Eurozone: fiscal consolidation challenges for governments

Widespread fiscal consolidation will restrain euro area growth in the near term, but as growth becomes more dependent on private demand, uncertainties about the magnitude and duration of the business cycle recovery mean that risks to growth are tilted to the downside.

content of study:

• Fiscal consolidation by euro area countries will be slower and about half the size of that seen during the early 2010s crisis, and the focus on reducing the extraordinary support packages used in recent crises will reduce the risk of long-term growth shocks that could undermine fiscal consolidation.
• There are downside risks if the withdrawal of support measures adversely affects the consumption recovery. However, we believe households are well placed to absorb the reduction in government support. Strong wage growth and rising savings rates (supported by higher deposit rates) should provide a cushion to support a consumption recovery.
• Strong global demand, competitive currencies, and expected significant monetary easing should support private demand. Balance sheets lack the large external imbalances of the late 2000s, so private sector deleveraging risks are low. However, many euro area countries could tighten spending at a time of weak demand, undermining efforts to contain fiscal deficits.
• Successful fiscal consolidation would help limit debt issuance and rollover risks at a time when the European Central Bank withdraws from government bond markets. However, improvements could be uneven if consolidation plans in countries with large deficits come under political pressure. Fiscal consolidation also poses downside risks if the reintroduction of EU fiscal rules discourages long-term government investment that would reduce potential growth.