Transcript The Future of Europe

The European growth
prospects: what are we
expecting?
Prof. Carluccio Bianchi
Università di Pavia
La crisi dei debiti sovrani e le prospettive dell'Italia
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A deep and long recession
The European Union (EU) as a whole and the Eurozone in
particular experienced a period of heavy downturn and
prolonged economic slowdown after the Great Crisis first and
the European sovereign debt crisis afterwards.

Next graphs show the dynamics of GDP growth, of the
unemployment rate and of the investment ratio in the USA,
the EU28, the Eurozone and the UK, whose performance was
definitely better than the average of EU countries.

The growth performance
GDP growth rates after the Great Crisis
4,0
3,0
2,0
1,0
0,0
2007
2008
2009
2010
2011
2012
2013
-1,0
-2,0
-3,0
-4,0
-5,0
United Kingdom
United States
Euro area
EU28
2014
2015
The unemployment rates
Unemployment rates after the Great Crisis
13
12
11
10
9
8
7
6
5
4
2007
2008
2009
European Union (28 countries)
2010
2011
2012
Euro area including Lithuania
2013
United Kingdom
2014
2015
United States
2016
The investment rates
Investment rates after the Great Crisis
24
22
20
18
16
14
12
2007
2008
2009
Euro area
2010
2011
European Union
2012
United Kingdom
2013
2014
United States
2015
2016
A two-speed Eurozone
Within the EMU, however, a divergent performance
characterizes core central countries (mainly Germany, and
excluding France) with regards to peripheral (GIPSI)
countries.
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Next graphs show the recent dynamics of GDP growth and of
the unemployment rate in Germany versus the GIPSI
countries.
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A two-speed EZ
Growth rates in Germany and GIPSI average
6
4
2
0
2007
2008
2009
2010
2011
2012
2013
2014
2015
-2
-4
Germany
-6
GIPSI
A two-speed EZ
Unemployment rates
20
GIPSI average
Germany
18
16
14
12
10
8
6
4
2
0
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fiscal policy and growth
The different economic performance between countries after
the Great Crisis and within EZ member States after the
European sovereign debt crisis is of course mainly due to the
different stance of fiscal policy.
 In the USA and in the UK Government deficits were allowed
to widen greatly immediately after the Great Crisis and then
fiscal retrenchment was a slow still-ongoing process.
 In the EU, but especially in the Eurozone, fiscal policy was at
first weakly expansionary, because of the EU Treaties
constraints, but then pro-cyclical fiscal consolidations were
required to peripheral countries during the sovereign debt
crisis.
The process is still continuing, albeit at a slower pace.
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The Government deficits
0,0
0,0
General Government financial balances
General Government financial balances
2007
2007
2008
2008
2009
2009
2010
2010
2011
2011
2012
2012
2013
2013
2014
2014
-2,0
-2,0
-4,0
-4,0
-6,0
-6,0
-8,0
-8,0
-10,0
-10,0
-12,0
-12,0
-14,0
United
UnitedKingdom
Kingdom
United
UnitedStates
States
Euro
area
Euro
area
EU28
EU28
2015
2015
2016
2016
Austerity vs growth
The EMU situation has been, and still is, conditioned by the
European orthodox attitude towards economic policy, according
to which monetary policy should aim to price stability only and
fiscal policy to balanced budgets.
The austerity measures taken had a strong negative impact on
growth and unemployment. The triggered recession, then,
increased Government spending, decreased taxation revenues
and thus increased the deficit/GDP and the debt/GDP ratios.
 Therefore austerity led to pro-cyclical fiscal policies, which
reduced growth rates and required new austerity measures.
The simultaneous reduction in deficits of all countries amplified
the negative effects of austerity on member countries.
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The crisis spiral
The contradictions of austerity
When the output gap worsens, the Government deficit (or
borrowing requirement) increases (because expenditures rise and
taxes fall).
 Let us label e as the responsiveness (sometimes also called
elasticity) of the public budget to the output gap (og). Then it will
be: Dbr=e og, where br is the deficit/GDP ratio.
 e will depend on the type and burden of the taxation system and on
the type and extension of the Social Welfare system.
 In the case of Italy it is believed that e is approximately equal to
0.5. Obviously e is higher in Nordic-Scandinavian countries, a bit
higher in core Continental Europe and lower in the UK and in the
Mediterranean countries.
In the case of Italy, then, if ceteris paribus the growth rate of GDP,
and thus the output gap, falls by 2%, then the public deficit will
worsen by 1%.
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The contradictions of austerity
To evaluate the possible effects of a fiscal restraint on income, it is
useful to refer to the income multiplier (m), whereby
Dy=m DBR.
1
 The multiplier is equal to
with regards to direct Gvt.
1  c(1  t )  m
c
expenditure and to
with regards to taxation or
1  c(1  t )  m
transfers (with a positive sign).
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In Italy approximately we have c=0.8, t=0.4 and m=0.4. This
means that the expenditure multiplier is about 1.1 and the tax
multiplier 0.9, i.e. not very different from 1.

Multipliers not very different from 1 seem to characterize the
average EU situation.
The contradictions of austerity

Hence, since Dy=m DBR, we may write that Dy=DBR, and
Dy DBR
g 

 Dbr
y
y
It follows that a budget restraint of 2.5% will determine a fall
in the growth rate of GDP substantially by the same amount.
 But then, since Dbr=e og, the fall in g (and thus the increase
in the output gap) of 2.5% will determine a worsening of the
budget by half, i.e. 1.25%
 This in turn will require new austerity measures of the same
amount (1.25%), which in turn will imply a further fall in the
growth rate by half (.625%) and a new worsening of the public
budget, requiring new restrictive measures.

The contradictions of austerity
The just described process implies smaller and smaller
reductions in the growth rate until a new equilibrium is reached
with a stable GDP (actually a GDP rise in line with potential
GDP growth).
 Summing up all GDP declines, starting from an initial
reduction of 2.5%, one gets an overall loss of 5%, possibly
distributed over several years.
 Thus, a fiscal restraint implies a feed-back effect through GDP
reduction on the Government budget, that hampers the
assumed recovery of the economic system, which might never
take place, especially if restrictive measures are taken by
several countries together.

The contradictions of austerity
Indeed experience shows that the EZ fiscal restraints had the
expected effects on GDP, but the opposite, unintended effects
on the dynamics of the public debt/GDP ratios.

The EU growth prospects
As we saw before, after the disappointing 2014 results (0.8%
in the EZ and 1.2% in the EU), GDP growth is supposed to
regain momentum this year (1.1-1.5% in the EZ and 1.7-2% in
the EU) and improve further in 2016 (2.1% in the EZ and 2.6%
in the EU).
 This more favourable growth dynamics rests on 4 main
factors:
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1)
2)
3)
4)
the reduced price of oil and energy;
the ECB QE effects;
the depreciation of the euro
more accommodative fiscal policies in member countries.
The EU growth prospects
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There are however downside risks due:
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1) political conflicts (Russia/Ukraine and IS threat in the Middle-East);
2) financial instability connected to the solution of the Greek bailout;
3) less favourable effects of the QE (there is evidence, for instance,
that the Italian banks are using the liquidity granted by the ECB to
buy German bonds rather than make loans);
4) a more pronounced and possibly longer period of price deflation,
leading to a change in inflationary expectations;
5) slowdown in the growth process of emerging economies;
6) a new stock market downturn after the relatively high P/E ratios
recently reached;
7) slowly-proceeding effects of the recent structural reforms in many
EU countries;
8) the sword of Damocles of the Fiscal Compact.
The EU growth prospects
Anyway the current growth forecasts are insufficient to
eliminate the negative output gap inherited from the past.

Output gaps in the EU and in the EMU
4
3
2
1
0
2007
2008
2009
2010
2011
2012
-1
-2
-3
-4
Euro area
EU28
2013
2014
2015
2016
The problem of the Fiscal Compact
According to the agreements made, the FC rules should have
started in 2015. However it was also established that for
countries that incurred in the EDP, compliance to the Pact
should begin 2 years after the closure of the EDP; for instance,
in the case of Italy, the FC should start in 2016.
 According to the recent Italian DEF, compliance to the Pact is
postponed to 2018, when the overall Government budget
would be balanced, more or less in line with the structural
budget.
 The dynamics of the Government primary and overall financial
balances implied by the most recent DEF and compliance to the
Pact are shown in the next graph.
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Italy’s problems with the Fiscal Compact
Time dynamics of the Government primary and financial
balance to fulfill the FC requirements
5,00
pb
4,00
3,00
2,00
1,00
fb
0,00
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
-1,00
-2,00
-3,00
-4,00
The problem of the Fiscal Compact
Since in 2014 the deficit is at 3% and the primary surplus at
1.6%, and in 2015 the figures would not change for the primary
surplus, but only slightly for the overall balance, thanks to the
reduction in interest payments, one can wonder how the required
primary surplus of 3.8% can be reached in 2018 (2.2 percentage
points higher), with no effect on the growth rate, assumed to
remain constant around 1.1-1.2%.
 Furthermore the graph shows that in the path towards the 60%
target of the public debt/GDP ratio, the decline in interest
payments would lead to the transformation of the current deficit in
a surplus that would finally reach 2% of GDP. This dynamics, still
required by the FC rule in order to reduce the debt/GDP ratio to
the reference value of 60%, would imply a budget surplus even
excessive in relation to what is required by the Treaty itself
(balanced structural budget or deficit equal to 0.5%).
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A new framework for Europe
If EMU countries can return to a stable satisfactory growth
path, the architecture of the Eurozone must be changed,
introducing the following novelties:
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ECB mandate to care both about unemployment and price stability
and to attribute her the function of lender of last resort with no
constraints
Centralized fiscal policy, with a federal budget of an adequate size,
federal transfers, discretionary counter-cyclical fiscal policy aimed to
increase public investments financed with the issue of Eurobonds
(EIB)
Risk-sharing authority to guarantee bank depositors and creditors
Pooling of national debts, at least at the Maastricht threshold level
Use of real indicators of divergence (such as current account
imbalances) in order to impose symmetric adjustments on deviating
member States and require surplus countries to expand aggregate
demand (as in the Six-Pack agreements).