In the context of present-day Europe, can austerity measures increase growth via a negative fiscal multiplier? No — and I’ll tell you why, says Guy Monson
EUROPE’S TWO-PRONGED attempt at corralling the sovereign crisis with cheap ECB money and a pledge for fiscal discipline seems to be in jeopardy after recent elections in France and Greece. This is mainly because austerity has become discredited as the solution to today’s problems; in the current world economy, too many countries are deleveraging at the same time, and within economies too many sectors are deleveraging at the same time. If the public sector does not go against the tide, then deleveraging risks becoming a self-fulfilling negative spiral.
The siren call for austerity was always misguided. At its heart lies the notion of Ricardian equivalence, or the view that the fiscal multiplier (the economic impact of one unit of government spending) is null. Taking Ricardo’s views to an extreme is the concept of an expansionary fiscal contraction, or the idea that austerity can increase growth via a negative fiscal multiplier. Such cycles have occurred in the past, in Denmark and Ireland in the Eighties. However, the Danish and Irish examples (two small, open economies benefiting from a strong global growth environment) are not comparable to that of Europe today: a synchronised European fiscal consolidation in a slow-growth world.
Moreover, recent academic papers point to a strong fiscal multiplier across Europe well into positive territory: namely, every euro of public spending cut reduces GDP by roughly €1.40. Similarly to figures of growth, inflation and competitiveness, huge differences exist also for fiscal multipliers from country to country within the eurozone, from heavy-hitting multipliers of 2.4 in Greece, around 2 in Spain or Portugal and 1.7 in France to only 0.7 in Germany. This surely must help explain why Germany, thanks to the low knock-on impact of government expenditure there, appears to see austerity as short-term (small) pain for long-term gain, while the large fiscal multipliers in Greece and other peripheral countries serve to make spending cuts feel like all pain, no gain.
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Despite its tough talk, Germany would be better off if it avoided forcing the rest of Europe into an austerity trap. Indeed, the rest of the euro area remains Germany’s main trading partner — though its share has been declining over the past five years — and the intra-euro financial interconnection will no doubt magnify any negative economic or confidence impact. What’s more, imposing too harsh austerity on economies already in recession could not only push Spain into asking to shelter under the EU/IMF umbrella, but could also make the public finances of the current ‘programme’ countries (ie Ireland, Portugal and Greece) even more unsustainable, altogether increasing the cost (both economic and political) of the bailouts.
Many nations have already passed the compact without incident (Portugal, the third to be bailed out, was first past the post, with no significant parliamentary opposition to the new agreement), but generally just the process of ratifying the treaty has rendered it vulnerable to dissent within some member states. Although the compact was theoretically already ratified by the previous technocrat government, a second round of voting in Greece in June could potentially throw a spanner in the works there, while Ireland is the only country to have deemed the agreement worthy of a full-scale referendum.
AGAINST THIS BACKDROP, new French president François Hollande’s call for a fresh growth agenda and a renegotiation of the fiscal compact treaty may actually offer a good opportunity to set a new stage for Europe. Angela Merkel has recently stated that the fiscal compact is not up for negotiation, but she has also acknowledged the importance of good relations between herself and the new French president, for the benefit of Europe as a whole. While Hollande’s strategy for Europe may look at odds with that of Merkel, then, EU leaders must ultimately find common ground if they are to avoid becoming obstacles rather than allies to one another in the early stages of Hollande’s presidency.
Luckily they have options, from becoming more flexible on the fiscal target to launching a limited infrastructure plan for Europe. The former would have only a marginal impact on growth, but it would show that Europe remains unified and committed to the fiscal consolidation. The latter proposition — already partly on the cards — would be more positive for growth but would need time to be implemented and contains some execution risks.
Finally, the structural reforms in the labour market, the pension system or the product market in several countries will also in the longer term bring back confidence, competitiveness and ultimately growth to the peripheral countries. However, in the very short term, local politics in Greece, Ireland and Spain still has the ability to derail the European strategy, whether it be for growth or austerity.
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