How to consolidate government budgets in view of external imbalances in the Euro area? Evaluating the risk of a savings paradox

This paper contributes to the debate on the macroeconomic effects of fiscal consolidation. The analysis focuses on the western European countries of the EMU. In deviation to the relevant literature external imbalances are explicitly taken into account and the longer-term impact on productivity growth is analysed. This present paper provides evidence that austerity measures in the EMU have affected labour productivity growth adversely. Therefore, the view that fiscal contractions are expansionary in the longer run is rejected in the case of the EMU. In particular the results of this paper suggest that Euro area countries, which run a current-account surplus, should only start with austerity measures if a sustainable upturn sets in. Otherwise a negative spill-over for other EMU members is to be expected. As all Euro area countries cut their budgets simultaneously a savings paradox is likely. The latter may only be averted by either a fundamental change of fiscal stance in the current-account surplus countries such as Germany or if the current recovery in these Euro area countries boosts domestic demand in due time. Additionally in the past, the level of public debt in the EMU would not appear to have interfered with fiscal policy.