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The ECB outlined when fiscal consolidation will be effective. Have the Euro politicians read their work?

    Yesterday, Ed Balls apologised. He apologised for Polish immigration and for the regulation (or lack of) of the banking sector, and promised to enforce fiscal rules to ensure that the Labour party can reclaim economic credibility in any future Government.
    Whilst the admission of these policy failures is welcome, the one thing that he would not do is admit to being wrong about public expenditure increases under the previous Labour Government.
    Between 1999-2007 (i.e. before the crash), the expenditure to GDP ratio for the UK increased by 5.1 per cent points. The average change across the Euro area was a contraction by 2.1 per cent, and the G7 average increase was by 1 per cent point.
    This increase in the size of the expenditure of the state made us ill-prepared to deal with the financial crisis of 2008. The high spending commitments, coupled with the loss of tax revenue as a result of the recession, meant that the UK budget deficit in 2010 was the highest of any G7 country at 10.5 per cent of GDP.
    Yet the dynamics of population change are attempting to increase this expenditure gap further. The European Commission estimates that the effects of our ageing population will add expenditure on health, pensions and long-term care to the tune of another 5.1 per cent of GDP by 2060.
    Worse still, the financial crisis has shown that private sector debt can become a contingent liability for the public sector. Not useful when the sum of household and corporate debate is well over 200 per cent of GDP, as it does here.
    And this is even before considering potential contingent liabilities from third countries.
    All this evidence is presented in a good paper written by three members of the ECB, called ‘More Gain Than Pain', which outlines the case for fiscal consolidation throughout the Eurozone. It rightly highlights the long-term benefits of fiscal contraction: macroeconomic stability and higher economic growth. On these, there appears to be a political consensus – it’s why all parties highlight the need to reduce the deficit.
    The key debate line is the effects of consolidation in the short-term. Deciding the extent of cuts is a trade-off between the direct reduction on domestic demand and the potential positive effects on confidence and expectations. Evidently, growth is required, but fiscal contraction combined with other measures can achieve this.
    Helpfully, the paper lays out five conditions that maximise the likelihood of fiscal contraction having large positive effects:

    •     When the starting fiscal position is weak
    •     When the plan is ambitious and credible
    •     When the composition of the adjustment is focused on reducing disincentives to work and save, on enhancing expenditure efficiency and on protecting growth friendly expenditure
    •     When the share of households that can adjust their saving is high
    •     When the impact is offset by means of the exchange rate or low interest rates

    The UK fits many of these criteria. But perhaps the European politicians should examine how effective large-scale consolidation will be in other European countries. It should ask a number of questions.
    Why, for example, did the ECB increase interest rates from 1.25 to 1.5%? How will Greece and others implement consolidation effectively without the ability for an independent exchange rate adjustment? Are plans that would force fundamental change on national work habits credible?
    The criteria set out by members of the ECB suggest that the euro framework itself will make fiscal contraction more difficult.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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