Macroeconomic Conditions of Budget Consolidation in Europe

New indebtedness of the public sector in the countries of the EU has surged since the economic crisis in the mid-seventies. While budgets were balanced before the recession of 1973, huge deficits totaling almost 5 percent on average developed at the beginning of the nineties. Gross indebtedness of the public sector rose from an average of 41 percent in 1980 to 72 percent in 1994. Given the present perspectives, it is likely that the third phase of the European Monetary Union can only be reached if the fiscal convergence criteria are loosely interpreted. Nonetheless, in some countries there were phases of successful budget consolidation. Discretionary expenditure cuts or tax increases are the main focal points in public discussion. An analysis of successful consolidation drives shows the importance of macroeconomic factors in fiscal restraint. Several macroeconomic constellations facilitate budget consolidation: 1. An improvement in international competitiveness and the generation of a surplus in the current account. One instrument for lowering domestic production costs vis-à-vis other countries in the short term is a devaluation; such a policy measure facilitated the consolidation efforts in Sweden (1982-1986) and in Italy (1992-1995). But this combination of fiscal restraint and improvement in the current account raises serious problems: an improvement is achieved at the cost of other countries whose current account will necessarily worsen ("beggar-my-neighbor"); such a policy can only be successful if incomes policies succeed in keeping inflation down and in maintaining the real devaluation effect; and finally this policy measure raises foreign indebtedness and interest payments. Ireland's success in reducing its budget and current account deficit between 1986 and 1993 was mainly due to the substantial transfer payments from the EU (amounting to 5½ percent of GDP in 1995). During the years from 1987 to 1992, when the European Monetary System had the effect of stabilizing nominal exchange rates, the hard-currency countries, such as Germany and the Netherlands, managed to improve their competitive and fiscal position by holding down price and cost increases. 2. The expansion of domestic demand by raising the propensity to incur debt on the part of private households. In times of underutilization of productive capacity, this policy eases the strain on the public sector by raising income and employment. Deregulating credit markets and making interest payments of private households deductible from income taxes are the main venues for a "budget consolidation with falling saving rates", typical of the Scandinavian countries and the U.K. during the second half of the 1980s. This type of fiscal consolidation usually results in inflation and current account deficits and finally in a serious recession and budget crisis. 3. "Budget consolidation in tandem with a (credit financed) expansion of business investment" is a constellation which characterizes most European economies in the second half of the eighties. These policies have the strongest long-term effects on growth and the fiscal position but is an economic policy option that is hardly feasible in the short run. It is rather the result of a favorable relation between the yields of capital outlays and the yields of alternative financial assets, of long-term stable social and economic developments, and of steady macroeconomic growth. Discretionary policy measures such as expenditure cuts and tax hikes continue to play an important role in phases of fiscal restraint; the application of these instruments is greatly facilitated by favorable macroeconomic circumstances. Discretionary tax increases (with the tax burden rising from 40 percent to 44 percent of GDP) were the main instrument for consolidating the budget in Germany during the period from 1990 to 1995, even though this period was characterized by adverse economic developments.