18.11 Weekly Viewpoint : The post-election scenario in the US is highly uncertain

The European Commission has judged the Draft Budgetary Plans of six countries, including Italy, as being at risk of infringing fiscal rules. A final opinion will be given after the constitutional referendum, or in the spring…..

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The post-election scenario in the US is highly uncertain. A reflationary turn in economic policy is very likely, but details on the size and timing of fiscal expansion won’t be available for months. Moreover, the weight of the protectionist vein of Trump’s manifesto remains a risk. Caution

The European Commission has judged as being “at risk of non-compliance” with fiscal rules, due to a “significant deviation from the adjustment path towards the medium-term objective”, the Draft Budgetary Plans of 6 countries: Italy, Belgium, Cyprus, Lithuania, Slovenia, and Finland (Moscovici stressed that for Italy and Cyprus the deviation is greater than for the other 4 countries). In particular, on Italy and Belgium, that are in the preventive arm of the Stability Pact and are indicated as not compliant with the debt rule, the Commission will publish a report on debt in a couple of months’ time (therefore after the Italian referendum). In its overall assessment of the euro area’s budgetary situation, the Commission notes that “there is a case for a moderately expansionary fiscal stance […] in light of the slow recovery and risks in the macroeconomic environment”, while adding that this is a “collective responsibility of the member states”. For now, the Commission has not recorded significant changes in the tax revenue structure, nor an increase in public investments/GDP.

In Italy’s case, the Commission’s observations were expected and virtually inevitable, as the country would not respect the debt rule neither in 2016, nor in 2017 (the deviation from the level of debt necessary to meet the rule is significant, at around 7% in the biennium), and is at risk of a significant deviation from the rules on the structural deficit and spending in 2017. In particular, the deviation from the required adjustment on the year is a hefty 1.1%, as the structural deficit in 2017 will worsen by half a point of GDP according to the Commission’s estimates, instead of improving by 0.6% or more, as required. The deviation drops to 0.8% in the year when taking into account the “additional clauses”, i.e. spending on the migrant crisis and the earthquake, which for the Commission are worth three tenths of GDP on the whole (0.15% and 0.18% respectively), one tenth less than estimated by the government. Considering the average over two years and the clauses, the deviation from the rules decreases to 0.5%, but remains significant. Furthermore, in theory part of the flexibility conceded for 2016 could also be placed in question, as it was tied to a recovery of the adjustment process towards the medium-term objective starting in the following year, which is not the case with the 2017 Draft Budget, and co-financed investment spending in 2016 could fall short of the 0.25% flexibility allowed by the specific clause, which would make the deviation even larger. The next appointments will be the Eurogroup and Ecofin meetings on 56 December. The final opinion on Italy could also depend on the outcome of the referendum; a full rejection of the Draft Budget could be avoided for the time being, and that the final opinion, with the request for slight ex-post corrections, may be issued next spring. A request for a correction sooner cannot be ruled out a priori – although the Italian government could in any case decide to run the risk of incurring in the Excessive Deficit Procedure.

The markets’ reaction to the outcome of the US elections has been violent. In just a few days, markets have priced in the macroeconomic effects of the likely reflationary turn in Washington: higher inflation and stronger growth as a result of lower taxes and higher spending, implying larger deficit and debt. While these are likely trends in the next few years, given the Republican Party’s control over both the Presidency and Congress, after an initial phase of “half-full glass” euphoria, other factors will have to be priced in.

1) Uncertainty over economic policy has increased with the election of a President with no political track record.

2) The necessary cooperation between Trump and Congress will make for a less extreme fiscal plan, the implementation of which will take some time: the effects of the tax reform and of any spending hikes, will only become visible, at best, in late 2017, and be worth a few tenths next year (more later).

3) The protectionist element of Trump’s manifesto, if implemented even only part, would have “stagflationary” effects. A pause for reflection is needed.

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