Is the EU fiscal stimulus sufficient?

Much of the recent comment on this blog has understandably focused on the specifically Irish angles in saving the banks and getting credit flowing again, getting on top of the government deficit and improving competitiveness. But any progress towards these goals in a purely Irish context will be set at naught if the global economy continues to head south. We thus have a vital interest in the success of the various stimulus packages intended to reverse, or at least reduce, the slide into global recession.

The IMF’s most recent World Economic Outlook update (published January 28th last) presented its third downward revision of its economic forecasts in just four months. It now projects global growth of just ½ per cent in 2009, with advanced economies expected to suffer their deepest recession since World War II. Collectively, advanced economies are expected to contract by 2 per cent in 2009 – the first annual contraction in the post-war period.

The importance of the external environment needs no underlining, even if there are very different views on how this will evolve. Garret Fitzgerald in his article in today’s Irish Times notes that the Department of Finance projections recently presented to the European Commission expected Irish output to fall by 4.5 per cent this year, while projecting growth during a subsequent 2010-2013 recovery at little over 2.5 per cent a year. He contrasts this with the ESRI December 2005 Medium-Term Review which examined the likely consequences for Ireland of a possible combined global credit crunch and Irish housing boom collapse, and which he argues foresaw a possible 5.5 percent growth rate during the recovery period (though I could not find this figure in the ESRI Review when I went to look for it). Garret opines that

“This suggests that, if the global economy does survive this crisis, we could end up better placed to resolve our borrowing problem than the Department of Finance expects”.

At the present time, Garret’s hopes for a healthy global economy look very optimistic. International trade, which is a key driver of economic activity for a small open economy such as the Irish one, is plummeting. The IMF estimates that (the value of) global merchandise exports fell by an extraordinary annualised 42 per cent in the three months to November 2008, in part because of difficulties in accessing trade finance. Against this background, the IMF warned that “Monetary and fiscal policies need to become even more supportive of aggregate demand and sustain this stance over the foreseeable future, while developing strategies to ensure long-term fiscal sustainability.”

IMF global production and trade
IMF growth in global production and trade Jan 2009

A recent paper by two economists at attempts to compare the size of the stimulus packages introduced by EU, US and China. Their methodology only counts impacts which will take effect in 2009, is designed to measure the active fiscal stimulus (and not the automatic stabilisers), and deliberately counts separately government-sponsored provision of extra credit to producers and consumers on the reasonable argument that its economic impact is not commensurate on a euro-for-euro basis with fiscal measures.

On their estimates, the fiscal stimulus breaks down as follows: for the US €199.6 billion or 1.8% of US GDP; for the EU, €112.5 billion or 0.9% of GDP, and for China €233.1 billion or 7.1% of GDP. The US figure is much lower than the headline figure in the Obama package because it only counts impacts which  take effect in 2009. The EU figure is only just over half the promised €200 billion stimulus agreed at the December 2008 European Council meeting, although if government-sponsored credit provision is included the EU target of a stimulus of 1.2% of GDP would be reached even by the end of 2009. But the question is, is this a sufficient contribution from the EU on the fiscal side to support aggregate demand in the coming year?

21 replies on “Is the EU fiscal stimulus sufficient?”

I have been inclinded towards the Blanchard/IMF view on fiscal stimulus where countries have the capacity. But Willem Buiter’s recent piece provides some distasteful food for thought. It’s well worth a look:

On the underlying growth potential of the economy: we must be concerned that the property boom masked a significant deterioration in the underlying trend. We can’t forget about the competitiveness/productivity agenda even as we struggle with crisis management.

The IMF has also produced estimates of fiscal stimulus for the G20 countries. See page 18. What stands out (to me) as much as the generally low stimulus for EU countries overall is the variation between them. Italy has almost no none at all and France is small. We can calculate an EU stimulus but there is no meaningful coordination behind it.

Actually, I disagree even with the way the question is being framed. I see no reason why all this fiscal stimulus will have any positive effect on aggregate demand anywhere.

The first effect will be to drive up the cost of public borrowing to a point where the private sector will be largely crowded out. Then, “crowding in” can only occur if the stimulus money is well spent – ie to support nascent industries with high long-term growth potential.

So far, we have only seen evidence that the opposite is happening. By recapitalising failed banks, the governments are in effect propping up the bad investment decisions which got the banks in hot water in the first place.

The rest of the money looks like it will be spent on sectors of the economy with low growth potential but vocal and trusted unions that can exert political pressure on the governments controlling the pursestrings. Peugot PSA and GM somehow come to mind…

Propping up monoliths and their failed financiers is bad enough, but doing so at the expense of innovation is a cocktail certain to be fatal for any future growth.

There is no private sector any more to be crowded out, just look at the rocketing unemployment figures. If the government employs previously unemployed people, then you can’t point to a private sector entrepreneur that is missing out on employees.

With high unemployment, the famous multiplier kicks in. Even if the government employs people to dig holes in and fill them in, the knock effect in the private sector will be larger; and most of those consumption and investment decisions will be made by private individuals according to the usual motives. So the productive work that is done will outweigh any small amount of potentially unproductive work directed by the state.

Can we have a thread here to sort out, once and for all, the debate over multipliers being greater than 1? And to prove that, during periods high unemployment, almost any stimulus programme will work (to the benefit of everybody) as long as the government directly purchases goods and services.


I’m unconvinced by this argument. If the government employs a man to dig a hole and fill it in, the deadweight loss to the economy is the productive labour which the man did not engage in during that time – in other words, the opportunity cost of the income paid to him. You may say that the economy is somehow failing to provide him with that alternative productive labour, and there may be a role for the government to help there, but the answer is certainly not in assigning him busywork.

In mathematical terms, multipliers have to be normalised intertemporally and across all production vectors in the economy; only then will they take account of deadweight loss. In other words, the promise of a multiplier of, say, 1.5 isn’t a justification for a fiscal intervention if it comes at the expense of a private sector investment which has a multiplier of 1.6.

Anyway, my issue was not really with labour, but with capital. What I think stimulus is about is forcing high returns on intrinsically worthless investments, thus making it hard for investment with real value to compete. We are a long way from the kind of prosperity that will allow us to idly dig holes all day.

Up until last year, there was consensus among economists that fiscal policy was largely ineffective. Nothing in economic theory has changed in the interim. Since government expenditure just heralds greater taxation, one would have to be “mug” to believe fiscal policy made you richer. Keep in mind, though, that, as a result of government incompetence, Ireland already has a large fiscal expansion in place.

In your hypothetical example, if there is declining private sector spending then its multiplier of 1.6 is harming the economy. If anything, that is an argument in favour of fiscal stimulus even if it’s only 1.5. The private sector has already ran out, and therefore cannot be crowded out; if anything the private sector will grow faster than the public sector when stimulus is in place.

This famous ‘consensus among economists’ is a strange beast. It’s like the ‘consensus’ amount ‘right thinking scientists’ that global warming isn’t man made 🙂

Seriously though, this shouldn’t be seen as a political or ideological argument; we have to look at the evidence of history. Decades of real world experience show that multipliers exist and that Keynes was essentially right. Full employment, and growing output, reigned from WWII up to the 80s, and unemployed soared (with falling output, if you discount the North Sea oil) under Thatcher because she, unlike Reagan, ditched Keynesian policies. And deflation, not inflation, is the threat now so even monetarists have to see the benefit of fiscal stimulus now.

Multipliers aren’t some weird financial theory – they are rooted in the real world of real people doing work. Give an unemployed man some money and he will spend it. A chain of previously unemployed people will be formed, each doing work they wouldn’t otherwise have done. So the government could spend $20 and $100 dollars of work could be done. Hence a growing economy rushes into surplus and we are all grateful for the stimulus because it meant that the debt burden actually decreases in the long term.

“Up until last year, there was consensus among economists that fiscal policy was largely ineffective.”

I think the consensus may have been that fiscal policy was inferior to monetary policy?

Sure, in normal times, if governments borrow they push up interest rates and crowd out private investment, but these are not normal times. Interest rates are near the floor, private consumption, investment and international trade have collapsed, the real economy (for advanced economies as a group) is contracting for the first time since the War, so there is no expenditure to be crowded out. Krugman makes the case here more eloquently than I can. In fact, economists across the political spectrum in the US support a fiscal stimulus at this time – see the views of Greg Mankiw former economic advisor to President Bush or the views of Richard Posner.

Clearly, the main constraint on using fiscal policy in the current crisis is the threat of long-term fiscal unsustainability, particularly in countries where ageing and rising health care costs will add to fiscal burdens in any case. Thus, it is clear that some countries are in a better position to launch a fiscal stimulus than others, and yet others, such as Ireland, had carried out such an extremely pro-cyclical policy in recent years that they don’t even have this option. Buiter’s blog post that John draws attention to above is also sceptical than fiscal policy in the US and UK will work because of the lack of a credible exit strategy in these countries – whether he is correct in this assessment or not I don’t know – but he is fully supportive of fiscal stimulus in countries with fiscal credibility.

It was in this context that I asked if people think that the EU as a group is doing enough or could be doing more?

To me, the fear of crowding out private investment and the fear of the government default on bonds is rather the same thing. The risk of default arises from an expectation that the fiscal impulse will generate less economy-wide value than it costs. If this were not the case, every bondholder could sleep soundly in the knowledge that the beefy multiplier attached to his fiscal investment would ensure sufficient Exchequer returns to pay him back.

The ‘cost’ of the stimulus is in turn set by the market. Bond yields are still pretty low right now, because money just isn’t very productive at the moment. But that doesn’t matter – what matters is that the yields are high relative to what private investments are paying out. That’s bad news, because it is these private investments that will create the recovery.

What’s wrong with Krugman’s piece in the IHT is that it fails to take account of the fact that the monetary economy is broken. But the solution to a broken monetary economy is not fiscal – that’s just like pouring oil into an engine that’s blown a gasket. And the Fed’s Interest rate tool is a bit like a clutch pedal with a broken clutch cable – you can press it as much as you like, but that won’t get you into gear.

So I am just going to stay out on my limb and contradict this consensus: These stimuli are a bad idea and they will hurt, not aid, the recovery, unless governments start spending the money in a much better way than they are doing at present.

That would mean getting back to supply-side basics: Identify market failures (externalities, myopia, informational asymmetry, imperfect competition) and correct for them. Saving General Motors is also like pouring oil into an engine that’s blown a gasket – in more ways than one!

Alan: I don’t think the EU is doing enough, but I also think this is inevitable given the current institutional set-up. This is a major problem for the Eurozone IMO. As a result, we are relying on an ECB that is still focussed on solving the problems of the 1970s rather than the problems of the 1930s. In the long run, I don’t think that the fiscal problems of a couple of peripheral economies will bring down the Euro. But, if the world economy keeps collapsing for a few years, and Frankfurt remains excessively cautious, that might do the trick.

If you’re looking for historical evidence, what about the 1930s and Roosevelt’s fiscal stimulus? As far as I’m aware that depression went on until 1940 and was only broken by a wolrd war, doesn’t sound like the stimulus back then had much effect. If it takes a world war and all the central planning that that involves to make a stimulus work, I’d rather have my freedom.

The so-called consensus in the US in favour of the proposed stimulus is receiving more and more criticism,Authorised=false.html?

What about the Mises school of thought, the government (the Fed) got us in to this mess so they shouldn’t be the ones trying to fix the problem. It’s largely a crisis of capital so cut taxes.

Ciaran, both Paul Krugman and Brad DeLong have ably debunked this revisionist view, I suggest you check them out.

Actually Kevin, Krugman is one of the main proponants of the “WW2 got the US out of the Great Depression” notion. See here:

In a similar vein he has also argued that the Japanese recession lasted so long not because the government was subsidising unprofitable firms, but rather they did not spend *enough* money. 100 trillion yen is not serious money for Krugman.

Krugman, and Alan Matthews above are already covering their tracks, claiming that the action being taken is not aggressive enough. How can you argue for something that can’t be proven? I guess that takes a bit of faith.

“…Krugman is one of the main proponants of the “WW2 got the US out of the Great Depression” notion.”

Yes, because it represented a suitably massive fiscal stimulus/public works programme.

…while imposing a command economy, rationing, diversion of resources from productive ends to non-productive ones, and forcing the unemployed to join the military and imprisoning those who refused. Not a very good formula for economic success.

Contrary to what the figures tell you there was no “wartime boom” nor a massive crash after it. Robert Higgs has done a lot of work into the economics of war. Surprisingly, it turns out war’s bad for the economy.

The economy got out of the recession once the price and wage controls were eliminated in 1946, and the uncertainty of the Roosevelt regime was put to rest.

It’s interesting that those who predicted and called the crisis are labelled “revisionists”, for example Peter Schiff in 2006:-

The savings may have come to the US from China but the Fed did not put any brakes on the increase in the money supply, and when combined with perverse incentives, the results were predictable.

Also this idea that giving someone money to dig a hole (and fill it back in again) represents a useful (or profitable) way to stimulate the economy seems to be taking things too far. Why don’t we give each person a million dollars and all become millionaires!!

The waste and pork in the stimulus represent a real deadweight loss and one which people will end up paying for through higher taxes and, no doubt, inflation.

Peter Schiff again on CNN World – 1st Feb 2009

This crisis was easily predictable, and the New Deal was too puny. Call one or both or neither of these statements ‘revisionist’ if you like, but both are true.

Schiff was adamant that decoupling would save the world economy, but was wrong. Roubini seems to be the most prominent name that was right about everything

Anyway, returning to your allegation about deadweight losses. Unemployed people scratching their ass all day is a deadweight loss. If you employ some of them to dig a hole, they will employ a few others when they spend the money.

All these cliches only apply to a booming economy in full employment. In a depression, it’s almost impossible for proper stimulus to fail.


What do you mean by “proper stimulus”? We already have economists claiming that the US and EU stimuli will not work becuase they “are not large enough”. As I said before, this is an excellent way not to have to reconsider your belief in Keynesianism.

And second of all, a recession ends when all the bad investments of the boom are liquidated and wages fall enough to re-employ the unemployed. So whereever Keynes and his ilk describe an “underempoyment equililibrium” they are talking nonsense. Clearly there is a massive disequilibrium where some wage or price isn’t allowed to adjust.

Just like no man ever spent his way to a fortune, no country will find the path to riches this way either.

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