Macro-economic environment and public finance
Economic growth – measured by annual changes in GDP per capita – fluctuated in the past decade (Figure 1). In both the CEMR countries and the euro area, the first stage of economic development and recovery started after 2013. At the end of the period under study, there was a severe economic downturn in 2020 with a 5% fall in GDP per capita. During the intervening years, growth was stable and averaged around 3 to 4%, although there was a relative slowdown in 2016. Annual economic growth was highest in 2017, with an average of 6% in the CEMR countries.
Figure 1 Economic development stages, CEMR countries, euro area GDP per capita current prices, annual change
The level of economic growth showed diverse regional patterns Some of the smaller CEMR countries were the leaders in high annual growth during the recovery period, including several of the transition and Balkan countries, plus Israel and Ukraine. Interestingly, it was the same group of countries that were the worst affected by the first year of the pandemic in 2020, although large economies like Spain (-10.3%) and Turkey (-8.6%) were also among those the most severely affected.
Unemployment increased until 2014 in the 33 CEMR member countries with comparable data. The annual average unemployment rate then was above 11%. Countries in southern Europe, such as Greece, Spain, Portugal, and some of the Western Balkan countries, were hit the hardest by high unemployment. By the last half of the decade, increased economic growth had led to more jobs and the unemployment rate in the CEMR countries fell to an average of 7% by 2019.
Economic growth was constrained by the deflationary environment. Even the typically low inflation (EU country average of 2-3%) gradually vanished by the middle of the decade. From 2014 to 2016, the average inflation rate dropped close to zero in the EU countries.
The European welfare states provide a broad range of public services and manage numerous governmental functions (Figure 2). The GGE ratio came close to 45% of GDP in 2010. Owing to restrictions and the economic growth rate, this indicator steadily dropped to 41% by 2017-2019. In the first year of the pandemic, government expenditure again increased to 50% of GDP due to high government spending programmes and a shrinking economic base.
With respect to government expenditure, there are significant differences among the CEMR countries. In 2010, public spending in the Scandinavian countries, France, Belgium, Austria, Greece and Portugal exceeded 50% of GDP, whereas in North Macedonia, Turkey, Albania, Kosovo and Georgia, it did not even reach 35% of GDP. This huge gap, which reflects a high diversification of overall government functions in the first group, can be telling of a country’s potential scope of decentralisation since countries with a larger public sector can more easily devolve services to subnational governments.
Figure 2 High general government expenditure in the European welfare states
Government expenditure (in GDP ratio) was lower in 2020 than in 2010 only in countries with extended public budgets (e.g. Denmark, Latvia, Portugal) . Yet, all governments found it necessary to increase their expenditure from the previous year by an average rate of 7%. The biggest increases in the ratio of government spending to GDP, all above 10%, were found in Greece, the UK and Spain. In many countries, local governments suddenly had to cope with random and unjustified budget cuts (see the case of Serbia in Box 1).
Box 1 Fiscal policy changes hit local budgets in Serbia
The process of financial consolidation resulted frequent changes of the Law on Local Self-government Finance. In 2009 local self-governments were stripped of RSD 15 billion (EUR 158 million) by an ad hoc decision of the Government. Although this measure could be justified it was implemented very hastily and the reduction of transfers was done in the middle of the budget year. No objective and measurable criteria were followed for reducing funds by municipalities. It has caused financial problems and political turbulence between the central and local levels of government. Political pressure lead to a new Law in 2011, which allocated RSD 40 billion (EUR 420 Million) to the local level, again without proper justification. This amendment led to an implosion of the national public finances and was subsequently revised twice (in 2013 and 2016).
Portugal, as one of the countries hit the hardest by the economic crisis, was subject to a coordinated stabilisation programme set up by the major international organisations, which had an impact on local governments as well (see Annex 2).
The economic crisis of 2008-2009 was managed in part through active government borrowing. By 2010, high government indebtedness was a by-product of the efforts to subsidise failing businesses and help domestic banks. Among the EU Member States, where comparative data is available, 11 economies were burdened with both general government debt above 60% of GDP and net borrowing amounting to more than 3% of GDP. There were several countries, mostly from the group of new EU Member States, whose annual net borrowing exceeded the Maastricht threshold of 3%.
Box 2 The Austrian Stability Pact
In 2012, the "Austrian Stability Pact" was set up in agreement with the territorial authorities, whereby the European fiscal rules (mainly the Stability and Growth Pact) were transposed into national law. Its aim is to maintain sustainable, orderly budgets and in particular to avoid over-indebtedness. The most important fiscal rules concern the government deficit (borrowing) and the debt ratios.
Government indebtedness continued to increase over the last decade until 2017. Then, following three years of decline, general government debt rose once again, reaching 80% of GDP in 2020. This amounts to a steep 18% increase from the year before the pandemic (CEMR country average). This means that 15 countries, from both the group of large, developed economies and the smaller ones, are currently well above the Maastricht limits. Only Denmark and Sweden have been able to maintain their status through low debt and limited annual borrowing (Figure 3).
Figure 3 General government debt and net borrowing, 2020
In short, this economic environment was a clear determinant of the local scope of manoeuvre. Public spending was confined by hard budget constraints in the first few years of the past decade. High general government debt limited local spending and subnational borrowing. Slow economic growth reduced municipal revenue-raising options. Then, beginning in the middle of the decade, budget conditions gradually normalised, although there were striking differences among the CEMR member countries. Nevertheless, in the first year of the pandemic, all economies contracted. These losses were partially compensated by fiscal policy measures: wage subsidies, special spending programmes, reduced taxes. In contrast to the earlier economic crisis, these active fiscal instruments created a more favourable economic environment for the government sector. However, the economic decline was more severe at the beginning of the pandemic – and in the subsequent years.