The Euro Area’s Brewing Clash Over Fiscal Policy

Dr Ivanovitch - MSI Global
Dr. Michael Ivanovitch

Compared to America’s 12.4% of GDP budget deficit for the fiscal year 2021, the euro area’s narrowing budget gap to 6.9% of GDP in this year’s second quarter looks like a paragon of virtue. Indeed, something to cheer about, because the monetary union’s deficit was nearly halved over the previous twelve months.

Even the area’s stabilizing gross public debt to GDP ratio of 98.3% seems entirely manageable in comparison to Uncle Sam’s rapidly rising liabilities to 126% of GDP.

So, what’s the euro area’s problem – why are its north and south wings spoiling for the fight over debts and deficits?

It’s the perennial issue of big differences in fiscal positions of major member countries.

Germany, of course, wants to serve as a fiscal point of reference, although the Dutch are credibly vying for that unique privilege.

The reference point in question is a treaty obligation (Maastricht Treaty, signed February 7, 1992) for all euro area members: they have to keep their budget deficit and public debt limits at 3% of GDP and 60% of GDP respectively.

Most countries, including Germany, found it very difficult to permanently adhere to those fiscal rules. As a result, workarounds have been found for “temporary” deviations, without changing the treaty conditions imposed by Germany in the early 1990s.

Another round of German fiscal austerity?

At the moment, Germany is running a budget deficit of 6% of GDP and a public debt of 69.7% of GDP. The Netherlands is the only major euro area country meeting the monetary union’s public finance conditions.

Germany is horrified by what some of its mainstream media call a “calamitous” state of public finances.

But it now looks like the “fix” is on the way. A tough talking “neoliberal” (i.e.  ultra-conservative) finance minister, Christian Lindner (the leader of the coalition’s Free Democratic Party), will soon be taking Germany’s most powerful cabinet position.

Lindner, apparently, prevailed to introduce in the government’s four-year program the commitment to (a) “no new taxes” and (b) “no new public debt” after next year.

The FDP is well-known for its fiscal conservatism, and Germans like the idea of “no new taxes.” They see that as conservatives’ victory over Social Democrats’ and Greens’ perceived propensity to tax and spend. “No new debt” is also seen as a check on future taxes, and it is literally called that way: “debt brake” (“Schuldbremse” in the vernacular).

Predictably, Germany’s euro partners -- who take 40% of Berlin’s exports and generate 40% of its trade surplus – are far from sharing the German enthusiasm for the “debt brake.” They fear that, as always, Germany will not stimulate its domestic demand, forcing the business community to turbocharge exports and grow on the back of their trade partners.

Paris and Rome will resist

That is an old problem, and there is nothing the Europeans can do about it. [Trump was the only American president who wanted to slash chronic U.S. trade deficits with Germany. The latest numbers are showing that the German trade surplus with the U.S. is running at an annual rate of $60 billion -- nearly one-half of the American trade deficit with the EU.]

But that is only part of the problem, because Germany’s new finance minister is expected to put pressure – through the EU Commission – on euro area governments to tighten fiscal policies in order to bring debts and deficits in line with the monetary union’s requirements.

Last week, France and Italy took a preemptive strike at such growth-killing procyclical fiscal policies. They voiced the same complaints heard when Germany imposed fiscal austerity on the sinking euro area economies during the financial crisis and a Great Recession.

A repeat of such measures is unthinkable to those two countries. Hosting the French president in Rome last Friday, November 26, Italy’s Prime Minister Mario Draghi vigorously opposed restrictive fiscal policies at a time when the economic recovery is struggling to stabilize under the impact of an intractable pandemic. On top of that, Draghi reminded that the EU countries are now invited to invest heavily in game-changing green and digital economies.

That was also a moment in history of the European project. By signing the French-Italian Enhanced Cooperation Treaty, the two countries wanted to coordinate and reinforce their positions in matters of the EU’s economic, security and foreign policies.

As things now stand, France and Italy seem to share close or identical views on key questions in all those areas. That is a powerful and a stabilizing signal at a time when Germany is in an apparently major transition, while “the new Europeans” from the eastern and central parts of the continent are posing serious issues of EU membership.

This, therefore, is not the time to push ill-judged and divisive euro area fiscal policies.