Cutting public deficits during a recession is highly damaging to the economy, indicates a recent study from the University of Helsinki.

During the 2010s, countries in the euro area made major cuts to their public deficits through tax hikes and cuts to public spending. This austerity policy had a negative impact on the economy, as it reduced production and productivity in the long term, indicates the study Hysteresis and Fiscal Policy, by University of Helsinki Professor (acting) Juha Tervala and Philipp Engler.

Fiscal policy measures are effective during a recession

Previous research has corroborated the hysteresis hypothesis, which suggests that recessions have permanent effects on the level of production. The new study suggests that when hysteresis is taken into account, the fiscal output multiplier goes from less than one to more than four. This means that while under normal circumstances, a one-euro increase in public spending increases production by less than one euro, under a recession, the impact can be more than four.

According to Juha Tervala, the idea of a recession resulting in what is called creative destruction, which is ultimately beneficial to the economy, is a misconception.

“Recessions are destructive, and the greatest benefit of a  expansionary fiscal policy is its ability to mitigate the long-term damage recessions cause to the levels of output and productivity. For this reason, expansionary fiscal policy is extremely effective during a recession,” says Tervala. 

Fiscal policy should take hysteresis into account

According to another finding from the study, the welfare effect of expansionary fiscal policy is only positive under circumstances where hysteresis is present, which is to say, during a recession. During an economic boom, fiscal stimulus is not recommended, even though it increases production, as its welfare effect is negative. Hysteresis should be a defining factor in the implementation of fiscal policy.

“Our results suggest that cutting public deficits in the euro area during the recession of the early 2010s was a grave mistake.” Austerity policies are primarily accountable for the poor economic growth in the euro area during the early 2010s.

“Now the economy of the euro area is growing, and countries have almost stopped cutting their deficits, even though now would be the time for fiscal consolidation,” states Tervala.

The study analyses the implications of hysteresis  for fiscal policy. If hysteresis did not exist, economic growth after a recession would be lightning fast, and production would regain its pre-recession growth path quickly. The main reason for hysteresis is the decrease in productivity during recessions. The study uses the dynamic stochastic general equilibrium (DSGE) model, which assumes that recessions have a detrimental impact on the level of productivity and output.

The study Hysteresis and Fiscal Policy has been published in the Journal of Economic Dynamics and Control.

Graph of the GDP and projected GDP of the US

Further information:
Professor (acting) Juha Tervala, University of Helsinki
Tel. +358 50 586 2968