After Brexit: A Lighthouse Initiative for the Euro Area

Tuesday, 15 November, 2016

by Peter Bofinger

1.     Lessons from Brexit

Two lessons can be drawn from Brexit: First, it has created a high degree of uncertainty which increases the risks for the euro area. This adds to an already rather difficult global outlook due to the situation in the emerging market economies, above all in China. With Chinese exports and imports on a declining trend for almost two years, the global economy has lost a major growth locomotive. If the Eurozone (EZ) falls back into a recession, the ECB would not be able to provide an additional significant monetary stimulus. This calls for a proactive fiscal policy approach in the EZ.  

The Brexit shock also shows an obvious dissatisfaction of the average citizens with “Europe” in general and their overall living standards. Above all there is no shared project which would make it possible to identify with “Europe”. Thus, in order to avoid further political erosion, a joint “lighthouse initiative” is needed to make the positive effects of Europe clearly and widely visible to Europe’s citizens.

2.     Public expenditures for growth and sustainable development

An obvious candidate for both purposes is a joint fiscal policy initiative for investment and innovation. In the era of digitalization, future-oriented investments should be understood in a comprehensive way which goes far beyond the traditional brick and mortar approach. An interesting concept was developed by Michael Thöne (2005). For Germany he tried to derive an indicator for “public expenditures for growth and sustainable development” (PEGS). This indicator includes expenditures on education, including childcare, on research, family support, active labour market policies, health care, protection of nature and the environment, subsidies for renewable energies and infrastructure investment. Unfortunately, his calculations were not updated and no attempts were made to apply them to other countries.

As a rough approximation for PEGS, the sum of public investment, public funding of business research and development, public education expenditures and public expenditures in childcare can be used. They show the interesting result that Germany’s future investments in this definition are very low. Only Italy, Turkey, Chile and Greece have a lower ratio. Thus, the rule of the Stability and Growth Pact and the Fiscal Compact can have the negative effect that countries which try to follow them in a stringent way neglect investments which are at least as important for future generations as a balanced budget. 

Figure 1 

*Public investment+ Public funding of business research and development + Public education expenditures + Public expenditures in childcare. Source: OECD Going for Growth 2016

Thus, the lighthouse initiative should be designed in such a comprehensive way.  It should be based on the “golden rule” of public finance which allows the debt financing of government deficits if it is used for future-oriented investments. Accordingly, for the financing of these projects, member states should be allowed an exemption from the Stability and Growth Pact. The exemption can be justified by a sound economic principle: With long-term government bond rates close to zero it is not very difficult to find public future-oriented expenditures which generate a much higher return.

The annual size of the lighthouse initiative should be 1 % of the EZ GDP for a period of five years. This would be a total amount of 500 billion Euro. In contrast to the European Fund for Strategic Investments (EFSI), which receives public funds of only 21 billion Euro, this amount should be totally funded by governments. In order to avoid windfall gains, the member states would have to demonstrate that the funds are used to finance additional expenditures. This would require the projects to be checked and approved by the European Commission.

3.     Impact on public finances

For countries with high levels of government debt, any proposal that calls for additional deficits raises the question whether this could cause negative effects on fiscal sustainability and on financial markets. However, additional government expenditure must not necessarily increase the debt to GDP level. The debt dynamics depend above all on the multiplier of public spending, the debt to GDP level and the revenue ratio, which determines the additional government revenues due to a higher GDP. While there is an intensive debate on the actual size of spending multipliers, there is some agreement that

-        multipliers are higher in recessions than in booms

-        multipliers are much higher when monetary policy has reached the zero lower bound (ZLB) so that the stimulating impact of additional government spending is not compensated by higher interest rates.

As most EZ countries still have negative output gaps - the OECD estimates an output gap of -1,5 % for 2016 - the spending multipliers will be relatively high. In addition, one can expect that the ECB will not raise its interest rate for the next few years so that the ZLB will be maintained. A survey by Batini et al. (2014) shows that in the situation of the zero lower bound government spending multipliers range between 2.3 and 4.

As a simple exercise we calculate the impact of a 1 % increase in government spending on the debt levels of EZ member countries. This follows the simple formula which one can find in the paper by Eyraud and Weber (2013) (see Figure 2).

Figure 2. Impact of 1% increase in government spending on debt levels of Eurozone countriesSource: Eyraud and Weber (2013)

For the combined effects of a negative output gap and the ZLB we assume a relatively low multiplier of 2 and a revenue ratio of 0.3.  Table 1 shows that an increase in government spending of the size of 1 % of GDP would lead to a pronounced reduction of the debt to GDP ratio. The only exception is Estonia. But even for a multiplier of 1, for most countries an increase in the debt to GDP ratio can be avoided. For instance, in the case of Italy a multiplier of 0,6 would still avoid an increase in the debt to GDP ratio. Thus, in the current and foreseeable macroeconomic environment the lighthouse initiative would be at least self-financing.

As far as the effects of financial markets are concerned the lighthouse initiative should be implemented as soon as possible so that it can benefit from the stabilizing effects of the ECB’s quantitative easing.

Table 1: Effects of an increase of government spending of the size of 1 % of GDP on the debt to GDP level assuming a multiplier of 2 and a revenue ratio of 0.3

Country

Debt to GDP ratio (2016)

Change in debt to GDP ratio with a multiplier of 2

Change in the debt to GDP ratio with a multiplier of 1

Belgium

106,4

-1,728

-0,364

Germany

68,6

-0,972

0,014

Estonia

9,6

0,208

0,604

Ireland

89,1

-1,382

-0,191

Greece

182,8

-3,256

-1,128

Spain

100,3

-1,606

-0,303

France

96,4

-1,528

-0,264

Italy

132,7

-2,254

-0,627

Cyprus

108,9

-1,778

-0,389

Latvia

39,8

-0,396

0,302

Lithuania

41,1

-0,422

0,289

Luxembourg

22,5

-0,05

0,475

Malta

60,9

-0,818

0,091

Netherlands

64,9

-0,898

0,051

Austria

84,9

-1,298

-0,149

Portugal

126

-2,12

-0,56

Slovenia

80,2

-1,204

-0,102

Slovakia

53,4

-0,668

0,166

Finland

65,2

-0,904

0,048

Source: Eurostat and own calculations

With its broad focus, the lighthouse initiative would make it possible to hire teachers and professors, doctors and nurses, to establish new facilities for child care, to support research in renewable energy and energy storage. This would make its effects widely visible and tangible. To avoid problems after the five year investment period, hiring in the public sector should ideally be made for positions which are currently taken by employees that will retire within the next five years. This would provide a specific boost for labour markets with high youth unemployment.

The initiative should be evaluated after four years. Depending on the outcome, the rules of the SGP could be changed in the direction of the Golden Rule.    

4.     The ideal time for more public investment

The need for additional fiscal action at European level was obvious already before Brexit. Private and public investment in relation to GDP are at very low levels. At the same time, the annual increase in labour productivity has declined to about 0.5 % - much less than in the period 1997-2001 (1.3 %) and the period 2001-2006 (1.0 %).

As very low interest rates are unable to stimulate private investment, only public investment is able to boost productivity in Europe. In addition, the weak private investment activity implies that huge amounts of liquid private financial assets cannot find investors that are willing to pay attractive interest rates.

Thus, with the very low nominal and real interest for public borrowers it is the ideal time for a broadly-based public investment initiative for the euro area. 

References:

Batini, Nicoletta, Luc Eyraud, Lorenzo Forni, and Anke Weber (2014), Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections, IMF Technical Guidance Note, October 2014

Eyraud, Luc  and Anke Weber (2013),  The Challenge of Debt Reduction during Fiscal Consolidation, IMF Working Paper WP/13/67

Thöne, Michael (2005) Wachstums- und nachhaltigkeitswirksame öffentliche Ausgaben (WNA). FiFo-Berichte. Internet: http://kups.ub.uni-koeln.de/1442/