Nip and tuck
Europe’s plans for fiscal austerity are not quite the threat to recovery they seem
INVESTORS who may once have doubted that euro-zone countries could right their public finances seem now to fear that crisis has spurred too much austerity. A handful of countries, notably Greece but also Spain, Portugal and Ireland, have been forced to take drastic action by nervy bond markets. To avoid a similar fate, Italy pledged in May to cut its budget deficit by €24 billion ($30 billion) by 2012.
Now even the most creditworthy are joining in. On June 8th Germany’s government announced a package of measures that will save it around €80 billion by 2014. Its chancellor, Angela Merkel, said Germany should set an example of budgetary discipline to other euro-zone countries. France has also said it will act to trim its deficit by abolishing tax exemptions and freezing most spending programmes from next year. This rush to don the hair-shirt raises a fresh concern: if budget cuts are too severe, might they push the economy back into recession, defeating their purpose?
Judged by the claims of those who welcome the new fiscal austerity, as well as those who fear it, a gigantic fiscal blow is about to land. The true picture is not quite so dramatic. Take Germany’s measures, for instance. The €80 billion of cuts claimed by the government will be made over four years. Most of the savings are coming in 2013 and 2014. The effect on next year’s budget will be just €11.2 billion, less than 0.5% of GDP. With all the talk of cuts, it is easy to forget that Germany’s budget deficit will widen this year by 1.5-2% of GDP as the delayed effect of earlier stimulus measures comes through.
The smaller countries at the edges of the euro block are pulling back harder. Greece’s budget cuts amount to 7% of GDP this year and 4% next year (see table), according to Laurence Boone at Barclays Capital. Spain, Portugal and Ireland are set to cut their budgets by 2-3% of GDP in 2010 and 2011. Yet they are a fairly small part of the region’s economy. Greece is just 2.6% of euro-zone output. Portugal and Ireland are smaller still. With Spain these countries account for less than a fifth of euro-area GDP. Their planned austerity will have a correspondingly small effect on the euro-zone economy. Ms Boone reckons that measures aimed at cutting budget deficits in the euro area will come to around 1% of GDP next year, when weighted by the size of each country’s economy. That is big but not excessive for a block that is forecast by the European Commission to have an average budget deficit of 6.6% of GDP in 2010.
There is much uncertainty about the economic impact of fiscal tightening, not least because some temporary measures will also have run their course by next year. Budget cuts weaken GDP growth by shrinking aggregate demand. The simplest gauges of such “Keynesian” effects suggest that each euro of lost public spending reduces GDP by around the same amount.
But in some circumstances budget cuts can help growth—or cause less harm to it than Keynesian models suggest. Firm action to tackle budget deficits may induce anxious consumers to save less (and firms to invest more) by lowering uncertainty about future tax changes. Such anxiety is likely to be bigger when public debts are worryingly high because taxpayers judge that the need to reduce the deficit will soon hurt their finances. Research by Christiane Nickel and Isabel Vansteenkiste of the European Central Bank found that rising budget deficits in high-debt countries are associated with higher private savings.
A lot also depends on how budgets are cut. A much-cited study by Alberto Alesina of Harvard University and Roberto Perotti, now of Milan’s Bocconi University, found that budget adjustments that rely on cuts in welfare payments or the government’s wage bill are more likely to produce lasting benefits—lower public debt and faster GDP growth—than those based on tax increases or cuts in public investment. The least harmful taxes were on firms’ profits or on consumer spending.
Examples of such “expansionary fiscal contractions” are much harder to replicate now. Countries that managed to grow strongly in the past while cutting budget deficits were often aided by a falling exchange rate or were rewarded by a big drop in borrowing costs. Most rich countries today already enjoy low bond yields. And not everyone can devalue their currencies.
It is clear, nonetheless, that certain kinds of austerity are less harmful to growth. The packages announced by euro-area countries seem fairly well designed. Most countries plan to slim the government wage bill and reduce entitlements—the sorts of cuts that are least damaging to economic recovery. Big cuts in public-sector pay and allowances have been pushed through in Ireland, Spain and Greece. Italy plans a three-year wage freeze and, like Germany and Greece, will replace only a fraction of retiring workers with new hires. Welfare payments have been slashed in Ireland and will be reduced in Germany from 2011. Pension costs will be cut in Greece and shaved in Spain and Italy.
No country has relied too much on cuts in public investment, which often cannot be sustained. Spain and Ireland have made large cuts in their capital budgets but have lowered current spending by more. Portugal’s austerity relies too heavily on higher taxes, though it has reduced unemployment benefits. Greece has had to raise revenue as well as cut spending but is at least looking to the “right” sorts of levies, such as value-added tax (VAT) and “sin” taxes on cigarettes, alcohol and petrol.
Given the seriousness of its fiscal troubles Greece had little choice but to attack its deficit on all fronts. Germany is not under the same sort of bond-market pressure. It might have delayed its cuts a little longer. Officials are now more willing, in private at least, to admit that weak domestic demand in Germany is a problem. But running deficits for longer is perhaps not the best way to tackle it. In a small way, the measures to cut German welfare benefits may help if they encourage more non-workers into the labour force and boost consumers’ spending power. At least the government kept tax rises to a minimum.
Budget cuts are rarely good news for the economy. But Europe’s austerity drive could have been a lot worse.