showCASE No. 114: Expansionary Fiscal Policy in Times of Covid-19: a Crisis Measure or a Long-Term Shift?
The ever-spiking budget deficits in 2020 and rather hazy outlook for 2021 lead many governments and economists to agree on the short-term need for fiscal stimulus in response to the Covid-19. Some, however, see the current willingness to expand public spending as a welcome indication of a long-term shift in government’s approaches to fiscal policy.
Against this background, in this edition of showCASE we join a long-lasting debate on the appropriatness and relevance of the EU-wide fiscal rules as well as alternative approaches to public deficit and debt in the EU.
Written by Machteld Bergsta
A Shift in Macroeconomics?
From the onset of the pandemic, there has been a widespread acceptance among economists and governments that to protect households and firms and boost demand in response to the Covid-19 crisis, governments must temporarily accept a large increase in public debt.
The OECD argues that in case the recovery lacks vigor, it might be necessary to continue expansionary fiscal policy for a sustained period to stimulate broader household consumption and business investment. This willingness to increase government spending, with government debt reaching up to 89.8% of GDP in the EU in Q3 2020 (up from 79.3% in the same period the year before), represents a new way of thinking in macroeconomics for some, while being strictly a crisis measure for others. In this edition of showCASE, I will shed light on the ongoing debate on fiscal policy and debt sustainability and will discuss its potential impact on the future of fiscal policy.
Debt Sustainability in the EU
Following the 2008 crisis, the European Commission introduced changes in the EU fiscal policy that strengthened the monitoring of Member States’ budgetary position and aimed to encourage more responsible budgeting. The crisis showed a weakness in the EU’s economic governance and demonstrated a need for increased policy coordination to prevent the rise of imbalances and to ensure stability. There is now a greater emphasis on improving public finances in structural terms including more guidance on how to achieve this, combined with a better warning system of unsustainable debt and wider sanctioning options.
Nevertheless, one could argue that two reference values remain central. While routinely surpassed by a portion of the Member States – for e.g., reaching close to 180% in Greece, exceeding 120% in Italy, and nearing 100% in France and Spain in 2018/2019 – the 60% gross debt-to-GDP ratio and the 3% of GDP overall deficit limit
arguably retain an important role in the eyes of the public as an insurance that Member States would not take on excessive, or in other words, unsustainable, debt.
According to some economists, with the leading voice of Olivier Blanchard, current debt limits are too low and the economic situation both before and after the onset of the pandemic warrants higher government spending, i.e., higher deficit and debt-to-GDP ratio.
Already before the outbreak of the Covid-19 pandemic, Blanchard has repeatedly argued that in an environment of low interest rates, public debt can be increased without significant fiscal costs if the growth rate exceeds the interest rate – a major intellectual shift in macroeconomics. According to Blanchard, increased government spending can be vital for securing the livelihoods of workers or the survival of businesses. Inversely, the economic costs of not doing so could be substantial. Choosing fiscal prudence out of a desire to remain below the debt limit of 60% would – in Blanchard’s mind – be unwise, as the benchmark is highly context-specific and there is a room to increase public debt throughout the EU without running unmanageable risks.
Not all Member States agree with that logic. In the Netherlands, the Studiegroep Begrotingsruimte (SBR), a nonpartisan national advisory group on budgetary principles, which has made recommendations on budgetary policy since 1971, recently issued their recommendations for the coming government term. The SBR claims that, while low interest rates make borrowing cheap, they certainly do not make it low risk.
The current low interest rates create a highly favorable situation for the Netherlands to borrow money, but this does not mean that extra public debt can be taken on without significant costs. Borrowing works as long as lenders believe the debt will be repaid.
Currently, indeed, the difference between the interest rate and the growth rate is negative, which creates an ever-low debt quote. However, the SBR stresses that one cannot rely on this differential to remain negative. In the past, both the Netherlands and other countries have known as many periods of negative interest-growth differentials as periods of positive ratios. In case of a positive interest-growth differential, the deficit and debt will get bigger and bigger. On the other hand, even with a negative interest-growth rates differential, debt sustainability is not a given as interest rates could increase over time or once the European Central Bank (ECB) halts its loose monetary policy.