Fiscal Consolidation in the Euro Crisis: Politico-economic and Institutional Causes 3030577678, 9783030577674

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Kai Guthmann

Fiscal Consolidation in the Euro Crisis Politico-economic and Institutional Causes

Fiscal Consolidation in the Euro Crisis

Kai Guthmann

Fiscal Consolidation in the Euro Crisis Politico-economic and Institutional Causes

123

Kai Guthmann Bern, Switzerland

ISBN 978-3-030-57767-4 ISBN 978-3-030-57768-1 https://doi.org/10.1007/978-3-030-57768-1

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© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Acknowledgements

This book corresponds to my doctoral thesis submitted at the Faculty of Business, Economics and Social Sciences of the University of Bern, Switzerland. It is dedicated to those who made it possible. From a mainly academic and professional perspective, I am deeply grateful to Prof. Dr. Klaus Armingeon, for his unwavering support and flexibility, to Prof. Dr. Uwe Wagschal, for his role as my second advisor, and to Dr. David Weisstanner, for being an outstanding colleague and co-author of other publications. From a more fundamental personal perspective I would like to thank my parents Eva and Bernhard Guthmann, my sister Anke Lütkepohl, my nephew Joris and my niece Fine, and my friend Carolina Voß. Last but not least, I am grateful to many others who, in one way or the other, did play a role in enabling me to finish this book, such as, to name just a few, Carolin Rapp, Franzisca Schmoker, Bianca Lüthi, and Mandy Beeler.

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Contents

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1 7 11 12 13 14 15 16 18 19

2 Fiscal Adjustment in Europe . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 The Concept of Austerity in the Context of the Euro Crisis 2.2 Operationalization of Austerity . . . . . . . . . . . . . . . . . . . . . 2.3 Data and Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Sample and Observation Period . . . . . . . . . . . . . . . . . . . . . 2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Planned (2-Year) Fiscal Policy Stances . . . . . . . . . . 2.5.2 Occurrence and Size of Austerity Plans . . . . . . . . . . 2.5.3 Plan Realization in the Euro Crisis . . . . . . . . . . . . . 2.6 Chapter Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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36 36 42 46 52

3 Theoretical Framework: Austerity’s Institutional Origins . . . 3.1 Economic and Politico-economic Roots of the Argument . 3.2 The Politico-economic Trilemma of EMU . . . . . . . . . . . . 3.3 Intra-EMU Diversity as an Imbalance of Capitalisms . . . . 3.4 An EMU Economic Regime Common to All . . . . . . . . . . 3.5 The Euro Crisis: Institutional Misfit and Its Consequences

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55 59 66 69 78 82

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Research Questions, Object of Study, and Relevance 1.2 Theoretical Framework and Argument in Brief . . . . . 1.2.1 Capitalist Diversity in the EMU . . . . . . . . . . 1.2.2 EMU’s Economic Regime . . . . . . . . . . . . . . 1.2.3 Institutional Roots of the Euro Crisis . . . . . . 1.2.4 Constrained Policy Options . . . . . . . . . . . . . 1.2.5 Enforcement . . . . . . . . . . . . . . . . . . . . . . . . 1.2.6 EMU Versus Democracy . . . . . . . . . . . . . . . 1.3 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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3.6 Trilemma at the Country-Level: Who Has to Consolidate? 3.6.1 Export-Led Growth Models with NIIP Surpluses . . 3.6.2 Demand-Led Growth Models with NIIP Deficits . . 3.7 Hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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4 Empirical Analyses: Intra-EMU Heterogeneity and Austerity . . 4.1 Determinants of Macroeconomic Imbalances . . . . . . . . . . . . . 4.2 Determinants of Austerity in the Euro Crisis—Descriptive Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Determinants of Planned Fiscal Stances . . . . . . . . . . . 4.2.2 Determinants of the Initiation and Size of Austerity Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Determinants of Austerity in the Euro Crisis—Regression Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Main Explanatory Variable(s) and Multicollinearity . . . 4.3.2 Regression Models of Planned Fiscal Stances . . . . . . . 4.3.3 Regression Models of the Initiation of Austerity Plans . 4.3.4 Regression Models of the Size of Austerity Plans . . . .

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114 114 116 125 128

5 Adjustment by Force: The Realization of Austerity . . . . . . . . . . . . . 133 5.1 Descriptive Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 5.2 TSCS Models of the Realization of Austerity . . . . . . . . . . . . . . . . 137 6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Appendix A: Dataset of Fiscal and Economic Plans . . . . . . . . . . . . . . . . . 163 Appendix B: Variables, Operationalizations, and Data Sources . . . . . . . 169 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Abbreviations

AMECO BoP CA CAB CAPB CC CME CrC DG ECFIN EAP EC ECB EDP EMS EMU EPL ERM EU EU15 EU25 EUR FE FRI GBY GDP GLS GR IMF ISO LDV

Annual Macro-Economic Database of the DG ECFIN Balance of Payments Current Account Cyclically Adjusted Balance Cyclically Adjusted Primary Balance Comparative Capitalism Coordinated Market Economy Crisis Case Dummy Directorate-General for Economic and Financial Affairs of the EC Economic Adjustment Program European Commission European Central Bank Excessive Deficit Procedure European Monetary System Economic and Monetary Union of the EU Employment Protection Legislation European Exchange Rate Mechanism European Union The 15 member countries of the EU as of 1995–2004 The 25 member countries of the EU as of 2004–2006 Euro (Currency) Fixed Effects Fiscal Rules Index Government Bond Yields Gross Domestic Product Generalized Least Squares Great Recession International Monetary Fund International Organization for Standardization Lagged Dependent Variable

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LME MIP MME NIIP OB OCA OECD OLS PCSE PMR pp. RE SCP SGP TSCS ULC USD VoC WW1 WW2

Abbreviations

Liberal Market Economy Macroeconomic Imbalance Procedure Mixed Market Economy Net International Investment Position Overall (Headline) Budget Balance Optimum Currency Area Organisation for Economic Co-operation and Development Ordinary Least Squares Panel-Corrected Standard Error Product Market Regulation Percentage Point Random Effects Stability and Convergence Programs Stability and Growth Pact Time-Series Cross-Section Unit Labor Costs United States Dollar (Currency) Varieties of Capitalism First World War Second World War

List of Figures

Fig. 2.1 Fig. Fig. Fig. Fig. Fig.

2.2 2.3 2.4 2.5 2.6

Fig. 2.7 Fig. 3.1 Fig. 3.2 Fig. 3.3 Fig. 3.4 Fig. 4.1

Overview of approaches to austerity conceptualization and operationalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Planned Fiscal Stances over time . . . . . . . . . . . . . . . . . . . . . . . Planned and Actual Fiscal Stances by time period . . . . . . . . . . Proportion of Fiscal Stances qualifying as Austerity Plan . . . . . Average Size of Austerity Plans over Time . . . . . . . . . . . . . . . Realization of Austerity Plans over time (based on % of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realization of Austerity Plans over time (based on %-change in absolute spending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The politico-economic trilemma of EMU . . . . . . . . . . . . . . . . . The politico-economic ‘non-trilemma’ of EMU for export-led economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Development of CA balances in EMU countries 1970–2014 . . The politico-economic trilemma of EMU for demand-led economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporatism (Siaroff) and the 1999–2009 change in NIIPs . . . .

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29 41 43 44 45

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48

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51 66

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91 95

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.. 97 . . 108

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List of Tables

Table 1.1 Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 2.5 Table 2.6 Table 2.7 Table 2.8 Table 2.9 Table 3.1 Table 3.2 Table 3.3 Table Table Table Table

3.4 3.5 3.6 3.7

Table 3.8

Actual nominal spending cuts and real growth in the EU25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Planned 2-year Fiscal Stances in the EU from 1992 to 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Univariate statistics for selected fiscal stance and economic variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Planned Fiscal Stances by time period . . . . . . . . . . . . . . . . . Occurrence and average sizes of Austerity Plans 1992–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occurrence and average sizes of Austerity Plans by time period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realization of Austerity Plans (based on % of GDP) . . . . . . Realization of Austerity Plans (based on % of GDP) by time period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realization of Austerity Plans (based on %-changes in absolute spending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realization of Austerity Plans (based on %-changes in absolute spending) by time period . . . . . . . . . . . . . . . . . . Corporatism (Jahn) and VoC types within EMU, 2007 and 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporatism (Siaroff) and centralized wage bargaining index, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . OECD employment protection legislation index (version 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business and regulatory environment . . . . . . . . . . . . . . . . . . Growth models by export shares according to Hall (2012) . Average inflation rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Growth models: export shares pre EMU adjusted by population size and surface area . . . . . . . . . . . . . . . . . . . Development of prices, wages, and labor productivity during EMU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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5

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38

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49

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51

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72

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72

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73 74 75 76

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77

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Table 3.9 Table 3.10 Table 3.11 Table 3.12 Table 4.1 Table 4.2 Table 4.3 Table 4.4 Table 4.5 Table 4.6 Table 4.7 Table 4.8 Table 4.9 Table 4.10 Table 4.11 Table 4.12 Table 5.1 Table 5.2 Table 5.3 Table 5.4 Table 5.5 Table 5.6 Table 5.7 Table 5.8 Table 5.9

List of Tables

Development of unit labor costs (ULC) during EMU . . . . . Growth models: export shares during EMU adjusted by population size and surface area . . . . . . . . . . . . . . . . . . . External imbalances: development of NIIPs during EMU . Internal balances: development of unemployment rates during EMU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annual correlation coefficient between corporatism and NIIPs before and during EMU . . . . . . . . . . . . . . . . . . . Regressions of NIIP levels on interactions of corporatism/growth models with EMU . . . . . . . . . . . . . . . . . Correlation between NIIP and planned fiscal stances by EMU membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EMU mean fiscal policy stances by NIIP surplus/deficit and period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Correlations between NIIP and the occurrence and size of Austerity plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regressions of fiscal stances, economic base models . . . . . . Regressions of fiscal stances, EMU imbalance of capitalisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marginal effects of changes of the NIIP on fiscal stances . . Regressions of overall budget balances . . . . . . . . . . . . . . . . Marginal effects of changes of the NIIP on the budget balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Logistic regressions of the occurrence of Austerity plans . . . Regressions of austerity plan sizes . . . . . . . . . . . . . . . . . . . . Austerity plan realization by NIIP, EMU, and time period (based on % of GDP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plan realization by NIIP, period, EMU (based on %-ch nominal spending) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regressions of realization errors (% of GDP), economic base models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regressions of realization errors (% of GDP), EMU imbalance of capitalisms . . . . . . . . . . . . . . . . . . . . . . . . . . . Economic characteristic of crisis- and non-crisis-cases . . . . . Regressions of realization errors (% of GDP), FRI . . . . . . . Regressions of realization errors (% of GDP), government partisanship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regressions of realization errors (% of GDP), elections . . . . Marginal effect estimates for Tables 5.6, 5.7, and 5.8 . . . . .

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84

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86 87

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95

. . 107 . . 110 . . 112 . . 112 . . 113 . . 117 . . 120 . . 122 . . 123 . . 125 . . 127 . . 129 . . 134 . . 136 . . 138 . . 140 . . 144 . . 146 . . 147 . . 149 . . 150

Chapter 1

Introduction

In July 1926, Raymond Poincaré—then returning to power as the prime and finance minister of a national unity government of the French Third Republic—ended a period of severe political instability and economic uncertainty. After a multi-year political impasse between left and right about the appropriate level of public spending and taxes, he embarked on austerity, and resolved the ‘crisis of the franc’, thereby preparing the country for the reconstructed interwar gold standard (Eichengreen, 2008b, p. 54). 57 years later, in 1983, the moderate wing of the French Socialist Mitterrand government effectively put an end to the 2-year long ‘French Experiment’ of left-wing economic reforms and expansionary fiscal policies. Under pressure of massive reserve losses in the context of a strictly monetarist German Bundesbank engaged in tightening its monetary policy to curb domestic inflation, the French government, under the leadership of finance minister Jacques Delors, reversed course and initiated a program of fiscal consolidation.1 It thereby managed to avoid another devaluation of the franc against the Deutschmark (it would have been the fourth such measure within less than two years) and was able to preserve the country’s membership in the European Monetary System (EMS) (Eichengreen, 2008b, p. 160 ff.; Gourevitch, 1986, p. 185 ff.). Another 30 years on it was François Hollande presiding over a French Socialist Government’s economic policy U-turn, when politico-economic circumstances compelled him to renege on the far-reaching expansionary promises of his 2012 presidential campaign, and he embarked on fiscal austerity. Just as in 1983, the moderate wing of the Socialist party regained control, and, with the appointment in 2014 of former investment banker Manuel Valls as the Minister of the Economy, started to bring economic and fiscal policies better in line with the country’s

The terms fiscal consolidation, fiscal adjustment, and austerity are used interchangeably in this thesis.

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© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 K. Guthmann, Fiscal Consolidation in the Euro Crisis, https://doi.org/10.1007/978-3-030-57768-1_1

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powerful external monetary constraint—now called the Euro (Economist, 2014; Financial Times, 2014). The thesis at hand is not a study of French history. What these examples are supposed to illustrate is that there are historical patterns in economic and fiscal policy making that for some reason and to some degree tend to repeat themselves. While I am explicitly not intending to make a deterministic proposition about the French case being forever doomed to failing left-wing expansionary experiments making way for economically orthodox austerity drives, there may still very well be some structural, historical, path dependent explanation for why the French Republic has struggled so often with keeping its promise of a fixed exchange rate and with bringing its economic, social, and especially fiscal policies in line with the socio-economic imperatives of its respective monetary arrangement. And what may be true for France may be true for other countries as well. As it turns out, much of the politico-economic logic underlying the examples above is highly relevant for the delicate situation and uncertain future the Eurozone is facing today. The crisis of the European monetary union that followed on the heels of the global financial crisis originating from the United States, has laid open for everyone to see the profound external constraints for economic, social, and fiscal policymaking in the countries constituting the Eurozone. As so often in the past, financial markets and supra- or international organizations such as the European Union (EU) and the International Monetary Fund (IMF) were blamed as the main culprits interfering with domestic politics and even democracy itself, when imposing harsh internal devaluation and fiscal adjustment programs that appear to condemn whole societies to prolonged recession and decline, poverty and mass unemployment. As the examples on the French case suggest, however, the macroeconomic imbalances that demand correction through painful programs of economic adjustment at least partially have structural roots, deeply entrenched in countries’ politico-economic institutional fabric. And both in 1983 and 2013— although much less so in 1926—Germany may serve as the counterexample of a country with considerably more leeway to design policies based on domestic economic necessities and political preferences. For so many others, however, despite their very diverse political systems, traditions and cultures, power configurations and preferences, the multidimensional crisis of 2008-today has eventually yielded a very common response: austerity (Armingeon, 2012b)! This is the first puzzle motivating this thesis: how come that cross-country heterogeneity and partly very different types of economic problems can yield such a common response? The second puzzle revolves around the observation how widespread and how sizable austerity has actually been in response to the crisis. To see this, one must acknowledge how hard European economies were actually hit by their own idiosyncratic version of this international, multi-faceted crisis, and how deep their economic, but also political malaise against the background of the “uneasy halfway house” (O’Rourke, 2011, p. 11) called EU actually is. What came disguised as a financial crisis when it swept over the Atlantic and transformed into the Great Recession, turned out to be the worst economic downturn since the 1930s in

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Europe. Behind the ensuing sovereign debt crises, the offshoots of which continued to rage for years in countries like Greece, Portugal, or Spain, linger veritable and systemic balance-of-payments (BoP) crises, which have plunged the EU into what is arguably the most existential crisis since its founding with the ‘Treaty of Rome’ some 60 years ago. Although as of 2017 it doesn’t regularly make its way into the evening news anymore—now being overshadowed by the refugee crisis, by rising populism, the looming Brexit, or the crisis of democracy in Hungary and Poland— and although the most vigorous austerity squeeze seems to have somewhat abated, many observers agree that this crisis of the common currency is far from over. And the outcome of the 2016 constitutional referendum in Italy, Spain’s never-ending political stalemate in trying to form a new government in 2015/2016, or the temporary fear of another populist gaining power in the 2017 presidential election in France keep reminding us that even the most pessimistic voices in this debate may have a point. For them, in both economic and political terms not only the future of the Eurozone but also that of the EU as a whole may be in doubt (Höpner & Lutter, 2014; Scharpf, 2014, 2015; Stiglitz, 2016; Streeck, 2015b). Any honest analysis must therefore acknowledge the very difficult context the Euro crisis presents for initiating and successfully implementing economic adjustment and austerity policies.2 To be more specific, first, growth, usually one of the most potent catalyzers for successful fiscal consolidations (Alesina & Perotti, 1996), remained severely depressed over a very long period of time, partly exacerbated by austerity packages themselves, thereby creating mass unemployment levels not seen since the Great Depression. Second, while the European Central Bank (ECB) has eventually eased monetary policy considerably to support aggregate demand in the Eurozone, the transmission mechanism to translate low ECB policy rates to low financing rates in the most crisis-ridden peripheral countries became defunct as a result of the crisis (Al-Eyd & Berkmen, 2013). Until this day, fractured EMU financial markets, weak banks, and political and economic uncertainty continue to constitute formidable obstacles for a comprehensive resumption of lending to businesses on similar terms across all countries comprising the Eurozone. At least until the start of quantitative easing in early 2015, monetary policy therefore also failed to rekindle growth on a sustained basis. Third, exchange rate policy in the form of a currency devaluation—usually the first choice to solve BoP-crises, support fiscal adjustments, and mitigate their recessionary consequences—is inherently unavailable for EMU members sharing a common currency (Frankel & Rose, 1996; Obstfeld, 1983, 1997a). Fourth, efforts to fight the recession through deficit spending were short-lived at best and restricted to very few countries (Armingeon, 2012b). This seems not too surprising for those nations facing a sovereign debt crisis. But even in countries such as Germany, which in principle would have considerable leeway to pursue a more expansionary policy and thereby

While austerity, or fiscal adjustment, refers to a consolidation of the finances of the public sector, the term economic adjustment describes a consolidation or rebalancing of the entire economy of a given country.

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Introduction

support growth and mitigate adjustment burdens in peripheral countries through the trade channel, fiscal policy remained rather restrictive (Copelovitch et al., 2016). Finally, possibly also as a result of the crisis itself, many countries have witnessed not only a very high degree of political instability and thus uncertainty in the wake of the Great Recession, but also an erosion of political and societal support for economic adjustment and austerity, and thus exhibit a lack of local ownership for reforms—usually another important ingredient of successful reforms/fiscal consolidations (Blavoukos & Pagoulatos, 2008; Drazen 2002). Eventually, as national sovereignty is perceived as being undermined, and unemployment levels continue to stagnate at very high levels, the crisis may even evolve into a full-scale crisis of democracy in some member states of the European Union (Armingeon & Guthmann, 2014; Armingeon et al., 2015, 2016b). Based on such an unfavorable environment, much of the traditional fiscal consolidation literature would predict rather few and ultimately unsuccessful—often defined as unsustainable—fiscal consolidation plans and polices, be it as the direct effect of this hostile environment, or as second-order effects of the recessionary consequences of fiscal adjustment itself (e.g. Alesina & Ardagna, 1998; Alesina & Perotti, 1996; Ardagna, 2004; Heylen & Everaert, 2000; Mulas-Granados, 2005; Von Hagen & Strauch, 2001). But this is not what is happening. Rather—almost against all odds—what we observe (and what this thesis will show) is something very different: the Euro crisis has seen not only a very large number, but also extremely ambitious consolidation plans and packages. Actually, it culminated in some of the harshest fiscal consolidation programs ever envisaged and implemented in modern history. Consider the following: A layperson without any background in the social sciences would probably first and foremost think of an austerity measure as an instrument that reduces government spending. Moreover, suffering from money illusion (Shafir et al., 1997), she would probably think of it in nominal terms, say from a government budget of 108 billion Euros in one year, down by 20 billion to 88 billion Euros in the next year, which would constitute a very substantial 18.5% cut. Now this view does not reflect reality. First—leaving aside for now the fact that an austerity measure doesn’t need to constitute a spending reduction at all (it could also be achieved through raising revenue)—there are usually no nominal cuts. Most of the time cuts are only visible in real terms—i.e. after being corrected for inflation. Second, when there is a nominal cut in absolute Euro spending, this is usually at least partly offset by economic growth, so that spending in percent of GDP (the most common operationalization) may still not decline or may even rise. In normal times, there are no nominal cuts when there is a recession. Times are not quite normal, though. As it turns out, in the wake of the Euro crisis we’ve seen very substantial nominal cuts to government spending, and most of the time these were implemented right in the middle of a recession. Actually, the substantial 20 billion Euro spending cut just mentioned is not a random number: these are the respective figures for Greece in 2013/2014 (see Table 1.1). Table 1.1 shows all cases when absolute nominal government spending decreased for more than one year in a EU25 member country between 1970 and 2015 (operationalizations and sources provided in the appendix). Cases when

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Table 1.1 Actual nominal spending cuts and real growth in the EU25 Country

Time period

D absolute nominal gov. spending [1] (%)

Real GDP growth [2] (%)

[1] + [2] = [3]

United 1985–1990 −1.0 17.7 0.167 Kingdom Italy 1993–2000 −5.8 16.0 0.102 Latvia 1999–2001 −4.5 12.9 0.084 Sweden 1992–1997 −2.4 10.8 0.084 Germany 2003–2007 −2.3 9.1 0.068 Slovakia 2000–2004 −13.2 20.0 0.068 United 2009–2014 −3.0 9.0 0.06 Kingdom Sweden 1985–1987 −1.1 6.1 0.05 Spain 1993–1996 −5.2 7.2 0.02 Ireland 1987–1989 −9.2 10.7 0.015 Germany 2010–2012 −2.6 4.0 0.014 Ireland 1982–1984 −3.3 4.1 0.008 Denmark 2012–2014 −3.2 1.0 −0.022 −0.029 Latvia 2009–2012 −9.8 6.9 Slovenia 2011–2015 −4.8 0.5 −0.043 Netherlands 2010–2013 −3.6 −1.0 −0.046 Italy 2009–2015 −3.6 −1.7 −0.053 Greece 1985–1987 −3.5 −1.8 −0.053 Ireland 2010–2013 −9.7 2.6 −0.071 Spain 2009–2015 −7.1 −1.0 −0.081 Hungary 2006–2012 −10.0 −4.2 −0.142 Lithuania 2008–2012 −9.6 −4.6 −0.142 Hungary 1994–1996 −17.4 1.5 −0.159 Portugal 2010–2015 −13.0 −4.2 −0.172 Cyprus 2011–2015 −12.5 −9.8 −0.223 −11.0 −12.6 −0.236 Estonia 2008–2010 Greece 2009–2015 −30.7 −19.4 −0.501 Notes own calculation based on total spending in % of GDP, real GDP, and real GDP growth. Cases that fall in the Great Recession period are printed in bold. Consolidation episodes that can be considered expansionary are printed in italics. Variable operationalizations and sources provided in Appendix B

spending dropped in one year but returned to or above its previous level in the next are therefore excluded. Column [1] shows the change in nominal spending over the given time period, column [2] shows aggregate real growth over that period, and the far right column is the sum of these two measures as a very rough proxy for whether the consolidation episode was contractionary or expansionary in the aggregate (I am not asserting any cause-and-effect relationship between spending

6

1

Introduction

and growth at this point). The table is sorted according to this measure in column [3]. Note that these sums are not unlikely to even give a too optimistic picture, because spending is measured in nominal but growth is measured in real terms. As can be seen, there are only two cases of contractionary consolidation episodes that do not fall at least partly in the time period of the Great Recession: Greece in 1985–1987 and Hungary in 1994–1996. Analogously, there are only two cases of fiscal adjustments during the Great Recession (all such cases are printed in bold) that could, again by this very rough measure, be considered expansionary. In other words, nominal spending cuts implemented in the midst of a recession is an almost entirely new phenomenon not seen in Europe before the Great Recession. In should also be noted that the cuts implemented in post-crisis Portugal, Cyprus, and Greece in particular, are extraordinary even if we look beyond the European experience to some of the worst crises in middle-income countries. For example, during the Argentinian Great Depression that started in 1998, absolute nominal spending initially continued to rise and then stagnated. Only in 2001–2002 there was a sharp 28.5% one-year drop, but that was reduced to minus 20% in 2003, and another two years later, in 2005, spending already exceeded pre-crisis levels. Moreover, while GDP dropped by 11% in 2001–2002, by 2004 it had grown to almost 6% above its 2001 level. Similarly, the 1994 Mexican ‘Tequila Crisis’ triggered only a one-year drop in spending and GDP. In 1996 already, both spending and GDP levels had recovered to pre-crisis levels.3 In contrast, in some of the Eurozone crisis countries spending and growth remained severely depressed even four or five years after the initiation of an austerity program. In conclusion, both the scope and the size of austerity programs initiated in response to the Euro crisis appear extraordinarily large when compared to other times and places. As these quite straightforward comparisons already make clear, something seems not quite right with the simplistic narratives sometimes dominating public debates on the crisis, revolving around spendthrift Southerners, watered-down austerity packages, ill-disciplined governments, missed targets or corrupt politicians (Hobolt, 2014; Picard, 2015). Any divisive, blame-shifting rhetoric of prudent northern taxpayers having to bail out profligate Southerners misses the point. This picture is incomplete at best—if not utterly wrong. In fact, as I will show in detail below, for the post-2009 period, being a Eurozone country with a large BoP-deficit not only virtually guaranteed the initiation of an austerity program (almost 90% of the relevant cases sketched out such a plan), but these programs also tended to be much larger than anything witnessed in other countries and contexts. Even more strikingly, however, when systematically taking into account the extremely unfavorable—and often rapidly deteriorating rather than improving— politico-economic environment briefly sketched out above, the degree to which

3

Data on Argentinian and Mexican general government spending were sourced from the United Nation’s ECLAC (2016), while absolute nominal GDP figures come from the World Bank (2016a). Changes in spending and GDP are own calculations based on data from these sources.

1 Introduction

7

many of these very ambitious plans were actually realized is astonishing, especially in the Eurozone’s deficit countries hit hardest by the crisis. This observation is the third and final major puzzle motivating the investigation at hand. I will show in detail that in some cases, by some measures, governments even exceeded initial fiscal consolidation targets when it comes to plan realization. The Greek case already hinted to above may again serve as one of the most striking examples: Greece cut its nominal spending by 30 billion Euros from 117.8 in 2010 down to 87.6 billion in 2014 (sources for total absolute spending data provided in Appendix B). The respective nominal reduction in government spending foreseen by the Greek authorities in collaboration with the IMF and its EU partners based on the 2011 EAP, however, amounted to only 3.5 billion Euros (calculation based on the procedure introduced in Chap. 2, sources for planned spending data provided in Appendix A).4 In other words, by this measure Greece exceeded its initial target by a staggering 750%. In Chap. 2 I will elaborate in detail in how far European countries planned fiscal adjustments and were able to realize their plans. To conclude the preceding discussion for now, puzzlingly austerity became not only the only game in town (Armingeon, 2012b) after Europe was hit by the Great Recession. That game was also played as fervent as seldom before, and as things stand, it appears as if many countries have little choice but to keep playing it almost to the bitter end.

1.1

Research Questions, Object of Study, and Relevance

This thesis revolves around two main research questions. First, what explains the initiation and ambition (size) of fiscal adjustment plans and policies in the Euro crisis? This will help understand why there has been so much austerity in the periphery of the Eurozone, in countries such as Spain, Portugal, Greece, or Ireland, but relatively little in its core, such as in Germany, Austria or the Netherlands, for instance. Chapter 2 will provide an overview of all fiscal adjustment episodes under investigation. Second, what explains that some governments succeed in realizing their consolidation plans, while others fail to do so? By implication, this will also shed light on those factors that have only little or no explanatory power at all in the peculiar context of the Euro crisis. From 2008 onwards, Europe was hit by not just one but many very complex and multi-faceted crises, which in their characteristics and intensity varied considerably both over time and across countries (see e.g. Lane, 2012). To name just a few, there was the U.S. subprime mortgage crisis spreading to and exacerbating the bursting of the housing/investment bubbles in Ireland and Spain, the concomitant banking

This figure must not be confused with the sum total of austerity measures deemed necessary to achieve the plans/projections with regard to all fiscal and economic variables.

4

8

1

Introduction

crises, the structural growth crisis in Italy, and the Great Recession in almost all European countries. Arguably however, the structural crisis of the common currency sits at the core of many of the other crises and can to a substantial degree explain their depths and persistence. Without it, Europe’s economic woes may even have been solved long ago. As the phrasing of my research questions already makes clear, the analytical focus of this thesis is therefore of course—first—on the Euro crisis. In other words, in the analysis that follows, the very specific politicoeconomic context in which austerity programs are being initiated and implemented is explicitly taken into account. This is a first factor from which the study at hand draws its relevance. Arguably, it is only through the explicit theoretical and empirical acknowledgment of context, that the two empirical puzzles hinted to above—which appear to contradict some earlier research on the topic—may be resolved. When it comes to crisis response and resolution, that Euro crisis eventually triggered comprehensive reforms at virtually all levels of Europe’s multilevel system of governance. Most visible among these are the so-called Economic Adjustment Programs (EAP) designed for those countries that had to seek financial assistance from the IMF and their EU partners. In return for multi-billion Euro bailouts, these EAPs compel recipient countries to implement profound and often politically highly sensitive reforms spanning multiple policy areas, which may in some cases take decades rather than years to complete. For example, the 2011 Portuguese EAP alone lists close to 700 policy measures to be implemented by the Portuguese authorities, divided up into nine reform areas across all administrative levels and sectors of the economy, compliance with which is monitored in a total of eleven, usually semiannual, reviews.5 The analytical focus of this thesis, however, is—second—exclusively on fiscal consolidation plans and their realization, as defined and operationalized in Chap. 2. Austerity is not only the most visible and politically salient response to the crisis, but clearly also the most consequential with the regard to the impact it has on crucial economic and social variables that affect people’s lives more generally. Any endeavor that strives to understand this episode of extreme crisis-induced austerity must therefore quite naturally be of high relevance to both the academic and public debate. While the economic, administrative, or social reforms implemented in a specific country as part of an EAP or autonomously are not analyzed in any detail in the thesis at hand, these can arguably at least partially be considered part of the same ‘package’—drawn up and implemented not least to promote and facilitate the process of internal devaluation/ austerity and economic adjustment. In consequence, the findings of the study at hand may very well be generalizable to such reform areas as well. Third, the analytical focus of this thesis is on fiscal adjustment from an outcomes perspective. That is, I will not examine in any detail the specific policy measures drawn up to achieve a consolidation, and explore if and why policymakers succeeded or failed to properly implement them—i.e., a policy implementation

5

Own calculations based on documents sourced from the European Commission (2016a).

1.1 Research Questions, Object of Study, and Relevance

9

perspective. Rather, it is about why they specified an austerity program in terms of a given quantitative fiscal outcome (still the outcome of very specific policy measures of course), and succeeded or failed to realize what they had promised in terms of these outcomes. A possible ‘realization failure’ may very well be the result of incomplete policy implementation, but may also result from other factors, such as the poor economic environment, a non-accommodative monetary policy, from low inflation or insufficient recourse to debt restructuring, among others. To some degree, this outcomes perspective is certainly motivated by pragmatism and parsimony. Given that most EAP’s essentially aim at a comprehensive re-balancing of the entire economy, and in light of the immense density of very diverse reforms with often rather intractable direct and indirect fiscal consequences, evaluating thorough implementation of each and every policy measure would warrant a much more in-depth examination, that is outside the scope of the analysis at hand. More importantly, however, as much of the fiscal consolidation literature has repeatedly shown (see e.g. Alesina & Ardagna, 1998; Alesina & Perotti, 1996; Hallerberg, 2000; Heylen & Everaert, 2000), and as this crisis illustrates as clearly as few did before, even the most thorough implementation of spending cuts or tax increases may not suffice to consolidate public finances on a sustained basis. If we want to know why such consolidations come about and can be realized or not, we have no choice but to look beyond mere policy implementation. This is a third factor from which the study at hand draws its relevance, especially for the general public: it starts from what is most consequential for people’s lives—the outcomes of polities, politics, and policies—and does not restrict itself to policy implementation—as only one among many other factors that may or may not have brought these outcomes about. Finally, the thesis at hand aims at uncovering the underlying causes rather than the sources of austerity. Arguably social scientists sometimes happen to end up identifying not much more than the superficial sources of what they intend to explain. This may be a consequence of the academic reality: to advance our academic career, we need to get published as much and as high-ranking as possible, and to be able to do that, we need results that have some significance—and in the quantitative social sciences this usually implies statistical significance. Thankfully, any direct source triggering a given phenomenon tends to be strongly correlated with that phenomenon (e.g., budget deficits lead governments to announce a fiscal adjustment plan). In many cases, however, that trigger may be a mere symptom of an underlying cause. Our statistical effect estimates help us tracing that symptom, but not necessarily the cause.6 In the words of Mancur Olson in his famous example about the sources versus the causes of growth: “[…] they trace the water in the river to the streams and lakes from which it comes, but they do not explain the rain” (Olson, 1982, p. 4).

6

See Morgan and Winship (2007) or Angrist and Pischke (2009), for instance, for a thorough discussion of the difficulties involved with linking causes and effects.

10

1

Introduction

Applied to the peculiar context of the Euro crisis, many of the variables that are usually held accountable for the occurrence, size, or success of fiscal consolidation programs—or, for that matter, of many other economic policy choices—are, as I will argue below, the symptoms and outcomes of more deep-rooted, structural causes. To fully understand these causes, however, we not only need to know why deficits occurred in the first place, but also why growth was poor in the first place, for instance, or why real interest rates were too low a couple of years ago but are too high now, why Eurozone price levels diverged so markedly despite a common monetary policy, why national governments in the periphery could not bring wage growth under control, why banks had lend too aggressively in the past, but are unable now to translate low ECB rates into cheap credit for small businesses in need. We may attempt to model such immensely complex conditional relationships, but when trying to test them based on a sample of just 28 highly interdependent EU or as few as 15 EMU countries, we quickly reach the limits of even the most sophisticated among our statistical methods. Contrary to what my research questions may suggest, I therefore do not intend to search for the collection of independent variables that offer—in statistical terms— the most complete explanation possible for the variance in fiscal adjustment variables. Neither do I indent to statistically isolate and estimate as precisely as possible all their respective effects. Rather, I intend to focus on the few major underlying structural causes of austerity in the Euro crisis and to show that these alone go a long way in explaining both the variance in the main dependent variables as well as the more immediate sources of that variance. This is a final factor from which the study at hand draws its relevance, which also makes this a somewhat interdisciplinary approach. Oftentimes, variables such as budget deficits, debt, and fiscal consolidations are treated as purely economic phenomena that are best explained based on the variances of some other economic variables. In consequence, the study of such things as monetary arrangements, exchange rates, capital flows, or countries’ balance of payments tends to be left to the economics professions, leaving political scientists with what little there is still unaccounted for in the variance of some dependent variable after all these powerful economic factors have been included. Unfortunately, what they often tend to find is that there is not much left to explain, and that many political variables only have a negligibly small effect, if at all. What I contend in this thesis, is that many of these powerful economic variables are not so much the cause, but mere sources derived from some underlying phenomena, and these phenomena, in turn, are deeply political in nature, deeply entrenched in counties historically grown politico-economic institutional fabric. This ought to become much clearer shortly, when I summarize the main argument of my thesis.

1.2 Theoretical Framework and Argument in Brief

1.2

11

Theoretical Framework and Argument in Brief

My main argument has theoretical roots in both political science as well as economics. With regards to economic theory, it mainly revolves around an extension of the so-called ‘Impossible Trinity’ from New Keynesian macroeconomics, which describes the policy trilemma that fixed-exchange rates, capital mobility, and monetary autonomy cannot be attained simultaneously (Fleming, 1962, 1971; Mundell, 1961, 1962, 1963). Today being discussed most prominently in the context of the theory of Optimum Currency Areas (OCA), which has attracted renewed academic interest since the onset of the Eurozone crisis, the MundellFleming trilemma presents the most straightforward explanation for why intra-EMU monetary policy had to be unified at the level of the ECB in the first place (De Grauwe, 2013; Krugman, 2012b). Extending the impossible trinity to the political sphere, the economist and political scientist Eichengreen (2008b) describes a trilemma between fixedexchange rates, capital mobility, and democracy. In other words, here not only monetary autonomy needs to be sacrificed in an EMU-like monetary regime, but national autonomy with respect to virtually all policy areas—from economic and fiscal, to redistributive social and welfare state policy, for instance—may have to be given up as well. By implication, democracy itself may lose out if fixed exchange rates and capital mobility are to be attained and upheld. Eichengreen himself traces his argument as far back as to Polany’s (1944) presumed inherent incompatibility between democracy and the market, which the latter developed in his groundbreaking book ‘The Great Transformation’. In Polany’s times, ‘the market’ was— besides the prevalence of laissez-faire capitalism, underdeveloped welfare state institutions, and the first globalization wave prior to World War I (WW1)—most prominently characterized by the Gold Standard in one of its many versions. ‘Incompatibility of democracy with the market’, so defined, therefore stemmed in large part from the painful policy implications that strict adherence to the Gold Standard had for the adolescent western democracies. Recalling the volatile economic and political developments at those times, which eventually had consistently culminated in the collapse of the respective regime of fixed-exchange rates, it is not too surprising that the Euro of today is sometimes compared to the Gold Standard of the pre-WW1 or interwar years (Economist, 2010, 2011). A third very similar trilemma was more recently developed by Rodrik (2011) and has globalization, the nation state, and democracy as its three mutually exclusive objectives. This was taken up and applied to the Eurozone crisis context by Crum (2013), who has the EMU replace globalization as one of the three nods— with the nation state and democracy remaining as the other two. As long as the EMU remains intact in this trilemma—which, at least in normal times, also implies that two objectives of the Mundell-Fleming trilemma are attained: namely fixed exchange rates and capital mobility—either the nation state (i.e., national diversity) or democracy loses out.

12

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Introduction

Although it does so at a rather high level of theoretical abstraction, Crum’s (2013) simple trilemma essentially illustrates all the major constraints and tradeoffs, and concomitant difficult choices, Europe is facing today. I will therefore develop from it a politico-economic trilemma of EMU serving as the overarching theoretical framework of this thesis, mainly utilized to embed in it the various strands of my argument and to derive empirically testable hypotheses about which variables under which conditions ought to—or ought not to—affect the initiation, size, and realization of austerity in the Euro crisis. While Crum discusses his trilemma mainly at its most general level—i.e., for the EU/EMU as a whole—I will eventually also bring it down to the country level, in order to lay out in detail for which country, under what conditions, the severe constraints implied by the trilemma become acute or remain dormant. My main argument, which for the most part has its origins in the various strands of the comparative capitalism (CC) literature (see Nölke (2015) for an overview) can be divided into six components and is introduced briefly below.

1.2.1

Capitalist Diversity in the EMU

The first component of the argument is firmly rooted in comparative capitalism research and historic institutionalism and has been thoroughly discussed in the maturing debate on the causes of the Euro crisis already (Nölke, 2015). In essence it contains the acknowledgement that there is some considerable heterogeneity in the European varieties of capitalism (Höpner & Schäfer, 2012) that has important repercussions for the inner workings of the Euro, which have prematurely been neglected by economic theory and the architects of EMU alike. This capitalist heterogeneity has deep historic origins, reflecting long-grown idiosyncratic national traditions, cultures, and norms, and is therefore reflected in path dependent and very sticky political, economic, and social institutions. Ultimately it is this heterogeneity that made possible not just such seminal contributions as Lijphart’s ‘Patterns of Democracy’ (Lijphart, 1984, 1999, 2012), or Esping-Andersen’s ‘Worlds of Welfare’ (Esping-Andersen, 1990), but it is also what the whole comparative capitalism literature is trying to make sense of. At this point it is less important, what dimensions can best describe that diversity—be it Varieties of Capitalism’s early distinction between coordinated (CMEs), liberal (LMEs), and mixed market economies (MMEs) (e.g. Hall & Soskice, 2001; Hancké et al., 2007), for instance, or the more recent juxtaposition of export- versus demand-/consumption-led growth models (e.g. Baccaro & Pontusson, 2016). What is important, is that Europe is in effect characterized by a serious and structural “imbalance of capitalisms” (Johnston & Regan, 2015) that directly translates into and manifests itself in an imbalance in terms of the economic outcomes of those capitalisms—the most relevant in the context of this thesis being price level and thus real exchange rate developments.

1.2 Theoretical Framework and Argument in Brief

13

Accepting persistent cross-national diversity as a given in the EU is a crucial first step in understanding the structural foundations of Crum’s (2013) trilemma and thus also the political economy of economic adjustment in the Euro crisis. If there was no diversity in institutions and outcomes, the era of European nation states may have ended long ago. Ongoing diversity explains why the nation state and the trilemma exist and persist, and why it extends so far beyond just the sphere of monetary policy as described by the model-world of Mundell-Fleming’s ‘Impossible Trinity’.

1.2.2

EMU’s Economic Regime

One of the centerpiece assertions of the VoC perspective is that no single type of capitalism is superior or inferior to the other when it comes to economic performance (Hall & Soskice, 2001, p. 21). This may be true in the open economy context, for stand-alone countries, but not so anymore when very different types of capitalism are united under the roof of a common, irrevocably fixed currency. EMU came not only with a new currency common to all, but also with a common set of institutionalized rules—an EMU economic regime—that some of the very heterogeneous national capitalist systems in the Eurozone would inevitably have a hard time adjusting to and complying with. In essence, EMU represents a certain type of capitalism in itself—or at least its institutional design favors one type of capitalism over another, and thereby confers a comparative institutional advantage to some, but a disadvantage to other Eurozone member states (Johnston, 2012; Johnston et al., 2014; Johnston & Regan, 2015; Stockhammer, 2011). As is mostly the case when new institutions come to life, the specific design of EMU in general, and the ECB in particular, represents the final outcome of a long chain of past decisions and events—i.e., path dependency (Mahoney, 2000; Pierson, 2000). More specifically, as a result of the historically grown—and ultimately also historic-institutionally conferred—hard currency status of the Deutschmark, bolstered by the size of the German economy and its concomitant economic and political power position in Europe, the German currency had served as the anchor of each and every one of the post-Bretton Woods European monetary arrangements (Eichengreen, 2008a). Consequently, not only was the ECB set up with the decidedly monetarist, non-accommodative Bundesbank in mind. Rather, EMU as a whole (with its focus on rules-based fiscal prudence as enshrined in the Stability and Growth Pact (SGP), for instance) was designed according to—and thereby set on a trajectory towards— a German model of running the economy (Schelkle, 2015, p. 138). In the words of Streeck, EMU by now effectively resembles a “European Consolidation State” geared towards export-led (i.e., German-style) growth (Streeck, 2010, 2014a, 2014b, 2015a; Streeck & Elsässer, 2014). Irrespective of their own idiosyncratic growth models and traditions, the members of this consolidation state are now forced to operate under a hard currency

14

1

Introduction

regime and compete on world markets alongside and against the traditional ‘export-powerhouse’ Germany. One of the key factors their economic performance depends on in this setting—now even more so than in the days of the EMS—is their ability (or inability) to keep up with German export-competitiveness—and in order to do so they would have to keep wage growth in check, but productivity improvements steady. Unfortunately, some countries simply never had the institutional prerequisites to do so (Hall, 2012; Höpner & Lutter, 2014; Höpner & Schäfer, 2012; Scharpf, 1986). This is the second component of my main argument: the diverse nation states joined together in the Eurozone are forced to operate their national economies according to a common set of rules embodied by EMU’s economic regime that in many cases is incompatible with their ‘more natural’, traditional type of capitalism (see e.g. Johnston & Regan, 2015).

1.2.3

Institutional Roots of the Euro Crisis

The preceding two subsections imply that there is a serious misfit between some of the multiple capitalist varieties joined together under the Euro on the one hand, and EMU’s economic regime common to all of its very diverse members on the other hand. With hindsight, this misfit not only explains why it was practically impossible to prevent the Euro crisis from happening—although the specific timing of its outbreak may have been different, had it not been for the subprime mortgage and concomitant global financial crisis sweeping over the Atlantic in 2008. More seriously, this misfit—both in its economic manifestations and their political, institutional, cultural roots—has actually helped create the Euro crisis in the first place, and now presents the most insurmountable obstacle for implementing an effective crisis response and resolution (Armingeon & Baccaro, 2012; Hall, 2012; Pisani-Ferry, 2014; Young, 2014). Unifying monetary policy at the ECB was meant to prevent divergent wage and price dynamics. When, as a result of the heterogeneous institutional underpinnings of European political economies, divergence occurred anyway, however, the common monetary policy actually reinforced divergence instead of preventing or mitigating it (Johnston & Regan, 2015). Right after the introduction of the Euro, relative prices and wages had started to diverge markedly across the currency union, resulting in the accumulation of substantial macroeconomic imbalances between the Northern European export- and the Southern demand-driven economies (Armingeon et al. 2016: 3, Hall 2012). Had it been possible during the first decade of EMU to tailor monetary policy to the individual needs of these emerging two camps—with higher interest rates constraining aggregate demand in the South, and lower rates to stimulate demand in the North—the buildup of Southern external indebtedness may have been prevented. Ultimately, however, and this is the core of the third part of my argument, the causes for the emergence of intra-EMU macroeconomic imbalances run deeper that just policy, all the way down to polities. In essence, the Euro crisis is a systematic

1.2 Theoretical Framework and Argument in Brief

15

crisis of a monetary union with insufficient institutional foundations and crisis resolution mechanisms (Copelovitch et al., 2016; Hall, 2012; Höpner & Lutter, 2014; Johnston et al., 2014; Lane, 2012). In economic terms, the crisis unfolds mainly as a BoP-crisis in the EMU peripheral countries, the most politically salient symptom of which is a debt and/or sovereign debt crisis (O’Rourke, 2011). In this sense, the Euro crisis bears considerable similarity with the crisis of earlier of monetary regimes, such as the gold standard of the interwar years, which contributed to the severity of the Great Depression and thereby arguably also the rise of fascism and even WW2, or the recurring crises of European monetary regimes. EMU’s current economic regime, with its ordoliberal ideological legacy and its rules-based framework geared towards constraining domestic demand, price and wage growth, serves only the Northern export-models (Brunnermeier et al., 2016; Young, 2014). The Southern peripheral economies, in contrast, are “struggling to cope with what for them [is] the novelty of a hard currency regime” (Streeck, 2014a, p. 107). Instead of getting rid of the monetary straightjacket attached to their earlier monetary anchor—the Deutschmark—they now effectively find themselves locked on to that anchor much tighter than ever before (Johnston & Regan, 2015)— with the only difference being that it is now called the Euro. Instead of promoting unity, as it was supposed to do, the Euro during its first decade mainly divided the union into creditors in the North, and debtors in the South.

1.2.4

Constrained Policy Options

If it was not for the Euro, the solution to the severe BoP-crisis which the Eurozone’s Southern peripheral countries have been facing after the onset of the Great Recession, would be relatively straightforward: currency devaluation to realign intra-EMU price levels and thereby restore Southern competitiveness in one stroke. Possibly there would also be some sovereign default or debt restructuring—usually not an uncommon solution of crises of this kind (Dalio, 2012; Kindelberger & Aliber, 2005; Reinhart & Rogoff, 2009). Under EMU’s current politico-economic regime, however, the policy options available to policymakers are severely constrained. First, not only is national monetary autonomy gone, but also common ECB monetary policy is not a particularly potent tool to stimulate aggregate demand in the most crisis-ridden economies. On the one hand, there have been substantial political reservations against a more accommodative monetary policy stance at least until Mario Draghi assumed the presidency of the ECB in November 2011. Indeed, his predecessor, Jean-Claude Trichet—fully in line with Germanstyle monetarist thinking—actually raised ECB policy rates twice right in the midst of the Euro crisis only months before Draghi took over, thereby making the economic situation of Southern deficit countries even more precarious (Eichengreen, 2015, p. 8). On the other hand, even when European monetary policy did turn expansionary, the transmission mechanisms to translate low ECB policy rate into cheap business lending in Southern Europe was defective as a result of the crisis

16

1

Introduction

(Al-Eyd & Berkmen, 2013). Second, not only was national fiscal policy severely constrained by the SGP, which was made even more stringent in the course of the crisis, but it was also severely constrained as a result of encompassing capital flight that resulted when doubts about the sustainability of Southern debt became widespread in financial markets. Finally, while financial assistance from European partners did arrive rather promptly, it fell well short of the horizontal transfers that OCA theory would deem appropriate to sustain the currency union—and assistance also came with way too many conditionalities. For one, this “much criticized Eurozone crisis management is the result of an ideological difference based on economic doctrines that are conditioned by a legacy of national varieties of capitalism” (Young, 2014, p. 136). From the perspective of political theory, on the other hand, this approach also is understandable, however, because any more far-reaching financial assistance or EU-wide collectivization of sovereign debt would lack democratic legitimacy in the creditor nations of the North (Crum, 2013). In consequence, the politico-economic context of the Euro crisis defines rigid boundaries for Southern national governments’ room of maneuver. The only remaining policy option to resolve their BoP-cum-debt crises is to engineer the most painful solution possible: BoP-adjustment must be achieved with an internal devaluation through domestic product and labor markets, which is quite naturally accompanied by austerity, recession, unemployment, and potentially even civil unrest. Moreover, in line with OCA theory there will be structural reforms in order to introduce more flexibility into the labor market so than prices and wages gain in (downward) flexibility, thereby accelerating the process of internal devaluation. In other words, when it comes to alleviating the immediate fiscal pressure emanating from capital flight in the BoP-crisis-context, austerity is the only remaining policy option available to policymakers. It becomes the only game in town (Armingeon, 2012a). In effect, then, Eurozone countries’ institutional heritage, as it manifests itself in their type of capitalist system as a demand- versus an export-led growth model, or a CME versus a MME, for instance, determines not only whether a country ends up with a BoP crisis or not, but also determines the options available to policymakers with respect to crisis response and resolution.

1.2.5

Enforcement

The fifth component of my argument concerns the enforcement of austerity and economic adjustment in the peculiar context of the Euro crisis. Note first, that ultimately it is the compatibility (institutional fit) of a national economy with EMU’s economic regime that determines which countries eventually has to adjust to it. Note second, that this regime currently clearly favors the export-led hard-currency countries alongside Germany, and that, third, the creation of any meaningful common fiscal capacity at the Eurozone level that could share the burden of adjustment more evenly among all EMU members is out of question in the current political context. In this situation, the politico-economic trilemma

1.2 Theoretical Framework and Argument in Brief

17

introduced above will bite with full force in deficit countries. That is, as long as macroeconomic imbalances persist, and the currency union is to survive in its current form and composition, austerity will have to be realized at all cost in the countries caught in a BoP-crisis. There are two main enforcement mechanisms. First, as capital is leaving BoP-crises countries in doubt about the solvency of both its public and private debtors, interest rates on newly issued sovereign debt climb to prohibitively high levels. Since national Eurozone have relinquished control over their money supply —it is in the hands of the ECB now—they have no other options left than to cut spending and/or raise taxes—i.e., engage in fiscal consolidation (De Grauwe, 2011). In principle, sovereign nations are no ‘Swabian housewives’—even though that metaphor is brought up by German policymakers from time to time (Bennhold, 2010). Sovereign countries could print their own money if needed, or they could default on their debt almost at will—which is why credibility is so important a factor in the sovereign bond markets. When it comes to their own currency and monetary matters more generally, EMU member countries however are no sovereign countries anymore. Their only choice is to either leave EMU or do exactly as the Swabian housewife would do when her money runs out: she implements austerity programs no matter what. Seen from this perspective, one could argue, that the metaphor of the ‘Swabian housewife’ should not be so easily dismissed, after all. However, ultimately it is precisely the dominant German power position within EMU, and the interplay between EMU’s German-style, ordoliberal, rules-based economic regime on the one hand, and intra-EMU institutional heterogeneity on the other, that works to degrade entire nations to ‘Swabian housewife status’. The chief enforcement mechanism for austerity in particular and economic adjustment programs more generally is therefore ‘external pressure’, which manifests itself mainly in the interest rate on sovereign debt. When the interest rate shoots up, austerity will be enforced. By now, however, BoP-deficit countries are quite well aware of their economic predicament and the ultimate causes of external pressure. In the end, the interest rate is therefore merely a symptom, a direct source of external pressure, just as IMF or Troika conditionality is just a source. The only reason for the IMF to offer financial assistance is that private capital has already left the respective country. The causes of pressure run deeper, beneath even the macroeconomic imbalances (i.e., the BoP-deficits) that lie at the heart of the Euro crisis. The ultimate explanation as to why certain countries have no choice but to implement and actually realize austerity is institutional. It is because they operate demand-led growth model in a non-optimal currency area that is dominated by, and operate according to rules that favors countries relying on export-led growth. A second enforcement mechanism is more subtle in its effects, and could be called ‘internal pressure’. As the term implies, it does not arise from any external imbalance, as the relevant country is still able to match its imports with sufficient exports, but from an internal imbalance, as it would most clearly be indicated by a persistently high unemployment rate. For standalone countries with flexible exchange rates, an internal imbalance would—as macroeconomic theory explains— also be mitigated by a depreciating currency (Krugman & Obstfeld, 2009).

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1

Introduction

Within EMU, however, this adjustment channel is blocked. If they wish to reduce unemployment, and restore their internal balance, countries may therefore have no choice but to deflate their economies by means of an internal devaluation and austerity program as well. France may be a case in point again. Historically, all of the French economic/fiscal policy ‘U-turns’ described above, were triggered not so much by external, but by internal imbalances. Each of the fiscal consolidation programs that followed, however, was accompanied by some form of currency devaluation—i.e., an ‘adjustment to the peg’. Since EMU, that policy option is gone. In consequence, when in 2012 a Goldman Sachs study indicated that the French economy has a devaluation need of about 20% relative to Germany (Höpner & Lutter, 2014, p. 2), it could have been expected that ultimately this can only be achieved by means of an internal devaluation in France, and comprehensive domestic economic reforms. Where France differs from BoP-deficit countries such as Greece, Portugal, Spain, or Ireland, is that it does not suffer from an external balance. External pressure in the form of skyrocketing interest rates is therefore unheard of in France. This may help explain why it took another four years of economic and political turmoil in France (which translates into a total of eight years since the start of the Great Recession), until French president Hollande started to seriously consider fiscal and economic reforms (Economist, 2015; Financial Times, 2016). It may also help explain, why in 2017 newly-elected French president Emmanuel Macron quickly established himself as one of the most fervent advocates for a sizable fiscal capacity at the level of the Eurozone (Chassany et al., 2017; Economist, 2017).

1.2.6

EMU Versus Democracy

The sixth and final component of my argument completes the politico-economic trilemma by establishing the link between all earlier components and democracy. As just discussed, austerity will, in the countries deeply mired in BoP-crises and burdened by prohibitively high interest rates, ultimately be implemented no matter what. In other words, the economic imperatives associated with EMU membership will, if that membership is to be retained and substantial external financial support is not forthcoming, trump all other factors, which may usually also have an impact on the occurrence, size, and realization of austerity programs. Most importantly, external pressure will most likely trump politics, and thus democracy. Other than those related to the capitalist diversity found in EMU, national institutional and political variables should lose their explanatory power for austerity in the peculiar situation that EMU deficit countries find themselves in. This is also what Armingeon and Baccaro (2012) find in their study of countries policy responses to the Great Recession. They argue that “domestic institutions and politics matter very little for explaining responses to the sovereign debt crisis, and that external constraints are much more important. […] All that is left for domestic actors to do is to blunt popular opposition to the imposed policy” (Armingeon & Baccaro, 2012).

1.2 Theoretical Framework and Argument in Brief

19

Austerity has become the only game in town, and cross-national differences in political institutions, ideologies, actor constellations, and preferences do not matter anymore. In consequence, elections and government changes, partisan and government ideology must not be expected to make much difference to austerity in the Euro crisis. One of the defining features of this crisis is therefore the Europeanization of economic policy—in crisis countries if not for all EMU members. Domestic political battles about economic policies are becoming mere side-shows about how long reforms and policies from Brussels can be resisted, or how far they can be watered-down. That is, while it may seem like politics per se does not matter anymore, it is actually only domestic politics that has declined in importance. At the supranational level, where the grand decisions are made by the most powerful actors, it is still very much alive. This kind of democracy, however, looks more like a technocratic oligarchy, a mode of economic governance dominated by national governments and non-elected technocrats that is far detached from any democratic processes of will-formation and decision making rooted in civil society (also see Habermas (2011)). When the latter variant of politics does not matter anymore, however, democracy is on retreat.

1.3

Structure

The main phenomenon to be explained in the thesis at hand is the fiscal consolidation plans and their realization in the Euro crisis. Therefore, as a first step of the investigation, Chap. 2 will introduce the concept of austerity and provide a comprehensive empirical overview of the number, the sizes, and the realization of fiscal adjustment plans not only in the Euro crisis in particular, but also embedded into their historical context more generally. This will not only lay out more thoroughly the empirical puzzles motivating this study, but more importantly also serve as the foundation for developing the overarching theoretical framework in Chap. 3. Moreover, the descriptive findings presented in this chapter will provide some guidance and structure to the more rigorous empirical analyses conducted in the subsequent chapters. Chapter 3 introduces the theoretical framework for understanding fiscal consolidation and economic adjustment in the Euro crisis, which revolves around a politico-economic trilemma of the Eurozone defined by the three irreconcilable nods of national diversity, EMU, and democracy. In a next step, I will outline the six components of my main argument, embedded in their respective literature form both economics and political science, and—in some form of dialogue between theory and data (Gschwend & Schimmelfennig, 2007)—confront the main propositions of that argument with the latter. The chapter closes with a derivation of a total of twelve empirically testable hypotheses from the theoretical arguments to structure the empirical analyses that follow.

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Introduction

The theoretical arguments presented in Chap. 3 partly build on the assertion that the macroeconomic imbalances found in the Euro area have important institutional roots in the very diverse national varieties of capitalism assembled in the union. Therefore, in an introductory part of Chap. 4, this assertion will be tested empirically in a combination of both descriptive and inferential statistical data analysis. The remainder of Chap. 4 can be understood as the first stage of the analysis of austerity presented in the thesis at hand. That is, in pursuit of the first research question of the thesis, the determinants of planned fiscal policy stances, of the initiation of austerity plans, and of the size of these plans are analyzed. The chapter starts out with a descriptive part, and closes with a more rigorous inferential part comprising several pooled TSCS regression models. Chapter 5 can be conceived of as the second stage of the analysis of austerity presented here. Given that austerity plans of a certain size have been initiated, it analyses the determinants of the realization of those plans. As in the previous chapter, the empirical analysis is divided into a descriptive part first, and an inferential part comprising more rigorous inferential statistical analyses in the form of several pooled TSCS regression models next. Finally, Chap. 6 concludes by summarizing the main arguments and re-evaluates them in light of a summary of the main empirical findings, hypotheses and main research questions. Moreover, it includes a discussion of the strengths as well as limitations of the study and provides an outlook on a possible future research agenda.

Chapter 2

Fiscal Adjustment in Europe

This chapter introduces the concepts, definitions, operationalizations, and provides a great amount of empirical data on the main phenomena to be explained in this thesis: the initiation, size, and realization of fiscal adjustment (in the Euro crisis) and its broader context of the EMU and crisis-induced economic adjustment. It concludes by summarizing in detail the main puzzles emerging from that data (already laid out in brief in the introduction), and motivating the subsequent theoretical framework used to exploring and resolving these puzzles, as well as the empirical investigations in Chaps. 4 and 5.

2.1

The Concept of Austerity in the Context of the Euro Crisis

Austerity is commonly defined as the reduction of public budget deficits and thus ultimately the reduction—or stabilization—of public debt (Armingeon et al., 2016a). Correspondingly, an austerity policy is any policy program adopted with the intention of reducing deficits (and debts). While some governments choose to consolidate their finances through cuts in spending, and others focus on raising taxes, most will opt for a mixture of tax hikes and spending cuts (Armingeon et al., 2016a, p. 630). However, as has been made clear in the introduction already, the analytical focus of the thesis at hand is on outcomes, not on policy implementation. From this perspective, and leaving aside the difficulties associated with operationalization and measurement for now, the concept of austerity is quite clearly defined. However, to fully comprehend the meaning of austerity in the specific context of the Euro crisis, some elaborations are in order. I will focus on three aspects. First, should the public sector really be seen in isolation from the private sector and its debt? The financial situation of private households and businesses can, after © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 K. Guthmann, Fiscal Consolidation in the Euro Crisis, https://doi.org/10.1007/978-3-030-57768-1_2

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all, make a considerable difference to the need, willingness, and ability of the public sector to reduce its deficit and debt. Take the oft-cited case of Japan, which, despite its sovereign debt just having surpassed a staggering 250% of GDP and its general government budget deficit averaging 7.3% over the past decade (2007–2016), managed in 2014 to initiate a massive fiscal stimulus package worth more than 6% of its GDP in the course of Japanese Prime Minister Shinzō Abe’s Keynesian-inspired ‘Abenomics’ economic policy (Economist, 2016).1 In sharp contrast to the situation in the Eurozone, however, record Japanese public indebtedness is not of much concern to international capital markets, who are well aware that the Japanese economy as a whole stands out as the world’s most affluent creditor by far.2 In consequence, sovereign bond yields remain miniscule in Japan and therefore represent neither any meaningful incentive to engage in austerity, nor any significant obstacle to achieving it. Taking a look at the situation in Europe in contrast, Greece’s much smaller sovereign debt, at around 146% of GDP in 2010, had financial markets panic, thereby forcing the country to seek a bailout from the IMF and its EU partners. Similarly, Spain, which, in full compliance with the stipulations of the SGP, recorded an average 2.4% surplus on its primary balance between 1998 and 2007, and managed to reduce its sovereign debt from 63 to just 35% of GDP over that same period, found itself seeking financial assistance too in 2012, when the government felt obliged to rescue its failing domestic banking system.3 As these examples suggest, we may learn a lot about the political economy of fiscal consolidations by incorporating the balance sheets of both the public and the private sector into our analyses. Second, we should take the alternative policy options into account that governments have at their disposal when initiating an austerity program, as well as the conditions for successful—and sustainable—fiscal consolidations. Oftentimes, policymakers and analysts alike appear to suffer from the fallacy of the ‘Swabian housewife’, when emphasizing that some bold cuts to government spending were indispensable if public finances were to be put (back) on a sounder footing (see e.g. Skidelsky 2013). In principle at least, however, the public sector could achieve a consolidation of its finances without any recourse to spending cuts or tax hikes. Being part of a sovereign country, it could consider to inflate some of its debt away through monetization, to devalue its currency—although this may be counterproductive when the debt is denominated in foreign money—or even consider to default on and/or restructure all or part of its debt (Dalio, 2012; Das et al., 2012). In fact, the mere theoretical availability of these options could, through its effect on market expectations and thus bond yields, facilitate or at least ease a consolidation.

1

Data on deficits and debt sourced from OECD (2017). The 2014 Japanese net international investment position stood at a surplus of around USD 3.4 trillion, followed by mainland China with around USD 1.8 and Germany with around USD 1.5 trillion. Source: IMF, http://data.imf.org/regular.aspx?key=60947518, data retrieved 6 June 2017. 3 Data sources and detailed operationalizations are provided in the appendix. 2

2.1 The Concept of Austerity in the Context of the Euro Crisis

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In other words, instead of confining itself only to its fiscal policy toolkit, a government could make use of monetary, exchange rate, or even regulatory policy. Ultimately any policy that generates growth will tend to reduce both deficits and the debt ratio. By implication then, even the most meticulous implementation of even the harshest fiscal cuts or tax hikes may produce nothing but more debt when those measures turn out to stifle aggregate demand to the point where the economy plunges (back) into recession. This phenomenon, described as the ‘paradox of thrift’ by Maynard Keynes already (Keynes, 1936; Krugman, 2012a), tends to render austerity policies ‘self-defeating’—and by now many analysts agree that many of the consolidation measures implemented during the Euro crisis have been contractionary in the sense that they ended up worsening and prolonging the recessions in the Eurozone periphery (Corsetti, 2012). In line with this observation, the earlier literature on the topic has shown that fiscal adjustments are most likely to be successful—i.e., sustainable—when they are accompanied by growth-promoting measures such as expansionary monetary policies or currency devaluations (Alesina & Ardagna, 1998; Alesina & Perotti, 1996; Heylen & Everaert, 2000)—alternatives that are simply not available to the countries hit hardest by the current European crisis. The discussion of the role of the private sector and the alternatives to austerity leads to a third and final important aspect to consider when thinking about fiscal adjustments: the motivations behind and the ultimate objective of austerity. From the narrow perspective reflected in the definition introduced earlier, fiscal consolidations are about reducing public deficits and debt. By far, however, this view does not capture all the rationales why austerity may be and often is pursued. As the above-mentioned comparison of the Japanese with the Greek and the Spanish case already suggested, austerity may not only be just one (policy) option among others to consolidate public finances, but just one (policy) option among others to achieve a deleveraging of all sectors of the economy combined (Dalio, 2012; Eggertsson & Krugman, 2012). Taking all the idiosyncratic politico-economic external constraints of a given situation into account, it may even be the only remaining policy option to achieve some progress in the resolution of an intricate economic crisis. In essence, this precisely describes the situation many European governments are facing today. While the Greek, Spanish, or Portuguese EAPs, for instance, do indeed—among others—aim at a reduction of public deficits, and are periodically evaluated based on explicit deficit reduction targets, they at the same sit at the core of those countries’ last resort to resolve their balance of payments crises without having to withdraw from the Eurozone. A key lesson to be drawn from the preceding discussion therefore is that in order to fully understand fiscal consolidations—i.e., their initiation, sizes, but especially the degree to which and why they are realized or not—it is necessary to appreciate the specific politico-economic/institutional context in which they are taking place. Arguably, context often tends to be somewhat underappreciated in large-n quantitative studies in comparative political economy in particular, which strive for identifying individual explanatory variables and isolating their effects ceteris paribus (see e.g. Falleti & Lynch, 2009). In the real world, however, ceteris non

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paribus—everything else is not constant. Economic variables in particular tend to move in tandem. Modeling the multiple conditionalities and interactions emerging from such co-movements, however, is, from a purely methodological viewpoint, often neither feasible nor reasonable based on samples that rarely cover more than 20 or 30 countries (Franzese, 2009; Kittel, 2006). This remains true even when samples are artificially expanded to yield much larger, but highly interdependent, time-series cross-sectional (TSCS) datasets, which require even more sophisticated econometric techniques to ensure unbiased and efficient effect estimates. Especially when the main explanatory variables are institutional, structural factors, and thus do not tend to change much over time, the apparent gain the researcher hopes to obtain from adding a time dimension to his cross-sectional dataset may prove illusory (Beck, 2011; Beck & Katz, 2001; Breusch et al., 2011b; Greene, 2011a, 2011b; Plümper & Troeger, 2007, 2011). The main difficulty then, lies not so much with clearly defining the concept of austerity—that has been achieved with the very first sentence of this subsection— but with recognizing it when we see it, with operationalizing and measuring it, with incorporating context non only into our theoretical argumentation, but also our analyses whenever possible and necessary, and most importantly with drawing correct and meaningful conclusions from the interpretation of our inherently imperfect empirical results. During the Euro crisis, austerity often came as part of much more comprehensive economic adjustment packages designed to restore countries’ international export competitiveness and correct long-grown macroeconomic imbalances by engineering harsh internal devaluation programs supported by far-reaching supply-side structural reforms. The EMU context therefore not only implied immense pressure for initiating sizable fiscal consolidations, but also immense obstacles for being able to achieve what was needed and demanded. Moreover, the EMU context can partly also be held accountable for causing the crisis, by helping to create the very macroeconomic imbalances that now sit at the core of many countries’ intractable economic woes. Simply treating austerity programs as if they were isolated events occurring in the model world of independent, autonomous, sovereign nation states, will neither help analysts to understand, and policymakers to resolve the multi-faceted European crisis, nor will it contribute to an understanding of austerity as arguably the most salient crisis response. Therefore, in order to fully comprehend fiscal consolidations in the Euro crisis, we must place them in their broader politico-economic context. We need to understand (i) why there were persistent deficits and debts in the first place, (ii) what triggered austerity in the first place, (iii) the status of austerity policies in terms of them being part of a much more comprehensive policy package, and (iv) the alternatives to austerity and the degree to which these alternatives have or have not been, could or could not have been employed. This shift towards a somewhat broader view is also reflected in the macroeconomic imbalance procedure (MIP) that has been initiated by European policymakers in the course of the crisis. Rather than just tracing the developments of

2.1 The Concept of Austerity in the Context of the Euro Crisis

25

budget deficits and public debt (the main thrust of the original SGP that came with the Maastricht treaty), the MIP monitors a broad variety of economic indicators covering countries’ both external and internal balance. Among these are net international investment positions (NIIP), export market shares, real effective exchange rates, private sector debt stocks and credit flows, and changes in property price indices, among others, reflecting the fact that each of these variables could be decisive in being able to spot another dangerous macroeconomic imbalance looming on the horizon, which may ultimately require another round of painful fiscal consolidations to facilitate the inevitable economic adjustments. In summary, austerity is for the purpose of this thesis rather straightforwardly defined as the reduction/stabilization of public budget deficits/debt. The task of explaining austerity—its occurrence, size, and degree of realization—however, will consistently be pursued with the much broader politico-economic/institutional context of the Euro crisis in mind.

2.2

Operationalization of Austerity4

The standard approach in comparative political economy to operationalize fiscal consolidations starts from changes in countries’ primary budget balance (Wagschal & Wenzelburger, 2008b, 2012) or its cyclically adjusted version (CAPB) (Alesina & Ardagna, 2009). Based on this approach, any noticeable improvement in this balance (i.e., a sharp reduction in budget deficits) indicates a fiscal consolidation. For example, Alesina and Ardagna (2009, p. 41) code a year as one of fiscal adjustment if the budget balance improves by at least 1.5 percentage points of GDP. In addition to that, several authors also incorporate the development of the public debt ratio into their operationalization [for an overview see Wagschal and Wenzelburger (2008a) or Wenzelburger (2009)]. More recently, however, the literature on the topic has become skeptical about the validity of this operationalization based on the primary balance or CAPB (IMF, 2010, p. 96; Wenzelburger, 2009). These indicators measure the outcome of consolidations, but not consolidation policies—which may or may not have caused measured outcomes. By implication then, even a random improvement of the budget balance ‘by chance’ could be recorded as a fiscal adjustment by a researcher who follows the traditional outcome-based approach. In principle, the CAPB is sometimes seen as a remedy to that problem, intended to capture discretionary policy changes by adjusting primary balances for the effects of the business cycle. The methods to correct for cyclical changes, however, are usually inconsistent across different data sources and suffer from “measurement errors that are likely to be correlated with economic developments” (IMF, 2010,

The first four paragraphs of this subsection draw heavily from an earlier publication by Klaus Armingeon, David Weisstanner, and myself (see Armingeon et al., 2016a).

4

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p. 96). As Eichengreen (cited from Alesina et al., 1998, p. 256) puts it: “the one thing economists know about cyclical adjustments is that we do not know how to do them.” Even if an exact cyclical correction were possible, the political motivations behind the resulting figures would still be disregarded. Note for instance, that fiscal consolidation programs which, for whatever reason, did not produce any noticeable results even after some business-cycle adjustment, are not captured at all by the traditional outcome-based approach. In this sense, that approach restricts the analysis of fiscal consolidations to somewhat ‘successful’ cases only. To sum up, the overall validity of traditional purely outcome-based indicators of fiscal adjustments is questionable. More recently, this led to a different approach at operationalizing austerity based on analyzing specific consolidation policies by identifying tax hikes and spending cuts passed by political actors. This so-called historical or action-based approach underlies the work by Devries et al. (2011), for example, who compiled a dataset of policy measures motivated explicitly by fiscal consolidation (rather than by restraining aggregate demand during periods of strong growth, for instance) in 17 OECD countries between 1978 and 2009. In order to learn about policymakers’ motivations behind a specific measure, the authors make use of policy documents such as budget speeches, central bank reports, or OECD, IMF, and EU sources, and provide estimates of the aggregate budgetary impact of these measures (Armingeon et al., 2016a, p. 635). While this action-based approach appears perfectly adequate for analyzing policy implementation, it has at least two disadvantages. First, it is restricted to fiscal policy instruments and neglects alternative policy tools that could be utilized to consolidate public finances, such as monetary, exchange rate, or regulatory policies for instance—a problem I already hinted to above. When a fiscal adjustment (i.e., a reduction of the budget deficit) is achieved without any recourse to fiscal austerity measures in the narrowest sense of the term, it is usually not captured by the action-based approach. Second, measuring policymakers’ motivations is not unlikely to be imprecise and error-prone. What if, for example, a government adopted spending cuts primarily as a means to deflate the economy in an attempt to engineer an internal devaluation? This may or may not be recorded as an austerity measure, depending on the weight an individual analyst attaches to the multiple motivations behind government actions. The issue of correctly attributing motivations may get even more complicated with more sophisticated measures, such as those recently implemented in Spain and Portugal, for instance, designed to achieve a ‘fiscal devaluation’ that promotes exports (Farhi et al., 2013; Gomes et al., 2014). In the analysis at hand, I intend to overcome some of the disadvantages of both the outcome and the action-based approach, by building on an operationalization of austerity used by Mauro (2011), which, among others, incorporates a measure of austerity motivations into the traditional outcome-based approach. When it comes to explaining the occurrence and the size of austerity (the focus of the first research question), I will analyze fiscal adjustment plans, specified in terms of expected/forecasted outcomes of fiscal and economic variables—the most

2.2 Operationalization of Austerity

27

significant one being the improvement in the budget balance over a pre-specified time horizon. It is important to note that these expectations/forecasts are made and published by national authorities, and neither produced nor revised by any supranational or international entity (such as the EU, the IMF, or the OECD) that may change government figures to correct for possible unrealistic (most likely too optimistic) assumptions and forecasts. The only adjustments made by EU staff are meant to ensure methodological and measurement consistency across the multiple national sources.5 Fiscal adjustment plan data are therefore based on outcomes, but it is ex ante outcomes reflecting national policymakers’ intentions (also see Mauro (2011) on this). That is, ‘random’ improvements in the budget balance are not misleadingly recorded as consolidations anymore. To some degree, planned improvements in the budget balance therefore do capture the motivations of policymakers, just as the action-based approach does, while at the same time overcoming the imprecisions associated with trying to ascertain motivations based on government speeches or publications. At the same time, the disadvantage of the traditional outcome-based approach of being restricted only to successful consolidations is avoided as well. When it comes to examining the degree to which pre-specified austerity plans have been realized (the focus of the second research question), I will—again following Mauro (2011)—compare ex ante (planned) outcomes with ex post (actually achieved) outcomes, by calculating the difference between the respective values of the relevant fiscal (or economic) variables. I will introduce measurement details further below. This operationalization based on subtracting ex ante outcomes from ex post outcomes is also quite widely used in the economic literature on fiscal policy credibility, where the resulting difference is commonly conceptualized as the ‘projection error’ (see e.g. Beetsma & Giuliodori, 2010; Beetsma et al., 2009; Brück & Stephan, 2005; Cimadomo, 2012; Pina & Venes, 2011; Strauch et al., 2004; Von Hagen, 2010). Among others, research questions in this field revolve around whether institutional or political factors lead to systematically biased government projections/forecasts with respect to fiscal or economic variables. In contrast, Mauro (2011) explicitly focuses on the implementation of fiscal consolidation plans in his work combining qualitative case studies with a quantitative analysis of the determinants of the differences between plans and outcomes—the latter are accordingly conceptualized as ‘implementation errors’. In the thesis at hand, I will use the term ‘realization error’ when comparing plans with outcomes, not least owing to the fact that austerity plans may also fail (or succeed, for that matter) due to factors totally unrelated to incomplete policy implementation, such as unexpectedly poor (or strong) economic growth, unforeseen political events, or simply a change of plans, to name just a few. Having said 5

As the respective European Commission staff remarks repeatedly in the relevant commission documents, recalculations by the Commission services are based on the information provided in the relevant national sources, using the common agreed methodology. See the commission staff document for the 2013 Austrian stability program (European Commission, 2013, p. 10, Footnote 7) as an illustration.

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that, policy implementation and growth may still be the two most important variables affecting plan realization by far, when considering that the effect of most other factors must ultimately run through one (or both) of these two variables. For example, the ideology of the party in government may affect policy implementation and may also affect growth [through an effect of partisan ideology on financial markets, for instance (Armingeon, 2012a)], but it is unlikely that party ideology has any other notable direct effect on plan realization. Figure 2.1 places my conceptualization/operationalization of austerity in the context of the other common approaches that have just been introduced. At the conceptual level (the upper half) the figure essentially shows a simplified version of the policy process from the drafting and announcement of an austerity program by national authorities, over the policy output (i.e., written into secondary law by national or subnational policymakers), to the policy outcome in terms of an actual consolidation of public finances—which may be achieved or not achieved. The plan and the implemented policy combined constitute the entire consolidation policy program. Of course, the implemented policy often deviates from the plan already. Besides the fiscal consolidation policy itself, the consolidation outcome is affected by other, mainly macroeconomic factors, which in turn may partially also be influenced by the announcement of an austerity plan as well as its implementation.6 The different approaches to operationalizing austerity are shown in the bottom half of the figure. As discussed earlier, the traditional outcome-based approach starts from the final outcome of the entire policy process and thus comes (i) with the disadvantage of classifying outcomes as consolidations irrespective of the factors that led to theses outcomes, and (ii) with the disadvantage of being restricted only to somewhat ‘successful’ cases, with success usually being defined based on a pre-specified threshold, such as, for example, a 1.5 percentage-point improvement in the budget balance. The historical/action-based approach comes with the advantage of measuring actual consolidation policies, and therefore does capture policymakers’ motivations (given that these are assessed correctly), but largely neglects the impact other factors might have had on outcomes. Admittedly, though, these latter effects may partly be controlled for statistically. Finally, the approach pursued in the thesis at hand (shaded in grey) seeks to overcome the major disadvantages of the other two approaches, by starting at the very beginning of the policy process (planned austerity in terms of ex ante outcomes) and comparing these planned ex ante outcomes with actually achieved outcomes ex post, irrespective of whether the latter indicate an improvement or a deterioration of the relevant fiscal variable. Following the most common operationalization in the literature, most austerity variables analyzed in this thesis are operationalized as planned or realized

6

The effect of a mere announcement of austerity plans on the macro economy runs mainly through the effect on (expectations of) financial market participants, which in turn determine risk premia on sovereign bonds (Mauro, 2011, p. ix).

2.2 Operationalization of Austerity

29

consolidation policy program

ex ante defined outcomes (this thesis, based on Mauro (2011))

implementation

policy outcomes

policy output specific consolidation measures

historical/ action-based approach (Devries et al., 2011)

consolidation

austerity plan as drafted, announced, and published by national authorities

NO consolidation

OPERATIONALIZATION

CONCEPT LEVEL

other factors (e.g. growth, interest rates, inflation)

not captured by traditional outcome approach

traditional outcome approach (ex-post success)

Realization of austerity plans (comparison of ex ante outcomes vs. ex post outcomes) (this thesis, based on Mauro (2011)) Notes: author’s illustration

Fig. 2.1 Overview of approaches to austerity conceptualization and operationalization

improvements in the budget balance over a specific time horizon7 as a percentage of GDP.8 This operationalization, however, carries the disadvantage that the resulting Dbalance/GDP ratio is strongly influenced by changes in its denominator (GDP). Moreover, considering how fiscal policy affects aggregate demand, any large change in the numerator will have an impact on the denominator as well, so that, in the worst case scenario, budget cuts may be completely offset by the recessionary effect of these cuts on the denominator—the phenomenon known as self-defeating austerity (Corsetti, 2012). This problem is likely to be particularly severe in the volatile economic context of the Great Recession. In the most extreme case of Greece, real GDP dropped by more than 25% between 2008 and 2013—a reduction that had not been expected when the first substantial consolidation plans were drawn up in 2010. When GDP decreases by such large margins, however, even the harshest consolidation program is unlikely to show up in public finance data operationalized as a percentage of GDP. Complicating things further, with

Analyzing multi-year as opposed to annual data, takes the multi-year character of fiscal consolidation programs into account (Wagschal & Wenzelburger, 2008b, p. 14 ff.; 2012). 8 Details on the operationalization of all variables, as well as data sources, are provided in the appendix. 7

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automatic stabilizers kicking in to alleviate the recession (through both lower tax revenue and higher social spending), the numerator of the ratio is becoming less useful as a measure of fiscal consolidation as well. Taken together, even the most sophisticated—but still inherently imperfect—cyclical adjustment, or the most advanced statistical technique may not provide an entirely satisfactory solution to these complications. In order to tackle the problem in the most straightforward manner, I will therefore complement my analyses using a second operationalization of austerity, which relies exclusively on planned and realized changes in government spending measured in absolute national currencies. While this approach can partly be conceived as a mere robustness test, it will, as shown below, offer surprising additional insights with regard to plan realization performance of many Eurozone countries. This leads to a discussion of the main austerity dataset and the details of measuring fiscal consolidation variables, presented in the following subsection.

2.3

Data and Measurement

The data on austerity plans (ex ante outcomes) used in the thesis at hand is primarily based on data collected from national governments and published as stability or convergence programs (SCP) through the European Commission’s Economic and Financial Affairs Directorate (DG ECFIN) in the framework of the SGP. Starting in 1998, this data is submitted annually by national EU governments and made available to the public through the homepage of the European Commission (EC) in the form of annual reports for each EU member country. Instead of drawing all data from that source by myself, I started with a dataset compiled and kindly provided by Mauro (2011), who supplemented the DG ECFIN’s data with pre-1998 figures from national country authorities, libraries, and IMF archives, to yield a dataset covering a maximum of 25 EU countries (the EU25, i.e., all members that had joined prior to 2007) between 1992 and 2007. After verifying that data for 2005–2007 using the original source, I expanded it by the years 2008-2014 from the annual country reports drawn from the EC website. Whenever some data points were missing from that source, they were obtained from other national/EU documents, such as ‘National Reform Programs’ submitted to the EU commission, or directly from the Economic Adjustment Programs compiled in the context of the EU’s crisis-related financial assistance to member states, for instance.9 For each publication year, planned or actual data on a total of ten fiscal and economic variables for a maximum of nine years are available. These variables are: the overall (i.e., non-adjusted) general government balance, general government expenditures, general government revenues, gross general government debt, interest

9

Details on these sources are provided in Appendix A.

2.3 Data and Measurement

31

expenditures on debt, a GDP deflator, nominal GDP growth, real GDP growth, inflation rates, and a measure of the output gap. Besides the publication year (t), the data covers a maximum of four past years (t − 1, t − 2, t − 3, and t − 4) and four plans/projections for future years (t + 1, t + 2, t + 3, and t + 4). All fiscal variables are operationalized as a percentage of GDP. Until 2008/2009, the respective stability programs (for countries that had already adopted the Euro) or convergence programs (for countries that had not yet joined the currency area) were usually published in around December of a given year, so that t would refer to that year, and the respective value of the variable would thus partly be ex ante data (a plan/projection) already, while t − 1 would refer to the year prior to publication, and thus constitute ex post data. From 2009 onwards, however, the publication date was shifted to occur usually around April of the next year, about four month later than for the pre-2009 data. In response to that change, I decided to define t to be the year of publication for the post-2009 data (publication around April of year t), but the year after publication for the pre-2009 data (publication around December of t − 1). This makes sure that t − 1 consistently corresponds to ex post data. In consequence, my publication years correspond to Mauro’s (2011) ‘vintage year’ + 1.10 This yields a dataset of fiscal/economic plans/ projections spanning the period from 1992 to 2014. The corresponding data for realized (ex post) outcomes, used to analyze austerity plan realization, is obtained from the AMECO database, which is also published by the DG ECFIN. Details on the AMECO variables used in this thesis are found in appendix B. In order to analyze and explain fiscal consolidations based on this dataset, I create the following four dependent variables, which will reappear again and again in the thesis at hand: (i) an annual fiscal plan variable indicating governments’ intended ‘fiscal stance’; (ii) a binary austerity plan ‘dummy’ variable; (iii) a continuous austerity plan size variable, which takes on the value of the fiscal stance variable but is not observed annually; and (iv) a ‘realization error’ variable as a measure for the degree of plan realization. All four variables—details on their measurement are introduced below—are mainly operationalized based on planned and/or realized improvements in the overall general government budget balance over a period of two years (t + 1 minus t − 1). The choice of a 2-year horizon, as opposed to a 3-year horizon, for example, results from the following considerations. First, while most ex ante outcome data obtained from the DG ECFIN is available for planning horizons longer than just

10

The following example serves as an illustration of the adjustment procedure: consider a government that, in December 2006, published among others, its planned budget deficits for 2005, 2006, 2007, and 2008. So this is pre-2009 data. Based on my definition, I would record the 2006 data as t − 1, the 2007 data (the year after publication) as t, and the 2008 data as t + 1. The vintage year would therefore by t = 2007. In April 2010 (post-2009) the same government publishes its planned budget deficits for 2008, 2009, 2010, and 2011. Based on my definition I would now record the 2009 data as t − 1, 2010 (the publication year) as t, and the 2011 data as t + 1.

32

2 Fiscal Adjustment in Europe

two years, this is not the case for all countries and time periods. In other words, data availability constraints make the 2-year horizon more useful. Second, and somewhat related to that, since 3-year horizons look further into the future, ex post outcome data to calculate realization errors is not yet available for the most recent years. When taking into account that the Euro crisis is still ongoing, however, one should think twice before dropping the most recent observations from the analysis. Finally, as it turns out, the sizes of 2-year austerity plans (or fiscal stances, for that matter) are highly correlated with 3-year plans. The respective correlation coefficient is as high as 0.97 for the universe of 378 fiscal stances (or 183 adjustment plans) analyzed in this thesis. The decision to examine overall (=headline) budget balances (OB), as opposed to primary balances, cyclically adjusted balances, or cyclically adjusted primary balances, for instance, owes to the following observations. First, as discussed above, cyclically adjusted variables suffer from measurement errors and inconsistent methodologies, with the resulting biases being particularly strong when the cyclically adjusted ex post data has only recently been published, before the measurement errors could be corrected through several rounds of revisions. In particular in the volatile environment characteristic of economic crises, the difficulties associated with correctly measuring cyclically adjusted balances are so severe, that some researchers advise to avoid using them for quantitative data analysis altogether (Blanchard et al., 2013, p. 347). Second, all the economic variables that go into the calculation of primary balances with or without cyclical adjustment (such as growth, output gaps, or sovereign bond yields and the associated interest rate expenditures) can be perceived as subcomponents of the OB that could serve as explanatory variables in any model of overall balances. For example, despite sizable consolidation measures, the OB may not improve as intended because growth turned out much weaker than expected or because interest expenditures were much higher than foreseen in the plans. Since I do have ex ante data on growth as well as on interest expenditures available from national governments, such a situation could be easily modeled without having to resort to inherently error-prone and unreliable cyclically adjusted budget balances. This also reflects the analytical focus of this thesis, which is on the realization of austerity plans as a whole, not merely on the success or failure of policy implementation. For an examination of the latter, in contrast, cyclically adjusted data may very well be more appropriate. Finally, for the data at hand, the correlation between an operationalization based on CAPBs with one based on overall balances (i.e., fiscal stances when measured annually) is consistently above 0.9, no matter whether a 2-year or a 3-year horizon is used. As a t-test confirms, then, there is no statistically significant difference between the means of austerity plans based on overall balances and those on CAPBs. To summarize the preceding discussion, all four main dependent variables are based on planned improvements in overall budget balances over a time horizon of 2-years. The details of measurement are introduced next. The first of these variables is the ‘planned fiscal stance’, a continuous variable calculated annually as the difference between the ex ante OB (in percent of GDP) at

2.3 Data and Measurement

33

t + 1 and the ex ante OB at t − 1. Data on this variable is available for 378 country-years between 1992 and 2014. As discussed above, this operationalization comes with a number of disadvantages as a result of having the GDP as the denominator of the Dbalance/GDP ratio. Therefore, a second operationalization of planned fiscal consolidation is used, which measures the planned percentage change in government spending over the same 2-year period based on absolute national currencies. In order to compute that figure, data on planned government spending in absolute national currencies is needed. Unfortunately, that data is not consistently made available in the stability or convergence programs submitted to the EC. Moreover, these programs not always include estimates for absolute GDP. And even insofar as they do, absolute GDP data may not be strictly comparable because (i) it may be based on different national definitions to begin with, and (ii) the methodologies for calculating GDP data are revised from time to time. What is available from the reports submitted to the EC are data on planned government spending in percent of GDP, as well as projected real and nominal GDP growth rates. Therefore, I calculated the required figures for planned government spending in absolute national currencies using the following four-step procedure: (1) use ex-post nominal GDP data as published in the AMECO database (in absolute EUR or absolute national currency) to get an estimate for GDP projections at t − 1. Since by definition the GDP data for t − 1 as published in stability/convergence programs must be ex post data already, the AMECO ex post data should be a valid and reliable proxy for the absolute GDP figures not consistently made available in the national documents; (2) based on the figures obtained from step 1, use the ex ante nominal GDP growth projections (in percent at t, t + 1, …) as published in the plans to get estimates for ex ante planned nominal GDP figures in absolute national currencies; (3) for the fiscal variables (spending, revenue components), use ex-ante figures in percentage of GDP as published in the plans and the ex-ante absolute nominal GDP estimates, as just calculated, to compute ex-ante fiscal variables in absolute EUR/national currencies; (4) calculate the percentage change in the resulting variable from t − 1 to t + 1. The second variable is a dummy indicating the presence of a fiscal consolidation plan in a given year. Note that this is different from the fiscal stance—the fiscal stance may be positive or negative; it may constitute fiscal expansions or consolidations, while the austerity plan dummy indicates only the presence or absence of a consolidation plan. As with any primarily outcome-based approach, this requires first and foremost the definition of the criteria according to which (planned) improvements in the budget balance qualify as fiscal adjustments, with the most common criterion in the literature being the size of a consolidation program in terms of the improvement in the budget balance. Based on a comprehensive examination of the sizes of fiscal stances in my austerity dataset, I developed the following procedure to identify (large) austerity plans. First, as a baseline criterion, I coded all fiscal stances as 1, which indicated a 2-year improvement of at least 0.7% of GDP on both, the overall balance and the CAPB. While 0.7% may seem arbitrary, it is arguably no less arbitrary than the 1.5% threshold most commonly found in the literature. Moreover, the 1.5%

34

2 Fiscal Adjustment in Europe

threshold is usually used with 3-year time horizons. A proportionate adjustment to fit the 2-year horizon would thus lead to a 1% threshold. I chose to reduce that further to 0.7% mainly because this 0.7% threshold cuts the universe of my 378 fiscal stances almost exactly in half. Only a few pages earlier, I emphasized the multiple disadvantages of the CAPB and concluded that it was more appropriate to focus on overall balances in the study of austerity. That argument, however, applies mainly to the operationalization of fiscal consolidations based exclusively on traditional outcome approaches (which do not tend to distinguish between ex ante and ex post outcomes) or to using the CAPB to derive policymakers’ motivations from ex post outcomes. Based on ex ante outcome data, in contrast, the CAPB may very well be useful. Imagine a government that is already well aware of its rapidly deteriorating economy and will therefore not project the overall balance to improve by much, despite very harsh austerity measures. Such a government will most likely project an improving CAPB, however. Therefore, when it comes to measuring austerity rhetoric using planned (ex ante) outcomes, it makes sense to also take a government’s CAPB projections into account. This resulted in a total of 132 austerity plans out of 378 fiscal stances. In a second step of the identification procedure, I introduced the first of two exceptions, by also coding those fiscal stances as 1, which miss the baseline criterion on the CAPB, but at the same time indicate an improvement of at least 1% of GDP on the overall balance (37 additional cases). This is done in order not to disregard plans developed in a more or less normally functioning economy. Analogously, I introduced a second exception in a third step, by also coding fiscal stances as 1 which miss the baseline criterion on the overall balance, but indicate an improvement of at least 1% of GDP on CAPB—in order not to disregard plans in a particularly poor economic environment (13 additional cases). The choice of 1% thresholds is grounded in adjusting the 1.5% threshold commonly found in the literature from the standard 3-year down to the 2-year horizon used here. Finally, I re-examined all cases identified or not identified based on my procedure and made adjustments whenever deemed necessary based on the information provided by (Mauro, 2011) as well as the qualitative information on country cases included in SCP documents. In particular, I dropped four cases which had been added based on exception 1 or 2, but should nevertheless not be considered fiscal consolidation plans. The justification for dropping these cases is provided in appendix B. Moreover, I added five cases, which had so far not been identified based on any of my quantitative criteria, but should—based on qualitative country case information—nevertheless be considered austerity plans. Again, a justification is provided in Appendix B. This procedure leads to a total of 183 fiscal adjustment plans out of 378 country-year observations in my dataset. The third dependent variable indicates the size of austerity plans and simply takes on the value of the fiscal stance whenever the austerity plan dummy equals 1. This is done for both the operationalization of fiscal stances in percent of GDP and the one based on percentage changes in nominal government spending. These are therefore continuous variables, but they are not observed when the consolidation plan dummy equals 0.

2.3 Data and Measurement

35

Finally, the fourth variable indicates the degree of austerity plan realization, conceptualized as ‘realization errors’, again operationalized in both percentages of GDP and percentage changes in spending measured in absolute national currencies. In order to calculate realization errors, a variable indicating the degree (i.e., size) of actual austerity must be created, operationalized analogously to the variable measuring the size of consolidation plans (and therefore also planned fiscal stances). The required ex-post outcome data is sourced from the AMECO database. Afterwards, realization errors based on percentages of GDP are calculated as the actual 2-year improvements in the overall budget balance (actual fiscal stances) minus the planned improvements in that balance (planned fiscal stances). As for the austerity plan size variables, realization errors are not observed whenever the consolidation plan dummy equals 0. Based on this measurement, a positive realization error indicates an overachievement of austerity plans, while a negative realization error indicated an underachievement. Analogously, realization errors based on percentage changes in nominal government spending are calculated as actual percentage 2-year changes in spending minus planned percentage changes in 2-year spending. The resulting figure is multiplied by −1 in order to facilitate the same interpretation as for the percentage of GDP operationalization. That is, positive realization errors again indicate an overachievement, while negative realization errors indicate an underachievement of austerity plans. Based on the data and variables introduced so far, the remaining sections of this chapter will provide an overview of the occurrence, size, and realization of austerity during the Great Recession, as well as in the almost two decades leading up to that crisis.

2.4

Sample and Observation Period

The dataset of fiscal consolidation plans used in the analysis at hand covers a maximum of 378 country-years between 1992 and 2014. If the entire dataset was to be divided up into subcomponents, a balanced panel of all 25 EU countries is analyzed for the period between 2005 and 2014. The three newest EU members Bulgaria, Romania, and Croatia, are not included in the analysis at all for reasons of data availability. For the 1999–2004 period there is a balanced panel of 90 country-years comprising all EU15 members. For the pre-1999 period, there is an unbalanced panel covering 38 country-years.11 Note, however, first, that the reduced data availability in the pre-1999 period is mostly caused by the lower 11

The pre-1999 observations are distributed across countries and years as follows (country codes are based on the ISO 3166-1 alpha-3 standard): 1998: AUT, DNK, ESP, FIN, GBR, ITA, PRT, SWE; 1997: AUT, BEL, DEU, DNK, FIN, FRA, GBR, IRL, SWE; 1996: AUT, DNK, FIN, GBR, SWE; 1995: DNK, GBR, GRC, NLD; 1994: DEU, DNK, FRA, GBR, IRL, PRT; 1993: BEL, GRC; 1992: ESP, ITA, NLD, PRT).

36

2 Fiscal Adjustment in Europe

number of EU members. This is illustrated by the fact, that there are only four time gaps in the dataset for the 1996–2014 period if all EU members were included. Those gaps are the 1998 observations for Belgium, Germany, France, and Ireland. Second, all pre-1999 data was obtained from Mauro (2011), who compiled only those data points from national sources, which qualified for a fiscal consolidation program according to his criteria, from which the criteria used in this analysis are partly derived. In other words, it is highly unlikely that there have been any large fiscal consolidation years in the post-1991 EU that are not included in the analysis at hand. The restriction to pre-2015 years is mainly a result of analyzing both ex ante and ex post data on austerity based on two-year time horizons. That is, to be able to add 2015 data, we would require ex post data on fiscal consolidation as well as on all main independent variables for 2016. At the time of writing, such data is either unavailable or—in the case of economic growth data, for instance—unreliable until at least the first round of revisions has been carried out. The justification for confining the analysis to EU countries only is partly theoretical, as has been made clear above, and partly also due to data availability. With respect to the latter, the European Commission simply does not regularly compile fiscal or economic ex ante data for non-EU countries. And while the IMF does, that IMF data goes through substantial IMF revisions and corrections, so it cannot confidently be considered national ex ante data reflecting the intentions of national authorities anymore, but may rather reflect the economic expectations of and methodologies used by IMF staff.

2.5

Occurrence, Implementation, and Realization of Fiscal Consolidation

Based on the operationalizations and measurements just introduced, I will, in the remainder of this chapter, provide substantial empirical data on the main phenomena to be explained in the analysis at hand: the occurrence, size, and realization of fiscal consolidation during the Great Recession in Europe as well as in the two decades leading up to that crisis.

2.5.1

Planned (2-Year) Fiscal Policy Stances

The first dependent variable used to understand austerity in the Euro crisis is the ‘planned fiscal stance’, a continuous variable calculated annually as the difference between the ex ante OB (in percent of GDP) at t + 1 and the ex ante OB at t − 1. The main advantage of examining this variable is that it provides a straightforward, easy-to-understand impression of the planned and actual development of

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

37

government budgets. It is simply the amount by which a government plans/expects their budget balance (or their spending or revenues) to change over the coming two years. This change could be positive (i.e., an improvement of the budget balance, a fiscal consolidation, a restrictive fiscal policy stance, austerity) or negative (i.e., a deterioration of the balance, a fiscal expansion or stimulation, an expansionary fiscal policy). Table 2.1 provides a comprehensive overview of all 378 fiscal stances by country and year for the interested reader. As just stated, positive values stand for a planned 2-year improvement in the overall government budget balance. Take the case of Sweden in 1997 as a reading example, where the Swedish government planned (in 1996) to improve its budget balance by a quite considerable 3.8 percentage points (pp) between 1995 and 1997. Note that the average (mean) fiscal stance across all 378 country-years is a planned 2-year fiscal contraction at the amount of 0.93 pp.12 The median is at 0.7 pp, and the standard deviation is at 2.23 pp. These latter figures are also shown in Table 2.2, which summarizes several univariate statistics for fiscal stances as well as for economic growth. Besides ex ante data on plans (or ‘projections’, which may be the more appropriate term when it comes to growth), the table also includes some ex post data on actual fiscal and economic outcomes. Moreover, the overall balance is broken down into its subcomponents: government spending and government revenue. On average, the consolidation of public finances conveyed by these figures was mainly to be achieved through a reduction of government spending. Indeed, government revenues were even planned/projected to decrease by 0.22 pp on average across all 378 fiscal stances (a revenue-based consolidation of public finances would be achieved through increasing revenues), implying a disproportionate reliance on spending cuts at the amount of 1.15 pp. Note, however, that these figures are computed based on different sample sizes, so these results should be taken with a grain of salt. In any case, the 0.93 pp contraction planned was not realized on average. With only 0.06 pp over two years, the actual contraction of public finances was miniscule based on this indicator. Not surprisingly, this difference between plans and outcomes is highly statistically significant, too, and tends to confirm earlier research on the topic in their conclusion that fiscal plans tend to be overly optimistic in the sense that planned contractions are usually not (fully) realized (see e.g. the literature on ‘projections errors’ cited in the beginning of this chapter). Finally, Table 2.2 also displays summary statistics for the second operationalization of planned fiscal stances and consolidations, which measures the planned percentage change in government spending over the same 2-year period based on absolute national currencies. For illustrative purpose this indicator is also supplemented with the analogous figure for the development of government revenues. On average, spending was planned/projected to increase by 7.3%. Note, however, that these are nominal 2-year figures, not adjusted for inflation. In real terms, such a

I avoid using the term “fiscal consolidation” or “austerity” when referring to average fiscal policy stances, since these are summary statistics that combine expansions with consolidations.

12

3.3

1996

0.9

1.5

1998

1.2

0.5 0.6

0.5

2000

0.4

1.4

2001

0.5

1.7

−0.5

0.8

−0.9

2.3

−1.0

1.1

−1.9

0.9

−1.1

−0.4

1.5

−0.9

0.7

0.1

0.7

−1.7

0.2

0.8

−1.7

1.0

−1.0

0.9

0.9

1.1

−0.2

0.7

0.9

−1.5

1.4

3.3

0.6

1.4

0.1

0.2

1.5

−1.1

2.8

2.0

0.6

0.4

−0.2

−0.3 −0.3

1.0 −1.0

−0.4

−0.5

NLD

0.2

−0.7

−0.7 0.0

0.0

0.7

0.9

0.0

1.6

0.1

0.3

1.0

−0.4

1.3

−1.2

0.1

−2.6

0.0

1.3 0.4

0.6

0.2

−0.9

1.1

−0.3

0.7

−0.1

−1.1

0.6

−0.1

0.5

2.3 0.4

1.5

0.7

0.3

1.1

2006

2.9

0.6

2.5

0.8

1.1

1.0

1.1

0.9

0.2

1.5

0.0

0.3

−0.2

2005 −0.4

2004 −0.2

2003 −0.1

LVA

−0.6

2.8

1.6

0.9

0.0 −0.1

0.5 −0.7

1.5

0.5

0.0

2002

MLT

4.0

1.2

2.4

1.0

1.5

0.5

0.6

0.5

1999

1.3

5.6

3.5

5.8

1.1

1.3

1.4

1.6

1997

0.5

LUX

LTU

ITA

IRL

HUN

−0.2

0.3

GBR

GRC

1.3

FRA

FIN

EST

ESP

1.5

0.7

DEU

DNK

0.7

3.0

1995

3.1

1994

1.4

1.2

1993

CYP

0.9

1992

CZE

BEL

AUT

Country

Table 2.1 Planned 2-year Fiscal Stances in the EU from 1992 to 2014

0.0

0.2

1.0

1.5

0.7

−0.5

1.1

0.9

−1.6

3.0

1.9

0.5

0.7

−0.9

−1.6

−0.6

−1.8

2010

−1.3

−0.4

3.0

−1.4

−1.5

−0.1

0.9

4.0

−3.9

3.3

1.4

−0.7 2.0

1.7

−2.7

1.1

7.1

−0.2 0.9

3.5

3.2

1.5

5.2

0.2

4.3

1.9

23.8

1.7

4.9

3.5

2.4

1.8 1.9

−0.8

4.8 −2.2

3.9

−1.8

1.8

1.2

2.7

1.3

1.3

2011

0.6

−1.6

0.2

−3.3

0.9

−1.4

−1.2

−4.0 −4.2

1.6 1.8

−2.4

1.8

−0.5

−0.3

−1.0 0.8

−2.8

0.0

1.7

2009 −4.3

0.5

0.5

2008

0.6

0.7

2.6

−1.4

5.8

0.8

0.8

0.9

−0.2

−1.3

−0.5

−0.6

0.6

0.0

0.2

0.5

0.4

2007

1.6

1.0

2.1

−0.6

3.5

3.4

5.6

0.4

1.2

0.2

−0.6

1.2

0.9

4.2

−0.6

10.6

2.0

1.3

1.0

−0.3

2.9

−2.1

0.0

−0.8

−0.7

1.2

0.1

2014

(continued)

1.1

1.2

0.3

0.2

1.7

1.2

3.2

6.7 −0.7

4.7

−0.4

2.0

0.6

0.3

1.5

2.3

−0.2

1.5

−1.3

1.9

1.0

2013

−6.5

2.3

2.2

0.0

−1.7

5.5

0.0

0.5

0.2

5.7

1.6

0.5

2012

38 2 Fiscal Adjustment in Europe

SWE

−0.2 0.3

0.9

2000

−0.1

0.8

2001

−2.4

1.2

2002

Notes Own calculation. Details on operationalizations and sources of fiscal plan data provided in Appendix A

2.4

0.8

1999

−0.1

0.9

2003

1.0

0.7

2004

2005

−0.3

0.3

0.9

1998

0.9

3.8

1997

SVN

4.3

1996

SVK

5.0

1995

0.4

3.5

1994

PRT

1993 2.2

1992

POL

Country

Table 2.1 (continued)

−0.3

0.3

2.5

2.3

0.7

2006

−0.2

0.0

1.3

2.0

0.9

2007

0.1

0.0

0.7

1.5

0.0

2008

2.1 1.5

−0.7 −3.0 0.1

2.7

−0.7

−1.2

1.3

2010

0.4

2009

2.1

1.6

3.8

4.6

5.0

2011

0.2

3.9

0.3

1.2

2.9

2012

−0.4

1.4

1.0

2.4

0.6

2013

0.9

12.3

0.3

2.4

1.8

2014

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation 39

40

2 Fiscal Adjustment in Europe

Table 2.2 Univariate statistics for selected fiscal stance and economic variables Variable

n

Mean

Std. dev.

Minimum

Maximum

Planned fiscal stance 378 0.93 2.23 −6.50 23.80 Actual fiscal stance 378 0.06 3.66 −25.38 24.37 Planned spending 359 −1.15 2.15 −23.30 4.50 Actual spending 378 0.14 3.50 −23.81 24.03 Planned revenue 359 −0.22 1.56 −7.70 9.40 Actual revenue 378 0.19 1.50 −6.11 6.43 Planned spending, %-change in abs currency 341 7.3% 7.2% −32.0% 39.0% Actual spending, %-change in abs currency 345 8.3% 9.5% −33.0% 64.4% Planned revenue, %-change in abs currency 341 9.4% 6.6% −7.0% 45.0% Actual revenue, %-change in abs currency 345 8.4% 8.9% −20.5% 63.4% Projected growth 378 5.03 3.57 −12.26 17.17 Actual growth 378 3.72 5.80 −20.06 21.80 Notes Own calculation. Details on operationalizations and sources of fiscal/economic plans and their actual development (ex post) are provided in the Appendix (A and B)

spending increase is small at best—spending may even remain constant in real term. Revenues were also planned/predicted to increase by a roughly similar magnitude of 9.4% on average. An important difference compared to the earlier operationalization based on %-of-GDP, which is a lot more common in the literature, is therefore, that based on the absolute currency-based figures, government’s plans/ projections were realized in practice. While plans still appear to be slightly too optimistic, the difference between plans and actual outcomes is not statistically significant, as a t test confirms. An explanation for these slightly contradictory findings may already be found in the last statistic included in the table: projected and actual economic growth (in real terms). On average, economic growth has been projected stronger that it actually turned out: about 5% cumulative 2-year growth in governments’ plans versus about 3.7% in reality. Lower growth, however, has a direct effect on the denominator of the OB/GDP-ratio. In consequence, the failure to achieve what was planned when it comes to improving the budget balance (in % of GDP) may to a substantial degree result from the systematic overestimation of future economic growth (and/or the inability to promote it)—another common finding in the literature. This is also what Mauro (2011) tends to find in his empirical analysis on the implementation of austerity programs. Note, however, that up to this point no distinction has been made between the period before and after the Great Recession. That is, the figures that have just been presented are likely to be strongly influenced by the extraordinarily large fiscal consolidations (in both plans and reality) we’ve seen in Europe after 2009. Figure 2.2 takes up on this issue by showing the development of cross-country averages of planned fiscal stances over time. The grey shaded area merely shows

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

41

8.0

6.0

Euro introduction

4.0

2.0

0.0

-4.0

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-2.0

Notes: Own calculation and illustration. Details on operationalizations and sources of fiscal plan data provided in appendix A. Fig. 2.2 Planned Fiscal Stances over time

the upper and lower standard deviation from those means to give a rough impression of the distribution of the variable. As is easily seen, average fiscal policy stances were decidedly contractionary in the run-up to EMU, remained more or less neutral in the years before the crisis, and turned strongly contractionary again after the onset of the Great Recession and a brief intermezzo of countercyclical spending in 2009. While especially the pre-EMU consolidation phase may seem to be perfectly in line with earlier literature on the topic, there is an important qualification to be made: the pre-1999 period is likely to suffer from selection bias for this variable. This is because all the pre-1999 observations were collected by (Mauro, 2011) based on the criterion that they qualify as fiscal consolidation plans. It is not surprising, therefore, that fiscal stances appear to be uniformly contractionary before 1999. In other words, I will refrain from drawing any conclusions from this pre-1999 data at this point. Another important fact to keep in mind is that the pre-1999 years are represented by only 38 observations in total, and that the number of annual observations increases from 15 in 1999–2004 to 25 from 2005 onwards. Table 2.3 breaks down the summary statistics of planned fiscal stances by periods. Those numbers just confirm what has been conveyed by the preceding figure already: after a decade of roughly neutral—or slightly contractionary at best

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Table 2.3 Planned Fiscal Stances by time period

Period 1991–1998

M 1.97

Std. dev. 1.57

n 38

1999–2008 0.44 1.09 190 2009 −1.18 1.88 25 2010–2014 1.79 3.10 125 Total 0.93 2.23 378 Notes Own calculation. Details on operationalizations and sources of fiscal plan data provided in Appendix A

—planned policy stances leading up to the crisis, and a sharply expansionary intermezzo in 2009, fiscal plans turned decidedly contractionary again from 2010 onwards. Figure 2.3 is just a graphic depiction of the statistics in Table 2.3, but compares the planned (ex ante) fiscal stances with the actual ones (ex post). I do not interpret the data for the 1992–1998 period. What is noteworthy for 1999-2008—and not too surprising against the background of the findings of earlier literature on the topic (Beetsma et al., 2009; Mauro, 2011; Strauch et al., 2004)—is that fiscal stances appear to have turned out less contractionary than planned. Similarly, in 2009, actual fiscal stances were even more expansionary that planned, which mainly is a result of the rapidly deteriorating economic situation. At least in part, it may therefore be an artifact of a shrinking denominator (GDP). What may very well be surprising to some readers, however, is that in the 2010–2014 period fiscal plans appear to have been achieved—at least based on this visual inspection of the boxplots shown in the figure. This finding will be explored in much more detail in the subsequent subsections and chapters. What is also noteworthy is the high variance of fiscal stances in the post-GR period, which is visible both in Figs. 2.2 and 2.3, and also confirmed by Table 2.3: the standard deviation for the 2010-2014 period (at 3.1) is almost three times that of the 1999–2008 period (at 1.09). In other words, intra-EMU fiscal policy has become much more heterogeneous since the onset of the Euro crisis. This is a finding that will come up repeatedly in the empirical results presented in the thesis at hand.

2.5.2

Occurrence and Size of Austerity Plans

The second main dependent variable is a dummy indicating the presence of a fiscal consolidation plan in a given year. The identification procedure described earlier yielded a total of 183 fiscal adjustment plans out of 378 country-year observations in my data. The variable is shown in Table 2.4, together with some basic summary statistics on the third main dependent variable, which corresponds exactly to the fiscal stance variable but is observed only when the austerity plan dummy equals 1. As can be seen, the average size of consolidation plans in the data is a 2.27 pp 2-year improvement in the overall budget balances, with a standard deviation of

43

-30

-20

-10

0

10

20

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

1991-1998

1999-2008

2009

planned fiscal stance

2010-2015 actual fiscal stance

Notes: Own calculation and illustration. Details on operationalizations and sources of fiscal/economic plans and their actual development (ex post) are provided in the appendix (A and B) Fig. 2.3 Planned and Actual Fiscal Stances by time period

Table 2.4 Occurrence and average sizes of Austerity Plans 1992–2014

FA plan dummy

Mean size

Std. dev.

Frequency

No austerity plan [0] −0.32 1.12 195 Austerity plan [1] 2.27 2.36 183 Total 0.93 2.23 378 Notes Details on operationalizations and sources of austerity plan data provided in the appendix

2.36. This compared to an average 0.32 pp. deterioration for country-years without an austerity plan. Figure 2.4 takes us back one step, showing only the proportion of 2-year fiscal stances that qualified as an austerity plan in any given year between 1992 and 2014 fiscal. In other words, this is the proportion when the dummy indicating the occurrence of a fiscal consolidation equals 1. It is shown that before the Great Recession (defined here as pre-2009, because only in 2009 the Great Recession had a clear notable impact on government budgets), a majority of country-years did not have austerity plans, while after the Great Recession (post-2009), a majority did.

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100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

0%

Notes: Own calculation and illustration. The vertical dashed line marks the fiscal shock caused by the Great Recession, and thereby divides the sample into a pre-Great Recession and a post-Great Recession period. Details on operationalizations and sources of austerity plan data provided in the appendix. Fig. 2.4 Proportion of Fiscal Stances qualifying as Austerity Plan

Indeed, 69% of the 125 post-2009 observations did have FA plans, while only 40% of the 203 pre-2009 observations had. This reduces further to just 32% if the bias resulting from sample selection is eliminated, by way of excluding the pre-1999 observations (shaded in grey). Keep in mind that this selection bias results from the fact that this data is sourced from Mauro (2011), who selected only austerity episodes (but not non-austerity episodes) to begin with. That the proportion of austerity fiscal stances does not consistently reach 100% in those years results from differences in the identification procedures used by Mauro (2011) and in the analysis at hand, the different time horizons used, as well as the small number of observations prior to 1999. It seems safe to assume that apart from the cases selected by Mauro (2011), there was no more substantial austerity taking place in any of the countries and years covered by their analysis, so that we could safely code these as “no austerity plan” [0] on the fiscal plan dummy. Based on this exercise, the proportion of fiscal stances qualifying as austerity episodes is reduced to only 28% for the pre-1999, and 31% for the entire pre-2009 period. In other words, compared to what can be observed after the Great Recession in Europe with regard to the presence of austerity plans, the earlier years—which include the run-up to EMU—have seen surprisingly little austerity (operationalizations and sources provided in the appendix).

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

45

10.0 8.0 6.0 4.0 2.0 0.0

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-2.0

Notes: Own calculation and illustration. The horizontal dashed line marks the mean size of austerity plans over time. Details on operationalizations and sources of austerity plan data provided in the appendix. Fig. 2.5 Average Size of Austerity Plans over Time

The pattern just described is also confirmed by Fig. 2.5, which depicts the development of the third variable over time—the size of the 2-year fiscal stance whenever the austerity dummy indicated the presence of a fiscal consolidation plan. The dashed horizontal line shows the average size of all 183 austerity plans: a 2.27 pp 2-year improvement in the overall general government balance Note that, while the dummy suffers from sample selection bias for the pre-1999 period, this is not the case for this austerity plan size variable. This is because by definition the underlying sample of that variable is confined to fiscal consolidation plans only anyways. The figure confirms what previous data had already suggested, and can be summarized as three main findings: first, the pre-EMU period was characterized by relatively large (above-average) fiscal consolidation plans, but there was also some variance in the plans. Second, EMU’s first decade, in contrast was characterized by relatively small (below-average) austerity plans, and there was also not much variance in that. Third, with the Great Recession, large austerity came back with a vengeance, but with it also came some considerable fiscal policy heterogeneity with respect to the sizes of consolidation plans.

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Table 2.5 Occurrence and average sizes of Austerity Plans by time period

Period

Occurrence Proportion (%)

Obs

Size Avg size

Std. dev.

1992–1998 76 (29%) 29 2.4 1.5 1999–2008 33 62 1.5 0.9 2009 24 6 0.9 1.6 2010–2014 69 86 2.8 3.1 Overall 48 183 2.3 2.4 Notes Own calculation. The figure in parantheses indicates the relevant proportion after the elimination of selection bias base on the procedure described above. Details on operationalizations and sources of austerity plan data provided in the appendix

Finally, Table 2.5 shows summary statistics for both the dichotomous austerity plan dummy and the continuous austerity plan size variable by period. With respect to the occurrence of plans, the pattern conveyed by Fig. 2.5 is confirmed: the proportion of country-years with consolidation plans more than doubled after the Great Recession, when compared to the pre-Great Recession period. Comparisons with the pre-1999 period must be taken with a grain of salt, however. Only when adjusting the pre-1999 data to eliminate the selection bias as described above, it becomes clearly visible how extraordinary the post-Great Recession period actually is when compared to at least the preceding 25 years in Europe. The size variable, which does not suffer from selection bias to begin with, shows a similar, only slightly different, picture. First of all, it confirms that there has indeed been some EMU-induced austerity in the run-up to EMU, at least with respect to plans. In the 1992–1998 period, fiscal plans averaged 2.4 pp. Since the proportion of country-years was still relatively low when corrected for selection bias, however, it is hard to argue that large austerity was particularly widespread. Indeed, that only came in response to the Great Recession, just as it was shown in Fig. 2.5.

2.5.3

Plan Realization in the Euro Crisis

The fourth main dependent variable indicates the degree of 2-year austerity plan realization, conceptualized as ‘realization errors’, and operationalized in both percentages of GDP and percentage changes in spending measured in absolute national currencies. Recall that a positive realization error indicates an overachievement of austerity plans, while a negative realization error indicates an underachievement. This is true for both operationalizations of the variable, even though the

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

47

Table 2.6 Realization of Austerity Plans (based on % of GDP) Variable

Obs

Mean

Std. dev.

Min

Max

Planned balance improvement 183 2.3 2.4 −1.4 23.8 Actual balance improvement 183 1.3 3.4 −8.5 24.4 Balance realization error 183 −0.9 2.5 −12.2 4.1 Planned spending reduction 174 −1.9 2.6 −23.3 4.5 Actual spending reduction 183 −0.7 3.5 −23.8 9.9 Spending realization error 174 −1.1 2.5 −6.1 14.1 Planned revenue increase 174 0.4 1.6 −4.3 9.4 Actual revenue increase 183 0.6 1.4 −4.5 4.9 Revenue realization error 174 0.2 1.7 −8.4 5.8 Notes Own calculation. The main dependent variable (the mean) is printed in bold. Details on operationalizations and sources of austerity plan data and their realization are provided in the appendix

subcomponents of the absolute-currency-based realization error (planned and actual spending) may suggest otherwise.13 Table 2.6 shows summary statistics on the realization of austerity plans based on the %-of-GDP operationalization. For illustrative purposes, the main dependent variable is again supplemented by its subcomponents: government spending and revenue. On average across all country-years in the sample, plans were not met. The realization error was −0.9 pp, indicating that while there was a 2-year improvement of 2.3 pp planned in the budget balance, the actual improvement was only 1.3 pp. As the realization of the spending and revenue component of those plans suggest, plans were missed on the spending side on average. While spending was planned to be reduced by 1.9 pp, it was actually reduced by only 0.7 pp. Note that the sample sizes used to compute average figures varied slightly, but this is unlikely to have caused substantial biases. Plans on the revenue side, in contrast, were even overachieved by 0.2 pp. When taking into account that over the last decades many European governments had intended to shrink the size of their government sectors (Pierson, 1994, 1998, 2001a; Streeck, 2014a), it is questionable if this overachievement can really be interpreted as an exceptional over-performance, however. Figure 2.6 depicts the development of the average realization of austerity plans over time, which the grey bars showing the number of observations per year. At first glance, there is not much variation in plan realization over time, when disregarding the sharp drop in 2008, which was caused in 2009 by a combination of collapsing GDP and government revenues, and strong countercyclical fiscal spending driven by automatic stabilizers or rescue packages. At a closer look,

13

Absolute currency-based realization errors have been multiplied by (−1) to facilitate a straightforward comparison with the %-of-GDP based operationalization. That is, positive realization errors stand for better fiscal consolidation performance—spending growth over a two-year period has been lower than foreseen in the plans.

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23

22 Freq. planned

18

18 16

actual realization error

14

13

13

10 8

8

3

3

2

3

4

4

8 5

6 4

4 2

3

16

9 6

3

-2

-7

Notes: own calculation and illustration. Details on operationalizations and sources of austerity and their actual development and realization (ex post) are provided in the appendix (A and B)

Fig. 2.6 Realization of Austerity Plans over time (based on % of GDP)

however, we see that average plan realization (i.e., actual austerity), while it had been clearly positive until 1999, dropped below zero for the following years, consistently resulting in negative realization errors. Then, shortly before the Great Recession, but especially afterwards, both plans and realization turned positive again. In other words, we do see some indication that there was indeed a pre-EMU austerity drive in Europe both in fiscal plans and their outcomes, confirming the findings by Mulas-Granados (2006). In the first decade of the Euro, austerity ebbed of a little, hypothetically because the main incentive for ensuring sound public finances—the prospect of becoming an EMU member—was gone. Table 2.7 summarizes the earlier graphical depiction by time period. The pattern just described is confirmed: on average, planned—and relatively sizable—fiscal consolidation was to a large degree achieved in the run-up to EMU. The plan realization ratio calculated from the average sizes of planned and achieved austerity was at 88%. The much smaller plans of the 1999–2008 period were not achieved, just as—not surprisingly—those of 2009, when the Great Recession triggered a substantial fiscal shock to European countries. The large consolidation plans of the post-Great Recession years, in contrast, were met to a relatively large extent again, with an average realization ratio of 77%. What is also clearly visible that there is

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation

49

Table 2.7 Realization of Austerity Plans (based on % of GDP) by time period Planned consolidation

Actual consolidation

Realization error

Mean realization ratio

1992–1998

Obs 29 29 29 Mean 2.44 2.14 −0.30 88% Std. 1.48 2.17 2.25 dev. 1999–2008 Obs 62 62 62 Mean 1.52 −0.02 −1.54 0% Std. 0.86 3.04 2.89 dev. 2009 Obs 6 6 6 Mean 0.86 −0.98 −1.84 0 Std. 1.55 2.76 2.55 dev. 2010–2014 Obs 86 86 86 Mean 2.84 2.18 −0.66 77% Std. 3.10 3.67 2.25 dev. Notes Own calculation. The main dependent variable (the mean) is printed in bold. Details on operationalizations and sources of austerity and their actual development and realization (ex post) are provided in the Appendix (A and B)

much more diversity especially in austerity plans, but also their realization, in 2010– 2014 when confirmed to the earlier periods. In fact, compared to the 1999-2008, the standard deviation of planned consolidations almost quadruples in 2010–2014. With Table 2.8, I turn to the description of the second operationalization of the fourth main dependent variable: the realization of austerity plans measured based on %-change in absolute spending. Interestingly, the pattern is quite different than that obtained from the earlier operationalization. Nominal spending was planned to increase by no more than 4.8% on average over two years—and that goal was achieved.14 The spending realization error calculated from these numbers is as low as 0.6%, which would correspond to a spending-based realization ratio of more than 100%.15 That is, based on this indicator, it is fair to conclude that European austerity plans in 1992–2014 have been realized on average. Here it is important to emphasize once again that these government spending figures are nominal figures, and for a 2-year time horizon. These two factors explain that spending increase, as opposed to spending reductions, are foreseen even during austerity episodes. Also keep in mind what has been laid out briefly in the introduction to the analysis at hand already: empirically, nominal cuts to government spending are extremely rare. Cuts usually occur in real terms and when measured relative to GDP, not in nominal absolute currency amounts. 15 Note that austerity based on this indicator is defined as decreasing government spending. Therefore, when a government planned an increase in spending while being in a fiscal consolidation program (note that this could, for example, result from high inflation or a shrinking 14

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Table 2.8 Realization of Austerity Plans (based on %-changes in absolute spending) Variable

Obs

Mean (%)

Std. dev. (%)

Min (%)

Max (%)

Planned %-change in absolute nominal 159 4.8 7.8 −32.0 39.0 government spending Actual %-change in absolute nominal 165 4.3 8.0 −33.0 33.1 government spending Spending realization error 146 0.6 5.5 −30.6 23.5 Notes Own calculation. Details on operationalizations and sources of austerity and their actual development and realization (ex post) are provided in the Appendix (A and B)

One qualification to the conclusions drawn from this table is the variance in the number of observations across the three variables. This shortcoming will be addressed in the empirical Chaps. 4 and 5, however. For now I would like to point out that the findings remain substantively unaltered if the number of observations is kept constant across those variables. Analogous to Fig. 2.6 (for the %-of-GDP operationalization), Fig. 2.7 depicts the development of average austerity plan realization for the operationalization based on percentage changes in nominal spending. Three observations are worth pointing out. First, planned and actual austerity appear to roughly move in tandem. In other words, the main conclusion drawn from the overall average is stable over time: by and large, austerity plans have been realized more or less in Europe over the course of the last two decades. Second, however, at a closer look, the average realization error computed based on plans and outcomes had been slightly negative between about 1997 and 2008 (indicating underachievement of plans). Only with the Great Recession it turned sharply positive in 2009, and the dropped to remain roughly stable around the zero-line until 2014. Finally, third, the small or even positive realization error is all the more noteworthy when taking into account that planned fiscal consolidation became much more sizable after the Great Recession, which is also shown in the figure. While spending was foreseen to increase by about five to eight percent on average before 2009, this number dropped to only between zero and three percent afterwards.16 Table 2.9 summarizes the realization of consolidation plans by period, confirming the pattern seen in the preceding figure. First, in 1992–1999, consolidation plans were no met on average. Admittedly, though, actual austerity was only slightly off, with a realization error of −0.7 that was certainly not statistically

economy, among others), then an actual increase that turned out lower than planned is considered an overachievement of plans. 16 Note in the interpretation of Fig. 2.7 that the realization error has been multiplied by −1 to facilitate a straightforward interpretation and comparison with the operationalization of austerity realization based on %-GDP figures.

2.5 Occurrence, Implementation, and Realization of Fiscal Consolidation 20.0% 15.0%

51

planned actual realization error

10.0% 5.0% 0.0% -5.0% -10.0%

Notes: own calculation and illustration. Details on operationalizations and sources of austerity and their actual development and realization (ex post) are provided in the appendix (A and B)

Fig. 2.7 Realization of Austerity Plans over time (based on %-change in absolute spending)

Table 2.9 Realization of Austerity Plans (based on %-changes in absolute spending) by time period Variable

1992–1998

Planned percentage point spending change

Actual percentage point spending change

Realization error

Actual compared to planned D spending

Obs 5 5 5 Mean (%) 5.2 5.8 −0.7 12 Higher Std. dev. (%) 5.0 1.8 3.9 1999–2008 Obs 56 56 56 Mean (%) 7.4 9.9 −2.5 34 Higher Std. dev. (%) 6.6 6.2 6.0 2009 Obs 5 5 5 Mean (%) 5.6 −2.8 8.4 NA Lower Std. dev. (%) 3.3 5.8 5.1 2010–2014 Obs 80 80 80 Mean (%) 1.4 1.2 0.2 −16 Lower Std. dev. (%) 6.8 7.9 4.6 Notes Own calculation. The main dependent variable (the mean) is printed in bold. Details on operationalizations and sources of austerity and their actual development and realization (ex post) are provided in the Appendix (A and B)

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2 Fiscal Adjustment in Europe

significantly different from zero. Actual spending was about 12% higher than planned on average. Second, actual austerity was more clearly off when compared to plans in the 1999–2008 period. With an actual spending increase of almost ten percent over the 2-year horizon, spending was about 34% higher than planned. Third, in 2009 (which stands for the 2008–2010 period), the fiscal shock triggered by the Great Recession is clearly visible. While spending was foreseen to increase by 5.6% on average, it ended up being reduced by 2.8% as a result of the massive austerity programs that kicked in 2010. Finally, spending was planned to be increased by an average 1.4% between 2010 and 2014. These plans were achieved in their entirety: the actual spending increase ended up averaging 16% lower than plans.

2.6

Chapter Conclusion

Apart from introducing the concept of austerity and discussing it in the broader context of the Great Recession and the Euro crisis in particular, the main purpose of this chapter was to provide an empirical overview of the main phenomena to be explained in the analysis at hand: the occurrence, the size, and the realization of fiscal consolidation programs in the Euro crisis as well as in the roughly two decades leading up to that crisis. The conclusions drawn from this exercise are best summarized in accordance with the three puzzles presented in the introduction to this thesis. In essence, these state that, from a comparative perspective, austerity was not only extremely widespread in the post-Great Recession period in Europe, but also extraordinarily sizable. On top of that, it was also realized to a surprisingly large degree, when recognizing the extremely difficult politico-economic context European countries found themselves in. Having read about Pierson’s ‘Age of Austerity’ as an undergraduate student in the mid-2000 s (Pierson, 1994, 1996, 2001a), it made me wonder if, when working on the analysis at hand, and perusing the data on the massive austerity programs hastily drawn up at the onset of the Euro crisis in 2010, this was just the continuation of ‘permanent austerity’, or if Pierson might have heralded its start a decade too early. After all, the proportion of country-years in fiscal consolidation was as high as 69% after 2009, much higher than the about 29% in Pierson’s times (i.e., before 1999, see Table 2.5). The average size of these consolidation programs was as high as 2.8 pp. after the Great Recession, but only 1.8 pp before 2009. And finally, pre-Great Recession consolidation plans often were not even realized, while a prime characteristic of the post-2009 austerity episodes was their extraordinarily high realization (details on operationalizations and data sources provided in the appendix).

2.6 Chapter Conclusion

53

In other words, the ‘Age of Austerity’ appears to have been taken to a whole new level in the since 2010, when compared to the phenomena Pierson was referring to in his original publications. Pierson focused much on resilience of the welfare state; and he emphasized in his 1998 piece (Pierson, 1998), only one year before the official introduction of the Euro, that globalization was not the main factor to blame for ever tighter constraints on government budgets after the end of the ‘Trente Glorieuses’, but internal shifts were. He referred in particular to developments such as deindustrialization and the rise of the service economy, such as the maturation of government commitments in western welfare states, as well as population ageing. What was more or less neglected in his publication, however, is the crucial role that various versions of European fixed exchange rate regimes played in limiting the economic, social, and fiscal policy options available to national governments since the end of Bretton Woods. And in the sense that this type of European economic integration can surely be understood as some form of international economic integration, and regionalization is just globalization on a lower level, one could argue that globalization is an important factor to blame. Up to this point, I have neither engaged in any bi- or multivariate comparison of austerity plans and outcomes, apart from some comparisons over time, nor in any comparisons across countries. This shortcoming will be resolved in the following chapters. In these I will attempt to make clear the crucial role of the European exchange rate regime in eventually bringing about what Streeck (2015a) in reference to the Eurozone calls the emerging ‘European Consolidation state’.

Chapter 3

Theoretical Framework: Austerity’s Institutional Origins

As the title to this chapter makes clear, I content in this thesis that the extraordinarily large number of very sizable fiscal consolidations (in both rhetoric and reality) during the Euro crisis ultimately stems from the immense institutional asymmetries between the countries comprising EMU. In this sense, the theoretical roots of my main argument lie firmly in historic institutionalism, in line with large sections of the comparative capitalism literature (Hall & Soskice, 2001; Hancké et al., 2007; Nölke, 2015; Steinmo et al., 1992). This will become abundantly clear in the following subsections. Acknowledging the fact, however, that the creation of (fixed) exchange rate regimes, and currency unions as their most extreme form in particular, is, from a purely economic perspective at least, ultimately a means to facilitate international trade and investment, my argument connects to the globalization literature as well. After all, the desire to keep exchange rates stable or even totally fixed is no less geared towards deepening international economic integration as the removal of trade barriers is—or the gradual liberalization of capital flows, which picked up steam with the advent of monetarism and the ‘Great Moderation’ from the late 1970s onwards (Ferguson et al., 2011; Krippner, 2012). At the same time as factors of production, goods and services move more and more freely across borders, and as businesses and production chains become increasingly globalized, the regulation and taxation of such flows and entities, as well as economic governance, politics, and policies more generally, remains much more fragmented along the lines of rather impervious boundaries between national polities. This fragmentation is merely a reflection of the tremendous cross-national institutional and cultural diversity that still exists even among Western European nations, despite these having lived through more than half a century of integration and harmonization. The resulting tension between a globalized—or Europeanized for that matter— economic, but still largely national political sphere (which makes the rules governing national economies), essentially creates a situation where nation states end up competing for the increasingly mobile factors of production, for businesses, © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 K. Guthmann, Fiscal Consolidation in the Euro Crisis, https://doi.org/10.1007/978-3-030-57768-1_3

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peoples, and not to forget their wealth—and this competition may exert substantial adjustment pressures for the national governments of those countries that tend to lose out from this competition.1 The globalization literature has identified at least two different ways governments may alter the allocation of their resources in response to globalization: by spending more ‘efficiently’ (i.e., spending less against the background of supposedly ‘inefficient’ welfare states and public spending programs more generally), or by compensating the ‘losers’ from globalization through higher spending. The empirical evidence is mixed with regard to both the efficiency and the compensation hypothesis. If anything, both can claim some empirical support in different times and contexts (Boix, 1998; Dreher, 2006; Dreher et al., 2007; Garrett, 1995, 1998, 2001; Garrett & Mitchell, 2001; Rodrik, 1997; Schulze & Ursprung, 1999). Other literatures, such as Welfare State Research or European Politics, have also studied extensively the impact that external developments and forces may have on national politics and policymaking (Armingeon, 2013b; Cameron, 1978; Katzenstein, 1985; Pierson, 1998, 2001a, b, Swank, 1997). Unfortunately, however, before the Euro crisis many of these literatures appear to have somewhat neglected the consequences that monetary regimes have for the interplay between national institutional configurations on the one hand, and the immense and diverse pressures emanating from the international, globalizing economy on the other (exceptions found e.g. in the (economic) fiscal consolidation literature, which often finds that successful, i.e. sustainable, consolidation tend to be supported by currency devaluations/depreciations (Alesina & Ardagna, 1998; Alesina & Perotti, 1996)). In part, this negligence may owe to the prevalence of a too simplistic view of the role of monetary/currency matters especially in the political sciences over the course of the past three decades; or maybe the belief that the effects of such purely economic factor could simply be controlled for by means of statistical technique. After all, one may ask, have exchange rates in the Western world—until the advent of the Euro at least—not become entirely flexible with the collapse of Bretton Woods? De facto at least they have not. Rather, from the so-called ‘Snake in the tunnel’, over the European monetary system (EMS), up until EMU, European countries have from the early 1970s onwards always aimed at advancing monetary cooperation and thereby stabilizing their exchange rates. The only flexible—partly institutionalized—element in these successive regimes of pegged or fixed currencies were the periodic, crisis-induced adjustments against the Deutsche Mark, to be implemented whenever inflation differentials had accumulated, and price levels therefore diverged so markedly that they could no longer be corrected through other policy instruments alone; at least 1

This competition may be too subtle to be directly observable; even policymakers may not be fully aware of that competition. But in the end, every emergence of persistent macroeconomic imbalances is just a reflection of one country winning and another country losing out in the competition for a specific factor or production. This is not to say that globalization is a zero-sum gain in general; in the specific politico-economic context defined by EMU, however, it may very well be, as elaborated on below.

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not without inflicting serious damage to national economies. Eichengreen (2008b, p. 161) provides an extensive overview of the history of European monetary regimes and counts 12 adjustments between September 1979 and January 1990 alone. While exchange rate stability aimed at deeper economic integration, or deeper integration required more stable currencies,2 the correspondingly higher capital mobility at the same time tended to make it more and more difficult to confine currency fluctuations to narrow bands in Europe. Increased capital freedom and thus higher and more volatile cross-border capital flows translated into stronger upward or downward pressure on both nominal and real exchange rates. Note that some degree of (both de jure and de facto) exchange rate flexibility may actually reduce de facto capital mobility, mainly as a result of the risk premiums that capital markets attach to cross-borders transactions that involve some currency conversion. With currencies tightly pegged to each other, however, and the ‘age of financialization’ at its climax, perfect capital freedom must be taken as a given in Europe. The introduction of the Euro, so the architects of the common currency had hoped, would end these successive unstable arrangements somewhere halfway between fully flexible and irrevocably fixed exchange rates. That at least was one of the key economic arguments for EMU (European Commission, 1990). From a political viewpoint, the Euro was meant to unite the peoples of Europe by strengthening the European identity, and therefore be another decisive step towards a fully-fledged political union. By giving up their national currencies, however, Eurozone members ended up relinquishing their exchange rates as the most potent safety valve to swiftly correct balance of payments positions in a situation of crisis. And as it turned out, despite having centralized monetary policy at the ECB in 1999, and ensured strict European oversight over fiscal policy in the context of the SGP, that safety valve would soon be badly needed. When the Euro crisis hit by early 2010, the massive macroeconomic imbalances and underlying competitiveness problems that had accumulated during the first decade of the Euro became visible for everyone to see. Being deprived of the opportunity to release at least part of the resulting adjustment pressure and re-align diverged price levels through the exchange rate, as it had regularly been done before EMU, crisis countries had no choice but to resort to politically much more challenging and economically much more painful structural adjustments to fiscal policy and many other policy fields. They had to start learning the hard way, that, when giving up control over the value of their money, they may eventually be giving up sovereignty not only over monetary affairs, but also over fiscal and economic policy more generally. Ultimately, they may have to subordinate all of their domestic affairs under the economic imperatives of their monetary arrangement.

2

The EU’s Common Agricultural Policy (CAP), for instance, calls for a certain level of exchange rate stability for its smooth operation (Cooper, 1999).

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By implication of the preceding paragraphs, very diverse political systems, national politico-economic institutional configurations, cultures and traditions may indeed be able to co-exist in a globalized world with flexible exchange rates—just as implied both by Pierson’s argument that globalization was not to blame for the dawn of permanent austerity, and by the ambiguous findings of the globalization literature. Policymakers may very well be able to choose among different coping strategies—such as those described by the efficiency and the compensation thesis, for instance. When the exchange rate is irrevocably fixed through membership in a monetary union, however, it may be impossible to maintain that diversity in the long term. Instead, at some point countries may be forced to adjust to reduce cross-country diversity. At some point they need to produce economic outcomes— relative prices and wages in particular—that will restore and maintain external balance, even if the adjustments required to do so should lack democratic legitimacy and come in tandem with mass unemployment and economic decline (in the short term at least). The internal and the external balance of their economies have come into conflict. As briefly laid out in the very first paragraphs of this thesis, the possibility of such a tension between international economic integration and democracy is nothing new. Since the collapse of the interwar gold standard in the early 1930s, however, it has arguably never been as pressing and as consequential as it is in the EMU of today. Probably one of the earliest instances illustrating the conflict that may arise from balancing economic integration (and thus monetary arrangements) with democracy, was exemplified by the “Cross of Gold speech” delivered by former US representative William Jennings Bryan in 1896. Referring to the excruciating recessionary consequences that resulted from strict adherence to the American Gold standard that had been in place since 1873, Bryan argued that “you shall not crucify mankind upon a cross of gold”.3 Although the economic logic underlying the pressures emanating from that late 19th century Gold standard is different from that of more recent monetary arrangements—the recessionary consequences of the former can largely be attributed to the deflationary bias ultimately caused by the mere scarcity of Gold (Eichengreen, 2008b)—the politico-economic implications of trying to adhere to it are no different from those seen in the ongoing Euro crisis. In the past as today, for countries burdened by persistent trade deficit, this translates into harsh austerity and internal devaluation. Moreover, a key economic rationale for the 19th century Gold Standard was—as it was for the Euro and its precursors—the desire to facilitate and ease international trade.4 The communalities between the crisis of the interwar gold standard and the Euro crisis are even more striking, and extend to the underlying economic logic too. Both in the interwar years and during the Euro crisis, policymakers in crisis countries

3 Cited from the Financial Times Lexicon, http://lexicon.ft.com/Term?term=Cross-of-Gold-speech, last accessed 23 November 2017. 4 And in the European context of the last decades: to facilitate international exchanges more generally, maybe even as a catalyst for helping to create a common European identity.

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eventually had to succumb to the immense external pressure they were facing, and chose monetary stability over economic stability, sacrificed their internal balance in order to be able to restore their external balance, and eventually ended up subordinating all domestic policy objectives under the single goal of adhering to the politico-economic imperatives of their respective monetary arrangement, irrespective of the politico-economic ramifications. In 2014, then French economy minister Emmanuel Macron also “compared Europe’s woes with those the continent faced in the 1930s, when social discontent and populism were rife: ‘If political leaders do not take more risks, we will get bogged down in economic stagnation and will have political consequences’.” (Carnegy & Chassany, 2014). Beth Simmons (1997) analyzes for the interwar years, how these external pressures got mediated by domestic politics and political institutions. Eventually, however, mediation was not enough. The Gold standard collapsed in the early 1930s, after years of restrictive, deflationary fiscal and monetary policies had prolonged and exacerbated the Great Depression worldwide, and may have thereby contributed to the rise of fascism in Germany. The Euro, in contrast, at least for now, seems destined to survive. According to many scholars and policy practitioners alike, however, its survival may come at the cost of democracy (Armingeon et al., 2016b; Crum, 2013; Scharpf, 2013, 2015; Stiglitz, 2016; Streeck, 2015b). This argument is not much different from Polany’s (1944) presumed inherent incompatibility between democracy and the market, with ‘the market’ in Polany’s times being characterized among others by laissez-faire capitalism, underdeveloped welfare states, the first globalization wave, and of course the Gold Standard. As discussed in the next section, however, the implicit economic logic of Polany’s argument was formalized only several decades after his death.

3.1

Economic and Politico-economic Roots of the Argument

The main economic roots of my argument can be traced back to the ‘Impossible Trinity’ (or the trilemma) of international macroeconomics. Developed around the early 1960s (Fleming, 1962, 1971; Mundell, 1961, 1962, 1963), but made prominent in around 1997 by Obstfeld (1997b), the impossible trinity states that the three economic policy objectives of fixed-exchange rates, capital mobility, and monetary autonomy are mutually exclusive in the sense that only two of these three can be achieved at the same time. In brief, the logic goes like this: inflation and interest rates are crucial determinants of exchange rates, mainly through their effect on the demand and supply of a specific currency, but certainly also on the expectations of economic agents with regard to supply, demand, and future exchange rate changes (besides the abovementioned pieces by Mundell and Fleming, noteworthy contributions from the economic literature on the determinants of exchange rates include: Branson, 1977,

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1979; Cassel, 1918; Dornbusch, 1976; Frenkel, 1976; Friedman, 1956; Krugman, 1979, 1995, 1997; Meade, 1951; Mussa, 1976, 1979; Turnovsky, 1981).5 Inflation cannot be controlled directly by authorities (even though policymakers end up trying from time, by imposing rather futile price controls, for example), but interest rates are set by the central bank, making them the most important policy tool at the disposal of the authorities to influence the price of their currency. Capital flows are also considered determinants of exchange rates, but ultimately these flows are only the medium through which supply and demand are brought into balance in the currency markets. When an exchange rate is to be fixed ‘artificially’—that is, authorities would like to achieve the objective of exchange rate stability between two currencies—the crucial disturbances to the exchange rate must be eliminated. That is, based on the logic of the impossible trinity, either interest rates must be prevented from creating incentives for currency trading and cross-border capital flows, or cross-border capital flows must be prevented. With regards to interest rates, this implies that authorities must relinquish their monetary autonomy. Instead of setting policy interest rates according to domestic policy objectives, such as to stimulate aggregate demand in times of recession, they must be set so as to balance supply and demand in the currency markets. Oftentimes this means that interest rates in a specific country must mirror those prevalent in the country of the anchor currency. As the economic literature puts it (Krugman & Obstfeld, 2009), monetary policy autonomy is forfeited and instead gets ‘imported’ from abroad. If authorities would like to maintain their ability to use monetary policy as an instrument to achieve domestic policy objectives, they have the theoretical option to restrict capital flows by imposing capital controls. In other words, while supply and demand of a currency may not be in balance (due to some interest rate divergence creating profit opportunities in currency markets, for instance), and thus there is some upward or downward pressure on the exchange rate, this pressure cannot be relieved through currency trading. That at least is how it works in theory. In practice, in turns out that strict capital controls are extremely difficult to sustain, and, in the globalized world, usually result in the emergence of secondary black market exchange rates. Moreover, if the upward or downward pressure on the currency is not relieved by other means, the concomitant macroeconomic imbalances will at some point lead to crisis, potentially culminating in a more or less explosive one-time devaluation,6 possibly with serious economic repercussions. This lesson has been learned repeatedly in various monetary regimes over the past decades (Eichengreen, 2008a, 2008b; Eichengreen et al., 1995). Capital mobility creates the pressure, fixed rates eliminate the safety valve. During Bretton Woods, capital mobility was much less advanced to begin with—and partly on purpose, in

5

For an overview see Copeland (2005), Engel et al. (2007), Sarno and Taylor (2002). Note that upward pressure on a currency, that is, an undervalued currency, can usually be accommodated even over very long periods of time. That is why we usually see explosive devaluations, but not realuations of currencies.

6

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order to retain some monetary policy leeway for the countries whose currencies had been pegged to the US dollar. But Bretton Woods did see quite some devaluations —mostly construed as revaluations of the Deutsche Mark—nevertheless. At the times of Europe’s ‘Snake in the tunnel’ or its successor, the EMS, more emphasis was put on capital mobility. In consequence, however, participating countries were forced to mirror German interest rates (with the Deutsche Mark as the natural anchor currency) much more closely. This often led to crisis, such as when it culminated in the exit of the British pound sterling from the EMS in 1992, when German interest rates had, in response to the German reunification, increased much more sharply than the British economy was able to tolerate. Against the background of globalization and especially financialization in the real world, and the advent of monetarism and the re-invigoration of neo-classical economics after the ‘end of Keynesianism’ in the world of economic ideas, however, capital controls became more and more elusive. Dani Rodrik concludes on this topic: “it is dangerous to hold on to the value of its currency when financial capital is free to move in and out of a country.” (Rodrik, 2011, p. xi) That this lesson can be learned from EMU as well, is argued by (De Grauwe, 2011). Still, according to the theory of the impossible trinity, fixed exchange rates and capital mobility can be achieved and maintained under the condition that monetary policy does not create any disturbances to prices, and thus exchange rates. In Europe’s EMU, this was to be achieved through centralizing monetary policy at the independent ECB. As we know by now, however, theory only works until reality kicks in. As economic theory puts it, an exchange rate is nothing but a price—the price of one currency in terms of another—and can be conceived as the aggregate price of all the goods and services produced in one country. As hinted to above already, prices, and thus inflation, are affected by many more factors than interest rates alone. Or more specifically, policy rates as set by central banks—just as the more unconventional instruments form the monetary policy toolkit—may be insufficient to keep inflation at the target rate.7 In part, this was acknowledged by the architects of EMU, which is why they agreed on strict criteria with regards to fiscal policy enshrined in the SGP, and continued to promote EU-wide harmonization in various other policy fields as well. As many social scientists had warned even well before Maastricht, however, even the most far-reaching policy harmonization may not be enough to ensure 7

While many neo-classical economists may argue, in a logical reversal of the theory on the neutrality of money, that in the long run only the money supply (relative to population and economic growth) will affect prices—and while Keynesians may respond that ‘in the long run we are all dead’ anyway—, this logic gets complicated by the fact that in currency unions such as EMU national money supplies are not controlled by national governments or any other entity. The Eurozone-wide money supply is controlled by the ECB, but national money supplies may vary wildly in response to market expectations and the concomitant (often speculative) cross-border capital flows. In other words, national money supplies cannot be controlled in EMU and are therefore entirely at the mercy of sometimes irrational market forces (see e.g. Shiller, 2000; Shleifer, 2000).

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convergence of national wage and price dynamics, and thus functioning of EMU (see e.g. Scharpf, 1986). This is mainly because “inflation divergences are also driven by institutional differences across countries, especially in the fields of industrial relations and collective bargaining” (Armingeon et al., 2016b; Fleming, 1971). And such cross-country institutional diversity is nothing less but a reflection of historically grown, path dependent political and economic traditions, norms, and cultures, which must come to bear in democratically constituted nation states. In other words, structural differences in inflation rates must not be interpreted narrowly as resulting from some insufficient harmonization of monetary or fiscal policy. Rather, they can ultimately be seen as a manifestation of diversity, of economic models, of capitalist varieties, as the outcome of democratic choice. The impossible trinity from macroeconomics is therefore much too limited to allow for a thorough analysis of the political economy involved in the governance of currency unions such as EMU. In other words, it does not work. Even if monetary autonomy is relinquished and all members of the union are facing a single, common interest rate, institutional cross-country differences may cause national price levels to diverge. That is, despite nominally fixed rates, real exchange rates are changing within the currency union, leading to a structural overvaluation of some, but a structural undervaluation of other ‘national currencies’. Since capital is allowed to move freely, this, in turn, creates potentially persistent macroeconomic imbalances within the currency union. Countries with overvalued real exchange rates will become uncompetitive and suffer from trade deficits and external indebtedness, while countries with undervalued real rates become more and more competitive and enjoy large trade surpluses and net international creditor status. As the first decade of the Euro has illustrated, even the most restrictive fiscal policy may not be able to prevent the emergence of such imbalances. Take Spain as an example, which recorded overall government budget surpluses on average during the first decade of the Euro, and managed to reduce its sovereign debt from slightly more than 60% in 1999 down to about 36 percent in 2007.8 In other words, at first sight at least, it could have been considered the poster child of the SGP. By 2012 however, Spain was in the midst of a balance of payments crisis, and had to seek financial assistance from its Eurozone partners. While national monetary autonomy is commonly considered detrimental to maintaining fixed exchange rates, it would actually be very helpful in a situation like this, as it could be used to stimulate depressed economies and bring divergent Eurozone price levels back in line. Indeed, as agued by Johnston and Regan (2015) it was precisely the flexibility offered by national central banks, that made the EMS and earlier European monetary arrangements of fixed exchange rates more or less sustainable. In economics, situations like this are by now mostly analyzed in the field of OCA theory, which has gained renewed academic interest since the onset of the Eurozone crisis, and has certainly also seen some considerable advances since then

8

Operationalizations and data sources provided in Appendix B.

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(De Grauwe, 2006, 2011, 2012b, 2013; Krugman, 1990, 2012b). As its name implies, OCA theory explains the conditions under which a currency union is optimal in the sense that it is likely to be sustainable in the long term. In essence, it deals with the question, how a steady intra-union divergence of price levels—and the concomitant buildup of macroeconomic imbalances—can be prevented; and how these imbalances can be resolved or permanently accommodated by way of some risk sharing system among the members of the union. OCA theory lists three (depending on how you count) main conditions that make a currency area ‘optimal’ (conditions are partly cited from (Armingeon et al., 2016b): First, it should exhibit a high degree of labor and capital mobility, as well as wage-price flexibility (Mundell, 1961). This flexibility is partly needed as a preventive measure to facilitate smooth automatic re-adjustment whenever national price and wage levels across the area have started to diverge. By the same logic, it is also required as a resolution mechanism, as only a high degree flexibility in labor and product markets can bring prices up or down quickly when needed. Second, the business cycles of the member countries should be similar to prevent asymmetric shocks from creating macroeconomic imbalances that are difficult to resolve with a common monetary policy. Finally, third, especially if labor and wage-price flexibility are limited, some risk sharing arrangement, such as a central fiscal capacity with enough spending power to engage in demand management, or a system of fiscal transfers, should be in place to resolve balance of payments crises within the area. Post-re-unification Germany is a good example of how fiscal transfers can support uncompetitive regions, even over long periods of time. The intra-Italian transfers from the competitive North to the economically far less developed Mezzogiorno are another example. In the Eurozone, however, with a common EU budget totaling only one percent of GDP, there is no fiscal capacity capable of serious Keynesian countercyclical spending to fight asymmetric shocks to the system. Also with respect to the other criteria an optimum currency area should meet, the Eurozone fares rather poorly (De Grauwe, 2013). As has become increasingly obvious over the last couple of years, however, the main obstacle to resolving the ongoing European crisis is not so much in the economics, but in the politics of currency areas. And the politics is not seriously touched upon neither by the impossible trinity nor by OCA theory. The argument by Eichengreen (2008b), which builds upon Polanyi (1944), and can be interpreted as a politico-economic extension of the impossible trinity, comes much closer to explaining Eurozone reality. According to Eichengreen (2008), it is the three objectives of stable (fixed) exchange rates, capital mobility, and democracy, which are mutually exclusive. With the hindsight of any careful observer of the Great Recession and subsequent Euro crisis, the logic is rather straightforward: since, as just discussed, (i) the centralization of national monetary policies at the level of the currency area is— contrary to what the impossible trinity would suggest—not sufficient to ensure smooth functioning and sustainability of a currency union such as EMU; and since (ii) the additional harmonization and strict monitoring of national fiscal policies, such as implemented in the SGP, is also insufficient to prevent the buildup of

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macroeconomic imbalances; and since (iii) the correction of these imbalances requires far-reaching and painful reforms virtually across all policy areas in the countries hit hardest by the crisis—and not just in the somewhat ‘obscure’ and technical sphere of monetary policy; one must conclude that adherence to a ‘fixed exchange rate regime’ such as the Euro not only comes into conflict with monetary autonomy at the national level, but with national level democracy per se. By now, this is not a new argument anymore. It has been made in many varieties already, such as by Scharpf (2013), for instance. Its roots, however, can—just as Eichengreen (2008b) suggests—indeed be traced as far back as Polanyi’s presumed inherent ‘incompatibility of democracy with the market’; even though one should be very careful about what ‘the market’ looked like in Polanyi’s times. While nation states in the late 19th century may still have been able to pursue the painful adjustment policies needed to adhere to the gold standard, Eichengreen argues, the duopoly of the emerging welfare state and the gradual introduction of universal suffrage in Western countries made that more and more difficult. Democratic nations with encompassing social safety nets would neither have the (wage and labor market) flexibility, nor the legitimacy to implement the far-reaching and economically and socially painful adjustment policies required whenever the artificially fixed exchange rate had diverged too much from the real rate as a result of persistent inflation differentials. Polanyi’s ‘Great Transformation’ is also important in this context for a concept that could be called ‘democratic backlash’. According to Polanyi, the advance of capitalism that was triggered by the industrial revolution, and which pervasively transformed people’s lives in accordance with the ‘unforgiving logic’ of market forces, begot its own counter-revolution in the form of the emergence of the political left in the late 19th century, and eventually the introduction of universal suffrage and the creation of the welfare state (Polanyi, 1944). Eichengreen takes up on this argument, applying the concept to the special case of the interwar gold standard, and argues that it eventually failed not least because of some form of democratic backlash (although he does not use this term). That is, democratization and emerging demands for a minimum of social protection in industrialized societies (as opposed to those still relying largely on subsistence farming) were too deeply entrenched already so as to have the people and electorate bear the economic and social costs of adhering to an overvalued gold standard any longer; especially not in the context of the Great Depression. In other words, the policies required to stick to gold ultimately failed for their lack of democratic legitimacy. Eventually, i.e., by the time when one country after another dropped out of the gold standard in the early 1930s, the conflict between restoring the external or the internal balance was decided in favor of the latter (even though the ensuing economic improvement may have come too late to curb the rise fascism in Germany). In consequence, the interwar gold standard collapsed. Obviously, economic theory alone is not well equipped to analyze questions of democratic legitimacy. Indeed, as argued below, it is also insufficient to understand the ultimate causes of the Euro crisis, or fiscal consolidation policies as the dominant response for that matter.

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The trilemma by Eichengreen that has just been laid out is certainly a good starting point, but there are other, very similar, concepts worth being discussed as well. In his book ‘The Globalization Paradox. Democracy and the Future of the World Economy’, Harvard economist Dani Rodrik, for example, describes another trilemma—a ‘trilemma of the world economy’—where he considers the three nods of economic integration, national self-determination, and democracy as mutually exclusive (Rodrik, 2011). Starting with an encompassing historical overview of the tensions between globalization and democracy over time, he concludes that: the demands of hyperglobalization require a […] crowding out of domestic politics. The signs are familiar: the insulation of economic policy-making bodies (central banks, fiscal authorities, regulators, and so on), the disappearance (or privatization) of social insurance, the push for low corporate taxes, the erosion of the social compact between business and labor, and the replacement of domestic development goals with the need to maintain market confidence. Once the rules of the game are dictated by the requirements of the global economy, domestic groups’ access to, and their control over, national economic policy making must inevitably become restricted (Rodrik, 2011, p. 202).

This trilemma by Rodrik is applied explicitly to the EMU context by political scientist Crum (2013), in what he calls a ‘normative framework’ to understand the tensions coming to bear in the Euro crisis as well as the options available to European policymakers. The trilemma by Crum, therefore, is comprised of the three nods of EMU (replacing the more general ‘economic integration’), national self-determination (also conceived as the maintenance of some form of national level diversity), and democracy. These represent three ‘political goods’ or ‘values’, of which only two can be attained at the same time. From combining two of these goods, but relinquishing the third, European policymakers are therefore presented three political choices, which Crum distinguishes as governance models of the Eurozone. The first, which he considers to have been dominating European crisis response patterns up to this day, can be characterized as ‘executive federalism’ (Habermas, 2011). In executive federalism new powers are centralized at the Eurozone level, but “political control remains with the (creditor) states and surveillance takes place through depoliticized procedures and technocratic institutions” (Crum, 2013, p. 615). In other words, some national self-determination is maintained, but at the cost of democracy. An alternative model would be the one of ‘democratic federalism’, where national states would be weakened considerably in favor of a genuine European federation. This would formally ensure democratic decision-making (now very much shifted to the European level), but at the cost of the nation state, and therefore also at the cost of national level diversity.9 Finally, the third model would be EMU dissolution.

9

Note, however, that the democratic legitimacy of any far-reaching centralization of powers is highly questionable in itself. Europe’s peoples are arguably not ready to relinquish their nation states, against the background of strong national identities, but a still weak European identity (see e.g. Kohler-Koch & Rittberger, 2007). So any formal gain in legitimacy may amount to nothing when the means to achieving this gain (i.e., much deeper political integration) are illegitimate themselves.

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Crum’s trilemma will serve as the foundation of the overarching theoretical framework I am developing to explain economic adjustment and fiscal consolidation during the Euro crisis. It is discussed in the following section.

3.2

The Politico-economic Trilemma of EMU

As shown in Fig. 3.1, the political-economic trilemma of EMU consists of the three nods—conceptualized as political goods or values—of EMU, the nation-state, and democracy. For the most part, I am adopting both its terms and logic from Rodrik (2011) and especially Crum (2013), which can, just as the trilemma introduced by Eichengreen (2008b), be conceived of as politico-economic extensions of the impossible trinity from macroeconomics. In doing so, I will however deviate somewhat from the rather high level of theoretical abstraction of Crum’s framework in particular, and also from his intentionally normative conclusions, by way of simplification and adaptation for the purpose of my analysis. That is, I am applying this overarching framework to illustrate the trade-offs, tensions, and constraints inherent in the EU/EMU only insofar as to be able to embed in it the individual components of my theoretical argument. In the remaining sections of this chapter I will proceed as follows. First, I will briefly discuss the individual nods and their implications for the Eurozone member countries and for the strategic options available to European policymakers with respect to policy response and resolution in the Euro crisis. Next, in Sects. 3.3–3.6, I will introduce the six components of my main argument, already underpinned and illustrated with empirical data. Finally, I will conclude this theoretical chapter with deriving hypotheses about the underlying determinants of the occurrence, size, and realization of fiscal consolidation during the crisis. The first nod is EMU, which represents the latest and most far-reaching step in more than 50 years of European political and economic integration. Obviously, the desirability of maintaining EMU is out of question for its members—at least for now and among the parties and governments currently in power in the countries comprising the Eurozone. Fig. 3.1 The politico-economic trilemma of EMU

EMU

nation-state

democracy Notes: author’s illustration

3.2 The Politico-economic Trilemma of EMU

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Note that EMU, by institutional design if not definition, implies capital mobility and fixed exchange rates already—thereby merging two nods of the impossible trinity into just one in this trilemma. By implication, to prevent destabilizing effects for interest and inflation divergences, and thus exchange rates, national monetary autonomy must be relinquished, which is why in 1999 it has been centralized at the ECB as agreed in the treaty of Maastricht. EMU’s institutional fabric encompasses much more than fixed rates, capital mobility, and a common monetary policy for its members. There are, of course, the constraints for national fiscal policy autonomy enshrined in the SGP, as another crucial mechanism designed to ensure convergence of wage and price dynamics. In general, however, the constraints created by EMU are not only characterized by what is present in terms of institutional configurations, formal or informal political agreements, but also by what is—or until recently was—absent. To name just a few factors, there is/was the no-bail-out clause incorporated in the Maastricht treaty, there is no common EMU budget besides and in addition to the EU budget, there is/ was no banking union with a common deposit insurance mechanisms, and there is/ was no other risk-sharing arrangement worth the name that could alleviate imbalances among EMU members. This, however, will be discussed more thoroughly below. To summarize for now, EMU—and the EU as a whole, for that matter— appears to be stuck somewhere in the middle between a full centralization of powers at the European level at one extreme, and full national sovereignty of its members at the other. In consequence (and this is its most crucial characteristic), ultimately EMU determines the rules of the game according to which all members of the Eurozone need to play and adjust if necessary. The content of those rules, however, are highly unlikely to suit the still very heterogeneous countries equally well—we must only think of the oft-cited liberal bias of the EU, of the rather monetarist ECB, and in general the strictly rules-based fiscal framework that has always been geared towards a rather restrictive, austere fiscal policy stance. These rules can be perceived as a reflection of some very (country-)specific economic ideology and tradition; but there are other economic traditions and ideologies present among the countries comprising EMU, which could in theory also serve as a basis for common EMU rules, but turned out not to. In consequence, some countries will inherently be able to stick to these rules with ease, while others can be expected to struggle quite a bit. This brings us to the second nod, the value of preserving national level diversity within the Eurozone. Despite strong cultural similarity, and despite decades of EU-induced harmonization, policy diffusion, and immense social, cultural, economic, and political exchange, European countries still exhibit a considerable degree of heterogeneity with respect to economic conditions, politico-economic institutions, opinions, preferences, and languages, most of which are embodied in the nation-state. Ultimately, diversity sits at the core of the political good of preserving European nation states. Indeed, if nation states did not differ, if there was no heterogeneity, then there would be no point in having and preserving nation states to begin with. Without diversity, there would be no trilemma. Such a perfectly homogeneous European population, well aware of them sharing the same

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institutions, cultures, languages, preferences, could be expected to be happy to get rid of their nation-states and build a new European super-state sharing the Euro. In reality however, the existence of national level diversity must be taken as a given for the foreseeable future in Europe. Note, however, that all of this multi-dimensional diversity per se—and for the purpose of this thesis I will mostly focus on institutional diversity, which can be expected to correlate with most other dimensions of this concept—must not necessarily present an obstacle for the smooth functioning of EMU. What ultimately counts, are the diverse economic outcomes likely to be produced by diverse institutions. More specifically, the institutional diversity embodied in European nation-states may come into conflict with the trilemma’s political goals/values of EMU and democracy if, and only if, it produces lasting divergences in crucial economic outcomes—the most important among these being prices, wages, and thus real exchange rates. The third nod of the politico-economic trilemma of EMU is the value of democracy. Conceptually, it is very much related to national-level diversity (also see Crum, 2013 on this). Indeed, democracy could be perceived as one dimension of diversity among others, representing the very different democratic political systems we find in Europe. Moreover, from the perspective of the Western democracies I am dealing with in this thesis, the concept of national self-determination (i.e. the nation state) may appear to be inextricably linked with democracy, at least as long we associate the ‘self’ with the people of the respective country. As also pointed out by Crum, it may therefore be a rather complex endeavor to disentangle and clearly delineate these two values from one another. There is no need to dive into the details of this task for the purpose of the analysis at hand, however. What is important, first, is that the two nods/values/political goods need to be interpreted together, and second, that democracy may operate on two levels: the national and the European/EMU level. By moving away from this nod (compare Fig. 3.1), that is by giving up the nation state, we move from national level to European level democracy. That is, if the nation-state is to be maintained, democracy must also be maintained at the level of the nation-state. As predicted by the trilemma, though, that may not be possible within EMU. Diverse institutions, cultures, traditions, and political and economic preferences will tend to produce diverse economic outcomes. When diversity in outcomes needs to be suppressed in order to be able to maintain EMU, however, either diverse institutions must be harmonized/centralized, or the policy effects of diverse cultures, traditions, and political preferences must be suppressed through strict European oversight and monitoring. In other words, in order to minimize diversity, democracy may have to be suppressed at least in some member countries of EMU. Their economic, fiscal, regulatory, and social policies must first and foremost be subjected to the economic imperatives of maintaining the common currency (Crum, 2013; Eichengreen, 2008b)—a task often carried out by technocratic governments or supranational unaccountable bodies such as the ECB (Rodrik, 2011). If democracy were to be maintained all across the currency area, it would— against the background of heterogeneous nation-states leading to divergent

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economic variables—have to be moved up from the national level, and reinvigorated at the European level, where the governance of the currency union takes place, and where the political decisions that so pervasively interfere with many peoples’ lives are made. The democratic legitimacy of such a European super-state, however, would be highly questionable, as has already been hinted to earlier. To conclude this section, it is worth pointing out that OCA theory touches upon at least two of the nods of the politico-economic trilemma as well. Its condition of labor and capital mobility can be conceived as a mechanism to reduce diversity with respect to economic outcomes, and thus accommodate institutional diversity. This is because a high degree of labor and wage mobility will provide a safety valve to mitigate imbalances and thus result in price and wage (re-)convergence across the currency area. In the Eurozone, however, labor mobility is severely restricted—if not de jure, then de facto, as a result of language and cultural barriers, for instance. Wage mobility too is restricted in many countries, as a result of relatively encompassing welfare states, comprehensive employment protection legislation (EPL), and rather generous (in international—i.e. not purely European—comparison) unemployment benefits. From an ideational perspective, this part of OCA theory is therefore by no means neutral, but is based on an economically liberal normative conception of how economies and welfare states should look like. In other words, from the perspective of the first condition of OCA theory, optimal currency areas should engage in liberalization and deregulation. Another condition for an optimal currency area, is that it features some form of risk-sharing arrangement, such as a large enough common budget to engage in countercyclical fiscal spending, or an area-wide system of unemployment insurance, for instance. What OCA theory often tends to neglect, however, is that any such mechanism will (i) imply the politically highly sensitive transfer of sovereignty from the nation state to the level of the currency area, and (ii) needs to be based on legitimate democratic institutions at that level. Even for a union as deeply integrated as the EU, however, this may be much more than the still very national peoples of Europe may be ready to accept. The following sections will one by one develop the main six branches of my theoretical argument in more detail, contrast them with empirical data, and embed them in the politico-economic trilemma of EMU just introduced.

3.3

Intra-EMU Diversity as an Imbalance of Capitalisms

“United in diversity” is the motto of the European Union. And as has already been argued repeatedly at this point, diversity we find within EMU, not only with respect to different cultures and languages, traditions and norms, but also when it comes to mapping out that diversity, just as it’s done in Esping-Andersen’s (1990) “worlds of welfare”, for instance, or in Lijphart’s (1999) “Patterns of democracy”. These researchers have classified countries according to their electoral systems, their

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executive-legislative relations, social insurance systems, or labor market institutions, to name just a few. When it comes to explaining how this considerable cross-country heterogeneity came about, historic institutionalism can do us great service, according to which diversity must result from path dependency. Past decisions, being casted in institutions over time, have determined a given path in the past that cannot easily be deviated from today and in the future. Institutional change can therefore only be slow and incremental, both formally and informally constraining the options available to today’s actors, as well as framing the latter’s ideas, opinions and preferences. In consequence, despite some 50 years of European integration and harmonization, and tremendous cross-cultural social and economic exchange, communication, and policy diffusion, intra-European heterogeneity does persist. Indeed, against the background of several rounds of enlargement of both the EU and EMU, diversity has even increased—with the eastern enlargements of 2004, 2007, and Croatia in 2013, the number of EU members almost doubled, while the number of Eurozone members has grown by almost 50 percent since Slovenia introduced the common currency in 2007. Diversity not only exists with respect to political and economic institutions, but also with respect to the political ideologies, or economic ideas from which institutions draw their legitimacy to a considerable degree (also see Brunnermeier et al., 2016). A reflection of these—also path dependent—ideologies is also found it Esping-Andersen’s distinction between liberal, social-democratic, and conservative welfare states. Similarly, in comparative capitalism research we find various classifications of countries according to their distinctive economic models, such as in the Varieties of Capitalism approach developed by Hall and Soskice (2001). As several contributions from comparative capitalism research have shown by now, the way countries organize their political economies can go a long way in understanding both the causes of the Euro crisis as well as the political and policy responses to it. In his overview of the contribution of comparative capitalism (CC) to the analysis of the causes of the crisis, Nölke (2015) distinguishes three generations of CC research. The main feature of the first generation, with the focal point being the contribution by Hall and Soskice (2001), is the juxtaposition of the CMEs (exemplified by Germany and Japan) and LMEs (such as the USA and the United Kingdom), each of which are based on specific coordination mechanisms across various ‘spheres’: the sphere of industrial relations, of vocational training and education, of corporate governance, of inter-firm relations, and of the relations of firms with their employees. While LMEs tend to rely, all across these spheres, more on market-based coordination, CMEs are characterized by a stronger reliance on non-market relationships for coordinating their endeavors. An important contribution of the second generation of CC research—often called ‘post-VoC’—was the broadening of the country focus by including mainly Eastern and Southern European countries and the acknowledgement of “the role of the state for capitalist coordination—but also for rent-seeking and state capture”, as conceptualized in the MMEs found in Southern Europe and France (Nölke, 2015).

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With its focus on labor market institutions, and the different modes of wage bargaining and wage formation, both the VoC and the post-VoC approach bear strong resemblance with the corporatism literature—and indeed, the different VoC types can easily be distinguished based on the strength of corporatist institutions in the relevant countries. While corporatist systems of labor relations are mainly found in the CMEs of continental Northwestern Europe, such as in the Netherlands, Belgium, Germany, and Austria, the MMEs of Southern Europe, but also the LMEs, tend to be much closer to the pluralist end of the corporatism-pluralism spectrum. Tables 3.1 and 3.2 provide an overview of the strength of corporatism across European countries, the centralization of wage bargaining, as well as their classification as CMEs, LMEs, or MMEs according to the VoC literature. To increase the robustness of my findings, I measure corporatism based on two different indices: an index recently developed by Jahn (2014), which is available for a large proportion of the country-years used in the analysis at hand, and the Siaroff index (Siaroff 1999), which is available for less countries and only in 5-year increments. Note that the two indices do not yield substantively different results with regard to the analyses performed in the context of this dissertation, and the correlation coefficient between the two is a highly significant 0.75 for the data at hand.10 The first two columns in Table 3.1 are sorted in descending order from the most to the least corporatist country (based on Jahn’s index), in 2007 as well as in 2010. For illustrative purposes, the CMEs among the three VoC-types shown in the third column are—in Tables 3.1, 3.2, and throughout the analysis at hand—shown in italics. As is easily seen, the CMEs are almost perfectly aligned to be the most corporatist countries. That is, only the CME of Luxembourg is rated slightly less corporatist that an LME or MME; all other CMEs are consistently rated as more corporatist as any MME or LME. Moreover, as shown in Table 3.2, apart from the two outliers of Ireland (which, as discussed below, can be interpreted as an exception that proves the rule) and again Luxembourg, the CMEs consistently have more centralized wage bargaining systems than the MMEs and LMEs. For illustrative purposes, Table 3.2 also ranks countries according to the Siaroff index (not the Jahn index shown in Table 3.1), where the distinction between CMEs in the upper, and MMEs in the lower half of the table is perfect. In other words, both the presence of corporatist (labor market) institutions as measured by the two indices, 10

Own calculation; operationalizations and data sources found in the appendix. I will intentionally not go into the details as to whether the Jahn and/or the Siaroff index are good, valid, reliable indicators of corporatism or the underlying institutional configurations, however defined. These details of operationalization and measurement are, I contend, irrelevant for the purpose of the analysis at hand, which focuses on the broad picture of cross-country institutional heterogeneity that is clearly visible in the consistent rank ordering depicted in the tables and figures of this subsection. In other words, I contend that the empirical data conveyed by these tables and figures must be interpreted to approximate a validity/reliability test by itself, in the sense that this highly consistent pattern across multiple indicators from various different sources could not have been brought about based on invalid and/or unreliable indices of corporatism and the underlying capitalist varieties I intend to measure.

72 Table 3.1 Corporatism (Jahn) and VoC types within EMU, 2007 and 2010

3 Theoretical Framework: Austerity’s Institutional Origins Corporatism index (Jahn) Country 2007 Country

2010

VoC Country

Type

AUT 0.85 AUT 0.89 AUT CME NLD 0.81 BEL 0.78 BEL CME FIN 0.79 NLD 0.73 NLD CME BEL 0.74 FIN 0.66 FIN CME DEU 0.66 DEU 0.66 DEU CME IRL 0.65 ESP 0.62 LUX CME ESP 0.61 LUX 0.59 IRL LME LUX 0.59 IRL 0.55 ESP MME ITA 0.53 ITA 0.52 ITA MME GRC 0.50 PRT 0.49 PRT MME PRT 0.45 GRC 0.49 GRC MME FRA 0.40 FRA 0.37 FRA MME CYP 0.33 CYP 0.36 CYP MME Notes Details on the operationalization and source found in Appendix B

Table 3.2 Corporatism (Siaroff) and centralized wage bargaining index, 2007

Corporatism index (Siaroff) Country 2007 AUT FIN DEU LUX NLD BEL ITA IRL PRT FRA ESP GRC

Centralized wage bargaining Country 2007

4.63 4.38 4.13 4.13 4.00 3.75 3.00 2.63 2.38 2.25 2.00 2.00

AUT 0.93 NLD 0.57 IRL 0.53 DEU 0.48 BEL 0.46 FIN 0.40 ESP 0.38 ITA 0.34 PRT 0.34 GRC 0.33 LUX 0.31 CYP 0.25 FRA 0.21 Notes Details on the operationalization and source found in Appendix B

and more centralized wage bargaining institutions, are key structural characteristics of CMEs. No such clear pattern emerges when we rank countries according to the stringency of the Employment Protection Legislation (EPL), as shown in Table 3.3.

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Here, the strictest EPL—based on version 3 of the OECD EPL index for 2008—is found in the MMEs Portugal and Italy, followed by the CMEs Germany, Belgium, and the Netherlands, and then again two MMEs with France and Greece. As will become clear below, however, the EPL may provide some important insights into the political economy of fiscal consolidation in the Euro crisis nevertheless. In fact, one could even argue that it is precisely the absence of a pattern what may help understand both the direction of structural reforms during the crisis as well as why economic adjustment proceeded so painfully slow in the most affected countries. Intra-EMU diversity also exists with respect to the business environment and product market regulation, as is shown in Table 3.4. Here, the already familiar pattern emerges once again. Not surprisingly, Ireland, the only LME in the table ranks high as a country with a favorable business environment (the World Bank indicator mostly comprises several measures of economic freedom), and relatively low product market regulation. Moreover, roughly the upper half of the table consists of the CMEs. The MMEs, where the state plays a more dominant role in the economy, and the risk of rent-seeking is higher, are populating the bottom half of the table both for the business environment and for product market regulation. Earlier I stopped the discussion of the different branches of CC scholarship as identified by Nölke (2015), after introducing only the first and the second generation. While these two have focused almost exclusively on the supply side of the economy, Nölke distinguishes a third generation of CC research, which started to incorporate the demand side as well. This ‘critical comparative capitalism’ school brought with it a new distinction between export-led and profit/demand-led growth models, instead of the earlier dominant one between CMEs, LMEs, and MMEs. The export-led growth regime is usually considered to be best exemplified by Germany, and therefore overlaps to a considerable degree with the CME type, while the demand, or consumption-led regime is mostly found in the southern European

Table 3.3 OECD employment protection legislation index (version 3)

Country

2008

PRT 3.51 ITA 3.03 DEU 2.98 BEL 2.95 NLD 2.93 FRA 2.87 GRC 2.85 LUX 2.74 ESP 2.66 AUT 2.44 FIN 2.17 IRL 1.98 Notes Details on the operationalization and source found in Appendix B

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MMEs. This growth model perspective, and its export versus demand-led distinction, introduced by the third wave has become highly relevant to understanding the Euro crisis, and will therefore stand at the core of the analysis at hand. Interestingly, it also bears some resemblance with a much earlier approach by Gourevitch (1986) who, among other things, examines countries’ production profile in order to understand their responses to economic crises. Following Hall (2012), Table 3.5 provides an overview of some EMU countries’ growth models, operationalized based on their shares of exports relative to GDP. As is easily seen, the CMEs again cluster in the upper half of the table, together with the LME Ireland. In other words, the Northern European CMEs of the Eurozone tend rely on export-led growth, while the Southern European MMEs are rather found in the demand-led camp. Upon closer look, the position of Ireland among the CMEs is not a surprise. As convincingly shown by Regan (2014), the Irish LME has a very strong export sector, making it at least partially an export-led economy. It is important to note that, as it is stressed in the VoC literature, countries’ type of capitalism or growth model is not a matter of strategic choice, but rather the result of path dependency—of historically grown political and economic institutions, such as those structuring labor relations and collective bargaining, but also education and innovation systems, among others. Capitalist varieties and growth models are therefore ‘slow moving objects’ (Pierson, 2004) that cannot be changed easily, which is a result of them being deeply entrenched in countries’ institutions, norms, cultures, traditions, and last but not least people’s normative ideas of how a country and an economy ought to be organized.

Table 3.4 Business and regulatory environment

World bank doing business, DTF Country 2010

OECD product market regulation Country 2010

IRL 82.3 NLD 0.96 FIN 81.0 FIN 1.34 DEU 80.0 IRL 1.35 AUT 76.7 AUT 1.37 NLD 75.0 DEU 1.41 BEL 74.1 LUX 1.44 PRT 71.4 ITA 1.49 ESP 70.8 FRA 1.52 FRA 70.4 BEL 1.52 CYP 66.3 ESP 1.59 ITA 65.6 PRT 1.69 LUX 65.5 GRC 2.21 GRC 62.2 Notes Details on the operationalization and sources of the variables found in Appendix B

3.3 Intra-EMU Diversity as an Imbalance of Capitalisms Table 3.5 Growth models by export shares according to Hall (2012)

Country BEL IRL NLD AUT DEU FIN PRT ITA FRA ESP GRC Note Source: Hall (2012)

75 Export share 0.81 0.79 0.73 0.56 0.46 0.45 0.31 0.29 0.27 0.26 0.23

When it comes to measuring countries’ type of growth model, an obvious starting point is to look at its outcomes (just as Hall (2012) has done, as illustrated in Table 3.5). This is of particular importance in the analysis at hand, too, because, as discussed earlier, the tensions inherent in the politico-economic trilemma of EMU are not created by institutional diversity per se (which may also be called growth model heterogeneity), but ultimately result only from the associated divergence in the (mainly economic) outcomes. The VoC literature has by now explored in considerable detail how the various capitalist varieties differ in their propensities to save, invest, and consume, in the availability for long- versus short term financing, in their structures of public and private indebtedness, as well as the chief means to deleverage and find a way out of their debt, and last but not least in their peoples’ and businesses’ capacity and willingness to invest in generalized or specific training and innovate (Culpepper, 2005; Hall & Soskice 2001; Hancké et al., 2007; Thelen, 2012). The commonalities and differences in countries’ employment relations and the structures of their labor markets have also been mapped out in great detail— together with the consequences these have for wage and price growth, and thus ultimately also for the real (and in flexible monetary regimes also nominal) value of their currencies. Most relevant in the context of the politico-economic trilemma of EMU presented here, are the consequences that different institutional structures of labor relations in export-led versus demand-led growth models have for wage, price, and productivity dynamics, as well as the impact these have on international competitiveness. As pointed out by Hancké (2013, p. 10), the wage-setting system of the Northern European export-led models, being “organized around the German wage-setting system, [have] led to systematic disinflation. Nominally, EMU may have become a symmetric structure in which every member state’s voice counts the same, but de facto remained an asymmetric system with German wage-setters at its core. […] In

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the DM-bloc in the 1980s, under the Maastricht process of the 1990s, and after the introduction of the euro in 1999, wage moderation became one of the primary means to pursue low inflation policies.” In contrast to that, the demand-led MMEs “Spain, Portugal, Greece and Italy inherited fractious labour movements divided into competing confederations that allowed for periodic social pacts but made sustained wage co-ordination difficult; and they lacked the institutional capacities for co-ordinated skill formation and incremental innovation normally required for successful export-led growth” (Hall, 2012, p. 359). The economic outcome of these institutional differences between export- and demand-led growth models are illustrated in Table 3.6, which summarizes average inflation rates in EMU countries over different time periods—two before EMU, and the other one during EMU but before the Great Recession. The by now familiar pattern reappears once again: the CMEs tend to be clustered in the upper halves of all three columns of the table, featuring structurally lower inflation than the MMEs, which are found mostly in the bottom halves. The pattern is less clear during EMU than before, however, which can be interpreted as an indication that the convergence programs initiated in preparation for EMU, as well as the SGP during EMU, were successful in generating some convergence of intra-EMU wage and price dynamics in the run-up to the Euro. The SGP failed when it comes to keeping divergent wage and price dynamics in check after the introduction of the common currency, however, and thereby contributed to the massive macroeconomic imbalances that Eurozone countries were struggling to correct in painful economic adjustments a decade onwards. The economic logic goes as follows: structurally higher inflation rates in one country, when not

Table 3.6 Average inflation rates Country

1994–1998 (%)

Country

1996–1998 (%)

Country

1999–2007 (%)

LUX 1.1 DEU 1.1 FIN 1.6 FIN 1.1 LUX 1.2 DEU 1.6 FRA 1.5 FIN 1.2 AUT 1.7 DEU 1.6 AUT 1.3 FRA 1.8 BEL 1.6 FRA 1.3 BEL 2.0 AUT 1.6 BEL 1.4 ITA 2.3 NLD 1.7 NLD 1.7 NLD 2.4 IRL 2.1 IRL 1.8 CYP 2.6 CYP 3.2 PRT 2.3 LUX 2.7 PRT 3.2 ESP 2.4 PRT 2.9 ESP 3.3 ITA 2.6 ESP 3.1 ITA 3.5 CYP 2.9 GRC 3.2 GRC 7.5 GRC 5.9 IRL 3.4 Total 2.5 Total 2.1 Total 2.4 Notes Own calculation based on harmonized consumer price index; details on the operationalization and sources of the variable ‘inflation’ provided in Appendix B

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‘justified by’ or compensated for by offsetting labor productivity improvements, will result in increasing unit labor costs (ULC). When the latter are again ‘not justified’, by a higher product quality, for instance, growing ULC can be interpreted as an indication of the eroding competitiveness of the export sector. Over time, and at fixed nominal exchange rates, exports—and eventually the entire export sector— will therefore tend to shrink, while imports will grow. In other words, the entire economy will be even more geared towards domestic consumption than it has been before. The preceding discussion justifies theoretically the operationalization of growth models based on export shares as done by Hall (2012) in Table 3.5. Upon closer look, however, that data is deceiving. As thoroughly discussed in the globalization literature, the economic openness of a country—commonly operationalized as the ratio of exports (or exports plus imports) to GDP—is strongly related to its size, both in terms of the land area and population size. To control for that relationship, export shares should be adjusted for the size of an economy (Alesina & Wacziarg, 1998). Table 3.7 therefore shows a replication of the operationalization of overall export shares as in Hall (2012) on the left; and compares these to an operationalization of growth models based on export shares that are adjusted by population size and land area according to the procedure proposed by Alesina and Wacziarg (1998). Note that this is pre-EMU data; and as is easily seen, at least for this pre-EMU period shown in the table, countries growth models’ and their institutional underpinnings are not as clearly reflected in export share data anymore, when these are corrected for population size and land area. This does not call the operationalization based on adjusted export shares into question, however. In fact, this somewhat

Table 3.7 Growth models: export shares pre EMU adjusted by population size and surface area

Export share pre-EMU Country 1991–1998

Adjusted export share Country 1991–1998

LUX 1.08 IRL 0.40 IRL 0.70 NLD 0.32 CYP 0.69 FRA 0.26 BEL 0.60 CYP 0.25 NLD 0.57 DEU 0.25 AUT 0.34 ESP 0.23 FIN 0.32 FIN 0.23 PRT 0.26 ITA 0.22 DEU 0.23 AUT 0.19 FRA 0.23 PRT 0.14 ITA 0.22 GRC 0.08 ESP 0.21 GRC 0.15 Notes Own calculation; details on operationalization and sources provided in Appendix B

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puzzling finding actually supports, rather than undermines, the theoretical arguments made up to this point, as will soon be clarified further below. To conclude this section, there is some considerable capitalist diversity found within the Eurozone, both with respect to political and economic institutions and their economic outcomes. These differences can quite easily be mapped out along a dimension running from the more export-led growth models found in the Northern European CMEs, to the more demand-driven growth models found in the Southern European MMEs. While especially their corporatist labor market institutions traditionally enable the former to keep wage and price growth in check, and thereby ensure the cost-competitiveness of their export sectors (while their education and innovation systems promote their non-cost competitiveness as well) the latter traditionally exhibit much higher wage and price inflation propensities. What happens, when such heterogeneous capitalist varieties—traditional strong currency countries on the one hand, traditional weak currency countries on the other —are joined together under the umbrella of a common currency (Hancké, 2013; Johnston et al., 2014; Johnston & Regan, 2015) is discussed in the next two subsections.

3.4

An EMU Economic Regime Common to All

As members of the Eurozone, the heterogeneous nation states comprising Europe are confronted with a single set of rules common to all. To see how this set of rules looks like, and how this ‘EMU economic regime’ came about, it is helpful to take a look at the decades-long history of European integration, of which EMU represents only the latest and most far-reaching step. This step can be traced at least as far back as to the late 1940s, and the efforts to restart trade and investment after WW2. According to Eichengreen (2008a), the restoration of international trade and investment relationships can be considered the most crucial precondition for a resumption of growth in war-devastated Europe, ultimately laying the groundwork for what was to be named the ‘Trente Glorieuses’. After current account (CA) convertibility had been achieved de jure, it was hindered de facto by the need for currency conversion in an environment of ongoing and substantial post-war exchange rate variability. At first this was temporarily overcome with the introduction of Bretton Woods, which, promoted especially by the United States, can be considered the natural successor of the pre-war Gold Standard. Note that the principle need for an international system of fixed exchange rates was, in line with dominant economic thinking at the time, largely out of question. Based strictly on the (politico-)economic logic introduced in the preceding subsections, the following can be expected to occur whenever exchange rates between some countries are fixed—but not irrevocably fixed as in a currency union —at a specific price: First, as a result of persistent cross-country institutional heterogeneity, prices levels will gradually diverge, leading to a relative

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undervaluation or overvaluation of certain currencies. In consequence, the undervalued currencies will tend to have trade surpluses and thus accumulate reserves, which tend to be used to finance the trade deficits of the countries with relatively overvalued currencies. In other words, some countries are becoming net creditors (at the times of the Gold Standard, they were said to ‘suck in gold’), while the others are becoming net debtors, so that macroeconomic imbalances begin to emerge. At some point, net creditors will get concerned about their overseas investments and start to demand higher risk premiums, thereby generating pressure for net debtors to deleverage their economies. Rather sooner than later in a system of fixed exchange rates, some of the countries with overvalued currencies will have to adjust their peg and devalue so that their balance of payments is brought back into balance. Note that the economic pressure to adjust rests almost exclusively on the overvalued currencies, not the undervalued ones. It is relatively easy to hold your own currency fixed at an undervalued level relative to another currency for a long period of time. It is near impossible, however, to do the same for an overvalued level. Countries with undervalued currencies may very well come under political pressure to do something about their exchange rate—just observe the accusations in 2017 of newly elected US president Donald Trump towards countries like China or Germany. Sometimes that political pressure may even succeed, as it did several times between the 1960s and 1980s, when the West-German government, under pressure from the US and its European partners, agreed to participate in a coordinated adjustment to the peg under Bretton Woods or the EMS, by revaluing the Deutschmark and raising fiscal spending. The economic pressure to cooperate in such an endeavor, however, is subtle at best, and usually far outweighed by the economic benefit derived from an undervalued currency—which is sometimes dubbed the ‘beggar-thy-neighbor-advantage’ in the literature on the topic (Eichengreen, 2013; Geisst, 2013; Krugman, 2014). As a result of the logic just laid out, devaluations—or internationally coordinated adjustments to the peg—have therefore been a recurrent phenomenon in all fixed-exchange rate regimes (but not all currency unions) that have existed to date. As another crucial result, note that in any system of fixed exchange rates, the ‘strongest’ currency tends to become the anchor currency—with strength being derived mainly from relative stability (i.e., structurally low inflation), but certainly also the size of an economy. Note that this was also one of the key factors that made Bretton Woods so difficult to maintain in the long run: the US dollar, while being the traditional anchor in the Bretton Woods system, was not the strongest currency any more, after war-torn Europe had enjoyed a period of strong catch-up growth relative to the US, and regained economic, fiscal, political, and therefore also monetary stability. This was especially true as the US started to feel less obliged to subordinate its domestic policy objectives under the task of supporting its allies, which became apparent when it decided not to reign into its “twin deficit” shortly after it had appeared for the first time in the mid-1970s. With the ensuing collapse of Bretton Woods in 1973, the Europeans were thus left to themselves in their endeavor to ensure exchange rate stability; and quite naturally, the Deutschmark, as Western Europe’s strongest currency and that of the

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largest economy, became the anchor of what would henceforth be dubbed the ‘Deutschmark-bloc’, consisting, besides Germany, mainly of the Netherlands, Austria, Luxemburg, and Belgium. These countries gradually adjusted to Germany not only with respect to their monetary and fiscal policies, but also in terms of their labor markets institutions. As Hancké (2013, p. 3) puts it, “The Deutschmark-bloc would be impossible to understand without a sense of how labor market institutions in the participating member states were reorganized in response.” Over the next two decades, that Deutschmark block, and the other European countries pegged to it inside the ‘Snake’ or the later EMS, were characterized by recurrent crisis-induced devaluations of the weaker currencies, mostly embedded in a more encompassing economic adjustment and austerity package. The ‘French experiment’ mentioned in the introduction to the analysis at hand falls just as well in this category as the 1992 ERM crisis, which, triggered by German tight monetary policy after the German reunification, culminated in the British exit from the EMS. From the perspective of economic history, the goal of Maastricht then—besides the political goal of promoting an ever closer union—was to end once and for all the need for such periodic devaluations, by going all the way to an irrevocably fixed exchange rate regime in the form of a currency union (Eichengreen, 2008a, p. 346 ff.). In order to be able to ensure the stability required for a functioning union, EMU was made to have the following three main design features. First, fully consistent with the logic of the impossible trinity, national monetary policy sovereignty was transferred to the European level, where it was centralized at the strictly independent ECB, modeled after the monetarist German Bundesbank. That it was the German Bundesbank serving as the ECB’s blueprint, and not any of the other central banks in Europe, was of course no co-incidence. First and foremost, this resulted from the dominant German power position in economic and political terms, derived mainly from its strong currency status as the long-standing anchor of the Deutschmark block. Also, as shown by “the literature on the interaction between wage and monetary policy […] conservative central banks [simply] work better in interaction with coordinated wage bargaining” such as that found in German labor relations (Höpner & Lutter, 2014, p. 6). Any loosening of the independence of the ECB would therefore have run clearly against German economic interests. But also from the perspective of economic ideas, perseverance of the Bundesbank’s main design features is understandable, when considering the dominant position of the monetarist paradigm in economic thinking after the end of Keynesianism and in the wake of the Great Moderation. Finally, the widespread desire in many European countries for the kind of monetary, price and wage stability that the German population had enjoyed over the last couple of decades should not be underestimated. In many countries, governments and their electorates hoped that price stability could finally be achieved when putting monetary policy in the hands of a Bundesbank-like ECB. EMU’s second main design feature are the constraints on national fiscal policy enshrined in the SGP—if not so much during the first decade of EMU and for all its members alike, then certainly since the onset of the Great Recessions and for the

3.4 An EMU Economic Regime Common to All

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countries mired in BoP-crisis. The SGP is meant to ensure fiscal prudence across the Eurozone in order to eliminate any other disturbances to relative prices and thus real exchange rates. Finally, third, while not formally designed to be that way, another key characteristic of EMU—and actually of the EU more generally—is, from a regulatory point of view, its longstanding, and often criticized (neo-)liberal bias. From a theoretical viewpoint this bias is not too surprising. More than 75 years ago already, Hayek (1939) explained that any federation of nations must necessarily have a rather liberal economic and regulatory regime, which is also why Streeck (2014a, p. 97 ff.) tends to label EMU (somewhat derogatory) a Hayekian federation of nations. Also from the perspective of OCA theory, a liberalization of product and labor markets would be required to make the union work. In this context, many researchers bring forward that actually it is not the LMEs, which perform best in EMU, but the coordinated export-led growth models with much stricter EPL and quite encompassing labor markets (see e.g. Scharpf, 2011). While this observation is correct, its conclusions may not necessarily be, however. These researchers sometimes tend to overlook that the over-performance of CMEs inside EMU at least partially derives from the zero-sum game revolving around export-competitiveness (Hancké, 2013, p. 4) that these export-led economies are playing out with their demand-driven EMU peers—and that zero-sum game is only being established by EMU rules. In other words, it comes at the cost of the weak-currency MMEs in the South. Deprived of their institutional comparative advantage—and the associated ‘beggar-thy-neighbor’ advantage—the CMEs inside EMU may not perform much better than Germany did in the early 2000s, before it regained its competitiveness by going through a decade-long period of wage restraint and gradual internal devaluation. As already laid out earlier, EMU’s institutional design is not only defined by the presence of certain features, but also by the absence of others, many of which are analyzed in their very details by OCA theory. Most crucially, there is virtually no potent horizontal transfer mechanism between the members of the Eurozone, such as a sizable common EMU budget or other form of fiscal union or insurance mechanism. While a banking union has been hastily set up in response to the crisis, a workable common deposit insurance mechanism will most likely be years in the making. In summary, from the start, the institutional design of EMU was characterized by a strong focus on self-responsibility and fiscal discipline underpinned by depoliticized procedures and technocratic institutions, and thereby clearly biased towards the preferences of the country with the traditional anchor-currency, Germany (Crum, 2013, p. 615; Habermas, 2011). With the exception of the neoliberal component, the EMU’s economic regime ended up being almost perfectly tailored to the “German model of running an economy” (Schelkle, 2015, p. 138) geared towards export-led growth. When it comes to economic ideology, the “longstanding differences in the economic doctrines espoused by German economists, many of whom were linked to the Freiburg school of economics and committed to balanced budgets, and the economists of France and Italy who often held more

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Keynesian views” (Hall, 2012, p. 367) were effectively brushed aside in the institutional design of EMU. Just as the design of the ECB, almost the entire set of rules determining EMU’s economic regime reflected German economic doctrine with its “rigid constitutional-legal approach” and a willingness “to impose harsh austerity rules” if necessary (Young, 2014, p. 136). As Hall (2012, p. 367) continues, it “is notable that the ordo-liberal approach dovetails nicely with the institutional structures underpinning export-led growth in northern Europe, while Keynesian approaches are more congruent with the demand-led growth models of southern Europe.” In other words, EMU’s rules of the game both originate from and work to the benefit of the Northern-European export economies and to the disadvantage of the more demand-led economies found mainly in Southern Europe. Not only is European politics, and the field of EMU economic and fiscal policy in response to the crisis in particular, dominated by creditor states, but one could go as far as to argue that these countries becoming creditor states was pre-determined by EMU’s institutional design from the outset. Against this background, any argument for self-responsibility voiced by European policymakers today—such as in fall 2017 from the leader of the German liberal democrats, Christian Lindner (Chazan, 2017)—appears to ignore that Eurozone economies are effectively competing against each other, but on an uneven playing field that is tilted by institutional design towards the comparative institutional advantage of Germany.11

3.5

The Euro Crisis: Institutional Misfit and Its Consequences

Instead of bringing the economies of the Eurozone closer together, the common currency has laid their deep institutional differences wide open for everyone to see. While different growth models were able to function alongside one another in the pre-EMU world(s), they ceded to do so during EMU and its ‘one-size-fits-all’ economic regime. With the elimination of nominal exchange rates, and the simultaneous elimination of national central banks able to pursue an independent monetary policy, there has been no inflation adjustment mechanism in EMU anymore—a mechanism that was used regularly in pre-EMU times (Johnston & Regan, 2015).

11

I do not intend to draw the normative conclusion that Germany should agree to the creation of a sizable EMU budget any time soon, not least because and substantial fiscal centralization at the EMU or European level comes with its own problems of democratic legitimacy. What this example is supposed to illustrate, is that many policymakers today still seem to be stuck in narrow ideological trench warfare over the appropriate crisis diagnosis, and that the extreme intractability of the political-economic crisis the EMU is facing today is only rarely acknowledged to the fullest in the public debate.

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The crucial point in understanding the causes of the macroeconomic imbalances that emerged during the first decade of EMU is that in the Southern European MMEs, the “absence of wage moderation in [the] non-tradable sectors […] places upward pressure on national prices, leaving export-oriented firms with an inflationary disadvantage vis-à-vis northern European exporters” (Herrmann, 2005; Johnston & Regan, 2015, p. 7). As inflation rates—at the same time despite and because of a common monetary policy for all—remained systematically higher in the demand-led MMEs, when compared to the CMEs in Northern Europe, intra-EMU price levels and thus nominal wages diverged markedly in the run-up to the crisis. Table 3.8 depicts this development by summarizing the aggregate changes in price, wage, and productivity levels during EMU (for prices, also compare the left panel of Table 3.6 a couple of pages earlier). Just as in previous tables, a familiar pattern emerges for prices and nominal wages, but crucially, not for productivity. With minor exceptions, the MMEs plus Ireland tend to cluster at the bottom halves of the table, representing the countries with the strongest price and nominal wage growth. In theory, rising prices and wages must not result in an erosion of competitiveness, if compensated for by a proportional rise in productivity. Such a proportional rise did not materialize, however, as the rightmost panel of the table indicates, where no clear pattern is recognizable with regard to countries’ VoC or type of growth model. While Greek labor productivity improved by 10%, for example, prices rose by 32%, and nominal wages by as much as 59%—so wages rose 49 percentage points ‘faster’ than labor productivity. Compare this to the Austrian case, as an example from the CME camp, where the difference between labor productivity and nominal wage growth was a much more moderate 20 percentage points.12 In consequence, as Table 3.9 confirms, rising prices and wages translated into sharply rising unit labor costs (ULC) in the demand-led economies of the Eurozone, especially in the manufacturing (tradable) sector, where international competition is strongest.13 In other words, Southern European export competitiveness declined significantly in the run-up to the crisis, both relative to their export-led Eurozone

12

It is important to note that these indicators can only provide a partial picture of the development of the relative export competitiveness in European economies. For example, wages do not need to rise slower than productivity in order for the competitiveness of an economy to improve. Among other things, this is because total factor productivity, a measure of technological progress, is not incorporated in the labor productivity figures in Table 3.8. 13 The LME Ireland is again an exception to the rule that CMEs are best able to promote export-led growth. Ireland features a very strong export sector precisely because it was able to keep wage growth in check in the manufacturing sector, and has therefore seen stagnant manufacturing ULC between 1999 and 2009, which is why it ranks among traditional exporters such as Germany, Austria, or Finland in the right panel of Table 3.9. Overall Irish ULC, in contrast, grew even faster than in Greece, driven for the most part by the domestic-demand driven construction sector, which was artificially inflated by the Irish housing bubble (Regan, 2014). In consequence, Ireland ranks among demand-led MMEs such as Greece or Spain, when it comes to the development of overall nominal ULCs.

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Table 3.8 Development of prices, wages, and labor productivity during EMU Price level (aggregate inflation) Country D 1999–2009 (%)

Nominal wages Country

D 1999–2009 (%)

Productivity Country

D 1999–2009 (%)

DEU 16 DEU 11 ITA −4 FIN 18 AUT 28 LUX −4 FRA 19 BEL 31 ESP 4 AUT 19 FRA 31 DEU 4 BEL 21 ITA 35 BEL 5 NLD 23 FIN 36 FRA 6 ITA 23 LUX 40 NLD 7 PRT 26 NLD 40 PRT 7 CYP 27 PRT 41 CYP 8 LUX 28 CYP 46 AUT 8 IRL 29 ESP 49 FIN 9 ESP 30 GRC 59 GRC 10 GRC 32 IRL 67 IRL 18 Notes Own calculation of D indices with base year 1999 = 100 based on variables ‘inflation’, ‘nominal wages’, and ‘productivity’; details on the operationalization and sources of the variables provided in Appendix B

Table 3.9 Development of unit labor costs (ULC) during EMU

Nominal ULC Country

D 1999–2009 (%)

Nominal ULC manufacturing sector Country D 1999–2009 (%)

DEU 8 FIN −6 AUT 15 IRL 1 BEL 23 FRA 1 FRA 23 BEL 4 FIN 25 AUT 5 NLD 27 DEU 7 PRT 29 PRT 10 CYP 30 NLD 11 ITA 35 ESP 15 ESP 39 GRC 36 GRC 40 ITA 37 IRL 44 LUX 67 LUX 47 CYP 84 Notes Own calculation of D indices with base year 1999 = 100 based on variables ‘ULC’ and ‘manufacturing ULC’; details on the operationalization and sources of the variables provided in Appendix B

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partners in the North, where ULC growth was systematically lower, as well as relative to the world, where the combination of rising national price levels with a strong Euro—the Euro exchange rate was mainly driven by the traditional hard currency countries of the former Deutschmark-bloc—put them at a considerable disadvantage.14 As a result, exports from the South declined considerably, while imports, bolstered by artificially inflated wages relative to the north of the Eurozone, skyrocketed.15 Both the traditional demand-reliance of Southern MMEs and the traditional export-reliance of Northern CMEs therefore intensified noticeably during the first decade of EMU. This pattern is also visible in countries’ adjusted export shares, the main variable used in the study at hand to measure countries’ growth models. These adjusted export shared are shown in Table 3.10 for the pre-EMU period (this is the same data presented in the right panel of Table 3.7), for the first half decade of EMU, and for the second half decade of EMU. This resolves the puzzle that has been hinted to in the discussion of Table 3.7 a couple of pages earlier, which may have led the reader to question the appropriateness of (adjusted) export shares as a measure of countries’ growth model. There has always been heterogeneity in institutions, or capitalist diversity, among the countries now forming the Eurozone. Some were traditional exporters, others were more reliant on domestic demand. But before the Euro, these economies were still able to compete with one another on a more or less even footing. In line with one of the centerpiece assertions of the VoC literature, one country’s VoC did not make it superior in its economic performance in any way, but merely reflected an individual approach to organizing its political economy. The theoretical arguments and empirical data of the preceding few paragraphs help explain why in the pre-EMU period export-led Austria was only barely distinguishable from more demand-driven countries such as Portugal based on this indicator (compare Table 3.10). Analogously, they help explain why the traditional export-powerhouse Germany ranks between more demand-driven France and Spain in that table. The crucial point is that while all export-led growth models have always had the institutions necessary to keep wage growth in check, and productivity growth high —in other words all the institutions that made them exporters—they had to live with periodic adjustments of their exchange rates, so they could never just ‘lean back’ and enjoy some uncontested institutional comparative advantage.. There was no institutionalized ‘beggar-thy-neighbor’ advantage. The comparative advantage

14

There were additional reasons for the erosion of export competitiveness in Southern Europe, such as their specialization in low value-added industries, such as textiles, which suffer from strong international competition from Asia (this issue is adressed multiple times in the SCP reports published by the European Commission, 2016a). While these factors may have played an important role, they are not in the focus of the analysis at hand, however, not least because had it not been for those countries membership in this hard currency EMU, their export competitiveness vis-à-vis Asia may have been retained to some degree. 15 Import/export data is not shown separately, but can be derived from CA balances and NIIP data provided below.

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Table 3.10 Growth models: export shares during EMU adjusted by population size and surface area Country

1991–1998 (mean)

Country

1999–2004 (mean)

Country

2005–2008 (mean)

LUX 0.66 LUX 0.85 IRL 0.49 IRL 0.40 BEL 0.35 BEL 0.35 NLD 0.32 NLD 0.31 NLD 0.33 FRA 0.26 DEU 0.27 DEU 0.29 CYP 0.25 FRA 0.25 AUT 0.22 DEU 0.25 FIN 0.23 FIN 0.22 ESP 0.23 ESP 0.23 FRA 0.21 FIN 0.23 AUT 0.21 ESP 0.18 ITA 0.22 ITA 0.20 ITA 0.17 AUT 0.19 CYP 0.18 PRT 0.08 PRT 0.14 PRT 0.11 CYP 0.07 GRC 0.08 GRC 0.08 GRC 0.05 Notes Own calculation; details on the operationalization and sources of the variable are provided in Appendix B IRL

0.40

derived from their politico-economic institutions was not yet ‘made permanent’ in the sense of being casted in the institutional underpinnings of the EMU economic regime. In consequence, while there was diversity in institutions, this did not so much translate into some form of systematic diversity with respect to their economic outcomes, so that diversity did not imply divergence. This changed with the introduction of the Euro. Within EMU in its current form, export-led growth seems clearly superior, and CME exports are able to crowd out exports from the demand-led MMEs. As Table 3.10 illustrates, growth models therefore gradually consolidated into their respective camps only after exchange rates got irrevocably fixed with the introduction of the Euro. The clear ‘division’ along the dimension running from export to demand-led growth only came about after all previous adjustment mechanisms had been eliminated by way of creating the common currency, but no new adjustment mechanisms (such as a system of horizontal transfers, a full-scale banking union, or at least a central bank permitted to assume the role of a lender of last resort in times of crisis) had been established. EMU thereby divided the union by solidifying the institutional differences of its members, instead of uniting them as it was meant to achieve in the minds of the common currency’s architects. Only inside EMU, the heterogeneity of capitalist varieties therefore had tangible economic consequences in the form of the macroeconomic imbalances that came to lie at heart of the Euro crisis (Hall, 2012). While they may always have been imbalances in Europe also before EMU, these were not yet as persistent, and not yet so strongly related to specific capitalist varieties, and growth models in particular.

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Table 3.11 External imbalances: development of NIIPs during EMU Country

2001

Country

2007

Country

2010

Country

D 1999-2009

LUX 95.5 LUX 98 FIN 182.1 BEL 28.9 BEL 50.9 DEU 29.5 DEU 8.7 DEU 26.5 DEU 35.4 NLD 24.9 CYP 11.7 NLD 24.5 AUT 18.2 FRA −2 FRA −1.5 FIN 21.4 BEL 17.6 ITA −5.8 NLD −6 AUT −6.2 FRA −1.4 NLD −13.4 AUT −18.2 FRA −12.5 LUX −13.7 IRL −15.2 IRL −19.5 ITA −24.9 CYP −15.3 AUT −25.6 ITA −25.4 CYP −35.6 ITA −21.5 ESP −35.6 FIN −27.9 IRL −88 GRC −43.1 GRC −46.5 ESP −78.1 ESP −89.1 ESP −61.7 PRT −47.5 PRT −87.9 GRC −98.4 PRT −78.8 FIN −82.2 GRC −96.1 PRT −107.2 IRL −142.8 Notes Own calculation; details on the operationalization and sources of the variable are provided in Appendix B

Table 3.11 depicts the emergence of these persistent external imbalances, operationalized as levels of net international investment positions (NIIP) in 2001, 2007, and 2010, as well as the 1999–2009 change in that variable. The NIIP is defined as a nation’s total stock of foreign assets minus its foreign liabilities.16 It therefore includes both the public and the private sector, and both debt instruments and assets, and could therefore be conceived of as a nation’s total net financial wealth in the sense of its balance sheet with the rest of the world. As is easily seen, Table 3.11 essentially reverberates for external imbalances, what has been conveyed for the underlying growth models by Table 3.10. At around the time of the introduction of the Euro, NIIP deficits and surpluses were distributed rather equally across different capitalist varieties within the Eurozone. By the beginning of the Euro crisis in 2010, however, NIIP deficits had become almost a defining feature of demand-led growth models and MMEs (plus the exception Ireland), while NIIP surpluses were found almost exclusively in export-led growth models and CMEs. In the analysis at hand, NIIP levels will serve as one of the main explanatory variables for austerity and economic adjustment. This is because conceptually the NIIP is very close to the main underlying institutional causes of the crisis (growth model heterogeneity within EMU and the resulting macroeconomic imbalances), but still not too far detached from the immediate economic sources of crisis response (such as interest rate hikes on sovereign debt, which follow from credit

European Commission, Economic and Financial Affairs, ‘Net International Investment Position’, 27 January 2017. URL: http://ec.europa.eu/economy_finance/graphs/2014-12-08_net_international_ investment_position_en.htm (last accessed 18 February 2018).

16

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risk assessments of atomistic economic agents on financial markets, and tend to translate into considerable external pressure). Note that by moving up the causal chain, and using countries’ growth models as operationalized based on adjusted export shares, for instance, as the main explanatory factor, we may generalize too much as to be able to empirically link austerity to its main underlying causes. The oft-mentioned outlier Ireland, for example, accumulated a massive NIIP deficit after being forced to bail out its banking system in 2010, but had a strong export performance before (and after) the crisis nevertheless. At the same time, it clearly cannot be considered a CME or even a pure export-led economy (Culpepper & Regan, 2014; Regan, 2014). By generalizing all the way up to institutional—and thus rather time-invariant—causes, such idiosyncrasies would be blurred, resulting in inefficient, or even biased statistical effect estimates. Moving down the causal chain, in contrast, to measuring just the immediate sources of austerity (such as interest rates on sovereign debt, or even budget deficits), may lead to considerably higher levels of statistical significance of whatever effects are found. At the same time, however, this approach would not be of much value when it comes to identifying the underlying causes of what I intend to explain. The somewhat intermediate approach chosen here, supplemented by empirical data to support what I argue to be the main causal chain, therefore seems most appropriate. To summarize this subsection, the institutional diversity embodied in the European nation states clashes with the need for economic homogeneity implied by EMU, and has resulted in massive macroeconomic imbalances, thereby dividing the Eurozone into debtors in the South and creditors in the North. In other words, the Euro itself must be blamed for the crisis of the common currency that followed on the heels of the Great Recession in around 2010. This conclusion is not meant to oversimplify the crises in its many complex dimensions, or to brush aside the idiosyncrasies of crisis development at the country level. What I do argue—in line with the conclusions of large parts of the politico-economic literature on the topic (see above for a summary)—is that all these very different types of economic or politico-economic crises as well as the options and strategies of crisis resolution are inextricably linked with one another through the common currency. Were it not for the Euro’s monetary regime, the affected countries could have solved their own idiosyncratic crises long ago; and if they had not, these long-lingering crises would not have had these highly contagious effects on the rest of the Eurozone. The structural crisis of the common currency, and the concomitant macroeconomic imbalances, therefore not only lie at the heart of many countries’ economic woes, but they also explain their depth and persistence. This can also be learnt from the conclusion drawn by Eichengreen (2015, p. 13): By creating the mirage of stability, the euro system set in motion large capital flows toward Southern European countries ill equipped to handle them, like those of the 1920s. When those flows reversed direction, the inability of national central banks to print money and national governments to borrow it consigned economies to deep recession, as in the 1930s. Pressure mounted to do something. Support for governments that failed to do so began to

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dissolve. Increasingly it was predicted that the euro would go the way of the gold standard; governments in distressed countries would abandon it. And if they hesitated, they would be replaced by other governments and leaders prepared to act. In the worst case, democracy itself might be placed at risk.

Even though these remarks by Eichengreen do not focus so much on the division of the Eurozone in demand- and export-led growth models, but more on the more immediate chain of events taking place within Europe’s monetary and financial, and eventually also political systems, the underlying logic, and especially the implications for crisis response and democracy in Europe, are the same. The following subsection will discuss these implications in detail.

3.6

Trilemma at the Country-Level: Who Has to Consolidate?

The politico-economic trilemma of EMU introduced above illustrates the tensions between national-level diversity, EMU, and democracy at the level of the currency union as a whole. Ultimately, however, the trilemma manifests itself mostly at the level of the individual EMU member countries. To derive testable hypotheses from the trilemma and its underlying theoretical arguments, its implications must therefore be examined at the country level. At the core of the politico-economic trilemma of EMU lies the conviction that cross-national diversity creates a tension within the Eurozone as it is currently designed. Since the onset of the Great Recession and Euro crisis, the overriding priority of all EMU members has become to comply with the ‘rules of the game’ implied by EMU’s economic regime. While this is much easier for some countries than others, EMU in its current form clearly rules out too much capitalist diversity. But which countries have to adjust in what direction to reduce diversity? In general, the degree to which EMU’s economic regime impacts on the domestic level is highly conditional on the fit of national-level institutions, ideas, and outcomes with that EMU regime. When compatibility is high, such as in Germany, for instance, compliance with the rules of the game is easy, and political autonomy and self-determination may be retained. In fact, high compatibility with the EMU regime may even open up policy choices that would not have been available outside or before EMU. When compatibility is low, in contrast, compliance is hard, and may come at the cost of political autonomy and national democratic self-determination. In the following, I will discuss the shape and implications of the trilemma first for countries with NIIP surpluses, and next for those exhibiting NIIP deficits. As shown above, this distinction based on economic outcomes is almost perfectly aligned with the dimension running from export- to demand-led growth models. The last three of the six components of my theoretical argument are therefore

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discussed separately for these two types of growth models.17 It is important to emphasize once more, that in reality countries scatter somewhere along the continuous dimension running from the one extreme of an ideal type export-led growth model, to the other extreme of an ideal type demand-led growth model. Actually, one could certainly complicate this further by coming up with additional dimensions to map out countries’ capitalist variety in more detail. The two-fold distinction used repeatedly in the thesis at hand is used mainly for ease of presentation and interpretation.

3.6.1

Export-Led Growth Models with NIIP Surpluses

Export-led growth models, who tend to be surplus countries as a result of their undervalued exchange-rate vis-à-vis both intra- and extra-EMU trading partners, are enjoying an institutional comparative advantage inside the Euro area, which ultimately is not much different from the ‘beggar-thy-neighbor-advantage’ in the times of Mercantilism. As a result of their artificially undervalued real exchange rate, they tend to benefit from a relatively strong export performance and persistent CA surpluses, and therefore also tend to enjoy budget surpluses and most likely decreasing public and private external indebtedness. EMU export-led growth models can therefore be expected to be in an even better position than non-EMU export-led growth models, as the latter would have to fear a continuous or periodic (depending on their exchange rate regime) devaluation/depreciation or their currencies, which would reduce their international competitiveness and hurt their economic performance in the short-term at least. National self-determination and political autonomy is therefore highly unlikely to actually be constrained in any way. To the contrary, due to their politicaleconomic power position, some individual surplus countries may be quite likely to dominate the policymaking agenda at the level of EMU, and therefore be able to (continue to) shape the rules of the game of EMU to their advantage. This is quite precisely what Crum (2013) describes as EMU’s executivefederalism: EMU rules and EMU policymaking, and this implies crisis response, are dominated by national governments, and more specifically by the governments of creditor countries—that is, the camp of Northern export-led growth models led by Germany. Except for immediate crisis situations, where the future of the entire EMU economic regime is at stake (such as when, under severe pressure by financial markets, bailout packages or institutional reforms were agreed on in around 17

As laid out in the introduction to this thesis, the six components of my theoretical argument are best summarized as (1) capitalist diversity in the EMU (see Sects. 1.2.1 and 3.3), (2) EMU’s economic regime (see Sects. 1.2.2 and 3.4), (3) institutional roots of the Euro crisis (see Sects. 1.2.3 and 3.5), (4) constrained policy options (see Sect. 1.2.4), (5) enforcement (see Sect. 1.2.5), (6) EMU versus democracy (see Sect. 1.2.6).

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Fig. 3.2 The politico-economic ‘non-trilemma’ of EMU for export-led economies

EMU

nation-state

democracy

Notes: author’s illustration

2010–2012), these export-led models must not be expected to act against their national economic interest and dominant economic ideology. Therefore there are virtually no major EMU-determined constraints on domestic policymaking in these countries. The design of new EU policies such as the fiscal pact has clearly been dominated by export-led countries and tends to be fully in line with their own domestic institutions, national interests, and economic ideology. Since there are no constraints, there is no enforcement of them in the form of any financial market pressure, for instance. To the contrary, enforcement may even be negative in the sense that their interest rates on sovereign debt, the value of their common currency, as well as their unemployment rates may be far lower than they would be for the same country outside of the monetary union. Germany may be a case in point in this regard. We may very well observe austerity plans and policies in countries with export-led growth models, and these may even be realized to a considerable degree. This, however, is very likely to result from domestic ideological preferences, rather than from any meaningful economic, financial, or political pressure exerted on the national political system from the outside. In conclusion, democracy will be retained in those countries. Figure 3.2 depicts this ‘trilemma’ as it presents itself to surplus countries. I chose to show the trilemma without the connecting arrows, and with the three nods being located very close to each other, in order to illustrate the fact that ultimately, there is no noticeable trilemma for traditional export-led NIIP-surplus countries within EMU.

3.6.2

Demand-Led Growth Models with NIIP Deficits

Demand-led growth models within EMU tend to experience a comparative institutional disadvantage vis-à-vis their EMU trading partners, and therefore often suffer from overvalued exchange rates and the concomitant emergence of persistent NIIP deficits.18 In the absence of a substantial sharing of adjustment burdens Indeed, Höpner and Lutter (2014, p. 2) point out, that in the midst of the Euro crisis in 2012, “a Goldman Sachs study indicated that the German economy needed a revaluation of about 25% and the Portuguese economy a devaluation of about 35%, with all other euro members positioned in between these two extremes”, and that the “most alarming finding of that study was the devaluation need of about 20 percent in the case of France.”.

18

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between surplus and deficit countries (e.g. reflation in surplus countries or ongoing fiscal transfers to accommodate macroeconomic imbalances) the burden to adjust and facilitate a correction of intra-EMU macroeconomic imbalances will fall entirely on these demand-led deficit countries. Based on the Eurozone’s contemporary economic regime and its political support coalitions, such wide-ranging burden sharing is not forthcoming, however. Just as German ordoliberal thinking had dominated the design phase of that EMU regime, it also dominates the phase of crisis resolution, with its view that “the solution [lies in] an anti-Keynesian, export-led monetarist rule-based model for the European Union” (Young, 2014, p. 136), that in the current economic environment essentially builds on the neoclassical “doctrine of expansionary fiscal consolidation” (Eichengreen, 2015, p. 10). This translates into severe external constraints for the room of maneuver available for NIIP deficit countries. While one may argue that many of these constraints had been present all along—in the sense that since the introduction of the Euro, fiscal policy had always been constrained by the SGP, and both monetary and exchange rate policy had always been in the hands of the ECB—they became imminent only when the crisis hit. As Streeck (2014a) puts it, this is simply because the period of ‘buying time’ had been brought to an end by the crisis (even though Streeck’s argument also incorporates developments that extend farther back than just to the introduction of the Euro). Now deficit countries have no choice but to adjust, and adjustment means harsh austerity (or better: a deleveraging of the entire economy), internal devaluation, and supply side reforms to promote (downward) wage-price flexibility that can help smooth internal devaluation. Not only is this policy package without alternative in the most severely affected countries, which are facing a depleted macroeconomic policy toolkit, but the crisis also defines an extremely unfavorable economic environment to even be successful with internal devaluation and austerity, as these policies are likely only to prolong the depression and its immense social costs. No matter if austerity is in this sense ‘self-defeating’, however—and most observers agree that it is or has been (Corsetti, 2012; IMF, 2013)—these policies will be enforced. At the face of it, ‘enforcement’ is due to international financial markets or supranational organizations, such as the Troika, the EU, or the IMF. Ultimately, however, the need to adjust directly follows from the mere fact of being an EMU BoP-deficit country that wants to keep the common currency. In other words, the cause is mainly institutionally determined. Everything down the causal chain can essentially be interpreted as a mere collection of symptoms or sources, but not root causes: as credibility is lost, capital inflows have dried up, and investment and/or consumption bubbles have burst, capital flight ensues, so that debt-financing is no longer possible, so that interest rates are skyrocketing and translate into massive external pressure for reform,19 so that the Troika intervenes and offers financial

So that countries are indeed, as described in the introduction, degraded to ‘Swabian housewives’, who do not have any autonomous control over their own money supply. 19

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assistance in return for stringent conditionalities for reform and economic adjustment. Deleveraging has thus become the only game in town, and competitiveness needs to be restored to be able to pay for what in retrospect was an irrational exuberance [borrowing this term from Shiller (2000)] of ever-rising wages and unit labor costs, culminating in persistent trade deficits. This is not to say that sources are not important. To the contrary: external pressure implied by sharply rising interest rates on sovereign debt is clearly the chief mechanism through which economic adjustment, internal devaluation, and austerity are ultimately enforced. The institutional cause is in this sense necessary, but it is not sufficient to trigger enforcement. There is a second enforcement mechanism, however, which may come to bear even in situations where external pressure is absent or minimal, as in the case of France, for instance. Here, enforcement may come in the somewhat more subtle form of persistent internal pressure, which most clearly comes to bear in the form of persistent high unemployment rates. Countries with more internal, but less external pressure, may not feel the full force of an external imposition of austerity by financial markets. They are likely, however, to remain caught in their economic/ fiscal quagmire for longer, as internally-induced adjustment pressure tends to be stretched out over the long term. That these countries will struggle considerably to reduce unemployment rates without implementing some comprehensive economic adjustment—again, this implied mainly internal devaluation, austerity, and supply-side reforms—follows directly from the argument that the root cause of the crisis is intra-EMU institutional heterogeneity. As long as the real value of the French ‘currency’ (see footnote 40 earlier) is overvalued for structural reasons related to a mismatch between its national capitalist variety and the non-optimal (in the sense of OCA theory) EMU monetary regime, the only way to restore internal balance (i.e. to reduce unemployment) in France is through internal devaluation— and by around 2016/2017, this seems to be what French economic reforms are aiming at. The only alternative for France (or any other more or less demand-led EMU country in a similar situation) would be to try to alter EMU’s economic regime to better match its own growth model, which is exactly what French president Emanuel Macron is hoping to achieve with his EU/EMU reform initiatives launched in late 2017 (Brunnermeier et al., 2016; Chassany et al., 2017; Economist, 2017). For the time being, however, the EMU economic regime remains clearly biased towards export-led growth—and this can also be derived from the trends in EMU member countries’ external (im)balances since the onset of the crisis. It is important to note that NIIPs provide a measure of external imbalances as they have accumulated over time, but not so much of their short-term variability as they are partially reflected in current account (CA) balances, for instance, which are a crucial component of the change rate of NIIPs. When it comes to BoP-crisis resolution (and this is what the Euro crisis for the most part is about), where countries are ultimately

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forced to correct their imbalances, the most potent means is a positive CA balance —i.e., countries will be under immense external pressure to promote exports and reduce imports. Once the CA is (back) in balance, BoP deficit countries may be relieved considerably from the external pressure to do something about their still very much existent macroeconomic imbalance (as measured by the NIIP). In this sense, many observers argue that EMU corresponds to the institutionalization of export-led growth in Europe. Within EMU, there seems to be no path to prosperity left anymore, other than to follow the German example, no matter if national institutions are compatible with that style of export-led growth or not. Figure 3.3 gives an indication of how pervasively the mantra of export-led growth has started to dominate the currency union since the onset of the crisis, by plotting CA balances of 12 Eurozone countries between 1970 and 2014. This data also clearly shows the buildup of macroeconomic imbalances from the introduction of the Euro in 1999 until the Great Recession, which can be grasped from the divergence in intra-EMU CA balances form the mid-1990s to the 2007 (ceteris paribus, persistent CA surpluses or deficits will accumulate to imbalances such as those reflected in countries’ NIIPs). With the onset of the Great Recession, CA balances converged rapidly again, but as is easily seen, this adjustment has rested entirely on deficit countries (in the context shown in the figure, these are especially IRL, PRT, GRC, and ESP). As soon as by 2013, the standard deviation of CA balances was as low as it had never been before.20 Moreover, almost all CA balances have swung into surplus, or were only narrowly in deficit. With a mean of slightly less than two percent, average EMU CA balances became as high as never before in the last four decades. This glance at the data may only be a snapshot in time, insufficient to make any predictions without doubt. When taking into account how massively the EU has expanded its framework of economic oversight in response to the crisis—besides the fiscal compact now also encompassing the so-called macroeconomic imbalance procedure—it simply does not seem feasible anymore that intra-EMU growth model diversity can be retained any longer—at least as long as growth model diversity implies diversity in their economic outcomes (which does not need to be the case). It almost seems as if all EMU members will be forced to function as export-led growth models, no matter if they have the institutional prerequisites to do so. If they fail—which is not totally implausible—they will nevertheless be forced to restore and maintain external balance, but they may have to live with the consequences in the form of persistent internal imbalances. Table 3.12 provides an overview about how internal imbalances have developed since the start of EMU—with internal balances/imbalances being approximated using the unemployment rate.

20

Own calculation based on the CA variable; operationalizations and sources provided in Appendix B.

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.1 0 -.1 -.2

Current Account Balance, % of GDP

.2

.3

3.6 Trilemma at the Country-Level: Who Has to Consolidate?

1970

1980

1990

2000

2010

year AUT FIN DEU IRL LUX PRT

BEL FRA GRC ITA NLD ESP

Notes: own calculation and illustration; details on the operationalization and sources of the variable are provided in appendix B. Fig. 3.3 Development of CA balances in EMU countries 1970–2014

Table 3.12 Internal balances: development of unemployment rates during EMU

Country

1999 (%)

Country

2007 (%)

Country

2011 (%)

LUX 2.4 NLD 3.6 AUT 4.2 NLD 3.5 CYP 3.9 NLD 4.4 CYP 3.6 LUX 4.2 LUX 4.8 AUT 3.9 AUT 4.4 DEU 5.9 PRT 5.0 IRL 4.7 BEL 7.2 IRL 5.6 ITA 6.1 FIN 7.8 BEL 8.5 FIN 6.9 CYP 7.9 DEU 8.6 BEL 7.5 ITA 8.4 FIN 10.2 FRA 8.0 FRA 9.2 ITA 10.9 ESP 8.2 PRT 12.9 FRA 11.3 GRC 8.4 IRL 14.7 GRC 12.0 DEU 8.7 GRC 17.9 ESP 13.6 PRT 8.9 ESP 21.4 Notes Own calculation; details on the operationalization and sources of the variable are provided in Appendix B

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As is easily seen, there was no clearly recognizable pattern in unemployment rates depending on countries’ type of growth model in the past, neither in 1999 nor in 2007. In 2011, however, all the demand-led political economies, now deeply mired in recession, are found in the bottom half of the table with the highest unemployment rates. What has happened was, first, that owing to their macroeconomic imbalances they were hit much harder by the crisis, and second, when it comes to crisis response, they had no choice but to attempt to correct their external imbalances by slashing imports (and initiating harsh internal devaluation and austerity programs), with no regard to the consequences for their internal balances. In a way, they were successful in their attempt to correct (short-term) external imbalances: as Fig. 3.2 has shown, CA deficits were swiftly eliminated. As a logical corollary of this, however, unemployment rates skyrocketed (in fact, in 2011, which is shown in the table, unemployment rates were still well below theirs peaks that would be seen a couple of years later). The average unemployment rate across the six CMEs shown in the table, in contrast, was actually lower in 2011 (in the midst of the Great Recession and Euro crisis), than both in 1999 and 2007. This is another indication of how differently demand-led and export-led growth models were affected by the crisis. When comparing the data on external balances presented in Table 3.11 with that on internal balances presented in Table 3.12, we get a glance of the well-known trade-off between the internal and the external balance (Krugman & Obstfeld, 2009) —a tradeoff which so many countries had to face so often in the long history of fixed-exchange rate regimes. While Southern European21 external imbalances (in terms of NIIPs) were at their maximum in 2007—right before countries were hit, in very much the same order, by the Global Financial crisis first, the Great Recession next, and finally the Euro crisis—their internal balances were moderate at best. Actually, historically, unemployment rates at the order of around eight percent must be considered low for many Southern European countries. Actually, in some cases, unemployment rates in 2007 marked a long term minimum (such as a 31-year minimum in Italy, a 28-year minimum in Spain, a 24-year minimum in France, or a 14-year minimum in Greece.22 More importantly, unemployment rates were largely unrelated to countries’ type of growth model and external balances before the Euro crisis. By 2011, however, only four years later, that picture had reversed. When these crisis countries had been forced to correct their external imbalances in an extremely painful process of economic adjustment, austerity, and internal devaluation (mostly true for countries like Spain, Greece, Ireland, Portugal, and later also Cyprus), or were at a minimum being deprived of any macroeconomic tools to fight the recession through the demand channel (such as France or Italy) they had to sacrifice their internal balance.

As before, I am using the term ‘Southern European’ rather imprecisely to refer to all EMU crisis countries struggling with macroeconomic imbalances and BoP crisis. 22 Data source of unemployment data is provided in Appendix B. 21

3.6 Trilemma at the Country-Level: Who Has to Consolidate? Fig. 3.4 The politico-economic trilemma of EMU for demand-led economies

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EMU

nation-state

democracy Notes: author’s illustration

It is certainly not too far-fetched to argue that, if EMU is to survive in the long run, it has to enable its member states to operate their economies in a way that allows them to ensure both external and internal balance at the same time, even though temporary deviations may very well be sustainable both economically and politically. Whether or not the current economic regime of EMU is capable to achieving that, however, remains to be seen. As a general rule for demand-led EMU countries in BoP-crisis (i.e., this is not so much the French or Italian, but rather the Portuguese or the Greek case, for instance), one can conclude that politics—and this is mainly domestic politics— does not matter much anymore. Internal devaluation-cum-austerity programs have to be implemented at all cost if Euro-membership is to be maintained [and some true ‘democratic federalism’ at the EU or EMU level is not forthcoming (Crum, 2013; Habermas, 2011; O’Rourke, 2011)], no matter what citizen’s vote for, no matter which party is in power. In other words: democracy pays the price. Figure 3.4 depicts this effective neutralization of democracy in the affected countries graphically. At its core, this tension between democratic politics on the one hand, and policymaking dictated by functional requirements on the other, is not much different from what Mair (2013) calls the conflict between ‘responsive and responsible government’ or what Streeck (2014a, p. 79 ff.) describes as a conflict between ‘Staatsvolk’ and ‘Marktvolk’. The only difference is that within EMU, this conflict has effectively been institutionalized for the demand-led growth models of the Eurozone. For these countries it can be expected that many of the factors characteristic of national-level democratic choice, interest formation and aggregation, have lost their explanatory power in the aftermath of the crisis.

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Hypotheses

From the theoretical discussion presented in this chapter so far, I will now derive several hypotheses to be tested in the empirical analyses presented in Chaps. 4 and 5. Determinants of Macroeconomic Imbalances (Chap. 4) As argued both in the thesis at hand as well as in much of the politico-economic literature on the Euro-crisis, macroeconomic imbalances in the EMU have their origins largely in intra-EMU institutional heterogeneity with respect to national varieties of capitalism (De Grauwe, 2011, 2012b, 2013; Hall, 2012; Höpner, 2014; Höpner & Lutter, 2014; Höpner & Schäfer, 2012; Johnston et al., 2014; Scharpf, 1986, 2011, 2013). More specifically, being equipped with the (historically grown) institutional prerequisites to be able to operate an export-led growth model under the current politico-economic regime of EMU, should amount to a considerable institutional comparative advantage relative to other members of the union, which are operating growth models that traditionally rely to a higher degree on domestic demand and its stimulation. Outside the currency union, any such institutional comparative advantage would probably be short-lived, at least in the sense that it would be unlikely to translate into any lasting economic benefit—i.e., trade surpluses—, since even in a fixed-exchange rate regime such as the earlier EMS, periodic exchange rate adjustments would eliminate any temporary gain in (cost) competitiveness, and thereby work to bring countries’ BoP (back) into balance. Inside EMU, however, the institutional comparative advantage derived from the successful operation of an export-led growth model should translate into persistent trade surpluses, which can in turn be expected to accumulate into large positive NIIPs. This leads me to a first hypothesis to be tested empirically in the following chapter: H1: The more an EMU member country relies on export-led growth, the higher its NIIP. At its core, the empirical testing of H1 seeks to confirm the findings of the above-mentioned literature based on the concepts, operationalizations, and data utilized in the thesis at hand. Moreover it must be understood as a more systematic and sophisticated examination of the descriptive data that has been presented in this theoretical chapter already. One of the key drivers of the comparative institutional advantage of export-led growth regimes is their ability to keep wage growth in the non-tradable sector in check, which is usually achieved through corporatist institutions that link wage growth together across the different sectors of an economy. This is exactly what Johnston et al. (2014) show in their contribution on the underlying causes of the Euro crisis (but also see Hancké, 2013, among others). When corporatism is one of the key sources of success of export-led growth models within EMU, then corporatism should also be linked with rising NIIP during the Euro crisis. This leads me to a second hypothesis to be tested empirically:

3.7 Hypotheses

99

H2: The stronger corporatism is in an EMU member country, the higher its NIIP. If H2 is supported by the data, this ought to lend credibility to the presumed causal chain running from corporatist institutions through export-led growth to NIIPs in the Euro area. Determinants of Austerity Plans (Chap. 4) As has been laid out in Chap. 2 in particular, austerity plans in the study at and are analyzed based on at least three different dependent variables: a continuous variable indicating countries’ 2-year fiscal stances, a dummy indicating the presence of a 2-year consolidation plan, and a continuous variable indicating plan size, which is identical to fiscal stances, bot observed only when the fiscal plan dummy equals 1. All of the hypotheses derived below will refer to one of these variables. As argued above, intra-EMU macroeconomic imbalances can to a considerable degree be interpreted as the outcome of intra-EMU growth-model diversity (I am using this rather restrictive growth-model-terminology here to keep the discussion as simple and parsimonious as possible). I content that this is the underlying cause not only of macroeconomic imbalances, but eventually also of austerity. The effect of these underlying, largely institutional causes should mainly run through the two enforcement mechanisms introduced earlier (mainly interest rates on government debt, but to a somewhat more subtle degree also unemployment). I therefore contend (as argued in more detail above) that ultimately these enforcement mechanisms are the immediate sources of policymakers’ incentive to initiate austerity plans of a certain size. The complexities involved in the decision whether to better use institutional causes, or more immediate economic sources as main explanatory variables, will be discussed in more detail in the following empirical chapters. With the onset of the Euro crisis, which followed on the heels of the Great Recession, the severe macroeconomic imbalances, and the concomitant precarious economic situation of Eurozone countries in BoP-deficit, could no longer be ignored, and the need to act became more than obvious with several countries finding themselves at the brink of sovereign default. Capital flight from the periphery into the Eurozone’s core had set in, and culminated in several bailout packages under involvement of the IMF, which from 2010 onwards acted in collaboration with the ECB and the European commission in the so-called Troika. This leads me to the following hypothesis: H3: For EMU countries in the post-GR period, negative NIIPs lead to contractionary fiscal stances. In the politico-economic context of the Euro crisis, contractionary fiscal stances should mostly be equivalent to a fiscal consolidation program (note that in a non-crisis environment, contractionary fiscal stances may result from many other, non-policy related factors). The decision to use separate variables for what is in this case the same phenomenon is partly grounded in methodological considerations, and partly in the fact that there are several instances of contractionary fiscal stances in the data that should not automatically be considered consolidation programs.

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When it comes to the task of formulating hypotheses, the differences are miniscule, however. Therefore, the effect of intra-EMU macroeconomic imbalances on the initiation of austerity plans is hypothesized as follows: H4: For EMU countries in the post-GR period, negative NIIPs increase the probability of an austerity plan being initiated. As some recent fiscal consolidation literature has shown (see e.g. Armingeon et al., 2014a; Hübscher & Sattler, 2014), the factors determining the initiation of austerity programs on the one hand, and their size on the other, may very well differ. Also in the study at hand I content that they do. Most importantly, while an EMU country mired in a BoP-crisis after the onset of the Great Recession may have absolutely no other option than to initiate a fiscal consolidation program, the size of that program must not be expected to be associated with the size of its BoP-deficit, for instance. One reason for that is simply, that the NIIP, which measures the degree of macroeconomic imbalances, is composed of both public and private external indebtedness. And while even private indebtedness alone may very well suffice to force a government into consolidation, the size of that consolidation program should rather be related to public indebtedness alone. This may seem somewhat contradictory at first. The logic can be illustrated very well with the case of Spain in the current crisis. Both Spanish public debt and the Spanish public budget balance were relatively low at the outset of the Great Recession. In fact, the budget was in surplus for almost 10 years when the country was hit by the global financial crisis in around 2008, and Spain’s sovereign debt stood at a very low 35.5% in 2007 (data sources provided in Appendix B). Spanish private indebtedness, in contrast, had increased substantially during the first decade of the Euro, creating precisely the kind of macroeconomic imbalances that now lay at the heart of the crisis in so many countries, eventually forcing the country into seeking a bailout. In the end, that bailout only became necessary because the Spanish public sector was forced to come to the rescue of its failing banking system, and in this process assumed large portions of private debt, so that the Spanish sovereign debt almost doubled almost tripled from its 2007 low to more than 100% by 2015. In other words, ultimately its overall NIIP-deficit in the EMU context was to blame that the Spanish government had to embark on austerity, despite the fact that this NIIP-deficit was almost in its entirety caused by private, not public indebtedness. When it comes to the size of that consolidation program, however, we should rather take into account how Spanish public finances developed in response to the crisis, and the associated take-over of large chunks of private debt. To conclude this discussion, I hypothesize that the size of an austerity program, given that this program has been initiated, should mostly be related to more technical factors approximating the current state of public finances. The most important of these technical factors should—and in this I very much agree with recent literature on the topic (Armingeon, 2013a)—be the government’s initial budget balance. This leads me to the following hypothesis:

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101

H5: The higher (more positive) a government’s initial budget balance, the smaller the austerity plan. Keep in mind, however, that the initial budget balance itself should be strongly related to the precarious situation several EMU member countries are facing as a result of their considerable BoP-deficits as measured by the NIIP. Determinants of the Realization of Austerity Plans (Chap. 5) The initiation of austerity plans has been hypothesized to be directly correlated with the severity of macroeconomic imbalances that EMU countries are facing since the onset of the Great Recession/Euro crisis, while the pattern of macroeconomic imbalances, in turn, has largely been institutionally determined. When it comes to the size of these plans, in contrast, it has been argued that macroeconomic imbalances should have less immediate explanatory power. Rather, technical factors approximating the state of public finances should be more helpful in understanding austerity. For the realization of austerity plans, I contend, the severity of macroeconomic imbalances resulting from their institutional determinants should also play an important role. That is, the peculiar context defined by being an EMU-NIIP-deficit country should result in some considerable effort made by national governments to realize those plans. In this sense, the size of macroeconomic imbalances (and the underlying institutional causes of these) can be expected to affect positively austerity plan realization. This leads to the following hypothesis: H6: For EMU countries in the post-GR period, more negative NIIPs lead to higher plan realization. As explained before, however, the presence of considerable NIIP deficits may be considered a necessary, but not a sufficient condition for ambitious plan realization. That is, in certain times and contexts, NIIP deficits may not result in higher austerity plan realization (actually, this was true for most of the Southern European demand-led countries in the year leading up to the crisis). Only if BoP deficits (a) actually translate in external (financial market or Troika) pressure (which has certainly been the case in the early years of the Euro crisis), or (b) policymakers expect that such external pressure may ensue, they can be expected to have any meaningful impact on plan realization. This is why I will test another hypothesis that touches upon the more immediate sources of austerity, namely the degree of external pressure reflected in interest rates on sovereign debt: H7: Stronger external pressure leads to better plan realization. Based on the theoretical discussion of the previous subsections, it can be expected that the statistical effect estimates obtained from the tests of H7 will indicate a stronger relationship with austerity plan realization than those obtained from the tests of H6. Besides the factors introduced so far, austerity plan realization will also depend on some technical factors that are for the most part beyond a government’s control. Following Mauro (2011), I will focus on two factors in particular. First, there is the

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degree, to which economic growth over the relevant fiscal consolidation period turned out better or worse than foreseen in austerity plans. This can be labelled a growth surprise, which can be positive (growth better than expected) or negative (growth worse than expected), and leads to the following hypothesis: H8: The higher the growth surprise, the better is plan realization. A second important technical factor is based on the observation that the Great Recession has seen several very sizable bank recapitalization packages implemented by national governments, with correspondingly sizable repercussions for general government budgets. Insofar as these came unexpected (which they oftentimes did), they should have had a severe negative impact on plan realization. This leads to another hypothesis: H9: The costlier an unforeseen bank recapitalization, the worse is plan realization. Finally, I argued above that democracy loses out in the countries most affected by the Euro crisis (which, as shown repeatedly, are the demand-led NIIP deficit countries of the Eurozone), and that therefore (democratic) politics does not matter anymore in these countries. In other words, political factors that are commonly (i.e., in ‘normal’ times and contexts) associated not only with democratic policymaking in general, but also with better or worse austerity plan realization in particular, should lose most of their explanatory power in the specific context these countries find themselves in. I will focus on three factors in particular, one of them political-institutional, the other two clearly political: the impact of the stringency of domestic fiscal rules, as indicated by the European Commission’s Fiscal Rules Index (FRI), the effect of government partisanship, and the impact of elections. This leads to three final hypotheses: H10: In NIIP deficit countries in the context of the Euro crisis, the stringency of fiscal rules ceases to have a noticeable effect on plan realization. H11: In NIIP deficit countries in the context of the Euro crisis, government partisanship ceases to have a noticeable effect on plan realization. H12: In NIIP deficit countries in the context of the Euro crisis, elections cease to have a noticeable effect on plan realization. The FRI could be conceived of as a component of the rule of law—containing, for example, clearly defined provisions regarding the budgetary processes, or even some form of ‘balanced budget rule’ incorporated in a countries constitution. In this sense, when the rule of law is upheld, the FRI should have an effect on government policy and lead to more positive budget balances—and this is also what the literature on the topic tends to find (see e.g. Guichard et al., 2007). In other words, a statistically significant effect on this variable may be considered an indication of a functioning democracy. Similarly, the respective coefficients of the two political variables should indicate statistically significant relationships if a democracy is working properly. Note

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103

that for the government partisanship variable the direction of this effect is irrelevant for the purpose of the thesis at hand. This is not about whether left or right perform ‘better’ or ‘worse’, such as in Tavares (2004), for instance. What matters here is merely that in a democracy it should make a difference when different governments are in power. In other words, government partisanship should, both from a positivist as well as normative perspective, matter for government policy and its outcomes.

Chapter 4

Empirical Analyses: Intra-EMU Heterogeneity and Austerity

This chapter presents the empirical analysis on the determinants of austerity during the Great Recession and Euro crisis. The first Section (Sect. 4.1) deals with the determinants of macroeconomic imbalances, which can be considered both the main economic source—but not the underlying cause—of the Euro crisis, and therefore arguably also the most important factors explaining austerity in the crisis. In this sense, it can be conceived of as an introductory subsection. The following two subsections move directly to the analysis of austerity. Section 4.2 relies mainly on descriptive multivariate statistics, while Sect. 4.3 is more inferential in nature, being comprised mainly of several pooled time-series cross-sectional (TSCS) regression models.

4.1

Determinants of Macroeconomic Imbalances

In essence, this subsection is intended to establish an empirical link between countries’ growth models (export- vs. demand-led growth) and macroeconomic imbalances, as well as between corporatism—one of the main components of growth models—and macroeconomic imbalances. In this sense it can be interpreted as an extension of the theoretical arguments made in Sect. 3.5 about the causes of the Euro crisis, and an attempt to confirm the findings on the relevant earlier literature on the topic based on the data at hand as summarized in Chap. 3. The two hypotheses formulated regarding the relationship between capitalist varieties and macroeconomic imbalances were as follows: H1: The more an EMU member country relies on export-led growth, the higher its NIIP H2: The stronger corporatism is in an EMU member country, the higher its NIIP.

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 K. Guthmann, Fiscal Consolidation in the Euro Crisis, https://doi.org/10.1007/978-3-030-57768-1_4

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Empirical Analyses: Intra-EMU Heterogeneity and Austerity

I will begin with the examination of H2, because corporatist institutions can be considered an underlying subcomponent, or characteristic, of countries’ growth models. For each year between 1992 and 2014, Table 4.1 shows the correlation coefficient between corporatism as measured by the Siaroff index (Siaroff, 1999) and macroeconomic imbalances as measured by countries’ NIIPs.1 While the left part of the table is based on all countries for which data was available, the right part only utilizes EMU member countries for the calculation of correlation coefficients. As is easily seen from the table, there is no statistically significant correlation between corporatism and NIIPs before 2004. Based on all countries, the correlation becomes clearly positive and statistically significant only from 2004 onwards, and gets gradually stronger until it reaches a correlation of around 0.70 in the year 2009, and remains roughly stable afterwards. When looking at EMU member countries only (the right part of the table), the correlation gets clearly positive and statistically significant one year earlier, in 2003 already. Moreover, it grows slightly stronger, reaching a level of almost 0.80 in 2009, and also remains roughly stable afterwards. On the one hand, any correlation coefficients computed on such a relatively small number of observations should be interpreted with caution. On the other hand, these results can be interpreted as at least a first indication that the relationship between corporatism and macroeconomic imbalances is for the most part driven by EMU countries. This would of course be entirely in line with the theoretical predictions introduced earlier. Figure 4.1 is similar to Table 4.1 in the sense that it also depicts the relationship between corporatism and macroeconomic imbalances. The figure is slightly closer to theory, however, by showing the aggregate change in NIIPs from the introduction of the Euro in 1999 until the onset of the Great Recession in 2009 (as before, 2009 is chosen as the threshold year because this is the year when the Great Recessions had the clearest impact on countries’ economies and government finances). By and large, the results obtained from the table are confirmed. Stronger corporatist institutions appear to have been related to large positive changes in NIIPs, while weak corporatism was associated with negative changes. Both, Table 4.1 and Fig. 4.1 provide some empirical support to H2 already, on the basis of which stronger corporatism (as operationalized in the thesis at hand) in an EMU member country was expected to be associated with a higher growth in that country’s NIIP. Table 4.2 present the results of several pooled time-series cross-sectional (TSCS) regression models of NIIP levels to analyze the relationship between NIIP

1

As has been discussed in Chap. 2 already, using the Siaroff index as a measure for corporatism is not beyond critique. One of the oft-mentioned shortcomings of this measure is that it is not available on a yearly basis, but only in 5-year increments. This low over-time variability must not necessarily be problematic for the purpose of the analysis at hand, however. First, corporatism itself is an institutional feature of countries that does not vary much over time. Second, this considerable over-time stability (no matter if as an actual reflection of reality, or a result of measurement methodology) ensures that any change in the correlation coefficient must be due to changes in the second variable—the NIIP.

4.1 Determinants of Macroeconomic Imbalances

107

Table 4.1 Annual correlation coefficient between corporatism and NIIPs before and during EMU Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

All countries Corr. −0.10 0.83 −0.15 0.72 −0.13 0.74 −0.14 0.72 −0.29 0.41 −0.39 0.21 −0.28 0.36 −0.27 0.36 −0.24 0.44 −0.02 0.94 0.33 0.24 0.40 0.13 0.50* 0.06 0.50* 0.06 0.54** 0.04 0.59** 0.02 0.62** 0.01 0.69*** 0.00 0.72*** 0.00 0.66***

Obs.

EMU countries Corr.

Obs.

7 8 9 9 10 12 13 13 13 13 15 15 15 15 15 15 15 15 15 15

−0.37 0.32 −0.31 0.42 −0.01 0.98 0.43 0.16 0.51* 0.09 0.61** 0.04 0.58** 0.05 0.60** 0.04 0.64** 0.02 0.73*** 0.01 0.78*** 0.00 0.80*** 0.00 0.74***

9 9 10 12 12 12 12 12 12 12 12 12 12 (continued)

108

4

Empirical Analyses: Intra-EMU Heterogeneity and Austerity

Table 4.1 (continued) Year

All countries Corr.

EMU countries Corr.

Obs.

0.01

Obs.

0.01

0.71*** 15 0.79*** 12 0.00 0.00 2013 0.68*** 15 0.77*** 12 0.01 0.00 2014 0.67*** 15 0.77*** 12 0.01 0.00 Notes Own calculation. *