Euro Area: Rising Trends in Structural Public Spending to Test Fiscal Space for Post-Pandemic Agenda

by Warrior2

Euro area governments need to reconcile plans for higher long-term investment with rising social-welfare costs. Pension and labour-market reforms to contain spending and enhance growth could limit the risk for public finances.

Euro-area governments have announced spending strategies for post-pandemic recoveries that reverse some of the adverse public expenditure trends of recent years. However, there appears to be limited room for potential savings on other expenditure items that could provide the requisite fiscal space.

Plans to raise public investment and strengthen healthcare systems, reversing some of the cost containment of the past, coincide with the prospect of further rises in social-welfare payments due to ageing populations and labour markets strained by the severity of the Covid-19 crisis. Some governments cannot rely on substantive additional future savings on interest payments to make up much of the difference when interest rates are already near zero, if not negative.Advertisement

Pension, labour-market reform, public investment could limit damage to public finances

We see two possible avenues to reconcile governments’ policy agendas with adverse structural expenditure risks.

Reforms of pensions and labour markets can help contain increases in social-welfare payments. Together with well-targeted public investment facilitated by fund inflows from the EU, they could boost growth, resulting in extra budgetary room over the medium term.

The alternatives are less attractive: higher taxes and social contributions or persistent budget deficits becoming a ‘new normal’ long term.

In our latest study on the composition of public expenditure across euro area countries, we note that in the 15 years pre-crisis, average annual government expenditure as a share of GDP increased in the period 2010-14 compared with 2005-2009, before declining in the period over 2015-19, when public expenditures grew more slowly than nominal GDP. This resulted in an overall zero net increase in average annual public expenditure as a share of GDP between 2005-09 and 2015-19.Advertisement

Governments held overall spending in check, but social welfare costs on the rise

However, looking at the individual expenditure components, we see a more heterogenous picture. Structural increases in social payments were in the past being offset by lowered interest payments and personnel costs as well as cuts in public investment as a share of GDP.

The share of social payments in total expenditure rose over time from 44% on average in 2005-09 to 47.5% in 2015-19. Other expenditure areas have declined in relative significance, notably the share for interest payments, down to 4% in 2015-19, from 6% in 2005-09, investment (5.7% vs 7%) and personnel costs (21% vs 21.8%). Even though governments held overall expenditures in check pre-crisis, this was not true of all components of spending even then.

Looking at expenditure projections for forthcoming years, governments’ proposals to raise public investment and strengthen healthcare systems would reverse some past underinvestment in these areas; however, without proposing counterbalancing savings, this could set debt on an unsustainable trajectory.

Spending pressures vary across the euro area’s largest economies

The extent to which euro area governments will be affected by expenditure hikes varies across countries, as the examples of the four biggest economies show:

  • Germany may need to temporarily abandon strict expenditure controls to enhance public investment.
  • France may benefit from less significant demographic pressures than peers. Pressures on expenditure items outside of ageing-related costs appear more rigid for France, however. For instance, the share of employee compensation in GDP is much higher than that of peers.
  • Italy will be a major beneficiary of EU recovery funds over 2021-26 to enhance public investment and could benefit from further declines in interest payments as well as debt is rolled over at much-lower market rates than in the past. At the same time, high and rigid expenditures for pensions at 16% of GDP (12% is the average for the euro area) strain public finances while employment and labour-participation rates remain low.
  • Spain could significantly benefit from EU recovery funds to reverse recent underinvestment in capital spending. A key pressure-point in reforming Spain’s rising social expenditures relates to its weak labour market, with Spain having even before the corona crisis displayed the highest structural unemployment in the euro area (of about 14% in 2019).

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