Budget cuts in Europe: The "virtuosi" and the "laggards”

Budget cuts, fiscal sustainability, exit strategies – the debate on what Europe should do is raging (Giavazzi 2010, IMF 2010). Less analysis, however, has been devoted to the question of who should do what – which countries are doing too little or too much from a European perspective? Who are the “laggards” and who the “virtuosi”? And what lessons can we draw from the evidence?

In a previous Vox column (Manasse 2010) I argued that the present allocation of budget cuts in Europe makes some sense.

• The planned consolidations for 2010 to 2015 tend to be larger for countries with higher public debt-to-GDP ratios and larger primary fiscal deficits, as required by the need to address solvency issues.
• Countries with larger current-account deficits have planned (ceteris paribus) tougher cuts, as required for correcting imbalances within Europe.

The snag is that cuts tend to be larger where unemployment is higher. This feature does not bode well for the recovery in Europe.

The first column in Table 1 shows the planned cumulative budget cuts for 2010-2015 for countries in the Eurozone and the UK (source: CESIFO). On average (last row) the fiscal consolidation effort in Europe is substantial, 4.2% of the area’s GDP, and it is mostly concentrated in 2011-2013.

It would be misleading, however, to compare each country’s effort with the European (weighted) average, and to label a country a “laggard” or “virtuoso” if cuts are below or above the average. By doing so, one would wrongly conclude that Germany and the Netherlands are “laggards”, which obviously they are not.

Table 1. Budget cuts, debts, and deficits in Europe

Sources: Author's calculations from CESIFO, OECD Economic Outlook, EIU data.

Clearly, we have at least to consider each country’s debt and primary balance. Take Italy, for example. It accounts for 14.2% of the European GDP (Eurozone plus UK, last column of the Table), but is responsible for almost 24% of the outstanding public debt in Europe (second column). Presumably its adjusment should be higher than the actual meagre 1.6% of GDP (first column). Yet note that the primary balance in Italy in 2010 (at -1% of GDP) is more than 4 percentage points above the European (weighted) average (third column). Presumably, Italy should adjust less on that count. How can we put all this information together? Clearly, we need a “European” benchmark .

To this end, I construct such a benchmark with the help of a simple cross-section regression that adjusts for varying economic fundamentals – such as debt-to-GDP ratio, primary balance, overvaluation of the exchange rate, and the current account [1]. In essence, I ask how the adjustment of a particular country compares with the adjustment that the “average European ” would have chosen had it experienced the same economic fundamentals [2].

The results are illustrated in Figure 1, for two exercises (the first excluding and the second including Greece in constructing the benchmark). A positive/negative value indicates that the country “over/under adjusts relative to the European benchmark.

Figure 1. Excess cuts in Europe