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 ….