ECB’s Recommendations for Sound Fiscal Policy

The European Central Bank points out that the effects of excessive stimulus spending have been negligible.

Throughout the euro crisis, the European Central Bank in Frankfurt has been staunch proponent of austerity. Most recently, its president Jean-Claude Trichet urged European governments to cut spending, noting that monetary responsibility on the part of his bank cannot continue to substitute for fiscal irresponsibility on the part of individual member states.

Two recent ECB studies are no less adamant about the need to rein in public spending. In an entry at the libertarian Cato Institute’s blog, Daniel J. Mitchell cites both reports, the first of which focuses on debt reduction in European core countries.

Entitled “Major Public Debt Reductions: Lessons From The Past, Lessons For The Future,” (PDF) the report unambiguously concludes that spending restraint is the right way to reduce deficits and debt, according to Mitchell. “Tax increases, by contrast, are not successful,” he observes. The study summarizes its major findings as follows.

First, major debt reductions are mainly driven by decisive and lasting (rather than timid and short lived) fiscal consolidation efforts focused on reducing government expenditure, in particular, cuts in social benefits and public wages. Revenue based consolidations seem to have a tendency to be less successful. Second, robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to “grow their way out” of indebtedness. Here, the literature also points to a positive feedback effect with decisive expenditure based fiscal consolidation because this type of consolidation appears to foster growth, in particular in times of severe fiscal imbalances.

In other words, reducing government spending is the best method to fostering economic growth. Mitchell notes that the Obama Administration has been doing the very opposite with its stimulus policy. “The American economy would have enjoyed much better performance if the burden of spending had been reduced rather than increased,” he believes.

That assertion is supported by the ECB’s other study, “Towards Expenditure Rules And Fiscal Sanity In The Euro Area” (PDF). Its authors find that, “on the basis of real time rules, expenditure and debt ratios in 2009 for the euro area aggregate would not have been much different with neutral expenditure policies than actually experienced” — neutral expenditure meaning no excess increases in spending to affect productivity and growth.

Primary expenditure ratios would have been 2-3½ [percentage points] of GDP lower for the euro area aggregate, 3-5 pp of GDP for the euro area without Germany and up to over 10 pp of GDP lower in certain countries if expenditure policies had been neutral.

In plain English, the ECB is saying that with an annual cap in place on the growth of government spending, its burden could have been reduced by up to 10 percentage points of GDP. “To put that figure in context,” Mitchell notes that “reducing the burden of government spending by that much in the United States would balance the budget overnight.”