Despite economic recovery: crisis will be felt in public finances for a long time

• The Dutch economy is expected to grow by 1½% this year and 2% in 2011. Following the historically deep economic contraction in 2009 (of 4%), unemployment will rise to 500,000 (on average) in both years. The average contractual wage increase is projected to equal inflation, at 1¼% in 2010 and 1½% in 2011.
• Due to the financial crisis, the Dutch economy has lost about 5% of GDP compared with previous projections. This loss will probably not be recovered in the next cabinet period.
• In a no-policy-change scenario, GDP growth will average 1¾% per year over the next cabinet period (budget years 2011-2015). Relative to earlier cabinet periods, growth in the next period is lower, due to a much smaller increase in labour supply. Unemployment is projected to diminish somewhat from 6½% in 2011 to 5¼% in 2015.
• The credit crisis has demonstrated once again that projections are uncertain. The average margin of error with regard to projected growth is plus or minus ¾%-point.
• In the no-policy-change scenario, purchasing power will increase by (on average) ¼% per year during the next cabinet period. This is significantly less than the increase of 1¼% per year between 2006 and 2010. If the incoming government decides to cut spending or raise taxes, GDP growth and the increase in purchasing power will be lower.
• The budget deficit is expected to fall from 6.3% in 2010 and 4.9% in 2011 to 2.9% of GDP in 2015. This reduction in the deficit by 18 billion euros will occur under the no-policy-change assumption. It follows from policies that have already been implemented, from lower spending on unemployment, from a recovery of corporate tax receipts, and from tax receipts that will "automatically" exceed the growth of the economy (due to the progression).
• Total spending on health care is projected to increase by 4% per year (in real terms). It is assumed that the collective part of the funding of this spending growth is limited to the rate of GDP growth and demography (including the increasing share of the elderly), which together equal 3% volume growth. This technical assumption implies that co-payments will have to increase substantially over the next cabinet period. The incoming government may of course opt for alternatives- either a larger increase in (public) health care premiums, or cuts in health care expenditure.
• Remaining life expectancy at the age of 65 is projected to increase by 3½ years between 2009 and 2060. These projections have been revised upwards since 2006. The Dutch also enjoy a longer life in good health.
• The higher life expectancy causes a greater burden for the public finances. With unchanged policies, budget deficits will soar and the government debt will become unsustainable. With a projected budget deficit of 2.9% of GDP in 2015, an improvement of the structural budget balance by 4½% GDP- or 29 billion euros- is needed in order to make the public finances 'ageing-proof'.
• The challenges have grown considerably since the previous calculations (at the start of Balkenende IV), for two main reasons: the starting position has deteriorated as a result of the crisis, and life expectancy has increased, yet again.
• The challenges remaining with regard to the public finances are considerable and are comparable with those of the '80s. They will demand the full attention of the government. The experience of the '80s has shown that the Dutch economy can grow stronger out of such challenges, but it also taught us that the fruits of the structural adjustment were only reaped in later cabinet periods.

These are the main points from today's Central Economic Plan (CEP) and the 2010 Economic Outlook 2011-2015. In addition to analyses and forecasts for the Dutch economy and the world economy in the years 2010 and 2011, CPB Netherlands Bureau for Economic Policy Analysis discusses the outlook for the coming cabinet period in the Economic Outlook 2011-2015. That document elaborates on the expectations for the economy and public finances (including health care expenditure). The Economic Outlook also includes an update of the ageing sums. The projections can serve as input for the election and/or for the Study Group on the Budgetary Margin.
Background

Central Economic Plan 2010

Growth recovers
In the second half of 2009, the Dutch economy GDP regained growth. This growth is expected to continue in 2010 and 2011. The recovery came sooner than expected last year. Yet the damage from the crisis is still far from recovered. The contraction of 4% in 2009 was the biggest post-war decline- even greater than during any single year of the 1930s. Relative to expectations at the beginning of the previous cabinet period, the Netherlands has missed some 5% of GDP growth. The initial blows were borne by business (profits) and government (budget deficits and rising public debt).

Average inflation is expected to equal 1¼% in 2010 and 1½% in 2011. This moderate inflation reflects the fall in demand due to the crisis. Contractual wages usually follow the decline in inflation and the rise in unemployment with some delay. The projection implies a contractual wage increase in upcoming collective agreements equal to average annual inflation. The development in purchasing power follows the crisis with some delay. During the main crisis year 2009, purchasing power increased relatively strongly. The crisis is, however, clearly visible in the development of purchasing power in 2010. The median decline in purchasing power averages ½% that year. Purchasing power is also expected to fall in 2011, by ¼% on average (with unchanged policies). Corporate profits are expected to recover this year and next, following a big drop in 2009.

Public finances hit hard
The budget deficit is expected to come out at 6.3% of GDP in 2010 and 4.9% of GDP in 2011. These deficits are well above the "Maastricht' ceiling of 3%. The large deficits, together with the interventions in the financial sector in recent years, cause an expected increase in public debt from 45.5% of GDP in 2007 to 68.9% of GDP in 2011. The Central Economic Plan 2010 analyses what would have happened if the government had decided to take measures (expenditure cuts and tax increases) in order to keep the deficit at 3% of GPD. Economic growth in 2010 would then have been about 2 percentage points lower, while unemployment in 2010 would have been approximately 150,000 higher- at some 8¼% of the workforce.

The rise in unemployment is modest, compared to international and historical experience.
Given the sharp drop in production, the implications for the labour market seem to be relatively modest. Employment is expected to grow slightly by ½% in 2011. In the projections, the number of unemployed persons increases from 379,000 in 2009 to 500,000 in 2010 and 2011- amounting to 6½% of the workforce.

Compared to the previous downturn (2002-2003), the rise in unemployment seems modest: the economic downturn is now much stronger, while the increase in unemployment is comparable. The labour market appears to be more flexible, including the increasing number of self-employed. These self-employed have contributed to flexibility when the labour market was tight, and their earnings were relatively high then. Now they bear the brunt of the crisis and see their earnings fall- while again contributing to flexibility. In addition, companies have been relatively reluctant to lay off employees. Thanks to relatively good profitability prior to the crisis, they can afford to do so. Perhaps they also anticipate a continued tight labour market for skilled personnel.

Economic Outlook 2011-2015

Level of GDP has been affected by the crisis; future growth has not
For the next cabinet period (2011-2015), CPB expects an average GDP growth of 1¾%. The estimated actual growth is the sum of average potential growth and a limited catch-up growth. The estimate for the average potential GDP growth is lower now than it was during earlier cabinet periods, mainly due to demographic changes (ageing, slower growth in female participation). The lasting impact of the crisis on estimated future growth is slight, however - neither upward (catch-up growth), nor downward.

The level of GDP is permanently affected by the crisis. Since the beginning of the crisis, consumption, investment and exports have fallen sharply. As a result, actual production has fallen far short of expectations at the time of the start of Balkenende IV. This loss in the level of GDP is about 5%- and it will not be recovered during the next cabinet period. The total catch-up growth after 2011 is only ½% of GDP.

The development of the Dutch economy is closely linked with that of the global economy. The forecast for global economic development coincides with the outlook for the Netherlands (and the expectations of international institutions such as the OECD). As a result of some catch-up growth, global trade growth will be slightly above the long-term average in the coming period. Ample labour supply (globally) and strong competition (including that from low-wage countries) will keep global inflation subdued.

Large uncertainty
The uncertainty in economic forecasts is substantial. That was the case prior to the Great Recession, it was definitely the case during the event, and it always will be. The Central Economic Plan 2010 discusses this uncertainty in a special chapter, addressing the (erroneous) forecasts around the Great Recession. CPB forecasts are compared with those of other agencies. The Economic Outlook 2011-2015 illustrates the uncertainty by a range within which average GDP growth over this period will fall (with a probability of two-thirds). This bandwidth is ± ¾%-point per year, compared with the expected growth of 1¾%. In the pessimistic scenario (with an average GDP growth of 1% per year), the budget deficit in 2015 falls to 4.1% of GDP- well above the 3% deficit ceiling.

Unemployment relatively low
Unemployment will fall by 1¼%-point during the scenario period and will equal 5¼% in 2015. The 2015 unemployment rate will thus still be higher than prior to the crisis. This follows previous experience with financial crises- although the increase in the Netherlands is very modest both in an international and a historical comparison. Employment reacts with some delay on the economic development and will increase by ¼% per year over the period 2011-2015 (following sharp declines in 2009 and 2010). This projected increase in employment is more than fully realized in the health care sector. Market sector employment is stable, and employment in the government sector will fall by 1% per year following expenditure cuts in 2011 and other policies that have already been implemented.

Small increase in purchasing power
The median purchasing power will rise by ¼% per year over the next cabinet period. This is significantly less than the average increase over the period 2006-2010 (at 1¼% per year). Moreover, the estimate of ¼% per annum is based on unchanged policies. If the next government decides to cut spending or increase taxes in order to reduce the budget deficit, this will mean a lower increase in purchasing power. For the coming period, contractual wages (market sector) are projected to increase by 2½% per year. Projected inflation (CPI) averages 1½% per year. Inflation is relatively moderate, mainly because production will start out below potential output. The reduction of budget deficits in trading partners will also reduce inflationary pressures from abroad. The prices of oil and other commodities are assumed to remain constant in real prices. Purchasing power is influenced not only by wages and prices, but also by (already implemented) policy measures and by rising health care costs.

Budget deficit will remain high- even in 2015
The Economic Outlook 2011-2015 is based on 'unchanged policy' as of 2012. Based on the economic outlook, the EMU deficit will improve by 18 billion euros in real terms between 2010 and 2015. The increase in public spending (15 billion euros) lags far behind that of the government revenues (32 billion euros). Six and a half billion euros of this increase in government revenues stems from previously implemented policies. Revenues improve mainly because corporate tax receipts are rebounding and automatic tax progression measures are in place. This will increase the tax burden by 1.8%-point over the period 2011-2015. The budget deficit can improve from 6.3% of GDP in 2010 to 2.9% of GDP in 2015. The deficits of both the state and the municipalities and provinces are expected to fall between 2010 and 2015. The overall deficit will improve the most in 2011. This is due almost entirely to the expiry of crisis spending measures and to budget cuts already decided.

Health care expenditure grows faster than GDP
The trend in (collectively and privately funded) health care spending is an increase of 4% per year in real terms. This growth is higher than the projected GDP growth, so the costs of health care will claim a growing share of the GDP- even when taking demographics into account. How the increasing costs of health care should be financed is, however, a political decision. The Economic Outlook makes the technical assumption that the growth of health care spending related to GDP growth and demographics (including the increasing share of the elderly) is financed collectively, and that the additional growth is financed privately. This means that the collectively funded health care portion increases by 3% per year- but it is no longer automatically assumed that higher health care expenditures due to technological developments will also be collectively funded. It is assumed that the additional 1% increase in health care costs will be raised from individual care consumers through higher co-payments. In the projection, the co-payment for health care insurance was therefore increased from 165 euros to 775 euros per person per year, and the private contribution for the AWBZ (the Exceptional Medical Expenses Act) was increased as well. Obviously, it is for politicians to decide whether or not to implement these significantly higher co-payments and private contributions. An alternative could be to raise the collective health premiums, or to cut health care expenditure, otherwise.

Update ageing (in Economic Outlook 2011-2015

We live longer, in better health- at a cost
The structural position of public finances is unsustainable without changes in policy. The ageing of the Dutch population will increase expenditure on health care and on state pensions (AOW). This increase is only partly offset by the projected higher tax revenues. With a budget deficit of 2.9% of GDP in 2015, a 'sustainability gap' of 4½% of GDP remains. This means that with the projected budget deficit of 2.9% of GDP in 2015, an improvement of the structural budget balance by 29 billion euros will be needed in order to reach the necessary structural surplus of 1½% of GDP. A smaller surplus in 2015 implies that after the next cabinet period, additional measures will be needed to make public finances sustainable- be they measures to address the increase of ageing-related costs over the medium- or long term, or to increase revenues over the same period.

The challenge to public finances has grown by 1½% of GDP since the previous calculations (at the start of Balkenende IV): from a sustainability gap of 3% then to a gap of 4½% of GDP now. Of this increase, 1¼%-points can be attributed to the worsened starting position due to the crisis. The sustainability gap has increased by 1¾%-points because of higher life expectancy, but decreases by ¾%-point because we stay healthy for longer. The sustainability measures that were taken in the last period have moderated the increase in the sustainability gap by ½%.

The sustainability gap is the structural adjustment in government spending (or revenues) that is required by 2015 in order to make public finances sustainable. Meanwhile, the ageing of population is visibly impacting public finances: the number of people on a state pension will rise by around half a million over the next cabinet period. Any delay in reducing the sustainability gap means that the gap will increase, because in the meantime the interest costs will rise. Postponement also implies that a greater proportion of the burden will be borne by future generations.

Significant changes in government budget inevitable
The sustainability gap is 4½% of GDP. This implies that a structural fiscal adjustment to the tune of 29 billion euros is needed (or 1,750 euros per capita). Over the next cabinet period, serious structural reforms will be needed- the severity of which could be compared with those implemented in the nineteen eighties, following the Wassenaar agreement. Those structural adjustments were at times painful: the public finances were cleaned up, wages and benefits were reduced, and the labour market was made more flexible. But these policies proved very successful. In the 1980s, Dutch unemployment was at the euro area average. Over the next twenty years, it declined from 8.1% in the '80s to 4.9% in the first decade of this century- almost the lowest level in the euro area. The current problems are of a completely different nature and require a different response. Nevertheless, the experience of the '80s holds some lessons for future policy. First, if a good set of measures is chosen (leading to more labour, higher productivity, and an effective government), the Netherlands will ultimately benefit. Second: this does require patience. The fruits of the structural adjustment were only reaped in later cabinet periods.