Reducing the public deficit: a lot of questions and some answers

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The role that must be played by the public sector during the recession continues to monopolize the debate on economic policy in most developed countries and will more than likely continue to be the focus of discussion in 2013, especially in countries such as Spain. The underlying dilemma, austerity or economic stimulus, is nothing new. But economists devoted little attention to this question during the boom years and, now that recession has arrived, are unable to give a clear, flawless answer. One reflection of this is a shift in the discourse of international bodies, which has led to some uncertainty at a time when there's a wealth of questions but a dearth of answers.

In November 2008, when it saw the dreadful growth figures for most European countries, the European Commission (EC) launched the European Economic Recovery Plan under the slogan «time to act is now». The plan had two pillars. On the one hand, «a major injection of purchasing power into the economy, to boost demand». To this end, 200 billion euros were allocated, 1.5% of the European Union's GDP. The second pillar consisted of «action to reinforce Europe's competitiveness in the long term».

In clear contrast to promoting an expansionary budget policy, two months later the EC initiated an Excessive Deficit Procedure (EDP) against Spain. The public deficit of 2008 was estimated at 3.4% of GDP, above the figure of 3.0% set by the Stability and Growth Pact (SGP). Moreover, it was expected to reach 6.2% in 2009. However, this was relegated to second place as the level of public debt seemed to be under control. In 2008, this was 40% of GDP, one of the lowest in the euro area and clearly below the figure of 60% set in the SGP.

The reality, however, exceeded all expectations. In 2009, the public deficit ended up at 11.2%, almost double what had been initially forecast. It was therefore believed that there was very little room to carry out expansionary policies. The fear was that, in spite of having a relatively low level of public debt, if the deficit wasn't corrected quickly this could rise to less comfortable levels within a short period of time. Consequently, since then meeting the deficit targets set by the EC has influenced the design of Spain's economic policy, as it has in other countries, too.

The strategy employed by the EC to ensure that countries not complying with the SGP correct their deficit has aroused intense debate. Specifically, when an EDP is initiated, the EC sets a series of targets to reduce the public deficit and another series to reduce the structural deficit. This second pillar is based on a solid conceptual argument: the part of the deficit that is cyclical will correct itself once the economy starts to grow again. Therefore, in order to stop public debt from entering a situation of unsustainable growth, efforts must be focused on adjusting the structural part of the deficit.

In practice, however, implementing this theory is no easy matter. In order to identify which part of the deficit will be structural and which part will be cyclical, it must first be determined what rate the economy might grow at once it comes out of its recession or, in other words, its potential growth rate. Unfortunately, economics is far from being an exact science in this area. It therefore comes as no surprise that the IMF and EC disagree not only in their forecasts concerning the structural and cyclical components of the deficit but also in the historical trend (see the above graph).

Another element that has led to controversy is the fact that the deficit targets set by the EC do not explicitly include the fiscal effort a country must make. Fiscal effort is understood as the number of measures to increase taxes and reduce spending carried out by the country. This element is important in times of recession as the fiscal effort and ultimate reduction in the deficit usually differ: economic decline, be it cyclical or structural, reduces the effect the fiscal effort can have.

In a system where a level of fiscal effort is not explicitly determined, it's not easy to determine whether failure to meet deficit targets is due to a greater economic decline that predicted or because the necessary measures were not adopted. As the process is not very transparent, the incentives to carry out adjustments with a high political cost are limited. Moreover, as the international community is aware of this, it tends to interpret failing to meet deficit targets as due to a lack of political will. The controversy this normally generates does not help to restore confidence among the different agents.

Moreover, as if this uncertainty were not enough, in its last Economic Outlook report the IMF questioned the speed with which adjustments have to be made in the public deficit, recommending that this should be slower. The reason: never has such a huge fiscal effort occurred, simultaneously, in so many countries. This, they argue, means that the negative effects of fiscal effort on economic growth have been greater than initially forecast and might actually be one of the main reasons for the European economy's relapse 2012.

The EC reacted promptly to this. In its autumn economic forecast it argued that the fundamental reason for this relapse has actually been the reappearance of financial tensions. As can be seen in the graph below, the drop in growth prospects for 2012 occurred between the months of June and December 2011. During this period, among other things, it was announced that Greek debt would be written off and the European Banking Authority also carried out stress tests on banks, determining the public debt of the different countries likely to default, fuelling fears that what had happened in Greece would be repeated in other countries. Perhaps most importantly, while all this was happening, the outlook for the public deficit in 2012 remained almost unchanged. Within this context, it's very unlikely that a change in the planned fiscal policy could have caused the European economy to suffer a relapse.

As time passes, the role that must be played by the public sector becomes more confused. The debate regarding compliance of deficit targets, generated by a system of setting targets that is difficult to verify, as well as discrepancies concerning the effects of fiscal consolidation on growth, seem difficult to resolve. In this respect, the creation of an independent fiscal agency, as established in the MOU for financial aid to Spain, will help make the process more transparent in the Spanish case. Once this agency has been set up, it will also help to evaluate, from a technical point of view, the pros and cons of the different measures that can be carried out. The path ahead is still long and will certainly lead to more questions but the few answers we have should be implemented as soon as possible.

This box was prepared by Oriol Aspachs Bracons

European Unit, Research Department, "la Caixa"