Fiscal policy in Europe: What is the appropriate stance? Gernot Müller (U Bonn and CEPR) ETLA fiscal policy seminar Helsinki, October 16, 212
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 1/29 Fiscal stance in Europe Public debt is high (as elsewhere in the world...) Fiscal austerity to reduce debt levels Appropriate stance? More austerity necessary to reduce debt levels Or, rather, is austerity self-defeating
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 2/29 Outline of the talk Basic facts on current fiscal stance in Europe Assessment of appropriate stance tricky What determines government spending multipliers? with G. Corsetti and A. Meier (Economic Policy, October 212) Sovereign risk, fiscal policy and macroeconomic stability. with G. Corsetti, K. Kuester and A. Meier (Economic Journal 213) New results for small open economies (work in progress)
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 3/29 Public debt 27 and 21 (% of GDP) Spain Portugal Italy Ireland Greece Germany Austria United States United Kingdom Iceland 27 21-27 1 1
Fiscal stance in Europe Estimating multipliers Fiscal Source: policy International and sovereign Monetary Fund, risk World Economic Final remark Outlook Database, 4/29 October 212 European deficit and debt levels well above targets Gross Governme ent Debt, 212 (Percent of GDP) 18 GR 16 3 percent of GDP Deficit 14 IRL P IT 12 BEL ESP CY FR AT NL MT 1 GER8 6 FIN SVR SL 4 6 percent of GDP Debt Limit LUX 2 EST 9 8 7 6 4 3 2 1 Government Deficit, 212 (Percent of GDP)
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark /29 Fiscal stance changed considerably since 211 Early response to crisis expansionary: European Economic Recovery Programm Discretionary spending/tax cuts by about 1-2 percent of GDP 29 and 21 By 211 most European countries shifted to austerity Response to rising concerns regarding solvency Implication is pro-cyclical fiscal stance
Fiscal stance in Europe Estimating multipliers Fiscal Source: policy International and sovereign Monetary Fund, risk World Economic Final remark Outlook Database, 6/29 October 212 Since 211 structural balances rise, even as growth declines 4 3 2 1 1 2 3 2 Structural balance Structural balance 212 211 Portugal 4 6 28 8 29 21 1 12 Growth Ireland 27 8 6 4 2 2 4 6 2 29 4 6 8 1 21 12 28 14 Growth 212 211 27 Structural balance Structural balance Greece 8 6 4 2 2 2 4 212 4 6 211 8 1 21 12 27 14 28 16 18 29 2 Growth Spain 4 3 2 1 1 1 2 3 4 2 27 3 4 28 212 6 7 8 21 211 9 29 1 Growth
Fiscal stance in Europe Estimating multipliers Fiscal Source: policy International and sovereign Monetary Fund, risk World Economic Final remark Outlook Database, 7/29 October 212 A tendency to go northwest Structural balance Structural balance Italy 6 4 2 2 4. 212 1 1. 2 2. 3 27 3. 21 29 28 211 4 Growth Germany 6 4 2 2 4 6. 212 1 28 211 29 27 1. 2 21 2. Growth Structural balance Structural balance France 4 3 2 1 1 2 3 1 2 3 4 Finland 3. 3 212 28 27 211 29 21 29 6 Growth 2. 1.. 28 212 211 27 21 1 8 6 4 2 2 4 6 8. Growth 3 2 1
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 8/29 Actual fiscal stance: structural government balances 1 8 6 4 2 21 27 212 21 2 4 6 8
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 8/29 Structural government balances (percent of GDP) 1 8 6 4 2 21 27 212 21 2 4 6 8
a. Planned Fiscal Outlook fiscal in the consolidation Euro Area: 212 April substantial WEO evels well above targets... 18 16 cit 14 12 1 EA DEU 8 AT MT 6 FIN 4 LUX 2 EST -4-2 2 11 (Percent of GDP) Cumulative Change in Structural Balance, 211-17...planned fiscal consolidation is substantial... 7 IRL CYP 6 GRC PRT BEL 4 FRA ESP MLT 3 NLD ITA 2 SVK AUT 1 DEU FIN SVN -1-8 -6-4 -2 2 4 LUX -1 EST -2 Structural Balance, 211 (Percent of GDP) ntloaded......allowing debt ratio to peak earlier and at a lower level than in other economies 1/ 11 26 Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 9/29
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 1/29 Will it work? Austerity may be self-defeating... Reduces economic activity: multiplier measures percentage change of output, given increase in spending/tax cut equal to 1% of GDP Semi-elasticity of the budget ranges.3.6 in OECD countries Overall decline in revenues larger than savings? Size of the multiplier key Multiplier above 2: austerity possibly self-defeating Notoriously difficult to assess
Estimating multipliers Time-series studies differ in terms of approach and sample period Estimated multipliers vary, but more so for taxes data spending taxes Blanchard/Perotti 22 US 1.3.78 Mountford/Uhlig 29 US.61 3.7 Romer/Romer 21 US... 3. Ramey 211 US 1.1... Barro/Redlick 211 US.7 1.1 Beetsma/Giuliodori 211 EU 1.... Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 11/29
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 12/29 Corsetti/Meier/Müller: unconditional effect of government spending shock (panel of OECD countries) Government spending 2 2 Output 1 Consumption 1 Investment 1. 1. 1 1.. 1. 2 4 6 2 2 4 6 1 2 4 6 2 2 4 6 1 1 Net exports 4 2 2 4 Exchange rate 4 2 2 Inflation 6 4 2 2 Interest rate 2 2 4 6 6 2 4 6 4 2 4 6 4 2 4 6
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 13/29 Government spending multiplier common findings of unconditional effects Government spending Multipliers are probably below 1 (certainly << 2) Robust across approaches and sample periods If it were for these findings Fiscal stimulus of limited use But also: austerity not self-defeating However, findings may be not very informative for issue at hand
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 14/29 After all, no such thing as the multiplier Effects of fiscal policy likely to differ depending on Monetary policy (and exchange rate regime) Unemployment Health of banking and financial system Credibility of fiscal policy, fiscal stress Expansion versus contraction Openness (trade and capital) Findings of studies that average across these conditions, hide differences in effects across different states of the economy
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 1/29 Recently, this has been recognized among others by Perotti 1999, Tagkalakis 28, Ilzetzki/Mendoza/Vegh 212, Auerbach/Gorodnichencko 212 In Corsetti/Meier/Müller we explicitly consider Exchange rate regime (Peg vs float) Financial crisis (Reinhart-Rogoff dummies) Fiscal stress (critical debt and/or deficit levels) Our baseline: floating exchange rate in good times (no fiscal/financial stress)
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 16/29 Baseline scenario not much of a multiplier Government spending 2 Output Consumption Investment 1 2 4 6 2 4 6 2 4 6 2 4 6 Net exports 1 Exchange rate Inflation Interest rate 1 2 4 6 2 2 4 6 2 4 6 2 4 6
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 16/29 Baseline scenario vs peg Government spending 2 Output Consumption Investment 1 2 4 6 2 4 6 2 4 6 2 4 6 Net exports 1 Exchange rate Inflation Interest rate 1 2 4 6 2 2 4 6 2 4 6 2 4 6
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 16/29 Baseline scenario vs financial crisis Government spending 2 Output Consumption Investment 1 2 4 6 2 4 6 2 4 6 2 4 6 Net exports 1 Exchange rate Inflation Interest rate 1 2 4 6 2 2 4 6 2 4 6 2 4 6
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 16/29 Baseline scenario vs fiscal strain Government spending 2 Output Consumption Investment 1 2 4 6 2 4 6 2 4 6 2 4 6 Net exports 1 Exchange rate Inflation Interest rate 1 2 4 6 2 2 4 6 2 4 6 2 4 6
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 17/29 Output multipliers for baseline specification Impact Maximum Cumulative ( Y t / G t ) Y /G max Y /G year: 2 4 6 Baseline...2 1.1 1. Currency Peg.6.6.6.2. Financial crisis 2.3 2.9 2.2 2. 2.6 Weak Public Finances.7.2 1.2 1.1.8
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 18/29 Caveats Limited number of observations/heterogeneity of circumstances makes identification difficult Particularly true for what defines a financial crisis, a peg, but also fiscal strain/weak public finances Need to spell out specifics Focus on weak public finances/sovereign-debt crisis in what follows
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 19/29 Fiscal policy and sovereign risk How a sovereign-debt crisis can alter the effects of fiscal policy: joint work with Corsetti/Kuester/Meier Closed economy model Constraint on monetary policy: zero lower bound Key feature of current crisis: sovereign-risk channel Sovereign debt crisis: risk premium very sensitive to fiscal outlook Adverse effect on borrowing conditions of private sector
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 2/29 correlation Sovereign high risk risk channel.8 in the euro area low risk.31 7 6 4 3 2 1 CDS Spreads in Low Spread Euro Area (Basis points) Nonfinancial corporates Sovereigns 28 29 21 211 212 1 9 8 7 6 4 3 2 1 CDS Spreads in High Spread Euro Area (Basis points) Nonfinancial corporates Sovereigns 28 29 21 211 212 Causation can run either way Sovereign risk driven by private risk (ailing banks) Sovereign risk creates jurisdiction risk (balance sheet effects, taxation risk, tariffs increase, social unrest,...)
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 21/29 Canonical macro model Phillips curve relates inflation to expectations and activity π t = βe t π t+1 + κy t γg t Aggregate demand relates activity to real interest rate y t = E t y t+1 E t g t+1 [i t E t π t+1 ] Taylor rule approximates the way central bank sets its rates... i t = φ π π t... plus a link between sovereign risk and fiscal outlook ϖ t = ξe t (deficit t+1 )
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 21/29 Canonical macro model with sovereign risk Phillips curve relates inflation to expectations and activity π t = βe t π t+1 + κy t γg t Aggregate demand relates activity to real interest rate y t = E t y t+1 E t g t+1 [i t E t π t+1 ] + ϖ t Taylor rule approximates the way central bank sets its rates... i t = φ π π t φ ω ϖ t... plus a link between sovereign risk and fiscal outlook ϖ t = ξe t (deficit t+1 )
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 22/29 Implications of sovereign risk channel If monetary policy can/does not offset change in sovereign risk Amplification of business cycle Risks to macroeconomic stability due to self-fulfilling expectations Fiscal multiplier very sensitive to state of the economy
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 23/29 Adverse Unpleasant expectations implications become of a self-fulfilling sovereign risk channel : self-fulfilling pessimistic growth expectations Negative expected output growth Lower demand Increase in public debt Higher private borrowing cost Higher sovereign risk Systematic spending cuts in a recession (pro-cyclical policy) can prevent expectations from becoming self fulfilling
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 23/29 Adverse Unpleasant expectations implications become of a self-fulfilling sovereign risk channel : self-fulfilling pessimistic growth expectations Negative expected output growth Lower demand Increase in public debt Higher private borrowing cost Higher sovereign risk Systematic spending cuts in a recession (pro-cyclical policy) can prevent expectations from becoming self-fulfilling
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 24/29 Multiplier depends on state of the economy Constraints on monetary policy, as severe recession pushes economy at zero lower bounds preventing further cuts of policy rates Expected duration of zero lower bound episode: 1/(1 µ) quarters Initial level of public debt determines strength of sovereign risk channel Sensitivity of risk premium to fiscal outlook: ξ
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 2/29 Effect of spending cuts depends on state of the economy Output (% ss GDP) Deficit (% ss GDP)
Effect of spending cuts depends on state of the economy Output (% ss GDP) Self-defeating Consolidation Deficit (% ss GDP) Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 2/29
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 2/29 Effect of spending cuts depends on state of the economy Output (% ss GDP) Deficit (% ss GDP) Expansionary Consolidation
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 26/29 Sovereign debt crisis alters fiscal policy transmission profoundly...... provided that monetary policy may not contain the effects of sovereign risk on private sector borrowing Both, self-defeating and expansionary austerity possible Sovereign risk channel very strong and monetary policy constrained: multiplier negative austerity is expansionary Sovereign risk channel weaker and monetary policy constrained: multiplier large austerity is self-defeating
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 27/29 Financial assistance in a monetary union Fixed exchange rate arrangement such as EMU Constraints on monetary policy, but multiplier limited (Corsetti/Kuester/Müller) Sovereign debt crisis may change sign of the multiplier such that austerity is expansionary ESM/ECB-style intervention which puts a ceiling on sovereign risk may be effective in eliminating the sovereign risk channel Multiplier positive, but austerity unlikely to be self-defeating
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 28/29 Austerity in member country of currency union with sovereign risk channel and without (preliminary result) Output.2.4.6.8 1 1 2 Public debt 1 2 3 4 1 1 2 Public debt declines even in the absence of sovereign risk channel ( financial assistance )
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 29/29 Final remark In principle, austerity can be self-defeating Government spending multiplier can be large if monetary policy constrained by the zero lower bound Sovereign risk channel emerges as a result of sovereign debt crisis; provides a rationale for pro-cyclical stance May help anchoring expectations Multiplier tends to decline Fiscal stance in Europe about right
Fiscal stance in Europe Estimating multipliers Fiscal policy and sovereign risk Final remark 29/29 Final remark In principle, austerity can be self-defeating Government spending multiplier can be large if monetary policy constrained by the zero lower bound Sovereign risk channel emerges as a result of sovereign debt crisis; provides a rationale for pro-cyclical stance May help anchoring expectations Multiplier tends to decline Fiscal stance in Europe about right