Slow recoveries through fiscal austerity

Francesco Bianchi, Diego Comin, Howard Kung, Thilo Kind 26 February 2019

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Sovereign bond yields and public debt levels skyrocketed during the Great Recession and the European debt crisis. Several European countries such as Spain, Ireland, Portugal, and Greece responded by implementing austerity programmes – increasing taxes on consumption, labour, and capital, and reducing government expenditures. These programmes stood in contrast to the traditional Keynesian approach that would have called for expansionary fiscal policy to support aggregate demand during the recession. Advocates of austerity measures argued that the recession was largely due to low productivity rather than deficient demand and that, consequently, structural reforms and fiscal consolidation were the appropriate policy response (Feld et al. 2015).

With particular attention to the effects on technology, in a new paper (Bianchi et al. 2019) we investigate the medium-run consequences of the austerity measures taken in European countries in the context of a two-country model with endogenous technology adoption. Even in the absence of a role for demand stabilisation, austerity programmes have adverse effects on productivity and output. They deepen the recession in the short run. In the medium run, fiscal austerity deters both investment in capital and investment in the adoption of new technologies. This reduces adoption rates and leads to a slower recovery. The negative effects of austerity are strongest for programmes that rely on raising labour taxes to stabilise public debt. 

The model

We build a two-country open economy model that features an endogenous response of technology adoption rates to business cycle fluctuations.1 The world technology frontier moves exogenously, but firms have to invest in technology adoption in order to make use of new technologies. Successful investments expand the set of intermediate inputs that can be used for final goods production in the respective country, as in Romer (1990). To capture the linkages between euro area countries, our model considers two open economies – Spain and Germany – which are connected through trade in final goods and government bonds. Each country produces a distinct final good that is consumed by domestic and foreign households. While the stocks of adopted intermediate goods, productive capital, and labour are country-specific, government bonds are held by both domestic and foreign savers. Trade in government bonds is subject to quadratic transaction costs similar to Benigno (2009) and Ghironi et al. (2007). Finally, the government has a wide range of fiscal policies at its disposal. These include distortionary taxes on labour, capital, and consumption, which were the most important taxes in Spain’s austerity programme of 2012.2 In the absence of austerity measures, fiscal policy follows the same rules as in Leeper et al. (2010).

Fiscal distress in Spain, modelled as a liquidity shock that increases the transaction costs for Spanish government bonds, leads to an increase in spreads between German and Spanish bonds of close to 4 percentage points as observed during the crisis. The consequences for output and productivity in the medium run depend heavily on the fiscal response.

Austerity leads to slow recoveries

Austerity measures limit the increase in the debt-to-GDP ratio to 10% and help to contain the increase in spreads between Spanish and German bonds at 1.2 percentage points. Without the austerity package, the debt-to-GDP ratio would increase by 50% and spreads would rise by more than 3.5 percentage points. Figure 1 shows the responses of the technology adoption rate, output, and consumption with and without the austerity programme. The tax increase implemented to consolidate the government’s budget reduces the incentive to invest in capital and technology adoption. Slow adoption of new technologies depresses productivity growth, deepens the recession, and leads to a slow recovery. Fifteen years after the shock, the technology adoption rate is more than 2% lower when austerity measures are implemented. Output is 3% below trend under the austerity regime, while it would be only 1% below trend if fiscal policy rules had remained unchanged.

Figure 1 Impulse responses to a liquidity shock

Notes: The figure shows the responses of the technology adoption rate, GDP, and consumption after a liquidity shock under normal fiscal policy (blue) and under fiscal austerity (green). All figures show percentage deviations from the balanced growth path.

The recession is deeper if consolidation relies on labour tax

The exact design of the austerity package greatly affects its consequences. Based on the calibration used in our paper, the adverse effects of labour tax raises on GDP and consumption are the strongest. Raising capital taxes is the preferred means of fiscal consolidation. An austerity programme that relies solely on higher capital taxes to stabilise debt leads to a trough response of output of –3% ten years after the shock. The recession is much deeper when only the labour tax is used to stabilise debt. For this scenario the model predicts an output trough of –17.5% five years after the shock.

Adverse effects on foreign country

Due to the trade linkages between Spain and Germany, fiscal distress in Spain has negative effects on the German economy – the shock to the liquidity of Spanish government bond depresses consumption in Germany by more than 2%. Importantly, the magnitude of this spillover effect depends on Germany’s fiscal policy. 

Benefits of austerity

An important argument in favour of austerity measures is that they reduce borrowing costs. If a high debt-to-GDP ratio serves as an indicator of a greater default probability, fiscal austerity can bring down interest rate spreads if it succeeds to reduce public debt relative to GDP. We investigate the effects of austerity in response to a deficit shock that raises spreads.3 In this situation, fiscal austerity can accelerate the recovery if the benefits stemming from reducing borrowing costs outweigh the costs of temporarily larger tax distortions. 

Conclusion

Fiscal austerity together with endogenous adoption of new technologies can account for the slow recoveries after the Great Recession in Europe. Austerity measures taken in response to fiscal distress, as in several European countries, slow down the adoption of new technologies and depress productivity growth in the medium run. These negative consequences are particularly strong if the austerity programme relies on labour taxes. 

CEPR is a partner of the FRAME Project, which is co-ordinated by ZEW. The CEPR team is led by Diego Comin, a Research Fellow in its Macroeconomics and Growth Programme. The FRAME project has received funding from the European Union's Horizon 2020 Research and Innovation Programme under the grant agreement No #727073

References 

Benigno, P (2009), "Price stability with imperfect financial integration." Journal of Money, Credit and Banking 41(s1): 121-149.

Bianchi, F, D Comin, T Kind, and H Kung (2019), "Slow recoveries through fiscal austerity."

Comin, D, N Loayza, F Pasha, and L Serven (2014), "Medium term business cycle in developing countries." American Economic Journal: Macroeconomics 6(4): 209-245.

European Commission (2012), Tax policy challenges for economic growth and fiscal sustainability: 2012 report, Brussels.

Feld, L, C Schmidt, I Schnabel, B Weigert, and V Wieland (2015), "Greece: No escape from the inevitable", VoxEU.org, 20 February.

Ghironi, F, J Lee, and A Rebucci (2007), "The Valuation Channel of External Adjustment." NBER Working Paper 12937.

Leeper, E, M Plante, and N Traum (2010), "Dynamics of fiscal financing in the United States." Journal of Econometrics 156(2): 304-321.

Romer, P M (1990), "Endogenous Technological Change." Journal of Political Economy 98(5): S71-S102.

Endnotes

[1] See Comin et al. (2014)for a related model that captures the technological links between a developed and a developing economy.

[2] In 2012, Spain increased the VAT tax rate from 18% to 21%. The top rate on personal income was increased from 43% in 2010 to 52% in 2012. In 2011, a temporary net wealth tax was introduced for the years 2011 and 2012 (European Commission 2012).

[3] The dependence of spreads on debt through default expectations is modelled via a direct relation between the investors’ perceived default probability and the level of debt. Note that also in the absence of fiscal uncertainty, debt levels affect the spread because of the quadratic transaction costs.

This project has received funding from the European Union’s Horizon 2020 research and innovation programme under grant agreement No 727073

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Topics:  Global crisis Macroeconomic policy

Tags:  austerity, recessions, European debt crisis, Great Recession

Associate Professor of Economics, Duke University; CEPR; NBER

Professor of Economics, Dartmouth, and CEPR

Assistant Professor of Finance, London Business School

PhD candidate in Finance, London Business School

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