Greece, Portugal, Italy, Spain, Ireland and even the Netherlands.
Indeed, the decline in growth is so substantial that fiscal deficits stopped narrowing in early 2012 in several countries (Spain, Greece, France, Italy and Portugal), requiring additional fiscal austerity measures to be adopted. But these measures will further weaken growth, especially because they are being adopted simultaneously by most of Europe (the euro zone and the United Kingdom). This could lead to an absurd situation later in the year whereby unemployment soars while the fiscal deficits fail to fall. European countries are moving increasingly to the right of the Laffer curve, where a more restrictive fiscal policy subsequently leads to a higher fiscal deficit due to a fall in economic activity.
The only solution: Expansionary monetary and exchange-rate policy
Euro-zone countries are at an impasse if the current policy mix is too restrictive, and the resulting fall in economic activity prevents them from reducing their fiscal deficits. The only solution is then to emulate the successful fiscal consolidations in the nineties by changing over to an expansionary monetary and exchange-rate policy. So – while there is no longer much to be gained from short-term interest rates in the euro zone – it is possible to reduce long-term interest rates in the countries where they are abnormally high.
In order to achieve this, these countries need to regain medium-term fiscal credibility, i.e. financial markets need to be convinced of their determination to stabilise their public debt ratios. This would enable the ECB to resume its government bond purchase programme (SMP) – aimed at accelerating the decline in interest rates – without fear of encouraging these countries to not reduce their deficits.
Furthermore, the euro must be weakened. Indeed, exchange-rate depreciation played an important role in the fiscal consolidation programmes of the nineties. And like Switzerland, China, or once again Japan, the ECB could accumulate foreign exchange reserves (in dollars in the ECB’s case) to push down the euro’s exchange rate against the dollar.
A depreciation of the euro would directly benefit the countries with large-scale industry (Germany, Italy, Ireland, Finland, Austria and Belgium) as well as countries with large-scale exports outside the euro zone (Belgium, Ireland, the Netherlands and Germany), while Spain, France, Portugal and Greece would indirectly benefit from the positive effects of the euro depreciation on these other euro-zone countries.
Although resuming its government bond purchase programme and accumulating foreign exchange reserves runs counter to the ECB’s culture, if it does not do this, several euro-zone countries will soon reach the absurd situation of the simultaneous increase in both unemployment and fiscal deficits at the same time that fiscal deficit reduction policies are being carried out. Indeed, the examples from the past clearly show that successful fiscal consolidations have always been combined with expansionary monetary and exchange-rate policy.