The European Union''s co-ordinated fiscal expansion plan launched in November 2008 was the right response to the rapid economic slowdown that was happening in the wake of the financial crisis. That is one of the&##160;findings of research by Professors Roel Beetsma andMassimo Giuliodori, which analyses 40 years of EU data on the impact and effectiveness of fiscal stimulus through increased government spending.
Their study, published in the February 2011 issue of the Economic Journal, finds that:
- On average, an increase in public spending equal to 1% of GDP in an EU country generates a maximum increase in GDP of 1.5% after one year.
- The benefits differ substantially across countries. Countries that have relatively little foreign trade experience on average a maximum GDP increase of 1.6%. But countries that trade heavily with other countries enjoy an increase in GDP of only 0.9%.
- For more open countries, those engaged in a great deal of foreign trade, much of the stimulus leaks abroad, thereby benefitting the main countries from which goods and services are imported.
- On average, an increase in public spending equal to 1% of GDP raises private consumption by 1.1% and private investment by 3.3% after one year. The government budget balance deteriorates by 0.6% of GDP, but returns to zero in the longer run.
- An increase in public spending equal to 1% of GDP also affects trade: imports rise by 1.7%, while exports fall by 0.9%. The trade balance deteriorates by a maximum of 0.8% of GDP after one year, but returns to zero in the longer run.
- A split into more and less open economies in terms of foreign trade shows that both deterioration of the budget balance and the trade balance are larger for more open economies.
- A unilateral increase in government spending equal to 1% of GDP in one of the five largest economies of the EU (France, Germany, Italy, Spain and the UK) raises GDP substantially in the rest of the EU – on average by 0.35%.
The researchers draw the following conclusion from their findings:
''A concerted fiscal expansion during a deep euro-area wide recession is an effective way to alleviate the economic slowdown. Hence, the European Economic Recovery Plan adopted by the EU in November 2008 was a suitable response to the economic circumstances at the time.''
The plan aimed at a cumulative (over the crisis period) fiscal stimulus of about 1.5% of EU GDP, with 1.2% of GDP directly coming from the member States. A concerted expansion of this kind avoids ''free-riding'' behaviour of individual countries that want to benefit from expansion elsewhere without incurring any cost of domestic action.
Obviously, any fiscal expansion has to weighed against the resulting increase in the public debt and, hence, higher future taxes. Hence, fiscal expansion needs to be confined to instances when the need for stimulus is high.
''The Effects of Government Purchases Shocks: Review and Estimates for the EU'' by Roel Beetsma and Massimo Giuliodori is published in the February 2011 issue of the Economic Journal.