The Effect of Fiscal Austerity: Why Spending Cuts Worked Better

Deficit reduction policies have increasingly been seen as the main culprit for the recessions experienced by many European countries in the aftermath of the great financial crisis of 2008/2009. Such fiscal austerity can be implemented through a combination of spending cuts and tax increases. However, while deficit reduction primarily based on tax increases generates a sensible drop in a country's Gross Domestic Product (GDP), the same austerity policy implemented through comprehensive government spending cuts only marginally affects the level of aggregate output. This is perhaps the most striking result of Austerity in 2009-2013 (forthcoming in Economic Policy), an article by Carlo Favero (Department of Finance), Francesco Giavazzi (Department of Economics), Alberto Alesina (Harvard University and Tommaso Padoa-Schioppa Visiting Professor at Bocconi), Omar Barbiero (Harvard University), and Matteo Paradisi (Harvard University).

Government budgets worsened significantly with the start of the great financial crisis, in many cases because governments had to foot the bill of distressed financial institutions. Large increases in budget deficits meant that many European countries, around 2009, had their fiscal policies began to be monitored by the European Commission. More prominently, after the start of the Greek crisis in 2010, there were renewed worries about the unsustainability of public debt in some European countries. Responding to these pressures, most European countries began fiscal consolidations, starting multi-year deficit reductions plans, despite the weak growth projections for the years to come. Although the optimal fiscal adjustment policy to be implemented remains unknown, it might be worth discussiing the effect of different forms of fiscal austerity on the economic growth.

In their article, the authors aim at providing an effective empirical measure of the effects of these deficit reduction policies on output growth. To reach such key goal, the authors construct a new detailed "narrative" data set which documents the actual size and composition of the fiscal plans implemented by several countries in the period 2009-2013. More prominently, the authors investigate the relationship austerity-recessions by conditioning on the different types of fiscal austerity policies, and also examine whether the recent round of fiscal consolidation policies have had peculiar effects compared to those implemented in "normal" times.

Interestingly, the empirical evidence provided by the authors indicates that the difference between the spending cuts and tax increases policies is very large and significant. Over an estimation period (1978-2007) the average tax-based adjustment plan with an initial size of one per cent of GDP results in a cumulative contraction in GDP of two per cent in the following three years. On the other hand, spending-based deficit reduction generates mild recessions with an effect on the aggregate economic growth not significantly different from zero. In this respect the recent episodes of austerity do not look different from previous ones.

The authors' results point decisively to the role of government spending cuts as a more effective way to reduce deficits, at least in several European countries. Such results, however, are mute on the question whether the countries that have been studied did the right thing implementing fiscal austerity at the time they did, that is 2009-13.