Sunday, October 31, 2010

EMU fiscal austerity: Will it hurt? Yes, but not so dramatically

  • After the presentation of the 2011 Budget Law in several eurozone countries, we re-assess our estimate of the size of fiscal consolidation at the area-wide level and its impact on GDP.
  • We argue that the fiscal stance will remain broadly neutral this year and turn restrictive next year by around 1.2% of GDP. Most likely, the dampening effect on 2011 GDP should be in the 0.7-0.8pp area.
  • The estimate is vindicated by a recent IMF analysis, which carries out simulations under different hypothesis for monetary policy, degree of coordination in fiscal tightening across advanced economies, sovereign risk premia, and composition of the fiscal adjustment.
Austerity measures ahead
In the past few weeks, several eurozone countries have presented their 2011 pre-budget to their respective parliaments for approval, which is due before year-end. This seems to us the best time to re-assess the estimate of the size of fiscal consolidation at the area-wide level and its likely impact on 2011 real GDP13.

For peripheral countries like Greece, Spain and Portugal, which had already announced new consolidation measures in May to avoid an escalation of the sovereign debt crisis, the drafting of the budget was supposed to merely translate the commitments already undertaken into specific measures. In fact, this was true only for Greece, which strictly adhered to the agreements with the IMF/EU. The situation is different for the other two countries. On the one hand, Portugal was forced to strengthen its fiscal adjustment in order to address the lack of improvement in the central government budget balance so far. Accordingly, our new estimate for Portugal’s 2011 fiscal tightening reflects additional austerity measures worth 0.5% and 2.1% of GDP for 2010 and 2011, respectively.

On the other hand, Spain disappointingly refrained from specifying the measures that would make it possible to achieve an 8% reduction in the central government’s nonfinancial public expenditures – a measure worth 1% of GDP that was announced in late May, in addition to the EUR 15bn package announced earlier the same month as a backstop to contagion from Greece. Accordingly, we left our estimate of the size of the Spanish fiscal adjustment for 2011 unchanged versus our July projection.

Impact likely not too dramatic
A comprehensive analysis of the effects of fiscal consolidation recently published by the IMF14 is particularly useful to assess the implications of the fiscal adjustment on eurozone GDP (far-right column of the above table). The Fund’s analysis highlights that a fiscal consolidation equal to 1% of GDP typically reduces domestic demand by 0.5pp in the first year, with about half of the drag on GDP being offset by higher net exports via a nominal exchange rate depreciation.

The negative impact on GDP is ultimately around 0.25pp, implying a fiscal multiplier of 0.25. If we had to rely on past experience, but we exclude any cushioning impact that may derive from changes in the nominal exchange rate which is fixed within the monetary union, the GDP drag at area-wide level of a consolidation worth 1.2% of GDP would be in a range of 0.6-0.8pp (fiscal multiplier: 0.5-0.7). However, we think that the average response of GDP to historical episodes of fiscal tightening may provide only a lower-bound estimate
of the fiscal multiplier that might apply today, given the exceptional features of the current fiscal tightening phase.

Below, we list some of the main reasons why this may be the case. In brackets we report the sign of the impact on the multiplier.
1) (+) Interaction with monetary policy. When the interest rate is already very close to zero and therefore cannot be reduced much further to mitigate the effects of fiscal tightening on demand and inflation, the budgetary adjustment displays ceteris paribus its effect in full. According to the IMF, the output cost of a consolidation worth 1% of GDP is on average one full percentage point in the first year (fiscal multiplier: 1).
However, this number may overstate the actual GDP impact as it doesn’t take into account unconventional monetary policy tools.
2) (+) Fiscal consolidation is implemented simultaneously across regions. This is a critical factor, whose impact we found difficult to quantify in July given the lack of pertinent studies on the subject. Now, the IMF hints that the output cost of a fiscal tightening of 1% of GDP could be large, possibly twice as large – i.e. 2pp – than in the case consolidation is unilaterally implemented, assuming that the policy rate is 
close to zero. Here, again, the fact that all major advanced
countries have adopted some unconventional monetary
policy tools throughout the crisis should help cushion the
drag on GDP from “global consolidation”.
3) (-) Perceived sovereign risk. The output cost of fiscal
tightening tends to be significantly smaller in countries that
face a higher perceived sovereign default risk, since budgetary
consolidation helps countries regain market confidence
and thus reduce the cost of servicing the debt. Should this be
the case, fiscal tightening’s negative impact on GDP could
be ceteris paribus halved, according to the IMF.
4) Composition of the consolidation program. We think that
the most interesting finding of the IMF analysis consists in
demystifying the role of spending-based deficit reductions
versus tax-based adjustments. The Fund argues that the
main reason why the contractionary impact of spendingbased
consolidation is typically lower than tax-based
consolidation is that the former has usually been followed by
monetary policy accommodation to mitigate the negative
impact on domestic demand. For spending-based programs,
there is also empirical evidence that the ensuing expansion
in exports is typically larger, but this should be seen as a
second-order effect. In this respect, we think that the fiscal
adjustment foreseen in the euro area – focused on lower
public spending, namely lower government consumption and
capital transfers, but also accompanied by revenueenhancing
measures – is appropriate as it addresses both
the structural roots (too high spending levels) and cyclical
drivers (decline in revenues) of the deficit shortfall. As this
balanced structure increases the credibility of the government’s
commitment to pursue deficit reduction, we see it having an
overall cushioning impact on the GDP contraction via the
confidence channel.

Taking all these elements into account, the most likely GDP
impact of the envisaged fiscal adjustment in the euro area
should be in the 0.7-0.8pp area. This is very close to our
0.5-0.7pp July assessment and, importantly, is now vindicated
by the IMF analysis, which carries out simulations under
different hypotheses for monetary policy, degree of coordination
in fiscal tightening across advance economies, sovereign risk
premium, and composition of the fiscal adjustment.
We think worth highlighting that the IMF also takes a position
in the debate concerning the existence of non-Keynesian
effects of fiscal consolidation, strongly supported by a recent
influential paper by Alesina and Ardagna15. Backing some
earlier critics of (among others) Krugman16, the Fund
acknowledges that the statistical method used by Alesina

and Ardagna to identify fiscal expansions – a large increase
in the cyclical adjusted budget balance – biases the analysis
towards downsizing contractionary effects and overstating
expansionary ones. The method based on changes in the
cyclical adjusted budget balance tends to select periods
associated with favorable outcomes but during which no
austerity measures were actually taken, whereas it also
tends to omit cases of fiscal austerity associated with
unfavorable outcomes. To put it bluntly, when you measure
fiscal policy action precisely (i.e. focusing only on intended
fiscal adjustment) there is not such a thing as an “expansionary
fiscal consolidation” in the near term. Certainly, the
negative impact on GDP may be mitigated by a sound and
credible fiscal adjustment, but it can hardly be totally offset. It
is only over the longer term that it makes sense to talk about
expansionary effects of consolidation. Lower government
debt levels eventually reduce real interest rates, thereby
stimulating private investment and creating fiscal room for
cutting discretionary taxes, notably labor taxes. In specific,
for a permanent 10pp decline in the debt/GDP, the level of
GDP rises by 1.4% in the longer term. It typically takes three
years from the beginning of consolidation before some
positive effects on GDP start materializing.

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