Non-technical summary of ESM Working Paper 73: Spending composition and fiscal consolidation: Enhancing resilience in the face of economic shocks

This paper develops a formal framework to assess how the initial composition of public spending – particularly the share of rigid expenditure such as pensions and public wages - affects the feasibility and success of fiscal consolidations (i.e. government efforts to reduce budget deficits and public debt ratios) in euro area countries. The authors find that while high shares of rigid spending do not prevent governments from carrying out fiscal consolidations, they significantly lower the chances of their success by failing to put public debt ratios on a declining path. Moreover, successful consolidations are more likely during economic recoveries and when supported by strong fiscal rules and institutional quality. Political factors also play a role - fiscal consolidations are more often initiated after elections, and left-leaning governments are less likely to pursue them. While consolidation efforts tend to coincide with financial crisis episodes, they are less likely to be successful, possibly due to adverse macroeconomic conditions.

Next, using local projections, the authors find that countries with a high degree of spending rigidity disproportionately cut flexible spending items - especially public investment and intermediate consumption - while maintaining their pension and public wage expenditure during consolidations. This fiscal adjustment pattern leads to persistent employment losses, larger cuts in investment and deeper GDP contractions with a slower recovery. As negative growth effects outweigh fiscal gains, these countries can even experience a rise in public debt ratios at the start of consolidations, undermining the success of debt reduction strategies. In contrast, countries with more flexible spending structures experience more balanced expenditure cuts and as such enjoy faster economic recovery and more durable debt reduction.

These findings highlight the importance of proactive fiscal planning aimed at shifting spending towards more flexible categories to improve fiscal flexibility and resilience. Such reforms would create room for more balanced and effective consolidations when needed and protect growth-enhancing expenditures like public investment. This approach is critical for navigating future shocks and ensuring long-term fiscal sustainability in the face of pressing long-term challenges such as population ageing and the green transition.