The Eu stability pact and the output gap

A paper by Fedele De Novellis and Salvatore Parlato looks at the status of several EU countries with respect to the output gap, their fiscal policy stance and the restrictions that would have to be enforced in order to comply with the stability pact. It then analyzes four different fiscal policy scenarios for this group of countries.

The authors state that "GDP is lower than potential output for all the countries in the euro area and the average output gap for the European Union is -1.2 per cent for each year. In absolute terms, therefore, a reduction in taxation that would stimulate growth with effects on demand would be desirable for all countries. In relative terms those countries furthest behind with respect to the European average are The Netherlands, Portugal, Finland, Germany, Italy, Austria and to a lesser extent Belgium, all with a greater need to reduce taxation."

The paper proceeds to evaluate the following four economic scenarios:

1) Target: balanced budget in 2005
2) Target: stabilization of the debt to GDP ratio (reduction by 4 per cent of GDP per year for Italy and Belgium), assuming persistent inflation differentials
3) Target: theoretical stabilization of the debt to GDP ratio, assuming the same inflation rate for all the countries
4) Target: theoretical stabilization of the debt to GDP ratio, assuming the GDP growth equals the average cost of debt servicing

One of the results is that "if it is assumed that the gain resulting from revising the pact is used to reduce taxation and that this has the effect of raising GDP with an elasticity of 2, what emerges is an increase in the variation of output gaps with respect to the current situation... Account must therefore be taken of the trade-off between raising GDP growth rates in the European Union (and in the euro area in particular) and the importance of convergence between countries. It is in fact found that the achievement of the former objective is tied inevitably to pursuing policies that favor Germany and which not necessarily involve a reduction in existing differentials in the euro area in the short term."

Therefore, Euroland can choose between a) policy persistence and acceptance of adverse effects on growth (demonstrating that it is basically a treaty-bound assembly of nation-states) or b) policies designed to maximize growth (demonstrating that Euroland is a Federalist project that - while slowly harmonising price levels and market regulation - does not prevent differential growth rates in regions (in this case, the nation-state terminology would, of course, have to be considered as ultimately irrelevant: "favouring Germany" should certainly not be a goal, but would be an effect - just like differential long-term growth rates between regions of the U.S. - let´s say, the Appalachians vs. California - are definitely not a result of policy design and actors´ intentions.)

If the EU really does enforce the stability pact in its present form, however, then it is a virtual certainty that another weakness built into Euroland´s policy framework is going to be exposed: the fact that the ECB is not yet a lender-of-last-resort. A short-term recovery in Germany followed by a massive downturn would likely put the European payments system under pressure. This might even be a desirable outcome, since long-term economic progress in Euroland cannot be envisaged without episodes of creative destruction on the institutional level (including, of course, shifting more budgetary responsibilities to Brussels/Strasbourg.)