1

1 This note draws heavily on two previous papers:Barrell, R., Holland, D. and Hurst, A.I. (2012), ‘Fiscal consolidation Part 2: fiscal multipliers and fiscal

consolidations’, OECD Economics Department Working Paper No. 933.Bagaria, N., Holland, D. and Van Reenen, J. (2012), ‘Fiscal consolidation during a depression’,

National Institute Economic Review, No. 221, pp. F42-F54.I would like to acknowledge the significant contributions of our co-authors from both papers to this

work. However, any errors in this current version of the paper remain my own.

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Paper prepared for ENEPRI Conference: EU GrowthProspects in the Shadow of the Crisis

22 October 2012

2

INTRODUCTIONThe severe recessions suffered as a result of the financial crisis in 2008-9 resulted in a

sharp rise in government budget deficits in almost all major industrialised countries. Thecyclical impact was compounded by fiscal stimulus packages and emergency financial sectorsupport. This in turn has led to a sharp rise in global government debt, giving rise to concernsabout long-term fiscal sustainability. Pressures have been particularly high in some Euro Areacountries, where government bond yields have risen to exceptionally high levels. As a result,fiscal consolidation packages have been introduced by many of the major economies to stemthe rise in sovereign debt.

This paper assesses the economic impact of fiscal consolidation plans for the period2011-2013 in the EU economies. The analysis is based on a series of simulations using theNational Institute Global Econometric Model, NiGEM2. The key features of the model arethat it is estimated and has a common structure across the countries analysed. If the resultsdiffer across countries it will be because they are different. Some of these differences, such asthe openness of the economy, are important. They change over time and they are not relatedto estimation. Others, such as the speed of response to changes in income, do depend uponhow the model was estimated.

Fiscal multipliers differ across countries because the structure and behaviour ofeconomies differ. They also differ within countries, depending on factors such as the fiscalinstrument implemented, the monetary policy response to fiscal innovations, and expectationformation by economic agents. Much of the recent literature on fiscal multipliers alsosuggests that the size of the multiplier may also depend on the state of the economy (see, forexample, Delong and Summers, 2012; Auerbach and Gorodnichenko, 2012, IMF, 2012).Others have focused on identifying links between the fiscal position and the risk premium ongovernment borrowing, which is of particular importance in the Euro Area (see eg. Arghyrouand Kontonikas, 2011; Bernoth et al, 2012; De Grauwe and Ji, 2012; Schuknect et al, 2010).

The purpose of this study is to assess the likely impact on the economy and on the fiscalposition of the consolidation programmes that have been introduced. The impact will dependon the factors discussed above – structure and behaviour of the economy, fiscal instruments,expectation formation, policy response, state of the economy. We set the context for thescenarios by estimating short-term fiscal multipliers in each country for different fiscalinstruments and consider how these are affected by the state of the economy and the effect ongovernment borrowing premia. We then look at the magnitude of fiscal adjustment planned ineach country over the period 2011-2013, and assess the likely impact of these policies withinthe current environment. We compare the impact of unilateral fiscal adjustment to thewidespread global fiscal adjustment that is currently underway.

SHORT-TERM IMPACT MULTIPLIERSThe fiscal multiplier is generally defined as the expected impact on output in the first

year, following a policy innovation that raises spending or cuts taxes by 1 per cent of GDP (exante). Barrell, Fic and Liadze (2009) demonstrate that multipliers are time and statedependent. Fiscal multipliers differ across countries because the structure and behaviour ofeconomies differ. They also differ within countries, depending on factors such as the fiscalinstrument implemented, the policy response to fiscal innovations, and expectation formationby economic agents. Thus there is no single ‘multiplier’ that can be attributed to a giveneconomy, as the impact of a fiscal innovation on GDP depends on a wide range of factors.

2 For a full description of NiGEM see http://nimodel.niesr.ac.uk. A brief overview is provided as anappendix.

3

Fiscal instruments

In order to establish a preliminary estimate of fiscal multipliers in a cross-countrycomparative context, we first run a series of scenarios under a set of common defaultassumptions and settings. We compare the impact of two fiscal instruments – a cut ingovernment consumption spending and a rise in personal sector income tax3. In order todetermine the effects of an ex ante change in fiscal policy one has to avoid offsetting orreinforcing policy effects, but the model must otherwise be allowed to run. In each of oursimulations in this section we make the following assumptions:

• Fiscal policy reactions are turned off for the first two years:

The government does not target the deficit for the first two years. The model hasa feedback rule which adjusts the direct tax rate in relation to the gap betweenactual and target deficits. This is switched off for two years.

Government investment is fixed at the baseline for two years and does notrespond to long-term factors. The same, where this is appropriate, is true forgovernment consumption.

Other tax rates and all benefit replacement rates are held constant throughout thesimulation period.

• Markets work and all quantities and prices can react and there are no exogenousvariables in the model, with the exceptions of policy targets, labour supply and riskpremia:

The central bank sets interest rates, and follows a targeting regime that stabiliseseither the inflation rate or the price level.

Financial markets look forward and are assumed to follow arbitrage paths, andexpectations for those paths are outturn consistent.

� Long-term government bond rates are the forward convolution of futureshort- term policy rates plus an exogenous premium.

� Long-term real interest rates are the forward convolution of future short-termreal policy rates plus an exogenous risk premium made up of the bondpremium plus private sector risks.

� Equity prices are the discounted value of future profits, where the discountfactor is the market interest rate plus the exogenous equity premium.

� Exchange rates “jump” when future interest rates change and they follow thearbitrage path given by nominal interest rates.

Labour markets are described by an exogenous labour supply, a labour demandequation and by a wage equation based on search theory, where the bargaindepends on backward and forward looking inflation expectations.

Capital stocks adjust slowly towards that associated with expected capacityoutput four years ahead, which in turn depends upon a forward looking user cost

3 For a comparison to multipliers using other fiscal instruments in NiGEM see Barrell et al (2012).

4

of capital. Expectations are rational and factor demands and capacity output arebased on a CES production function.

Consumers respond to their forward looking financial wealth, but are not fullyforward looking.

• The transmission channels of fiscal policy are assumed to operate as they wouldunder “normal” equilibrium conditions. Below we will relax this restriction andconsider some factors that may affect the multiplier when the economy is in aprolonged downturn.

Table 1 reports the estimates of the first year multipliers for 12 EU countries, under thedefault assumptions described above, for a 1% (ex ante) GDP rise in taxes or cut in spendingthat is reversed after two years. We include the US as a comparator. Simulations are run onecountry at a time, so there are no spillovers across countries in this preliminary set of baselinemultipliers. Fiscal multipliers tend to be less than 1, primarily due to import leakages, theanticipated monetary policy response, and an offset through the consumption channel throughsavings. Generally multipliers peak in the first year and then decline, and the ex postimprovement in government revenues will normally be less than 1% of GDP, as tax baseschange. Some of the effects of the impulse would generally be expected to be offset bydeclines in interest rates. Both short and long rates should fall. Below we will consider theimplications of interest rates that may be trapped at the lower bound.

Table 1. First-year multipliers from 1% of GDP temporary innovations

GovernmentConsumption Income tax

Austria -0.52 -0.13Belgium -0.62 -0.12Finland -0.61 -0.06France -0.67 -0.27Germany -0.48 -0.26Greece -1.35 -0.53Ireland -0.36 -0.08Italy -0.63 -0.13Netherlands -0.59 -0.20Portugal -0.73 -0.11Spain -0.81 -0.11United Kingdom -0.54 -0.09United States -0.92 -0.19

Note: No shift in the budget target. Experiments conducted in one country at a time.

The multipliers reported in Table 1, illustrate some of the key differences across fiscalinstruments, and also highlight important differences across countries. In a model such asNiGEM multipliers are small. Government consumption spending multipliers tend to belarger than tax multipliers, as a fraction of any disposable income change is absorbed througha temporary adjustment to savings. However we should bear in mind that it is not necessarilyfeasible to cut the provision of government goods and services at short notice. Taxes orbenefits can be cut by 1% of GDP relatively easily both in the model and in the world. Whilemultipliers appear larger for cuts in real government spending, this relies on the assumptionthat such cuts can be implemented immediately, and this is certainly not always the case. It isalso in part because government consumption is part of the income identity and hence whenthey are cut (and reduce the number of people employed or goods and services bought)measured real output falls. If one were to reduce government spending by as much, but do it

5

through wage reductions, then the impact on real GDP would be much less, and the secondround effects of the shock would effectively be the same as an increase in taxes.

Structure of the economy

Country size is an import distinguishing factor across country multipliers, as the longterm fall in real interest rates that is produced by consolidations that is reflected in currentlong term real interest rates is an international phenomenon. When capital moves freelybetween countries, real interest rates are determined largely by the balance between globalsaving and global investment, and large countries such as the United States have much moreimpact than small ones such as Greece. In addition the initial interest rate response will besmaller in countries in EMU because the ECB responds to euro area inflation.

Multipliers tend to be smaller in more open economies, because the more open aneconomy is the more of a shock will spread into other countries through imports, and smallopen economies such as Ireland have small multipliers. Another structuring factor is thedegree of dependence of consumption on current income. This is often related to liquidityconstraints, with a higher current income elasticity more common in financially unliberalisedeconomies such as Greece than in Belgium or the United States. The degree of liquidityconstraints in the economy is likely to vary over the cycle, and may be particularly heightenedwhen the banking system is impaired. We explore the sensitivity of the multiplier to thisparameter below. Finally the speed of response of the economy depends in part on theflexibility of the labour market and the speed at which policies feed into prices.

Table 2. Key factors determining cross-country differences in multipliers

Temporaryspendingmultiplier

Temporaryincome taxmultiplier

Importpenetration

Incomeelasticity

Austria -0.52 -0.13 0.50 0.23Belgium -0.62 -0.12 0.80 0.17Finland -0.61 -0.06 0.39 0.00France -0.67 -0.27 0.30 0.51Germany -0.48 -0.26 0.39 0.68Greece -1.35 -0.53 0.34 0.48Ireland -0.36 -0.08 0.72 0.17Italy -0.63 -0.13 0.27 0.14Netherlands -0.59 -0.20 0.70 0.23Portugal -0.73 -0.11 0.38 0.08Spain -0.81 -0.11 0.37 0.00United Kingdom -0.54 -0.09 0.29 0.17United States -0.92 -0.19 0.16 0.15Spending correlation 0.43 -0.12Tax correlation 0.22 -0.73

Note: Consumption and direct tax multipliers from Table 1. Import penetration is measured as the volume of goodsand services imports as a share of GDP in 2005. Income elasticity is the estimated response of consumptionto current changes in income, from the consumption equations in NiGEM.

Table 2 compares the temporary government consumption spending and direct taxmultipliers from Table 1 to some of the key factors determining the differences in themagnitude of multipliers across countries: import penetration (measured as the volume ofimports of goods and services in 2005 as a share of GDP) and the estimated short-termincome elasticity of consumption. At the bottom of the table the correlations between eachfactor and the two multipliers are reported.

6

Import penetration has a strong correlation with the impact multipliers, suggesting thatmore open economies tend to have smaller multipliers, both in response to spending cuts andtax rises. Figure 1 illustrates the strength of this correlation with the temporary spending ongoods and services multiplier.

Figure 1. Temporary spending multiplier and import penetration

Figure 2 Temporary tax multiplier and income elasticity of consumption

The short-term income elasticity of consumption has little relationship with the first yeargovernment consumption multipliers, as government consumption is a direct component ofGDP, and the impacts on GDP via the household consumption channel are secondary.However, this elasticity shows a 50% correlation with income tax multipliers, which feeddirectly into personal income, and affect GDP through the household consumption channel.The sensitivity of household consumptions to current income may vary over the cycle, and inparticular may differ when the banking system is impaired. Below we will explore thesensitivity of this analysis to this parameter.

Austria

Belgium

FinlandFrance

GermanyGreece

Ireland

Italy

Netherlands

Portugal

SpainUnited Kingdom

United States

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

-1.6 -1.4 -1.2 -1 -0.8 -0.6 -0.4 -0.2 0

Impo

rt pe

netra

tion

Temporary spending multiplier

AustriaBelgium

Finland

France

Germany

Greece

IrelandItaly

Neths

Portugal

Spain

UKUS

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

-0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0

Inco

me

elas

ticity

of c

onsu

mpt

ion

Temporary tax multiplier

7

STATE OF THE ECONOMYThe baseline multipliers reported in table 1 reflect the expected impact of fiscal

innovations when introduced during ‘normal’ times, when the economy is operating close toits equilibrium. However, we do not appear to be in ‘normal’ times but in a prolonged periodof depression, which we define as a period when output is depressed below its previous peak.As Delong and Summers (2012), Auerbach and Gorodnichenko (2012), IMF (2012) andothers point out, the impact of fiscal tightening during a depression may be different from thatin normal times.

There are a number of channels that the differences may feed through. In this study weconsider two of these channels. First, there is the interest rate response. Under normalcircumstances a tightening in fiscal policy can be expected to be accommodated by arelaxation in monetary policy. However, with interest rates already at exceptionally lowlevels, further tightening of fiscal policy is unlikely to result in such an offsetting monetarypolicy reaction. While quantitative easing/credit easing measures have been introduced, theeffects of these measures are also limited by low interest rates on ‘risk-free’ assets. It is lessclear that monetary easing measures have a significant impact on the risk premia attached toassets that bear a greater risk of default.

Second, during a downturn, when unemployment is high and job security low, a greaterpercentage of households and firms are likely to find themselves liquidity constrained. This islikely to be particularly acute when the downturn is driven by an impaired banking system, aslending conditions will tighten beyond what would be expected in a normal downturn. Thereis less scope to smooth consumption in response to short-term income losses through anadjustment in savings.

Impaired interest rate channel

In general, a fiscal tightening can be expected to be accompanied by a monetary loosening,as an inflation targeting central bank maintains a given inflation target with lower rates of interest.Our baseline fiscal multipliers reflecting the response in ‘normal’ times allow an endogenousresponse in short-term interest rates.4 With forward-looking financial markets, the long-terminterest rate, which determines the borrowing costs of firms for investment, is driven by theexpected path of short-term interest rates over a 10-year forward horizon. As monetary policyloosens, long-term interest rates fall, stimulating investment and offsetting part of the fiscalcontraction.

However, when interest rates are close to zero, their downward flexibility may berestricted (the ‘zero lower bound’). The Federal Reserve, and other major Central Banks, cutinterest rates to near zero levels in 2009. More recently, the Federal Reserve has announcedthat these exceptionally low levels of interest rates are expected to remain warranted untilmid-2015, and financial market expectations for the UK and Euro Area point to a similarinterest rate path. This suggests that there is limited scope for monetary accommodation of thefiscal consolidation programme in the near term. With no offsetting stimulus from lowerinterest rates, the impact of a fiscal consolidation programme on GDP would be somewhathigher.

We consider the impact on the first-year fiscal multiplier of a fiscal innovationintroduced during a period like the present, where there is little scope for downwardflexibility in interest rates. This is compared to the estimated multiplier with full downward

4 The policy rule followed is the standard two-pillar rule in NiGEM, which is described in theappendix.

8

flexibility in interest rates. We use the United Kingdom as an example, but similar results canbe expected in most of the other economies in our sample.

Figure 3 illustrates the impact on GDP of a 1% of GDP fiscal consolidation enactedthrough cuts in government spending in the UK. The figure compares the expected impactunder normal conditions when the interest rate response is endogenously driven by a targetingrule, to the same consolidation plan in an environment where there is no downward flexibilityof interest rates. The first-year fiscal multiplier increases from 0.5 to 0.8 per cent when theinterest rate channel is impaired. Without the automatic stabilizing mechanism of the interestrate adjustment, the impact of the consolidation measure also has a much more prolongednegative impact on the level of output.

Figure 3. Impact of an impaired interest rate adjustment on GDP

Notes: Impact on the level of GDP of a 1% of GDP fiscal spending consolidation(permanent) in the UK, with and without an interest rate response.

Source: NiGEM simulations

We should note that exchange rate movements within NiGEM are governed by anuncovered interest parity condition. When the interest rate channel is impaired, the exchangerate channel will also be impaired. In any case, exchange rate adjustments in response to aconsolidation programme should reflect not just the policy adopted in the consolidatingcountry, but the relative stance of fiscal policy in a global context. The scenarios we presentin this paper are restricted to consolidation programmes in Europe, although a broader globaltightening of fiscal policy is currently underway. In this case, the assumption of a neutralimpact on the exchange rate is probably justified. If Europe is tightening relatively morethan its trading partners, we would expect to see a modest depreciation of theexchange rate, whereas if it is tightening relatively less than its partners the exchangerate would appreciate, holding all other risk factors constant.

Heightened liquidity constraints

In the presence of perfect capital markets and forward-looking consumers with perfectforesight, households will smooth their consumption path over time, and consumer spendingwill be largely invariant to the state of the economy or temporary fiscal innovations. In the

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

% d

iffer

ence

from

bas

e

Normal Impaired interest rates

9

extreme example of a fully Ricardian world, the fiscal multiplier is effectively zero, as fiscalpolicy will simply be offset by private sector adjustments to savings behaviour. However, atany given time, some fraction of the population is liquidity constrained; that is, they havelittle or no access to borrowing, so that their current spending is largely restrained by theircurrent income. In the baseline multipliers, we make the assumption that savings behaviourand the number of liquidity constrained consumers are as in normal times. However, in aprolonged period of depressed activity, this is unlikely to be the case, especially when thedownturn has at its roots an impaired banking system. In this section we consider the effectsof an increase in the share of consumers that are liquidity constrained. We operationalise thiseffect in the NiGEM model through an adjustment to the short-term income elasticity ofconsumption. If liquidity constraints are not important, households can borrow when incomesor profits are low in order to smooth their spending path. In this case, the path of consumptionwill be less sensitive to short-term fluctuations in income or profits. However, when liquidityconstraints are high, there is less scope to borrow to smooth spending, and consumption willbe much more reliant on current revenue streams.

The share of the population that is liquidity constrained will affect the short-term incomeelasticity of consumption, given by parameter b1 from equation (1) below:

( ) ( ) ( ) ( ) ( )[ ]{ }( ) ( ) ( )ttt

tttt

HWbNWbRPDIbRPDIbTAWbaCC

lnlnlnln1lnlnln

321

10101

+++

++=

(1)

where C is consumption, TAW is total asset wealth, which is the sum of net financial wealth(NW) and tangible wealth (HW), RPDI is real personal disposable income, Δ is the differenceoperator, and the remaining symbols are parameters.

Cross-country differences in the average short-term income elasticity of consumption have astrong correlation with the tax multipliers, as highlighted above. However, access to credit isdependent both on credit history and on current income, and so is necessarily sensitive to thestate of the economy. As unemployment rises, a greater share of the population will be unableto access credit at reasonable rates of interest – at precisely the moment when they are in needof borrowing to smooth their consumption path. This means that consumption is likely to becyclical, and that b1 is likely to be time varying and dependent on the position in the cycle.Following a banking crisis the effects can be expected to be particularly acute, as bankstighten lending criteria, as discussed by Barrell, Fic and Liadze (2009). This also suggests thatfiscal multipliers are dependent on the state of the economy – especially tax innovationmultipliers – and this is consistent with recent studies such as Delong and Summers (2012)and Auerbach and Gorodnichenko (2012).

The estimated impacts on GDP of a 1% of GDP rise in taxes in the UK, under differentassumptions on the short-run income elasticity of consumption, are reported in table 3 below.With no liquidity constraints, we would expect a temporary rise in taxes to have essentially noimpact on output, while with no options for borrowing to smooth consumption we wouldexpect output to decline by ½ per cent. This illustrative example for the UK can be used as aguide for other countries, as to the sensitivity of multiplier estimates to these key parameters.

10

Table 3. Impact of consolidation programme (tax rise) on UK GDP, under differentshort-term income elasticities of consumptionModel Short-run income elasticity

of consumption (b1)First year multiplier

1 0 -0.012 0.1 -0.063 0.2 -0.114 0.3 -0.155 0.4 -0.206 0.5 -0.257 0.6 -0.318 0.7 -0.369 0.8 -0.4110 0.9 -0.4711 1 -0.52

FISCAL CONSOLIDATION AND GOVERNMENTBORROWING PREMIA

A number of studies have looked at the links between the risk premium on governmentborrowing (generally measured within the Euro Area as the spread of 10-year governmentbond yields over those in Germany) and fiscal sustainability, captured by current or expectedvalues of the general government deficit or the stock of government debt. Table 4 reports keyresults from a sample of these studies. These studies suggest that rising government debt islikely eventually to put upward pressure on interest rates, so that fiscal tightening is likely tobe necessary at some point. While the severe tightening of fiscal policy across the Euro Areahas clearly made a significant contribution to the downturn, these studies generally suggestthat improvements in the fiscal position are linked to a decline in government borrowingpremia and therefore improve the medium-term sustainability of pubic finances and partlyoffset the contractionary effects of the consolidation.

Table 4. Empirical relationship between government borrowing premia and fiscalvariables

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Note: Spread is defined as the 10-year government bond yield over that in Germany, expressed in basispoints. (t+1) indicated expectations 1 year ahead. (t)2 indicates the current debt to GDP ratio squared.

The empirical estimates, on average, point to a 2–4 basis point rise in interest rates for a1 per cent of GDP rise in the government debt to GDP ratio. This may overstate the impactsfor non-Euro Area countries. IMF (2012b) points out that, “fiscal indicators such as deficit

11

and debt levels appear to be only weakly related to government bond yields for advancedeconomies with monetary independence”.

In order to assess the impact of the potential feedback on borrowing premia, we modelthe government borrowing premium as:

GDRGPREM *04.0=

Where GPREM is the government borrowing premium and GDR is the government debtto GDP ratio. Figure 4 illustrates the expected impact of a 1% of GDP fiscal consolidationprogramme on long-term interest rates, with and without allowing for the feedback from thedecline in government debt on the borrowing premium in the UK. Similar results can beobtained for other countries. The impacts increase over time as the debt position improves.The impacts on GDP in the short-term are negligible, although over time they become moresignificant. Where there is little scope for downward adjustment in interest rates, this channelcan be expected to be impaired. However, where significant risk premia are present within theEuro Area (Greece, Ireland, Portugal, Spain, Italy) there is certainly scope for a decline inborrowing costs.

Figure 4. Impact of 1% of GDP fiscal consolidation in the UKon long-term interest rates

ASSESSING FISCAL CONSOLIDATIONPROGRAMMES 2011-2013

In this section the expected impact of the actual fiscal programmes announced andenacted for 2011-13 will be discussed. Table 5 reports the planned fiscal consolidationprogrammes in the countries covered in this paper for 2011-13. The policy impulse is definedas the expected impact of legislative changes to tax rates and spending commitmentsintroduced in a given year on total government spending or revenue, as a per cent of ex anteGDP. A positive impulse represents an expansion (a tax cut or a spending increase) whereas anegative impulse indicates a contractionary policy. The policy impulses to be introduced ineach year are split into those that affect revenues and those that affect expenditure.

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11

Endogenous borrowing premium Exogenous borrowing premium

12

Table 5. Ex-ante Net Fiscal impulses 2011-2013, as announced by governments2011 2012 2013

Fiscalimpulse (%

of2011GDP)

ofwhich

taxbased

ofwhichspendi

ngbased

Fiscalimpulse(% of2011GDP)

ofwhich taxbase

d

ofwhichspendi

ngbased

Fiscalimpulse (% of

2011GDP)

ofwhich

taxbased

ofwhichspendi

ngbased

Austria -0.9 -0.4 -0.5 -0.4 -0.2 -0.3 -0.1 0.0 -0.1Belgium -0.7 0 -0.7 -1.2 -0.5 -0.7 -1.3 -0.4 -0.9Finland -0.3 -0.3 -0.1 -0.6 -0.5 -0.1 -0.1 -0.1 0.0France -1.4 -1.1 -0.3 -1.7 -1.1 -0.6 -1.7 -0.8 -0.8

Germany -0.5 -0.2 -0.3 -0.2 0.0 -0.2 -0.1 -0.1 0.0Greece -2.7 -1.2 -1.5 -5.1 -3.5 -1.6 -2.0 -0.9 -1.1Ireland -3.4 -0.9 -2.5 -2.4 -1.0 -1.4 -2.1 0.7 -1.4

Italy -0.5 -0.3 -0.2 -3.0 -2.4 -0.6 -1.5 -0.6 -0.9Netherlan

ds-0.8 -.3 -0.5 -0.6 -0.5 -0.1 -0.6 -0.45 -0.15

Portugal -5.9 -2.7 -3.2 -2.1 0 -2.1 -1.9 -0.5 -1.4Spain -2.5 -0.5 -2.0 -2.1 -0.4 -1.7 -1.4 -0.3 -1.1UK -2.1 -1.1 -1.0 -1.8 -0.2 -1.6 -1.0 0.0 -1.0

Source: Euroframe (2012). Does not include fiscal plans introduced after January 2012.Note: Here we define the fiscal impulse as the ex-ante expected change in revenue/spending as a % of 2011 GDPas a result of announced policy changes. The impact on GDP will depend on the fiscal multipliers in each country,and cannot be read directly from this table. The ex-post impact on government balances will depend on theresponse of GDP, and so also cannot be read directly from this table.

Fiscal policy turned restrictive in all countries in our sample in 2011, with the deepestconsolidation measures introduced in Portugal, Ireland and Greece – the three countries onbail-out programmes. Cumulative measures over the three-year period amount to close to 10per cent of GDP in Greece and Portugal and 8 per cent of GDP in Ireland. Consolidationmeasures amounting to 5-6 per cent of GDP are planned in France, Italy, Spain and the UK,while only a modest adjustment is planned in Germany and Austria.

In order to assess the impact of these planned consolidation packages on GDP, the deficitand the stock of government debt, a series of simulations are run. We consider two alternativescenarios. In the first scenario, we implement the policy plans detailed in table 5, under theassumption that the economy is behaving as in ‘normal’ times, eg. with flexible interest ratesthat do not bind, and liquidity constraints in line with the long-run average. In the secondscenario, we allow for an impaired interest rate channel and heightened liquidity constraints.

In order to calibrate the relative magnitude of liquidity constraints within the economywhen they are heightened, we use the 10-year government bond spreads over Germany as anindicator of the relative degree of tensions in the banking sector in each country. Figure 5illustrates the average spreads in September 2012.

13

Figure 5. 10-year government bond spreads over Germany, Sept 2012

We raise the short-term income elasticity of consumption by 0.1 percentage point inGermany and by 0.4 percentage points in Greece, with proportional adjustments in othercountries.

Table 6 reports the estimated impact of the planned consolidation programmes inEurope on GDP under the two scenarios. These scenarios were run with all countriesconsolidating simultaneously, and so capture the spillover effects of policies betweencountries. The output declines are expected to more than double in most countries by 2013due to the impaired interest rate and credit channels.

Table 6. Impact of consolidation programmes on GDP2011 2012 2013

Scenario 1 Scenario 2 Scenario 1 Scenario 2 Scenario 1 Scenario 2Austria -0.2 -1.0 -0.2 -2.1 -0.3 -2.9Belgium -0.6 -2.2 -0.7 -4.3 -1.6 -5.2Finland 0.0 -0.9 0.1 -1.8 -0.1 -2.2France -0.5 -1.4 -1.1 -2.9 -2.0 -4.0

Germany -0.1 -1.0 0.0 -1.9 -0.1 -2.2Greece -2.4 -4.6 -6.7 -13.0 -8.1 -13.2Ireland -0.9 -1.2 -1.3 -3.1 -2.3 -5.0

Italy 0.0 -0.7 -0.7 -2.6 -1.9 -4.1Netherlan

ds-0.6 -1.9 -0.7 -3.3 -1.1 -3.9

Portugal -3.2 -4.4 -5.9 -7.8 -7.7 -9.7Spain -1.7 -2.5 -3.2 -5.3 -4.2 -6.7UK -0.5 -2.2 -1.2 -4.3 -1.8 -5.0

Euro Area -0.5 -1.5 -1.0 -3.1 -1.7 -4.0Note: Per cent difference from base in level of real GDP

Figures 6 and 7 illustrate the estimated impact on the fiscal balance and the debt stock ofthe programmes in 2013. While the budget balance is expected to improve in most countriesunder both scenarios, when liquidity constraints are heightened and the interest rate channelimpaired, the potential improvement in the budgetary position is significantly weaker. Forexample, in Greece, the 10 per cent of GDP ex-ante consolidation programme is expected to

0

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4

6

8

10

12

14

16

18

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Finl

and

UK

Net

herla

nds

Aust

ria

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Italy

Irela

nd

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Portu

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14

improve the budget balance by just 2 per cent of GDP by 2013, as the level of output isexpected to contract by 13 per cent as a result of the programme.

Figure 6. Impact of consolidation on fiscal balance, 2013

While the budget balance is expected to show some improvement, the debt to GDP ratiois actually expected to rise by 2013 in most countries given the current state of the economy.This seemingly perverse outcome reflects the relatively modest adjustment to the stock ofdebt in the numerator of this ratio compared to the sharp contractions expected in the level ofGDP in the denominator of the ratio. While the level of debt is expected to decline in mostcountries, the rate of decline cannot keep pace with the drop in output, leading to a rise in thedebt-to-GDP ratio.

Figure 7. Impact of consolidation on government debt, 2013

The perverse impact on the debt to GDP ratio suggests that if we allow for anendogenous feedback from the government debt ratio to government borrowing premia, asdiscussed above, this would in fact raise interest rates and exacerbate the negative effects onoutput. This suggests that pressure to consolidate public finances rapidly, despite the state ofthe economy, in an effort to bring down government borrowing costs may well be misguided.

-1

0

1

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Aus

tria

Bel

gium

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y

Gre

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Irela

nd Italy

Net

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nds

Por

tuga

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Spa

in UK

diff

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ce fr

om b

ase,

% o

f GD

P

Scenario1 Scenario2

-15

-10

-5

0

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10

15

20

25

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35

Aus

tria

Bel

gium

Finl

and

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nd Italy

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Por

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in UK

Eur

o A

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ce fr

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% o

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P

Scenario1 Scenario2

15

In order to gain insight into the magnitude of policy spillovers, we next run each countryindependently, and compare the multipliers from the scenario 2 of the joint scenarios to a setof unilateral scenarios based on the same assumptions of an impaired interest rate channel andheightened liquidity constraints.

Figure 8 illustrates the difference in the expected level of GDP in 2013 in each countryin the joint scenario compared to the unilateral scenarios. On average, the negative impact ofthe programmes on the level of GDP in each country is 2 percentage points greater by 2013when policies are enacted jointly rather than unilaterally. Negative spillovers are more severein the very open economies, such as Belgium and the Netherlands and more muted in the lessopen economies of France, Italy and the UK.

Figure 8. Impact of joint policy action relative to unilateral action

Note: The figure compares the per cent difference from base of GDP from theunilateral scenarios to the joint consolidation scenario.

CONCLUSIONSIt has been argued that the poor growth performance of most EU countries (including the UKas well as Euro area countries) in the last two years cannot be primarily attributed to fiscalconsolidation, given the historical evidence on its impacts. This paper suggests the contrary:when account is taken of the magnified impact of consolidation in a depressed economy, andof the spillover effects of coordinated fiscal consolidation across almost EU countries, fiscalmultipliers will indeed be considerably elevated, and the impact on growth correspondinglylarger.

The direct implication is that the policies pursued by EU countries over the recent past appearto have had perverse and damaging effects. Our simulations suggest that coordinated fiscalconsolidation has not only had substantially larger negative impacts on growth than expected,but may have actually had the effect of raising rather than lowering debt-GDP ratios. Not

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16

only would growth have been higher if such policies had not been pursued, but debt-GDPratios would have been lower.

REFERENCESAuerbach, A.J. and Gorodnichenko, Y. (2012), ‘Fiscal multipliers in recession and

expansion”, American Economic Journal: Economic Policy, 4(2), pp. 1–27.Baldacci, E. and Kumar, M. (2010), ‘Fiscal deficits, public debt and sovereign bond

yields’, IMF Working Paper 10/184.Ball, L.M. (1996), ‘Disinflation and the NAIRU’, NBER Reducing Inflation:

Motivation and Strategy, pp. 167–94.Barrell, R., Fic, T. and Liadze, I. (2009), ‘Fiscal policy effectiveness in the banking

crisis’, National Institute Economic Review, 207.Barrell, R., Holland, D. and Hurst, A.I. (2012), ‘Fiscal consolidation Part 2: fiscal

multipliers and fiscal consolidations’, OECD Economics Department WorkingPaper No. 933

Bernoth, K. and Erdogan, B. (2012), ‘Sovereign bond yield spreads: a time-varyingcoefficient approach’, Journal of International Money and Finance, 31, pp. 639–56.

Blanchard, O.J. and Diamond, P. (1994), ‘Ranking, unemployment duration andwages’, Review of Economic Studies, 61(3), pp. 417–34.

Calmfors, L. and Lang, H. (1995), ‘Macroeconomic effects of active labour marketprogrammes in a union wage-setting model’, Economic Journal, 105(430), pp.601–19.

DeLong, J.B. and Summers, L.H. (2012), ‘Fiscal policy in a depressed economy’,Brookings Papers on Economic Activity 2012.

Elsby, M.W.L. and Smith, J.C. (2010), ‘The great recession in the UK labour market:a transatlantic perspective’, National Institute Economic Review, 214, p. R26.

Holland, D. (2012), ‘Reassessing productive capacity in the United States’, NationalInstitute Economic Review, 220.

Ilzetzki, E., Mendoza, E.G. and Végh, C.A. (2010), ‘How big (small?) are fiscalmultipliers?’, Centre for Economic performance Discussion Paper 1016.

IMF (2012a), Fiscal Monitor Update, July.— (2012b), United Kingdom 2012 Article IV Consultation, Country Report No.

12/190.Laubach, T. (2009), ‘New evidence on the interest rate effects of budget deficits and

debt’, Journal of the European Economic Association, 7, pp. 858–85.Machin, S. and Manning, A. (1999), ‘The causes and consequences of long term

unemployment in Europe’, Handbook of Labour Economics, Vol. 3.Manning, A. (1993), ‘Wage bargaining and the Phillips curve: the identification and

specification of aggregate wage equations’, Economic Journal, 103(416), pp. 98–118.

Nickell, S.J. (1987), ‘Why is wage inflation in Britain so high?’, Oxford Bulletin ofEconomics and Statistics, 49(1), pp. 103–28.

OECD (2009), ‘Adjustment to the OECD’s method of projecting the NAIRU’, OECDEconomics Department.

Schuknecht, L., von Hagen, J. and Wolswijk, G. (2010), ‘Government bond riskpremiums in the EU revisited. The impact of the financial crisis’, European CentralBank Working Paper, No. 1152.

17

APPENDIX: THE NIGEM MODELThe National Institute’s global econometric model (NiGEM) can be used in a number of

ways, from a backward looking structural model to a version that has similar long-runproperties as the dynamic stochastic general equilibrium models used by institutions such asthe Bank of England.5 Although the model is estimated it has a strong role for expectations,and it is also flexible, as it can be run under different models of expectations formation,depending upon the thought experiment being undertaken. Financial markets normally followarbitrage conditions and they are forward looking. The exchange rate, the long-term interestrate and the equity price will all ‘jump’ in response to news about future events. Fiscal policymaking involves gradually adjusting direct taxes to maintain the deficit on target, but it isassumed that taxes have no direct effect on labour supply decisions. Monetary policy makinginvolves targeting inflation with an integral control from the price level, as discussed inBarrell, Hall and Hurst (2006) and inflation settles at its target in all simulations. Some of thekey features of the model that determine the outturns of the simulation studies are detailedfurther below.

Production and investment

GDP (Y) is determined in the long run by supply factors, and the economy is open andhas perfect capital mobility. The production function has a constant elasticity of substitutionbetween factor inputs, where output depends on capital (K) and on labour services (L), whichis a combination of the number of persons in work and the average hours of those persons.Technical progress (tech) is assumed to be labour augmenting and independent of the policyinnovations considered here. Fiscal tightening measures have a negative impact on GDP inthe short-run, but unless they permanently shift the desired level of capital, labour supply ortechnical progress these effects dissipate over time, and will not affect the level of output overthe longer-term.

/1)))(1()(( += techLLeKY (1)

Equation (1) constitutes the theoretical background for the specifications of the factordemand equations. Demand for capital is determined by profit maximisation of firms,implying that the long-run capital output ratio depends on the real user cost of capital. Ingeneral, forward looking behaviour in production is assumed and because of ‘time to build’issues investment depends on expected trend output four years ahead and the forward lookinguser cost of capital. However, the capital stock does not adjust instantly, as there are costsinvolved in doing so that are represented by estimated speeds of adjustment. The user cost ofcapital is influenced by corporate taxes, depreciation and risk premia and is a weightedaverage of the cost of equity finance and the margin adjusted long real rate. Fiscal innovationsthrough the corporate tax rate or through government investment can permanently shift thelevel of the capital stock, and through this shift the long-run level of potential output.

Labour market and wage setting

Demand for labour is also determined by profit maximisation of firms, implying that thelong-run labour-output ratio depends on real wage costs and technical progress. Labour

5. The Bank of England Quarterly model is discussed in Harrison et al. (2005). NiGEM isdiscussed in Barrell, Holland and Hurst (2007), Barrell, Hurst and Mitchell (2007) and inother papers at www.niesr.ac.uk. NiGEM does not impose maximising equilibriumconditions in the same way as Dynamic Stochastic General Equilibrium models, but has thesame steady-state equilibrium properties.

18

supply is modelled as essentially exogenous, determined by demographics and an exogenousrate of participation.

The equilibrium level of unemployment is the outcome of a bargaining process in thelabour market, as discussed in Barrell and Dury (2003). NiGEM assumes that employers havea right to manage, and hence the bargain in the labour market is over the real wage. Realwages, therefore, depend on the level of trend labour productivity as well as the rate ofunemployment. The dynamics of the labour market depend on the estimated speed ofadjustments in the wage and labour demand equations, and the extent to which short-termwage dynamics depend on (rational) expectations of future inflation and on current or pastinflation. The degree of price inertia/real wage flexibility in the economy is an importantfactor underlying the different dynamic profiles observed in response to a fiscal innovation.

Consumer behaviour

As Barrell and Davis (2007) show, both the level of total asset based wealth (ln(TAW) orln(NW+HW)) and changes in financial (dln(NW)) and especially housing wealth (dln(HW))will affect consumption (C).6 Their estimates suggest that the impact of changes in housingwealth have five times the impact of changes in financial wealth in the short run, althoughlong-run effects are the same. Barrell and Davis (2007) also show that adjustment to the long-run equilibrium shows some inertia as well. Al Eyd and Barrell (2005) discuss borrowingconstraints, and investigate the role of changes in the number of borrowing constrainedhouseholds. It is common to associate the severity of borrowing constraints with thecoefficient on changes in current real incomes (dln(RPDI)) in the equilibrium correctionequation for consumption (parameter b1). These coefficients are important in evaluatingimpact multipliers. They may also be time-varying and dependent on the state of theeconomy, as the number of liquidity constrained consumers will rise during an economicdownturn. This may be a key channel through which fiscal multipliers become dependent onthe state of the economy, as suggested by eg. Delong and Summers (2012). One can write theequation for dln(C) as

( ) ( ) ( ) ( ) ( )[ ]{ }( ) ( ) ( )ttt

tttt

HWdbNWdbRPDIdbRPDIbTAWbaCCd

lnlnlnln1lnlnln

321

10101

+++

++= (2)

where the long-run relationship between ln(C) and ln(RPDI) and ln(TAW) determine theequilibrium savings rate, and this relationship forms the long-run attractor in an equilibriumcorrection relationship. The logarithmic approximation is explained in Barrell and Davis(2007).

Operating in forward-looking consumption mode, consumers react to the presentdiscounted value of their expected future income streams, which is approximated by totalhuman wealth (TW), although borrowing constraints may limit their consumption to theirpersonal disposable income in the short run. Total human wealth is defined as

))1)(1/((1 tttttt myrrTWTYTW +++= + (3)

Y is real income, T are real taxes, and the subscript t+1 indicates an expected variable which isdiscounted by the real interest rate rrt and by the myopia premium of consumers, myt. Theequation represents an infinite forward recursion, and permanent income is the sustainableflow from this stock. Fiscal multipliers are sensitive to the expectations formation ofhouseholds. Fully forward-looking consumers anticipate that current consolidation measures

6. Throughout d is the change operator and ln is the natural logarithm.

19

may entail lower tax rates in the medium- to longer-term, offsetting some of the negativeimpact on consumption in the short-term, as households aim to smooth their consumptionpath. Multipliers are higher with myopic consumers.

Government sector

In order to evaluate multipliers a reasonably disaggregated description of both spendingand tax receipts is needed. Corporate (CTAX) and personal (TAX) direct taxes and indirecttaxes (MTAX) on spending are modelled, along with government spending on investment (GI)and on current consumption (GC), and transfers (TRAN) and government interest payments(GIP) are separately identified. Each source of taxes has an equation applying a tax rate to atax base (profits, personal incomes or consumption). As a default, government spending oninvestment and consumption are rising in line with trend output in the long run, with delayedadjustment to changes in the trend. They are re-valued in line with the consumers’expenditure deflator (CED). Government interest payments are driven by a perpetualinventory of accumulated debts. Transfers to individuals are composed of three elements,with those for the inactive of working age and the retired depending upon observedreplacement rates. Spending less receipts gives the budget deficit (BUD), which adds to thedebt stock.

BUD =CED*(GC+GI)+TRAN+GIP-TAX-CTAX-MTAX (8)

It has to be considered how the government deficit (BUD) is financed. Either money (M)or bond financing (DEBT) are allowed:

BUD = d(M) + d(DEBT) (9)

and rearranging gives:

DEBT= DEBTt-1 + BUD - d(M) (10)

In all policy analyses a tax rule is used to ensure that governments remain solvent in the longrun. The default rule is applied to the personal direct tax rate, which is adjusted endogenouslyto bring the government deficit into line with a specified target. This ensures that the deficitand debt stock return to sustainable levels after a shock. A debt stock target can also beimplemented and this is discussed below. The income tax rate (TAXR) equation is of the form:

TAXR = f(target debt or deficit ratio - actual debt or deficit ratio) (11)

If the government budget deficit is above the target, (e.g. 3% of GDP and the target is 1%)then the income tax rate is increased.

Monetary policy

A tighter fiscal policy will allow short-term interest rates to be lower now and in thefuture if there is no change to the monetary policy target, and hence long-term interest rateswill be lower now. Expansionary fiscal contractions, however, are exceptionally rare. Interestrates are set by the monetary authority in relation to a targeting regime, where policy interestrates are set in relation to a rule that is normally forward looking. Fiscal multipliers depend onthe assumed targeting regime, and the extent to which fiscal innovations are accommodatedby monetary policy in the short-term. We distinguish two types of rules, those that target onlyinflation and those that target the price level or a nominal variable such as GDP or the moneystock. During the “great moderation” era central bankers and many economists becameconvinced that they had changed the world they lived in by adopting simple feedback rulesfor monetary policy in combination with rules for fiscal policy that kept debt in bounds. The

20

simple feedback rule was based on the Taylor Rule (TR) that suggests that when inflationincreases the central bank should increase the interest rate more than in proportion to the risein inflation, and hence the real interest rate would rise and help choke off demand. In aforward looking world it is possible to improve on this principal. If agents see the centralbank as fully credible, then the announcement of a price level target (PLT), rather than just aninflation target, will stabilise fluctuations in output and in inflation. A price level targetingcentral bank will loosen policy more rapidly as it has to get the price level back to target. Theconverse will be true in a boom. These two feedback rules are shown in equation (12) below,with int being the intervention rate, ssr being the steady state (endogenous) real interest rate,og being the output gap, inf and inft being the inflation rate and the target, and P and PT beingthe price level and the price level target.

( ) ( )tttttt PTPainftinfaogassraaint ++++= + 413210 (12)

In a Taylor Rule a0 is zero, a1 is 1.0, a2 is 0.5, a3 is 1.5 and a4 is zero, whilst in a PLTregime a(1) is zero, a(2) is also zero, and a(3) is set to 0.7 and a(4) to 0.4. The PLT rule has theadvantage of working only on observables. The same is true of a two pillar strategy asembraced by the ECB. The bank responds to deviations of inflation from target and alsodeviations of a nominal aggregate (NOM) – the money stock for instance – as described inequation:

( ) ( )tttt NOMTNOMbinftinfbbint ++= + 2110 (13)

Forward looking financial markets

A deflationary shock such as a fiscal tightening will have a weaker interest rate responseunder a Taylor Rule than under price level targeting, and both may be weaker than a twopillar rule. If actors know the rule is in place then they will form expectations of the futurepath of short rates, and this will cause the current long rate to change, along with theexchange rate and the equity price. If fiscal policy is expected to be tightened in the futurethen long rates will fall now, increasing the offset, and perhaps even inducing a short-termexpansion of output. Forward looking long rates (LR) should be related to expected futureshort-term rates:

( ) ( ) = ++=+T

jT

jtt intLR1

/111 (14)

Forward looking equity prices (EQP) are related to future profits (PR) in a forward recursionwhere eprem is the equity premium

( )( )tt

ttt epremint

EQPPREQP++

+= +

111 (15)

The exchange rate depends on the expected future path of interest rates and the exchangerate risk premia, solving an uncovered interest parity condition, so that the expected change inthe exchange rate is given by the difference in the interest earned on assets held in local andforeign currencies:

( )tt

ttt rpee +

+

+= + 1

int1int1 *

1 (16)

21

where et is the bilateral exchange rate at time t (defined as domestic currency per unit offoreign currency), intt is the short-term nominal interest rate at home set in line with a policyrule, intt* is the interest rate abroad and rpt is the exchange rate risk premium.