Monday, 7 November 2011

Fiscal adjustments in the Euro Area: Greece and some other cases

Although I suspect that the latest developments in my native Greece has kept and is still keeping us all busy, I decided to write a post tonight, since it's been a long time and my keyboard fingers are getting itchy...

I was shifting through some data about fiscal policy today and it suddenly struck me how eloquently all the current problems of Greece are reflected into the next chart. 


source: AMECO

As you can see, general government's total expenditures (as a % of GDP) have never actually declined in the years that AMECO data run, appart from the current adjustment.

The previous fiscal adjustment (pre-EMU accession), which admittedly was rather large, in its entirety came from the revenues side of the state budget. It comes as no surprise then that for many people this seems totally outlandish.

Another thing that we can discern from the chart is that post EMU-accesion fiscal policy in Greece was, for the most part, pro-cyclical.This only serves to make booms more spectacular and busts infinitely more painful. The fact that the pre-EMU adjustment was counter-cyclical in nature (even though it was revenue-based) made things easier (as did the fact that the reason for it was the up and coming EMU membership, which the majority of Greek people regarded favourably).

A period when many large fiscal adjustments happened simultaneously, was the run-up to the Euro introduction. I want to take a look at some of these cases and more specifically at the structure of these adjustments.

Let's start first with the southern Euro Area countries. Here's Italy.

source: AMECO

As you can see from the chart, the brunt of the adjustment in Italy came from the expenditures side of the budget. Now let's take a look at Spain.


source: AMECO

Here too, general government expenditures accounted for the entirety of the adjustment. After EMU accession Spain kept a rather prudent fiscal stance, helped in part by a spike in general government revenues (could that be attributed tot he property bubble?).

Now, let's take a look at some northern/central Euro Area countries. First one up is the Netherlands.


source: AMECO

As the graph makes obvious, expenditures were slashed to meet the accession criteria. Revenues were broadly unchanged or even declined slightly. After the EMU admission hurdle was cleared, the Netherlands followed a clearly counter-cyclical fiscal policy, that allowed it some room for fiscal maneuver during the present crisis.

Now let's take a look at Belgium.


source: AMECO

One first takeaway fromt he chart is that for a rather long time Belgium ran huge fiscal deficits, that at some point in the 80s reached the stratospheric level that characterized Greek budget balances in the 80s as well. After that there was a first wave of adjustment (during the 80s) based mostly on cuts in expenditures and a bit on revenues (but towards the end of the decade revenues fell again). The second wave of fiscal adjustment was enacted in order to meet the EMU admission criteria and it was more balanced than the previous one.

Finally, here's Finland, which I think is a really interesting case.


source: AMECO

Finland experienced a banking crisis in the early 90s which coupled with the wilting of traditional industries like forestry and the collapse of the USSR (that was a significant trade partner) resulted in a really deep recession. Since the country adhered to a counter-cyclical fiscal policy prior to the early 90s crisis, was able to ramp un government spending to unprecedented levels in order to support the economy in these hard times. That only meant that a monstrous adjustment was required for the EMU accession criteria to be met. All of it came from the expenditures side of the ledger.

All of the adjustments reviewed above, despite their different structure, had one thing in common they were countercyclical (they were imposed when the economy was expanding) hence the whole process was less painful.

Of all the cases shown above, the Greek case is unique. It is the only one that general government expenditures were left untouched.

I think that all the above highlight the merits of counter-cyclical fiscal policy...

P.S. Here are the real GDP growth rates for the countries displayed above in case you want to check out whether revenue-based adjustments were less painful than expenditure-based ones. There is no evidence of something like that, nor did the countries slip into recession because of the adjustments undertaken. Moreover, Finland that undertook such a large expenditure-based fiscal adjustment didn't find itself in a depression because of that (and even if growth during the first year out of the recession was due to a low-base effect what about the next years?). Of course, these adjustments are not comparable to the current one attempted in Greece due to the fact stressed above they were counter-cyclical while the current one is pro-cyclical.


source: AMECO


source: AMECO


Of course, in no case can the real GDP growth that each country displays be attributed solely to its fiscal policy but to a million other idiosyncratic factors.

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