Are European Economies Reaching Their Fiscal Cliff?

While most of the attention during the past few weeks fell on the U.K. and for a good reason, Europe’s economies seem to be in deep trouble. The European Union appears to be facing similar problems, if not even worse in some EU member states. Similar to the U.K., Eurozone countries are experiencing huge inflationary pressures. Just like the BoE, the ECB has a very poor track record when it comes to containing, or even fighting (as it claims) this surge in increases in the general price level. In fact, both Central banks have failed to uphold their most important task of their mandate which is none other than price stability. Both the Euro and the Pound have performed very poorly. Not surprisingly the ECB has tried to shift the blame to other factors like the Russian invasion of Ukraine, or the ‘’speedy recovery from the pandemic.” The president of the ECB went as far as to say that inflation “pretty much came out of nowhere,” ignoring the alarming inflation trends above the 2% mark way before the invasion started.

It is very unlikely Eurozone countries will get any soft landing from the necessary but late increases in interest rates. This time around, the non-monetary factors that are at play, such as the negative supply chain shock due to the pandemic and the war in Ukraine are harming European economies, putting them at risk of recession. Monetary policy works with a time lag which is why the tightening should have been done earlier. Fears of harming the labor market and workers due to tight monetary policy ignore the fact that unemployment has been slowly falling. Furthermore, real wages are down since nominal wages can’t rise fast enough to compensate for the increase in prices.

The increase in interest rates is putting huge pressure on countries within the Eurozone. Especially those in the south who for years have run poor fiscal policies accumulating more debt along the way. This was possible mostly due to negative real interest rates and the ECB’S bond-buying scheme. With the inevitable rise in interest rates due to inflation and the looming specter of recession long-term bond yields have seen a rise.

If the current governments keep a business-as-usual economic policy without any reforms, a new European fiscal crisis is looming. The rise in public debt is just the symptom caused by a more widespread problem of excessive government spending in relation to GDP. Some would argue that raising taxes would be a solution. But how high can tax levels in the EU rise? After all, even if we put aside the fact that an overburdened economy has a negative impact on economic growth, raises the cost of living and so forth, most EU countries already employ substantially higher tax burden on their citizens, especially for lower and middle-income families, compared to other countries from the OECD block.

When countries have reached the peak of the Laffer curve, like some within the EU, new tax increases won’t necessarily bring any more revenue. A recent study from the OECD reports that some European countries have reached their top effective marginal tax rates (income, payroll, consumption taxes). In other words, higher taxes won’t generate new revenue in the state coffers. A pro-growth policy focused on increasing productivity and alleviating the pressure from the cost-of-living crisis, along with cuts in excessive and wasteful government spending that crowds out the private sector are the only long-term solution. Increases in government spending in the form of continuous relief packages are not only costly but inflationary as well by increasing aggregate demand and canceling out any of their ‘help’ provided to lower and middle-income households

Even before the pandemic countries in the European south were barely seeing any significant growth compared to other countries within the Euro area and the EU. This is even more troubling if you consider the fact that most countries within the EU such as Germany were also growing at an anemic pace but still higher than countries like Greece, Spain, Italy, and Portugal which are at the bottom for GDP per capita growth.

While there have been some rules and guidelines for Eurozone members in relation to their debt to GDP and other economic figures, for political reasons they were largely ignored in the past. There is a more effective way to reduce the fiscal burden of European governments on their citizens while at the same time reducing their debt to GDP. This type of proposal is very moderate and feasible since the only thing that needs to be done is for government spending growth to be slower than that of the private sector. A spending cap is more efficient and effective than anti-deficit rules or balanced budget proposals (since politicians can’t abuse the tax code), the Swiss debt brake, or Hong Kong’s constitutional spending cap (before the CCP took over) being good examples to follow. Even international agencies and organizations that are not the most free-market oriented such as the IMF, OECD, and even the ECB have acknowledged that spending caps are very effective.

Moreover, budgetary constraint reforms are just as essential as tax reforms, the U.K. proving this very recently. Unlike the U.K. and Japan (which has the highest debt-to-GDP ratio) which have proven far more reliable in fulfilling their debt obligations, Southern European countries don’t have that luxury. Greece or Italy, for example, are in even greater danger of reaching their fiscal cliff since. Such a spending cap would have certainly prevented the 2009 Greek debt crisis. Additionally, a spending cap would have allowed more fiscal leeway to support lower-income households in the recent energy crisis, similar to what Germany has done.

Since the EU has been against any reforms that would enhance tax competition, productivity, and innovation, it is more likely that the opposite will be the case. Politicians in Brussels and Strasbourg have been trying to do the exact opposite by trying to penalize low-tax countries, harmonize taxation and regulations, extraordinary interventions in already heavily regulated markets such as energy. All this with the help of the ECB whose political independence is questionable, to say the least, even though its powers like its American counterpart are greater than ever.