Europe's Recovery Hinges on Fiscal Policy

The eurozone’s economic expansion has hit a soft patch. Manufacturing has been shrinking for four months—but not at an alarming pace that would indicate a recession. The services sector continues to expand but at a much slower pace than in 2017 and 2018. Except for France, Europe remains politically fractured with fragile coalitions governing most countries. Recent EU elections hardly provided clarity, with nationalist and Eurosceptic parties and pro-Europe liberals advancing at the expense of traditional center-right and center-left parties.

Figure 1: Lagging but Also Improving: Eurozone Unemployment The Lowest Since 2008.

As such, it’s easy to overlook Europe’s positives: unemployment hitting a 11-year low (Figure 1) and, unlike, the US and the UK, the eurozone economy is deleveraging.  It’s debt ratios (public + private) have fallen from a peak of 265% of GDP in 2015 to 247% by the end of last year (Figure 2). Over the same period, total U.S. debt edged up from 248% to 250% of GDP while UK debt increased from 252% to 257% of GDP.

Figure 2: Unlike US and UK, Eurozone Debt Levels are Falling.

Declines in debt are especially impressive in five eurozone nations: Ireland, Portugal, Spain (Figure 3), Austria and Germany (Figure 4). Debt ratios are also falling in Belgium, Finland, Greece, Italy and the Netherlands, albeit at a slower pace.  French debt levels have stabilized during the past two years (Figures 5 and 6).

Figure 3: Ireland, Portugal and Spain are Achieving the Most Impressive Deleveraging.

In theory, the combination of extremely low interest rates and falling debt ratios should open the door to fiscal stimulus. The problem is that the wrong countries are attempting it. Although Italy’s overall debt levels are below the Eurozone average, thanks to extremely low household and corporate debt, its government debt remains a colossal 132% of GDP.  As such, Italy’s bond market has spent the past 12 months threatening to collapse if the government cuts taxes and raises spending.  Nevertheless, Italy appears to be heading towards a major tax reform and the bond market appears to be taking it in stride.

Figure 4: Germany and Austria’s Debt Levels are Arguably Too Low with Lots of Stimulus Potential.

Germany, the country that is in the best position to deploy fiscal stimulus, isn’t doing so yet. Even though Germany’s public debt fell from 65% to 61% of GDP over the course of 2018 and probably continued to decline in the first six months of 2019, there is no hint of tax cuts or additional infrastructure spending. One might imagine that the German government, which can borrow for up to 15 years at negative yields, might be enthused at revamping the country’s ageing infrastructure and perhaps aligning its 30% corporate tax closer to the 23% OECD average.  Germany might also consider cuts to individual income tax rates if it wishes to attract business away from a pro-Brexit Britain.

Figure 5: Debt Levels are Falling in Belgium & Finland, Stabilizing in France.

Figure 6: Greece, Italy and Netherlands are also Deleveraging.

That day may come.  Both German Chancellor Angela Merkel’s CDU/CSU Union and their junior coalition partner, the SDP, have been sinking in the polls (Figure 7). They turned in dreadful performances in both local and EU elections. The fastest way back to popularity would probably be to boost government investment in areas like green energy, roads and railroads. Furthermore, to the best of our knowledge, no politician has ever become unpopular because they slashed tax rates. With the next election scheduled for on or before October 24, 2021, Germany’s governing coalition has 28 months to figure out how to save themselves from electoral doom.  With a 2% of GDP government budget surplus, negative borrowing costs for up to 15 years, ageing infrastructure and uncompetitive tax rates, isn’t the answer to their electoral woes obvious?

Figure 7: Will it occur to somebody in the CDU/CSU/SDP coalition to cut taxes or raise spending?

Since Germany is 30% of eurozone GDP, any fiscal easing there would generate beneficial effects that would spill far beyond its borders.  Even if Germany doesn’t alter its fiscal stance under pressure from populist movements, other European governments might do so on their own.  Individually none of them will have the impact that Germany could have but collectively Europe will likely shift from a decade of constrained government spending growth to a more normal pace of growth in public investment.  Tax rates might also be pared back as economies recover.

ECB: Can the loosen monetary policy by raising rates?

Amazingly, after expanding its balance sheet from 20% to 40% of GDP between 2014 and 2017 and after five years of negative deposit rates, the ECB has been unable to boost the eurozone’s core inflation above 1% (Figure 8).  In fact, the core inflation hasn’t been above its 2% target in 16 years.

Figure 8: Eurozone Core Inflation has been Below Target for 15 Years.

If the eurozone economy does go into a downturn, it’s hard to imagine what the ECB could do about it.  Perhaps the one step that they could take is the most counterintuitive one of all:  raising interest rates.  If the ECB merely took its -0.40% deposit rate back towards zero without substantially raising its 0% lending rate, it would remove a EUR7.5 billion per year tax on eurozone banks.  If taxing banks to deposit money at the ECB really encouraged credit creation and faster economic growth, debt ratios probably wouldn’t be falling and growth rates would probably be significantly above where they are today.

European Central Bank President Mario Draghi doesn’t seem inclined to abandon his negative interest rate experiment before he leaves office in October.  Perhaps in a few months’ time, Draghi’s successor will attempt the strangest monetary loosening in all of history: raising rates.

Even in the US, the first few rate hikes in late 2015 and 2016 did nothing to harm growth and may have even benefitted the economy by allowing a more normal function of short-term money markets.  The same could prove true for the Eurozone when it gets out of negative-rate territory.

Bottom Line

  • Unlike the US and the UK, Europe continues to deleverage.
  • Germany and others might tilt towards fiscal easing.
  • The ECB is at the end of its rope.
  • Negative rates cost Eurozone banks EUR 7.5 billion per year.
  • Higher ECB rates could actually ease monetary policy.


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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