The Estonian economy does not need fiscal stimulus
Governor of Eesti Pank
The annual meeting of the International Monetary Fund (IMF) is being held in Washington this week, and the discussion will focus on the state of the global economy, the main obstacles to faster development, and economic policy recommendations for overcoming those obstacles.
These discussions are even more topical for us because the obstacles to development in the world and in Estonia overlap to some extent. Like it is in the global economy, productivity growth is slowing down in Estonia. There are also important differences, however. The problem in many advanced economies is that there is insufficient demand, and this results in high unemployment and lower employment than before. This is a serious problem in several euro area countries, where unemployment is notably higher than it was before the global economic and financial crisis. In this case, the IMF recommends using fiscal policy to boost the economy.
In Estonia, however, the situation is different. Our employment rate is at its highest point of the past two decades and unemployment is relatively low. This means that Estonia has no obvious need right now to boost the economy through fiscal policy. Increasing government spending at a time when wages are rising very rapidly and productivity is growing more slowly than wages could cause unnecessary tensions in our economy. It is important for competitiveness that growth in productivity and in wages go hand in hand, and for this reason, increasing demand at a time when it will further fuel wage growth will pose a threat to our competitiveness and through that to a rise in living standards.
It is hard for economic policy analysts like the IMF to give recommendations for the euro area as a whole. Estonia is not the only country in the euro area where unemployment is low and employment is high. A good example among the bigger countries is Germany, where labour market indicators are strong and real estate prices are rising, indicating the strength of the economy. There are more countries in the euro area, however, where it would make sense to boost demand, as those countries have high unemployment, falling employment, stagnant wages and weak economic growth.
This is made more complicated by the government debt of the euro area countries, as the debts of the weakest economies are often very large. This limits fiscal space, because increasing government spending or cutting taxes could easily make creditors fear that those countries will be unable to repay their debts. In this way such efforts to boost the economy could have the opposite effect to that intended.
There are clearly differing views on how to resolve this dilemma. The former chief economist of the IMF, Olivier Blanchard, is one who offers a clear recommendation: to revive the economy of the euro area, Germany has to use its fiscal policy to give a further lift to its own economy and must accept that this could lead the German economy to overheat. Blanchard finds that this risk is a sacrifice that must be made for the difficulties facing the euro area countries to be eased, albeit an indirect one.
The recommendations of the IMF are more nuanced. Firstly it recommends that euro area countries consider carefully which changes would improve long-term competitiveness in their economies and then quickly enact those changes. Such changes are usually improvements to the functioning of markets, upgrading of infrastructure, promotion of research and development, or increasing efficiency in health and education systems. The second recommendation is for stricter adherence to and enforcement of the fiscal rules agreed for the European Union. Apart from anything else, countries with more successful economies are likely to be more willing to aid those that are worse placed when they are sticking to the rules. However, the IMF also recommends that countries with smaller sovereign debts and smaller budget deficits use their fiscal policy to boost their economies. There is quite a lot of uncertainty though around how much those countries should look to their own economic circumstances, and how much to the needs of the euro area as a whole.
This discussion raises the question of exactly what responsibility each euro area country has for itself and what responsibility the whole euro area has for the good health of the economy of a particular country. When the euro area was created, a lot of attention was focused on this question. Roughly speaking the answers were that the monetary policy decisions had to be made for the euro area as a whole, but as there would always be some differences in the economic circumstances of different countries, it may sometimes be the case that the single monetary policy designed for the whole euro area would be either too loose or too tight for some individual countries. Fiscal policy would help to avoid such mismatches. Those countries where the single monetary policy is too strict could use fiscal policy to boost their economy, while those where the single monetary policy is too loose should consider cooling their economies with fiscal policy. To underline that euro area country is responsible for its own economy, the ‘no bail-out clause’ was agreed upon – the principle that countries are not responsible for the solvency of other governments. To avoid excessive spending during the good times and to underline the responsibility of each euro area country for its own economy, common fiscal rules were also agreed.
Recent years have clearly shown that several euro area countries have not managed to stick to that framework. There are various reasons for this, such as countries living beyond their means during the good times, the inability to foresee the massive fiscal costs associated with the financial crisis, and the failure to assess adequately the difficulties of economic adjustment in the monetary union. The result has been that countries that need to boost their economy cannot do so because their public debt is too big, while countries that have the capacity to do it have no need to do so for their own sake. Estonia is in the second of these groups.
In conclusion, I find that in a situation where fiscal policy remains the main tool that a member state of the euro area has for managing its own economy, it should not be used for meeting the goals dictated by the aggregate indicators for the euro area. Especially so given that our small size means that an Estonian fiscal stimulus would have virtually no effect at all on the countries facing economic difficulties. It is equally hard to agree with a policy recommendation that countries with better fiscal discipline should risk upsetting the balance of their economies to improve the situation of the euro area as a whole.