The European experience with large fiscal adjustments

The key question for European policymakers and financial markets alike is now whether ‘Greece can make it’ (Burda 2010).

There is consensus that Greece must cut its deficit by about 10-12% of GDP in order to put the country’s public finances back to a sustainable path (see Gros and Alcidi 2010). The Greek government has promised that it will achieve this adjustment, but is this promise credible in the light of the experience in the EU? Our results suggest that an adjustment of this size is not without precedent, but it will probably take at least 5 years, and, even if the headline goal is reached, it might still leave the country in a highly unstable position.

What is the European experience?

Table 1 below shows the 12 largest fiscal adjustments observed over the last decades in the EU. We concentrate on the cyclically adjusted primary balance as the main metric because it provides a better measure of the adjustment effort of the country by correcting adjustments that were achieved to a large extent through the operation of the fiscal multipliers (e.g. Sweden). The data we use are those published by the European Commission (which differs somewhat from the OECD data widely used in financial market commentaries (see for instance Boone et al. 2010)).

Inspection of table 1 shows that at first sight there should be no problem. Greece achieved an adjustment of the size required today already once, namely in the early 1990s (then the improvement in the primary balance was almost 11% of GDP over five years). Other EU countries, namely Denmark, Sweden and Italy, have come close in terms of the overall adjustment. Others (Portugal, Finland and Belgium) would not be far behind with adjustments totalling about 8-9% of GDP.

Table 1. Primary balance adjustment

Country	Primary balance, adjustment period	Years	PB, start (% GDP)	Primary balance, adjustment (% GDP)	PB adjustment, per year (% GDP)
Denmark	82-86	4	-1.3	10.0	2.5
Greece	89-94	5	-6.0	10.8	2.2
Sweden	93-98	5	-2.5	9.0	1.8
Ireland	85-89	4	-0.9	5.9	1.5
Portugal	86-80	6	-5.8	8.2	1.4
Italy	89-97	8	-3.3	10.4	1.3
UK	93-99	6	-3.6	7.4	1.2
Finland	92-2000	8	0	8.2	1.0
France	93-97	4	-2.4	3.6	0.9
Belgium	81-90	9	-4.3	8.1	0.9
Austria	95-2001	6	-1.5	4.7	0.8
Netherlands	90-2000	10	-0.8	4.5	0.4

Source: European Commission (AMECO) and authors’ calculations. Note: Primary balance figures are adjusted for the cyclical component (adjustment based on GDP trend)

This seems to suggest that, even if painful, a fiscal adjustment of 10% of GDP is (or rather has been in the past) possible.

But how? There are interesting differences in the way the fiscal adjustment was achieved (i.e. through cuts in spending or increases in taxes) and in the extent to which debt was actually stabilised.

Expenditure cuts versus tax increases

Table 2 shows that in the Mediterranean countries (Greece, Portugal and Italy) the adjustment tends to occur through increases in government revenue, with small, if any, cuts on the expenditure side. This is in stark contrast with most other countries, and even more markedly with the Nordic ones, where the corrections tend to be based on large government expenditure reductions. France qualifies on this account as a member of the ‘Club Med’ since its adjustment in the 1990s (total ‘only’ of 3.6% of GDP, see table 1 above) was achieved to about 71% through revenue increases.

Table 2. Government revenue and expenditure adjustments as percent of total primary balance adjustment

Country	Primary Balance Adjustment period	% of total PB adjustment through increase in revenue	% of total primary balance adjustment through cut in expenditure
Portugal	86-80	110.6	-10.6*
Italy	89-97	85.3	14.7
Greece	'89-94	84.0	16.0
France	93-97	70.7	29.3
Denmark	82-86	28.2	71.8
UK	93-99	20.0	80.0
Austria	95-2001	12.2	87.8
Belgium	81-90	1.8	98.2
Sweden	93-98	-25.7*	125.7
Ireland	85-89	-46.9	146.9
Finland	92-2000	-63.4	163.4
Netherlands	90-2000	-89.1	189.1

Source: European Commission (AMECO) and authors’ calculations. Note: General Government revenue and expenditure figures are adjusted for the cyclical component (adjustment based on GDP trend). *Negative sign implies that expenditure increases

Stabilisation of the debt to GDP ratio

The goal of the large fiscal adjustments is to make public finances sustainable. However, as table 3 shows this goal was rarely achieved, especially if the primary balance was in large deficit at the beginning of the adjustment process.

For example, as shown in the first row of Table 3, during the 10 years its fiscal adjustment Belgium’s gross debt ratio increased by more than by 50 percentage points of GDP. Something similar happened during the adjustments in Greece, Portugal and Italy where the debt GDP ratio continued to increase by more than 20 percentage points of GDP. This implies that if Greece were to repeat over the next few years its performance during the early 1990s it would end the adjustment process with a debt ratio of over 150% of GDP.

However, the data also suggest that the adjustment periods considered did at least succeed in stabilising, or nearly stabilising, the debt ratio in most countries (it continued to increase, by a small amount only in Belgium and Greece).

The case of Italy is exceptional; debt kept increasing at fast pace during the time of the big correction and then, in the following years, a significant shift took place as the effect of a lower interest rate materialised.

Table 3. The effect of the primary adjustment on debt

Country	Primary balance, adjustment period	Debt, start (% GDP)	Implicit interest rate spread	Change in debt (% GDP)	Durable? Change in debt, 5 years after (% GDP)
Belgium	81-90	74.1	na	51.6	4.2
Greece	'89-94	64.2	7.5	32.1	4.0
Portugal	86-80	30.5	na	28.2	-1.2
Italy	89-97	93.1	3.9	25.0	-12.4
France	93-97	46.5	0.2	13.0	-0.5
Finland	92-2000	40.0	1.5	3.8	-2.0
Denmark	82-86	64.5	na	2.0	-3.7
Sweden	93-98	69.9	0.9	-0.9	-16.8
UK	93-99	44.5	1.0	-0.9	-3.1
Austria	95-2001	68.3	-0.3	-1.3	-4.8
Ireland	85-89	100.7	na	-1.3	-10.7
Netherlands	90-2000	76.8	0.9	-23.1	-2.0

 

Source: European Commission (AMECO) and authors’ calculations. Note: Implicit interest rate (interest paid as% of gross debt) spread is the difference between the average implicit interest rate of the country and the German average over the same time period.

Concluding remarks

Two patterns emerge from this brief review.

• Fiscal adjustments of the size now required by Greece (and probably soon Portugal and Spain) have been possible in the past.
• Adjustments of this size require time, typically at least 5 years; and the debt to GDP ratio keeps on increasing during the adjustment process.

For Greece the historical precedent suggest that a fiscal adjustment of 10 percentage points of GDP ought to be possible. But it might be based only on tax increases without reductions in expenditure and it is likely to leave the debt to GDP ratio at such a high level (150% of GDP) that the country would likely be excluded from financial markets for a long time.

References

Alcidi C. and D. Gros, (2010), ‘Is Greece different? Adjustment difficulties in southern Europe’, VoxEU.org, 22 April
Boone L., P. Ghezzi and C. Keller (2010), ‘Greece adjustment challenge. External support increasingly likely’ Barclays Capital Economic Research, February 2010
Burda, Michael (2010), “Greece: It’s not all tragedy”, VoxEU.org, 13 March