Can we raise growth through Expenditure Reforms? Of course, not!

The European Central Bank

In its April Monthly Bulletin the ECB had a section on public expenditure reforms in member countries and its impact on economic growth (page 61). It starts with the observation that seven member states introduced expenditure reforms in the 1980s and mid-1990s.  It so happens that the five countries that did not introduce exenditure reforms were later subject to the excessive deficit procedure. The authors show that the reforming countries cut expenditures by nearly 3% of GDP within two years and 9% over seven years. The highest contribution to this expentiture reduction comes from government consumption - through a combination of wage restraint and employment reduction in the public service sector - and through cuts in transfers and subsidies. The article suggests that expenditure reforms coincided with a rebound in potential growth and employment. 

In our view this distinction ignores the fact that expenditure reforms are much easier to implement in small countries. The successful countries listed by the ECB are all small countries with the expection of Spain. Given what we know from the literature, one can not draw the simple conclusion that expenditure reforms are growth enhancing in principle. More and better indicators are required to assess the growth impact of a budget, a task that is acknowledged by the ECB and the ECOFIN council (24 Jan 2006). Furthermore, in times when countries increasingly substitute tax rebates for subsidies and rely on off-budget funding, it will no longer be sufficient to study public spending only.