Austerity, Fiscal Uncertainty, and Economic Growth: Insights from Fiscally Weak EU Countries

Abstract

Recent empirical evidence suggests that during the last years fiscally weak European countries significantly cut their R&D budgets in an effort to reduce their deficit, according to the spirit of the Fiscal Compact. We propose a general equilibrium model that endogenously captures the trade-off between costs and benefits of austerity measures driven by a zero-deficit policy. Our analysis suggests that cuts in R&D spending undermine economic growth both in the short and the long run. We use our model to estimate the reduction of economic growth due to R&D cuts implemented by fiscally weak European countries during the period 2010-2012. The model predicts a reduction in real growth by 0.63%, 2.93%, and 4.46%, in the next 1, 5, and 10 years, respectively. Moreover, we show that the zero-deficit constraint hampers economic growth in the presence of either a productivity drop or a spending stimulus.