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Budget Cuts in Europe: Policy Coordination or German Diktat?

In order to provide a “good example”, the government of Angela Merkel recently introduced a Constitutional rule requiring, from 2016, the federal structural deficit not to exceed 0.35% GDP, and constraining the Laenders to run balanced budgets.

Predictably, the G7/20 recent summit in Canada sanctioned a compromise between the (US-backed) position that the fiscal stimulus should not be removed too prematurely and kill the recovery, the (UE-backed) requirement that markets ought to be reassured on Europe’s solvency, and the opportunity to ensure visibility for the large emerging economies.

Many observers have noted the “European” position, which focuses on fiscal discipline, mainly reflects the economic interests of Germany, a country that in recent years has witnessed strong gains in competitiveness and has managed to maintain a large external surplus in 2010 without compromising fiscal discipline (the debt ratio is currently at 79.6% and the primary budget at -3.5% of GDP). While German output fell by almost 5 points between 2009 and 2010, the unemployment rate has actually dropped. It is therefore understandable that Germany, in order to stimulate the economy, would rather rely on productivity gains and on the depreciation of the Euro, rather than on footing the bill of fellow Europeans’ stimuli (and possible defaults).

Similarly, budget “cuts” are on the agenda almost everywhere in Europe. The fiscal exit strategies differ from country to country, in terms of their size, their implementation horizon, their composition (spending cuts versus revenue increases), the nature of short or long term savings they generate, the allocation of cuts to central or local governments, and the degree of institutional reforms that accompany them. Table 1 describes the size of budget cuts in relation to GDP of different national programs for the period 2010-2015.

CESifo Group Munich - Database for Institutional Comparisons in Europe (DICE)

They range from the large adjustments of Greece, Spain, Portugal, Spain, France and the United Kingdom, to the modest cuts of Italy, Austria, Hungary, the Netherlands, and Slovakia (Ireland made large cuts prior to 2010 and therefore these do not appear fully in the table).

These adjustment programs pose an important question about fiscal policy in the Euro-area. To what extent are national policies the result of “policy coordination” in Europe, and therefore meet at least in part “European” interests, or rather obey the diktats of a “fiscal dominance” of Germany, possibly under the implicit threat of leaving the weak Southerners to their own destiny?

At this juncture, the “exit strategies” should strike a balance between three goals—the first two mainly, but not exclusively, “national”, and the third one a “European” target. The first one is obviously the solvency of sovereigns. The second is the need to calibrate the exit strategies so as not to aggravate unemployment, the so-called “internal equilibrium”. The third “European” objective is the reduction of current account imbalances within the Euro-zone. Let us consider them in turn.

Solvency

If cuts are intended to ensure solvency, countries with lower primary surpluses should implement stronger maneuvers. Figure 1 shows, on the y-axis, the magnitude of the cuts announced for 2010-15, and, on the x-axis, the primary balances in 2009. The figure shows that indeed a negative relationship seems to hold.

Figure 1: Budget Cuts in 2010-15 (adj) e Primary Balances in 2009 (pbax), % GDP

Source: author’s calculations

In Figure 2, budget cuts are plotted against the debt/GDP ratios: countries with more debt would require larger cuts in order to ensure solvency. The (positive) relationship between adjustment and debt is less clear cut. However, when the effect of other possible influences are controlled for[1], a positive relationship seems to hold.

Figure 2: Budget Cuts in 2010-15 (adj) and Public Debt in 2009 (pudp), % GDP

Source: author’s calculations

Unemployment

The consolidation measures in Europe do not appear to take unemployment into great consideration, to say the least. Figure 3 shows the relationship between the cuts programmed for 2010-15 (on the y axis) and the rate of unemployment (on the x-axis) in 2009. In principle, one would expected a negative relationship between the two: budget cuts should be lower where unemployment is higher. Yet, the figure shows that cuts are actually larger in countries where unemployment is higher[2].

Figure 3: Budget Cuts in 2010-15 (adj), %GDP, and unemployment rate 2009

Source: author’s calculations

Current Account Imbalances

The “European” objective of rebalancing current accounts in the Euro-zone requires that that the adjustment should be larger for countries with the high current account deficits. Clearly, this is because budget cuts tend to reduce aggregate demand, wages and prices benefitting the trade balance. The policies undertaken by European countries seem to be consistent with this objective. Figure 4 shows that the adjustment tends to be larger for countries with larger current account deficits.

Figure 4: Budget Cuts in 2010-15 (adj) e Current Account Balance 2009 (cara), % GDP

Source: author’s calculations

Policy Coordination or German Diktat?

In conclusion, the fiscal exit strategies that the major European countries have planned for 2010-15 seem to respond to the need to ensure the solvency, being related to the levels of deficits and national debts. Despite the lack of formal mechanisms to implement fiscal coordination in the Euro-zone, the planned exit strategy seems also consistent with the objective of promoting convergence among European countries, through the reduction of current account imbalances. Thus, the view that fiscal consolidation in Europe merely responds to the interests of Germany seems excessive. Yet, the evidence also suggests that consolidation efforts do not reflect the unemployment situation of member countries, and therefore risk aggravating it: in this respect the European consolidation efforts appears inspired by an orthodoxy of fiscal rigor of Teutonic imprint.

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