Restrictive Fiscal Policies in Europe: What are the Likely Effects?

C. Kerdrain and V. Lapègue
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C. Kerdrain: Insee
V. Lapègue: Insee

Documents de Travail de l'Insee - INSEE Working Papers from Institut National de la Statistique et des Etudes Economiques

Abstract: In Europe, fiscal policy will be distinctly more restrictive from 2011 onwards. The fiscal consolidation efforts scheduled for 2011 represent 1.2 percentage points of GDP in the eurozone and 1.8 percentage points in the UK. Such adjustments hit short-term demand and depress activity by Keynesian effects. However, non-Keynesian mechanisms can attenuate them, not least through expectations and supply effects. The impact of fiscal consolidation is also related to the economic background: in line with the recent developments on sovereign bond markets, fiscal variables are found to have a significant impact on interest rate spreads on euro area public bonds. According to our main result, when debt exceeds 100 percentage points of GDP, the marginal effect on the spread of one additional point of debt would be about 7 to 8 basis points. Accordingly, fiscal consolidation is likely to weigh down on euro area sovereign risk premiums. In this light, the NiGEM international macroeconomic model is used to assess the GDP impact of European fiscal consolidation plans. Overall, euro area's GDP in 2011 is estimated to have been 0.6% lower than in a scenario without fiscal consolidation. This impact may however be an upper bound: these simulations do not take account of the possibility of a sudden increase of financial distress following a major loss of confidence in the sovereign bonds of some euro area countries.

Keywords: Fiscal consolidation; sovereign risk spread; eurozone (search for similar items in EconPapers)
JEL-codes: E6 H6 (search for similar items in EconPapers)
Date: 2011
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