• Austerity in Europe: 2007-2014

    pdficon2David Howden
    Saint Louis University – Madrid Campus
    Email: dhowden@slu.edu

     

    Austerity is perhaps the most prolific and controversial policy to come out of the recent crisis for two reasons. On one hand, it is difficult to define exactly what it means for an economy to be austere. On the other hand, once this definition is established, the complexities of financial issues – owing to the fact that funding constraints exist in the present given future obligations – imply that a meaningful measure of austerity is difficult to pin down.

    An austere individual is someone who lives within his budget: in sum, someone who spends less than his income. Thus whether a government has or has not been austere can be measured by the change in its proclivity to spend. In table 1 below, we rank a set of 24 European countries (plus the United States) according to the change in the government’s share of nominal GDP over the period of 2007 – 2014. By this definition of austerity, only Lithuania has decreased the size of its government’s expenditures (and even then, just barely). Finland ranks as the least austere country under this measure, with an increase of nearly 12% in size of its government relative to GDP.

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    Table 1[1]: “Austerity” as Change in Government Spending (2007 – 2014)
    Source: Eurostat (2015)

    Of course, if one takes “austere” to mean living within ones means, spending is only half the equation, the other half being income. Under this definition, growth in total tax revenue represents an austere government, as the increase in taxes equates to an increase in one form of government revenue (the other two forms being seigniorage and deficit spending). An austere country would be one that has decreased its total tax revenue, as was the case with Cyprus over the period. (Note that this measure of austerity is passive in the sense that changes in tax revenue could be in the form of alterations to tax policy or, as was the case more often during this period, the result of falling income level in the private sector.) The least austere country under this methodology would be Greece, since that country’s tax revenue increased by nearly 4% between 2007 and 2014.

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    Table 2: “Austerity” as the Change in Tax Revenue (2007 – 2014)
    Source: Eurostat

    Of course, both of these measures of austerity can be summarized neatly by just focusing on the annual public deficit. In figure 3 below, we can see the average deficit each country incurred over the period of examination.

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    Table 3: Average Public Deficit (2007 – 2014)
    Source: Eurostat (2015)

    This measure has the appeal that it captures not just high revenue or low expenditures as a source of austerity, but the combination of the two. Therefore one can make the claim that Norway has been the most austere country over this period. The fact that the country’s public expenditures are quite high relative to others’ is offset by the fact that its tax collection (and revenues from State-owned enterprises) are also high. To the extent that Ireland increased public expenditures at a time when its tax revenues were falling, its government ranks as the least austere according to the measure.

    One deficiency of focusing exclusively on the deficit is that the one cannot easily see the magnitude of the deficit on the country’s public finances. Such a magnitude can be more easily captured with reference to the change in the total stock of public debt outstanding. Problems still persist with this method. While Malta may have been the most austere government over this period, the island’s government still managed to increase its public indebtedness by almost 6%. And while attention to Norway’s surpluses may give one the impression that its government debt has not been increasing, focusing on the total debt level reveals that it has pursued less austere policies than meet the eye.

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    Table 4: Change in Total Public Debt (2007 – 2014)
    Source: Eurostat (2015)

    The goal of these four tables has been only to impress on the reader the simple fact that measuring austerity is difficult. This outcome can be intuited by following the robust debate that surrounded the topic since the advent of the crisis in late 2007. One recourse to the thorny question could come from somehow aggregating these individual measures of austerity into some appropriately weighted “austerity index”.

    In table 5 I have ranked the countries according to their average rank in each of the four previously mentioned ways to define austerity. The resultant value of the “austerity index” represents this average. For example, Sweden ranked 11th in government spending, 6th in government spending, 3rd in the deficit and 2nd in its total public debt giving it an austerity index measure of 5.25 (the average of 11, 6, 3, and 2). Thus a lower austerity index value means that the country has been more austere. Though one could quibble about the appropriate weights or austerity components to include (e.g., perhaps the primary surplus should be used instead of the deficit, maybe the total interest payments should be included as well, etc.) the index has the appeal that it quickly ranks a country relative to others according to its austerity performance. It also accords with intuition. The usual suspects for the least austere countries appear near the end of the list (i.e., Spain, Portugal, Ireland, Greece, etc.) while those countries that seemingly enacted (whether by choice, necessity, or preference) the most austere policies are near the top of the list (e.g., Sweden, Norway, Germany, etc.).

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    Table 5: Austerity Index

    Such a ranking has two significant drawbacks. First, since the ranking is relative to other countries, the fact that Portugal comes in last and Sweden first only implies that the Portuguese government pursued less austere policies than did Sweden’s. This drawback becomes apparent once one questions whether the Swedish government has, in fact, been austere. (Attention to table 4 may cause one to rethink their answer to this question.) The prettiest girl of an ugly group is still ugly. Second, since the values of the austerity index are ordinal there is no way to discern the magnitude of difference between, e.g., Ireland’s more austere policies vis-à-vis Spain’s less austere policies. This index allows us to make qualitative comparisons between members of the group, but tells little with respect to how austere a country has or has not been.

    To rectify these problems, I have devised an alternative method to measure the degree of austerity of a country’s government. A better measure of austerity would account for a reduction in government spending, both in the present and future. Such a figure would remove the possibility that a country could give the appearance of being austere by lowering taxes but not reducing expenditure and running a deficit (e.g., Spain). Alternatively, a country could look profligate by increasing expenditures in the present, but by reducing the future debt burden by running cash surpluses it would actually be austere (e.g., Norway).

    The proposed austerity value takes the sum of the current tax charge T and the expected future portion of income P0 necessary to pay down the existing debt D0 and expected deficits d. Given that a government is an ongoing entity, the portion of a country’s income necessary to pay off the existing debt and expected annual deficit can be solved as net present value problem. Some appropriate fixed annual income payment, P0, will set the net present value of its debt and expected deficits equal to zero if

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    where i is the average interest rate on debt outstanding, and g is the nominal growth rate of the economy. Thus P0 is the perpetual payment necessary to set the present value of the repayment of debt D0 growing as per the yearly deficit d equal to zero. (All figures are expressed as a percentage of nominal GDP.)

    Combining this payment with the current level of tax revenue (also expressed as a percentage of nominal GDP) will result in an austerity value, as per table 6.

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    Table 6:[2] Austerity Value, 2013
    Source: Eurostat (2015) and author’s calculations

    Interpreting the austerity value is straightforward. The number represents the percentage of income necessary to maintain the current level of taxation and pay down the existing debt and expected deficits. This latter condition is necessary since if investors did not think that the government would ever repay its debt they would not fund it. (In this way the value of P0 given by the equation above is the minimum condition to ensure that investors lend money to the government, or in other words, that the existing debt and expected deficits are sustainable.)

    Thus, while Norwegians paid 40.5% of their income to the government in 2013 (T = 40.5), given the combination of low interest rates on Norwegian sovereign bonds (i), strong economic growth (g) and a public surplus (d > 0), they can expect to devote only 29.1% of their future income to maintain this level of public expenditure. Demark represents the other extreme. Given that it currently costs Danes 48.6% of their income to fund the government through taxes, and that they will need to devote 2.6% of their future income to paying down the public debt and deficit, they will need to spend 51.2% of their future income to maintain the government at its current size.

    In contrast to the Austerity Index represented in table 5, the austerity values of table 6 have the advantage that they are cardinal. As a result we can compare the future cost of public finances easily. For example, Austria and Italy share not just a border but also the cost of their current public sectors at 43.3% of GDP. However, given differences in each country’s existing debt level, expected deficits, interest expenses and economic growth rates we can expect that it will cost Italian citizens nearly 6% less of their income in the future to maintain their government at that size. One can just as easily reverse the statement and look at its corollary. For the same expense going forward (approximately 39% of GDP) the United Kingdom will only be able to sustain a government 5 percentage points smaller than Luxemburg’s.

    The Austerity Value that I define herein allows one to estimate the true cost of a country’s public sector, not just in the present in the form of taxes but in a future that necessarily must include debt repayments.

    I will conclude by shedding light on which countries were the most austere over the period of 2007 to 2014. In table 7 I summarize the changes to the Austerity Value in each country over the period. An increase denotes the additional income (as a percentage of GDP) that will be necessary to support that country’s public sector moving forward. A decrease implies that the country has decreased its cost of government, and thus has pursued what could be called an austere economic policy.

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    Table 7: Change in Austerity, 2007-2013

    To the extent that the Irish government can be estimated to cost 15.3% less as of 2013 than it did in 2007, I conclude that it has followed the most austere economic policies over the period 2007 – 2013. On the other hand, Denmark has been the most profligate country under examination and can be reasonable expected to require nearly 9% more income in the future to sustain its government at its current size.

    [1] I have shaded green those countries following austere policies under the relevant metric in tables 1 through 4, and red for those un-austere, or profligate, countries.

    [2] Countries in green are those whose P0 value is negative, implying that the public sector will cost less in the future than it does now (given a constant level of expenditures). This strange event comes about by either the country running a public surplus (as with Norway) or where the rate of economic growth g is greater than the interest charge i on its outstanding debt (as is the case with Belgium, Greece and Portugal, and indeed, the average of the Euro area.)