European Fiscal Policy: growth and employment potential

, by Harald Stieber

European Fiscal Policy: growth and employment potential

The current policy framework for discussing economic growth in the EU is the so called Lisbon Agenda. Having been a letter to Santa during its first 5 years - from 2000 to 2004 - where every politician put into objectives what nobody could ever reject (growth, employment, education, social cohesion, etc.) and after having been an almost complete failure as a consequence, the revived Lisbon process has become a more serious discussion at last.

It seems that member states, facing 19 million unemployed in Europe, are now willing to really pull up the sleeves, design specific policies and monitor their implementation.

So, if we have got Lisbon working, is there still a role for European fiscal policies? Fiscal policy plays an important role in member states when it comes to protecting the economy from external shocks. An external shock can be a sharp slowdown in demand for the economy’s products causing a sharp reduction in income with negative repercussions on employment, consumption, investment and, at the end of the day, standards of living. Fiscal policy via the tax system can cushion the economy to some extent against such shocks. Especially if the tax system exhibits progressive taxes on income, a reduction in income will automatically lead to a lower tax burden (due to this automatism, economists talk about automatic stabilisers). Facing lower marginal tax rates workers and employees will increase their supply of labour which in return, provided the economy allows some downward flexibility, will push down effective hourly wages thus increasing the competitiveness of the economy and thereby helping it to raise new demand for its products. Again, this currently takes place on the level of member states. But even if labour markets and wages are fully flexible, sometimes automatic stabilisers are just not enough. There is a clear case for additional fiscal stimulus [1] in the face of large shocks such as the burst of the dot.com bubble in the year 2000.

Comparing US and EU fiscal policies

To see what a single coherent European federal fiscal policy response could look like, take the example of the U.S. After 2000, not only did the U.S. let automatic stabilisers work fully, they complemented them with an impressive fiscal policy impulse. Taxes on income were lowered and public expenditures were raised substantially. Taken together, the fiscal policy stimulus amounted to 1.7% of GDP in the U.S. compared to 0.7% of GDP in the Eurozone. Not too dramatic if this had been the end of the story and both economies had started creating jobs again the year after. But this was not the case. In 2002, the difference in fiscal policy action became shocking: The U.S. provided their economy with an extra 3.4% of GDP of fiscal stimulus, the Eurozone coughed up a meagre 0.5% of GDP. At the same time U.S. monetary policy was more expansionary as well, but the difference to European monetary policy was less compelling and we will not dig further into that. In year 3 after the shock, U.S. fiscal policy remained expansive providing another 1.1% of GDP of fiscal stimulus.

...supremacy of fiscal policy on the federal level of the Union cannot be rivalled by Lisbon Agendas.

On the other side of the Atlantic, fiscal policy in the Eurozone was back to neutral - and European unemployment kept rising. Hopefully, this real life episode of economic policy making drives home the message to our top politicians, that supremacy of fiscal policy on the federal level of the Union cannot be rivalled by Lisbon Agendas. It can only be achieved via an effective European federal economic government and a European federal tax authority. For such a European federal economic government it would be sufficient to dispose of some 3% of the Union’s GDP to provide the Union with similar economic impulses if necessary in the face of a severe economic downturn. This is not much compared to public sectors sucking in 50% of GDP or more in European member states. Compared to today’s situation however, it means asking to give the Union 4 times the economic resources it currently has assuming (realistically) that all the current expenditure programmes stay in place and the additional 3% of GDP would come on top of that.

Conclusion

Concluding, let us go back to where we started. European federalists are sometimes accused to be in favour of strong centralist governments or even worse strong centralist bureaucracies. Of course, asking for a quadrupling of the European budget very much looks like that. But 4% of GDP is very much the upper limit of a useful European budget. One could add another 1% of GDP or so to provide for a common European army, but that is it. Furthermore, it is crucial to underscore the fact that such a 5% of GDP European budget would not necessarily translate into higher taxes for European citizens. Quite to the contrary, it could give room to somewhat lower taxes across Europe due to economies of scale. So the floor is open. In my view, federalists should be ready to offer constitutionally fixed limits to the size of the European budget if that is the prize for getting what is absolutely necessary.

Once we have effective European (fiscal) stabilization policies in place, we can go back to sweating the small stuff such as Lisbon agendas and stability pacts.

Footnotes

[1The fiscal policy impulse is computed as the change in the primary balance adjusted for the cyclical component expressed as a percentage of potential GDP. Data was taken from DG Ecfin’s AMECO database

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