EU governments have individually embraced severe austerity programmes in an effort to avoid becoming the next Portugal. This column presents results from the National Institute Global Econometric Model suggesting that these individually rational polices are leading to collective folly. Keynes’ 'paradox of thrift' is in full swing since EU nations continue to act like small open economies while in fact they are a large closed economy.
Is austerity – particularly the fiscal consolidation programmes currently under way in most EU countries – self-defeating? DeLong and Summers (2012) have argued that, in current economic circumstances, the negative impact of fiscal consolidation on growth may be so great that the impact on debt-GDP ratios will be perverse, causing them to rise rather than fall. This question has been thrown into sharp focus by the IMF’s belated reassessment of the magnitude of the “fiscal multiplier” in major industrialised countries during the Great Recession (IMF 2012), although their methodology, which is clearly not definitive, has been questioned by Giles (2012).
In recent research, we make the first attempt – to our knowledge – to model the quantitative impact of coordinated fiscal consolidation across the EU, using the National Institute Global Econometric Model, and taking account of the current economic conjuncture (Holland and Portes 2012).
The main conclusion is:
- While in 'normal times', fiscal consolidation would lead to a fall in debt-to-GDP ratios, in current circumstances fiscal consolidation is indeed likely to be 'self-defeating' for the EU collectively.
- The fiscal consolidation plans currently in train will lead to higher – not lower – debt ratios in 2013 in the EU as a whole.
- This will also be true in almost all individual EU nations, including the UK
- Ireland is an exception.
Coordinated austerity in a depression is indeed self-defeating.
Right tactics, wrong strategy
The implication is that the current strategy being pursued by individual Member States, as well as the EU as a whole, is fundamentally flawed. Even on its own terms, it is making matters worse.
We begin by estimating fiscal multipliers in “normal” times. As in much of the previous literature, multipliers are generally less than one, and smaller for more open economies. However, with most economies currently depressed, and with interest rates at or near the zero lower bound, there are several reasons why one might expect the negative impact of fiscal consolidation on growth to be greater now than in “normal” times.
First, under normal circumstances a tightening in fiscal policy can be expected to be accommodated by a relaxation in monetary policy. As monetary policy loosens, long-term interest rates fall, stimulating investment and offsetting part of the fiscal contraction. However, with interest rates already at exceptionally low levels, further tightening of fiscal policy is unlikely to result in such an offsetting monetary policy reaction. While quantitative easing/credit easing measures have been introduced, the effects of these measures are also limited by low interest rates on ‘risk-free’ assets, and it is unclear that they have a significant impact on the risk premia attached to assets that bear a greater risk of default.
Second, during a downturn, when unemployment is high and job security low, a greater percentage of households and firms are likely to find themselves liquidity constrained. In the presence of perfect capital markets and forward-looking consumers with perfect foresight, households will smooth their consumption path over time, and consumer spending will be largely invariant to the state of the economy or temporary fiscal innovations. However, in a prolonged period of depressed activity, this is unlikely to be the case.
Finally, with all countries consolidating simultaneously, output in each country is reduced not just by fiscal consolidation domestically, but by that in other countries (through trade linkages). In the European Union, such spillover effects are likely to be large.
The impact of fiscal consolidation 2011-2013
We now consider the impact of the actual fiscal programmes announced and enacted for 2011-13 in the EU. Fiscal policy became contractionary in all countries in our sample in 2011, with the deepest consolidation measures introduced in Portugal, Ireland and Greece – the three countries on bail-out programmes. Cumulative measures over the three-year period amount to close to 10 per cent of GDP in Greece and Portugal and 8% of GDP in Ireland. Consolidation measures amounting to 5%-6% of GDP are planned in France, Italy, Spain and the UK, while only a modest adjustment is planned in Germany and Austria.
In order to assess the impact of these planned consolidation packages on GDP, the deficit and the stock of government debt, we consider two alternative scenarios. In the first scenario, we implement the policy plans detailed in Table 1, under the assumption that the economy is behaving as in ‘normal’ times, eg. with flexible interest rates that do not bind, and liquidity constraints in line with the long-run average. In the second scenario, we allow for an impaired interest rate channel and heightened liquidity constraints; assumptions we consider more realistic under current conditions.
Table 1 reports the estimated impact of the planned consolidation programmes in Europe on GDP under the two scenarios, while Table 2 reports the impact on debt-GDP ratios. These scenarios were run with all countries consolidating simultaneously, and so capture the spillover effects of policies between countries.
Table 1. Impact of consolidation programmes on GDP
Note: Scenario 1 reflects expected impact were the economies operating near equilibrium. Scenario 2 allows for heightened liquidity constraints and impaired interest rate adjustment.
Figure 1. Impact of consolidation on government debt ratio, 2013
The negative impacts of consolidation on growth in the second scenario are much larger than in “normal” times. Moreover, the result of this in turn is that fiscal consolidation increases rather than reduces the debt-GDP ratio in every country except Ireland. This seemingly perverse outcome reflects the relatively modest adjustment to the stock of debt in the numerator of this ratio compared to the sharp contractions expected in the level of GDP in the denominator of the ratio. While the level of debt is expected to decline in most countries, the rate of decline cannot keep pace with the drop in output, leading to a rise in the debt-to-GDP ratio.
It is particularly striking that this is not just true in extreme cases like Greece; fiscal consolidation across the EU has the effect of increasing rather than reducing debt-GDP ratios in Germany and the UK as well. In both the UK and the Eurozone as a whole, the result of coordinated fiscal consolidation is a rise in the debt-GDP ratio of approximately five percentage points.
Of course, one argument frequently advanced in support of fiscal consolidation programmes is that they will reduce government borrowing premia in countries with high debt and deficits. But these simulations show that the opposite may in fact be the case: if we were to allow for endogenous feedback from the government debt ratio to government borrowing premia, this would in fact raise interest rates, exacerbate the negative effects on output, and in turn make debt-GDP ratios even worse; truly a “death spiral” .
It has been argued that the poor growth performance of most EU countries (including the UK as well as Eurozone countries) in the last two years cannot be primarily attributed to fiscal consolidation, given the historical evidence on its impacts. This paper suggests the contrary: when account is taken of the magnified impact of consolidation in a depressed economy, and of the spillover effects of coordinated fiscal consolidation across almost EU countries, fiscal multipliers will indeed be considerably elevated, and the impact on growth correspondingly larger.
The direct implication is that the policies pursued by EU countries over the recent past have had perverse and damaging effects. Our simulations suggest that coordinated fiscal consolidation has not only had substantially larger negative impacts on growth than expected, but has actually had the effect of raising rather than lowering debt-GDP ratios, precisely as some critics have argued. Not only would growth have been higher if such policies had not been pursued, but debt-GDP ratios would have been lower.
It is particularly ironic that, given that the EU was set up in part to avoid precisely such 'prisoner's dilemma' type problems in economic policy coordination, it should currently be delivering the exact opposite. Current policy looks less like optimal coordination – and more like a suicide pact.
Spero che abbiate gradito.