The multiplier effect of fiscal consolidation

Governments in the West and especially in the peripheral Eurozone economies are under pressure to reduce their deficits and bring down public debt levels, because investors are no longer willing to finance extra government borrowing. The problem is that any reduction in the fiscal deficit hurts the economy – at least in the short term – because it means that the government sector has a less positive contribution to the economy. This is true even when the government still runs a deficit.

The extent to which fiscal consolidation hurts economic growth is represented by the fiscal multiplier. This number is 1 when a 1% reduction in the deficit leads to a 1% contraction in GDP growth. A larger fiscal multiplier implies that fiscal austerity of 1% of the economy has a disproportionally negative effect on economic growth.

The size of the fiscal multiplier, in turn, is dependent on several factors, with the implication that austerity measures in Spain will most likely have more negative repercussions for the economy than in for example the UK.

 The factors that affect the fiscal multiplier are:

• Whether the country has a fixed or a flexible exchange rate. With a flexible exchange rate, as is the case in the UK, any austerity measures that lead to price reductions lower the exchange rate, such that a country becomes more competitive and the private sector flourishes. Spain, on the contrary, as a member of the Eurozone does not have its own currency it can weaken via a looser monetary policy. Consequently, there is no ‘exchange rate mechanism’ to ensure the fiscal tightening is compensated by a looser monetary policy and weaker currency
• Whether the country is relatively closed, or open to trade. In a closed economy where the trade sector does not play a large role, there is less room to compensate reduced government spending by higher export growth and lower demand for imports. The UK is more open to trade than Spain, so the UK is better positioned to withstand fiscal austerity
• How developed a country is. The more developed a country is, the more government consumption can positively affect economic activity. With the UK having a higher GDP (per capita) than Spain, this would suggest fiscal austerity in the UK has a more negative effect, although the difference is probably only small (the divergence in fiscal multiplier is larger when comparing a developing country with a high-income country)
• How indebted a country is. If a country already has a high debt, additional government spending can even have a negative fiscal multiplier, because the financial markets do not accept additional government borrowing as they fear a sovereign default. Consequently, rising interest rates will shortly render the government insolvent. In this case, it would make sense to restore the government’s fiscal health to reduce market fears. With the UK more highly indebted than Spain, the implication would be that fiscal austerity in the UK has a smaller negative effect than in Spain.