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EU Countries Know How to Slash Public Expenditures

by | March 11th, 2013 | 12:37 pm
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Note: Natalia Aivazova has kindly provided me with excellent research assistance.

Western democracies are commonly believed to be unable to cut public expenditures substantially. This would imply that they are not capable of resolving financial crises that erupt from time to time. Fortunately, this assumption is not correct, as is evident from the Eurostat financial statistics for 27 EU countries for the 15 pre-crisis years, 1993–2007.1

On average, public expenditures as a share of GDP declined from 52.1 percent in 1995 to a low of 44.8 percent in 2000, the year after the euro was launched. That is an impressive average cut of 7.3 percent of GDP in the course of five years. The level of public expenditures stayed at 46 to 47 percent of GDP until 2008, when the global financial crisis prompted a temporary rise of 3 percentage points because GDP fell while unemployment costs rose.

Many individual countries carried out far more radical fiscal adjustments. Ten of the 27 current EU members slashed public expenditures by at least 10 percent of GDP in this period (figure 1). Only three of these countries were formerly communist. Several of them had undertaken huge cuts from 1990-92. Notably, Bulgaria slashed public expenditures by 22 percent of GDP in those years, and the Baltic countries carried out similar cuts, but their statistics for those years are unreliable. Yet, seven of the ten big expenditure cutters were West European countries. Most of them belonged to Northern Europe, but Italy was one of the expenditure slashers.

Figure 1 Large drops of public expenditures in the European Union

figure 1

Source: Eurostat Statistical Database (accessed on March 8, 2013)

The biggest cuts were carried out by Sweden (20.7 percent of GDP), Finland (17.5 percent of GDP), and Slovakia (17.1 percent of GDP). Usually the cuts were gradual—1-2 percent of GDP a year, but for example Sweden cut public expenditures by 5 percent of GDP from 1994 to 1995. The East European countries tend to carry out more radical cuts because their access to financing is more tenuous.

The timing of peaks and cuts of public expenditure tend to coincide for these highly integrated countries. Many Western European countries experienced a peak in their public expenditures from 1993 to 1995, and then they realized that they could not finance them. In 1998, the East Asian and Russian crises boosted international borrowing costs, rendering public debts more expensive. At the same time, the Economic and Monetary Union (EMU) was being formed. It was established by the Treaty on the European Union signed in the Dutch town of Maastricht in February 1992, which set the rules for the introduction of the euro. It established the so-called Maastricht criteria, which imposed a ceiling on public debt of 60 percent of GDP and budget deficits of up to 3 percent of GDP. These rules were taken more seriously from1998 to 2000 than in the ensuing years. Many countries endeavored to cut public expenditures until 2000.

Then, a relaxation of fiscal order occurred. Germany violated the Maastricht budget rule for the five years 2001-05, Italy 2001-06, and France 2002-04. In October 2002, the President of the European Commission Romano Prodi (later Italian prime minister) described the Maastricht criteria (also called the Stability and Growth Pact) as stupid: "I know very well that the Stability Pact is stupid because all the decisions made under it are so rigid." This was presumably the most harmful statement that any president of the European Commission ever made. The consequences ensued. In November 2003, the governments of Germany, France, and Italy persuaded the EU ministers of finance (ECOFIN) to disregard the possibility of sanctions for countries violating the Maastricht criteria. In 2005, the same countries “reformed” the Stability and Growth Pact, in effect, precluding all sanctions. The governments of the three biggest EMU countries blatantly eliminated all fiscal discipline.

Even so, public expenditures fell as a share of GDP in many countries in 2006 and 2007. The reason was not expenditure cuts. GDP increased more than expected so that expenditures set in nominal terms became a smaller share of GDP, and fewer people qualified for means-tested social welfare during the boom. Conversely, when the global financial crisis hit, public expenditures rose as a share of GDP for the opposite reasons—increasing unemployment benefits and falling GDP.

The causes of the expenditure cuts can be summarized as belonging to three categories—fiscal crisis, external pressure through the Maastricht criteria, and free market ideology. Large budget deficits have been remarkably common, and nations usually learn from them. Around the start of their austerity, all the ten big expenditure cutters save Denmark had large budget deficits of 8 to 11 percent of GDP (at least one year from1993-96), which appears the immediate cause of their expenditure cuts. Three of these ten countries—Sweden, Finland, and Bulgaria—were mired in rampant financial crises.

All these countries, except for post-communist Slovakia and Slovenia, have had public debts exceeding the Maastricht limit of 60 percent of GDP. Still, the countries with the largest debts have not pursued the most austerity, with Belgium and Greece as prime examples. Nine of the large cutters had public expenditure of 49 percent of GDP or more when they changed policy, so they had much fat to cut. In the public debate, concerns about low growth and the rise of free market ideology from the United States and the United Kingdom in the 1980s were particularly prominent arguments.

Curiously, four EU countries have gone in the opposite direction and increased their public expenditures by more than 10 percent of GDP in the period 1995–2010. They are Cyprus, Greece, Portugal, and the United Kingdom (figure 2). A common feature is that they had comparatively low public expenditures in the 1990s.

Figure 2 Large increases of government expenditures in the European Union

figure 1

Source: Eurostat Statistical Database (accessed on March 8, 2013)

Cyprus, Greece, and Portugal were relatively poor. In line with Wagner’s Law (which holds that public expenditures are correlated to the GDP level), they should have had lower public expenditures. The Maastricht debt ceiling was presumably too high for vulnerable small countries, such as Cyprus and Portugal, while the Greek governments largely disregarded all EU rules. All three are EMU members and have been major beneficiaries from EU grants, and all three have ended up needing emergency stabilization programs. The EMU regime was not helpful to its weakest members, but instead tempted them toward excessive public spending.

The United Kingdom under Prime Ministers Tony Blair and Gordon Brown is quite another story. It pursued an extremely expansionary fiscal policy in the midst of the boom of the 2000s out of sheer fiscal irresponsibility or political opportunism for which the nation now must pay. Incredibly, the labor governments increased public expenditures from 36.8 percent of GDP in 2000 by 14.5 percent of GDP to 51.3 percent of GDP in 2009. Little surprise that this big populist misallocation of national resources has depressed Britain’s growth rate (see the RealTime post “Britain’s Contractionary Fiscal Stimulus“).

This simple survey of pre-crisis EU fiscal statistics leads us to four big conclusions:

1. All kinds of EU members have repeatedly excelled in undertaking major cuts in public expenditures. These are all reasons to believe that they can do so again.

2. Big budget deficits have delivered the wake-up signal. When the alarm has rung, nations have stayed focused on expenditure cuts for a long time. Since the average EU budget deficit was 6.9 percent of GDP in 2009 and 6.5 percent of GDP in 2010, virtually the whole of the European Union has now woken up, and fiscal conservatism is likely to follow in the whole of Europe for the next decade.

3. Contrary to common perceptions, the Stability and Growth Pact mattered greatly. From 1995 to 2000, it greatly improved fiscal discipline. It took quite an extraordinary, multi-year offensive of the leaders of the European Commission, Germany, France, and Italy to undermine it. Nothing so daft is likely to happen again. On the contrary, with the new fiscal compact, the reinforced fiscal powers of the European Commission, and the memory of this horrendous financial crisis, the Maastricht criteria are likely to be far more respected in the future.

4. At the same time, it is evident that the Maastricht criteria were neither sufficient nor adequate. Latvia was precluded from international financial markets in late 2008, when its public debt was only 20 percent of GDP. Similarly, Ireland and Spain ended up with serious financial crises, although their public debts were as low as 25 and 36 percent of GDP, respectively, in 2007, but they were hit by severe real estate and banking crises. Plans for a new EU banking union should mitigate that problem. Cyprus and Portugal were tempted to raise their public expenditures more than what was good for them in a tendency toward EU convergence of public expenditures rather than GDP. A lower debt ceiling would be desirable for poorer and more vulnerable countries.

Note

1. There are some obvious mistakes in the Eurostat statistics from the 1990s for the later East European members, for them I use European Bank for Reconstruction and Development (EBRD) statistics.