Working Paper: CEPR ID: DP13149
Authors: Antonio Fatas
Abstract: This paper studies the negative loop created by the interaction between pessimistic estimates of potential output and the effects of fiscal policy during the 2008-2014 period in Europe. The crisis of 2008 created an overly pessimistic view on potential output among policy makers that led to a large adjustment in fiscal policy. Contractionary fiscal policy, via hysteresis effects, caused a reduction in potential output that validated the original pessimistic forecasts and led to a second round of fiscal consolidation. The evidence suggests that this succession of contractionary fiscal policies was likely self-defeating for many European countries as the negative effects on GDP caused more damage to the sustainability of debt than the benefits of the budgetary adjustments. The paper concludes by discussing alternative frameworks for fiscal policy that could potentially avoid this negative loop in future crises.
Keywords: Fiscal policy; Hysteresis; Potential output
JEL Codes: E32; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| contractionary fiscal policy (E62) | reduction in potential output (E23) |
| reduction in potential output (E23) | validation of initial pessimistic forecasts (E27) |
| crisis of 2008 (G01) | overly pessimistic views on potential output (E66) |
| overly pessimistic views on potential output (E66) | contractionary fiscal policy (E62) |
| contractionary fiscal policy (E62) | further rounds of fiscal consolidation (E62) |
| further rounds of fiscal consolidation (E62) | negative impact on GDP (F69) |
| negative impact on GDP (F69) | higher debt-to-GDP ratios (H69) |