A multi-country analysis of a decrease in government spending: The case of the European Union

The economic effects of fiscal consolidation policies have been the subject of intensive research. An influential line of research claims that contractionary fiscal policies could provoke an expansionary effect on output: this is the literature on the so called “non-Keynesian” effects of fiscal policy.

On the other hand, especially in the member countries of the European Union (EU), the preferred way of implementing consolidation plans has been by reducing government spending, rather than increasing revenues. This fact can be related to the standard result in the literature on fiscal policy and growth of a negative and significant effect of the level of public consumption as a percentage of GDP (which would proxy government size) on the growth rate of countries. However, the use of government consumption as a proxy for public expenditure is not very clear . In particular, a model intended to analyse the effects of fiscal policy on growth should consider instead some other components of public spending more directly linked to growth, such as government capital stock, as well as public transfers. In fact, from a long-term viewpoint, consolidation strategies based on cutting public expenditure items such as education, health care, R&D or public investments might harm future growth prospects.

Our aim in this paper will be to analyse the global effects, i.e., the effects on the world economy, of a decrease in the level of public spending in the EU. Faced with an increase in government deficits in most EU countries following the financial crisis that started in 2008, the EU authorities have endorsed the implementation of fiscal consolidation strategies, known as austerity policies. While only partially successful in reducing government deficits, such austerity policies have resulted in deepening the recession in most EU countries. Specifically, we will simulate the effects of a decrease in the level of public spending in the EU as a whole, and examine its effects on the main macroeconomic variables of seven regions of the world economy (namely, the EU, the US, Japan, China, Asia-Pacific, Latin America and the rest of the world). The empirical methodology will make use of a computable general equilibrium (CGE) model, which allows measurement of the consequences of changes in a particular variable on the whole economy under analysis, as well as the specific effects across the different productive sectors. Thus, the potential of the CGE models lies in their ability to integrate micro and macro elements.