Committee for a Responsible Federal Budget

The ECB on Fiscal Consolidation

Jun 23, 2010 | Economics

The European Central Bank joined the Announcement Effect Club yesterday in its June Monthly Bulletin. In evaluating the costs and benefits of fiscal consolidation, the Bulletin said the following:

If the fiscal consolidation appears to the public as a credible attempt to reduce public sector borrowing requirements, there may be an induced positive wealth effect, leading to an increase in private consumption. Furthermore, the reduction of government borrowing requirements diminishes the risk premium associated with government debt issuance, which reduces real interest rates and allows the “crowding-in” of private investment.

Exactly. Along this same line of thinking, ECB said that there were many situations in which the costs are low and the benefits are high for fiscal consolidation:

  • if confidence in a country's public finance is low
  • if fiscal consolidation is pursued credibly and consistently
  • if it makes the long-term finances more sustainable
  • if economic adjustment is not impeded by nominal rigidities
  • if many consumers are "Ricardian consumers" (meaning they think that fiscal consolidation precludes the need for more drastic fiscal adjustment in the future and increase their consumption)
  • if the economy is very open 
  • if the fiscal consolidation is offset by expansionary monetary policy or currency depreciation.

Obviously, the first condition applies to many European countries, especially the PIIGS, who would have much to gain from an increase of confidence in public finance. ECB says that for these countries, fiscal consolidation can be beneficial in both the long-run and the short-run. For other countries, they indicate that the short-run costs may still be offset to an extent by the "expectation effects" of announcing a fiscal plan. And of course, they say that the long-term benefits to economic growth of reduced public borrowing more than outweigh the short term costs.

The ECB is now in the Announcement Effect Club. Congratulations.