Fiscal policy in Central and Eastern Europe

By: John Lewis

As commentators analyse the causes of the current slump in Central and Eastern Europe, the role of fiscal policymakers has been put forward.  They are often accused of having run loose fiscal policies which have contributed to the build-up of imbalances and which have left them with little budgetary room to manoeuvre in the downturn.  Some claim that fiscal policy has been asymmetric[1] (loosening in downturns, but failing to tighten in the good years) or that discretionary measures have been pro-cyclical[2].  Others however, have been much more positive about the conduct of fiscal policy in the region, arguing that public finances have been more responsive to the cycle than in Western Europe, and have been less inert[3].

 

In a recent empirical paper[4] I analyse how fiscal policy in CEECs has responded to economic conditions, and test for secular episodes of tightening or loosening unconnected with economic conditions. One novel feature with respect to other work on the region is that it makes use of “real time” data.  That is, the data which was available to policymakers at the time- as opposed to the “final” data which are often heavily revised.  This gives a better picture of what policymakers actually thought they were doing when setting fiscal policy, since both estimates of economic conditions, and the figures for budget balances can be quite substantially revised in subsequent years.   Indeed I find that the differences in the raw data in real time and later vintages are even larger in Central and Eastern European countries (CEECs) than for comparable variables in Western Europe.

 

Estimating a “Taylor Rule” for fiscal policy in CEECs, where the overall government balance is a function of the previous year’s balance and the rate of current economic growth, fiscal policy appears to be clearly countercyclical.  The planned budget balance improves by about 35 cents for every extra euro of economic growth.  That is very close to the European Commission’s average estimates of automatic stabilisers for CEECs[5] - suggesting that discretionary policy has not been deployed to counteract the cycle.  In addition, public finances seem to have tightened by the same amount in upswings as they have loosened in downswings.  The lagged budget balance has and meaning that shocks to public finances persist much less over subsequent years.

 

On the one hand, these points lead to a relatively positive picture- refraining from discretionary stabilisation measures and letting automatic stabilisers respond symmetrically is in line with the policy prescriptions of the ECB and the European Commission[6]. 

 

However, fiscal policymakers cannot be absolved of blame.  Augmenting the basic rule, it becomes evident that there was a secular trend towards looser fiscal policies in CEECs unrelated to the cycle.  Interestingly, the start of this expansionary episode is not EU accession, but several years beforehand. 

 

This is consistent with the story that countries keep fiscal policy tight when applying to the EU, but gradually start to relax their fiscal stance at some point after accession negotiations began.  Although there were no formal fiscal criteria for EU membership, the argument runs that disciplined public finances improve a country’s standing as a “good citizen”, and make them a more attractive candidate for membership, particularly in the early stages.

 

Earlier work by Berger et al[7] formulates a simple formal model of this process, and finds evidence that the large countries in the region- Hungary, Poland the Czech Republic, seemed to loosen fiscal policy after joining NATO.  The explanation put forward was that once inside NATO, these countries felt that EU accession was “in the bag” and hence felt no need to keep fiscal policy tight.  By contrast, other smaller countries of less geopolitical importance, felt no such assurance.  If true, then this hypothesis yields two further predictions which are directly tested in my paper.

 

First, the fiscal loosening in the three early NATO joiners should show up in real time data as well, because it reflects a conscious and planned loosening of fiscal policy by governments.  The data clearly bear this out- after stripping out the effect of the cycle and the previous year’s balance, real time fiscal positions loosen by about 0.75 percentage points of GDP per year for a period of four years beginning in 1999.  Cumulatively, this implies that from 2002 onwards budget balances were 3% of GDP worse than pre-1997, a very similar figure to that obtained by Berger et al on a much smaller dataset using ex post data.

 

Second, we should observe a later loosening in fiscal policy in the smaller countries, coincident with the time when they too felt EU accession was “in the bag”.  A natural candidate here is 2001- the year in which the Nice Treaty outlining the workings of a 27 nation EU was approved.  Although the specifics of each country’s accession still had to be negotiated and entry dates set, 2001 marks the point at which the EU agreed “in principle” to expand to the East.  This hypothesis is corroborated by the data- specifically I find evidence of a loosening of around 0.4 percentage points per annum beginning in 2001 and lasting for about seven years.  Again, the cumulative impact is that after controlling for other factors overall budget balances were about three percentage points worse in 2007 than they had been in 2000.

 

Equally interesting is that EU membership appears to have exerted no disciplining effect on fiscal policy.  This is true both when EU accession is included instead of the above mentioned “accession effects”, and when it is included alongside them.  Part of the explanation may lie in the fact that countries outside the euro do not face sanctions under the Excessive Deficit Procedure.  The only weapon the EU has is therefore the threat of denying entry to the euro if the deficit exceeds three percent of GDP.  For the CEECs this may have been rather ineffective. Some member states (e.g. Hungary) had little desire to join the euro soon after entry, and so policymakers were content to postpone the required consolidations.  Others did want to join as soon as possible (e.g. the Baltics), but their headline budget balances complied with the deficit criterion already. Until this year they felt no need to consolidate public finances in order to meet the reference value. 

 

Taken together, this implies that policymakers are innocent of the charge of running a pro-cyclical or asymmetric fiscal policy, but are guilty of a sustained loosening as EU accession drew near which was not reversed prior to the current crisis.  The costs of this in the ensuing downturn seem to correlate with the exchange rate regime.  For the countries with floating exchange rates (especially the Czech Republic and Poland), the lack of fiscal room for manoeuvre was less costly because exchange rates could move to dampen the shock.  But for the Baltics, with their fixed exchange rates, neither monetary policy nor the exchange rate could be used to soften the blow, making both the downturn sharper and the subsequent fiscal retrenchments more painful.

 

John Lewis, Economics and Research Division, De Nederlandsche Bank. The views expressed are those of the author and not necessarily those of De Nederlandsche Bank.

 

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