Fiscal friends or foes?
19 September 2017
The potential for a rotation away from monetary policy towards a greater reliance on fiscal policy support has been a significant source of debate in the Eurozone in recent years. Indeed, over a year ago we wrote about the opportunity that the low rates environment creates for Eurozone economies to invest in high-return infrastructure projects. Since then, growth in the Eurozone has continued to surprise to the upside to the extent that the ECB is beginning to take its first baby step towards policy normalisation, with a tapering of its asset purchase programme likely to begin in January. Meanwhile, 2017 has been an election-heavy year in Europe, with a new reformist president in France and Chancellor Merkel's party facing coalition uncertainty in the upcoming German election. Could these changing government dynamics move the fiscal dial in the year ahead?
In France, the election of Macron is already bearing fruit; labour market reforms are progressing, which should increase the efficiency of the notoriously bureaucratic and inflexible labour market. However, Macron's fiscal ambitions are actually to reduce the budget deficit through his tenure. He campaigned on a platform to reduce corporate tax, cut public services by €60bn and increase government investment in skills and infrastructure by €50bn. While the headlines will likely show fiscal tightening in France in 2018 - if Macron can follow through on election promises - this move towards targeted cost cutting alongside greater infrastructure investment would be encouraging. Meanwhile, in Germany, the legislative election this month is likely to see Merkel's centre-right CDU party lead the new government, though uncertainty around the composition of a coalition remains high. Whichever the coalition partner, fiscal policy is most likely to change in the areas of income tax relief and some increased infrastructure investment – though there are few signals of a major investment package. Overall, we expect the newly elected governments to alter the composition of fiscal spending somewhat without especially marked loosening. This will contribute to a broadly similar aggregate Eurozone cyclically-adjusted budget balance in 2018 as that of 2017 (see Chart 5).
While both Macron and Merkel are committed Europhiles, their respective visions for the future path of Eurozone fiscal integration are not identical. While both favour establishing a Eurozone budget and finance ministry, they have very different views regarding the scope of such institutions. Macron would like a large budget to the tune of "several" percentage points of Eurozone GDP, which the finance minister would oversee, while Merkel would like a small budget contingent on structural reforms by beneficiaries, with the finance minister principally responsible for overseeing cross-country policy coherence. Meanwhile, a larger challenge to any form of fiscal integration remains in the shape of Eurosceptic parties and their at best apathetic voters concerned about the loss of sovereignty. While feelings about the EU have generally become more positive as the recovery has taken hold, the feeling of a democratic deficit in Europe remains (see Chart 6). That said, the greatest opposition to fiscal unity is likely to come from voters in core states who would ostensibly be supplying fiscal support to more exposed peripheral states, like Greece. It is this lack of European identity that poses the greatest barrier to European fiscal unity.