Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier...

Public expenditure policies during theEMU period: Lessons for the future?1

*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) Assistant

professor at Pablo de Olavide University (Seville, Spain) and as research assistant at

Foundation 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 also

an Economist in the Fiscal Policies Division of the European Central Bank and worked

as a research assistant at the Centre for European Economic Research (ZEW). He holds

a 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 and

Monetary Policy at the German Ministry of Finance. Previously, he worked at the

European Central Bank, the World Trade Organisation and the International Monetary

Fund. His recent research mainly focuses on public expenditure policies and reform and

the analysis of economic boom-bust episodes.

A. JESÚS SÁNCHEZ FUENTES*/SEBASTIAN HAUPTMEIER**/

/LUDGER SCHUKNECHT***/

289

1. 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

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—by

290

1 The views expressed are the authors’ and do not necessarily reflect those of the authors’

employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense de

Madrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34

913942431. Email: [email protected].

The Future of the Euro

291

Chart 1. Developments in public finances, 1990-2011a) Fiscal balance

b) Public debt

Source: Ameco.


292

Chart 1. (cont.) Developments in public finances, 1990-2011c) Total public expenditure

Source: Ameco.

d) Total revenue


many advanced economies in the 1980s to return to sound public

finances and at the same time reinvigorate the economy.

The case of the euro area is of special relevance for a number of

reasons. While the crisis-related deterioration of public finances in

the euro area as a whole has not been as pronounced as for example

in the US or Japan (see Chart 1), heterogeneity at the Member State

level 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 economic

weaknesses and competitiveness deficiencies, in turn, fuelled market

tensions which - due to strong financial interlinkages – undermine

financial stability in the monetary union as a whole. Therefore, at

the time of writing, there is a particular urgency for euro area coun-

tries to regain market confidence through a swift return to sound

public finances. At the same time, euro area membership tends to

exacerbate adjustment efforts since the exchange rate mechanism is

not available, preventing an external devaluation. Therefore, fiscal

consolidation and the restoration of external competitiveness need

to strongly rely on internal adjustment processes.

Against the background, this study assesses expected public

expenditure developments of selected euro area countries for the

coming years. Based on the experience with expenditure reform in

the 1980s and 1990s, we argue that ambitious and high quality

expenditure reform as part of comprehensive economic reform pro-

293

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%.


294

2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-

lopments.


295

%% ooff GGDDPP 11998800 oorr nneeaarreesstt 11999900 22000000 22000077 22001100

MMaaxxiimmuummvvaalluuee

CChhaannggeemmaaxxii--mmuumm ttoo 22001100YYeeaarr RRaattiioo

Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9

Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2

Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6

France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1

Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7

Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6

Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3

Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0

Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2

Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9

Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0

Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4

EEuurroo aarreeaa ((1155) 4455,,44 4477,,99 4466,,22 4466,,00 5511,,00 11999955 5533,,11 --22,,11

Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0

Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2

Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7

Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4

Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8

Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2United Kingdom 47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9

United States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2

GG77 3388,,33 3399,,88 3388,,55 3399,,99 4455,,00 22000099 4455,,55 --00,,55

OOEECCDD 3399,,11 4400,,22 3388,,88 3399,,88 4444,,66 22000099 4455,,22 --00,,66

Table1. Total expenditure developments

Source: Ameco, OECD.

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-


296

3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euro

area countries since the start of EMU.

cit and debt figures is also obvious. But a number of countries mas-

tered the challenge of very large expenditure ratios with ambitious

reform programmes in the 1980s and 1990s. This experience will be

re-called in the next sections. These countries were typically not the

same 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 plans

of a number of euro area economies, notably Greece, Ireland and

Portugal (programme countries), Germany, France, Italy and Spain

(large euro area countries) in comparison to the UK and US. The

common feature of most of these countries (except Germany and

Italy) for the period up to 2007 was a drawn out economic boom

characterised by significantly positive output gaps. In principle, this

should 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 thanks

to the euro.

However, this is not what happened. All countries pursued an

expansionary expenditure stance, of the order of 1-5pp of GDP

except for Germany (Hauptmeier et al, 2011).4 This basically “ate


297

4 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.

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” inflated


298

Such an exercise was conducted by us last year (Hauptmeier et al, 2011). The study

found that most euro area countries had pursued expenditure policies that were more

expansionary than a reasonable expenditure rule would have proposed.


299

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee MMeemmoorraadduumm:: ddeeffiicciitt

11999999--22000077 22000077--22001100 22000077 22001100

Programme countries

GGrreeeeccee 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8

IIrreellaanndd 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3

PPoorrttuuggaall 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8

Large euro area countries

GGeerrmmaannyy 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1

FFrraannccee 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1

IIttaallyy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5

SSppaaiinn 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3

Large non-euro area countries

UUnniitteedd SSttaatteess 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6

UUnniitteedd KKiinnggddoomm 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3

Table 2: Recent total expenditure developments

Table 2: Recent expenditure developments for selected countries

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee

11999999--22000077 22000077--22001100

Programme countries

GGrreeeeccee 37,3 42,8 48,7 44,4 5,5 1,6

IIrreellaanndd 31,5 35,6 46,9 43,7 4,1 8,1

PPoorrttuuggaall 38,1 41,4 47,0 48,3 3,3 7,0


GGeerrmmaannyy 45,1 40,7 45,4 45,4 -4,4 4,7

FFrraannccee 49,6 49,9 54,3 54,2 0,3 4,3

IIttaallyy 41,5 42,7 47,1 45,9 1,2 3,2

SSppaaiinn 36,4 37,6 44,5 43,7 1,2 6,1

Large non-euro area countriesUUnniitteedd SSttaatteess 30,4 34,0 40,2 39,8 3,5 5,9

UUnniitteedd KKiinnggddoomm 36,0 41,7 49,6 47,7 5,6 6,0

Source: Ameco

Table 2: Recent cyclically adjusted primary expenditure developments

GDP. When this reversed over the crisis, both higher spending and

lower GDP drove up the expenditure ratio. Virtually all of the

expenditure ratio increase was on public consumption and transfers

and subsidies; public investment went up only slightly in a few

countries. Greece, Ireland and Spain also reported higher interest

expenditure as the rapidly rising debt ratio and higher interest rates

started 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 public


300

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee

11999999--22000077 22000077--22001100

Programme countries

GGrreeeeccee 37,3 42,9 48,6 44,4 5,5 1,5

IIrreellaanndd 31,7 35,8 46,6 43,5 4,0 7,7

PPoorrttuuggaall 38,2 41,4 46,9 48,3 3,2 6,9


GGeerrmmaannyy 45,1 40,9 45,0 45,2 -4,1 4,3

FFrraannccee 49,7 50,1 54,1 54,0 0,4 4,0

IIttaallyy 41,5 42,7 47,0 45,8 1,2 3,1

SSppaaiinn 36,5 37,7 44,3 43,4 1,2 5,7

Large non-euro area countries

UUnniitteedd SSttaatteess 0,0 0,0 0,0 0,0 0,0 0,0

UUnniitteedd KKiinnggddoomm 36,1 41,7 49,5 47,6 5,7 5,9

Source: Ameco

sector of below 40% of GDP (as defined by Tanzi and Schuknecht,

2000). Even the US, at 41.3% of GDP, featured a public sector that

was not much smaller than the euro area average before the crisis.

Greece, Portugal, France, Italy and the UK reported public spending

ratios of around to significantly above 50%.

It has been argued that the increase in expenditure ratios is not

very relevant as it presumably reflects almost solely the crisis and

should, thus, reverse itself over time as the economy normalises.

This reasoning implicitly assumes that output levels and growth

rates will more or less return to pre-crisis levels. As a large output gap

would be closed, public commitments should decline relative to

GDP. However, if the pre-crisis GDP was artificially inflated by boo-

ming sectors which have to shrink then both GDP level and growth

rates may be significantly lower post-crises. If the 2010 output gap

was only small, 2010 deficits and expenditure ratios would in fact

represent structural features of the examined economies. In any

case, significant fiscal adjustment is needed which in some cases

exceeds 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 developments

since the start of EMU, this section provides an analysis the public

expenditure stance across the three main expenditure components

that governments can influence in the short term: government

consumption, transfers and subsidies and public investment. We


301

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).


302

5 The earlier study applied six measures but the two additional ones did not provide

much additional insights.


303

Public consumption

Chart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditurestance, across rules.Primary expenditures


304

Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen-diture stance, across rules.

Public investment

Looking at the primary expenditures stance - panel a - suggests

a co-movement with the NPG rules which indicates the absence of

a prudence margin to operate when difficulties appear. Looking at

the 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 respective

expenditure rule. Second, for the transfers and subsidies compo-

nent, a strong counter-cyclical behaviour is observed, as one would

expect. However, the decreases in economic good times were much

less 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 be

already observed (returning to 2004 levels).

To complement this general view, we briefly describe the

country pattern for the main expenditure components.6 As in

Hauptmeier et al. (2011), for primary expenditures, we observe a

restrictive expenditure stance for Germany whereas all other coun-

tries show an expansionary policy stance over the 1999-2010

periods, notably as regards public consumption as well as transfers

and subsidies. However, the degree of expansion is different among

components. On the one hand, in the case of public consumption,

the magnitude of cumulative expansion ranged from near zero for


305

6 For the sake of brevity, related country-specific results are not included in the main

text. They are available from the authors upon request.

France to up to 5pp of GDP for Ireland. On the other hand, for

transfers and subsidies, Germany is highly restrictive by 2-3 pp,

and the rest is expansionary by 1-7pp depending on the rule and

country.

Finally, for public investment, the development of the cumula-

tive expenditure stance is quite interesting: restrictive for Germany

and Portugal, neutral for Italy and expansionary for all other coun-

tries with a tendency of neutralisation in 2010. However, overall

magnitudes are small.

In a second step, we repeat this same exercise component by

component, in order to decompose the cumulative deviation

observed. This analysis provides a view of the respective stance of

each expenditure component. The list of indicators included is in

line with those presented so far; i.e. (i) public consumption, (ii)

transfers and subsidies, (iii) public investment, and (iv) other

expenditures. Moreover, we split our sample period into sub-

periods to show the role of (i)-(iv) before (1999-2007) and during

the crisis (2008 – 2009, 2009-2010).

First, looking at the expenditures stance, Chart 3 presents the

decomposition of cumulative effects observed for ex-post and real-

time rules. When compared real-time and ex-post rules behaviour

both similarities and differences are found. While on the one hand

the dynamics are very similar, quantitative differences emerge

especially during sub-period (II), i.e. 2007-2009.


306


307

(II) Ex-post NPG rule. 1999-2007

Chart 3: Decomposition of cumulative changes to public primary spending ratioscompared to a neutral expenditure stance for selected periods

(I) Real-time NPG rule. 1999-2007

%GD

P%GD

P


308

Chart 3. (cont.) Decomposition of cumulative changes to public primary spendingratios compared to a neutral expenditure stance for selected periods



%GD

P%GD

P


309


Chart 3. (cont.) Decomposition of cumulative changes to public primary spendingratios compared to a neutral expenditure stance for selected periods


%GD

P%GD

P

An alternative way to look at these figures is going through the

different sub-periods. First, deviations in the pre-crisis period are

clearly dominated by public consumption. Moreover, if we leave

out Germany as the only restrictive country over this period, two

different country patterns can be observed: major deviations from

trend as regards public consumption in Italy, Spain and Ireland

while Greece and Portugal show strongly expansionary trends in

transfers and subsidies. Second, deviations from trend in transfers

become relatively more important with the start of the financial

and 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 determinants

of expansionary expenditure policies in the past. Hauptmeier et al.

(2011) therefore applied standard fixed-effects panel estimation

techniques on a sample of 12 euro area countries for the 2000-2009

period using the measure for the expenditure stance described

above, i.e. the (marginal) deviations of actual spending growth from

rule-based or neutral spending (under the NPG and the RPECB rule

in 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 political


310


311

economy variables. The results of the analysis are presented in

Table 3.

As one would expect, the macroeconomic environment measu-

red by the output gap (in % of potential GDP) constitutes an

important determinant of the expenditure stance. We find robust

support for a positive correlation between the output gap and the

expenditure 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 the

expenditure stance. We also do not find robust evidence for an

effect of revenue windfalls that arguably could increase spending

profligacy. 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 the

expected 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 national

level (Electoral cycle 1) tend to significantly increase the deviation

of actual from rule-based primary spending. The opposite holds true

for a second election-related variable (Electoral cycle 2) which cap-

tures the years left in the current election term. The negative sign on

this variable suggests that the incentives for fiscal discipline can be

expected to be higher at the beginning of the legislative period. We


312

((II)) ((IIII)) ((IIIIII)) ((IIVV)) ((VV)) ((VVII)) ((VVIIII))

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 90 108

Number of countries 12 12 12 12 10 10 12

R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11

corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77

adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0

R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02

R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11

R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53

standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53

panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17

fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19

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


313

((II)) ((IIII)) ((IIIIII)) ((IIVV)) ((VV)) ((VVII)) ((VVIIII))

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 90 108

Number of countries 12 12 12 12 10 10 12

R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09

corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82

adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03

R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01

R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09

R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61

standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36

panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16

fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2

Table 3. (cont)Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule

Notes: 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)

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 in


314

7 For a definition and a detailed description of the computation of this index see

European Commission (2006) and Debrun et al. (2008). The index takes into account

the share of public spending covered by the rule and qualitative features such as the

type of enforcement mechanisms and media visibility.

euro area countries is that the implementation of the Stability and

Growth 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 EDP

procedure dummy, the result is in line with this perception.

Moreover, the empirical analysis suggests that national budgetary

rules if well-designed can help to effectively reduce spending pro-

fligacy and therefore serve as important tools to promote sound

and sustainable public finances in line with the European fiscal fra-

mework. This reinforces the need for enhancing national fiscal

rules and frameworks as had been proposed by the European

Commission in the autumn of 2010.

3.3. Implications for public debt

Based on the analysis presented in Section 3.1, it is possible to

compute to what extent deviations of expenditure growth from

trend led to increases in government debt. Chart 4 shows alterna-

tive debt paths for the sample economies and across expenditure

rules. Consistent with the previous results, real time rules typically

lead to higher debt paths than ex-post rules. In the case of France,

for example, following a neutral expenditure path since 2000

would 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% and

100% of GDP in 2010, rather than at around 120% of GDP.


315

For a second group of countries (Spain, Greece, Ireland and

Portugal), the difference becomes even more drastic. Neutral spen-

ding policies in Portugal would have led to debt ratios of 40-60% of

GDP in 2010 rather than over 80% of GDP in reality. Spanish debt

would have been at a trough of 10-40% in 2007-08 and would have

remained well below the reference value in 2009 under all rules.

Ireland would have just about eliminated all its debt in good times

and thus created significant room for the subsequent rise. Under all

rules, 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 the

start of the crisis) and increased much more slowly in the crisis.

All in all, public debt positions in the euro area would have

been much sounder at the start of the crisis and in 2010, if euro

area countries had pursued at least a neutral expenditure stance on

average during EMU. Public debt could have been well around or

below the reference value in the euro area in most of its members

by 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 in

the 1980s and 1990s. They found that there were basically two


316


317

Chart 4: Public debt ratios - actual vs. rule-basedEuro area (12)

Germany


318

Chart 4: (cont.) Public debt ratios - actual vs. rule-based

France

Italy


319

Chart 4. (cont.) Public debt ratios - actual vs. rule-based

Spain

Greece


320

Chart 4: (cont.) Public debt ratios - actual vs. rule-based

Ireland

Portugal

reform waves in industrialised countries. Moreover, they found

that there were three groups of countries: (i) ambitious, (ii) timid

and (iii) non-reformers. Ambitious reformers were those that

managed to reduce public primary (non interest) expenditure by

more than 5pp of GDP from their peak within 7 years. Timid refor-

mers were those that cut primary spending between 0 and 5pp and

non-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 resulting

public deficits and adverse debt dynamics. The more ambitious they

were 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, Ireland

and the Netherlands did so again in the 1990s plus a number of

other countries: Finland, Sweden, Canada and Spain. Four countries

reduced public primary expenditure by more than 10% of GDP.

During this period, 10 countries undertook timid expenditure

reforms (amongst them the US, France, Germany and Italy at which

we will look again later). The three non-reformers included

Australia, which had always maintained a rather small government

sector, and Portugal and Greece.


321

It is, however, not just the magnitude of spending and reform

that is important but also the composition. The literature (e.g.,

Alesina and Perotti, 1995 and 1997) argues that reductions in

public consumption/wages and transfers and subsidies are particu-

larly “high quality”. They increase the chance of success of reform

by providing a strong signal of “willingness” and cuts tend to focus

on unproductive expenditure.


322

Max. primary expenditurein year

Change maximum to T7

AAmmbbiittiioouuss'' rreeffoorrmmeerrssFinland 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 -5,1

TTiimmiidd'' rreeffoorrmmeerrssAustria 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 -0,3

NNoonn'' rreeffoorrmmeerrssPortugal 2004 0,0Greece 2000 0,4Australia 1985 0,4

TTaabbllee 44:: EExxppeennddiittuurree rreeffoorrmm pphhaasseess 11998800ss aanndd 11999900ss

Table 5 illustrates that much of the expenditure cuts of

ambitious reformers came from transfers and subsidies and also

from government consumption. About two-thirds of the reduc-

tion in the total expenditure ratio and over 80 per cent of the

decline in the primary expenditure ratio occurred in these two

categories. Nine out of 11 reform episodes reported a decline in

public consumption by more than 2 per cent of GDP and eight

out of 11 featured a fall in transfers and subsidies by over 3 per

cent of GDP. At the same time, in most cases, government

investment and public education expenditure did not decline

disproportionately or in some cases even increased as a share of

GDP. Timid reformers did not report much of a decrease in

public 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 public

expenditure reform needed to be part of a comprehensive overall

structural reform strategy. It was argued on the basis of the litera-

ture that this would allow the improvement in public finances not

only via less spending but also via better growth prospects. An

overview of the reforms undertaken by ambitious countries is

reported in Table 6. Most of the ambitious reformers undertook

major 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


324

Change T0-T7

Total

expenditure

Interest

Spending

Primary

expenditure

Government

consum

ption

Government

investment

Transfers

and

Subsidies

Health

Education

Pensions

AAmmbbiittiioouuss''

rreeffoorrmmeerrss

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 (P

hase 1)

-13,3

-1,0

-12,4

-5,2

-3,2

-2,2

-1,7

-0,9

-0,7

Belgium (P

hase 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 (P

hase 1)

-10,5

-2,3

-8,2

-2,5

-0,3

-2,0

-0,3

-0,8

-0,5

Netherla

nds (Phase 2)

-9,8

-2,3

-7,5

-1,9

0,1

-6,5

-0,8

-0,4

-1,2

United Kingdom (P

hase 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 (P

hase 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

Netherla

nds (Phase 1)

-5,0

0,2

-5,1

-2,0

-0,2

-2,2

-0,1

-1,1

0,4

TTaabbllee 55:: CCoomm

ppoossiittiioonn ooff eexxppeennddiittuurree rree

ffoorrmm

to make future budgetary control and thus the avoidance of fiscal

problems more likely.8 A number of countries devalued their

currencies. All ambitious reformers initiated significant labour

market reforms that improved work incentives. All but one

country reformed the tax system. And most countries reduced the


325

Expenditure reform

Institutionalreform

Other macroeco-nomic reform

Structural reform

Publicconsumption

1/

Transfers &subsidies 1/

Labourmarketincenti-ves

Taxation Privatisation

Ireland 1 XX XX X X X X X

Ireland 2 X XX X X X X

Sweden X XX X X X X X

Canada XX XX X X X X

Finland XX XX X X X X X

Belgium XX XX X X

Netherlands 1 X X X X X X

Netherlands 2 ~ XX X X X X

Spain ~ XX X X X X

UK 1 X X X X X X X

UK 2 X X X X X

All 99 1111 1100 66 1111 1100 88

TTaabbllee 66:: SSuummmmaarryy ffiinnddiinnggss ffoorr aammbbiittiioouuss rreeffoorrmm eeppiissooddeess

8 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.

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 is

not surprising that the impact on public finances and the economy

were quite positive, compared to timid reformers (Chart 5). Panel

a) shows that ambitious reformers (here differentiating early and

late reformers) brought the public expenditure ratio down signifi-

cantly to levels similar or lower than those of timid reformers. This

was mainly achieved through cuts in public consumption and

transfers and subsidies while public investment did not change

much, at least for late ambitious reformers (see panels b)-d)). Panel

e) 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 (panel

f)), timid reformers did not achieve any significant reversal in debt

dynamics. Ambitious reformers, by contrast, managed to bring

debt 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 to

long 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 year

of public expenditure reduction and accelerated more strongly

where ambitious reforms were undertaken (panel g). Private invest-


326


327

Chart 5: Ambitious vs. timid reforms, 1980s and 1990s.a) Total public expenditures

b) Public consumption


328

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.c) Transfers and subsidies

d) Public investment


329

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.e) Fiscal balance

f) Public debt


330

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.g) Trend growth

h) Real private consumption

ment initially declined or was flat and showed a relatively less

favourable trend than for timid reformers but this reversed in the

medium term. In the seventh reform year, the private investment

ratio of timid reformers had increased by 1pp of GDP while that of

ambitious 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 as

the 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 the

latest European Commission forecast (Autumn 2011) (see Table 7).

For the US we consider the latest IMF World Economic Outlook


331

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.i) Private investment

Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)

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 of

GDP for Germany, Italy and the US to over 5pp in the UK and

Spain and to 7 to 10pp in the EU/IMF programme countries.

Expenditure reductions show a more or less linear pattern in most

countries. In the case of the US, the primary expenditure ratio

went down quite strongly in 2010. However, it is expected to decli-

ne only by another 1pp of GDP over 2011-13.


332

% of GDP PPrriimmaarryy eexxppeennddiittuurree

Actual Forecast

2009 2010 2011 2012 2013 2013 to max(0910)

PPrrooggrraammmmee ccoouunnttrriieess

Greece 48,7 44,4 43,6 42,4 41,7 -6,9

Ireland 46,9 43,7 42,1 39,6 37,0 -9,9

Portugal 46,9 48,3 44,9 42,0 39,9 -8,4

LLaarrggee eeuurroo aarreeaa ccoouunnttrriieess

Germany 45,4 45,4 43,3 43,2 42,8 -2,6

France 53,8 54,2 54,0 54,3 53,9 -0,3

Italy 47,1 45,9 44,8 43,8 43,0 -4,1

Spain 44,5 43,7 40,8 39,8 39,3 -5,2

LLaarrggee nnoonn--eeuurroo aarreeaa ccoouunnttrriieess

United States 42,1 39,3 39,6 39,0 38,5 -3,7

UK 49,6 47,7 46,8 45,3 43,9 -5,6

TTaabbllee 77:: EExxppeennddiittuurree ppllaannss

Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.

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 remain

significantly above 50%.

Projected spending developments should also be assessed from

a longer term perspective. When comparing the 2013 figures to the

1999 primary expenditure ratios it is noteworthy that spending

would still be 1-7pp of GDP higher in 2013 than in 1999 for 8 out

of 9 countries. This relative increase would be particularly sizeable

for Ireland, the US and the UK and appears unwarranted in view of

the expected ageing-related increases in social security outlays in

the 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’ expenditure

plans, it is noteworthy that five countries (Ireland, Greece,

Portugal, Spain and the UK) would meet the criteria of ambitious

reformers 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 that

public spending has been a major determinant of unsound public


333

finance developments in the past. Looking forward, it therefore

seems plausible to address this fact through the implementation of

prudent expenditure rules. Indeed, empirical studies suggest that

well-designed expenditure rules tend to limit the pro-cyclicality of

public spending (see, e.g. Holm-Hadulla et al (2010)). Recent policy

action 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 spending

net 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 the

maintenance of a margin of prudence. This is necessary to account

for 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 pp

in expenditure growth per annum appears warranted. In addition,

excessive price developments should not automatically feed into

higher expenditure growth as expansionary fiscal policies may

accelerate 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 reached

much lower levels in 2009. As a result, also public debt ratios in


334


335

Chart 6: Actual ratios versus neutral expenditure policies-based ratios (based onNPG – ½ pp and RPECB – ½ pp rules), 2009

Panel A: Primary expenditure ratios

Panel B: Public Debt ratios

Note: Includes GDP multiplier and compound interest effects.


336

2009 would have generally been much closer to 60% of GDP with

the 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 the

absence of fiscal imbalances. Any fiscal adjustment, e.g. to regain

sound fiscal positions in the aftermath of the crisis, would of cour-

se require a restrictive policy stance, i.e. spending growth rates

below potential GDP growth.

6. Concluding remarks

What are the main findings of this study and what policy lessons

can be drawn? Public finances in advanced economies are at a cross-

roads. In the fifth year of the crisis, fiscal deficits remain high and

public debt has reached unprecedented peace-time levels in most

industrialised countries. Public primary expenditure stands at or

near historical peaks in many countries and therefore constitutes an

important determinant of the fiscal imbalances. It therefore seems

straight forward to focus on expenditure restraint when striving to

regain 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 briefly

reviewed here, has been very positive. Within a few years from the

start of expenditure reform, public expenditure ratios went down

significantly, fiscal deficits largely or fully disappeared, public debt

was brought on a downward path, and economic growth and pri-

vate consumption resumed swiftly. We argue that this was because

ambitious expenditure reform was conducted in a growth-friendly

manner as part of comprehensive adjustment programmes.

Our study emphasises the key role of expenditure policies in

explaining fiscal developments during EMU in the euro area. It finds

that, almost all euro area countries (with the notable exception of

Germany) applied expansionary expenditure policies already before

the crisis. This resulted in much higher expenditure and debt paths

compared to a counterfactual neutral expenditure stance. Rules-

based spending policies could have led to much safer fiscal positions

much 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 context

of ambitious reform programmes. Spending based consolidation

efforts need to be complemented by structural reforms, notably

with a view to removing rigidities in national labour and product

markets, to reduce macroeconomic imbalances, improve competi-

tiveness and support potential growth. This will be particularly

important for the vulnerable countries in the euro area which do

not 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 on

reducing government expenditure as a ratio to GDP in the coming

years. However, the benefits of reforms are only going to materia-


337

lise under one condition, namely that all these plans are fully and

adequately implemented. This is their main challenge.

In addition, the empirical evidence on the determinants of euro

area countries’ expenditure stance provide a number of policy

implications. First, strong national budgetary institutions seem to

limit 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 the

context of the recent “Six-Pack” reform therefore constitutes a step

in the right direction. An effective enforcement of this rule should

help to limit overly expansionary spending policies in the future.

Furthermore, this chapter argues that a potential growth rule

with an extra ½ percentage point deduction from the resulting

annual expenditure growth targets would be a sufficiently prudent

and, thus, advisable expenditure rule for euro area countries. As

economic (e.g., population aging) and political economy reasons

suggest that overestimating potential growth could also occur in

the 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 this

study (March 2012), EU member states have set up new EU economic

governance principles with a view to ensuring a tighter and more


338

effective surveillance of economic and fiscal policies at the European

level. At the same time, policy makers have agreed - in the context of

the new fiscal pact - to strengthen national fiscal frameworks.

All in all, a stringent implementation and enforcement of the

fiscal surveillance at European level could well ensure the necessary

break with past expenditure trends and thus also secure sustainable

deficits and debt dynamics in the future. However, it remains to be

seen whether the main obstacle of the “old framework”—lack of

incentives and enforcement—is really sufficiently remedied.

Bibliography

- Alesina, A. and R. Perotti (1995) Fiscal expansions and adjustments in

OECD 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 and

growth: 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

- Coenen, G, C., Erceg, C. Freedman, D. Furceri, M. Kumhof, R. Lalonde, D.

Laxton, J. Lindé, A. Mourougane, D. Muir, S. Mursula, C. de Resende, J. Roberts, W.

Roeger, S. Snudden, M. Trabandt and J. in’t Veld (2010) Effects of fiscal stimulus

in structural models, Working Paper, 10/73, International Monetary Fund.

- Debrun, X., L. Moulin, A. Turrini, J. Ayuso-i-Casals and M. Kumar

(2008) Tied to the mast? National fiscal rules in the European Union,

Economic Policy, 23 (54), 297–362.

- European Commission (2006) Public finances in EMU - 2006, European

Economy, 3, Brussels.

- Hauptmeier, S., M. Heipertz and L. Schuknecht (2007) Expenditure

reform in industrialised countries: a case study approach, Fiscal Studies,

28 (3), 293-342.

- Hauptmeier, S., A.J. Sánchez-Fuentes and L. Schuknecht (2007)

Towards expenditure rules and fiscal sanity in the euro area, Journal of

Policy Modeling, 33, 597-617.

- Holm-Hadulla, F., S. Hauptmeier and P. Rother (2010) The impact of

numerical expenditure rules on budgetary discipline over the cycle, Working

Paper 1169, European Central Bank.

- International Monetary Fund (2011) Shifting Gears Tackling Challenges

on the Road to Fiscal Adjustment, IMF Fiscal Monitor, April 2011,

Washington D.C.


340

- Menguy, S. (2008) A dynamic rule applied to the threshold imposed on the

European budgetary deficits, Journal of Policy Modeling, 30, 1093–1105.

- Morris, R. and L. Schuknecht (2007) Structural balances and revenue

windfalls - the role of asset prices revisited, Working Paper 737, European

Central Bank.

- Poterba, J. and J. Von Hagen (eds.) (1999) Fiscal Institutions and Fiscal

Performance, University of Chicago Press, Chicago.

- Schuknecht, L. (2009) Booms, Busts and Fiscal Policy. Public Finances

in the Future? London: Politeia.

- Schuknecht, L. (2011) Fiscal activism in booms, busts and beyond, forth-

coming in Banca d’Italia, 2011.

- Tanzi, V. and L. Schuknecht (2000) Public Spending in the 20th century:

a global Perspective. Cambridge: Cambridge University Press.

- Turrini, A. (2008) Fiscal policy and the cycle in the Euro Area: The role of

government revenue and expenditure, European Economy - Economic

Papers 323, European Commission.

- Van Riet, A. (ed.) (2010) Euro area fiscal policies and the crisis,

Occasional Paper 109, European Central Bank.

- Wierts, P. (2008) How do expenditure rules affect fiscal behaviour?, DNB

Working Paper 166.


341

Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier...

Education

Transcript of Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier...