Austerity in the European Union: Keynesian stimulus versus fiscal consolidation

Beginning in late 2008, the global financial crisis and the subsequent recession increased government outlays for transfer payments to households and reduced tax receipts in the European Union, the United States and other developed countries. Many governments saw the financial crisis as an opportunity to recapitalize private sector entities (failing banks, insurers and other industrial firms). Governments also initiated Keynesian “stimulus” programs including infrastructure and such programs as one-time rebates, increased transfer payments to households, unemployment insurance, and disability provisions. Government deficits and public sector debt as a percentage of GDP rose sharply. This period is characterized by the emergence of highly publicized fiscal and monetary difficulties in Portugal, Italy, Greece, and Spain. Beginning in late 2009, the rising private and public sector debt levels around the world coupled with the downgrading of government debt in the US and some European states led to fears of a sovereign debt crisis. Causes of the sovereign debt crisis varied by country as well as the efforts to address the problem.

Given the soaring federal spending and ballooning federal debt in some countries, it is not surprising that public support arose for austerity programs to reduce spending and get the federal debt under control. The ensuing public debate became an attack on Keynesianism and its proponents in the EU and elsewhere. Austerity proponents cited studies which showed that programs which relied predominately or entirely on spending reductions are more likely to achieve their goals of government budget deficit reduction and debt stabilization as a percentage of GDP than programs that rely primarily on tax increases.

Research by Alberta Alesina, Carmen Reinhart and Kenneth Rogoff, and others shows that in the long term, fiscal consolidation programs that reduce government spending as a percentage of GDP spur economic growth. In the short term, fiscal consolidation programs that rely predominately or entirely on spending reductions have been expansionary “non-Keynesian” effects that may offset the contractionary Keynesian reduction in aggregate demand. Evidence from several countries shows that in some cases, “non-Keynesian” effects may make fiscal consolidation programs expansionary in the short term.

This paper examines the underlying framework of competing Keynesian theories and the effects of fiscal consolidation on economic growth in the EU and several other countries, discusses lessons learned, and articulates limitations of Keynesian economic theory.