Thesis
THE EFFECT OF FISCAL CONSOLIDATION ON THE LEVELS OF
PRIVATE INVESTMENT IN THE EUROZONE DURING THE
GREAT RECESSION
Including Case Study of Ireland
by
Jasper Hendrik van Dijk University of Amsterdam
February 2015
Thesis Supervisor: Ms N. Ciurila
Abstract
This thesis aim is to make a contribution to the literature and discussion of the effects of fiscal consolidation on growth in the Eurozone. It looks at the change of private investment after the beginning of the financial crisis in 2007. It does this by researching the effects of different austerity driven policies on the levels of private investment. It has one case studie, Ireland. Where different channels through which fiscal consolidation can have an effect on private investment will be researched. Overall, we find that countries with the most severe austerity measures also had the worst development in private investment. For case study Ireland the effects of fiscal consolidation on private investment are hard to disentangle. The results we obtained tell us that, if private investment was positively influenced by the measures of fiscal consolidation, this was only after a few years. These findings come in contradiction with earlier research that finds positive effects on private investment in the short-term. The results should be taken with caution as a lot of exogenous factors could shed light on the importance of these factors in conjunction with the austerity measures.
Part 1: Introduction
The recession that followed after the 2007 Wall Street Crash struck the countries in the Eurozone hard. After the financial system worldwide, as a result of this crash, came to a hold and nations saw their economies slide into a recession, the growth rate of countries in the Eurozone reached an all time low of -4.5 % in 2009; and with an overall contraction of -0.5% in 2013, the Eurozone was four years later still not fully recovered from this severe shock1. The Eurozone countries mainly tried to fight this recession by measures of fiscal consolidation. This policy had, by cutting spending and raising taxes, the desired effect of lowering the mostly large public debts and to avoid a default of the countries on its debt obligations. This default was considered a possiblity by the markets during the so called sovereign debt crisis in the Eurozone. While implementing these austerity measures the countries also hoped their economies would be able to grow. The effects of this austerity driven policy during a recession on growth are widely discussed in the literature and are currently subject to debate2.
These measures of fiscal consolidation were also undertaken in order to commit to the criteria of public debt and government budget deficit written down in the Maastricht Treaty (MT) and further specified in the Stability and Growth Pact (SGP)3. The MT and SGP set a ceiling for countries, disallowing public debts going over 60% of the nation’s GDP. However, a lot of countries in the Eurozone had the years after the crisis public debt levels above the 60%. Beside that, during the implementation of the austerity measures and enforcement of the SGP, economic theory and research4, in support of fiscal consolidation in times of high public debt and economic downturns, was available and used by policy makers. The problem where this thesis looks into is, if the countries in the Eurozone were able to create
1 Data retrieved from Eurostat: http://ec.europa.eu/eurostat
2 See Guarjardo, Leigh & Pescatori (2011) and DeLong, Summers, Feldstein & Ramey (2012)
3 The reformed SGP of 2011 forced countries to follow the criteria written down by the EU countries in
the MT in 1991. EU countries have to bring down their public debt to a level lower than 60% of their GDP; the annual budget deficit can not be higher than 3% of GDP. SGP added punitive measures if countries fail to meet these criteria.
4 Reinhart and Rogoff published in 2010 a widely popular and later heavily critized paper called Growth in a time of debt, which analyzed the effect of austerity measures in fiscal policy in countries
with high public debt. It argued, among other results, that if the debt of a country exceeds 60% to GDP, the growth rate of GDP declined by 2%; stressing the importance of fiscal consolidation if
growth while implementing these austerity driven fiscal policies. And this thesis looks especially at one important aspect for growth, namely private investment.
What happens to private investment after fiscal consolidation is an important question to look into. Does private investment, as found by Alesina, Ardagna, Perotti & Schiantarelli (2002), rise after fiscal consolidation measures are implemented? Or does fiscal consolidation, as a result of a possible decrease of overall production, have a deprived effect on the levels of private investment? The effects of fiscal consolidation on private investment can contribute to the overall discussion of the effects of the implementation of austerity measures in the Eurozone.
In 2013 private investment contributed 19,3 % to the GDP of the Eurozone. Not as much as consumption (46%) or other components1 of the national account, but it still has a significant effect on a nation’s GDP. Therefore it is worth scrutinizing this component during recessions, when GDP is falling and there is need for growth.
This thesis will look at the change of private investment and the implementation of fiscal consolidation measures in the Eurozone during the Great Recession. This thesis has one case study: Ireland. Ireland is chosen because it experienced a strong decline in its private investment levels after the crisis began. The other reason is that Ireland implemented a lot of fiscal consolidation measures including severe budget cuts. To analyze Ireland and look at the consequences of fiscal consolidation, the different channels where fiscal consolidation can have an effect on private investment will be researched. These channels are business and consumer confidence, interest rates and domestic demand. Before this thesis will focus on the data, the next section will make an overview of the relevant literature surrounding this topic.
Research method
The outline of this thesis is as follows. First, the literature around fiscal consolidation will be discussed. Here, there will be an overview of the literature of the effects of fiscal consolidation on growth. Beside that, the different forms of fiscal consolidation and the different channels where fiscal consolidation can have an effect on private investment, will be discussed. This will all be linked to the current situation in the Eurozone. The third part will focus on the data of the different countries in the
Eurozone and will look at their private investment levels. After that Ireland will be discussed in more depth. Finally, the last part will examine the different channels which were discussed in the literature and will look, with appropriate data, what happened precisely with these channels in Ireland. This thesis will end with a conclusion of what role fiscal consolidation played on private investment in the Ireland after the financial crisis of 2007.
Part 2: Literature
Forms of fiscal consolidation
It is important, before discussing the literature around the effects of fiscal consolidation on growth and private investment, to begin with making a distinction in how a government can achieve fiscal consolidation. The government can achieve this on the income and expenditure side of their fiscal balance. Fiscal consolidation can be achieved by raising taxes, so as to raise the government income; if the fiscal consolidation mainly consits of raising taxes, it is called tax-based fiscal consolidation. The government can also implement fiscal consolidation by cutting its spending; expenditure-based fiscal consolidation. Both with the implied effect of narrowing the nation’s deficit and bringing down its public debt. A combination of both, cutting government expenditure and raising taxes at the same time with the same importance, is also possible.
Raising taxes during an economic downturn, as argued by Alesina, Favero and Giavazzi (2012) will affect growth negatively and will hurt the economy severely. This policy will make the recession where the country is in even worse and the country will experience a long and deep lasting recession. On the other hand,Alesina et al. argue adjustments on the expenditure side are accompanied by mild short lived recessions and the loss in the growth levels of a country are small. The main component that lead to this distinction according to the authors is private investment.
Alesina, Ardagna, Perotti and Schiantarelli (2002) describe that tax-based fiscal consolidation has negative effects on the levels of private investment. They found the opposite for expenditure-based fiscal consolidation, here private investment does not fall much, and actually quickly recovers and rises. This is, however not the
case for the other, beside investment, key motor for creating growth: consumption1, this stays low. The main difference between consumption and investment is caused by the levels of confidence; business confidence quickly picks up after expenditure based fiscal consolidation while consumer confidence stays low.
It is also important to make a difference in the consistency over time of fiscal consolidation measures. That as Alesina et al. (2002) find, also plays a role in the effects of fiscal adjustments on growth. It matters if the spending cuts are permanent or transitory. Alesina et al. find evidence that shows that adjustments which are permanent have lower negative effects on growth than spending cuts, which are, as they call “stop and go”. The country researched in this thesis, Ireland had fiscal plans covering several years so we can say no “stop and go” fiscal adjustments. This is further specified in part 4 of this thesis.
Fiscal stimulus
This thesis looks if the implied positive effects of fiscal consolidation during a recession on growth hold by looking at one aspect, private investment. Some economists like Summers and Krugman argue that the opposite of fiscal consolidation should be the government policy during a recession. They stress for the need of fiscal stimulus in a depressionary situation, so for an increase of the government expenditures. DeLong, Summers, Feldstein, Ramey (2012) argue that in a depressed economy, with interest rates at their zero lower bound2, also known as a liquidity trap, fiscal stimulus will boost the economy and is also likely to be self-financing. Erceg and Lindé (2010) called this a “fiscal free lunch”. This “free lunch” is the consequence of a higher than normal3 Keynesian fiscal multiplier, which will have therefore minor budgetary costs. This policy, they argue, will pull the economy out of the recession and should therefore be global government policy during economic downturns. Fiscal consolidation is not the right path, as DeLong et al. conclude in their article, it will be counterproductive and can even increase the debt of a country. The United States implemented a mild form of fiscal stimulus after the financial crisis. This was not the case for the countries in the Eurozone. For these
1 See Alesia, Alberto and Ardagna, Silvia. “Fiscal Adjustments: Why They Can Be Expansionary” Economic
Policy: A European Forum, October 1998, (27), pp. 587-‐517
2 With interest rates close to zero, one could argue that the Eurozone hit the zero lower bound.
3 With ‘normal’ we mean a situation where a country is not in a recession or depression and has steady
countries the fiscal stimulus packages were neglectable with the much larger fiscal consolidation measures undertaken (Pontussen & Raess 2012). Because this thesis looks only at the Eurozone and the effects there of fiscal consolidation, the literature around fiscal stimulus will not be discussed in more depth. See Blanchard & Leigh (2013)for more informationof these Keynesian effects of fiscal policy.
Expansionary fiscal consolidation
Proponents of fiscal consolidation argue that austerity will reduce countries debt burden and it will help to pay back its creditors, this with the desired effect of not negatively affecting growth. This is the policy that was implemented by countries in the Eurozone after the financial crisis. Former European Central Bank president Jean-Claude Trichet was advocate of this policy and in an interview with La Republica stated that “confidence-inspiring policies will foster and not hamper economic recovery”. These positive effects on growth are known as “expansionary fiscal consolidation” or “expansionary austerity” (Pescatori, Leigh, & Guajardo, 2011) and are as Trichet argued, policies with the desired effect of letting confidence rise.
So proponents of fiscal consolidation argue that fiscal consolidation is the right path to follow during a recession, and as the fiscal adjustment is expenditure- and not tax-based, it will hopefully not hurt the economy severely. A reason why proponents of expenditure based fiscal consolidation argue it is the right thing to do during a crisis is the role private investment plays here. Fiscal consolidation will have as stated by Alesina, Favero and Giavazzi (2012) a positive effect on private investment and the private investment levels will, as they argue, rise quickly after the fiscal adjustments of the government were implemented. Private investment will be an important component for the effects of the “expansionary fiscal contraction”.
The channels
It is important to discuss the literature and theory around different channels where fiscal consolidation could have an influence on private investment before looking at the data.
One important channel works through confidence and this channel is dubbed the “confidence channel” by Perotti (2011).Investors can have confidence that, after implementation of fiscal consolidation measures, their planned investments will turn out profitable and they will adjust their investment levels accordingly.
Alesina, Favero and Giavazzi (2012) argue that business confidence, unlike consumer confidence, picks up immediately after the start of an expenditure-based adjustment of fiscal consolidation. With the increased confidence this might have, as discussed above, a positive effect on the private investment levels in that country. The potential increase in confidence has several underlying reasons. One reason why private investment will increase through the confidence channel is that lower government spending can mean lower taxes in the future and therefore higher households’ wealth, so higher consumption. If investors know people are going to consume more it can be more profitable to invest.
Beside that, Perotti argues that fiscal consolidation in some cases can make a process of wage moderation more credible, as taxes may decrease in the future. This wage moderation can make production cheaper and can boost exports making it more attractive to invest in the economy. Overall a change in the confidence of consumers and businesses might affect the levels of private investment.
The second channel are the interest rates. If interest rates fall they could positively influence the private investment levels, as lower interest rates makes it cheaper to borrow and more expensive to save, which could spur investment. These interest rates could also be linked to the previously discussed “confidence channel” as shown by Alesina et al. (2002). They argue that fiscal consolidation can reduce the risk premium on the interest rates, and can therefore reinforce the decline of these rates. This will be researched by looking at the interest rates a government pays on its bonds; as fiscal consolidation could make a default risk less likely and therefore lowering the risk premium on government bonds, which can cause government bonds interest rates to fall.
The third channel where fiscal consolidation could have an effect on private investment is the demand in the economy. Guajardo, Leigh and Pescatori (2011)find in their research of the effect of fiscal consolidation in OECD countries that after fiscal consolidation measures private investment decreases. This is the opposite as Alesina et al. found in their research. Guajardo et al. argue this is because private investment is influenced by the overall levels of demand and total demand decreases, they argue, after measures of fiscal consolidation.
Criticism confidence channel
The previously discussed confidence channel is criticized by Krugman (2010), a strong opponent of austerity driven policies during recessions, and coined the implied positive effects of fiscal consolidation on confidence the “confidence fairy”. Krugman argues that fiscal consolidation will make a recession only worse and that the need for austerity rests on a “foundation of fantasy”: the rise of confidence will not offset the harm done on growth by the austerity measures. Krugman points to Ireland having a depression partly because of those austerity measures.
Another paper which criticized the implied increase of confidence as a result of fiscal consolidation is Blanchard and Leigh (2013). They found as they looked at 27 different European countries, that fiscal multpliers in the years after the financial crisis in 2007 were much higher, than initially thought they were during the crisis. High fiscal multipliers are important when discussing the effect of fiscal stimulation or consolidation, because they measure the effect of government fiscal adjustments to the economy. During the crisis European policy makers thought that the positive confidence effects of fiscal consolidation could partly overset the effects of the fiscal contraction; thinking the fiscal multipliers were small. Blanchard and Leigh found that did was not the case and as a consequence the applied fiscal consolidation had the effect of lower economic growth than initially was expected.
Eurozone and fiscal consolidation
This thesis is focused on the effect of the policy measures undertaken by countries in the Eurozone after the financial crash in 2007. The policy measures undertaken were mainly adjustments on the expenditure side of the fiscal balance, as we will see more closely when discussing Ireland. These measures were mainly undertaken, because the Stability and Growth Pact and the Maastricht Treaty forced the countries to keep their budget deficit under the 3 % and their total debt-to-GDP ratio under 60%. Punitive measures as described in the SGP can be undertaken if a countries does not undertake the right measures to achieve this. Beside that, the countries suffered from high levels of public debt so fiscal consolidation was necessary as to avoid a default of the countries on their debts.
The next parts will research what effect this fiscal consolidation has on private investment. This will be done by looking at the Eurozone countries’ levels of private
investment and will look if there are differences between countries. After that there will be two case studies Ireland and Portugal.
An important note is that for comparing countries inside the Eurozone it helps that those countries have the same monetary policy, which is done by the European Central Bank. And the data is not disrupted by changes in the monetary policy between countries, because there is simply no difference between countries in monetary policy.
Part 3: Eurozone
This part will look at the private investment levels of the Eurozone after the financial crisis of 2007 and will look at differences between the Eurozone countries. After that Ireland will be researched in further depth. For Ireland the different channels where fiscal consolidation can have an effect on the levels of private investment will be researched.
Data fiscal consolidation
As mentioned before, this thesis will look at the years 2009-2013: the years after fiscal austerity measures were undertaken around different countries in the Eurozone.
The problem is that fiscal consolidation is hard to measure; it is not enough to look at government spending and revenues. This is because government expenditure and revenues are influenced by numerous different factors in the economy and not just the amount of expenditure cuts, or tax increases a country implements.
The main problem in generating data of fiscal consolidation is that the government budget is correlated with economic activity. So, the government budget is not only influenced by policy actions, like increasing taxes or cutting spending. To give an example for this correlation, one could think of the rise in unemployment during a recession. This rise of unemployment will increase the government’s expenditures, this is because the government has to pay more social securities for the unemployed. It will also decreases government revenues, because the unemployed will pay less taxes. Beside this unintended effect of economic activity on the government budget, there are also other factors that can have an effect on the
government budget, like interest rates on government bonds and the costs for bailing out banks.1
To measure the amount of fiscal consolidation is, as discussed above, problematic and precise data of fiscal consolidation in the Eurozone after 2009 is not present. However, there is data available of announcements of fiscal consolidation measures of several governments in the Eurozone, where they announce the implementation of different expenditure cuts and tax increases. This data could be taken into account and these government announcements could be linked to shocks in private investment.
Private investment Eurozone
First, we look at what happened to the private investment levels in the Eurozone in the years after 2007. Figure 1 shows the development of total private investment in the Eurozone in those years. We see that private investment first rose from 2007 to 2008, but after the financial crash in the United States, and the consequential Great Recession there is a drop in private investment. After 2009 the private investment levels remained relatively stable and in 2011 there was even a small rise. These are the years this thesis will look more closely at, because in these years fiscal consolidation was mainly implemented in different countries in the Eurozone2.
Figure 1: Development private investment Eurozone
Note: Figure set 2007=100. Source: Eurostat database
1 For more information and problems with measuring fiscal consolidation see Romer & Romer (2012)
and for a dataset of fiscal consolidation and its problems see Pescatori, Leigh, Guajordo & DeVries (2011).
2 For more information about fiscal consolidation measures in Europe see Barrios, Langedijk & Pench
(2010) 80 85 90 95 100 105 2007 2008 2009 2010 2011 2012 2013 Ch an ge p ri va te in ve st m en t Years Eurozone (18 countries)
Figure 2 gives a closer look at the change of the levels of private investment of the individual countries in the Eurozone. In this graph the pre-recession year 2007 is the starting point (100); before this year GDP and private investment levels were still rising, but after 2007 they experienced a large drop. Interesting is the dissimilarity one can observe between the different countries; a few countries saw their investment levels rise (Luxembourg, Austria, Belgium, Denmark), while others suffered from a large drop in their private investment levels. Interestingly, the largest decrease in private investment was among countries that implemented severe austerity measures, like Ireland, Portugal and Greece.
So from figure 2 it appears that in countries like Greece, Spain, Portugal and Ireland the fiscal consolidation measures did not have a positive effect on the development of private investment. These countries had more severe austerity measures than countries like Luxembourg, Germany and Finland1; these countries show an increase in their levels of private invesment. An important note here is that the countries which implemented more severe austerity measures could possibly also have other problems that negatively influenced their private investment levels. For example one could think of a more troubled banking system.
Most of the fiscal consolidation measures were undertaken in 2009 and therefore we should look what happened with private investment in the countries the years after. The private investment levels in Ireland were after 2009 still on a low level, but seem not to drop even further; it is important for our analysis to discover what is behind this effect precisely. Analyzing Ireland would give more answers how fiscal consolidation can have an effect on private investment.
Therefore the next section will look at Ireland more closely and will look at the timing of fiscal consolidation. This to see if this timing had an effect on the development of its levels of private investment. After that, this thesis will look at the different channels in Ireland where fiscal consolidation can have an effect on private investment.
1 For an overview of fiscal consolidation measures in different Eurozone countries see Barrios,
Figure 2: Private investment in different Eurozone countries (1)
Note: Figure set 2007=100. Source: Eurostat database
Part 4: Ireland
Before discussing Ireland’s performance after the financial crisis of 2007 and looking at its private investment levels, it is important to make a short overview of the performance of Ireland in the years before its bubble on the housing market burst and Ireland came in a severe recession.
Ireland was initially one of the most underdeveloped countries of Western-Europe. But in the 1990s this changed; Ireland achieved high levels of growth, in 1997 for example its GDP grew by 10.7%. Its per capita GDP even surpassed the one of its neighbour the United Kingdom. Because of this impressive levels of growth the metaphor Celtic Tiger was coined to Ireland (Donovan & Murphy, 2013)1.
From 2002 the nature of the boom of Ireland as Donavan & Murphy describe, began to change and a large bubble on the housing market started to emerge. At the height of the housing market boom, the value of assets in Ireland’s banks amounted to
1 For more information about Ireland’s rise and fall see the book by Donovan & Murphy, The fall of the
Celtic Tiger – Ireland & the Euro Debt Crisis
0 20 40 60 80 100 120 140 2007 2008 2009 2010 2011 2012 2013 EU (28 countries) Euro area (18 countries) Belgium Denmark Germany Estonia Ireland Greece Spain France Italy Luxembourg Netherlands Austria Portugal Finland
five times its GDP. And the real estates loans of its domestic banks were close to 30 percent of all loans given out in 2006. The bubble burst in 2008 and the housing prices fell 36% in 2010 from its peak value in 2008 (IMF Survey Magazine, 2010). Trying to save the then frozen financial system and protect Ireland from the consequences of an even more severe crash, Ireland’s government recapitalized the banks. This was paid out of public funds, which had the consequence that Ireland’s public debt rose the years after. Additionally, the government decided to guarantee the bank’s liabilities, which had the result that the bank debt was also added to Ireland’s public debt. As we can see in figure 4 Ireland’s public debt rose sharply the first years, as only to stagnate in 2011 and in 2012 there was a small increase (Donovan & Murphy, 2013).
The assistance from the Irish government to the banks was not enough. In November 2010 the Irish government received a bailout of €85 billion. This money had to be used to further liquidate the Irish banking sector and to cover partly the government’s budget deficit, so as to prevent Ireland’s bankruptcy. Without this bailout Ireland would have come into trouble paying its creditors. The bailout was given by the IMF, the European Financial Stabilization Mechanism1 and the European Financial Stability Facility2. The main goal of this support package as the IMF stated, was to restore confidence and financial stability. It did this by demanding that Ireland had to recapitalize, downsize and reorganize its banks. Beside that Ireland had to strengthen the bank supervision (IMF Survey Magazine, 2010).
Fiscal consolidation measures and the National Recovery Plan
From 2008 on Ireland implemented several fiscal consolidation measures, to try to get the country out of the recession and controlling its then large public debt. In figure 5 there is an overview of all the fiscal adjustments Ireland undertook in those years. As one can see the larger adjustments began in 2009 and a year later in December 2010, a month after its bailout, Ireland announced the National Recovery Plan (NRP), which had the largest fiscal adjustments of the reported years.
The National Recovery was a four-year austerity plan which consisted of cuts on the expenditure side and tax increases on the revenue side. These savings
1 Set up by the Eurozone countries to allow the EU to borrow money to grant financial assistece to member
states.
accounted to 9 percent of Ireland’s GDP. The amount of expenditure cuts (€10 bn) forecasted in the plan were twice as large as the forecasted revenues of the tax increase (€5 bn) (Hardiman, 2013).So we can say it was mainly an expenditure-based fiscal consolidation. Which is relevant in the discussion of the effect of fiscal consolidation on private investment as discussed in part 2 and found by Alesina et al. (2012).
In most of the graphs discussed below the NRP is indicated as an important point, when looking at the effects of fiscal consolidation. This is done because of two reasons. First, as discussed above after the NRP plan was the start of large fiscal adjustment to the Irish economy and the first long-term plan of the Irish government for fiscal consolidation. Secondly, it marks the years after the Irish bailout. Which can be seen as an important point in Ireland’s crisis.
Figure 4: Ireland’s debt to GDP & net lending/net borrowing
Note: all the values are in percentages Source: Eurostat database
0,0 50,0 100,0 150,0
2007 2008 2009 2010 2011 2012 2013 Ireland's debt to GDP
2007 2008 2009 2010 2011 2012 2013 Ireland 0,2 -‐7,0 -‐13,9 -‐32,4 -‐12,6 -‐8,0 -‐5,7 -‐40,0 -‐20,0 0,0 20,0
Figure 5: Overview fiscal consolidation measures Ireland
Time Intervention Budgetary measures Size of fiscal
adjustment
July 2008 Expenditure
adjustments Efficiency cuts €1 bn
October 2008 Budget 2009 Income levy; spending
cuts, including welfare
€2 bn
February 2009 Expenditure
adjustments
Cuts to public sector pay €2.1 bn (€1 bn in 2010)
April 2009 Supplementary
budget
Tax increases esp. levy €5.4 bn
December 2009 Budget 2010 Spending cuts on all
welfare; tax increases
€4.4 bn
December 2010 Budget 2011 Current cuts, capital cuts;
tax increases
€10 bn cuts, €5 bn tax (National Recovery Plan 2011-2014)
December 2011 Budget 2012 Current cuts, capital cuts,
tax increases €3.2 bn
Adjustment 2008-2011
€20.8 bn
Projected overall adjustment 2008-2014
65 % Expenditure €29.6 bn 35 % Revenue
Source: Hardiman (2013)
Private investment
Figure 6 shows the development of the levels of private investment in Ireland after the financial crisis. As one can see initially private investment experienced from a large drop and at the end of 2010 private investment stabilizes. This was after the announcement of the NRP, marked by the dark blue line.
Figure 7 shows the change in private investment and the change in government debt; both have the year 2009 (=100) as starting point. Here we observe that the stagnation and stabilization of private investment was accompanied by the stagnation of Ireland’s public debt. So the measures to bring down its public debt (fiscal consolidation) went along with a stagnation of its private investment levels.
Beside the NRP there were also smaller fiscal adjustments as showed in figure 5. These measures, which were implemented before the NRP, did not have an effect
as far as we can see in the graph and private investment still decreased. Important note here is that the fiscal adjustments take time to implement and the announcement of an expenditure cut is not the same time as the actual fiscal adjustment. But overall there is a minor to no effect observable in the levels of private investment. And what Alesina, Favero and Giavazzi (2012) found in their research, that after measures of fiscal consolidation private investment quickly rises. We do not observe that here in the figure. But there may be other factors that infuenced the levels of private investment and pushed these levels downwards beside the measures of fiscal consolidation.
A factor could be the troubled Irish banking system. The banks engaged, prior to the crisis, in high risk lending to commercial and residential property sectors. The values of these sectors plummeted after the beginning of the financial crisis when the bubble on the housing market burst. Dellepiane & Hardiman (2012) describe, that as a result of the large amount of distressed loans the banks hold after this burst, the banks were in 2009 not able to lend to the business sector. The Irish government tried to liquiditate the banks by several measures, but the question is in what extend this helped. Therefore, with banks in trouble, it could have been difficult for investors to get the necesary funds to do their investments and therefore could have had a negative effect on the private investment levels in Ireland (Honojan, 2009).
So private investment underwent a sharp decline and stabilized in 2010. But the question is if the stop in the falling of investment levels is due to fiscal consolidation measures like the NRP, or that there were other factors in play. Another possible reason could be that the levels of private investment simply hit a bottom level and therefore could not decrease any further. If we go back to figure 2, we saw that the initial drop in the levels of private investment in Ireland was large compared to other Eurozone countries, which could imply that private investment was at an extremely low level and could not fall much further.
To conlude, the effect that private investment picks up shortly after fiscal consolidation measures are implemented, as Alesina et al. (2012) found, we do not observe for Ireland. But to see if the stabilization of private investment, we see in figure 6 and 7, was due to fiscal consolidation and to see if there was a possible positive effect of this fiscal consolidation on private investment, it is important to look at the different channels where this effect could be explained. This will be done in the next section.
Figure 6: Private investment levels Ireland
Note: dotted dark blue line is the announcement of the NRP Source: Eurostat database
Figure 7: Change Debt to GDP and change private investment
Notes: dotted dark blue line is the announcement of the NRP; 2009 is set 100; left axis is change private investment and right axis is change debt to GDP.
Source: Eurostat Database
0 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000 2008 2009 2010 2011 2012 2013 T ot al P ri va te In ve st m en t Years 0 50 100 150 200 250 0 20 40 60 80 100 120 2009 2010 2011 2012 2013 Private investment DEBT GDP
Consumer confidence
The first channel to be researched is consumer confidence. Consumer confidence is an important indicator for economic growth and important for measuring the “confidence channel” as discussed in part 2. Figure 8 shows the levels of consumer confidence taken out of monthly surveys conducted by national institutions in the member states and collected by the European Commission (EC). The EC has the goal of harmonizing the surveys between the countries, as to make sure the countries ask the same questions in those surveys.
In the graph the blue line indicates the announcement of the National Recovery plan. And as one can see the level of consumer confidence remained relatively stable and low the years after. Consumers still did not have confidence in an improvement of the economy as the data shows. Only at the end of 2013 confidence grew; several years after the announcement of the first austerity measures. Chief economist Austen Hughes of KBC Bank Ireland argued this rise in consumer confidence is because of the state of the Irish economy: “It seems to reflect a range of good news on the Irish economy and, critically, growing expectations of a notably easier Budget” (Reddan, 2014). Interestingly and quite paradoxically, as Hughes argues the consumer confidence rise is partly the effect of a less severe fiscal consolidation program instead of an increase in more fiscal consolidation measures1.
Alesina et al. (2012)found,as discussed in part 2,that fiscal consolidation had a positive effect on consumer confidence in the long run. The data of consumer confidence in figure 8 slighly supports this view; only after a few years after the first announcements of fiscal consolidation measures, consumer confidence picks up. However, this also overlaps with the ending of the austerity program, hence this can also suggest a neutral effect of fiscal consolidation on consumer confidence. This effect, of an increase in consumer confidence after several years, does not correspond with timing of the stabilization of the levels of private investment after the anouncement of the NRP.
To conclude, if we look at the levels of consumer confidence and the levels of private investment we can, on basis of the graphs of consumer confidence and the levels of private investment, say that consumer confidence possibly did not influence the levels of private investment.
1 Paradoxically in respect to what Alesina et al. (2012) found, as discussed in part 2. Where more fiscal
Figure 8: Consumer confidence
Note: Anouncement NRP indicated with dotted line
Source: European Commission, business and consumer surveys
Figure 9: Diagrams of business confidence
Source: KBC Bank Ireland business confidence, October 2014.
http://www.kbc.ie/media/BusinessSentimentQ3141.pdf -‐35 -‐30 -‐25 -‐20 -‐15 -‐10 -‐5 0 5 10 15 ja n. -‐1 0 mr t.-‐1 0 me i-‐1 0 ju l.-‐1 0 se p. -‐1 0 no v. -‐1 0 ja n. -‐1 1 mr t.-‐1 1 me i-‐1 1 ju l.-‐1 1 se p. -‐1 1 no v. -‐1 1 ja n. -‐1 2 mr t.-‐1 2 me i-‐1 2 ju l.-‐1 2 se p. -‐1 2 no v. -‐1 2 ja n. -‐1 3 mr t.-‐1 3 me i-‐1 3 ju l.-‐1 3 se p. -‐1 3 no v. -‐1 3 Co n su m er c on ?i d en ce Time
Business confidence
The OECD and Eurostat do not have any data of business confidence for Ireland and Ireland is the only Eurozone country omitted in their data. Because business confidence is important in our analysis of Ireland and the private investment levels, data from private institutions is used. In figure 9 business confidence is showed measured by the Irish KBC bank in October 2014.
After the financial crisis struck Ireland in 2008, we see from diagram 2 (figure 9) business confidence dropped. When asked businesses indicated that their company’s level of business mainly decreased. These levels stabilised in 2010 and at the end of 2012 more businesses indicated an increase, instead of a decrease of their company’s level of business.
Diagram 3 gives an indication how Irish businesses see the future. This shows a similar story as diagram 2. With the difference that in 2010, after the announcement of the NRP, there is an increase in the number of responders who expect an increase in business activity. This increase modestly rises in the years 2011 and 2012, and in 2013 and 2014 this level of confidence rose strongly. As we have seen before in these years consumer confidence saw a big rise as well.
The question is if business confidence influenced the levels of private investment. The stop in decline and stablization of the levels of private investment, as discussed before, follow a similar path as the increase in business confidence as showed in diagram 3, so a correlation might exist. But note here, that it is hard to see what is the causality. Did the increase in private investment increase the business confidence or did as an effect of a rise in business confidence private investment increase?
As discussed before and found by Alesina et al. (2012) that business confidence, unlike consumer confidence quickly picks up after fiscal consolidation measures. This was one of the prerequisites why fiscal consolidation could have a positive effect on private investment. We can see this effect in a mild form in the graph. Business confidence did increase, but not severely and the real increase occurred only after a few years in 2013, this was also the time when consumer confidence rose.
To conclude, as Alesina et al. (2012) found, that business confidence quickly picks up after measures of fiscal consolidation, we can see in a mild form in the graph. Business confidence picks up, but the real increase is only after several years.
This increase could be the consequence of the implemented austerity measures by the Irish government, implying a positive effect of fiscal consolidation on business confidence.
Interest rates
This part looks at the interest rates channel and the effect of fiscal consolidation on interest rates. Beside that, it looks if interest rates help explain the stabilization of private investment after the announcement of the NRP.
Figure 10 displays the long-term interest rates: the interest rates Ireland pays on its long-term government bonds. As discussed before, fiscal consolidation measures could take time to implement and fiscal consolidation therefore, could have an effect on the interest rates only after several years. The fiscal consolidation measures the Irish government implemented had the desired effect of lowering its large public debt and lowering the interest rates Ireland pays for issuing new government bonds, by reducing the default risk and the risk premium. So it is possible the fiscal consolidation measures could have lowered the interest rates.
As showed in figure 10, the long-term rates were stable the years before the crisis and in 2010 these rates rose severely as the deficit and public debt of Ireland rose. This was also, as discussed before, the time of the Irish bailout.
The NRP is again shown in the graph. We see, after the announcement of the NRP and the implementation of fiscal consolidation measures the years after, first a rise and then a quite stable decline of its long-term interest rates. It is hard to say if the decline in the interest rates of Irish government bonds was due to the fiscal consolidation measures or due to the Mario Draghi 2012 ECB speech: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”1. This could have pulled the already decling rates down even further. A combination of both is also possible.
But the decline of the interest rates could have been caused by fiscal consolidation measures implemented by Ireland. If so, than through this channel Ireland could have affected its levels of private investment positively: the decline of interest rates were at a time the private investment levels stabilized. But there is no
1 This speech gave investors confidence ECB would do whatever it takes to make sure the euro would
succeed and countries would not leave the euro or default. Leading to a decline of the interest rates on different Eurozone countries’ bonds.
effect observable of interest rates in the short run on private investment. And as discussed by Alesina et al. (2012), the effects of fiscal consolidation on private investment happen mainly in the short run.
Figure 10: Long-term interest rates Ireland
Notes: The blue dotted line is the announcement of the NRP and the red dotted line is Draghi’s speech (see text). Long-term bonds are calculated as monthly averages. They refer to bonds with a maturity of 10 years traded on the secondary market.
Source: OECD stats
There are exogenous factors, beside Ireland’s fiscal consolidation meaures, that could have an influence on Irish interest rates. For example Ireland shares his currency with other Eurozone countries and its monetary policy is conducted at a transnational level at the ECB. Figure 11 shows, beside the interest rates in Ireland, also the interest rates in Germany1, the European Union and the Euro area.
From figure 11 we can see, as we compare Irish interest rates to the other Eurozone countries, that the big rise in interest rates was typical for Ireland. The spread, indicitated with light blue in the graph, shows the difference between the interest rates in the eurozone and that of Ireland. From this it is possible to make a
1 Germany is chosen, because it had the years after the crisis the lowest interest rates on its government
bonds and is therefore useful for comparison.
0,00 2,00 4,00 6,00 8,00 10,00 12,00 14,00 2008M 01 2008M 05 2008M 09 2009M 01 2009M 05 2009M 09 2010M 01 2010M 05 2010M 09 2011M 01 2011M 05 2011M 09 2012M 01 2012M 05 2012M 09 2013M 01 2013M 05 2013M 09 2014M 01 2014M 05 2014M 09
stronger claim of the effects of fiscal consolidation on interest rates: after Ireland had its public debt under control and its deficit shrunk1, the interest rates fell as well. From this, we can say that, it could be the case that the focus on fiscal consolidation and therefore the focus on controlling its large public debt had a positive effect on the interest rates2.
What we can conclude and what is important in our analysis of private investment, is that after the announcement of the National Recovery Plan, with a lag, the long-term interest rates decreased; a decrease in interest rates helps investors and businesses and could have positively affected the levels of private investment. This decrease was at a time the private investment levels stabilized and could therefore had a positive effect on private investment. It is difficult to say this decrease in interest rates is only due to the austerity measures undertaken, but the accompanied shrink in Ireland's public debt and government deficit implies a causality.
Figure 11: Long-term interest rates of Ireland, Germany, European Union and the Euro area.
Notes: The blue dotted line is the announcement of the NRP and the red dotted line is Draghi’s speech (see text). The spread is the difference between interest rates on Irish government bonds and the average of interest rates of government bonds of all Eurozone countries.
Source: Eurostat
1 See figure 4
2 Still, there might also be the effect of Draghi’s speech. The speech had the effect investors got more
confident in Eurozone countries that were in struggeling with large public debts with decling interest rates as a consequence. Interest rates in Germany increased after Draghi’s speech. This because other countries were considered less risky and more bonds were bought of those countries at the expense of the then popular bonds of Germany.
-‐2,00 0,00 2,00 4,00 6,00 8,00 10,00 12,00
Ireland’s GDP
Another channel that could influence the levels of private investment is total or aggregate demand, which will be measured here by looking at Ireland’s GDP. As discussed before, Guajardo, Leigh and Pescatori (2011) found that private investment decreases after measures of fiscal consolidation, this is they argue, because demand in the economy decreases as a consequence of those measures.
Figure 12 shows, beside the change in private investment, the change in GDP, household consumption and government expenditure. First, we see that private investment shows a stronger relative decline than Ireland’s GDP, but stabilizes at quite the same time. It is hard to say if the stabilization of private investment is due to the nation’s GDP from this graph: they will often follow a similar path, as private investment is included in a nation’s GDP. Guajardo, Leigh and Pescatori argue that private investment will not increase after measures of fiscal consolidation, as there is a lack of demand. This could be the case why private investment is not increasing from 2010 on. But this is a difficult causality and needs further research.
The graph also shows other main components of Ireland’s GDP. It is interesting to see that consumption suffered from a less extreme drop and stabilized quicker than the levels of private investment. This could contradict what Alesina et al. (2012) found: based on their findings they argued that private investment quickly rises after fiscal consolidation measures were implemented and consumption takes a long time to pick up. This does not correspond with what we see in the graph and one could expect a quicker and more substantial rise of private investment than we see here.
Figure 12: Change in GDP, private investment, consumption and government expenditure.
Note: starting point is 2007 (=100) Source: OECD statistics
Conclusions Ireland
After the financial crisis hit Ireland in 2007 the levels of private investment declined substantially. This decline stopped in 2009 and the levels slightly increased the years after; these were the years where a lot of fiscal consolidation measures were implemented. The results we obtain do not show, as Alesina et al. found, a big rise in the levels of private investment after the implementation of austerity measures; and therefore, the case of Ireland mainly contradicts Alesina et al. findings. Important here is that there could be other factors in play that pulled private investment downwards and hence concealed the fact that fiscal consolidation might have a positive impact on the levels of private investment in Ireland.
One of these factors could be the bad condition of Ireland's financial system with its underliquidated banks. With the banks in trouble it could have been hard for investors to collect the necessary funds for an investment.
If we look at the different channels, where fiscal consolidation could have had an effect on private investment, we see that business confidence picks up after the announcement of the consolidation measures. But a substantial increase is only observable after more than a year. Alesina et al. findings suggest that business confindence quickly picks up after the fiscal adjustments, this is not the case for Ireland. However, the rise of business confidence could have had a positive effect on the levels of private investment.
0 20 40 60 80 100 120 2007 2008 2009 2010 2011 2012 2013 GDP Government expenditure Household consumption Investment
If we look at consumer confidence, we see that confidence increased only after several years, which was at the end of the austerity program. It suggests a neutral impact of fiscal consolidation on consumer confidence.
For the interest rates channel, the findings suggest that fiscal consolidation measures did have an effect on Ireland's interest rates, but only after several years. This effect could be the result that these measures of fiscal consolidation lowered Ireland's deficit and public debt. Which had the consequence the interest rates on government bonds went down and these lower interest rates could have had a positive effect on private investment.
The last channel researched was total demand. Here we saw a drop in Ireland’s GDP. This could have influenced private investment, but it is hard to say if there is a causal relationship here.
What we can conclude is that what Alesina et al. found in their research is overall not the case for Ireland; private investment did not quickly rise after fiscal consolidation measures were implemented. Fiscal consolidation could have had a positive effect on private investment, but than this effect was small and only after a few years. An important note here is that the overall relation between fiscal consolidation and private investment is hard to disentangle and what other exogenous factors could have an influence on private investment is an important topic for future research. But compared to other Eurozone countries which implemented less austerity, Ireland performed worse. The fact that, although fiscal consolidation could have positively affected private investment in Ireland in some aspect, the overall effect of fiscal consolidation was not what the findings of Alesina et al. would suggest.
Future research recommendations
For future research it is important that the different channels will be researched more deeply, as to discover the relationship between fiscal consolidation and private investment. This relationship could also be researched by asking investors why they started or why they stopped investing. Beside that, including a channel which could link the troubled Irish banking sector with the levels of private investment can give more insight in the development of private investment and this would help to distinguish the effects of fiscal consolidation and the effects of the banking sector on the levels of private investment. If a good database of the different fiscal
consolidation measures becomes available, future research could focus on comparing the different countries in the Eurozone. Then, the relationship between fiscal consolidation and private investment could be analyzed through an econometric estimation.
Appendix
Figure 2, which shows the change of the private investment levels in different Eurozone countries, is composed of a lot of countries. Therefore the appropriate data is showed below in table 2 for a better intrepretation of the findings.
Table 2: Change in levels of private investment in countries in the Eurozone
Source: Eurostat database
2007 2008 2009 2010 2011 2012 2013 EU (28 countries) 100 100,5 86,5 88,2 91,3 91,0 89,6 Euro area 100 101,7 90,1 90,6 93,5 91,6 89,7 Belgium 100 106,6 98,9 100,8 107,9 110,2 108,8 Denmark 100 100,2 82,9 79,7 81,4 83,0 83,8 Germany 100 102,7 93,2 98,7 107,9 109,3 110,2 Estonia 100 86,7 54,1 52,6 71,1 80,1 86,1 Ireland 100 83,3 60,9 48,0 45,8 49,8 48,9 Greece 100 95,8 82,9 65,2 53,4 37,9 34,1 Spain 100 97,2 78,2 74,2 68,6 62,1 57,9 France 100 104,5 94,9 98,0 102,6 104,4 103,7 Italy 100 99,9 90,5 92,2 92,7 87,4 83,1 Luxembourg 100 112,5 100,5 101,4 118,0 124,2 119,4 Netherlands 100 106,9 98,6 94,7 99,1 92,8 89,1 Austria 100 105,1 99,1 97,9 107,3 110,2 110,2 Portugal 100 103,6 94,1 93,6 82,3 70,2 65,7 Finland 100 104,7 91,3 90,8 97,1 98,2 94,6
Bibliography
Alesina, A., Ardagna, S., Perotti, R., & Schiantarelli, F. (2002). Fiscal policy, profits, and investment. American Economic Review, 92(3), 571-589.
Alesina, A., Favero, C., & Giavazzi, F. (2012). The output effect of fiscal consolidations. National Bureau of Economic Research. (No. w18336).
Barrios, S., Langedijk, S., & Pench, L. (2010). EU Fiscal Consolidation After the Financial Crisis-Lessons from Past Experiences. Fiscal Policy: Lessons from the
Crisis, 561-593.
Blanchard, O. J., & Leigh, D. (2013). Growth Forecast Errors and Fiscal Multipliers.
American Economic Review, 103(3), 117-120.
Dellepiane, S., & Hardiman, N. (2012). The new politics of austerity: Fiscal responses to the economic crisis in Ireland and Spain. UCD Geary Institute Discussion Paper
Series; WP2012/07
DeLong, J. B., Summers, L. H., Feldstein, M., & Ramey, V. A. (2012). Fiscal Policy in a Depressed Economy [with Comments and Discussion]. Brookings Papers on
Economic Activity, 233-297.
Donovan, D., & Murphy, A. E. (2013). The Fall of the Celtic Tiger: Ireland and the
Euro Debt Crisis. Oxford University Press.
Erceg, C., & Lindé, J. (2014). Is There a Fiscal Free Lunch in a Liquidity Trap?
Journal of the European Economic Association, 12(1), 73-107.
Hardiman, N. (2013). Rethinking the political economy of fiscal consolidation in two recessions in Ireland. UCD Geary Institute Discussion Paper Series; WP2013/7.
Honohan, P. (2009). Resolving Ireland’s banking crisis. The Economic and Social Review, Vol. 40, No. 2, pp. 207–231.
IMF Approves €22.5 Billion Loan For Ireland (2010, December 16). IMF Survey
Magazine. Retrieved from http://www.imf.org.
Krugman, P. (2010, July 1). Myths of Austerity. The New York Times. Retrieved from http://www.nytimes.com.
La Republica Interview with Jean-Claude Trichet (2010, June 16). European Central
Bank. Retrieved from http://www.ecb.europa.eu.
Perotti, R. (2011). The" austerity myth": gain without pain? National Bureau of
Economic Research (No. w17571).
Pescatori, A., Leigh, D., & Guajardo, J. (2011). Expansionary Austerity New International Evidence. IMF Working Papers, 1-40.
Pescatori, A., Leigh, D., Guajardo, J., & Devries, P. (2011). A New Action-Based
Dataset of Fiscal Consolidation (No. 11/128). International Monetary Fund.
Pontusson, J., & Raess, D. (2012). How (and why) is this time different? The politics of economic crisis in Western Europe and the United States. Annual Review of
Political Science, 15, 13-33.
Reddan, F. (2014, October 6). Irish Consumer Sentiment at Eight Year High. The
Irish Times. Retrieved from http://www.irishtimes.com.
Reinhart, C. M., & Rogoff, K. S. (2010). Growth in a Time of Debt. American
Economic Review, 100(2), 573-578.
Romer, C. D., & Romer, D. H. (2007). The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. American Economic Review,
