Austerity in 2009–2013

The deficit reduction policies followed by several Organization for Economic Co-operation and Development (OECD) countries in 2009–13, often referred to as fiscal austerity, were motivated by the bond market’s reaction to the large debts and deficits that followed the Greek crisis. Austerity was clearly not meant to cool down overheating economies; on the contrary, several countries adopted austerity measures when recessions were not quite over and credit crunches were still retarding the recovery. This is not ideal, but the risk of a meltdown of the Euro area was significant.

Our research examines the effects of austerity on output growth. We focus especially on the composition of austerity measures: how they were divided between tax increases and spending cuts.

The research we summarize here uses the model estimated in Alesina, Favero, and Giavazzi to estimate the effects of the fiscal consolidations that occurred during 2009–13. We start by documenting how austerity has been implemented in each country. We estimate such a model with data running up to 2009. Then we simulate the model over 2009–13, feeding in the actual plans adopted in those years.

Our main finding is that fiscal adjustments based on spending cuts are less costly, in terms of output losses, than those based upon tax increases. Over our estimation period (1978–2007) the output effect of tax-based adjustment plans with an initial size of 1 percent of GDP is a cumulative contraction in GDP of 2 percent or more in the following three years, a result which is roughly consistent with Romer and Romer. In contrast, spending- based adjustments generate small recessions with an impact on output growth not significantly different from zero.

We also find little evidence that recent fiscal adjustments had larger negative output effects than past ones. This suggests that fiscal multipliers estimated using pre-crisis data give valuable information about the output loss associated with the post-crisis fiscal consolidations. This result contrasts with Blanchard and Leigh (2013), who argue that the costs of fiscal adjustments have been higher in recent years than previously estimated. The difference between our results and theirs is that we construct forecast errors that are conditional only upon deficit driven fiscal consolidations. Instead, the forecast errors in Blanchard and Leigh are conditional upon a scenario for all the exogenous variables that enter the International Monetary Fund (IMF) forecasting model. In other words, Blanchard and Leigh attribute any deviations from forecasted growth to fiscal policy. This is a questionable assumption.

To conclude, we note that our evidence has nothing to say about the desirability of the fiscal consolidations during 2009–13. What we can say is that, assuming that austerity was necessary (to avoid a collapse of the Euro, or banking crises, or even worse recessions), spending cuts were much less costly than tax increases. In other words, this paper shows there was significant heterogeneity in the effects of such fiscal adjustments depending on their composition — taxes versus spending — and, partly, on their credibility and persistence.

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