EU Elections and the Fiscal Compact

According to many commentators the results of the recent wave of  national (French and Greek) and administrative (Italian and German) elections in the EU,  show a “fatigue” with the (self) imposed austerity of Mrs. Merkel, enshrined in the “fiscal compact”. In particular in a recent piece  Francesco Daveri argues that since the protest comes from the very countries who, in terms of public expenditures, were more profligate (Greece), there are no credible alternatives to the “fiscal compact”. As concerns 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 issue, the measures of profligacy often used,  government spending as a share of GDP, and government spending in nominal terms, should be interpreted with caution. The empirical evidence 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 (1),  obtaining  Figure 2 .

The figure shows that, thanks to the moderation of prices, between 2000 and 2009 Germany was able to increase public spending in real terms much more rapidly than Spain and Greece (about 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 per cent in real terms. So the voters’ answer is quite understandable. In addition, spending cuts above 20 percent in real terms have also been made in Germany since 2009. Here lies the stupidity of the fiscal compact: a recessive corset imposed on everyone, those who (possibly) need it and those who do not, making things worse for everyone.

(1) In figure 2,  I subtract the rate on consumer price inflation from nominal spending growth. 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 Spain 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


3 Responses to "EU Elections and the Fiscal Compact"

  1. AndrewMGarland   May 16, 2012 at 4:07 pm

    Mr. Manasse,

    You write "The empirical evidence suggests that contractions in spending cause a more than proportional fall in GDP, as recent cases of Greece and Italy indicate quite clearly."

    Does "suggest" mean that you are not sure, or are surprised? Does this fit into many examples over time and space?

    Possibly, you are looking at graphs of government spending vs GDP. You observe that government sometimes spends less at a time when GDP falls.

    How have you established cause and effect? Wouldn't it be natural for a government to be unable to maintain spending levels (which they always want to maintain) at a time when GDP is falling? Your observation could be interpreted as "Governments decrease spending usually at a time when GDP is falling, and they almost never decrease spending proportionately to the fall in GDP".

    In numbers, when GDP falls 2%, the government might spend 1% less. That could be interpreted as "A spending decrease of 1% caused a 2% drop in GDP". But, the causation may be in the opposite direction.

    • paolo manasse   May 17, 2012 at 2:18 am

      Causality is an issue economics has been struggling with for decades. This is why I prefer to talk about correlations. There is an impressive empirical literature on "fiscal multipliers" (what is the effect of a 1% change in government exenditure (or taxes) on GDP?) with estimates ranging from -1 to 4! My reading of this literature is that the "true" government spending multiplier should be between 1 and 2, so that a 1% fall in spending shoud "cause" (other things equal!) a more than proportional fall in output. This is why I caution agaist using the spending/GDP ratio for assessing whether a government has been profligate or not.

  2. DiranM   May 18, 2012 at 7:52 am

    Nice piece!