The multiplier myth

Many international economists have recently claimed that fiscal multipliers are much larger now than in normal times. The economic recession in Europe’s South, so is the view, is primarily to be attributed to the fiscal consolidation undertaken that together with the larger multipliers has had devastating effects. Many good arguments speak in favour of this interpretation, including the fact that overall government spending in the four largest economies in the euro area has been growing below inflation in the last 3 years despite a weakening growth performance.

Yet, I would dispute the simple view that fiscal consolidation was the main driver of weak growth. Let’s look at the specific case of Spain that nicely illustrates my point. First of all, Spain has not engaged in a fiscal austerity programme – contrary to what is often claimed. The table below taken from the just released winter forecast of the European Commission (http://ec.europa.eu/economy_finance/db_indicators/ameco/index_en.htm) shows that the budget deficit during 2010-12 actually did not come down at all. In 2012, Spain even enacted a slight economic stimulus with an increase in the deficit by 0.8 percentage points. Second, government expenditures increased by almost 7 bn euros. When excluding the effect of higher interest rates on government expenditure, government expenditure still slightly increased by around 2bn.  Also in structural terms, the budget deficit increased. Third, however, at the same time GDP growth collapsed falling by 1.8 percentage points to lead to a 1.4% contraction of GDP. 

Applying a naïve multiplier analysis would thus suggest that the fiscal multiplier is not even zero but actually negative. This simple analysis suggests that different factors may have been responsible for the actual contraction of GDP. Perhaps the real reason for the deterioration in the economic situation in Europe was the massive drop in confidence of international investors in the ability of the euro area to overcome its more systemic problems. Perhaps there was also a more specific doubt about the ability of the Spanish government’s willingness to reduce its deficits to levels that would generally be seen as sustainability. Overall, the Spanish data thus put significant doubt on the naïve view expressed by some economists that excessive austerity is the main reason for the slowdown. Budget consolidation in Spain has certainly been moderate and deficit levels remain elevated. Instead, the breakdown in financial intermediation and the sharp increase in financing costs of the corporate sector may be the real evil.

Four conclusions follow. First and foremost, Europe needs to make progress on completing the banking union, resolving the problems in its banks and strengthening its institutional infrastructure. Second, monetary policy should be more aggressive in bringing down the financing costs and re-establishing the normal credit channel of monetary policy. Third, budget consolidations should continue in structural terms when fiscal deficits are clearly unsustainable – also in view of re-establishing confidence. Fourth, when tax revenues decline due to the decline in economic activity, one should not try to fill those holes – adding austerity to austerity would be the wrong choice.