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The macroeconomic effects of the Eurozone's fiscal consolidation

From 2011 to 2013, fiscal policy in the Eurozone turned progressively more restrictive. This column argues that output cost of fiscal consolidation strongly depends on presence and strength of credit constraints. With credit constraints both in the household and the firm sector, fiscal consolidation would be largely responsible for the weak growth performance during 2011-2013. Postponing the fiscal consolidation to a period of unconstrained monetary policy would have avoided most of these losses.

From 2011 to 2013, fiscal policy in the Eurozone turned progressively more restrictive. According to estimates by the European Commission (2012), spending cuts and tax increases accumulated to about 4% of annual Eurozone GDP between 2011 and 2013. The switch to fiscal austerity has been associated with a return of the Eurozone economy to recession. The role of the fiscal consolidation in driving the EZ’s disappointing economic performance is uncertain and disputed. Blanchard and Leigh (2013) argue that the IMF and the European Commission's projections have consistently underestimated the adverse effects of austerity. However, others have challenged this result (e.g. European Commission 2012a, Lewis and Pain 2015).

In Rannenberg et al. (2015), we assess the impact of fiscal consolidation in the EZ employing variants of two Dynamic Stochastic General Equilibrium (DSGE) models used for policy analysis by the ECB (the New Area Wide Model, NAWM) and the European Commission (QUEST III).

  • We show that under plausible scenarios, the output costs of fiscal consolidation were substantial.

In our baseline scenario, fiscal consolidation would be responsible for between one third (NAWM) and one half (QUEST III) of the decline of EZ’s GDP relative to its pre-crisis trend from the beginning of 2011 until the end of the EZ's recent recession in 2013.

We then consider two enhancements of the degree of financial frictions in the model: the introduction of credit constraints to the non-financial firm sector and an increase of the share of credit constrained households. In the scenario with enhanced financial friction, the share of the decline of GDP relative to trend attributable to fiscal consolidation would rise to about 80%. Moreover, most of the output costs of fiscal consolidation could have been avoided if it had been postponed until the zero lower bound constraint on monetary policy was no longer binding. Therefore, once out of the zero lower bound, the government-debt-GDP ratio could have been reduced much more quickly. We emphasise that any policy conclusions drawn from these results apply to the Eurozone as a whole and are thus not directly applicable to individual Eurozone members.

Key aspects of the simulation design

The components of the consolidation package are summarised in Table 1, which is taken from European Commission (2012). The table lists estimates of the budgetary effects of the legislated changes in individual expenditure items and taxes in the respective year, holding GDP and the tax base constant (the so called ‘ex-ante’ effect, as it abstracts from endogenous changes in government expenditure and the tax base). By the end of 2013, the total deviation of expenditures and revenues from their path in the absence of fiscal consolidation amounts to 4% of GDP. The fiscal consolidation is dominated by expenditure cuts, which in turn are dominated by transfer cuts (1.5 % of GDP by the end of 2013).

Regarding the distribution of the transfer cuts, we assume that transfer cuts are borne largely by credit constrained households, based on estimates of the marginal propensity to spend out of the US stimulus payments by Broda and Parker (2014).

We assume that the consolidation measures are kept in place for 10 years, after which they are gradually phased out following an autoregressive (1) process with a coefficient of 0.9. Thus, 10% of the measures are rolled back each quarter. We think it is likely that mounting political pressures will lead to a reversal of at least some of the simulated measures in the future. Furthermore, we want to account for myopia among forward looking households.

Table 1. Ex-ante deficit effects of consolidation measures implemented in the EA, % of GDP

Notes: Source: European Commission (2012). The numbers reported indicate by how much the respective measure affects the public deficit as percent of GDP assuming everything else staying the same.

Another key issue is the monetary policy response to the decline in output and inflation caused by the fiscal consolidation. In Rannenberg et al. (2015), we argue that the monetary policy response to the fiscal consolidation was limited based on financial market expectations and simulation results. We switch off the monetary policy rule after 6 quarters (i.e. in 2012Q3) and switch it on again after three years (i.e. 2015Q3).

Main results

In our baseline scenario, fiscal consolidation lowers GDP by between 2.5% and 3.5% at the through, depending on the model (Figure 1). The fiscal consolidation lowers government demand for goods and services and reduces the disposable income of households via lower transfer payments and higher taxes. The decline in their disposable income lowers the purchases of credit constrained households. Hence, GDP declines. The decline in GDP is further amplified by three mechanisms.

  • First, the drop in employment further reduces the purchasing power of credit constrained households.
  • Second, the real interest rate increases due to lower inflation, as nominal interest rates are stuck at the zero lower bound, which lowers both household consumption and investment.
  • Finally, the higher real interest rate and lower current and expected demand also reduce business investment. The cumulative multiplier of the fiscal consolidation amounts to 0.7 and 1.0 over 2011-2013, respectively (Table 2).

Figure 1. Responses of selected variables of the EA to the consolidation measures implemented in the EA between 2011 and 2013 for the baseline specication (low share of credit-constrained households, no financial accelerator), the baseline with a high share of credit-constrained households, the baseline with a financial accelerator, and the baseline with both a high share of credit-constrained households and a financial accelerator.

Table 2. Short run costs and benets of the scal consolidation, NAWM/QUEST III

We then investigate the impact of two plausible enhancements of the degree of financial frictions in the models on the costs of fiscal consolidation. First, we add a financial accelerator along the lines of Bernanke et al. (1999), which generates a positive relationship between the cost of external finance of non-financial firms and their leverage. It implies that any adverse shock that lowers firm's net worth and thus increases their leverage also increases the cost of borrowing (the so called external finance premium). Hence, future rental income from capital is discounted at a higher rate, depressing investment. Second, we allow for a crisis-related increase of the share of credit constrained households, drawing on evidence from the ECB's Household Finance and Consumption Survey. With both of these enhancements, the trough of GDP is lowered to about 4.5% in both models, while the cumulative multiplier increases to 1.3.

In all simulations, the decline in tax revenues and the increase in transfer payment caused by the decline in output imply that the primary deficit only gradually approaches the ex-ante deficit effect of the consolidation package, which as discussed above accumulates to 4% of GDP by the end of 2013. As a consequence of that and the decline in inflation (which increases the real value of the debt stock) as well as the direct effect of the decline in output, the government debt-to-GDP ratio increases initially in all scenarios in both models before declining below the non-consolidation case. With both a financial accelerator and an increased share of credit constrained households, the debt-to-GDP ratio declines below the non-consolidation case only during year five (NAWM) or six (QUEST III).

The adverse GDP effects of fiscal consolidation raise the question of whether the fiscal multipliers of individual fiscal instruments associated with the scenarios we consider are reasonable. In Rannenberg et al. (2015), we show that for the worst case scenario, they are mostly not out of line compared to the available empirical evidence.

Fiscal consolidation and the EZ recession

We also investigate the degree to which, according to our simulations, the EZ's fiscal consolidation has added to the weak growth performance of the EZ economy over the 2011-2013 period. Since 2008, the EZ economy has moved away from it pre-crisis growth trend. Figure 2 displays the part of that shortfall which took place after 2010Q4, as well as the simulated output effect of the fiscal consolidation in the two models under the various scenarios considered.

According to our simulation, by the end of the recent recession (black vertical line), EZ GDP had increased its distance from its pre-crisis trend by almost 6 percentage points. Under the baseline scenario, fiscal consolidation would explain more than one third (in the NAWM) or one half (in QUEST III) of the deterioration of the output gap during the recession. In the presence of a financial accelerator, this fraction increases to almost two thirds (NAWM) and more than 80% (QUEST III), respectively. With both an increased share of credit constrained households and a financial accelerator, the GDP decline relative to trend reproduced by the NAWM increases to 80% as well. Hence, it seems that for a plausible degree of financial frictions, the EZ's fiscal consolidation would be largely responsible for the weak growth performance over the 2011-2013 period.

Figure 2. Cumulative deviation from the pre-crisis trend in the Eurozone (black dashed line) since 2010Q4. The assumed pre-crisis trend growth rate equals the average quarterly GDP growth rate over the 1997-2007 period, ie 0.6%. The vertical line denotes the end of the last quarter of the EZ's recession

Table 3. Short run costs and benets of the scal consolidation in the absence of the zero lower bound, NAWM/QUEST III

Potential gains from postponing fiscal consolidation

The potentially high cost of fiscal consolidation raises the question of whether the output loss could have been reduced if the fiscal consolidation had been postponed to a period of robust economic recovery where the central bank would have been no longer constrained by the zero lower bound. As is shown in Table 3, across all scenarios, the simulated GDP loss would only be a fraction of the effect obtained under constrained monetary policy. Unlike in our baseline and its extensions, the central bank follows its interest feedback rule and thus lowers both the nominal and the real interest rate in response to the decline in inflation, thereby stabilising private consumption and investment. By contrast, with constrained monetary policy, the inflation decline causes an increase in the real interest rate.


Blanchard, O J and D Leigh (2013), “Growth Forecast Errors and Fiscal Multipliers”, American Economic Review, 103(3):117-120.

Broda, C and J A Parker (2014), “The Economic Stimulus Payments of 2008 and the Aggregate Demand for Consumption”, NBER Working Paper 20122.

European Commission (2012a), “European Economic Forecast”, Autumn 2012.

European Commission (2012b), “European Economic Forecast”, Spring 2012.

Lewis, C and N Pain (2015), “Lessons from OECD forecasting during and after the financial crisis”, OECD Journal: Economic Studies, 2014(1):9{39.

Rannenberg, A, C Schoder, and J Strasky (2015), “The macroeconomic effects of the euro area's fiscal consolidation 2011-2013: A simulation-based approach”, Research Technical Paper 03/RT/2015, Central Bank of Ireland.

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