Macroeconomic developments in Europe cast doubt on fiscal-consolidation strategies – not on the need for them but rather on their optimal pace (see the Vox Debate on this, Corsetti 2012). The optimal-pace issue is especially pressing for Spain where fiscal consolidation is making a crucial contribution to resolving the debt crisis, but its intensity can be questioned. De Long and Summers (2012), for instance, argue that excessively rapid fiscal consolidation can backfire, undermining rather than strengthening government-debt sustainability.
The pace of fiscal consolidation in the Stability Programme
The Spanish 2011–14 Stability Programme submitted in April 2011 assumed mildly positive economic performance. It envisaged GDP growth rising from 1.3% in 2011 to 2.3% in 2012,1 unemployment falling to 18.5% by 2012, and the deficit falling from 6% to 2.1% between 2011 and 2014.
In April 2012, we see that the economy has undershot these assumptions. Growth in 2011 was 0.7% (about half the forecast), unemployment was 21.6%, and the deficit was around 8.5% of GDP (two percentage points above the commitment to Brussels).
Recent forecasts for 2012 and 2013 depict a much more sombre panorama in terms of economic growth and unemployment.
The IMF (2012) predicts a growth rate of -1.7% in 2012, and -0.3% in 2013. The Bank of Spain (2012) expects that growth will be -1.5% in 2012 and 0.2% in 2013, with unemployment running at 23.4% and 23.3% over these two years.
Meanwhile, BBVA Research (2012) puts growth at -1.3% in 2012 and 0.6% in 2013, with unemployment increasing to 24.4% in 2012 and 24.6% in 2013.
What are the implications of this abrupt change to Spain's economic scenario in terms of its fiscal measures? To answer this question we need a little fiscal arithmetic breaking down the current deficit into its structural and cyclical components.
The cyclical component reflects the deficit's sensitivity to the cyclical situation of the economy due to the reaction of automatic income and expenditure stabilisers.
The structural component is the balance between the cyclical and observed deficit.
Of course, cyclical components cannot be observed; they must be estimated using procedures that are sensitive to a large number of hypotheses and availability of real-time information. Nevertheless, the distinction between cyclical and structural deficit proves to be quite a useful tool to assess fiscal policy. If more attention had been paid to this distinction in the early days of the crisis, Eurozone nations would have led much more prudent fiscal policies, and hence would now find themselves with much less acute budget imbalances.
In the case of Spain, a reasonable approach to the trajectory of the cyclical component of the budget balance may be provided by the following ratio to the output gap or cyclical component of GDP - ie the percentage deviation of GDP with respect to estimated potential GDP:
Annual cyclical budget balance = 0.65 * Annual output gap
Figure 1 shows the relationship between the budget balance as a percentage of GDP and the output gap estimated by BBVA Research. The curve estimated from the responses of the automatic stabilisers (using different tax and expenditure components) shows that for every six point change in the output gap, the cyclical budget changes by approximately four percentage points – hence the aforementioned ratio: 0.65=4/6 – a response within the Spanish range estimated recently by Fatás and Mihov (2011), slightly above the European Commission's estimate. The graph shows the current deficit and the output gap, and it is possible to deduce the structural deficit for a given year from the intersection of the vertical line at the zero output gap and the straight line with a 0.65 slope starting at the point representing the year concerned. Between 2007 and 2009 an increase was observed in both the cyclical deficit (five percentage points) and, more obviously, the structural deficit (approximately seven percentage points). Since then fiscal consolidation has brought the structural deficit down by some four points of GDP.
What is in store for Spain in 2012 and beyond in terms of fiscal efforts?
The fiscal effort envisaged in the Stability Programme for 2011 and 2012 is shown in the upper section of Table 1. This shows that – if the deficit targets and the GDP growth scenario for both these years are met – the structural deficit would fall by 4.6 percentage points - around 3.4 in 2011 and 1.2 in 2012.
The lower section of Table 1 depicts an alternative scenario, where the figures observed for growth (0.7%) and public deficit (8.5% of GDP) are used for 2011. These data show that the fall in the structural deficit in 2011 was much lower than that predicted in the Stability Programme – 0.9 percentage points against 3.4 percentage points.
This means that the shortfall must be offset in 2012 with a structural-deficit reduction of 3.7 percentage points of GDP. However, a growth rate of -1.3 further impairs the output gap to the tune of around two percentage points, and thus the cyclical deficit increases by 1.2% of GDP.
The bottom-line is that the equivalent discretionary cutback to which we actually committed ourselves in the Stability Programme would imply that the current deficit that can be achieved this year is only 6% (ie 8.5 minus 3.7 plus 1.2). Each tenth of a point below 6%, therefore, would be directly assigned to a reduction in the structural deficit, and so achieving a 4.4% deficit by year-end 2012 would entail a fiscal effort of 5% of GDP, ie, more than €1,100 per capita.
Table 1. Fiscal-consolidation scenarios
Source: Spain Economic Outlook, February 2012. BBVA Research
The maths of too much tightening for Spain
Using the formula linking changes in the cyclical budget balance and the output gap, we see that reaching the deficit target of 4.4% in 2012 would require a fiscal consolidation in the vicinity of five percentage points of GDP. This would represent the largest fiscal consolidation ever achieved by Spain, and one of the largest among OECD nations in recent decades (see Devries et al 2011).
The enormous contraction in the fiscal position will take place in a year of economic slump and thus be excessively procyclical.
The fiscal consolidation would be much greater than what was originally planned; Spain would reach the medium-run goal well ahead of the objectives of the Stability Treaty.
Maintaining the objectives of the Stability Programme this year and next year, entailing a public deficit of 3% of GDP in 2013, with an economic growth scenario of 0.6% in 2013 (the IMF puts growth even lower), would imply a situation of structural equilibrium by 2013 -- seven years ahead of the target of Spain’s draft Budget Stability Law.
Spain is facing a dramatic change in growth expectations, which requires deficit objectives to be redefined to enable fiscal adjustments in structural terms to keep pace with the trajectory that was originally established.
In these circumstances:
The EU must make changes to the fiscal consolidation strategy now demanded of member states.
The obsession with nominal deficit targets must be replaced with a credible and rigorous multi-year fiscal programme that avoids a spiral of negative growth.
Such programmes should make a genuine contribution to strengthening the long-term sustainability of public finances in all European countries. Specifically, Europe's consolidation strategy must be based on the following principles:
Deficit reduction targets must focus on the structural deficit and not on the nominal deficit, as stipulated in the new Stability Treaty. This means that what countries must be asked to do is take specific detailed measures in the years ahead to reduce spending or increase income by a certain amount determined ex ante. If, as a result of these measures, the economic situation worsens and the nominal deficit is affected (merely due to automatic stabilisers), member states should not be obliged to implement further savings schemes that same year.
The pace of structural consolidation must be sufficiently ambitious to guarantee the sustainability of public finances in the medium and long term, and sufficiently gradual to prevent any excessively adverse effects on the economy and employment in the short term.
In the case of Spain, we have estimated that the structural deficit in 2012 will be 5.5% of GDP. As part of what has come to be known as Europe's new fiscal-consolidation strategy, the path towards correction of the structural deficit, which ought to involve both General State Administration and Regional Administrations, could be 3.5 percentage points in 2012 (thus ensuring the initial fiscal effort designed in the 2011 Stability Programme), 1.5 points in 2013, and 0.5 points in 2014. The deficit's cyclical component would gradually fall as the economy returns to growth and net job creation.
This point is not novel, of course. Olivier Blanchard (2011) recently recommended, for a return to prudent levels of public debt, application of the proverb “slow and steady wins the race.” This recommendation was similar to that advocated by De Long and Summers (2012), who felt that excessively intense and rapid fiscal consolidation may jeopardise rather than guarantee the sustainability of public finances.
Bank of Spain (2012), “Informe de Proyecciones de la Economía Española”. Boletín Económico. Enero.
Devries, P, J Guajardo, D Leigh, and A Pescatori (2011), “A New Action-based Dataset of Fiscal Consolidation”. IMF Working Paper 11/128.
Ministry of Finance and Public Administration (2011), Stability Programme, 2011-14
. Madrid: Ministry of Finance and Public Administration.
See Table 3.2 in Ministry of Finance and Public Administration (2011).