Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 9 March 2016

Multipliers from Eurozone periphery austerity

For macroeconomists

We often see graphs relating fiscal consolidation to output growth since the Great Recession. Despite such scatter plots being very weak evidence, they appear to show that fiscal multipliers in the periphery countries like Greece have been very large indeed. At first sight this is not difficult to explain. These countries do not have their own monetary policies, and to the extent that fiscal consolidation reduces local inflation, real interest rates will rise, which increases the fiscal multiplier.

Unfortunately the basic New Keynesian (NK) model suggests this reasoning is incorrect, as Farhi and Werning show for temporary changes in government spending. While real rates might rise in the short run following a negative government spending shock, being in a monetary union ties down the long run price level in these economies. So, other things being equal, a negative government spending shock that reduces inflation now will be followed by higher inflation (compared to the no shock case) later, as the real exchange rate self-corrects. That in turn means that fiscal consolidation in the form of temporary cuts to government spending will produce a small rise in consumption for a period after the shock. (Consumption depends on the forward sum of future real interest rates, so as time progresses lower future rates dominate this sum.)

Of course that may simply mean that the basic NK model is incorrect or incomplete. As Farhi and Werning show in the same paper, with some credit constrained consumers we can get back to positive short term consumption multipliers, and therefore output multipliers greater than one. But it occurred to me, just before I was about to discuss this paper in an advanced macro graduate class, that the basic NK model could still give us what appeared to be large multipliers without such additions.

What we had in periphery countries was not just a government spending shock. In Ireland and Greece at least, that spending shock was preceded by a government debt shock. Either the government admitted to borrowing more than the official data suggested, or it had to bail out the banks. We can think of at least two types of response to a pure government debt shock. It could lead to a short sharp contraction in spending, in which case the analysis of Farhi and Werning would apply. Alternatively the government accepts that its debt will be permanently higher, and it only plans to cut spending or raise taxes to pay the interest on that additional debt.

In the latter case, assume that a significant proportion of that extra debt was owned overseas. We would have a permanent transfer from domestic to overseas citizens, and that would require a permanent depreciation in the real exchange rate. An increase in competitiveness is needed to make up for the permanently lower level of domestic demand that these transfers would produce. That in itself produces a terms of trade loss that impacts on consumption. But in addition in a monetary union, that depreciation would have to come about through a period of lower inflation, which would lead to a period in which real interest rates were higher. That in turn would decrease consumption, with the peak effect when the debt shock happened.

This is probably already written down somewhere, but it does explain why you could get apparently large multipliers in Greece and Ireland even if the simple NK model was broadly correct. What we had was a combination of a negative government spending shock and a positive government debt shock, and the latter could have led to significant falls in consumption. For these economies at least, true government spending multipliers may not be as large as they appear.

There I go again, choosing my economics to get the answer I want. Oh, wait ….


  1. Prof. Wren-Lewis,

    Excellent idea to change the subject so quickly after your last two posts!

  2. Since money is debt, all you need to do is turn this debt into money. And you do that by declaring that you will accept any Irish bond as settlement of Irish government taxes and charges at face value.

    That immediately puts a floor underneath the Irish debt market and ensures that there is always a demand for the stuff - in both the primary and secondary markets. Essentially you have created a parallel currency usable only in Ireland.

    And of course since taxation destroys money it would eliminate the bond reducing the stock of outstanding bonds.

    No doubt there are rules against this in the EMU. The solution for Greece and the Greeks is the same, although they'll have to remember to collect the tax this time...

    The only actual sanction the ECB then has is to turn off TARGET2 clearance access and effectively remove the peg between German Euros (let's be honest about who is in charge here) and Greek Euros. At which point Greek Euros start to float.

    And all that means is that for a Greek to pay a Spaniard they would have to exchange Greek Euros for German Euros via a third party transaction. Since the transactions are currently well matched, that's a nice little profit opportunity for some enterprising financial organisation.

    Of course if the ECB pull the plug, then all the ECB imposed restrictions on the Greek central bank disappear at the same time. The Greek clearing system carries on as before and as we know from MMT a central bank issuing its own liabilities can maintain the banking system pegged to those liabilities for as long as it wants.

  3. "Consumption depends on the forward sum of future real interest rates"

    Who ever thought that up?

  4. At last, some really serious macroeconomics: Complete gobbledy-gook. Keep up the good work!

  5. As an aside, there is a UK government advert about exporting running for the last few weeks on commercial radio stations which is saying, from what I remember, "the demand for UK goods overseas is rising fast."

    From where is this export demand 'rising fast'?

  6. Simon, Is the point that you are making here that in periphery countries, government spending was cut in order to ensure sustainability of govt debt- rather than just some exogenous shock. Given that, the usual expectations people might have when govt spending is cut, of future increases in the price level and lower real rates (to keep the real exchange rate constant) were not present. Agents realised their economies needed to restore some competitiveness and so did not expect the price level to rise back up as might usually be the case. As such, agents responded just to an anticipated period of higher real rates, and cut consumption?


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.