11 November 2015

VoxEU: The macroeconomic effects of the Eurozone's fiscal consolidation

With austerity both in the household and the firm sector, fiscal consolidation would be responsible for the weak growth performance in the eurozone during 2011-2013. Postponing the fiscal consolidation to a period of unconstrained monetary policy would have avoided most of these losses.

From 2011 to 2013, fiscal policy in the Eurozone turned progressively more restrictive. According to estimates by the European Commission (2012), spending cuts and tax increases accumulated to about 4% of annual Eurozone GDP between 2011 and 2013. The switch to fiscal austerity has been associated with a return of the Eurozone economy to recession. The role of the fiscal consolidation in driving the EZ’s disappointing economic performance is uncertain and disputed. Blanchard and Leigh (2013) argue that the IMF and the European Commission's projections have consistently underestimated the adverse effects of austerity. However, others have challenged this result (e.g. European Commission 2012a, Lewis and Pain 2015). [...]

Fiscal consolidation and the EZ recession

We also investigate the degree to which, according to our simulations, the EZ's fiscal consolidation has added to the weak growth performance of the EZ economy over the 2011-2013 period. Since 2008, the EZ economy has moved away from it pre-crisis growth trend. Figure 2 displays the part of that shortfall which took place after 2010Q4, as well as the simulated output effect of the fiscal consolidation in the two models under the various scenarios considered.

According to our simulation, by the end of the recent recession (black vertical line), EZ GDP had increased its distance from its pre-crisis trend by almost 6 percentage points. Under the baseline scenario, fiscal consolidation would explain more than one third (in the NAWM) or one half (in QUEST III) of the deterioration of the output gap during the recession. In the presence of a financial accelerator, this fraction increases to almost two thirds (NAWM) and more than 80% (QUEST III), respectively. With both an increased share of credit constrained households and a financial accelerator, the GDP decline relative to trend reproduced by the NAWM increases to 80% as well. Hence, it seems that for a plausible degree of financial frictions, the EZ's fiscal consolidation would be largely responsible for the weak growth performance over the 2011-2013 period.

Potential gains from postponing fiscal consolidation

The potentially high cost of fiscal consolidation raises the question of whether the output loss could have been reduced if the fiscal consolidation had been postponed to a period of robust economic recovery where the central bank would have been no longer constrained by the zero lower bound. As is shown in Table 3, across all scenarios, the simulated GDP loss would only be a fraction of the effect obtained under constrained monetary policy. Unlike in our baseline and its extensions, the central bank follows its interest feedback rule and thus lowers both the nominal and the real interest rate in response to the decline in inflation, thereby stabilising private consumption and investment. By contrast, with constrained monetary policy, the inflation decline causes an increase in the real interest rate.

Full article in Vox EU (with charts)

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