Received Wisdom and Beyond: Lessons from Fiscal Consolidation in the EU

Abstract

Restoring sustainable public finances in the aftermath of the Great Recession is a key challenge in most EU countries. In order to learn from history, our paper examines consolidation episodes in the EU since 1970. We shed light on the factors that favour the start of a consolidation episode and determine its success. Compared to the existing literature, we add a number of new dimensions in the analysis. First, we explore a broader set of potential ingredients of the 'recipe for success', including the quality and strength of fiscal governance and the implementation of structural reforms. Secondly, we check whether the 'recipe for success' changed over time. Our analysis broadly confirms received wisdom concerning the conditions triggering a consolidation episode and the role of the composition of adjustment for success, with some qualifications related to the role played by government wages. In addition it provides evidence that well-designed fiscal governance as well as structural reforms improve the odds of both starting a consolidation episode and achieving a lasting fiscal correction. We also show that, over time, successful and unsuccessful consolidation episodes have become more similar in terms of adjustment composition.

The Politics of Fiscal Austerity: Implications for the United States

“…As a general rule, fiscal consolidation is undertaken only when public finances are weak, as measured by rising deficits and debt levels (Molnar ). In fact, some studies suggest that the gravity of the initial fiscal conditions influences nations to undertake deeper and more prolonged consolidations, which have a greater chance of stabilizing debt in the future (Larch and Turrini ; Perotti ).…”

“…This included the shadow cast by the original economic and fiscal crisis of the mid‐1980s and the reliance of the Australian economy on foreign sources of capital to finance private investment. Today, as national leaders engage in yet a new round of consolidation to bring modest deficits into surpluses, one observer concluded that budget surpluses have come to serve as a symbolic metaphor for the competence of the government—the single most important “acid test” of a government's economic credentials (Hawke and Wanna ).…”

Democracies and Deficits: Prospects for Fiscal Responsibility in Democratic Nations

“…Cohesive single parties controlling government are more likely to develop and successfully achieve fiscal consolidation packages than fragmented coalitions. Coalition partners often have difficulty agreeing on packages compared to more unified parties (Larch and Turrini 2008). Since proportional representation systems tend to foster politically fragmented regimes, some have generalized that governments with majoritiarian electoral systems maintain tighter fiscal discipline than other systems (Persson and Tabellini 2003).…”

Medium-Term Prospects for the Public Finances

“…Evidence from the 1970s and 1980s suggested that fiscal consolidation on the scale we discuss was better done by cutting spending. Larch and Turrini (2008) look at more recent efforts, and suggest that this result reflected picking the low hanging fruit, and that a more balanced approach based on a strong fiscal framework would now be more appropriate.Given the increased debt stock, there is continual worry about the possibility that a risk premium will arise on UK government debt, and on UK debt in general, and that these would have a deleterious effect on prospects for the economy. If such a premium arises, then government interest payments and hence tax rates (or borrowing) will have to be higher.…”

“…Evidence from the 1970s and 1980s suggested that fiscal consolidation on the scale we discuss was better done by cutting spending. Larch and Turrini (2008) look at more recent efforts, and suggest that this result reflected picking the low hanging fruit, and that a more balanced approach based on a strong fiscal framework would now be more appropriate.…”