Weekend elections: Democracy and the fiscal compact

Francesco Daveri , 8 May 2012

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Sunday 6 May 2012 was Europe’s “Super Sunday” of elections:

  • The French presidential election gave the victory to Francois Hollande.
  • Parliamentary elections have left Greece without a coalition capable of governing.
  • There were local elections in Germany and Italy.

All these showed similar results.

With Europe in recession, voters rewarded those who oppose budget cuts. But the turnaround of budgetary policies advocated by the majority of voters runs up against an important constraint. The nations where voters demand lower taxes are those in which public spending has risen more in the last ten years. The only way out of today’s difficulties is the bold implementation of economic reforms. This has started in many countries, but it must continue.

The spectre of anti-austerity movements haunts Europe

In France, Nikolas Sarkozy started with a reformist bent but soon shelved the 316 proposals for reform and growth that had been produced by the Attali Commission (which, significantly, included the future Prime Minister of Italy, Mario Monti). After giving up his initial goal of rebuilding France from scratch, he narrowly lost the election, ending his race wooing Marine Le Pen’s voters at the very last minute. The winner Hollande made very generous promises during the election campaign – €20 billion worth by some reckonings. This would raise the French budget deficit above 5%.

In Greece, the two main parties – the conservatives of Nea Democratìa and the socialist Pasok – failed to reach the hoped-for Grand Coalition majority. The Greek voters are uncertain of which way to jump – into the dark unknown of Eurozone exit or the continued pain of austerity. Voters judged the two big parties to be guilty of providing parliamentary support to the budget cuts brought about by the Government led by the former central banker Lucas Papademos, seen as the local representative of the loathed troika (the ECB, IMF and the European Commission).

In Italy, the massive success achieved by the Five-Star Movement which ran against the Italian political caste is not very different from the electoral success of radical leftist movement Syriza in Greece as well as that of the neo-communist Mélenchon in France.

All these parties are driven by the electorate's aversion to restrictive fiscal policies that are necessary to keep them inside the monetary union. These policies, however, are increasingly identified as the eventual reason of the persistence of the crisis and not as an umbrella of protection against it (see the Vox Debate on whether austerity has gone too far).

The same applies, inter alia, to the German Pirate Party which has gathered more than 8% of the vote in Schleswig-Holstein, a state in northern Germany with a strong Danish minority. Even in these elections, the resilience of Angela Merkel’s CDU and the partial recovery of its current allies, the Liberal Democrats, were not sufficient to prevent a centre-left coalition from winning the local election.

Overall, the result of the European Super Sunday brings into question the fiscal compact and its logic. Though the agreement was signed by 25 EU countries only a few months ago, it has now become the hallmark of German-led fiscal rigour on the rest of Europe. The spectre of an international anti-austerity movement is haunting Europe, and nobody knows how to deal with it.

Reforming the fiscal compact is hard

The fiscal policy turnaround advocated by the majority of voters in Europe will encounter severe constraints which cannot be ignored, not even by the governments more seriously concerned by the social implications of the adoption of stringent fiscal policies. Taking a look at how public spending evolved in European countries over the past ten years, i.e. since the euro was introduced, provides a handful of examples of such constraints.

  • Since the end of 2001, the 17 countries of the Eurozone saw government spending rise from €3.3 to €4.7 trillion billion (in current euros), hence by 39.6%.
  • As a percentage of Eurozone GDP, spending has increased from 47% to 51% of GDP.

The post-2008 crisis was certainly a powerful factor in this increase. Yet if one looks at Germany alone, the picture looks quite different. On the one hand, the German economy suffered a major shortfall in 2009, with a real GDP decline in excess of 5 percentage points; and growth was not very fast even in the first part of the decade. This was when Germany was the sick man of Europe. But, between 2001 and 2010, government spending in Germany went up by a mere 18.5%, from just over €1 trillion to €1.2 trillion. As a result, the share of public expenditure to GDP has remained roughly constant in Germany, despite the crisis and bank bailouts, aid to automakers and, recently, generous wage increases to public employees. Government spending remains fairly high (48% of GDP), but its size has remained the same share of GDP as in 2001. This is, more or less, what the Germans mean by “fiscal discipline”.

The numbers are obviously subject to interpretation, but as such they cannot be questioned. Irrespective of what one thinks of the “German” fiscal rule, the data on Germany imply that, in the rest of the Eurozone without Germany, public spending has gone up at a much faster pace, by some 41.5% between 2001 and 2010. This is an increase of 23 percentage points higher than that in Germany. The country that has provided one fourth of the financial resources for the temporary EU bailout fund (EFSF) and will provide the same proportion of the future permanent bail-out fund (ESM) has witnessed a much smaller increase of its own public spending vis-a-vis that of the other EMU member states.

Union paradoxes

This, in a nutshell, explains the bulk of the current dissatisfaction of the German electorate with the euro and the current setting of the European institutions. It is this dissatisfaction that goes a long way towards explaining the seemingly erratic attitude of Chancellor Merkel in recent years. And Slovakia may also be appended to Germany as a case in point. As reported in the Wall Street Journal, it appears that Slovakia has committed, adding up disbursements and guarantees, a total of €13 billion to the EZ bailout funds. This figure is bigger than the annual tax revenue of the Slovak Government. Slovakia is giving its contribution to save a country like Greece which in 2010 had an income per capita of around €20,000, far greater than the €12,000 of the Slovaks. The discontent with the euro does not end in Germany but also extends to smaller Eastern and Northern states in Europe.

The list of big EZ spenders, however, shows some variability. For example, over this period, spending has increased by "only" 31% in Italy, while it has gone up by much more in other countries on the brink of default: +56% in Portugal, +72% in Greece and +89% in Spain. In France, the increase in expenditure reached +42%. As a result, the increases in expenditure as a proportion of GDP in the EuroMed countries have fluctuated between the +5 percentage points for France and Greece and the +9 in Portugal (with Spain in between with +7).

Confronted with the relatively less unfavourable data for Italy, one may question whether this can be ascribed to the ability of the guardians of the public purse (and especially of Giulio Tremonti, who was the minister of the Economy for most of the time between 2001 and 2010). Well, it might be. Most likely, however, the relatively smaller increase of spending in Italy had more to do with the very high initial level of public debt with which Italy entered in the euro. Italy’s public debt stock was already 105% of GDP in 2001, slightly higher than in Greece.

In France, Spain, and Portugal, by contrast, public debt in 2001 was much lower. Endowed with low debt, these countries didn’t think twice when, once in the euro, they enjoyed the bonanza of cheap credit brought about by German reputation. They kept spending habits that exceeded the long-run growth of their tax revenues. Now these other countries are footing more the bill for their past choices.

In Italy – with twice as much debt as the other Mediterranean countries – public spending should have fallen, at least as a proportion to GDP, rather than increasing. This was not to be. Regrettably, government spending (in current euros) went up by 31%, which led, given persisting low growth even from before the crisis, to increases that took spending from 47.9% to 50.6% of GDP.

The options ahead

The election outcomes of the European Super Sunday raise an important consistency issue for the current setting of European policies. Can democracy and the fiscal compact stay together?

The answer is unclear. Yet, it remains that, with the comparative data on public spending in hand, it is difficult and even unfair to ask Mrs Merkel to renegotiate the fiscal compact. That would put the spotlight on something – the importance of credibly implemented fiscal discipline – that has been largely overlooked for many years in Europe, even before the recent crisis.

Above all, asking Mrs Merkel to renegotiate it is like asking her to commit political suicide. It would also be unfair because Germany, under the same demographic and economic shocks as the other people of Europe, controlled public spending much more effectively than other European countries proved able to do. At least, they should not pay for this.

The right way forward is to use the flexibilities in the Treaty. Even in its current form, margins exist for less than automatic implementation of sanctions against lack of fiscal discipline in the face of proven success in the adoption of measures conducive to economic growth. This is the route to take if Europe is to gain further democratic legitimacy and return to growth at the same time. Moreover, leaving the structural reform road – even the half-hearted economic reforms under discussion -- would be a major, self-defeating, mistake. The monetary union as a whole would pay very dearly for such a mistake in the years to come.

Editor's note: This first appeared on our consortium partern's web site LaVoce.info in Italian; http://www.lavoce.info/articoli/pagina1003057.html.

Topics: Europe's nations and regions
Tags: austerity, Eurozone crisis

Comments

Re: Weekend election: Democracy and the fiscal compact

In a recent piece on EU elections (1) Francesco Daveri makes two points. The first is that the results across Europe share a common trait: the revolt of large sectors of the electorate, particularly in France and Greece, but also in the Italian and German administrative elections, against the (self-) imposed austerity of Mrs Merkel, enshrined in the "fiscal compact". The second is that there are few alternatives to the fiscal compact, given that most protests come from the very countries who, in terms of public expenditures, were more profligates. On the first point, to my reading, the true political 'surprises' in the Italian and French election, did not come from the winners, but from the 'outsiders', Ms LePen Jr and Mr Grillo. Their exceptional performances has arguably little to do with the austerity of the fiscal compact, and probably a lot to do with the protest against an arrogant, inept and often corrupt political establishment (the case of Greece is clearly different).

On the second point, the data commented in the article, government spending as a share of GDP and government spending in nominal terms should be interpreted with caution when discussing 'profligacy'. The empirical evidence (very controversial!) suggests that contractions in spending cause a more than proportional fall in GDP (a multiplier larger than unity), as recent cases of Greece and Italy indicate quite clearly. As a result, an increase in the ratio would occur when cuts in spending reduce output more than proportionately. Even greater caution should be used when interpreting changes in nominal terms. It's well known that the origin of the current imbalances within Europe is the loss of competitiveness of the peripheral countries against Germany. Figure 1 shows a familiar picture, consumer prices in Germany (blue line), Greece (red) and Spain (yellow). In the last two countries, between 2000 and 2010 consumer prices increased by respectively 16 and 23 percentage points more than in Germany. In order to get an index of 'real expenditures' I simply correct the nominal data with inflation (2), obtaining Figure 2.

The figure shows that, thanks to the moderation of prices, between 2000 and 2009 Germany was able to increase public spending much more rapidly than Spain and Greece (20 percentage points of real growth more). The figure also shows two other important aspects: after 2009, the cuts in Greece were very hard, about 30% in real terms. So the voters' answer is understandable. In addition, spending cuts above 20% in real terms have also been made in Germany since 2009. Here lies the stupidity of the fiscal compact: a recessive corset imposed to everyone, those who (possibly) need it and those who do not, that makes things worse for everyone.

(1)see http://www.voxeu.org/index.php?q=node/7960

(2) In figure 2, I subtract from nominal spending growth the rate on consumer price inflation. If the government spending deflator were available than that should be used. Note, however that since the consumer price index weights the price of tradables (which should be similar across countries) and of non-tradables, if consumer prices rise more rapidly in Greece and Span relatively to Germany, then it must be the case that the price of non tradables (such as public services) in Greece and Spain must rise even faster relatively to Germany's. Thus by using consumer prices to deflate nominal spending , I am actually over-estimating 'real spending' in Greece and Spain, and underestimating real spending in Germany.

Professor of Economics, University of Parma