The economic impact of fiscal austerity

INTRODUCTION 
Following the economic crisis started in 2008 in the US, the problem of whether fiscal contractions 
have a negative effect on output has turned to be much more relevant than in the past. 
The immediate response to economic downturn was the approval of fiscal stimulus packages and 
the injection of money via reduction in interest rates. Shome (2012, p. 49) points out that “Focus 
turned to fiscal stimuli through tax reductions and mainly current expenditure enhancements. But 
the size of the fiscal multiplier was not known either. Hence the dilemma as to whether the same 
fiscal stimuli would work to the same extent across countries.”  
In most advanced countries, debt-to-GDP ratios have rapidly grown because of bank rescuing and 
of an increasing demand for welfare support (especially unemployment income) combined with 
falling revenues due to declining employment rates. The intervention by governments and Central 
Banks to secure private savings through the recapitalization of private banks that were involved - 
directly or indirectly - in the mortgage crisis has caused a dramatic increase in public debt. This was 
more rapid in economies hardest hit by the financial crisis (US, UK, Iceland, Ireland and Spain). 
Other countries, such as Japan and Italy, already had high debt-to-GDP ratios. Table 1 shows that, 
also in Germany, government gross debt as a percentage of GDP increased. 
       Shaded cells indicate IMF staff estimates 
Country Subject Descriptor Units 2007 2008 2009 2010 2011 2012 2013 
France General government gross debt % of GDP 64,215 68,208 79,193 82,356 85,785 90,233 93,876 
Germany General government gross debt % of GDP 65,215 66,812 74,547 82,457 79,958 81,015 78,063 
Iceland General government gross debt % of GDP 28,542 70,411 87,999 90,579 100,866 97,216 90,204 
Ireland General government gross debt % of GDP 24,861 44,163 64,42 91,187 104,075 117,398 122,817 
Italy General government gross debt % of GDP 103,277 106,085 116,42 119,288 120,691 126,969 132,53 
Japan General government gross debt % of GDP 183,012 191,812 210,247 215,952 229,836 237,345 243,222 
Spain General government gross debt % of GDP 36,301 40,172 53,977 61,656 70,469 85,949 93,905 
UK General government gross debt % of GDP 43,724 51,89 67,096 78,456 84,319 88,562 90,095 
USA General government gross debt % of GDP 64,005 72,833 86,054 94,807 99,005 102,355 104,517 
Table 1 Source: IMF, World Economic Outlook Database, 2014 
However, the fact the crisis started from private sector encourages some scholars – see Blyth (2013) 
– to claim that it was not really a sovereign debt crisis. 
However, after 2010, the problem of increasing debt-to-GDP ratio has become more relevant 
because of the negative reaction of stock market and rating agencies. Shome (2012) argues that 
policies were refocused on fiscal consolidation, but there was not unanimous consensus about this 
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switch. One view was that fiscal loosening should continue; another view was that fiscal policy 
should be tightened; a third view was to adopt an intermediate path.  
Some economic areas, such as the European Union, have chosen an austerity path in order to secure 
public budgets of member States. This has implied the imposition of sharp spending cuts or tax 
increases to those countries who had an excessive Debt/GDP ratio (especially the Southern 
European countries) and blocking fiscal stimulus programs in those economies that did not suffer 
from this problem (Germany, the Netherlands). Recovery in the EU has been very slow – with some 
exceptions - making effectiveness of austerity policies a key issue in the electoral campaign for the 
European elections in 2014. Political debate has recently have been focused on the flexibility of 
budgetary parameters signed in the Maastricht Treaty and strengthened by means of the inscription 
of balanced budget rule in Member States’ constitutions. In his speech for the beginning of the 
Italian Presidency of European Union, Italian Prime Minister Matteo Renzi has stressed the 
importance of investment for growth in combination with the compliance of balanced budgets. 
Reuters (2014) publishes the answer by Manfred Weber, German head of European People’s Party, 
who claimed “more flexibility would be the wrong way forward” and invoked the compliance 
with budgetary rules. In an interview published on the Italian newspaper Il Fatto Quotidiano in 
August 2014, Tabellini contends that European budgetary rules are counterproductive since the 3% 
ceiling in the deficit-to-GDP ratio is too demanding for Southern Europe economies. He suggests a 
more aggressive deficit financed tax-based fiscal stimulus programme supported by extraordinary 
monetary tools as, for example, quantitative easing. 
In any case, we expect the issue of flexibility to be crucial in the political debate of European 
institutions, with an increasing confrontation between supporters of fiscal discipline – led by 
Germany and the Netherlands – and countries that require a switch towards investment and less 
rigid budgetary rules. 
Conversely, the United States have chosen a different path, mainly composed by more or less 
consistent fiscal stimulus packages and supported by an expansionary monetary policy, which 
included direct acquisition of public debt assets. These actions have raised many critiques about the 
use of debt to exit from a crisis provoked by debt. According to some scholars and conservative 
politicians, public intervention is likely to cause an important growth of the cost of financing, with 
an increase of the interest rate on public bonds. In April 2010, in his speech at the National 
Commission on Fiscal Responsibility and Reform, FED governor Bernanke pointed out that “The 
ultimate goal of the Commission's efforts should be to put us on a path to fiscal sustainability. One 
widely accepted criterion for sustainability is that the ratio of federal debt held by the public to 
national income remain at least stable (or perhaps even decline) in the longer term.” In July 2010, 
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Mort Zuckerman warned on the Financial Times “The president (Obama) has lost the confidence of 
employers, whose worries over taxes and the increased costs of new regulation are holding back 
investment and growth.” 
Nevertheless, like Figure 1 shows, the cost of long-term financing for US Federal Government has 
not increased, actually it decreased by 1%, suggesting that the threat of rising interest rates on 
public debt bonds was not grounded at that time.  
 
Figure 1 Nominal interest rate for 10 Years US Bonds.
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Krugman (2012) gauges the emphasis on the negative role played by government intervention in the 
economy an ideological claim, since academic debate has not provided any incontrovertible 
evidence supporting one thesis or the other.  
In his view, Keynesian theory is considered dangerous by conservative circles that consider it the 
first step of an escalation bringing the United States – and the world – under a socialist power. 
Because of that, they would have instrumentally used economic arguments in favour of a less 
expansionary fiscal policy in order to support their ideological believes and to safe economic 
interests of their traditional political supporters. Kalecki in 1943 wrote that capitalists have a sort of 
veto power against each public intervention since, in a laissez-faire capitalist system, confidence 
level is a key feature. If it decreases, so private investments do, with a bad effect on production and 
employment. However, “once the government learns the trick of increasing employment by its own 
purchases, this powerful controlling device loses its effectiveness”. 
Blyth (2013) argues that introducing in the presentation of macroeconomic measures some kind of 
morality play between “good austerity” and “bad spending” may lead into a period of self-defeating 
                                                             
1
 Source: US Department of the Treasury - Retrieved from http://www.treasury.gov/resource-center/data-chart-
center/interest-rates/Pages/Historic-LongTerm-Rate-Data-Visualization.aspx in July 2014 
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budget cuts. Krugman (2012) also criticizes this aspect, saying that it is not necessary to atone 
suffering from draconian cuts. 
A growing literature analyses the relationship between fiscal consolidation and output, developing 
two main paths.  
1. A “Keynesian” path, claiming that contractionary fiscal policy during crisis has a negative 
effect on aggregate consumption that cannot be offset by private investment growth.  
2. A non-Keynesian path, claiming that fiscal consolidation in some cases has no negative 
effect and can even foster growth in the short run as well.  
A key feature is the role of expectations, which can influence the behaviour of the actors: the main 
question is whether they can offset the effect of a lower government spending or not. 
While both theoretical models are valid and have some explanatory power, the empirical evidence, 
since financial crisis, suggests that there is a positive correlation between the size of a reduction in 
government deficits and a change in GDP. The greater the reduction in fiscal deficit, the worse the 
contraction in the economy. (Hall, 2012) 
Moreover, if until 2013 economists and politicians thought, consistently with an important paper by 
Reinhart and Rogoff, that a debt-to-GDP ratio above 90% can significantly undermine growth, 
recent studies have shown that this threshold is not so rigid. This debate is much more relevant 
since it has a direct impact on real policies applied by the biggest economies in the world, mainly 
the EU, the US and emerging countries. 
This dissertation aims to identify economic effects of fiscal consolidations of which Amo-Yartey et 
al. (2012, p. 16) provide a general definition: “the standard approach is to relate fiscal 
consolidation to a specific improvement in the cyclically adjusted primary balance (CAPB) as a 
percentage of potential GDP over a specific period.” Yet, in the literature, the identification of 
fiscal consolidation varies and partially reflects different study objectives.  
The thesis is divided in two part: the first one provides a review of relevant literature focusing on 
the factors that originate Keynesian effects and non-Keynesian effects and classifying the channels 
that work during a fiscal consolidation, defined as an exogenous policy shock. Requiring the fiscal 
shock to be orthogonal to business cycle shocks and monetary policy shocks is crucial in order to 
rule out the possibility that a spending cut or tax hike depend on the economic cycle (i.e. on GDP 
fluctuations and/or changes in monetary supply).  
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The second part is devoted to a deeper analysis of Alesina, Giavazzi, Favero (2012), and of the 
more recent paper in which the authors fixed some mistakes. The focus will be on economic 
growth, testing whether fiscal episodes listed in the paper started in expansionary periods or during 
recessions. Then, we will provide an estimation of the impact of fiscal shocks in good and bad times 
and of the role of previous economic performance.  
  
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