Fiscal Multiplier and European Austerity

  • The fiscal multiplier looks at how much an initial change in injections affects real GDP.  For example, if increased government spending of £1bn causes overall GDP to rise by £1.5bn, the multiplier effect is 1.5
  • If £1bn worth of tax rises causes real GDP to fall by £0.5bn, the multiplier effect is (0.5)

Since 2009, countries in the Eurozone (and others such as the UK) have pursued deflationary fiscal policy – reducing spending and increasing taxes to reduce their budget deficits.

These austerity measures have led to sharp falls in the rate of economic growth, suggesting the negative multiplier effect is larger than may be expected in usual situations.

As a rule of thumb, the IMF expect a fiscal multiplier of 0.5. This means if you tighten fiscal policy by 1%, you can expect a fall in the rate of GDP growth by 0.5%.

For example, the UK has tightened its cyclically adjusted budget balance by 3.8%, and (Real GDP % growth – trend) fell by 3.9%. This suggests a fiscal multiplier of 1.0.

However, in other countries such as Ireland and Spain, the fiscal tightening led to a bigger fall in GDP giving a fiscal multiplier of over 2.0. This suggests in the current climate of the Eurozone, fiscal tightening comes at a big cost.

 

 

 What Determines Size of Fiscal Multipliers?

There have been cases where countries, e.g. Canada 1990s, can pursue fiscal tightening with relatively limited impact on Real GDP. This is because they can:

  1. Pursue expansionary monetary policy; e.g. cutting interest rates to provide a monetary stimulus. (i.e people have higher taxes, but have lower mortgage payments so overall there is no change in spending)
  2. Depreciation in the exchange rate. If a country pursues fiscal tightening but monetary loosening there is likely to be a depreciation in the exchange rate. This makes exports cheaper, and imports more expensive. This helps to boost domestic demand.
  3. External Demand.  It is usually easier to tighten fiscal policy if neighbouring countries are growing strongly. Export demand can help overcome the fall in government spending.
  4. Situation of the economy. If there is spare capacity, then fiscal tightening is likely to cause a bigger negative multiplier effect. This is because the shock of falling demand is harder to absorb. If the economy is growing strongly, fiscal tightening may help reduce inflation and be easier to absorb.
  5. Confidence. If austerity measures improves confidence in future public finances, people may continue to spend. But, it is more likely austerity worsens confidence because of headline concerns over jobs and spending cuts.

(For A level students – always remember there are several factors affecting aggregate demand) AD=C+I+G+X-M

fiscal multiplier

Source: IMF Fiscal Compact April 2012

This shows that the multiplier effect is greatest when there is a negative output gap (spare capacity in the economy)

Fiscal Multiplier and European Austerity

This is bad news for the Eurozone. Countries in the Eurozone pursuing austerity are likely to find a large negative multiplier effect because:

  • There is no ability to depreciate their currency.
  • External demand is weak because of the global economy and Eurozone recession.
  • The ECB’s focus on low inflation means there is no monetary expansion to offset the fiscal shock.
  • Bond yields in the Eurozone have been higher than you might expect because of the dynamics of a single currency. This has meant they have spent more on interest payments making it harder to reduce deficit.

The Worst is Yet to Come

italy-portugal-spain-uk

Economic growth rates in Italy, Portugal, Spain and UK

Since 2011, Europe has continued on a path of austerity, and in some cases austerity has been accelerated – and also joined by new countries like France. There is likely to be further falls in economic growth in the coming months. Austerity will be a lot of pain, but not much gain.

Fiscal Multiplier and UK austerity

The UK fall in GDP could have been worse, but it shows limitation of Q.E. to expand economic growth.

Fiscal Multiplier and Impact on Revenue

If countries pursue fiscal tightening and see a large fall in GDP, at what point does fiscal tightening became revenue neutral? e.g. austerity reduces economic growth so much, tax revenues fall.

Evaluation:

Of course, there are other factors affecting economic growth apart from fiscal policy. For example, growth rates may be affected by the housing market and supply side factors. It is impossible to isolate just the effect of budget changes on Real GDP. But, there does seem to be a strong pattern which links fiscal tightening to lower real GDP growth.

Related

14 Responses to Fiscal Multiplier and European Austerity

  1. Rob Slack October 10, 2012 at 7:18 pm #

    “As a rule of thumb, the IMF expect a fiscal multiplier of 0.5. This means if you tighten fiscal policy by 1%, you can expect a fall in the rate of GDP growth by 0.5%.

    For example, the UK has tightened its cyclically adjusted budget balance by 3.8%, and (Real GDP – trend) fell by 3.9%. This suggests a fiscal multiplier of 1.0″

    The two paragraphs say very different things. The second does not mean a “fall in the rate of growth” but a fall in the level of GDP.

    • Tejvan Pettinger October 12, 2012 at 9:00 pm #

      Well spotted. Thanks The original data states the effect should be on Real GDP % change, so I updated 2nd paragraph.

Trackbacks/Pingbacks

  1. The Multiplier Effect | Economics Blog - October 4, 2012

    [...] The Fiscal multiplier and European Austerity [...]

  2. US vs EU Unemployment | Economics Blog - October 6, 2012

    [...] 2. Fiscal Tightening. The Eurozone has been seeking to meet deficit reduction targets. These deficit reductions have had a big impact (negative multiplier) effect. The US has not pursued spending cuts of any significance. See: Austerity and fiscal multiplier. [...]

  3. OBR Admit Failure to Predict the Double Dip Recession | Economics Blog - October 17, 2012

    [...] spending cuts and the fact the fiscal multiplier has proved larger than expected. Though the fiscal multiplier is hard to judge, the OBR seem to accept the recent study of the IMF about larger than expected [...]

  4. Why Did Europe Expect Fiscal Consolidation to Work? | Economics Blog - November 2, 2012

    [...] evidence from the IMF and other studies have shown the fiscal multiplier has proved much higher. In fact a multiplier of [...]

  5. Trotz des eitlen Selbstlobs von Wolfgang Schäuble: Die Eurokrise ist massiv zurückgekehrt 156 | A BLOG FOR NONCONFORMISTS - November 12, 2012

    [...] anderem gerade auch didaktisch vernünftig aufgebauten Artikel vom 4.10.2012 mit dem Titel “Fiscal Multiplier and European Austerity” findet ihr im Blog  “Economics Help“, der vom britischen Ökonomen Tejvan [...]

  6. What is Austerity? | Economics Blog - November 16, 2012

    [...] See: fiscal multiplier and European austerity [...]

  7. The wasted years of the UK Economy 2008-12 | Economics Blog - December 3, 2012

    [...] Freezing public sector spending, whilst the private sector is still very fragile, has led to a large negative multiplier effect. It is hard to avoid the conclusion that the double dip recession is largely the fault of economic [...]

  8. Portugal Economic Crisis | Economics Blog - December 4, 2012

    [...] balance was reduced 7.9% of GDP – a large tightening given the economic situation. (See: Fiscal multipliers in Europe). The government cut spending leading to job losses and lower disposable income. Higher taxes also [...]

  9. The Best Form of Economic Stimulus? - Economics Blog - February 11, 2013

    [...] The final point is that in a recession, the multiplier effect tends to be larger than during high growth. This is because there is spare capacity, and in the recession, people have cut back on spending, waiting for income to increase. (Fiscal multiplier and Europe) [...]

  10. Is Austerity Self Defeating? - Economics Blog - March 7, 2013

    [...] prolonged fall in GDP, and therefore austerity has been more damaging than usual. For example, the negative fiscal multiplier of austerity was greater than [...]

  11. Impact of fiscal consolidation on debt levels - Economics Blog - March 11, 2013

    [...] large fiscal multiplier of close to 1 can cause debt consolidation to increase debt to GDP ratios in the short [...]

  12. Irish economy summary | Economics Help - January 14, 2014

    […] Economists have argued that in a recession, the austerity measures have been counter-productive because of large negative multiplier. EU austerity and fiscal multiplier. […]