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7 October 2016

Gov­ern­ments Must Re­sist the Wind­fall Temp­ta­tion

Ludger Schuknecht, chief economist at the German Finance Ministry, explains why a fiscal stimulus now would risk the modest gains of recent reforms. A commentary published in the Wall Street Journal on 5 October 2016.

Dr. Ludger Schuknecht, Chief Economist at the German Finance Ministry

Dr. Ludger Schuknecht, Chief Economist at the German Finance Ministry
Ludger Schuknecht, chief economist at the German Finance Ministry

The International Monetary Fund and the Organization for Economic Cooperation and Development are once again calling for a coordinated spending boost by those countries that can afford it. Apparently, they believe that there´s more room for fiscal stimulus now given the low interest environment. It could even lead to lower debt, the IMF claims.

But whether this will really boost the global economy and not just add to the world´s debt is doubtful. And with several large economies heading for elections, calling for fiscal stimulus is an invitation for politicians to loosen the purse strings and postpone important policy reforms for the sake of getting elected.

Only a few years ago, global deficits and debt had sky-rocketed everywhere. Doubts emerged about whether governments could stay afloat, with credit spreads reaching very high levels even in important countries such as Italy and Spain.

Since then, through swift fiscal consolidation and reform, the commitment made at the 2010 G-20 summit in Toronto to lower deficits and public-debt stabilization have mostly been fulfilled. More remains to be done, but tailwinds from declining interest rates have helped yield big savings on government interest payments. Measured by public expenditure as a percentage of gross domestic product, some European countries now have governments hardly bigger - some even smaller-than the U.S.

A sustainable course for public debt is now in sight. This is a true success story of international policy coordination in the G-20 and in Europe. And it has been rewarded by renewed confidence and economic recovery. Growth is well above potential in the eurozone, and unemployment is expected to decline significantly in former crisis countries.

This achievement has been as remarkable as it has been timely. So why put it all at risk with calls for increased government spending? Fiscal stimulus was rightly applied at the height of the Lehman Brothers crisis. But today there is no crisis, only numerous arguments against the idea.

For one, even though it is being reined in, public debt remains very high almost everywhere. According to the IMF, it averages 120% of GDP in the G-7 and almost 100% in the eurozone. Deficits are just low enough to stabilize debt but not to bring it down markedly. Lower interest payments are flushing huge dividends into many countries´ coffers. And an aging workforce is about to shrink, which would increase fiscal obligations.

Lower growth prospects mean output and demand gaps will be lower than previously anticipated. Most major economies, including China, Germany, Japan, the U.K. and the U.S., are all approaching full employment, and G-7 output gaps are near their long-term average. For Germany, what would justify further expansion? The IMF has said that, in full employment periods, stimulus has little effect. Given Germany´s limited size and modest cross-border effects, a boost from Berlin would have little influence on European demand.

A change of course on fiscal policies would risk undermining fiscal rules and institutions. For decades, the European Commission, the IMF and the OECD have thrown their weight behind the rules that create hard budget constraints and avoid runaway expenditure. This is nowhere more appropriate than in Europe, where the Stability and Growth Pact is needed to anchor medium-term expectations. It would be shortsighted of these institutions to now call for more discretion and flexibility to facilitate a stimulus.

Low financing costs shouldn´t make governments foolhardy. The fiscal space that some countries currently see is mainly the result of quantitative easing and low central-bank rates. But these conditions must come to an end at some point. The ability of central banks to end QE and raise rates in a timely manner will depend on countries following through with sound medium-term fiscal strategies and debt reduction. Changing course on fiscal policies would therefore be risky for central banks.

Currently, there are only limited signs that such advice is gaining headway. But governments should resist the temptation to spend prematurely the windfalls of their efforts, and carry on with reforms.

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