Economic growth as the ultimate constraint: EU fiscal policies in 2020

Martin Larch, Janis Malzubris, Stefano Santacroce 19 May 2021

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Faced with a vertical fall of virtually all indicators of economic activity, in early 2020 the European Commission and the EU member states swiftly agreed to avail themselves of the extra flexibility allowed by the EU fiscal rules in the event of a severe economic downturn (Aussilloux et al. 2021). The combined effort of national governments and EU institutions was instrumental in mitigating the socioeconomic impact of the pandemic. As a result, deficit and debt-to-GDP ratios recorded the largest ever increase in a single year in post-WWII history.

In this column, we take a closer look at budgetary developments in the EU in 2020, highlighting a number of important cross-country differences normally hidden behind the conventional gauges of discretionary fiscal policy. Our analysis builds on the first annual update of the compliance tracker,1 a database the secretariat of the European Fiscal Board launched in the first half of 2020. Using estimates of medium-term rates of potential output growth, we show how the extra room for manoeuvre under the severe economic downturn clause of the Stability and Growth Pact (SGP) played out quite differently across member states due to longstanding pre-crisis legacies, notably a diverging medium-term growth performance.  

Figure 1 probably offers the most salient visualisation of the ultimate constraint on fiscal policy. It depicts real GDP of two emblematic members of the single currency area: Germany and Italy. Leaving aside short-term fluctuations, the level of economic activity has consistently followed an upward trend in Germany, as it did in most other euro area countries. In Italy, in contrast, real GDP has essentially levelled off at the end of the 1990s, weighing on the government’s aggregate revenue base and making it difficult for the country to respect fiscal rules while financing existing expenditure programmes, let alone crises-related support. Incidentally, Italy is the only EU country where, based on latest Commission projections, annual real GDP is not expected to return to the pre-pandemic level in 2022.

Figure 1 Real GDP in Germany and Italy, 1960-2020

Source: European Commission

Expenditure benchmarks: A more intuitive and informative yardstick 

The practice of fiscal policy making relies on more or less ingenious indicators to answer three questions: What part of an observed change in the government budget is the result of deliberate policy choices? Does the budget stimulate or dampen aggregate demand? And is the current course of fiscal policy sustainable in the long run?

For many years, the indicator of choice in EU fiscal surveillance and beyond was – and to some extent still is – the structural budget balance, i.e. the government budget balance net of cyclical factors and one-offs and other temporary measures. However, over the years, its use has given rise to growing frustration among practitioners, in part due to objective limitations and in part for political economy reasons (Larch and Turrini 2010, Mourre et al. 2013).

In search for alternatives, expenditure benchmarks have received growing attention both at the EU and the national level (Manescu and Bova 2021).2 The basic idea underpinning expenditure benchmarks is very intuitive: when government expenditures net of discretionary revenue measures outpace potential output – a good proxy of the aggregate tax base over the cycle – fiscal policy is stimulating aggregate demand and generally not sustainable if maintained over the long term.

Experts are perfectly aware that expenditure benchmarks and changes of the structural budget balance can be conceptually equivalent (European Commission 2011, Marinheiro 2020). However, the same experts will admit that benchmarking expenditure growth on the medium-term growth performance of a country is much easier to understand and communicate. Anecdotal evidence has it that even finance ministers occasionally struggle with the rather abstract notion of the structural budget balance, while everyone understands the import of government expenditures growing faster or slower than the underlying revenue base. 

In fact, and this is the point we want to hammer home in this column, expenditure benchmarks bring to light the two fundamental dimensions of public finances, that is, the budgetary aggregates directly controlled by lawmakers on the one hand and economic growth on the other. As we will show below, looking at these two dimensions in parallel, rather than hidden behind estimates of the structural budget balance, offers additional insights into what happened in 2020 and where the problems lie for the future.

EU public finances in 2020

The impact of the Covid crisis on government finances has been conspicuous. In 2020, the headline deficit of the euro area and the EU increased sharply to around 7% of GDP, up from ½% of GDP the year before, on the back of a broad range of fiscal initiatives aimed firstly to address the medical emergency and, secondly, to mitigate the economic impact of lockdown measures. Figure 2 shows government revenues and expenditures of the EU as whole as a percentage of GDP. What may seem striking at first is the remarkable stability of the revenue ratio; the increase in the headline deficit in 2020 was almost entirely due to higher government expenditures. These numbers illustrate two important features of fiscal policy in the EU: (1) the elasticity of total government revenues to GDP is roughly 1, i.e. progressive and regressive features of individual revenue sources broadly wash out in the aggregate; and (2) the bulk of automatic stabilisation originates in the inertia of discretionary government expenditures.

Figure 2 Budgetary aggregates of the EU

With an average size of government of more than 45% of GDP in the EU (37% in the US), for every 1% decline of GDP the deficit increases mechanically by close to 0.5% of GDP before any discretionary measures are taken. That is also why the bulk of the overall deficit increase recorded in 2020 is estimated as cyclical or automatic; the rest – some 2¼ % of GDP – is classified as structural. As usual, the exact split between cyclical and structural will be reassessed as more information becomes available. For the moment, the prevailing expectation seems to be the loss of economic activity in 2020 was largely cyclical. At the same time, an increasing number of observers sees the risk of scarring and, hence, of more lasting effects on the underlying fiscal position. 

The race between government expenditure and economic growth

Figure 3 looks at the same developments but through the lens of an expenditure benchmark. It shows how, in 2020, total government expenditures in the EU surged by more than 9% on the previous year vis-à-vis a medium-term rate of nominal potential output growth of less than 3% per year.3 The sharp expansion of government expenditure was totally warranted in light of the severe impact of the crisis. At the same time, expectations are expenditures will decline once the pandemic is under control and the economy rebounds, not least thanks to the operation of automatic stabilisers and the withdrawal of emergency measures. 

Figure 3 Government expenditure vs medium-term growth performance, 2020

Notes: (1) The medium-term rate of potential GDP growth is in nominal terms. It is calculated as the 10-year average of real  potential output growth plus the GDP deflator. (2) Fiscal space reflects the difference between the estimated structural budget balance and the medium-term objective (MTO).  The MTO is country specific; it is the level of the stuctural budget balance that ensures the sustainability of government debt. The fiscal space for Greece is set to zero due to fiscal commitments taken at the end of the economic programme. (3) Net expenditure growth refers to the growth rate of government expenditure  net of discretionary revenue measures and excludes interest expenditure, expenditure on EU programmes fully matched by EU funds revenue, and the cyclical part of unemployment benefit. Investment expenditures are averaged over four years. (4) The classification of short-term, medium-term and long-term sustainability risks is based on the latest Debt Sustainability Monitor (February 2021) of the European Commission. (5) Low debt countries = EE, LU, BG, CZ, SE, DK, RO, LT, LV, MT, PL; High debt countries = NL, IE, SK, FI, DE, HU, SI, AT, HR; Very high debt countries = CY, FR, BE, ES, PT, IT, EL.
Source: European Commission, our own calculations

Of note, the acceleration of government expenditures was far from uniform across EU member states. It should come as no surprise to see how countries entering the pandemic with very high government debt-to-GDP ratios4 recorded a significantly lower increase in expenditures in spite of (1) a more acute health crisis, and (2) a larger drop in economic activity. 

This outcome has to be seen against the backdrop of the medium-term growth performance of the countries concerned. Their aggregate level of economic activity in current prices, which ultimately constitutes the bulk of a government’s revenue base, is estimated to expand at less than 2% per year over the medium term. Countries with lower government debt ratios are growing at around twice that rate, which also allowed most of them to better target healthcare and labour market pressures (see the difference between the light blue triangles and the red circle in Figure 3) 

We are obviously looking at a manifestation of how fiscal space affects the room for manoeuvre in the event of shocks, even though in 2020 the ECB reacted much more swiftly to quell first signs of tension in sovereign bond markets. The diagnosis is confirmed when EU countries are grouped by their sustainability risks as assessed by the European Commission (2021). Figure 3 (right-hand panel) clearly shows that across all three time horizons – short-, medium- and long-term – high-risk countries are characterised by both lower medium-term potential economic growth and a lower increase in government expenditures. 

Not taking advantage of good economic times is often viewed as the main cause for the lack of fiscal space when a crisis hits. And in some sense this is also very true. In the four years of economic recovery preceding the Covid crisis, high-debt and high-risk countries on average sustained growth rates of government expenditures that significantly exceeded their meagre medium-term growth potential, hardly a sustainable policy (Figure 4).5 By contrast, countries with lower debt-to-GDP ratios followed a more prudent expenditure path or even curbed expenditure growth well below their medium-term rate of economic growth with a view to preparing for future shocks. And indeed, as indicated in Figure 3, they were able to draw on sizeable fiscal space in 2020.6 

Figure 4 Government expenditure vs medium-term economic growth, 2016-2019

Notes: (1) The medium-term rate of potential GDP growth, fiscal space and net expenditure growth, as defined in Figure 3. (2) Country groups are the same as in Figure 3.
Source: European Commission, our own calculations

However, our analysis also highlights an important subtlety. As mentioned above, in absolute terms expenditure growth was consistently lower in high-debt and high-risk countries, both before and during the Covid pandemic, an observation, which seems to clash with the indications of the structural budget balance. Compared to countries with lower debt and risks, the change of that indicator points to a much larger fiscal expansion. What reconciles the two readings is the plain fact that budgetary policies always need to be assessed against the more general economic outlook of a country. 

Conclusions

At this point, some may be tempted to launch a longish ‘chicken versus egg’ type of debate on how to close the gap between expenditure growth and the medium-term growth rate of the economy: with fiscal consolidation or debt-financed, growth-enhancing policies? In their extremes, both propositions are likely to be neither politically viable nor economically attainable. Both ends – poor fiscal policies and insufficient growth – will have to move. The implementation of the EU’s Recovery and Resilience Fund (RRF) offers a unique chance to overcome the notorious difficulties that hold back badly needed structural reforms; and we all expect the RRF to succeed in strengthening the growth outlook of economic laggards in the EU. If it did not, any future reform or review of the EU fiscal rules intent on making the pace of fiscal consolidation politically more feasible in the face of much higher government debt ratios will buy time, but not solve the underlying problem of sustainability. Quite a few member states will remain vulnerable to future shocks.

Authors’ note: The views expressed in this column are those of the authors and do not necessarily reflect the positions of the European Fiscal Board or the European Commission. 

References

Aussilloux, V, A Baïz, M Garrigue, P Martin and D Mavridis (2021), “Fiscal plans in Europe: No divergence but no coordination”, VoxEU.org, 19 February.

European Commission (2011), “Public finances in EMU 2011”, European Economy, 3/2011.

European Commission (2021), “Debt Sustainability Monitor 2020”, European Economy, Institutional Paper 143.

Larch, M and A Turrini (2010), “The cyclically adjusted budget balance in EU fiscal policymaking”, Intereconomics 45: 48–60.

Larch, M and S Santacroce (2020), “Numerical compliance with EU fiscal rules:  The compliance database of the Secretariat of the European Fiscal Board”.

Manescu, C B and E Bova (2021), “Effectiveness of national expenditure rules: Evidence from EU member states”, VoxEU.org, 7 February

Marinheiro, C (2020), “The expenditure benchmark: complex and unsuitable for independent fiscal councils”, Portuguese Public Finance Council Occasional Paper No. 02/2020.

Mourre, G, G-M Isbasoiu, D Paternoster and M Salto (2013), “The cyclically-adjusted budget balance used in the EU fiscal framework: an update”, European Economy Economic Paper 478.

Endnotes

https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policy-coordination/european-fiscal-board-efb/compliance-tracker_en

2 The EU fiscal surveillance framework includes an expenditure benchmark. It was added in 2011 alongside the headline deficit, the debt-to-GDP ratio and the structural budget balance. The performance of EU member states vis-a-vis these metrics is recorded in the compliance tracker of the European Fiscal Board, which we recently updated to include public finance data of 2020.

3 The European Commission estimates the medium-term rate of potential growth as a 10-year moving average of potential output growth. The average of year t encompasses the previous 5 years, the current year and forecasts up to t+4. 

4 This group encompasses countries with a debt-to-GDP ratio of more than 90% in 2019. It includes Italy, Spain, Portugal, Belgium, France, Greece and Cyprus. 

5 We use the period 2017-2019 as an example. The same pattern holds over longer periods of time.

6 We define fiscal space as the difference between the structural budget balance and the medium-term objective (MTO) of a country. The MTO is a key reference value in the EU fiscal surveillance framework. It is the level of the structural budget balance, which for a given set of macroeconomic assumptions ensures the sustainability of public finances.

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Topics:  Covid-19 EU policies

Tags:  COVID-19, fiscal policy, economic growth, Europe

Head of Secretariat, European Fiscal Board

Economic Analyst, Secretariat of the European Fiscal Board

Economist, Secretariat of the European Fiscal Board

CEPR Policy Research