Austerity and Productivity: Evidence from Euro Area Regions

We find that fiscal consolidations raise productivity significantly and persistently. In our data, a consolidation that lowers regional public spending by 1% on impact raises TFP by about 1% on impact and about 2% after two years, even as economic activity contracts. We document this using two innovations. First, we build a novel regional utilization-adjusted TFP series for Europe, covering 139 NUTS 2 regions in ten euro area countries over 1999– 2019, which corrects the Solow residual for cyclical variation in capital utilization and labor effort. Second, we isolate plausibly exogenous spending cuts with a Bartik-style instrument that interacts pre-accession regional spending shares with narratively identified national consolidation episodes. Productivity gains are larger than those observed in comparable downturns without consolidation and arise almost entirely within sectors and coincide with net exit of establishments, rather than reflecting reallocation across sectors.