VoxEU Column Macroeconomic policy Monetary Policy

What macroeconomic policies for the Eurozone?

In a recent column, the authors suggested coordinating monetary and fiscal expansions in the Eurozone through a money-financed temporary tax cut. The effectiveness of their proposal, however, has been questioned. In this column, the authors address some of the criticisms. They argue that the counter-cyclical fiscal policies adopted by the US and the UK, together with monetary easing, had a stabilising effect on output. Moral hazard due to the more lax monetary and fiscal policies is avoidable, increasing the credibility of the future spending cuts. 

In his recent article on Vox, Roberto Perotti takes issue with the proposal of coordinating a monetary and fiscal expansion in the Eurozone through a money-financed temporary tax cut, which we advocated in a column on 21 August (see Perotti 2014, Giavazzi and Tabellini 2014). He does not question the effectiveness of the proposal in stimulating aggregate demand. But he argues that a temporary expansion of the budget deficit of the order of 5% of GDP cannot be credibly reversed through future spending cuts, and that reversing the temporary tax cut through future tax increases would also be destabilising, economically and politically.

Counter-cyclical fiscal policies: Stabilising or destabilising?

The policies enacted in the US and in the UK during the Great Recession flatly contradict the second part of Perotti’s argument, as shown in Tables 1a to c below. The US let its budget deficit expand by almost 7% of GDP in a single year, through a combination of higher spending and lower revenues (Table 1a). Less than half of this change was due to the effect of fiscal stabilisers, the rest reflected deliberate policy decisions. The changes on both sides of the budget were later reversed. This was in part because the increase in the deficit due to the actions taken to bail out financial institutions was a one-off; in part automatically, as the economy recovered; and in part, through deliberate shifts in fiscal stance, such as the 2013 Sequester. Net of the effect of automatic stabilisers, federal outlays were reduced by more than 2.5% of GDP between the trough of the business cycle and now, while federal revenues net of automatic stabilisers increased by about 3% of GDP during the same period (source: Congressional Budget Office).

Table 1a.  US fiscal expansion during the Great Recession

Source: 2014 Economic Report of the US President, 2014 numbers are forecasts. The source for the cyclically adjusted deficit is the Congressional Budget Office, and the number refers to fiscal (as opposed to calendar) year.

In the UK, the budget deficit expanded almost as much as in the US (+ 6.4% of GDP in a single year), also through a combination of higher spending and lower revenues (Table 1b). Two thirds of this fiscal expansion was due to deliberate policy decisions. The fiscal expansion was entirely reversed during 2010-13 with about one half (56%) of the contraction due to deliberate policy actions, almost entirely on the spending.

Table 1b. UK fiscal expansion during the Great Recession

General government. Source: European Commission, Cyclical adjustment of budget balances, Spring 2014. Data for 2014 are forecasts.

In the Eurozone, the fiscal expansion in 2008-09 was smaller, as the area-wide budgets worsened by 4.2% of GDP, about two-thirds the size of the fiscal expansion in the US and the UK (see Table 1c). Half of this expansion was policy-induced. As in the UK, the fiscal expansion was subsequently entirely reversed, but with two significant differences.

  • Discretionary contractionary measures were twice as large as the expansionary measures which had accompanied the expansion (a contraction of 4% of GDP over 2010-14, compared with a policy-induced expansion of 2% in 2008-09).
  • And, most importantly, the fiscal policy impulse was pro-cyclical, as it was enacted in the middle of the sovereign debt crisis that squeezed credit and raised economic uncertainty in Southern Europe.
  • Moreover, in most countries it mainly took the form of tax hikes. The result was a 2-year long recession that erased some of the budgetary improvement.

Table 1c. Eurozone fiscal expansion during the Great Recession

Eurozone (18 countries), general government. Source: European Commission, Cyclical adjustment of budget balances, Spring 2014. Data for 2014 are forecasts.

There is almost unanimous agreement amongst economists that the countercyclical policies enacted in the US and the UK, together with the exceptional monetary easing, contributed to stabilising output fluctuations and explain the much more rapid recovery of these economies compared to the Eurozone, despite the fact that the heart of the financial crisis was in the Anglo-Saxon countries and not in continental Europe. The statement that in the current circumstances countercyclical fiscal policy cum quantitative easing (QE) would be economically destabilising is hard to understand to say the least, even if it was carried out entirely through changes in tax policies, and with no accompanying cuts in future government spending.

As stated above, not all of these swings in the US and UK fiscal outcomes were achieved through a mix of discretional policy changes. They also reflect cyclical fluctuations in output and prices. But this is precisely the point, and the same would be true in the Eurozone. A main purpose of engaging now in a fiscal expansion in the Eurozone would be to abandon the pro-cyclical fiscal stance that has inflicted unnecessary pain, and engage instead in countercyclical policies. In the Eurozone between 2009 and 2013, after the output gap had moved from +3.2% to -3%, the area-wide cyclically adjusted budget balance tightened by almost 4 percentage points of GDP. In some countries, the pro-cyclical tightening happened mostly via spending cuts (Spain and the UK in particular) and was more benign. Elsewhere, such as in Italy, it was almost entirely based on tax hikes and induced large and lasting recessions. Some of the tax cuts that we advocate would thus simply undo the pro-cyclical tax increases that were enacted in those countries during the peak of the sovereign debt crisis

As income and prices start growing again, at least some of the budgetary expansion would, as in the UK and the US, automatically be reduced without any policy intervention, since receipts as a fraction of GDP are pro-cyclical, while spending as a fraction of GDP is countercyclical. If the elasticity of the budget to the cycle were symmetric (which need not be the case) and using the numbers from the budget deterioration experienced in the Eurozone between 2007 and 2009 (a 2% of GDP cyclical worsening of the budget, that is net of policy measures, for a 6.6% worsening of the output gap) a return of the output gap to balance, from the current level (-3.8% at the end of 2013) would automatically improve the deficit by 1.2% of GDP, not a big number but not zero either.

Moral hazard and the credibility of future spending cuts

Perotti also reiterates the argument that more lax monetary and fiscal policies would create moral hazard, particularly in the countries of Southern Europe. There is no doubt that the governments of Italy and France seem to lack the political will, or the political majorities in Parliament, to carry through the major structural reforms that would be in the long-run interest of these countries. But it is not at all clear that prolonging the depression is a recipe for more willingness to reform. The contrary is more likely to be true, for two reasons.

  • First, a longer stagnation and higher unemployment can only reinforce the more radical and populist political parties in Europe. The recent surge of the Five Star movement in Italy and of the anti-Euro sentiment in France did not happen by chance, they are the by-product of the economic failures of the European project.
  • Second, political opposition to spending cuts and structural reforms tends to be stronger when the economy is depressed, because voters perceive such measures as likely to further dampen aggregate demand and increase layoffs.

The correct sequence, from both an economic and a political point of view, is an inter-temporal substitution – expansionary tax cuts now to restore some growth, and spending cuts on the way up as the economy recovers. To give credibility to the future painful measures, the spending cuts can be legislated immediately, but with a delayed implementation, and with a legislative commitment to raise taxes by a corresponding amount if the spending cuts were to be abandoned.

Is there an alternative strategy?

The alternative strategy suggested by Perotti – of contemporaneous incremental steps to reduce government spending and taxation at the same time – may work during normal times. But it is politically too difficult in the current circumstances. Moreover, and more importantly, it completely misses the point that now we need a major coordinated effort to jumpstart the Eurozone economy. Leaving this task to the ECB alone is bound to fail.

The new President of the European Commission has proposed to increase public investment by a cumulative €300 billion over the next several years. This strategy too is likely to fail, however, because the boost to aggregate demand would come too late, and because the resources would be too small to make a difference (and German policymakers have already scaled down the total by hinting that the overall sum would have to include the structural funds and would have to be financed also by the private sector).

Mario Draghi's speech in Jackson Hole, his recognition that growth in the Eurozone is demand-constrained, that the appropriate policy to relieve the constraint is a coordinated effort by both fiscal and monetary policy, and that monetary policy can play an accompanying role but can hardly be the driver of growth, has changed the policy landscape. If Eurozone governments miss this opportunity and keep muddling through, they will go down in history as the politicians responsible for having destroyed a 60-year long effort by Europeans to build a more peaceful continent. Unfortunately they seem determined to do just that.


Perotti, R (2014), “Eurozone recovery: There are no shortcuts”, VoxEU.org, 13 September

Giavazzi F and G Tabellini (2014), “How to jumpstart the Eurozone economy”, VoxEU.org, 21 August

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