When economies turn down this tends to increase government budget deficits since tax revenues fall while government spending rises. There are broadly two intellectual traditions about how governments should respond. The orthodox view puts fiscal probity first.
Higher borrowing makes it necessary for governments either to cut spending or increase taxes in order to reduce the deficit.
But this policy has the effect of intensifying the economic downturn. Accordingly, the second intellectual tradition, usually described as Keynesian, argues for governments to accept the increased deficits, or even deliberately to increase them by raising spending and/or reducing taxes in an effort to prop up aggregate demand.
Unless you are completely doctrinaire, which of these two approaches is correct depends on the circumstances at the time – whether there are alternative policies available, whether a fiscal stimulus would work and whether and for how long the public finances can stand additional borrowing.
The conflict between these two approaches is now coming to a head in the eurozone. For many years, eurozone governments have been under the cosh as they have striven to reduce fiscal deficits.
In some countries, including Greece, the improvement in the deficit has been remarkable. But in some cases, because economic growth has been so low, the ratio of government debt to GDP has failed to come down, or has even increased.
And now every passing week brings further news consolidating the impression that the eurozone economy is slowing considerably. Last week we heard that in December industrial production dropped by 0.9pc, having fallen by 1.7pc in November.
Meanwhile, we now know that in the fourth quarter of last year the German economy avoided a contraction by the skin of its teeth.
In these circumstances, the Keynesian argument has trumped the orthodox one. Across most of the eurozone some sort of fiscal relaxation is set to happen this year.
The Netherlands and Germany are planning fiscal expansions of about 0.4pc this year. Admittedly, France is planning an expansion of only 0.1pc. Even taking account of those countries planning smaller expansions and the few planning to tighten, this gives a fiscal expansion of about 0.3pc of GDP for the eurozone as a whole.
Mind you, these eurozone stimulus programmes are pretty small beer compared to what has happened in the United States. In proportionate terms, President Trump’s fiscal stimulus was about four times the size of the eurozone’s planned stimulus this year.
Accordingly, it is not surprising that calls are being heard across Europe for the German government to do much more. You might well expect them to fall on deaf ears.
Traditionally the Germans don’t really do Keynes. Indeed, only recently Olaf Scholz, the German finance minister, said that Germany would stick to its “black zero” policy of always running a surplus.
But the record is not quite as hawkish as the rhetoric. In the wake of the global financial crisis. Angela Merkel’s government implemented a fiscal stimulus of 1.5pc of GDP. And over the period in 2000 to 2002 Gerhard Schröder’s government implemented an even larger stimulus.
Germany could manage to do something similar again. Certainly its fiscal position is far stronger than the equivalent in many other European countries.
In 2018 it ran a surplus on its budget of 1.6pc of GDP, compared to an average deficit for G7 countries of 2.1pc.
Moreover, its ratio of debt to GDP will probably be less than 60pc this year, the lowest in the G7 by a considerable margin.
Yet there are limits to what it can do. Its own fiscal position is not exactly hunky-dory. After all, under the Maastricht treaty to enter the euro countries were supposed to have a ratio of government debt to GDP below 60pc.
Germany only just qualifies. And in the UK, Chancellor Gordon Brown set as one of his fiscal rules that the debt ratio should be below 40pc. Admittedly, Keynesian critics of Europe’s tight fiscal policy can argue that there are striking examples of countries running with much higher ratios of debt to GDP without encountering serious difficulties.
But Europe’s position is quite different from theirs. The reason is – you’ve guessed it – the euro. Countries like Japan, the United States and the UK can run very high ratios of government debt to GDP without stoking fears of default because they borrow in their own currency, which they can issue without limit.
There is a potential risk of inflation in these countries but not really a risk of default. In the eurozone, by contrast, no country issues its own money, not even Germany.
European debt ratios are high as the result of large borrowing in earlier years and sustained slow growth in recent years. This faces eurozone governments with a looming fiscal credibility problem. They have only limited room to launch a fiscal stimulus but people want much more.
Governments have to hope that any economic downturn will be as limited as their room for manoeuvre. Otherwise there will be fireworks.
As it is, the politics surrounding this issue look dangerous. In France President Macron has announced some comparatively modest measures in order to quell recent unrest. They have the consequence of driving the French budget deficit up to 3pc of GDP this year. With a debt to GDP ratio of 97pc, France is hardly in a position to engage in a further substantial fiscal expansion. Meanwhile, Italy’s truce with the European Commission over its budget plans could break down at any time.
In these circumstances, you can imagine the wrangling that is going to go on about who is going to pick up the tab for the UK’s lost contributions to the EU budget once we are no longer paying in our £10bn net each year.
An ancient Chinese curse is to wish for somebody to live in “interesting times”. If nothing else, developments in the eurozone promise to be decidedly interesting – in the Chinese sense.
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