Do we need more or less fiscal austerity in the eurozone?

Do we need more or less fiscal austerity in the eurozone? The answer is simple: it depends on the country and its economic circumstances.

Let’s first do away with some fairy tales. No: fiscal consolidations are not expansionary. The few studies that claim to prove expansionary fiscal consolidations typically relate to very specific circumstances with strong external growth and exchange rate adjustments. All these conditions are not in place in the euro area. But also no: from an economic point of view, fiscal consolidations cannot be self-defeating. A reduction of public spending will typically result in a reduction in GDP but an even greater reduction in debt. At any reasonable multiplier, the deficit to GDP as well as the debt to GDP ratio will be lower compared to the case of no fiscal consolidation. Expenditure cuts thus do reduce fiscal vulnerability and are not self-defeating.

So should countries that are in a recession and face market pressure always enact a fiscal consolidation? That essentially depends on three things.

First, is the external borrowing position of the country sustainable? In the case of Greece, the current account deficit of almost 10% in 2011 suggests that domestic demand is still excessive and further cuts seem unavoidable. Avoiding fiscal consolidations will only sustain excessive demand and increase borrowing from abroad leading to more political and market pressure.

Second, does the economy have the capacity to grow externally? Again, the absence of significant price adjustments in Greece suggests that export growth is unlikely to pick up soon.

Replacing the external demand with internal demand created by large fiscal deficits will only delay the adjustment and increase the dependence of Greece on external funding.

Third, there is a social dimension. Fiscal cuts hurt people and lead to unemployment. If such cuts render the ability to reform the country impossible, it may be preferable to delay fiscal adjustment, a point made by my colleague Jean. But we should push this argument further:

Ultimately it means that fiscal transfers may be needed in monetary union if political, social and economic stability is the highest priority. Fiscal union is still incomplete. The situation is certainly different in every country of the euro area.