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 4