Budgetary Policies during Recessions - Retrospective Application of the "Stability and Growth Pact" to the Post-War Period

Cover pagesText AnnexesThe purpose of this paper is to analyse budgetary policies carried out during and after severe recessions. Since the agreement on the "Stability and Growth Pact" by the European Council in Dublin in December 1996, interest in this issue has increased significantly. The Stability and Growth Pact, which sets the rules for budgetary behaviour in stage three of EMU, singles out severe recessions as specifically problematical periods during which a certain budgetary flexibility could be allowed. The rules laid out in the Stability and Growth Pact are used in this paper as a benchmark to evaluate past budgetary behaviour during recessions in the fifteen European Union Member States. More specifically, the paper provides elements to examine the following issues: what type of budgetary policies have been adopted during severe recessions in the past? Were the automatic stabilisers allowed to operate fully and did governments adopt an expansionary budgetary policy stance? Which factors influenced the policies undertaken and what was the composition of the measures adopted? Can the accumulation of debt, which took place in the past two decades in Europe, be explained by "tax smoothing" during periods of economic hardship?II/195/97-ENConcluding remarks The application of the provisions of the Excessive Deficit Procedure and the Stability and Growth Pact to the past is obviously a highly speculative exercise. Its results do not address the following questions: to what extent is past budgetary behaviour a reliable guide to assess the likely behaviour of national budgetary policies in EMU during recessions? More specifically, would Member States need larger or smaller changes in their budgetary positions to provide the degree of stabilisation which occurred in the past?A number of factors will play an important role:New policy regime under EMUDuring the third phase of EMU, the conduct of monetary policy will be centralised at the European level and will therefore no longer be available as a policy tool at the national level. Budgetary policy will thus be the main macroeconomic policy instrument still available for individual Member States to combat recessions, especially when shocks are asymmetric. The impossibility of lowering interest rates and resorting to currency devaluations might require larger deficit changes.On the other hand, according to the Mundell-Fleming framework, budgetary policy will in principle become more effective in dampening the amplitude of cyclical fluctuations in the new policy environment of EMU with centralised monetary policy and irrevocably fixed exchange rates between Member States.If, however, EMU enhances the process of economic integration, trade leakages of budgetary policies will gradually increase, thereby reducing the "domestic" effectiveness of budgetary policies. Unless national policies are co-ordinated, this factor raises the changes in the budget deficit required in order to attain the same degree of stabilisation achieved in the past."Pre-recession" deficit levelActual deficit changes observed during past recessions were applied in our retrospective exercise to "pre-recession" deficit levels chosen specifically for the exercise (0% and 2% of GDP). However, the actual deficit changes which took place during past severe recessions usually started from markedly higher pre-recession deficit levels. The impact on the economy of budgetary policy changes during recessions also varies depending on the deficit and debt levels. For instance, the markets' perception of an increase in the deficit from 0% to 2% of GDP during a severe recession will be different from that of a rise in the deficit from, say, 8% to 10% of GDP, the latter more likely being interpreted as shifting the deficit to an unsustainable path. This may lead to an increase in the risk premium on interest rates which reduces the effectiveness of the fiscal expansion.High budgetary imbalances may inhibit policy makers from using the budgetary instrument for stabilisation purposes. Indeed, the higher risk premiums which would raise the interest burden may represent a powerful disincentive to expanding fiscal policy in spite of the recession. As was pointed out in Section 4, budgetary reactions to economic downturns differ depending on the initial public finance conditions before the recession: countries with high deficit and debt levels tend to conduct tighter fiscal policies during recessions than those with lower deficit and debt levels. In the future, when medium-term targets have been achieved, Member States would have more room for manoeuvre to undertake accommodating policies.These factors point in different directions. As a consequence, the net effect on the requirement for budgetary stabilisation is ambiguous. If it proved necessary to reinforce the working of the automatic stabilisers during recessions in EMU, larger swings in budget deficits compared to the past would have to be allowed for. Under the provisions of the Stability and Growth Pact, this would imply, however, that during the third phase of EMU, Member States, and especially those with large automatic stabilisers, would have to run budgetary surpluses when in medium-term equilibrium.The present paper far from exhausts the issue of what can be learnt from the past budgetary behaviour for the implementation of the Stability and Growth Pact and, more generally, how budgetary authorities actually behaved in different economic circumstances.The following areas were not or were only partially covered, and therefore, provide scope for further research:Budgetary policies over the full cycle: this paper has focused essentially on recession episodes. The exercise could therefore be extended to other cyclical phases besides the recession. Indeed, as already indicated in this paper, the problem in the past has not been so much that Member States let budget deficits get out of hand too much during recessions but that they did not seize the opportunity presented by post-recession economic recovery to immediately correct their budgetary position.Composition of budgetary policies: the paper addressed the issue of the composition of budgetary policy reactions to recessions via a preliminary analysis of the overall revenue and expenditure components. Two extensions can be envisaged: first, an analysis of the composition of retrenchment policies over the years following the recession to assess, for instance, whether the length of the adjustment depends on the composition of budgetary consolidation; second, a further disaggregation of the overall components into more detailed government revenue and expenditure categories is necessary. This detailed analysis would allow conclusions to be drawn on the mechanisms causing budgetary policies to become unsustainable, as well as on the possible effectiveness and durability of budgetary consolidation efforts.