Public expenditure policies during the EMU period by Jesús Sánchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht

A. JESÚS SÁNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** /
/LUDGER SCHUKNECHT *** /

Public expenditure policies during the
EMU period: Lessons for the future?1

1. Introduction; 2. Long-term public expenditure in industrialised coun-
tries; 3. The first decade of EMU period: a missed opportunity?; 3.1. A
disaggregated assessment of past expenditure policies; 3.2. Determinants
of the expenditure stance; 3.3. Implications for public debt; 4. Looking
backward to the past, lessons for the future? an episodes based approach;
5. The need for prudent expenditure rules; 6. Concluding remarks;
Bibliography

*He currently works as Ph. D Assistant professor at Complutense University of Madrid.
Before he worked as external consultant at European Central Bank, as (Ph. D) Assistant
professor at Pablo de Olavide University (Seville, Spain) and as research assistant at
Foundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University
(with distinctions) and a Bachelor in Mathematics from University of Seville. His rese-
arch areas are mainly public economics and computational economics.
** He currently works as an Economist at the German Ministry of Finance. He was also
an Economist in the Fiscal Policies Division of the European Central Bank and worked
as a research assistant at the Centre for European Economic Research (ZEW). He holds
a Ph.D. in Economics from Munich University (LMU). His research focuses on empiri-
cal public finance and fiscal policy.
***Is heading the Directorate General Fiscal Policy and International Financial and
Monetary Policy at the German Ministry of Finance. Previously, he worked at the
European Central Bank, the World Trade Organisation and the International Monetary
Fund. His recent research mainly focuses on public expenditure policies and reform and
the analysis of economic boom-bust episodes.

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Public expenditure policies during the EMU period: Lessons for the future?

1. Introduction

The outlook for public finances in the advanced economies for
the second decade of the 21st century is extremely challenging, not
least due to the substantial fiscal expansion that took place in the
context of the financial and economic crisis. Public deficits in 2010
averaged around 6% of GDP in the euro area and exceeded 10% of
GDP in the US and the UK (Chart 1, panels a, and b). At the same
time, public debt in advanced economies has increased signifi-
cantly between 2007 and 2010: by some 20pp of GDP to around
86% in the euro area and so far by 30pp or more in the UK (to 80%)
and in the US (to over 90% of GDP). When including Japan, public
debt in the G7 countries already averaged over 100% of GDP in
2010.

A closer look suggests that most of the deficit increase since the
start of the crisis in 2007 was due to an increase in public expendi-
ture ratios which have reached or approached historical highs. By
contrast, revenue ratio declines have been rather limited (panels c
and d). It is, therefore, logical to look at public expenditure when
striving to correct fiscal imbalances in industrialised countries. This
approach is in fact pursued already by a number of countries with
fiscal difficulties. It was also the approach used—successfully—by

1 The views expressed are the authors’ and do not necessarily reflect those of the authors’
employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense de
Madrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34
913942431. Email: antoniojesus.sanchez@ccee.ucm.es.

290

The Future of the Euro

Chart 1. Developments in public finances, 1990-2011
a) Fiscal balance

b) Public debt

Source: Ameco.

291


Chart 1. (cont.) Developments in public finances, 1990-2011
c) Total public expenditure

d) Total revenue

Source: Ameco.

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many advanced economies in the 1980s to return to sound public
finances and at the same time reinvigorate the economy.

The case of the euro area is of special relevance for a number of
reasons. While the crisis-related deterioration of public finances in
the euro area as a whole has not been as pronounced as for example
in the US or Japan (see Chart 1), heterogeneity at the Member State
level is substantial. A number of countries, in particular Greece,
Ireland and Portugal, recorded double-digit deficit ratios and expe-
rienced significant increases in government debt as a ratio to GDP.
Unsustainable fiscal positions coupled with structural economic
weaknesses and competitiveness deficiencies, in turn, fuelled market
tensions which - due to strong financial interlinkages – undermine
financial stability in the monetary union as a whole. Therefore, at
the time of writing, there is a particular urgency for euro area coun-
tries to regain market confidence through a swift return to sound
public finances. At the same time, euro area membership tends to
exacerbate adjustment efforts since the exchange rate mechanism is
not available, preventing an external devaluation. Therefore, fiscal
consolidation and the restoration of external competitiveness need
to strongly rely on internal adjustment processes.

Against the background, this study assesses expected public
expenditure developments of selected euro area countries for the
coming years. Based on the experience with expenditure reform in
the 1980s and 1990s, we argue that ambitious and high quality
expenditure reform as part of comprehensive economic reform pro-

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grammes have the best chance of success. Furthermore, the role of
a prudent expenditure rule and the relevance of having a suitable
institutional framework are discussed.

Section 2 reviews public expenditure trends over the past 30
years. Section 3 reports on the main findings of earlier studies on
public expenditure policies during the first decade of EMU. Section
4 looks backward to the past to extract important conclusions on
the successful strategy exit of current crisis. Section 5 provides an
illustration on the preventive role of prudent expenditure rules
before section 6 concludes and draws some policy lessons.

2. Long-term public expenditure in industrialised countries

With a view to assessing recent developments in a broader his-
toric perspective, it is worth briefly taking stock of trends in public
expenditure and the size of the state over the past 30 years (Table
1).2 After a strong increase in the size of government in industria-
lised countries in the 1960s and 1970s, the average total public
expenditure ratio across OECD, G7 or euro area was broadly
unchanged in 2007 -just before the financial crisis- from 2000, 1990
and 1980. The average spending ratio for the euro area remained
around 45% of GDP and that of OECD and G7 around 40%.

2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-
lopments.

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Table1. Total expenditure developments

Maximum Change
value
1980 maxi-
% of GDP 1990 2000 2007 2010
or nearest mum
Year Ratio to 2010

Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9
Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2
Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6
France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1
Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7
Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6
Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3
Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0
Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2
Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9
Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0
Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4
Euro area (15) 4 5 ,4 4 7 ,9 4 6 ,2 4 6 ,0 51,0 1 9 9 5 5 3 ,1 - 2 ,1
Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0
Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2
Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7
Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4
Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8
Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2
United
47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9
Kingdom
United States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2
G7 3 8 ,3 3 9 ,8 3 8 ,5 3 9 ,9 45,0 2 0 0 9 4 5 ,5 - 0 ,5
OECD 3 9 ,1 4 0 ,2 3 8 ,8 3 9 ,8 44,6 2 0 0 9 4 5 ,2 - 0 ,6

Source: Ameco, OECD.

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However, this masks significant differences across countries.
The countries that undertook ambitious reforms in the 1980s and
1990s typically had much lower spending ratios in 2007 than in
1980 or at least than at their peak. A few countries, however, inclu-
ding many of those that we will refer to in the next sections (US,
Italy, Spain, Portugal, Greece, Ireland, UK) had significantly incre-
ased the size of government between 1980 and 2007 or least in the
2000-2007 period.3 This occurred notwithstanding an extended
economic boom in most of these when expenditure ratios should
have gone down.

With the start of the financial crisis, public expenditure ratios
went up everywhere by on average 5pp of GDP. This brought the
total expenditure ratio to about 50% in the euro area and 45% in
the OECD/G7 in 2010. For the euro area, the increase still consti-
tutes a decline in overall spending since the previous peak in 1995
but this was due to a lower interest bill. On the whole and for
many countries, public expenditure ratios are now at or near his-
torical peaks. This includes the European crisis countries, Portugal
and Greece and the UK and US.

These developments show that the challenge of containing the
size of the state is more present than ever. And together with deficit
and debt figures, the close link between rising public spending, defi-

3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euro
area countries since the start of EMU.

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cit and debt figures is also obvious. But a number of countries mas-
tered the challenge of very large expenditure ratios with ambitious
reform programmes in the 1980s and 1990s. This experience will be
re-called in the next sections. These countries were typically not the
same that face such challenges now—except Ireland and the UK.

3. The first decade of EMU period: a missed opportunity?

In this section, we examine expenditure developments and plans
of a number of euro area economies, notably Greece, Ireland and
Portugal (programme countries), Germany, France, Italy and Spain
(large euro area countries) in comparison to the UK and US. The
common feature of most of these countries (except Germany and
Italy) for the period up to 2007 was a drawn out economic boom
characterised by significantly positive output gaps. In principle, this
should have allowed bringing down public expenditure ratios signi-
ficantly, firstly, due to the impact of automatic stabilisers and,
secondly, in some cases also due to lower interest spending thanks
to the euro.

However, this is not what happened. All countries pursued an
expansionary expenditure stance, of the order of 1-5pp of GDP
except for Germany (Hauptmeier et al, 2011).4 This basically “ate

4 One of analysing the expenditure stance of a country is to compare it with the expen-
diture levels that should have occurred if a country had followed certain fiscal rules.

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up” the interest savings from introducing the euro. As a conse-
quence, total public expenditure only went down significantly in
Germany and even increased strongly in the three crisis countries
and the UK between 1999 and 2007 (Table 2). In the US, total spen-
ding grew by around 2pp of GDP between 2001 and 2006 but the
ratio remained well below 40% of GDP. Together with the US,
Ireland and Spain maintained the lowest spending ratios (below
40% of GDP), France’s public expenditure was the highest, at 52.4%
in 2007. The increase in public expenditure becomes even more
pronounced when looking at primary spending. For the crisis coun-
tries and the UK this went up by 3 to almost 6% of GDP between
1999 and 2007. As a result, most of the sample countries still had
significant deficits in 2007 while the debt ratio had hardly declined
or even increased between 1999 and 2007 (Schuknecht, 2009).

Expansionary expenditure policies during good times left most
of the countries “unprepared” when the crisis hit. As a consequen-
ce of the output fall and further expansionary programmes, public
expenditure ratios increased strongly between 2007 and 2009/2010.
Increases ranged from around 4pp of GDP in Italy and Germany, to
6-7½ pp in the UK and US to over 10pp in Ireland. The expenditu-
re increase was particularly strong in the countries where a credit-
fed real estate and financial sector boom had “artificially” inflated

Such an exercise was conducted by us last year (Hauptmeier et al, 2011). The study
found that most euro area countries had pursued expenditure policies that were more
expansionary than a reasonable expenditure rule would have proposed.

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Table 2: Recent total expenditure developments

% of G DP 1999 2007 2009 2010 Change Memoradum: deficit

1999-2007 2007-2010 2007 2010
Programme countries
Greece 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8
Ireland 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3

Portugal 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8

Large euro area countries
Germany 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1
France 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1
Italy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5
Spain 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3

Large non-euro area countries
United States 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6
United Kingdom 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3

Table 2: Recent expenditure developments for selected countries

% of GDP 1999 2007 2009 2010 Change
1999-2007 2007-2010
Programme countries
Greece 37,3 42,8 48,7 44,4 5,5 1,6
Ireland 31,5 35,6 46,9 43,7 4,1 8,1
Portugal 38,1 41,4 47,0 48,3 3,3 7,0

Germany 45,1 40,7 45,4 45,4 -4,4 4,7
France 49,6 49,9 54,3 54,2 0,3 4,3
Italy 41,5 42,7 47,1 45,9 1,2 3,2
Spain 36,4 37,6 44,5 43,7 1,2 6,1
Large non-euro area
countries
United States 30,4 34,0 40,2 39,8 3,5 5,9

United Kingdom 36,0 41,7 49,6 47,7 5,6 6,0

Source: Ameco

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Table 2: Recent cyclically adjusted primary expenditure developments

% of GDP 1999 2007 2009 2010 Change

1999-2007 2007-2010

Programme countries

Greece 37,3 42,9 48,6 44,4 5,5 1,5
Ireland 31,7 35,8 46,6 43,5 4,0 7,7
Portugal 38,2 41,4 46,9 48,3 3,2 6,9


Germany 45,1 40,9 45,0 45,2 -4,1 4,3
France 49,7 50,1 54,1 54,0 0,4 4,0
Italy 41,5 42,7 47,0 45,8 1,2 3,1
Spain 36,5 37,7 44,3 43,4 1,2 5,7


United States 0,0 0,0 0,0 0,0 0,0 0,0
United Kingdom 36,1 41,7 49,5 47,6 5,7 5,9

Source: Ameco

GDP. When this reversed over the crisis, both higher spending and
lower GDP drove up the expenditure ratio. Virtually all of the
expenditure ratio increase was on public consumption and transfers
and subsidies; public investment went up only slightly in a few
countries. Greece, Ireland and Spain also reported higher interest
expenditure as the rapidly rising debt ratio and higher interest rates
started to affect public budgets.

Where did countries stand in the third year of the crisis, 2010?
None of our sample countries still featured a relatively small public

300


sector of below 40% of GDP (as defined by Tanzi and Schuknecht,
2000). Even the US, at 41.3% of GDP, featured a public sector that
was not much smaller than the euro area average before the crisis.
Greece, Portugal, France, Italy and the UK reported public spending
ratios of around to significantly above 50%.

It has been argued that the increase in expenditure ratios is not
very relevant as it presumably reflects almost solely the crisis and
should, thus, reverse itself over time as the economy normalises.
This reasoning implicitly assumes that output levels and growth
rates will more or less return to pre-crisis levels. As a large output gap
would be closed, public commitments should decline relative to
GDP. However, if the pre-crisis GDP was artificially inflated by boo-
ming sectors which have to shrink then both GDP level and growth
rates may be significantly lower post-crises. If the 2010 output gap
was only small, 2010 deficits and expenditure ratios would in fact
represent structural features of the examined economies. In any
case, significant fiscal adjustment is needed which in some cases
exceeds 10 pp of GDP in the coming years (IMF, 2011).

3.1. A disaggregated assessment of past expenditure policies

To assess in more detail what drove expenditure developments
since the start of EMU, this section provides an analysis the public
expenditure stance across the three main expenditure components
that governments can influence in the short term: government
consumption, transfers and subsidies and public investment. We

301


apply the same methodology as in Hauptmeier et al (2011): given
the existing levels at the start of the EMU (1999), actual public
expenditure developments are assessed against an expenditure
path that should have been taken if countries had followed a neu-
tral expenditure stance, i.e. if governments had aligned expenditu-
re growth to that of potential GDP. The latter is measured on the
basis of two expenditure rules: (a) nominal potential GDP growth
(NPG rule) and (b) real potential GDP growth plus the growth rate
of the GDP deflator capped at the ECB’s price stability objective of
below but close to 2% (RPECB) based either on real time or ex post
data. This counter factual analysis provides four measures of the
expenditure stance.5 Deviations are analysed by looking at margi-
nal (annual) and/or cumulative (total period) deviations (expressed
as percentage of GDP). According to this procedure, on the one
hand, marginal deviations help to identify the year(s) in which
expansionary/restrictive policies were implemented. On the other
hand, cumulative deviations measure the degree of expansio-
nary/restrictive policies in percentage points (pp) of GDP accumu-
lated over the period (1999-2010).

Firstly, to provide a general perspective, we focus on cumulati-
ve effects for the aggregate euro area (Chart 2), comparing actual
and rule-based expenditure developments (expressed as percentage
of GDP).

5 The earlier study applied six measures but the two additional ones did not provide
much additional insights.

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Chart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditure
stance, across rules.
Primary expenditures

Public consumption

303


Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen-
diture stance, across rules.

Public investment

304


Looking at the primary expenditures stance - panel a - suggests
a co-movement with the NPG rules which indicates the absence of
a prudence margin to operate when difficulties appear. Looking at
the disaggregated developments, i.e. the main expenditure compo-
nents, gives a different picture: First, the results for public con-
sumption show an expansionary expenditure stance on this cate-
gory adding up to 0.5-2pp of GDP, depending on the respective
expenditure rule. Second, for the transfers and subsidies compo-
nent, a strong counter-cyclical behaviour is observed, as one would
expect. However, the decreases in economic good times were much
less significant than the increases during the crisis. Finally, the pat-
tern for public investment is clearly pro-cyclical. At the same time,
the adjustments carried out by some countries during 2010 can be
already observed (returning to 2004 levels).

To complement this general view, we briefly describe the
country pattern for the main expenditure components.6 As in
Hauptmeier et al. (2011), for primary expenditures, we observe a
restrictive expenditure stance for Germany whereas all other coun-
tries show an expansionary policy stance over the 1999-2010
periods, notably as regards public consumption as well as transfers
and subsidies. However, the degree of expansion is different among
components. On the one hand, in the case of public consumption,
the magnitude of cumulative expansion ranged from near zero for

6 For the sake of brevity, related country-specific results are not included in the main
text. They are available from the authors upon request.

305


France to up to 5pp of GDP for Ireland. On the other hand, for
transfers and subsidies, Germany is highly restrictive by 2-3 pp,
and the rest is expansionary by 1-7pp depending on the rule and
country.

Finally, for public investment, the development of the cumula-
tive expenditure stance is quite interesting: restrictive for Germany
and Portugal, neutral for Italy and expansionary for all other coun-
tries with a tendency of neutralisation in 2010. However, overall
magnitudes are small.

In a second step, we repeat this same exercise component by
component, in order to decompose the cumulative deviation
observed. This analysis provides a view of the respective stance of
each expenditure component. The list of indicators included is in
line with those presented so far; i.e. (i) public consumption, (ii)
transfers and subsidies, (iii) public investment, and (iv) other
expenditures. Moreover, we split our sample period into sub-
periods to show the role of (i)-(iv) before (1999-2007) and during
the crisis (2008 – 2009, 2009-2010).

First, looking at the expenditures stance, Chart 3 presents the
decomposition of cumulative effects observed for ex-post and real-
time rules. When compared real-time and ex-post rules behaviour
both similarities and differences are found. While on the one hand
the dynamics are very similar, quantitative differences emerge
especially during sub-period (II), i.e. 2007-2009.

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Chart 3: Decomposition of cumulative changes to public primary spending ratios
compared to a neutral expenditure stance for selected periods

(I) Real-time NPG rule. 1999-2007
%GDP

(II) Ex-post NPG rule. 1999-2007
%GDP

307


Chart 3. (cont.) Decomposition of cumulative changes to public primary spending
ratios compared to a neutral expenditure stance for selected periods
%GDP

%GDP

308


Chart 3. (cont.) Decomposition of cumulative changes to public primary spending
ratios compared to a neutral expenditure stance for selected periods
%GDP

%GDP

309


An alternative way to look at these figures is going through the
different sub-periods. First, deviations in the pre-crisis period are
clearly dominated by public consumption. Moreover, if we leave
out Germany as the only restrictive country over this period, two
different country patterns can be observed: major deviations from
trend as regards public consumption in Italy, Spain and Ireland
while Greece and Portugal show strongly expansionary trends in
transfers and subsidies. Second, deviations from trend in transfers
become relatively more important with the start of the financial
and economic crisis.

3.2. Determinants of the expenditure stance

An empirical analysis of factors that influence countries’ expen-
diture stances can provide further information on the determinants
of expansionary expenditure policies in the past. Hauptmeier et al.
(2011) therefore applied standard fixed-effects panel estimation
techniques on a sample of 12 euro area countries for the 2000-2009
period using the measure for the expenditure stance described
above, i.e. the (marginal) deviations of actual spending growth from
rule-based or neutral spending (under the NPG and the RPECB rule
in ex-post terms), as the dependent variable.

The aim of this empirical exercise was to explain the govern-
ments’ expenditure stance on the basis of fiscal and macroecono-
mic factors, relevant institutional characteristics as well as political

310


economy variables. The results of the analysis are presented in
Table 3.

As one would expect, the macroeconomic environment measu-
red by the output gap (in % of potential GDP) constitutes an
important determinant of the expenditure stance. We find robust
support for a positive correlation between the output gap and the
expenditure stance across rules and estimations, suggesting a pro-
cyclical spending behaviour.

As regards fiscal factors, surprisingly the level of public indeb-
tedness does not seem to significantly affect our measure of the
expenditure stance. We also do not find robust evidence for an
effect of revenue windfalls that arguably could increase spending
profligacy. We capture such windfalls by including the excess reve-
nue growth in a given year relative to previous year’s Autumn fore-
cast by the European Commission. However, while we see the
expected positive sign the effect is not significant.

We find empirical support for the importance of political eco-
nomy factors. In particular, parliamentary elections at the national
level (Electoral cycle 1) tend to significantly increase the deviation
of actual from rule-based primary spending. The opposite holds true
for a second election-related variable (Electoral cycle 2) which cap-
tures the years left in the current election term. The negative sign on
this variable suggests that the incentives for fiscal discipline can be
expected to be higher at the beginning of the legislative period. We

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Table 3: Determinants of expenditure stance
Dependent variable: Deviation of primary spending growth from rule-based growth rate
Panel A: Ex-post Nominal Potential GDP (NPG) rule

(I) (II) (III) (IV) (V ) (VI) (VII)
Output gap (based on Potential GDP) 0,525 0,476 0,401 0,463 0,274 0,374 0,476
[3.78]*** [3.01]** [2.50]** [3.04]** [1.65] [2.22]* [3.00]**
Public debt ratio (t-1) 0,054 0,056 0,035 0,071 0,042 0,033 0,057
[0.96] [1.04] [0.62] [1.20] [0.83] [0.67] [1.03]
Crisis dummy 3,946 3,649 4,028 3,138 2,241 2,34 3,341
[2.17]* [1.74] [1.64] [1.75] [1.08] [1.13] [1.22]
Strenght of expenditure framework *
Output Gap -0,262 -0,262
[2.09]* [2.08]*
Surprises in Revenues growth 0,09
[0.46]
Surprises in revenues growth -0,08
[0.86]
Electoral cycle 1 2,204
[3.64]***
Electoral cycle 2 -0,812
[3.66]***
Government Stability -2,699
[3.26]***
EDP 0,308
[0.16]
Constant -2,941 -2,998 -1,47 -4,148 -0,006 -0,512 -3,079
[0.72] [0.77] [0.39] [0.97] [0.00] [0.13] [0.78]

Observations 108 108 108 108 90 90 108
Number of countries 12 12 12 12 10 10 12
R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11
corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77
adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0

R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02
R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11
R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53
standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53
panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17
fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19

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Table 3. (cont)
Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule

(I) (II) (III) (IV) (V) (VI) (VII)

Output gap (based on Potential GDP) 0,469 0,429 0,299 0,419 0,277 0,377 0,429
[3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]* [2.58]** [2.72]**
Public debt ratio (t-1) 0,057 0,059 0,031 0,071 0,053 0,044 0,058
[1.19] [1.33] [0.64] [1.40] [1.18] [0.98] [1.33]
Crisis dummy 2,882 2,634 3,267 2,223 1,685 1,793 2,654
[1.56] [1.26] [1.26] [1.22] [0.74] [0.78] [0.90]
Output Gap -0,219 -0,219
[1.75] [1.74]
Surprises in Revenues growth 0,172
[0.91]
Surprises in revenues growth -0,044
[0.59]
Electoral cycle 1 1,798
[3.40]***
Electoral cycle 2 -0,798
[4.17]***
Government Stability -2,544
[3.48]***
EDP -0,02
[0.01]
Constant -2,808 -2,855 -0,747 -3,792 -0,392 -0,879 -2,85
[0.75] [0.82] [0.22] [0.97] [0.10] [0.23] [0.83]

Observations 108 108 108 108 90 90 108
Number of countries 12 12 12 12 10 10 12
R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09
corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82
adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03
R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01
R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09
R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61
standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36
panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16
fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2

Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoral
cycle and government stability , (IV - VI) and Baseline + European Institutions(VII).
Source: Hauptmeier, S., Sánchez-Fuentes, A.J. & Schuknecht, L. (2011)

313


also control for government stability as measured by the respective
index of the World Bank and find that the policy stance on the spen-
ding side is less expansionary if a government scores a higher value.

Most interestingly from a policy perspective, our results suggest
that the country-specific institutional framework exerts a significant
effect on the expenditure stance. In particular, we control for the
extent to which national expenditure policy faces domestic institu-
tional constraints using the expenditure rules index as developed by
Debrun et al. (2008).7 We interact this index with the output gap to
analyse to what extent strong institutions reduce spending profli-
gacy and find that, indeed, the strength of the national institutional
framework on the expenditure side significantly reduces the pro-
cyclicality of the expenditure stance. This finding is along the lines
of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the
same time, the EDP dummy which is included to capture whether a
country is facing an excessive deficit procedure (EDP) due to deficits
above the 3% of GDP reference value of the Stability and Growth
Pact, does not turn up significantly in our regressions.

The results on the impact of fiscal institutions may be put into
the perspective of the recent efforts to strengthen the European fis-
cal framework. One of the lessons from past fiscal developments in

7 For a definition and a detailed description of the computation of this index see
European Commission (2006) and Debrun et al. (2008). The index takes into account
the share of public spending covered by the rule and qualitative features such as the
type of enforcement mechanisms and media visibility.

314


euro area countries is that the implementation of the Stability and
Growth Pact has not been effective in delivering sound and sustai-
nable fiscal positions in Member States. While one has to be care-
ful when interpreting the non-significance of the effect of the EDP
procedure dummy, the result is in line with this perception.
Moreover, the empirical analysis suggests that national budgetary
rules if well-designed can help to effectively reduce spending pro-
fligacy and therefore serve as important tools to promote sound
and sustainable public finances in line with the European fiscal fra-
mework. This reinforces the need for enhancing national fiscal
rules and frameworks as had been proposed by the European
Commission in the autumn of 2010.

3.3. Implications for public debt

Based on the analysis presented in Section 3.1, it is possible to
compute to what extent deviations of expenditure growth from
trend led to increases in government debt. Chart 4 shows alterna-
tive debt paths for the sample economies and across expenditure
rules. Consistent with the previous results, real time rules typically
lead to higher debt paths than ex-post rules. In the case of France,
for example, following a neutral expenditure path since 2000
would have resulted in a significantly lower debt ratio in 2010, i.e.
between 70% and 75% of GDP. If Italy had followed a neutral spen-
ding path, public debt would now stand roughly between 80% and
100% of GDP in 2010, rather than at around 120% of GDP.

315


For a second group of countries (Spain, Greece, Ireland and
Portugal), the difference becomes even more drastic. Neutral spen-
ding policies in Portugal would have led to debt ratios of 40-60% of
GDP in 2010 rather than over 80% of GDP in reality. Spanish debt
would have been at a trough of 10-40% in 2007-08 and would have
remained well below the reference value in 2009 under all rules.
Ireland would have just about eliminated all its debt in good times
and thus created significant room for the subsequent rise. Under all
rules, debt would have remained below 60% of GDP in 2010.
Finally, Greek public debt would have fallen to 60-80% of GDP (rat-
her than remain broadly constant around 100% of GDP until the
start of the crisis) and increased much more slowly in the crisis.

All in all, public debt positions in the euro area would have
been much sounder at the start of the crisis and in 2010, if euro
area countries had pursued at least a neutral expenditure stance on
average during EMU. Public debt could have been well around or
below the reference value in the euro area in most of its members
by 2010 and nowhere above 100% of GDP.

4. Looking backward to the past, lessons for the future? an
episodes based approach

In an earlier study, Hauptmeier, Heipertz and Schuknecht
(2007) looked at the experience with public expenditure reform in
the 1980s and 1990s. They found that there were basically two

316


Chart 4: Public debt ratios - actual vs. rule-based
Euro area (12)

Germany

317


Chart 4: (cont.) Public debt ratios - actual vs. rule-based
France

Italy

318


Chart 4. (cont.) Public debt ratios - actual vs. rule-based
Spain

Greece

319


Chart 4: (cont.) Public debt ratios - actual vs. rule-based
Ireland

Portugal

320


reform waves in industrialised countries. Moreover, they found
that there were three groups of countries: (i) ambitious, (ii) timid
and (iii) non-reformers. Ambitious reformers were those that
managed to reduce public primary (non interest) expenditure by
more than 5pp of GDP from their peak within 7 years. Timid refor-
mers were those that cut primary spending between 0 and 5pp and
non-reformers never undertook much of a cut at all. These coun-
tries and country groups, the time and size of the maximum expen-
diture ratio and the change in the expenditure ratio within years
(T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4.

The study argued that conceptually, reforms needed to be ambi-
tious in order to make a significant difference for the resulting
public deficits and adverse debt dynamics. The more ambitious they
were the more they would even allow tax cuts. Already in the 1980s,
Ireland, Belgium, the UK, Luxembourg and the Netherlands had sig-
nificantly reduced their public expenditure ratio. The UK, Ireland
and the Netherlands did so again in the 1990s plus a number of
other countries: Finland, Sweden, Canada and Spain. Four countries
reduced public primary expenditure by more than 10% of GDP.
During this period, 10 countries undertook timid expenditure
reforms (amongst them the US, France, Germany and Italy at which
we will look again later). The three non-reformers included
Australia, which had always maintained a rather small government
sector, and Portugal and Greece.

321


Table 4: Expenditure reform phases 1980s and 1990s

Max. primary expenditure Change maximum
in year to T7
Ambitious' reformers
Finland 1993 -14,0
Sweden 1993 -14,0
Ireland (Phase 1) 1982 -12,4
Belgium (Phase 1) 1983 -12,3
Canada 1992 -9,5
United Kingdom (Phase 1) 1981 -8,2
Netherlands (Phase 2) 1993 -7,5
United Kingdom (Phase 2) 1992 -7,2
Spain 1993 -6,4
Ireland (Phase 2) 1992 -6,2
Luxembourg 1981 -5,7
Netherlands (Phase 1) 1983 -5,1

Timid' reformers
Austria 1993 -4,3
Denmark 1993 -3,9
New Zealand 1985 -3,8
United States 1992 -3,4
Italy 1993 -3,0
Japan 1998 -2,7
Belgium (Phase 2) 1993 -2,1
Germany 1996 -0,6
France 1996 -0,5
Switzerland 1998 -0,3

Non' reformers
Portugal 2004 0,0
Greece 2000 0,4
Australia 1985 0,4

It is, however, not just the magnitude of spending and reform
that is important but also the composition. The literature (e.g.,
Alesina and Perotti, 1995 and 1997) argues that reductions in
public consumption/wages and transfers and subsidies are particu-
larly “high quality”. They increase the chance of success of reform
by providing a strong signal of “willingness” and cuts tend to focus
on unproductive expenditure.

322


Table 5 illustrates that much of the expenditure cuts of
ambitious reformers came from transfers and subsidies and also
from government consumption. About two-thirds of the reduc-
tion in the total expenditure ratio and over 80 per cent of the
decline in the primary expenditure ratio occurred in these two
categories. Nine out of 11 reform episodes reported a decline in
public consumption by more than 2 per cent of GDP and eight
out of 11 featured a fall in transfers and subsidies by over 3 per
cent of GDP. At the same time, in most cases, government
investment and public education expenditure did not decline
disproportionately or in some cases even increased as a share of
GDP. Timid reformers did not report much of a decrease in
public transfers and subsidies and focussed on public invest-
ment in some cases and on public consumption including edu-
cation in others.

The study by Hauptmeier et al. (2007) also argued that public
expenditure reform needed to be part of a comprehensive overall
structural reform strategy. It was argued on the basis of the litera-
ture that this would allow the improvement in public finances not
only via less spending but also via better growth prospects. An
overview of the reforms undertaken by ambitious countries is
reported in Table 6. Most of the ambitious reformers undertook
major reforms that were complementary to expenditure retrench-
ment. Most countries strengthened their national fiscal institu-
tions. This not only facilitated fiscal retrenchment but also tended

323

324
Table 5: Composition of expenditure reform

Transfers
Total Interest Primary Government Government
Change T0-T7 and Health Education Pensions
expenditure Spending expenditure consumption investment
Subsidies

Ambitious'
reformers
Finland -15,7 -1,6 -14,0 -3,8 -0,3 -9,4 -1,3 -1,8 -1,5

Sweden -15,7 -1,8 -14,0 -2,8 -0,9 -8,0 -0,4 0,2 -1,7

Ireland (Phase 1) -13,3 -1,0 -12,4 -5,2 -3,2 -2,2 -1,7 -0,9 -0,7

Belgium (Phase 1) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6

Canada -11,4 -1,7 -9,5 -5,3 -0,5 -3,3 -1,1 -1,9 -0,2

United Kingdom (Phase 1) -10,5 -2,3 -8,2 -2,5 -0,3 -2,0 -0,3 -0,8 -0,5

Netherlands (Phase 2) -9,8 -2,3 -7,5 -1,9 0,1 -6,5 -0,8 -0,4 -1,2

United Kingdom (Phase 2) -7,1 0,1 -7,2 -2,7 -1,1 -2,6 -0,1 -0,8 -0,4

Spain -8,2 -1,8 -6,4 -1,5 -1,0 -4,1 -0,4 0,0 0,2

Ireland (Phase 2) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6

Luxembourg -5,9 -0,4 -5,7 -1,4 -2,1 0,0 0,1 -1,6 -0,8

Netherlands (Phase 1) -5,0 0,2 -5,1 -2,0 -0,2 -2,2 -0,1 -1,1 0,4


to make future budgetary control and thus the avoidance of fiscal
problems more likely.8 A number of countries devalued their
currencies. All ambitious reformers initiated significant labour
market reforms that improved work incentives. All but one
country reformed the tax system. And most countries reduced the

Table 6: Summary findings for ambitious reform episodes

Expenditure reform Structural reform

Institutional Other macroeco- Labour
Public
Transfers & reform nomic reform market
consumption Taxation Privatisation
subsidies 1/ incenti-
1/
ves

Ireland 1 XX XX X X X X X
Ireland 2 X XX X X X X
Sweden X XX X X X X X
Canada XX XX X X X X
Finland XX XX X X X X X
Belgium XX XX X X
Netherlands 1 X X X X X X
Netherlands 2 ~ XX X X X X
Spain ~ XX X X X X
UK 1 X X X X X X X
UK 2 X X X X X

All 9 11 10 6 11 10 8

8 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen
(1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fis-
cal rules in EU countries.

325


role of the state in the economy via privatisation.
Based on the fact that the reforming countries fulfilled the con-
jectures of ambition, high quality and comprehensive reforms it is
not surprising that the impact on public finances and the economy
were quite positive, compared to timid reformers (Chart 5). Panel
a) shows that ambitious reformers (here differentiating early and
late reformers) brought the public expenditure ratio down signifi-
cantly to levels similar or lower than those of timid reformers. This
was mainly achieved through cuts in public consumption and
transfers and subsidies while public investment did not change
much, at least for late ambitious reformers (see panels b)-d)). Panel
e) illustrates that public deficits were brought down very substan-
tially by ambitious reformers. The group of late reformers even rea-
ched sizable surpluses. As regards public debt developments (panel
f)), timid reformers did not achieve any significant reversal in debt
dynamics. Ambitious reformers, by contrast, managed to bring
debt down once fiscal balances had been sound enough.

Contrary to the concerns of vocal special interests and politi-
cians, ambitious expenditure reforms had very little (if any) adver-
se growth impact even in the very short run while the medium to
long term impact was very positive. Ambitious reformers experien-
ced a significant increase in trend growth by 1-2 percentage points
(panel g). By contrast, timid reformers experienced no such incre-
ase. Real private consumption started to recover as of the first year
of public expenditure reduction and accelerated more strongly
where ambitious reforms were undertaken (panel g). Private invest-

326


Chart 5: Ambitious vs. timid reforms, 1980s and 1990s.
a) Total public expenditures

b) Public consumption

327


Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.
c) Transfers and subsidies

d) Public investment

328


e) Fiscal balance

f) Public debt

329


g) Trend growth

h) Real private consumption

330


i) Private investment

Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)

ment initially declined or was flat and showed a relatively less
favourable trend than for timid reformers but this reversed in the
medium term. In the seventh reform year, the private investment
ratio of timid reformers had increased by 1pp of GDP while that of
ambitious reformers had increased by 2-3pp (panel i).

In a next step we assess recent and projected fiscal develop-
ments for 2012 and 2013 in selected euro area countries as well as
the UK and the US in the light of the evidence from past expendi-
ture reform periods described above. We do this on the basis of the
latest European Commission forecast (Autumn 2011) (see Table 7).
For the US we consider the latest IMF World Economic Outlook

331


projections. For all sample countries, the projections point to sig-
nificant primary expenditure reductions for the period up to 2013
(with the exception of France). This ranges from about 3-4pp of
GDP for Germany, Italy and the US to over 5pp in the UK and
Spain and to 7 to 10pp in the EU/IMF programme countries.
Expenditure reductions show a more or less linear pattern in most
countries. In the case of the US, the primary expenditure ratio
went down quite strongly in 2010. However, it is expected to decli-
ne only by another 1pp of GDP over 2011-13.

Table 7: Expenditure plans

% of GDP Primary expenditure

Actual Forecast
2009 2010 2011 2012 2013 2013 to max(0910)

Programme countries
Greece 48,7 44,4 43,6 42,4 41,7 -6,9
Ireland 46,9 43,7 42,1 39,6 37,0 -9,9
Portugal 46,9 48,3 44,9 42,0 39,9 -8,4

Germany 45,4 45,4 43,3 43,2 42,8 -2,6
France 53,8 54,2 54,0 54,3 53,9 -0,3
Italy 47,1 45,9 44,8 43,8 43,0 -4,1
Spain 44,5 43,7 40,8 39,8 39,3 -5,2

United States 42,1 39,3 39,6 39,0 38,5 -3,7
UK 49,6 47,7 46,8 45,3 43,9 -5,6

Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.

332


If projected spending developments materialise, primary expen-
diture ratios would decline to around 40% of GDP in most coun-
tries. The main exception is France where the ratio would remain
significantly above 50%.

Projected spending developments should also be assessed from
a longer term perspective. When comparing the 2013 figures to the
1999 primary expenditure ratios it is noteworthy that spending
would still be 1-7pp of GDP higher in 2013 than in 1999 for 8 out
of 9 countries. This relative increase would be particularly sizeable
for Ireland, the US and the UK and appears unwarranted in view of
the expected ageing-related increases in social security outlays in
the medium and long-term. Only Germany would post a signifi-
cantly lower primary expenditure ratio than at the start of EMU.

Coming back to the adjustment effort in countries’ expenditure
plans, it is noteworthy that five countries (Ireland, Greece,
Portugal, Spain and the UK) would meet the criteria of ambitious
reformers as applied in the earlier study by Hauptmeier et al. (2007)
whereas a second group of countries could be classified as “timid”
reformers (Germany, USA, and Italy).

5.The need for prudent expenditure rules

The evidence presented in this study supports the view that
public spending has been a major determinant of unsound public

333


finance developments in the past. Looking forward, it therefore
seems plausible to address this fact through the implementation of
prudent expenditure rules. Indeed, empirical studies suggest that
well-designed expenditure rules tend to limit the pro-cyclicality of
public spending (see, e.g. Holm-Hadulla et al (2010)). Recent policy
action in Europe goes in this direction. Notably, the EU fiscal sur-
veillance framework has been extended by a so called “expenditu-
re benchmark” which restricts the growth rate of public spending
net of discretionary tax measures to that of potential growth.
However, this new rule does not take into account some of the pro-
blems we identified in Section 3.1. Most notably, an effective rule-
based restriction of spending policies in real-time requires the
maintenance of a margin of prudence. This is necessary to account
for the tendency of overestimating potential GDP growth in real-
time. Given the past experience of systematic and persistent down-
ward revisions in potential growth, a margin of prudence of ½ pp
in expenditure growth per annum appears warranted. In addition,
excessive price developments should not automatically feed into
higher expenditure growth as expansionary fiscal policies may
accelerate an economic overheating. Therefore, the nominal com-
ponent of an effective expenditure growth rule should be capped,
e.g. at the ECB’s price stability objective (“close to but below 2%”).

Chart 6 shows that the application of such prudent expenditu-
re growth rules during EMU would have resulted in much safer fis-
cal positions. Primary expenditure ratios would have reached
much lower levels in 2009. As a result, also public debt ratios in

334


Chart 6: Actual ratios versus neutral expenditure policies-based ratios (based on
NPG – ½ pp and RPECB – ½ pp rules), 2009
Panel A: Primary expenditure ratios

Panel B: Public Debt ratios

Note: Includes GDP multiplier and compound interest effects.

335


2009 would have generally been much closer to 60% of GDP with
the highest ratio of around 90% in Italy. It is important to note,
however, that the proposed expenditure rules are intended to pro-
vide guidance for an appropriate, i.e. neutral, policy stance in the
absence of fiscal imbalances. Any fiscal adjustment, e.g. to regain
sound fiscal positions in the aftermath of the crisis, would of cour-
se require a restrictive policy stance, i.e. spending growth rates
below potential GDP growth.

6. Concluding remarks

What are the main findings of this study and what policy lessons
can be drawn? Public finances in advanced economies are at a cross-
roads. In the fifth year of the crisis, fiscal deficits remain high and
public debt has reached unprecedented peace-time levels in most
industrialised countries. Public primary expenditure stands at or
near historical peaks in many countries and therefore constitutes an
important determinant of the fiscal imbalances. It therefore seems
straight forward to focus on expenditure restraint when striving to
regain sound fiscal positions in the aftermath of the crisis.

In the 1980s and 1990s a number of countries undertook ambi-
tious expenditure reforms. Their experience, which was briefly
reviewed here, has been very positive. Within a few years from the
start of expenditure reform, public expenditure ratios went down
significantly, fiscal deficits largely or fully disappeared, public debt

336


was brought on a downward path, and economic growth and pri-
vate consumption resumed swiftly. We argue that this was because
ambitious expenditure reform was conducted in a growth-friendly
manner as part of comprehensive adjustment programmes.

Our study emphasises the key role of expenditure policies in
explaining fiscal developments during EMU in the euro area. It finds
that, almost all euro area countries (with the notable exception of
Germany) applied expansionary expenditure policies already before
the crisis. This resulted in much higher expenditure and debt paths
compared to a counterfactual neutral expenditure stance. Rules-
based spending policies could have led to much safer fiscal positions
much more in line with the EU’s Stability and Growth Pact (SGP).

The policy recommendations from these findings are obvious:
countries should focus on reducing public spending in the context
of ambitious reform programmes. Spending based consolidation
efforts need to be complemented by structural reforms, notably
with a view to removing rigidities in national labour and product
markets, to reduce macroeconomic imbalances, improve competi-
tiveness and support potential growth. This will be particularly
important for the vulnerable countries in the euro area which do
not have available the exchange rate mechanism to improve exter-
nal competitiveness. Latest projections suggest that governments’
consolidation plans in a number of countries indeed put a focus on
reducing government expenditure as a ratio to GDP in the coming
years. However, the benefits of reforms are only going to materia-

337


lise under one condition, namely that all these plans are fully and
adequately implemented. This is their main challenge.

In addition, the empirical evidence on the determinants of euro
area countries’ expenditure stance provide a number of policy
implications. First, strong national budgetary institutions seem to
limit expansionary spending biases. Second, the European institu-
tional framework needs to feature prominently expenditure moni-
toring and control. The incorporation of an expenditure bench-
mark in the preventive arm of the Stability and Growth Pact in the
context of the recent “Six-Pack” reform therefore constitutes a step
in the right direction. An effective enforcement of this rule should
help to limit overly expansionary spending policies in the future.

Furthermore, this chapter argues that a potential growth rule
with an extra ½ percentage point deduction from the resulting
annual expenditure growth targets would be a sufficiently prudent
and, thus, advisable expenditure rule for euro area countries. As
economic (e.g., population aging) and political economy reasons
suggest that overestimating potential growth could also occur in
the future, such a rule could provide a reasonably prudent bench-
mark for a neutral expenditure stance looking forward.

How does the debate on the overhaul of European economic gover-
nance fare against these conclusions? At the time of completing this
study (March 2012), EU member states have set up new EU economic
governance principles with a view to ensuring a tighter and more

338


effective surveillance of economic and fiscal policies at the European
level. At the same time, policy makers have agreed - in the context of
the new fiscal pact - to strengthen national fiscal frameworks.

All in all, a stringent implementation and enforcement of the
fiscal surveillance at European level could well ensure the necessary
break with past expenditure trends and thus also secure sustainable
deficits and debt dynamics in the future. However, it remains to be
seen whether the main obstacle of the “old framework”—lack of
incentives and enforcement—is really sufficiently remedied.

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