This is a European suicide pact

In normal times in the EU, co-ordinated austerity would lower member states' debt. But instead it's making things worse

• 
• • Jonathan Portes
  • The Guardian, 

Civil servants protest against government austerity measures in Madrid in July. Photograph: Reuters/Andrea Comas

In the aftermath of the 2008 financial crisis practically all European Union countries opted for the same strategy to put their finances back on track: cut spending; increase taxes; reduce deficits. Research published by economic thinktank NIESR this week makes the first attempt (to our knowledge) to estimate the impact of this co-ordinated fiscal consolidation across the EU. What we have found won't make for pleasant reading in the treasuries of European governments.

In "normal times" fiscal consolidation would lead to a fall in debt-to-GDP ratios, but in the current circumstances it is likely to be self-defeating for the EU collectively. As a result of the deficit cutting plans now in train, debt ratios will be higher in 2013 in the EU as a whole, rather than lower. This will also be true in almost all the individual states (with the exception of Ireland). Coordinated austerity in a depression is self-defeating. The implication is that the strategy being pursued by individual members, as well as the EU as a whole, is making matters worse.

Why so? There are several reasons one might expect the negative impact of fiscal consolidation on growth to be greater now. Normally, monetary policy offsets some of the impact of fiscal policy. But interest rates are already at exceptionally low levels – and it is far from clear that extraordinary measures, such as quantitative easing and the ECB's outright monetary transactions, are having much impact on the economy. Second, during a downturn, when unemployment is high and job security low, a greater percentage of households and firms are likely to find themselves without access to credit. And finally, with all countries consolidating simultaneously, output in each is reduced not just by fiscal consolidation, but by that in other countries (through trade links). In the EU, such spillover effects are likely to be large.

Fiscal policy started to achieve the opposite of what was intended in 2011, when deep consolidation measures were introduced in Portugal, Ireland and Greece – the three countries on bail-out programmes. Cumulative measures over the three-year period amount to close to 10% of GDP in Greece and Portugal and 8% in Ireland. Consolidation measures amounting to between 5% and 6% of GDP are planned in France, Italy, Spain and the UK, while only a modest adjustment is likely in Germany and Austria.

Our estimates are that in those normal times, fiscal consolidation would have reduced growth, but not by very much except in the bailout countries: the cumulative impact ranging from almost nothing in Germany to 8% in Greece and Portugal. The desired objective of reducing deficits and debt would have been achieved. But taking account of the current environment changes the picture dramatically: the hit to output in Germany is now 2%. In the UK it is 5%; and in Greece 13%. Still more shocking is the impact on debt-to-GDP ratios – the fiscal consolidation was supposed to improve fiscal sustainability; instead, it makes matters worse. And this isn't true just in extreme cases like Greece – fiscal consolidation across the EU has raised debt-to-GDP ratios in Germany and the UK as well. In both the UK and the euro area as a whole, the result of coordinated fiscal consolidation is a rise in the debt-GDP ratio of approximately five percentage points. For the UK, that means a debt-GDP ratio of close to 75% in 2013 instead of about 70%. We are not running to stand still; we are determinedly heading in the wrong direction.

The policies pursued by EU countries over the recent past have had perverse and damaging effects. Of course, European countries did need to get back on the path of fiscal sustainability, and that does mean cutting spending and raising taxes. But timing is everything, and our research shows 2011 was precisely the wrong time. Waiting until economies were clearly on the road to recovery would have been less painful socially, and much better economically. Growth would have been higher, debt-GDP ratios lower, and the necessary adjustment smoother and less painful.

What we have seen in Europe is the creation of a death spiral of deficit cutting, leading to reduced growth – which leads to reduced revenues and pressure to cut deficits faster. Paradoxically the EU was set up in part to avoid such problems by allowing members to co-operate to secure better outcomes. Co-ordinated EU fiscal consolidation looks less like economic policy co-operation and more like a suicide pact.