Self-Defeating Austerity in Europe

05/11/2012 13:09 GMT | Updated 23/01/2014 23:58 GMT

Is deficit-cutting - particularly the fiscal consolidation programmes currently under way in most European Union countries - self-defeating? 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. New research from NIESR, published in the National Institute Economic Review (£), makes 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.

The main conclusion is that, while in "normal times", fiscal consolidation would lead to a fall in debt-GDP ratios, in current circumstances, fiscal consolidation is indeed likely to be "self-defeating" for the EU collectively. As a result of the fiscal consolidation plans currently in train, debt ratios will be higher in 2013 in the EU as a whole rather than lower. This will also be true in almost all individual members states (including the UK, but with the exception of Ireland). Coordinated austerity in a depression is indeed self-defeating. 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.

Why is fiscal consolidation so much more damaging now? Under normal circumstances a tightening in fiscal policy would also lead to a relaxation in monetary policy . However, with interest rates already at exceptionally low levels, this is unlikely or infeasible. Moreover, 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. Finally, with all countries consolidating simultaneously, output in each country is reduced not just by fiscal consolidation domestically, but by that in other countries, because of trade. In the EU, such spillover effects are likely to be large.

Taking account of these factors makes a large difference to estimates of the impact of the actual fiscal programmes announced and enacted for 2011-13 in the EU. The chart below shows the impact of fiscal consolidation on debt-GDP ratios; scenario 1 shows the impact in "normal" times, while scenario 2 shows the impact under assumptions we consider more realistic in current conditions.


The negative impacts of fiscal consolidation on growth in the second scenario are much larger than in "normal" times; and the result of this in turn is that fiscal consolidation increases rather than reduces the debt-GDP ratio in every country except Ireland. In both the UK and the euro area 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 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" .

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 "Prisoners' Dilemma" type problems in economic policy coordination, it should currently be doing exactly the opposite.