Investment and employment can drop sharply even in countries that do not curtail public spending, write Antonio De Vito, Martin Jacob and Guosong X

De Vito, Antonio

Jacob, Martin

Xu, Guosong

English

LSE Research Online

The	impact	of	austerity	policies	in	a	country	can	befelt	across	its	bordersGovernment	spending	around	the	world	is	soaring	in	response	to	the	COVID-19	crisis.	Rising	spending	coupledwith	collapsing	tax	revenues	could	soon	drive	up	fiscal	deficits	as	well	as	government	borrowing	(Kapoor	andBuiter,	2020),	posing	a	potential	threat	to	budget	balances.	The	consequences	of	rising	fiscal	deficits	and	debt-to-GDP	ratios	would	be	severe	if	low	interest	rates	were	not	maintained	in	the	future.	In	addition,	public	finances	wouldbe	vulnerable	to	shortfalls	in	growth	and	other	shocks.	In	the	aftermath	of	the	crisis,	putting	the	debt-to-GDP	ratioon	a	downward	path	will	become	the	new	priority	(Barnes	and	Casey,	2020).In	the	menu	of	options	for	renormalising	public	debt	levels	(Reinhart	et	al.,	2015),	fiscal	consolidation,	or	austerity,has	gained	renewed	popularity.	Some	countries	have	already	enacted,	or	are	considering	enacting,	austeritymeasures	to	cope	with	the	rise	in	debt-to-GDP	ratios.	Other	countries	are	opposing	it,	with	some	commentatorsblaming	austerity	policies	for	the	slow	recovery	in	Europe	after	the	Great	Recession	(Ilzetzki,	2020).Amid	the	reignited	interests	in	austerity,	policymakers	have	increasingly	called	for	cooperation	in	fiscal	policiesacross	nations	(OECD,	2020).	Although	prior	research	has	delivered	evidence	on	the	domestic	consequences	ofausterity,	such	as	those	on	economic	output	(e.g.	Ramey,	2011)	and	investment	(e.g.	Alesina	et	al.,	2002),	muchless	is	known	about	the	effect	on	economies	outside	the	austerity	country.	At	the	micro	level,	few	studies	haveempirically	tested	the	transmission	of	fiscal	consolidations	among	firms	located	in	different	countries.	At	the	macrolevel,	the	channels	that	propagate	such	policies	across	national	borders	have	yet	to	be	established.In	a	recent	paper	(De	Vito	et	al.,	2020),	we	seek	to	fill	this	gap.	We	start	by	asking	whether	and	how	firms’investment	activities	react	to	fiscal	policy	shocks	emanating	from	abroad.	We	focus	on	multinationals’	internalnetworks	of	subsidiaries,	because	prior	studies	show	these	networks	contribute	to	the	transmission	of	non-localeconomic	shocks	(Cravino	and	Levchenko,	2017).	Moreover,	the	intra-firm	trade	of	multinationals	represents	one	ofthe	most	important	forms	of	economic	connections	between	countries.	In	the	second	step,	we	explore	macroimplications	by	assessing	the	quantitative	importance	of	the	spillover	for	aggregate	economic	activities	such	as	acountry’s	investment	and	employment.The	expected	effect	of	austerity	spillover	is	not	obvious.	On	the	one	hand,	a	local	subsidiary	exposed	to	a	foreignausterity	shock	could	increase	its	own	investment	activities	because	the	parent	company	shifts	resource	allocationsto	the	local	business	unit,	given	that	austerity	presents	a	negative	shock	to	the	company’s	operations	in	that	foreigncountry	(Giroud	and	Rauh,	2019).	On	the	other	hand,	such	shocks	could	disrupt	the	existing	production	linkagewithin	a	multinational’s	internal	networks	and	negatively	affect	a	multinational’s	internal	capital	market	or	businessconfidence,	thereby	curtailing	a	local	subsidiary’s	investment.LSE Business Review: The impact of austerity policies in a country can be felt across its borders Page 1 of 4		Date originally posted: 2020-09-01Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/01/the-impact-of-austerity-policies-in-a-country-can-be-felt-across-its-borders/Blog homepage: https://blogs.lse.ac.uk/businessreview/To	answer	our	research	question,	we	rely	on	the	datasets	built	by	Devries	et	al.	(2011)	and	Alesina	et	al.	(2015)and	gather	fiscal	consolidation	episodes	that	occurred	in	14	Eurozone	countries	from	2004	to	2014.	Crucial	to	ouridentification,	the	passage	of	these	(foreign)	fiscal	consolidations	(different	types	of	tax	hikes	or	governmentspending	cuts)	is	independent	of	the	economic	conditions	in	the	destination	country	where	a	subsidiary	operates.This	feature	allows	us	to	separate	the	effect	of	fiscal	policy	shocks	from	confounding	economic	prospects	in	drivingfirms’	resource	allocations.Our	empirical	approach	relies	on	comparing	the	investment	decisions	of	two	subsidiaries	in	the	same	(non-austerity)	country	and	same	industry,	with	one	subsidiary	having	ties	to	an	austerity	country,	and	the	other	not.	Werequire	the	two	subsidiaries	under	comparison	to	have	a	parent	firm	headquartered	in	the	same	foreign	country,absent	fiscal	consolidation.	This	condition	enables	us	to	separate	common	factors	from	the	parent	country	thatcould	affect	the	investment	of	the	subsidiary.To	understand	our	approach,	consider	the	Germany	subsidiaries	of	two	firms:	Safran	and	Thales.	Both	Safran	andThales	are	key	manufacturers	in	the	aerospace	sector,	headquartered	in	France.	In	2005,	Italy,	where	Thales	heldsubstantial	operations	while	Safran	did	not,	entered	into	an	austerity	plan.	This	exposed	Thales’	German	businessto	a	foreign	fiscal	policy	shock	via	its	internal	network.	Importantly,	in	the	same	year,	France	(the	parent	country),Germany	(the	subsidiary	country),	and	the	other	countries	where	Safran	operated	did	not	undergo	any	shifts	infiscal	policies.	Figure	1	provides	an	illustration.	We	ask	the	following	key	question:	Does	Thales’	German	subsidiaryadjust	capital	investment	relative	to	Safran’s	German	subsidiary	in	response	to	the	Italian	austerity?Figure	1.	Identification	strategyAs	shown	in	Figure	2,	we	find	negative	investment	spillover.	That	is,	in	our	example,	we	find	that	Thales’	Germansubsidiary	reduces	investment	significantly	more	than	Safran’s	German	subsidiary	does	in	the	year	of	fiscal	shocks.This	effect	is	economically	sizeable:	our	analyses	imply	investment	elasticities	of	-0.30	to	-0.33.	Importantly,	theeffect	is	not	driven	by	common	shocks	to	the	countries	or	industries	in	which	the	subsidiary	or	the	parent	firm	isoperating,	because	we	saturate	our	empirical	model	with	highly	granular	matched-pair	fixed	effects.	We	thuseffectively	compare	the	investment	of	business	subsidiaries	facing	the	same	local	and	parent-level	shocks	butexposed	to	different	levels	of	fiscal	policy	shocks	in	a	third	source	country.Figure	2.	Cumulative	changes	in	investmentLSE Business Review: The impact of austerity policies in a country can be felt across its borders Page 2 of 4		Date originally posted: 2020-09-01Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/01/the-impact-of-austerity-policies-in-a-country-can-be-felt-across-its-borders/Blog homepage: https://blogs.lse.ac.uk/businessreview/We	further	decompose	fiscal	adjustments	into	two	categories—public	spending	reductions	and	tax	hikes—and	testthe	magnitude	of	the	spillover	for	each	component.	We	find	that	the	tax	effect	is	more	than	four	times	as	large	asthe	effect	of	spending	cuts.	Additionally,	we	show	that	what	matters	are	subsidiaries’	linkages	to	acontemporaneous	foreign	fiscal	shock:	past	or	future	fiscal	adjustments	in	the	austerity	country	generate	virtuallyzero	spillover.We	then	explore	three	distinct	channels	to	understand	this	phenomenon.	We	first	consider	intra-firm	productionlinkages.	To	the	extent	that	some	subsidiaries	are	set	up	as	suppliers	to	other	subsidiaries	located	in	a	differentcountry,	shocks	to	these	suppliers	ultimately	transmit	to	their	customers	in	the	same	network	(Acemoglu	et	al.,2012).	Consistent	with	this	conjecture,	we	confirm	significantly	stronger	spillover	to	subsidiaries	that	are	likelycustomers	of	the	subsidiaries	in	the	austerity	country.	Interestingly,	we	find	that	foreign	policy	shocks	mainlypropagate	downstream	from	suppliers	to	customers,	but	not	the	other	way	around.	This	observation	is	in	line	withthe	argument	by	Briganti	et	al.	(2018),	that	tax	hikes	are	primarily	supply	shocks	that	transmit	downstream.	We	alsofind	that	as	the	multinational’s	business	confidence	dampens,	the	subsidiary	exposed	to	foreign	austerities	suffersfrom	a	greater	decrease	in	investment.	Furthermore,	we	find	that	subsidiaries	belonging	to	a	financially	constrainedmultinational	exhibit	larger	elasticities	of	local	investment	with	respect	to	foreign	fiscal	consolidation.Next,	we	assess	how	important	austerity	spillovers	are	for	the	economy	in	the	aggregate.	The	simple	observation	ofspillover	to	individual	subsidiaries	might	not	matter	at	the	country	level	if	the	investment	loss	in	those	subsidiaries	issubstituted	for	increased	investment	activities	in	other	domestic	firms.	To	address	the	question,	we	consider	theaggregate	investment	of	all	firms	in	the	same	country	and	industry.	Similar	to	our	findings	at	the	subsidiary	level,	wedocument	a	significant	decline	in	aggregate	investment	when	a	greater	share	of	local	firms	is	linked	to	foreignausterity	countries:	an	increase	of	one	standard	deviation	in	the	foreign	austerity	share	translates	into	an	investmentreduction	of	approximately	EUR	36.3	million	for	a	given	country–industry.	Hence,	micro-level	spillover	effectsmanifest	themselves	as	an	aggregate	investment	loss.Finally,	in	a	similarly	designed	analysis,	we	find	that	subsidiaries	decrease	their	employment	in	response	toausterity	exposure.	As	in	the	investment	analysis,	we	also	document	an	overall	decline	in	aggregate	hiring	activitieswhen	a	greater	share	of	domestic	firms	is	exposed	to	foreign	austerities.	Again,	these	findings	suggest	thatausterity	spillover	matters	for	the	domestic	economy.LSE Business Review: The impact of austerity policies in a country can be felt across its borders Page 3 of 4		Date originally posted: 2020-09-01Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/01/the-impact-of-austerity-policies-in-a-country-can-be-felt-across-its-borders/Blog homepage: https://blogs.lse.ac.uk/businessreview/To	conclude,	with	new	episodes	of	fiscal	consolidation	looming	in	a	post-crisis	environment,	we	visit	thisfundamental	policy	issue	with	a	refreshed	view.	Echoing	world	leaders’	call	for	a	coordinated	approach	in	fiscalplans,	we	show	that	austerity	policies	transmit	across	national	borders	and	cause	sharp	drops	in	investment	andemployment	even	in	countries	that	do	not	implement	them.	Considerations	of	such	spillover	effects	should	befactored	in	in	future	policy	agenda.♣♣♣Notes:This	blog	post	is	based	on	“Firms’	internal	networks	and	austerity	spillover”.The	post	expresses	the	views	of	its	author(s),	not	the	position	of	LSE	Business	Review	or	the	London	Schoolof	Economics.Featured	image	by	pascalkoenig,	under	a	Pixabay	licenceWhen	you	leave	a	comment,	you’re	agreeing	to	our	Comment	PolicyAntonio	De	Vito	is	an	assistant	professor	of	accounting	at	IE	Business	School,	IE	University;	Madrid.He	received	ta	PhD	in	business	and	economics	from	WHU	–	Otto	Beisheim	School	of	Management.Prof.	De	Vito	was	visiting	scholar	at	UNC	Kenan-Flagler	Business	School.	His	research	lies	at	theintersection	of	economics,	finance,	and	accounting,	with	special	attention	to	taxation-related	topics.Visit	his	webpage.	Martin	Jacob	is	Adidas	professor	of	finance,	accounting,	and	taxation,	WHU	–	Otto	Beisheim	Schoolof	Management,	where	he	is	a	faculty	member	since	2010.	He	has	published	in	the	leading	financeand	accounting	journal	and	has	(co-)	authored	several	policy	reports	for	Sweden	on	tax	policy.	Hisresearch	lies	at	the	intersection	of	economics,	finance,	and	accounting,	with	special	attention	to	theeffect	of	taxation	on	businesses.	Visit	his	webpage.	Guosong	Xu	is	an	assistant	professor	of	finance	at	Erasmus	University’s		Rotterdam	School	ofManagement	and	a	researcher	at	the	Erasmus	Research	Institute	of	Management	(ERIM).	Hereceived	his	PhD	from	WHU	Otto	Beisheim	School	of	Management	in	Germany	and	was	a	visitingscholar	at	Stern	Business	School,	New	York	University.	His	research	interests	lie	in	the	area	ofcorporate	finance,	political	economics,	and	behavioural	finance.	Visit	his	webpage.		LSE Business Review: The impact of austerity policies in a country can be felt across its borders Page 4 of 4		Date originally posted: 2020-09-01Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/01/the-impact-of-austerity-policies-in-a-country-can-be-felt-across-its-borders/Blog homepage: https://blogs.lse.ac.uk/businessreview/

The impact of austerity policies in a country can be felt across its borders

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The impact of austerity policies in a country can be felt across its borders

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