Central Bank publishes new research on the macroeconomic effects of fiscal consolidation in the Euro Area

The Central Bank of Ireland today publishes a new Economic Letter (Economic Letter Vol. 2015 No. 10), which summarizes the results of Technical Paper No. 03/RT/15 “The macroeconomic effects of the Euro Area's fiscal consolidation 2011-2013: A Simulation-based approach.”

The authors simulate the impact of the Euro Area’s fiscal consolidation over the 2011-2013 period on GDP and other variables employing variants of two DSGE models used for policy analysis by the European Central Bank (the New Area Wide Model, NAWM) and the European Commission (QUEST III). In their simulations, the authors attempt to account for the zero lower bound constraint on the Euro Over Night Index Average (EONIA). Furthermore, they investigate the effect of plausible enhancements of the credit constraints faced by households and non-financial firms on the effect of fiscal consolidation.

The main findings of the research are:

• In the baseline constructed by the authors, the simulated cumulative multiplier of the fiscal consolidation over the 2011-2013 period lies between 0.7-1.0, depending on the model. It increases to 1.3 with enhanced financial frictions. In the baseline scenario, the fiscal consolidation would achieve a lower government debt-to-GDP ratio only after one or three years, depending on the model. With enhanced financial frictions, the fiscal consolidation would lower the government debt-to-GDP ratio only after 4 or 5 years.
• According to the simulations, the GDP loss associated with the fiscal consolidation was substantial. Fiscal consolidation is estimated to have been responsible for between a third (baseline) and 80 per cent (enhanced financial frictions) of the decline of Euro Area GDP relative to its pre-crisis trend over the 2011-2013 period.
• The zero lower bound constraint on the EONIA has strongly increased the cost of fiscal consolidation. If the fiscal consolidation had been postponed to a period of unconstrained monetary policy, i.e. until after the economic recovery, most of the GDP losses associated with fiscal consolidation could have been avoided.