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Italy’s budget deficit of 2.4% of GDP is within the eurozone rules, but that is still much too high if the country wants to get a grip on its huge public debt of 159.3% of GDP.
Italy’s budget deficit of 2.4% of GDP is within the eurozone rules, but that is still much too high if the country wants to get a grip on its huge public debt of 159.3% of GDP.

ECB Expected to Offset Eurozone Fiscal Tightening

Last year, the eurozone got its budget deficit down to 1.8% of GDP from 2.1% in 2015. That was a stellar performance compared with 5% in the US and 5.2% in Japan

ECB Expected to Offset Eurozone Fiscal Tightening

If the eurozone countries continue to insist on balancing the books and cutting in half their current public debt to GDP ratio, it simply follows that the European Central Bank  has to provide an appropriate amount of monetary accommodation to offset the fiscal tightening and keep the economy on a steady and sustainable growth path, CNBC reported.
Here are some numbers to illustrate that fiscal-monetary alignment.
Last year, the eurozone got its budget deficit down to 1.8% of GDP from 2.1% in 2015. That was a stellar performance compared with 5% in the US and 5.2% in Japan.
But there are still big intra-area differences: The monetary union's fiscal balances span a range of a 4.6% of GDP deficit in Spain and a 0.5% of GDP surplus in Germany. France is somewhere in the middle with a deficit of 3.3% of GDP, slightly above the eurozone budget rule of 3%.
Spain and France have to bring their budget deficits to 3% of GDP by the end of this year. If they did that, they would cut 2% of the deficit-financed purchasing power from one-third of the eurozone economy—a significant hit to their domestic demand.

Cut Public Debt
Italy's budget deficit of 2.4% of GDP is within the eurozone rules, but that is still much too high if the country wants to get a grip on its huge public debt of 159.3% of GDP. Rome will now most probably refrain from any fiscal tightening because it is facing a possible general election in a few months.
Markets, however, may still force Italy's hand: Creditors are asking for higher interest rates, and the rising costs of debt service could lead to spending cuts to keep Italy's budget deficit below 3% of GDP.
Adding all this up, the ECB is looking at discretionary budget cuts (France and Spain) and similar market-imposed measures (Italy) in one-half of the eurozone economy. A fiscal tightening on such a scale clearly calls for an offsetting monetary policy.
Investors should expect that this sort of policy mix alignment will be in place for quite some time—if the eurozone's public debt of 109% of GDP is to be brought down to the mandated limit of 60%. The reason is very simple: Declining public debt can only be achieved with substantial and sustained primary budget surpluses (budget balance before interest charges on public debt).

Painful Structural Reforms
That won't be easy because serious socio-political issues will be raised as tighter budgets continue to erode Europe's unaffordable welfare states. These issues are called (painful) structural reforms. Countries like France and Italy find them politically flammable.
Striking down elaborate labor protection laws is strongly resisted; it is part of the class warfare and its short-run impact leads to losses of jobs and incomes. But windows of opportunity may be opening up.
The new government in France seems likely to have a comfortable parliamentary majority. That could help a quick passage of labor market reforms, especially if the rising business confidence and low credit costs were to lead to stronger investments and a new wave of job creation.
A similar scenario could happen in Italy, based on perhaps overly optimistic estimates that a reviving Democratic Party might benefit from political support of its earlier right-wing opponents. Regional elections (June 11) will tell us something about that. Either way, Italy's anti-EU and anti-euro forces seem now much more subdued than a few months ago.
As things now stand, the ECB should have no problem maintaining an accommodative policy stance in an economic system where 9.3% of the labor force is out of work, and where the core price inflation was declining to 0.9% last April.
The latest data indicate that most of the ECB lending goes to public sector borrowers. That credit aggregate has been growing at an average annual rate of about 10% in recent months, while lending to the private sector was increasing by less than 3%.
Lending to households and non-financial corporations is still weak. Credit extended to these two key sectors of the economy grew only 2.4% in the year to April, indicating a slow recovery of private consumption and business investments.

 

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