A. JESÚS SÁNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** /                                                         /LUDGER SCHU...
Public expenditure policies during the EMU period: Lessons for the future?       1. Introduction          The outlook for ...
The Future of the Euro Chart 1. Developments in public finances, 1990-2011 a) Fiscal balanceb) Public debtSource: Ameco.  ...
Public expenditure policies during the EMU period: Lessons for the future?  Chart 1. (cont.) Developments in public financ...
The Future of the Euromany advanced economies in the 1980s to return to sound publicfinances and at the same time reinvigo...
Public expenditure policies during the EMU period: Lessons for the future?       grammes have the best chance of success. ...
The Future of the Euro Table1. Total expenditure developments                                                Maximum Chang...
Public expenditure policies during the EMU period: Lessons for the future?             However, this masks significant dif...
The Future of the Eurocit and debt figures is also obvious. But a number of countries mas-tered the challenge of very larg...
Public expenditure policies during the EMU period: Lessons for the future?       up” the interest savings from introducing...
The Future of the EuroTable 2: Recent total expenditure developments           % of G DP            1999    2007 2009 2010...
Public expenditure policies during the EMU period: Lessons for the future?Table 2: Recent cyclically adjusted primary expe...
The Future of the Eurosector of below 40% of GDP (as defined by Tanzi and Schuknecht,2000). Even the US, at 41.3% of GDP, ...
Public expenditure policies during the EMU period: Lessons for the future?       apply the same methodology as in Hauptmei...
The Future of the EuroChart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditurestance, across rules...
Public expenditure policies during the EMU period: Lessons for the future?      Chart 2: (cont.) Euro Area (12). Expenditu...
The Future of the Euro   Looking at the primary expenditures stance - panel a - suggestsa co-movement with the NPG rules w...
Public expenditure policies during the EMU period: Lessons for the future?France to up to 5pp of GDP for Ireland. On the o...
The Future of the Euro       Chart 3: Decomposition of cumulative changes to public primary spending ratios       compared...
Public expenditure policies during the EMU period: Lessons for the future?        Chart 3. (cont.) Decomposition of cumula...
The Future of the Euro       Chart 3. (cont.) Decomposition of cumulative changes to public primary spending       ratios ...
Public expenditure policies during the EMU period: Lessons for the future?      An alternative way to look at these figure...
The Future of the Euroeconomy variables. The results of the analysis are presented inTable 3.   As one would expect, the m...
Public expenditure policies during the EMU period: Lessons for the future?Table 3: Determinants of expenditure stanceDepen...
The Future of the EuroTable 3. (cont)Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule      ...
Public expenditure policies during the EMU period: Lessons for the future?       also control for government stability as ...
The Future of the Euroeuro area countries is that the implementation of the Stability andGrowth Pact has not been effectiv...
Public expenditure policies during the EMU period: Lessons for the future?      For a second group of countries (Spain, Gr...
The Future of the EuroChart 4: Public debt ratios - actual vs. rule-basedEuro area (12)Germany                            ...
Public expenditure policies during the EMU period: Lessons for the future?      Chart 4: (cont.) Public debt ratios - actu...
The Future of the EuroChart 4. (cont.) Public debt ratios - actual vs. rule-basedSpainGreece                              ...
Public expenditure policies during the EMU period: Lessons for the future?      Chart 4: (cont.) Public debt ratios - actu...
The Future of the Euroreform waves in industrialised countries. Moreover, they foundthat there were three groups of countr...
Public expenditure policies during the EMU period: Lessons for the future?Table 4: Expenditure reform phases 1980s and 199...
The Future of the Euro  Table 5 illustrates that much of the expenditure cuts ofambitious reformers came from transfers an...
324      Table 5: Composition of expenditure reform                                                                       ...
The Future of the Euroto make future budgetary control and thus the avoidance of fiscalproblems more likely.8             ...
Public expenditure policies during the EMU period: Lessons for the future?role of the state in the economy via privatisati...
The Future of the EuroChart 5: Ambitious vs. timid reforms, 1980s and 1990s.a) Total public expendituresb) Public consumpt...
Public expenditure policies during the EMU period: Lessons for the future?      Chart 5: (cont.) Ambitious vs. timid refor...
The Future of the EuroChart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.e) Fiscal balancef) Public debt       ...
Public expenditure policies during the EMU period: Lessons for the future?      Chart 5: (cont.) Ambitious vs. timid refor...
The Future of the Euro   Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.   i) Private investment   Source: ...
Public expenditure policies during the EMU period: Lessons for the future?projections. For all sample countries, the proje...
The Future of the Euro  If projected spending developments materialise, primary expen-diture ratios would decline to aroun...
Public expenditure policies during the EMU period: Lessons for the future?finance developments in the past. Looking forwar...
The Future of the EuroChart 6: Actual ratios versus neutral expenditure policies-based ratios (based onNPG – ½ pp and RPEC...
Public expenditure policies during the EMU period: Lessons for the future?2009 would have generally been much closer to 60...
The Future of the Eurowas brought on a downward path, and economic growth and pri-vate consumption resumed swiftly. We arg...
Public expenditure policies during the EMU period: Lessons for the future?lise under one condition, namely that all these ...
The Future of the Euroeffective surveillance of economic and fiscal policies at the Europeanlevel. At the same time, polic...
Public expenditure policies during the EMU period: Lessons for the future?- Coenen, G, C., Erceg, C. Freedman, D. Furceri,...
The Future of the Euro- Menguy, S. (2008) A dynamic rule applied to the threshold imposed on theEuropean budgetary deficit...
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Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht

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Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht

  1. 1. A. JESÚS SÁNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** / /LUDGER SCHUKNECHT *** / Public expenditure policies during the EMU period: Lessons for the future?11. Introduction; 2. Long-term public expenditure in industrialised coun-tries; 3. The first decade of EMU period: a missed opportunity?; 3.1. Adisaggregated assessment of past expenditure policies; 3.2. Determinantsof the expenditure stance; 3.3. Implications for public debt; 4. Lookingbackward to the past, lessons for the future? an episodes based approach;5. The need for prudent expenditure rules; 6. Concluding remarks;Bibliography*He currently works as Ph. D Assistant professor at Complutense University of Madrid.Before he worked as external consultant at European Central Bank, as (Ph. D) Assistantprofessor at Pablo de Olavide University (Seville, Spain) and as research assistant atFoundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University(with distinctions) and a Bachelor in Mathematics from University of Seville. His rese-arch areas are mainly public economics and computational economics.** He currently works as an Economist at the German Ministry of Finance. He was alsoan Economist in the Fiscal Policies Division of the European Central Bank and workedas a research assistant at the Centre for European Economic Research (ZEW). He holdsa Ph.D. in Economics from Munich University (LMU). His research focuses on empiri-cal public finance and fiscal policy.***Is heading the Directorate General Fiscal Policy and International Financial andMonetary Policy at the German Ministry of Finance. Previously, he worked at theEuropean Central Bank, the World Trade Organisation and the International MonetaryFund. His recent research mainly focuses on public expenditure policies and reform andthe analysis of economic boom-bust episodes. 289
  2. 2. Public expenditure policies during the EMU period: Lessons for the future? 1. Introduction The outlook for public finances in the advanced economies for the second decade of the 21st century is extremely challenging, not least due to the substantial fiscal expansion that took place in the context of the financial and economic crisis. Public deficits in 2010 averaged around 6% of GDP in the euro area and exceeded 10% of GDP in the US and the UK (Chart 1, panels a, and b). At the same time, public debt in advanced economies has increased signifi- cantly between 2007 and 2010: by some 20pp of GDP to around 86% in the euro area and so far by 30pp or more in the UK (to 80%) and in the US (to over 90% of GDP). When including Japan, public debt in the G7 countries already averaged over 100% of GDP in 2010. A closer look suggests that most of the deficit increase since the start of the crisis in 2007 was due to an increase in public expendi- ture ratios which have reached or approached historical highs. By contrast, revenue ratio declines have been rather limited (panels c and d). It is, therefore, logical to look at public expenditure when striving to correct fiscal imbalances in industrialised countries. This approach is in fact pursued already by a number of countries with fiscal difficulties. It was also the approach used—successfully—by1 The views expressed are the authors’ and do not necessarily reflect those of the authors’employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense deMadrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34913942431. Email: antoniojesus.sanchez@ccee.ucm.es. 290
  3. 3. The Future of the Euro Chart 1. Developments in public finances, 1990-2011 a) Fiscal balanceb) Public debtSource: Ameco. 291
  4. 4. Public expenditure policies during the EMU period: Lessons for the future? Chart 1. (cont.) Developments in public finances, 1990-2011 c) Total public expenditure d) Total revenue Source: Ameco.292
  5. 5. The Future of the Euromany advanced economies in the 1980s to return to sound publicfinances and at the same time reinvigorate the economy. The case of the euro area is of special relevance for a number ofreasons. While the crisis-related deterioration of public finances inthe euro area as a whole has not been as pronounced as for examplein the US or Japan (see Chart 1), heterogeneity at the Member Statelevel is substantial. A number of countries, in particular Greece,Ireland and Portugal, recorded double-digit deficit ratios and expe-rienced significant increases in government debt as a ratio to GDP.Unsustainable fiscal positions coupled with structural economicweaknesses and competitiveness deficiencies, in turn, fuelled markettensions which - due to strong financial interlinkages – underminefinancial stability in the monetary union as a whole. Therefore, atthe time of writing, there is a particular urgency for euro area coun-tries to regain market confidence through a swift return to soundpublic finances. At the same time, euro area membership tends toexacerbate adjustment efforts since the exchange rate mechanism isnot available, preventing an external devaluation. Therefore, fiscalconsolidation and the restoration of external competitiveness needto strongly rely on internal adjustment processes. Against the background, this study assesses expected publicexpenditure developments of selected euro area countries for thecoming years. Based on the experience with expenditure reform inthe 1980s and 1990s, we argue that ambitious and high qualityexpenditure reform as part of comprehensive economic reform pro- 293
  6. 6. Public expenditure policies during the EMU period: Lessons for the future? grammes have the best chance of success. Furthermore, the role of a prudent expenditure rule and the relevance of having a suitable institutional framework are discussed. Section 2 reviews public expenditure trends over the past 30 years. Section 3 reports on the main findings of earlier studies on public expenditure policies during the first decade of EMU. Section 4 looks backward to the past to extract important conclusions on the successful strategy exit of current crisis. Section 5 provides an illustration on the preventive role of prudent expenditure rules before section 6 concludes and draws some policy lessons. 2. Long-term public expenditure in industrialised countries With a view to assessing recent developments in a broader his- toric perspective, it is worth briefly taking stock of trends in public expenditure and the size of the state over the past 30 years (Table 1).2 After a strong increase in the size of government in industria- lised countries in the 1960s and 1970s, the average total public expenditure ratio across OECD, G7 or euro area was broadly unchanged in 2007 -just before the financial crisis- from 2000, 1990 and 1980. The average spending ratio for the euro area remained around 45% of GDP and that of OECD and G7 around 40%.2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-lopments. 294
  7. 7. The Future of the Euro Table1. Total expenditure developments Maximum Change value 1980 maxi-% of GDP 1990 2000 2007 2010 or nearest mum Year Ratio to 2010Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4Euro area (15) 4 5 ,4 4 7 ,9 4 6 ,2 4 6 ,0 51,0 1 9 9 5 5 3 ,1 - 2 ,1Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2United 47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9KingdomUnited States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2G7 3 8 ,3 3 9 ,8 3 8 ,5 3 9 ,9 45,0 2 0 0 9 4 5 ,5 - 0 ,5OECD 3 9 ,1 4 0 ,2 3 8 ,8 3 9 ,8 44,6 2 0 0 9 4 5 ,2 - 0 ,6 Source: Ameco, OECD. 295
  8. 8. Public expenditure policies during the EMU period: Lessons for the future? However, this masks significant differences across countries. The countries that undertook ambitious reforms in the 1980s and 1990s typically had much lower spending ratios in 2007 than in 1980 or at least than at their peak. A few countries, however, inclu- ding many of those that we will refer to in the next sections (US, Italy, Spain, Portugal, Greece, Ireland, UK) had significantly incre- ased the size of government between 1980 and 2007 or least in the 2000-2007 period.3 This occurred notwithstanding an extended economic boom in most of these when expenditure ratios should have gone down. With the start of the financial crisis, public expenditure ratios went up everywhere by on average 5pp of GDP. This brought the total expenditure ratio to about 50% in the euro area and 45% in the OECD/G7 in 2010. For the euro area, the increase still consti- tutes a decline in overall spending since the previous peak in 1995 but this was due to a lower interest bill. On the whole and for many countries, public expenditure ratios are now at or near his- torical peaks. This includes the European crisis countries, Portugal and Greece and the UK and US. These developments show that the challenge of containing the size of the state is more present than ever. And together with deficit and debt figures, the close link between rising public spending, defi-3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euroarea countries since the start of EMU. 296
  9. 9. The Future of the Eurocit and debt figures is also obvious. But a number of countries mas-tered the challenge of very large expenditure ratios with ambitiousreform programmes in the 1980s and 1990s. This experience will bere-called in the next sections. These countries were typically not thesame that face such challenges now—except Ireland and the UK.3. The first decade of EMU period: a missed opportunity? In this section, we examine expenditure developments and plansof a number of euro area economies, notably Greece, Ireland andPortugal (programme countries), Germany, France, Italy and Spain(large euro area countries) in comparison to the UK and US. Thecommon feature of most of these countries (except Germany andItaly) for the period up to 2007 was a drawn out economic boomcharacterised by significantly positive output gaps. In principle, thisshould have allowed bringing down public expenditure ratios signi-ficantly, firstly, due to the impact of automatic stabilisers and,secondly, in some cases also due to lower interest spending thanksto the euro. However, this is not what happened. All countries pursued anexpansionary expenditure stance, of the order of 1-5pp of GDPexcept for Germany (Hauptmeier et al, 2011).4 This basically “ate4 One of analysing the expenditure stance of a country is to compare it with the expen-diture levels that should have occurred if a country had followed certain fiscal rules. 297
  10. 10. Public expenditure policies during the EMU period: Lessons for the future? up” the interest savings from introducing the euro. As a conse- quence, total public expenditure only went down significantly in Germany and even increased strongly in the three crisis countries and the UK between 1999 and 2007 (Table 2). In the US, total spen- ding grew by around 2pp of GDP between 2001 and 2006 but the ratio remained well below 40% of GDP. Together with the US, Ireland and Spain maintained the lowest spending ratios (below 40% of GDP), France’s public expenditure was the highest, at 52.4% in 2007. The increase in public expenditure becomes even more pronounced when looking at primary spending. For the crisis coun- tries and the UK this went up by 3 to almost 6% of GDP between 1999 and 2007. As a result, most of the sample countries still had significant deficits in 2007 while the debt ratio had hardly declined or even increased between 1999 and 2007 (Schuknecht, 2009). Expansionary expenditure policies during good times left most of the countries “unprepared” when the crisis hit. As a consequen- ce of the output fall and further expansionary programmes, public expenditure ratios increased strongly between 2007 and 2009/2010. Increases ranged from around 4pp of GDP in Italy and Germany, to 6-7½ pp in the UK and US to over 10pp in Ireland. The expenditu- re increase was particularly strong in the countries where a credit- fed real estate and financial sector boom had “artificially” inflatedSuch an exercise was conducted by us last year (Hauptmeier et al, 2011). The studyfound that most euro area countries had pursued expenditure policies that were moreexpansionary than a reasonable expenditure rule would have proposed. 298
  11. 11. The Future of the EuroTable 2: Recent total expenditure developments % of G DP 1999 2007 2009 2010 Change Memoradum: deficit 1999-2007 2007-2010 2007 2010Programme countriesGreece 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8Ireland 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3Portugal 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8Large euro area countriesGermany 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1France 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1Italy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5Spain 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3Large non-euro area countriesUnited States 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6United Kingdom 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3Table 2: Recent expenditure developments for selected countries % of GDP 1999 2007 2009 2010 Change 1999-2007 2007-2010Programme countriesGreece 37,3 42,8 48,7 44,4 5,5 1,6Ireland 31,5 35,6 46,9 43,7 4,1 8,1Portugal 38,1 41,4 47,0 48,3 3,3 7,0Large euro area countriesGermany 45,1 40,7 45,4 45,4 -4,4 4,7France 49,6 49,9 54,3 54,2 0,3 4,3Italy 41,5 42,7 47,1 45,9 1,2 3,2Spain 36,4 37,6 44,5 43,7 1,2 6,1Large non-euro areacountriesUnited States 30,4 34,0 40,2 39,8 3,5 5,9United Kingdom 36,0 41,7 49,6 47,7 5,6 6,0Source: Ameco 299
  12. 12. Public expenditure policies during the EMU period: Lessons for the future?Table 2: Recent cyclically adjusted primary expenditure developments % of GDP 1999 2007 2009 2010 Change 1999-2007 2007-2010Programme countriesGreece 37,3 42,9 48,6 44,4 5,5 1,5Ireland 31,7 35,8 46,6 43,5 4,0 7,7Portugal 38,2 41,4 46,9 48,3 3,2 6,9Large euro area countriesGermany 45,1 40,9 45,0 45,2 -4,1 4,3France 49,7 50,1 54,1 54,0 0,4 4,0Italy 41,5 42,7 47,0 45,8 1,2 3,1Spain 36,5 37,7 44,3 43,4 1,2 5,7Large non-euro area countriesUnited States 0,0 0,0 0,0 0,0 0,0 0,0United Kingdom 36,1 41,7 49,5 47,6 5,7 5,9Source: AmecoGDP. When this reversed over the crisis, both higher spending andlower GDP drove up the expenditure ratio. Virtually all of theexpenditure ratio increase was on public consumption and transfersand subsidies; public investment went up only slightly in a fewcountries. Greece, Ireland and Spain also reported higher interestexpenditure as the rapidly rising debt ratio and higher interest ratesstarted to affect public budgets. Where did countries stand in the third year of the crisis, 2010?None of our sample countries still featured a relatively small public300
  13. 13. The Future of the Eurosector of below 40% of GDP (as defined by Tanzi and Schuknecht,2000). Even the US, at 41.3% of GDP, featured a public sector thatwas not much smaller than the euro area average before the crisis.Greece, Portugal, France, Italy and the UK reported public spendingratios of around to significantly above 50%. It has been argued that the increase in expenditure ratios is notvery relevant as it presumably reflects almost solely the crisis andshould, thus, reverse itself over time as the economy normalises.This reasoning implicitly assumes that output levels and growthrates will more or less return to pre-crisis levels. As a large output gapwould be closed, public commitments should decline relative toGDP. However, if the pre-crisis GDP was artificially inflated by boo-ming sectors which have to shrink then both GDP level and growthrates may be significantly lower post-crises. If the 2010 output gapwas only small, 2010 deficits and expenditure ratios would in factrepresent structural features of the examined economies. In anycase, significant fiscal adjustment is needed which in some casesexceeds 10 pp of GDP in the coming years (IMF, 2011).3.1. A disaggregated assessment of past expenditure policies To assess in more detail what drove expenditure developmentssince the start of EMU, this section provides an analysis the publicexpenditure stance across the three main expenditure componentsthat governments can influence in the short term: governmentconsumption, transfers and subsidies and public investment. We 301
  14. 14. Public expenditure policies during the EMU period: Lessons for the future? apply the same methodology as in Hauptmeier et al (2011): given the existing levels at the start of the EMU (1999), actual public expenditure developments are assessed against an expenditure path that should have been taken if countries had followed a neu- tral expenditure stance, i.e. if governments had aligned expenditu- re growth to that of potential GDP. The latter is measured on the basis of two expenditure rules: (a) nominal potential GDP growth (NPG rule) and (b) real potential GDP growth plus the growth rate of the GDP deflator capped at the ECB’s price stability objective of below but close to 2% (RPECB) based either on real time or ex post data. This counter factual analysis provides four measures of the expenditure stance.5 Deviations are analysed by looking at margi- nal (annual) and/or cumulative (total period) deviations (expressed as percentage of GDP). According to this procedure, on the one hand, marginal deviations help to identify the year(s) in which expansionary/restrictive policies were implemented. On the other hand, cumulative deviations measure the degree of expansio- nary/restrictive policies in percentage points (pp) of GDP accumu- lated over the period (1999-2010). Firstly, to provide a general perspective, we focus on cumulati- ve effects for the aggregate euro area (Chart 2), comparing actual and rule-based expenditure developments (expressed as percentage of GDP).5 The earlier study applied six measures but the two additional ones did not providemuch additional insights. 302
  15. 15. The Future of the EuroChart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditurestance, across rules.Primary expendituresPublic consumption 303
  16. 16. Public expenditure policies during the EMU period: Lessons for the future? Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen- diture stance, across rules. Public investment304
  17. 17. The Future of the Euro Looking at the primary expenditures stance - panel a - suggestsa co-movement with the NPG rules which indicates the absence ofa prudence margin to operate when difficulties appear. Looking atthe disaggregated developments, i.e. the main expenditure compo-nents, gives a different picture: First, the results for public con-sumption show an expansionary expenditure stance on this cate-gory adding up to 0.5-2pp of GDP, depending on the respectiveexpenditure rule. Second, for the transfers and subsidies compo-nent, a strong counter-cyclical behaviour is observed, as one wouldexpect. However, the decreases in economic good times were muchless significant than the increases during the crisis. Finally, the pat-tern for public investment is clearly pro-cyclical. At the same time,the adjustments carried out by some countries during 2010 can bealready observed (returning to 2004 levels). To complement this general view, we briefly describe thecountry pattern for the main expenditure components.6 As inHauptmeier et al. (2011), for primary expenditures, we observe arestrictive expenditure stance for Germany whereas all other coun-tries show an expansionary policy stance over the 1999-2010periods, notably as regards public consumption as well as transfersand subsidies. However, the degree of expansion is different amongcomponents. On the one hand, in the case of public consumption,the magnitude of cumulative expansion ranged from near zero for6 For the sake of brevity, related country-specific results are not included in the maintext. They are available from the authors upon request. 305
  18. 18. Public expenditure policies during the EMU period: Lessons for the future?France to up to 5pp of GDP for Ireland. On the other hand, fortransfers and subsidies, Germany is highly restrictive by 2-3 pp,and the rest is expansionary by 1-7pp depending on the rule andcountry. Finally, for public investment, the development of the cumula-tive expenditure stance is quite interesting: restrictive for Germanyand Portugal, neutral for Italy and expansionary for all other coun-tries with a tendency of neutralisation in 2010. However, overallmagnitudes are small. In a second step, we repeat this same exercise component bycomponent, in order to decompose the cumulative deviationobserved. This analysis provides a view of the respective stance ofeach expenditure component. The list of indicators included is inline with those presented so far; i.e. (i) public consumption, (ii)transfers and subsidies, (iii) public investment, and (iv) otherexpenditures. Moreover, we split our sample period into sub-periods to show the role of (i)-(iv) before (1999-2007) and duringthe crisis (2008 – 2009, 2009-2010). First, looking at the expenditures stance, Chart 3 presents thedecomposition of cumulative effects observed for ex-post and real-time rules. When compared real-time and ex-post rules behaviourboth similarities and differences are found. While on the one handthe dynamics are very similar, quantitative differences emergeespecially during sub-period (II), i.e. 2007-2009.306
  19. 19. The Future of the Euro Chart 3: Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 1999-2007%GDP (II) Ex-post NPG rule. 1999-2007%GDP 307
  20. 20. Public expenditure policies during the EMU period: Lessons for the future? Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2007-2009 %GDP (II) Ex-post NPG rule. 2007-2009%GDP308
  21. 21. The Future of the Euro Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2009-2010%GDP (II) Ex-post NPG rule. 2009-2010%GDP 309
  22. 22. Public expenditure policies during the EMU period: Lessons for the future? An alternative way to look at these figures is going through thedifferent sub-periods. First, deviations in the pre-crisis period areclearly dominated by public consumption. Moreover, if we leaveout Germany as the only restrictive country over this period, twodifferent country patterns can be observed: major deviations fromtrend as regards public consumption in Italy, Spain and Irelandwhile Greece and Portugal show strongly expansionary trends intransfers and subsidies. Second, deviations from trend in transfersbecome relatively more important with the start of the financialand economic crisis.3.2. Determinants of the expenditure stance An empirical analysis of factors that influence countries’ expen-diture stances can provide further information on the determinantsof expansionary expenditure policies in the past. Hauptmeier et al.(2011) therefore applied standard fixed-effects panel estimationtechniques on a sample of 12 euro area countries for the 2000-2009period using the measure for the expenditure stance describedabove, i.e. the (marginal) deviations of actual spending growth fromrule-based or neutral spending (under the NPG and the RPECB rulein ex-post terms), as the dependent variable. The aim of this empirical exercise was to explain the govern-ments’ expenditure stance on the basis of fiscal and macroecono-mic factors, relevant institutional characteristics as well as political310
  23. 23. The Future of the Euroeconomy variables. The results of the analysis are presented inTable 3. As one would expect, the macroeconomic environment measu-red by the output gap (in % of potential GDP) constitutes animportant determinant of the expenditure stance. We find robustsupport for a positive correlation between the output gap and theexpenditure stance across rules and estimations, suggesting a pro-cyclical spending behaviour. As regards fiscal factors, surprisingly the level of public indeb-tedness does not seem to significantly affect our measure of theexpenditure stance. We also do not find robust evidence for aneffect of revenue windfalls that arguably could increase spendingprofligacy. We capture such windfalls by including the excess reve-nue growth in a given year relative to previous year’s Autumn fore-cast by the European Commission. However, while we see theexpected positive sign the effect is not significant. We find empirical support for the importance of political eco-nomy factors. In particular, parliamentary elections at the nationallevel (Electoral cycle 1) tend to significantly increase the deviationof actual from rule-based primary spending. The opposite holds truefor a second election-related variable (Electoral cycle 2) which cap-tures the years left in the current election term. The negative sign onthis variable suggests that the incentives for fiscal discipline can beexpected to be higher at the beginning of the legislative period. We 311
  24. 24. Public expenditure policies during the EMU period: Lessons for the future?Table 3: Determinants of expenditure stanceDependent variable: Deviation of primary spending growth from rule-based growth ratePanel A: Ex-post Nominal Potential GDP (NPG) rule (I) (II) (III) (IV) (V ) (VI) (VII)Output gap (based on Potential GDP) 0,525 0,476 0,401 0,463 0,274 0,374 0,476 [3.78]*** [3.01]** [2.50]** [3.04]** [1.65] [2.22]* [3.00]**Public debt ratio (t-1) 0,054 0,056 0,035 0,071 0,042 0,033 0,057 [0.96] [1.04] [0.62] [1.20] [0.83] [0.67] [1.03]Crisis dummy 3,946 3,649 4,028 3,138 2,241 2,34 3,341 [2.17]* [1.74] [1.64] [1.75] [1.08] [1.13] [1.22]Strenght of expenditure framework *Output Gap -0,262 -0,262 [2.09]* [2.08]*Surprises in Revenues growth 0,09 [0.46]Strenght of expenditure framework *Surprises in revenues growth -0,08 [0.86]Electoral cycle 1 2,204 [3.64]***Electoral cycle 2 -0,812 [3.66]***Government Stability -2,699 [3.26]***EDP 0,308 [0.16]Constant -2,941 -2,998 -1,47 -4,148 -0,006 -0,512 -3,079 [0.72] [0.77] [0.39] [0.97] [0.00] [0.13] [0.78]Observations 108 108 108 108 90 90 108Number of countries 12 12 12 12 10 10 12R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19312
  25. 25. The Future of the EuroTable 3. (cont)Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule (I) (II) (III) (IV) (V) (VI) (VII)Output gap (based on Potential GDP) 0,469 0,429 0,299 0,419 0,277 0,377 0,429 [3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]* [2.58]** [2.72]**Public debt ratio (t-1) 0,057 0,059 0,031 0,071 0,053 0,044 0,058 [1.19] [1.33] [0.64] [1.40] [1.18] [0.98] [1.33]Crisis dummy 2,882 2,634 3,267 2,223 1,685 1,793 2,654 [1.56] [1.26] [1.26] [1.22] [0.74] [0.78] [0.90]Strenght of expenditure framework *Output Gap -0,219 -0,219 [1.75] [1.74]Surprises in Revenues growth 0,172 [0.91]Strenght of expenditure framework *Surprises in revenues growth -0,044 [0.59]Electoral cycle 1 1,798 [3.40]***Electoral cycle 2 -0,798 [4.17]***Government Stability -2,544 [3.48]***EDP -0,02 [0.01]Constant -2,808 -2,855 -0,747 -3,792 -0,392 -0,879 -2,85 [0.75] [0.82] [0.22] [0.97] [0.10] [0.23] [0.83]Observations 108 108 108 108 90 90 108Number of countries 12 12 12 12 10 10 12R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoralcycle and government stability , (IV - VI) and Baseline + European Institutions(VII).Source: Hauptmeier, S., Sánchez-Fuentes, A.J. & Schuknecht, L. (2011) 313
  26. 26. Public expenditure policies during the EMU period: Lessons for the future? also control for government stability as measured by the respective index of the World Bank and find that the policy stance on the spen- ding side is less expansionary if a government scores a higher value. Most interestingly from a policy perspective, our results suggest that the country-specific institutional framework exerts a significant effect on the expenditure stance. In particular, we control for the extent to which national expenditure policy faces domestic institu- tional constraints using the expenditure rules index as developed by Debrun et al. (2008).7 We interact this index with the output gap to analyse to what extent strong institutions reduce spending profli- gacy and find that, indeed, the strength of the national institutional framework on the expenditure side significantly reduces the pro- cyclicality of the expenditure stance. This finding is along the lines of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the same time, the EDP dummy which is included to capture whether a country is facing an excessive deficit procedure (EDP) due to deficits above the 3% of GDP reference value of the Stability and Growth Pact, does not turn up significantly in our regressions. The results on the impact of fiscal institutions may be put into the perspective of the recent efforts to strengthen the European fis- cal framework. One of the lessons from past fiscal developments in7 For a definition and a detailed description of the computation of this index seeEuropean Commission (2006) and Debrun et al. (2008). The index takes into accountthe share of public spending covered by the rule and qualitative features such as thetype of enforcement mechanisms and media visibility. 314
  27. 27. The Future of the Euroeuro area countries is that the implementation of the Stability andGrowth Pact has not been effective in delivering sound and sustai-nable fiscal positions in Member States. While one has to be care-ful when interpreting the non-significance of the effect of the EDPprocedure dummy, the result is in line with this perception.Moreover, the empirical analysis suggests that national budgetaryrules if well-designed can help to effectively reduce spending pro-fligacy and therefore serve as important tools to promote soundand sustainable public finances in line with the European fiscal fra-mework. This reinforces the need for enhancing national fiscalrules and frameworks as had been proposed by the EuropeanCommission in the autumn of 2010.3.3. Implications for public debt Based on the analysis presented in Section 3.1, it is possible tocompute to what extent deviations of expenditure growth fromtrend led to increases in government debt. Chart 4 shows alterna-tive debt paths for the sample economies and across expenditurerules. Consistent with the previous results, real time rules typicallylead to higher debt paths than ex-post rules. In the case of France,for example, following a neutral expenditure path since 2000would have resulted in a significantly lower debt ratio in 2010, i.e.between 70% and 75% of GDP. If Italy had followed a neutral spen-ding path, public debt would now stand roughly between 80% and100% of GDP in 2010, rather than at around 120% of GDP. 315
  28. 28. Public expenditure policies during the EMU period: Lessons for the future? For a second group of countries (Spain, Greece, Ireland andPortugal), the difference becomes even more drastic. Neutral spen-ding policies in Portugal would have led to debt ratios of 40-60% ofGDP in 2010 rather than over 80% of GDP in reality. Spanish debtwould have been at a trough of 10-40% in 2007-08 and would haveremained well below the reference value in 2009 under all rules.Ireland would have just about eliminated all its debt in good timesand thus created significant room for the subsequent rise. Under allrules, debt would have remained below 60% of GDP in 2010.Finally, Greek public debt would have fallen to 60-80% of GDP (rat-her than remain broadly constant around 100% of GDP until thestart of the crisis) and increased much more slowly in the crisis. All in all, public debt positions in the euro area would havebeen much sounder at the start of the crisis and in 2010, if euroarea countries had pursued at least a neutral expenditure stance onaverage during EMU. Public debt could have been well around orbelow the reference value in the euro area in most of its membersby 2010 and nowhere above 100% of GDP.4. Looking backward to the past, lessons for the future? anepisodes based approach In an earlier study, Hauptmeier, Heipertz and Schuknecht(2007) looked at the experience with public expenditure reform inthe 1980s and 1990s. They found that there were basically two316
  29. 29. The Future of the EuroChart 4: Public debt ratios - actual vs. rule-basedEuro area (12)Germany 317
  30. 30. Public expenditure policies during the EMU period: Lessons for the future? Chart 4: (cont.) Public debt ratios - actual vs. rule-based France Italy318
  31. 31. The Future of the EuroChart 4. (cont.) Public debt ratios - actual vs. rule-basedSpainGreece 319
  32. 32. Public expenditure policies during the EMU period: Lessons for the future? Chart 4: (cont.) Public debt ratios - actual vs. rule-based Ireland Portugal320
  33. 33. The Future of the Euroreform waves in industrialised countries. Moreover, they foundthat there were three groups of countries: (i) ambitious, (ii) timidand (iii) non-reformers. Ambitious reformers were those thatmanaged to reduce public primary (non interest) expenditure bymore than 5pp of GDP from their peak within 7 years. Timid refor-mers were those that cut primary spending between 0 and 5pp andnon-reformers never undertook much of a cut at all. These coun-tries and country groups, the time and size of the maximum expen-diture ratio and the change in the expenditure ratio within years(T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4. The study argued that conceptually, reforms needed to be ambi-tious in order to make a significant difference for the resultingpublic deficits and adverse debt dynamics. The more ambitious theywere the more they would even allow tax cuts. Already in the 1980s,Ireland, Belgium, the UK, Luxembourg and the Netherlands had sig-nificantly reduced their public expenditure ratio. The UK, Irelandand the Netherlands did so again in the 1990s plus a number ofother countries: Finland, Sweden, Canada and Spain. Four countriesreduced public primary expenditure by more than 10% of GDP.During this period, 10 countries undertook timid expenditurereforms (amongst them the US, France, Germany and Italy at whichwe will look again later). The three non-reformers includedAustralia, which had always maintained a rather small governmentsector, and Portugal and Greece. 321
  34. 34. Public expenditure policies during the EMU period: Lessons for the future?Table 4: Expenditure reform phases 1980s and 1990s Max. primary expenditure Change maximum in year to T7Ambitious reformersFinland 1993 -14,0Sweden 1993 -14,0Ireland (Phase 1) 1982 -12,4Belgium (Phase 1) 1983 -12,3Canada 1992 -9,5United Kingdom (Phase 1) 1981 -8,2Netherlands (Phase 2) 1993 -7,5United Kingdom (Phase 2) 1992 -7,2Spain 1993 -6,4Ireland (Phase 2) 1992 -6,2Luxembourg 1981 -5,7Netherlands (Phase 1) 1983 -5,1Timid reformersAustria 1993 -4,3Denmark 1993 -3,9New Zealand 1985 -3,8United States 1992 -3,4Italy 1993 -3,0Japan 1998 -2,7Belgium (Phase 2) 1993 -2,1Germany 1996 -0,6France 1996 -0,5Switzerland 1998 -0,3Non reformersPortugal 2004 0,0Greece 2000 0,4Australia 1985 0,4 It is, however, not just the magnitude of spending and reformthat is important but also the composition. The literature (e.g.,Alesina and Perotti, 1995 and 1997) argues that reductions inpublic consumption/wages and transfers and subsidies are particu-larly “high quality”. They increase the chance of success of reformby providing a strong signal of “willingness” and cuts tend to focuson unproductive expenditure.322
  35. 35. The Future of the Euro Table 5 illustrates that much of the expenditure cuts ofambitious reformers came from transfers and subsidies and alsofrom government consumption. About two-thirds of the reduc-tion in the total expenditure ratio and over 80 per cent of thedecline in the primary expenditure ratio occurred in these twocategories. Nine out of 11 reform episodes reported a decline inpublic consumption by more than 2 per cent of GDP and eightout of 11 featured a fall in transfers and subsidies by over 3 percent of GDP. At the same time, in most cases, governmentinvestment and public education expenditure did not declinedisproportionately or in some cases even increased as a share ofGDP. Timid reformers did not report much of a decrease inpublic transfers and subsidies and focussed on public invest-ment in some cases and on public consumption including edu-cation in others. The study by Hauptmeier et al. (2007) also argued that publicexpenditure reform needed to be part of a comprehensive overallstructural reform strategy. It was argued on the basis of the litera-ture that this would allow the improvement in public finances notonly via less spending but also via better growth prospects. Anoverview of the reforms undertaken by ambitious countries isreported in Table 6. Most of the ambitious reformers undertookmajor reforms that were complementary to expenditure retrench-ment. Most countries strengthened their national fiscal institu-tions. This not only facilitated fiscal retrenchment but also tended 323
  36. 36. 324 Table 5: Composition of expenditure reform Transfers Total Interest Primary Government Government Change T0-T7 and Health Education Pensions expenditure Spending expenditure consumption investment Subsidies Ambitious reformers Finland -15,7 -1,6 -14,0 -3,8 -0,3 -9,4 -1,3 -1,8 -1,5 Sweden -15,7 -1,8 -14,0 -2,8 -0,9 -8,0 -0,4 0,2 -1,7 Ireland (Phase 1) -13,3 -1,0 -12,4 -5,2 -3,2 -2,2 -1,7 -0,9 -0,7 Belgium (Phase 1) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6 Canada -11,4 -1,7 -9,5 -5,3 -0,5 -3,3 -1,1 -1,9 -0,2 United Kingdom (Phase 1) -10,5 -2,3 -8,2 -2,5 -0,3 -2,0 -0,3 -0,8 -0,5 Netherlands (Phase 2) -9,8 -2,3 -7,5 -1,9 0,1 -6,5 -0,8 -0,4 -1,2 United Kingdom (Phase 2) -7,1 0,1 -7,2 -2,7 -1,1 -2,6 -0,1 -0,8 -0,4 Spain -8,2 -1,8 -6,4 -1,5 -1,0 -4,1 -0,4 0,0 0,2 Ireland (Phase 2) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6 Luxembourg -5,9 -0,4 -5,7 -1,4 -2,1 0,0 0,1 -1,6 -0,8 Netherlands (Phase 1) -5,0 0,2 -5,1 -2,0 -0,2 -2,2 -0,1 -1,1 0,4 Public expenditure policies during the EMU period: Lessons for the future?
  37. 37. The Future of the Euroto make future budgetary control and thus the avoidance of fiscalproblems more likely.8 A number of countries devalued theircurrencies. All ambitious reformers initiated significant labourmarket reforms that improved work incentives. All but onecountry reformed the tax system. And most countries reduced theTable 6: Summary findings for ambitious reform episodes Expenditure reform Structural reform Institutional Other macroeco- Labour Public Transfers & reform nomic reform market consumption Taxation Privatisation subsidies 1/ incenti- 1/ vesIreland 1 XX XX X X X X XIreland 2 X XX X X X XSweden X XX X X X X XCanada XX XX X X X XFinland XX XX X X X X XBelgium XX XX X XNetherlands 1 X X X X X XNetherlands 2 ~ XX X X X XSpain ~ XX X X X XUK 1 X X X X X X XUK 2 X X X X XAll 9 11 10 6 11 10 88 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen(1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fis-cal rules in EU countries. 325
  38. 38. Public expenditure policies during the EMU period: Lessons for the future?role of the state in the economy via privatisation. Based on the fact that the reforming countries fulfilled the con-jectures of ambition, high quality and comprehensive reforms it isnot surprising that the impact on public finances and the economywere quite positive, compared to timid reformers (Chart 5). Panela) shows that ambitious reformers (here differentiating early andlate reformers) brought the public expenditure ratio down signifi-cantly to levels similar or lower than those of timid reformers. Thiswas mainly achieved through cuts in public consumption andtransfers and subsidies while public investment did not changemuch, at least for late ambitious reformers (see panels b)-d)). Panele) illustrates that public deficits were brought down very substan-tially by ambitious reformers. The group of late reformers even rea-ched sizable surpluses. As regards public debt developments (panelf)), timid reformers did not achieve any significant reversal in debtdynamics. Ambitious reformers, by contrast, managed to bringdebt down once fiscal balances had been sound enough. Contrary to the concerns of vocal special interests and politi-cians, ambitious expenditure reforms had very little (if any) adver-se growth impact even in the very short run while the medium tolong term impact was very positive. Ambitious reformers experien-ced a significant increase in trend growth by 1-2 percentage points(panel g). By contrast, timid reformers experienced no such incre-ase. Real private consumption started to recover as of the first yearof public expenditure reduction and accelerated more stronglywhere ambitious reforms were undertaken (panel g). Private invest-326
  39. 39. The Future of the EuroChart 5: Ambitious vs. timid reforms, 1980s and 1990s.a) Total public expendituresb) Public consumption 327
  40. 40. Public expenditure policies during the EMU period: Lessons for the future? Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. c) Transfers and subsidies d) Public investment328
  41. 41. The Future of the EuroChart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.e) Fiscal balancef) Public debt 329
  42. 42. Public expenditure policies during the EMU period: Lessons for the future? Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. g) Trend growth h) Real private consumption330
  43. 43. The Future of the Euro Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. i) Private investment Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)ment initially declined or was flat and showed a relatively lessfavourable trend than for timid reformers but this reversed in themedium term. In the seventh reform year, the private investmentratio of timid reformers had increased by 1pp of GDP while that ofambitious reformers had increased by 2-3pp (panel i). In a next step we assess recent and projected fiscal develop-ments for 2012 and 2013 in selected euro area countries as well asthe UK and the US in the light of the evidence from past expendi-ture reform periods described above. We do this on the basis of thelatest European Commission forecast (Autumn 2011) (see Table 7).For the US we consider the latest IMF World Economic Outlook 331
  44. 44. Public expenditure policies during the EMU period: Lessons for the future?projections. For all sample countries, the projections point to sig-nificant primary expenditure reductions for the period up to 2013(with the exception of France). This ranges from about 3-4pp ofGDP for Germany, Italy and the US to over 5pp in the UK andSpain and to 7 to 10pp in the EU/IMF programme countries.Expenditure reductions show a more or less linear pattern in mostcountries. In the case of the US, the primary expenditure ratiowent down quite strongly in 2010. However, it is expected to decli-ne only by another 1pp of GDP over 2011-13. Table 7: Expenditure plans % of GDP Primary expenditure Actual Forecast 2009 2010 2011 2012 2013 2013 to max(0910)Programme countriesGreece 48,7 44,4 43,6 42,4 41,7 -6,9Ireland 46,9 43,7 42,1 39,6 37,0 -9,9Portugal 46,9 48,3 44,9 42,0 39,9 -8,4Large euro area countriesGermany 45,4 45,4 43,3 43,2 42,8 -2,6France 53,8 54,2 54,0 54,3 53,9 -0,3Italy 47,1 45,9 44,8 43,8 43,0 -4,1Spain 44,5 43,7 40,8 39,8 39,3 -5,2Large non-euro area countriesUnited States 42,1 39,3 39,6 39,0 38,5 -3,7UK 49,6 47,7 46,8 45,3 43,9 -5,6 Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.332
  45. 45. The Future of the Euro If projected spending developments materialise, primary expen-diture ratios would decline to around 40% of GDP in most coun-tries. The main exception is France where the ratio would remainsignificantly above 50%. Projected spending developments should also be assessed froma longer term perspective. When comparing the 2013 figures to the1999 primary expenditure ratios it is noteworthy that spendingwould still be 1-7pp of GDP higher in 2013 than in 1999 for 8 outof 9 countries. This relative increase would be particularly sizeablefor Ireland, the US and the UK and appears unwarranted in view ofthe expected ageing-related increases in social security outlays inthe medium and long-term. Only Germany would post a signifi-cantly lower primary expenditure ratio than at the start of EMU. Coming back to the adjustment effort in countries’ expenditureplans, it is noteworthy that five countries (Ireland, Greece,Portugal, Spain and the UK) would meet the criteria of ambitiousreformers as applied in the earlier study by Hauptmeier et al. (2007)whereas a second group of countries could be classified as “timid”reformers (Germany, USA, and Italy).5.The need for prudent expenditure rules The evidence presented in this study supports the view thatpublic spending has been a major determinant of unsound public 333
  46. 46. Public expenditure policies during the EMU period: Lessons for the future?finance developments in the past. Looking forward, it thereforeseems plausible to address this fact through the implementation ofprudent expenditure rules. Indeed, empirical studies suggest thatwell-designed expenditure rules tend to limit the pro-cyclicality ofpublic spending (see, e.g. Holm-Hadulla et al (2010)). Recent policyaction in Europe goes in this direction. Notably, the EU fiscal sur-veillance framework has been extended by a so called “expenditu-re benchmark” which restricts the growth rate of public spendingnet of discretionary tax measures to that of potential growth.However, this new rule does not take into account some of the pro-blems we identified in Section 3.1. Most notably, an effective rule-based restriction of spending policies in real-time requires themaintenance of a margin of prudence. This is necessary to accountfor the tendency of overestimating potential GDP growth in real-time. Given the past experience of systematic and persistent down-ward revisions in potential growth, a margin of prudence of ½ ppin expenditure growth per annum appears warranted. In addition,excessive price developments should not automatically feed intohigher expenditure growth as expansionary fiscal policies mayaccelerate an economic overheating. Therefore, the nominal com-ponent of an effective expenditure growth rule should be capped,e.g. at the ECB’s price stability objective (“close to but below 2%”). Chart 6 shows that the application of such prudent expenditu-re growth rules during EMU would have resulted in much safer fis-cal positions. Primary expenditure ratios would have reachedmuch lower levels in 2009. As a result, also public debt ratios in334
  47. 47. The Future of the EuroChart 6: Actual ratios versus neutral expenditure policies-based ratios (based onNPG – ½ pp and RPECB – ½ pp rules), 2009Panel A: Primary expenditure ratiosPanel B: Public Debt ratiosNote: Includes GDP multiplier and compound interest effects. 335
  48. 48. Public expenditure policies during the EMU period: Lessons for the future?2009 would have generally been much closer to 60% of GDP withthe highest ratio of around 90% in Italy. It is important to note,however, that the proposed expenditure rules are intended to pro-vide guidance for an appropriate, i.e. neutral, policy stance in theabsence of fiscal imbalances. Any fiscal adjustment, e.g. to regainsound fiscal positions in the aftermath of the crisis, would of cour-se require a restrictive policy stance, i.e. spending growth ratesbelow potential GDP growth.6. Concluding remarks What are the main findings of this study and what policy lessonscan be drawn? Public finances in advanced economies are at a cross-roads. In the fifth year of the crisis, fiscal deficits remain high andpublic debt has reached unprecedented peace-time levels in mostindustrialised countries. Public primary expenditure stands at ornear historical peaks in many countries and therefore constitutes animportant determinant of the fiscal imbalances. It therefore seemsstraight forward to focus on expenditure restraint when striving toregain sound fiscal positions in the aftermath of the crisis. In the 1980s and 1990s a number of countries undertook ambi-tious expenditure reforms. Their experience, which was brieflyreviewed here, has been very positive. Within a few years from thestart of expenditure reform, public expenditure ratios went downsignificantly, fiscal deficits largely or fully disappeared, public debt336
  49. 49. The Future of the Eurowas brought on a downward path, and economic growth and pri-vate consumption resumed swiftly. We argue that this was becauseambitious expenditure reform was conducted in a growth-friendlymanner as part of comprehensive adjustment programmes. Our study emphasises the key role of expenditure policies inexplaining fiscal developments during EMU in the euro area. It findsthat, almost all euro area countries (with the notable exception ofGermany) applied expansionary expenditure policies already beforethe crisis. This resulted in much higher expenditure and debt pathscompared to a counterfactual neutral expenditure stance. Rules-based spending policies could have led to much safer fiscal positionsmuch more in line with the EU’s Stability and Growth Pact (SGP). The policy recommendations from these findings are obvious:countries should focus on reducing public spending in the contextof ambitious reform programmes. Spending based consolidationefforts need to be complemented by structural reforms, notablywith a view to removing rigidities in national labour and productmarkets, to reduce macroeconomic imbalances, improve competi-tiveness and support potential growth. This will be particularlyimportant for the vulnerable countries in the euro area which donot have available the exchange rate mechanism to improve exter-nal competitiveness. Latest projections suggest that governments’consolidation plans in a number of countries indeed put a focus onreducing government expenditure as a ratio to GDP in the comingyears. However, the benefits of reforms are only going to materia- 337
  50. 50. Public expenditure policies during the EMU period: Lessons for the future?lise under one condition, namely that all these plans are fully andadequately implemented. This is their main challenge. In addition, the empirical evidence on the determinants of euroarea countries’ expenditure stance provide a number of policyimplications. First, strong national budgetary institutions seem tolimit expansionary spending biases. Second, the European institu-tional framework needs to feature prominently expenditure moni-toring and control. The incorporation of an expenditure bench-mark in the preventive arm of the Stability and Growth Pact in thecontext of the recent “Six-Pack” reform therefore constitutes a stepin the right direction. An effective enforcement of this rule shouldhelp to limit overly expansionary spending policies in the future. Furthermore, this chapter argues that a potential growth rulewith an extra ½ percentage point deduction from the resultingannual expenditure growth targets would be a sufficiently prudentand, thus, advisable expenditure rule for euro area countries. Aseconomic (e.g., population aging) and political economy reasonssuggest that overestimating potential growth could also occur inthe future, such a rule could provide a reasonably prudent bench-mark for a neutral expenditure stance looking forward. How does the debate on the overhaul of European economic gover-nance fare against these conclusions? At the time of completing thisstudy (March 2012), EU member states have set up new EU economicgovernance principles with a view to ensuring a tighter and more338
  51. 51. The Future of the Euroeffective surveillance of economic and fiscal policies at the Europeanlevel. At the same time, policy makers have agreed - in the context ofthe new fiscal pact - to strengthen national fiscal frameworks. All in all, a stringent implementation and enforcement of thefiscal surveillance at European level could well ensure the necessarybreak with past expenditure trends and thus also secure sustainabledeficits and debt dynamics in the future. However, it remains to beseen whether the main obstacle of the “old framework”—lack ofincentives and enforcement—is really sufficiently remedied.Bibliography- Alesina, A. and R. Perotti (1995) Fiscal expansions and adjustments inOECD countries, Economic Policy, vol. 10, pp. 205–48.- Alesina, A. and R. Perotti (1997) Fiscal adjustments in OECD countries:Composition and macroeconomic effects, IMF Staff Papers, vol. 44, pp. 210–48.- Brück, T. and R. Zwiener (2006) Fiscal policy rules for stabilisation andgrowth: A simulation analysis of deficit and expenditure targets in a mone-tary union, Journal of Policy Modeling, 28, 357–369.- Cimadomo, J. (2008) Fiscal policy in real time, Working Paper 919,European Central Bank. 339
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