1. Comments on “Fiscal Consolidations in Currency Unions: Spending Cuts Vs. Tax Hikes” by Christopher J. Erceg and Jesper Lindé (Federal Reserve Board) Christiane Nickel (ECB) Monfispol, Frankfurt, 20 September 2011 These comments should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the author and do not necessarily reflect those of the ECB.

2. 2 Summary of the paper This paper covers an extremely topical issue, which will remain in the center of attention for many years. Literature on fiscal consolidations largely in agreement: Use spending cuts! But disregards current circumstances: e.g. currency union member countries, zero bound constraint. This paper is rich and can be applied to many (current) circumstances, esp. in Europe Main policy lessons from the paper: To minimize adverse impact on output: If monetary policy can respond, use spending cuts because the effects of a labour tax hike on output would be more severe for a consolidating member of a currency union. If monetary policy cannot respond (small member country of a currency union, liquidity trap) use labour tax hikes because the effects on output are less severe in a member of a currency union. Spending cuts always negative on output irrespective of the way they are implemented (no expansionary fiscal consolidations as the literature on non-Keynesian effects would suggest.) Results derived from a two-country-block DSGE model calibrated to the euro area.

3. Issues for discussion 1.Temporary vs. permanent consolidation 2.Non-linearities –Private sector behaviour –Confidence effects 3.Policy implications for the current situation –Problematic steady state assumption –Crude definition of fiscal consolidation 3

4. 1. Temporary vs. permanent consolidation In the paper, the tax hike and the spending cut are not permanent (they follow an AR(1) process, i.e. go back to “normal” after a while). Thus, results could be interpreted as the “flip-side” of stimulus programmes. In this sense, the ECB’s New Area Wide Model yields similar results for stimulus programmes, i.e. –Labour tax cuts have a significantly lower multiplier than government consumption increases. 4

5. Euro area GDP multipliers: Results from the NAWM (for fiscal stimulus) Source: ECB Monthly Bulletin, July 2010, p. 77 5

6. 1. Temporary vs. permanent consolidation (continued) When considering permanent hikes in labour taxes or permanent cuts in government consumption, these results may change. Simulations with the ECB’s NAWM show that for a permanent 30 pp reduction in the debt-to-GDP ratio from 90% to 60% short-run costs of fiscal consolidation are typically small relative to the permanent gains. 6

7. Costs and benefits of fiscal consolidations: NAWM results Source: ECB Monthly Bulletin, July 2010, p. 80 7

8. 8 2. Non-linearities: Private sector behaviour In the paper, agents are believed to respond in an unchanged manner in ‘good times’ as in ‘bad times’ but: Behavior might change depending on e.g. the level of outstanding government debt (expectations  private net wealth effects) Importance of high or growing government debt noted by among others Reinhart and Rogoff (2010), Checherita and Rother (2010), Cecchetti et al (2011), Nickel and Vansteenkiste (2009) This might be relevant in a liquidity trap scenario as it often coincides with already high debt-to-GDP ratios Solution: Play with the share of non-Ricardian household. (Empirical evidence suggests that the crisis has increased the share of liquidity or credit constrained (non-Ricardian) households.)

9. 9 2. Non-linearities (continued): Confidence effects Literature on “non-Keynesian fiscal effects” postulates that favourable expectation effects could more than offset the contractionary impact of fiscal consolidation on growth. The credible announcement and implementation of a fiscal consolidation strategy may diminish the risk premium associated with government debt issuance. In the paper: risk premium is reduced (very) gradually, i.e. according to the actual reduction in the debt-to-GDP ration (see chapter 6.4). BUT: Already the announcement of a fiscal consolidation package may reduce the risk premium, i.e. the reduction in the risk premium could be much quicker -> already on the announcement of the fiscal package. See results for NAWM, final two columns of the table on slide 7 for an “ad hoc” permanent 30 basis point reduction in the financing costs (on the basis of a permanent fiscal consolidation). Suggestion: Expand chapter 6.4.: The reduction in the risk premium could be much less gradual in case of a credible announcement of a fiscal consolidation programme.

10. 3. Policy implications As said, paper can be applied to current situation. However, currently countries consolidate to restore market confidence. This implies: these countries are not in a steady state. No consolidation would have meant a situation spiralling out of control. Given that the model assumes a steady state as a starting point, the policy implication for the current situation is not clear. In addition: –At times when fiscal consolidation is needed most, raising taxes might be least implementable for political economy considerations 10 Steady state assumption is in the current situation problematic.

11. 3. Policy implications (continued) In practice: consolidation is a mix of revenue and expenditure measures. Labour taxes and government consumption are only a part of total government revenues and expenditure. Suggestion: Use a policy mix! This suggestion holds even more if one considers the position of countries on their respective Laffer curves: Trabandt and Uhlig (2010) show that for the EU-14 the revenues from labour and capital taxes are hardly increasable. For selected EU countries they show that it seems impossible to increase revenues by increasing those type of taxes. 11 Crude definition of consolidation:

12. General government revenue: Euro area (2010) 12 Source: AMECO.

13. 13 General government expenditure: Euro area (2010) Source: AMECO.

14. Cecchetti, S. G., M. S. Mohanty and F. Zampolli (2011). The real effects of debt. BIS Working Paper No. 352. Checherita, C. and P. Rother (2010). The impact of high and growing government debt on economic growth - an empirical investigation for the euro area. ECB Working Paper No. 1237. ECB (2010). July Monthly Bulletin. Nickel, C., P. Rother and L. Zimmermann (2010). Major public debt reductions – lessons from the past, lessons for the future. ECB Working Paper No. 1241. Nickel, C. and I. Vansteenkiste (2008). Fiscal policies, the current account and Ricardian equivalence. ECB Working Paper No. 935. Reinhart, C. M. and K. S. Rogoff (2010). The Aftermath of Financial Crisis, American Economic Review, Vol. 99(2), pp. 466-472. Trabandt, M. and H. Uhlig (2010). The Laffer curve revisited, Journal of Monetary Economics, doi:10.1016/j.jomeco.2011.07.003. References 14