Rebalancing the Eurozone: The Role of Northern Fiscal Policy

By Jasper De Meyer (Intern at ECIPE)

The Eurozone crisis muddles forth. Growth will be stagnant or even decline in 2012. Employment prospects remain bleak as unemployment rose by 2.6 million in the last year alone. In September, the ECB announced its Outright Monetary Transactions programme in an attempt to ease sovereign debt pressures and in December EU leaders tentatively moved towards an EU-wide banking union. But what role, if any, could Northern fiscal policy play to reduce EU-wide macroeconomic imbalances? A recent report by the EU Commission sheds light on this issue.[1]

In 1999, the European Union embarked on its most ambitious project yet: the establishment of a common currency. The shortcomings of the Euro are often heard these days, but they are worth repeating here. Economists have long argued that the Eurozone does not constitute an optimal currency area. For a common currency area to work, they argued that the business cycle and key economic variables such as growth and inflation would need to be in sync across the area. They warned that, in abandoning their national currencies, European countries would lose the necessary policy levers to deal with the inevitable asymmetric shocks that would arise after the Euro’s introduction.

A common interest rate policy, for instance, meant that immediately after the Euro’s introduction monetary policy was too restrictive for a struggling Germany, and too expansive for the booming peripheral economies of the South. This in turn fuelled consumption in the South, as well as inflation in assets and wages. And indeed, between 1996 and 2010, wages grew at disparate rates across the Eurozone. In Germany and France, unit labour costs increased respectively at just 8% and 13%. Meanwhile in Southern Europe, labour costs rose 24% in Portugal, 35% in Spain, 37% in Italy and an immense 69% in Greece.[2]Uneven wage inflation across the EU harmed the competitiveness of the Southern economies of the EU and increased their trade deficits vis-à-vis the fiscally prudent countries of the North. In Greece alone, the current account deficit soared from 6% of GDP in 2004 to 15% of GDP in 2007.

Without the Euro in place, balance of payment issues would have led to currency devaluations that in turn would have allowed the GIIPS countries to regain competitiveness relative to the rest of the world – in the process, remediating trade imbalances within the EU. But with no recourse to devaluation, some economists have begun to propose alternative ways in which the Eurozone economy and specifically intra-EU trade deficits could be rebalanced. A common policy suggestion is for Northern countries to increase fiscal spending in order to counter-act the depressive effects of austerity measures in the South. This argument often also takes on another form, where policy makers suggest wage increases in the North would have a similar effect on intra-EU trade. But could a Northern fiscal expansion or wage inflation rebalance EU trade?

A new report by the European Commission for the Directorate-General for Economic and Financial Affairs sheds light on this issue. Olli Rehn, the Commissioner for Economic and Monetary Affairs, argues that the impact of such proposed fiscal measures should not be over-estimated. A quick examination of the empirical data proves his point. Indeed, increases in German demand would have a much greater impact on its nearby trade partners than it would on the large deficit countries of the South. Countries to the East of Germany, such as the Czech Republic, Slovakia and Hungary would stand to benefit the greatest gains. Ironically, an increase in German imports would drive Northern surpluses upwards more than it would drive Southern deficits down. For instance, a 1% increase in German demand would have the largest effect on surplus-countries Austria and The Netherlands, where exports would respectively grow at 0.19% and 0.16% of GDP. In comparison, a similar increase in German demand would increase Spanish exports by 0.06% and Greek exports by 0.05%. Moreover, because increases in German demand would also boost German production, the actual trade balances of Spain, Italy and Portugal would only improve “by around 0.02% of their GDP, and the Greek balance even less.”[3]

Those in favour of a Northern fiscal expansion or wage inflation nevertheless argue that “alongside the described positive demand effect, deficit countries could further benefit from Germany rebalancing through yet another channel as the competition from German exports would decline.”[4]This would restore the competitiveness of Southern products at home and in third markets. Arguably, the latter would benefit countries like Spain and Italy more than it would Greece, as the former two have “a relatively high degree of overlap with German exports” whereas such similarities do not exist between Greece and Germany.[5]However, this can hardly be considered an optimal strategy, as it has the ultimate effect of making the whole of the EU less competitive on a worldwide basis. It would be more sensible to recognise that the bleak economic outlook in EU deficit countries reflects poor competitiveness relative to the rest of the world, “rather than [due to a] lack of demand from the core Euro area.” [6]Hence, policy should focus on rebalancing the competitiveness of the Southern European economies relative to its Northern neighbours. Progress is being made on this front, and Olli Rehn writes that Greece, for instance, has recouped its wage “competiveness losses in 2001-09 – expressed in terms of unit labour costs.”[7]Wage costs have similarly fallen in Ireland, where unit labour costs decreased 12.7% between 2008 and 2012.

But more can be done. Several economists have put forth the idea that trade deficits could be rebalanced through a process called fiscal devaluation.[8]A fiscal devaluation refers to the idea of instituting a VAT/payroll-tax swap, or an increase in the VAT level and a similar decrease in employers’ social security contributions. It would have a similar effect as a currency devaluation, in that it makes imports more expensive and exports cheaper. First of all, VAT increases would increase the costs of imports. Second of all, as exports are exempt from VAT changes and as lower social security contributions would lower wage costs for domestic producers, exports would become more competitive on the world market. Milton Friedman famously argued in favour of flexible exchange rates: why negotiate a price change for thousands of wage contracts, when a similar result can be more easily achieved by an exchange rate depreciation? In that sense, a fiscal devaluation has similar benefits to a currency depreciation, in that it targets all prices at once. The effect of a VAT/payroll-tax swap, meanwhile, would be tax neutral and the increased exports would have the potential of generating additional tax revenue. Naturally, certain sectors will benefit more than others, particularly the labour-intensive sectors and those where competition is the highest. Meanwhile, the risks associated with attempting a fiscal devaluation are very low, as studies have shown that a heaver reliance on income rather than consumption taxation is growth-distortive.[9]

VAT rates are already high in many European countries, and an unofficial commitment between EU countries not to surpass the 25% mark may suggest that there is little scope for further increases. However, IMF economists Mooij and Keen argue that “considerable more revenue could be raised from the VAT even without increasing the standard rate.” [10]This is especially true for the Southern European economies such as Greece, Italy and Spain where non-compliance with VAT rules is especially high. They calculate, for instance, that if compliance levels in Italy were “of the level found in France, it would increase VAT revenue by about 1.2% of GDP.”[11]Several countries have implemented fiscal devaluations in the recent past. Germany, for instance, raised its VAT in 2007 from 16% to 19% while simultaneously cutting “employers’ contributions to social insurance from 6.5% to 4.2%.”[12]France meanwhile implemented similar measures in 2012. The Southern economies of the EU should follow suit.

In any case, it is important to emphasise that no single measure will be the silver bullet that will rid the Eurozone of all its imbalances. The Eurozone crisis is a multi-faceted crisis that will require a whole slew of reforms, from labour market reforms to banking reforms as well as a strategy to create growth. Nevertheless, the effects of Northern fiscal policy on rebalancing intra-EU trade should not be exaggerated, and increasing the competitiveness of the Southern economies should remain the primary objective of policy reforms. Perhaps a fiscal devaluation offers one potential avenue through which the latter can be achieved.