On Democracy and the “Fiscal Compact”

Figure 2
Figure 2

In a recent piece about  EU elections (see voxeu )  Francesco Daveri makes two points. The first is that the election results across Europe share a common trait: the revolt of large sectors of the electorate, particularly in France and Greece, but also in the Italian and German administrative elections , against the (self) imposed austerity of Mrs. Merkel, enshrined in the “fiscal compact”. The second is that there are few alternatives to the fiscal compact, given that most protests come from the very countries who, in terms of public expenditures, were more profligates.

On the first point, to my reading, the true political “surprises” in the Italian and French election, did not come from the winnners but from the “outsiders”, Ms LePen Jr and Mr Grillo. Their exceptional performances has arguably little to do with the austerity of the fiscal compact, and probably a lot to do with the protest against an arrogant, inept and often currupt  political establishment (the case of Greece is clearly different).

On the second point, the data commented in the article, government spending as a share of GDP, and government spending in nominal terms, should be interpreted with caution, particularly when  when discussing “profligacy”. The empirical evidence on fiscal multipliers (very controversial!) suggests that contractions in spending cause a more than proportional fall in GDP (a multiplier larger than unity), as the recent cases of Greece and Italy indicate quite clearly. As a result, an increase in the ratio would occur when cuts in spending reduce output more than proportionately. Even greater prudence should be used when interpreting changes in nominal terms. It ‘s well known that the origin of the current imbalances within Europe is the loss of competitiveness of the peripheral countries against Germany. Figure 1 shows a familiar picture, consumer prices in Germany (blue line), Greece (red) and Spain (yellow). In these last two countries, between 2000 and 2010, consumer prices rose respectively by 16 and 23 percentage points more than in Germany.  By correcting the data on nominal growth of public spending with inflation (1), one obtains Figure 2 . This shows that, thanks to the moderation of prices, between 2000 and 2009 Germany was able to increase public spending much more rapidly than Spain and Greece (20 percentage points of real growth more).

The figure also shows two other important aspects: after 2009, the cuts in Greece were very hard, about 30 per cent in real terms. So the voters’ answer is understandable. In addition, spending cuts above 20 percent in real terms have also been made in Germany since 2009. Here lies the stupidity of the fiscal compact: a recessive corset imposed to everyone, those  who needs it and those who do not,  that makes things worse for everyone.

(1) Since the consumer price index weights the price of tradables (which are by definition similar  across countries) and of non tradables (such as public services), when consumer prices rise more rapidly in Greece and Spain relatively to Germany, then it must be the case that Greek and Spanish non tradables’ prices rise even faster, relatively to Germany’s. Thus by using consumer prices to deflate nominal spending , I am actually over-estimating  “real spending” in Greece and Spain, and underestimating real spending in Germany.