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Fiscal adjustment and economic growth in Europe

Autores: Javier Andres y Rafael Domenech. BBVA Research, Europe Economic Watch: 02/20/2013

Tuesday 26 February 2013, by Carlos San Juan

One of the most controversial issues since the start of the economic crisis has been the effect of fiscal policies on economic growth. In late 2008, attention was focused on the effects of the expansionary policies that began being applied to contain the sharp decline in activity that was occurring at the time. Since 2010, interest has shifted in quite the opposite direction: given the risk of fiscal non-sustainability that many European countries are facing, which has given rise to the debt crisis in Europe, the economic authorities started a fiscal retrenchment that has resulted in a contraction of economic activity. The stabilizing effects of fiscal policy on economic activity are typically measured using the fiscal multiplier, which is defined as the change in GDP relative to the change in public deficits due to discretionary policies (increase in expenditures, G*, less increase in revenues, T*, discretionary).

The interpretation of the fiscal multiplier is therefore quite immediate: it shows how much GDP varies for each unit of discretionary increase or decrease in public spending or revenues.

In an interesting article in 2009, during the debate on the appropriateness of applying fiscal policy to combat the free fall in developed economies, Robert Barro clearly explained the meaning of a multiplier greater or less than one. When the multiplier is equal to one, if the government purchases an airplane or builds a bridge, the economy’s total production increases exactly enough as to manufacture that airplane or construct that bridge without reducing the production of other goods, keeping private-sector consumption and investment unchanged. If the multiplier is greater than one, according to Barro “the process is even more amazing”; in addition to increasing production in that airplane or bridge, GDP grows even more because private consumption and/or investment do so as well. That is, an increase in public-sector demand has positive external effects, triggering other additional mechanisms that end up using idle production capacity and increasing private-sector demand.

Why does it matter whether the multiplier is higher or lower? If the multiplier is very high, the negative effects of fiscal austerity on GDP will be quantitatively significant, causing a decline in revenue through automatic stabilizers, which might exceed the ex ante projected savings from the adjustment. In this situation, fiscal consolidation in times of crisis would be self-defeating, and thus some economists (e.g., De Long and Summers, 2012) have even gone so far as to defend the notion that under these circumstances, to reduce the deficit, the appropriate measure would be to increase public spending

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