May Austerity be Counterproductive?

Abstract

This paper investigates the impact that fiscal policy has on economic activity and sovereign debt during economic downturns in the euro area, mainly Germany and Spain. Our theoretical and empirical framework shows that the feasibility of austerity measures depends crucially on the values of the fiscal multipliers. We find that, for the Spanish economy, even if policy makers just focus on the public debt ratio, ignoring output and unemployment, policies of deficit reduction are self-defeating. In fact, counter cyclical policies beat deficit consolidation policies in driving the sovereign debt ratio to a more sustainable path, no matter if shocks are on aggregate supply or aggregate demand. By contrast, in the German case, we cannot reject the hypothesis that austerity may be the proper alternative in a sluggish economy.