Fiscal Policy After the Great Recession | Barcelona GSE Lecture XXI

Fiscal Policy after the Great Recession Alberto Alesina May 2011

The problem  Major Fiscal Expansion during the recessions in the US and many European countries  Several countries already entered the recession with the fiscal house not in order, which made the problem worse  Now is the time to rein in the deficits both in the US and in Europe  Have we waited too long?

Conventional wisdom is gloomy  Fiscal adjustment lead to recessions, particularly those on the spending side.  Fiscal adjustments lead to electoral defeats and therefore this is why they are postponed

Conventional wisdom wrong?  Most likely.  Fiscal adjustments on the spending side are less costly in terms of short run recessions than tax based adjustments.  The short run cost of fiscal adjustment are often overemphasized  Many governments which have implemented large fiscal adjustments have been reappointed. No systematic relationship between deficit reduction policies and electoral results.

A methodological point  As economists we should be very clear about how little we know  Anti economic profession reaction is due to our self aggrandizing attitude

Basic Keynesian Ec 101 model  Spending multiplier (much) bigger than one.  Spending multiplier (much) bigger than tax multiplier.

Identification problem  Co-movements of G T and GDP. What causes what?  Are there third factors? What are we holding constant? Monetary Policy, exchange rates, labor regulations?

What do people do?  Dynamic general equilibrium models (real business cycle theorists)  Vector auto regression analysis (Blanchard Perotti)  Isolate episodes of exogenous changes in tax rates(Romer and Romer)  Isolate exogenous changes in spending, military spending (Barro Ramey)

Spending Multipliers  People find spending multipliers at most equal to one, many find them much smaller  Possibly a bit larger during recessions  Much smaller than Keynesian standard model would predict (much larger than 1)

Tax multipliers  Romer and Romer: size of 3!!!  Too large? Most likely  Jury still out  All serious research find them larger than spending multipliers (a non Keynesian result)

Large episodes  Long list if papers since 1990 on “episodes” if fiscal adjustments (and expansions).  First paper, Giavazzi and Pagano (1990)  Latest one Alesina and Ardagna (2010)  These papers look at episodes of large changes in fiscal policy in OECD countries from 1970 to today

Identifying assumption  A fiscal stimulus or contraction is needed given the state of the economy and or public finances  Decision about what side of the budget act upon is mostly political

Results  Fiscal contractions: those based upon spending cuts are less contractionary (or even in some cases expansionary) than those based upon tax increases.  Fiscal contractions: those based upon spending cuts leads to a more long lasting adjustment of deficit and debt reduction

Data description  21 OECD countries 1970-2007 (Economic Outlook database)  Fiscal contractions = year in which the cyclically adjusted primary balance improves by at least 1.5 per cent of GDP  107 episodes of fiscal contractions (15.1% of observations in sample) 65 episodes last 1 year,13 episodes last 2 years, 4 episodes last 3 years, 1 episodes (Denmark 1983-1986) lasts 4 years

Why?  Supply side effects of tax increases.  Demand side effect (positive) effect of future lower taxation if spending goes down.  Confidence credibility effects. An adjustment today eliminates the need of a bigger one tomorrow  If you don’t stop automatic spending growth taxes can never catch up!

Fiscal deficits and elections  There is not evidence that larger budget deficits increase changes of reelection.  Brender and Drazen (AER 2008) find the opposite: larger deficits are (weakly) associated with less success at the polls.

How about large fiscal adjustments?  Many large fiscal adjustments have been followed by reelection of government which implemented them.  Especially when the adjustment occurred early in the term

Reverse causality?  Could it be that only those governments which know they are strong engage in fiscal adjustment?  Thus government are reelected despite not because of fiscal adjustments.  Difficult to test. How do you define “strong”?  No obvious evidence of this effect.

A word on Europe  Some countries seem to have gotten the message above (UK Spain, Greece)  Some positive sign of attacking overgrown government spending  Greece, Portugal and (possibly) Ireland will probably restructure  Big question marks: Italy and Spain  Can the EU taker over fiscal policy?  Domestic fiscal rules?

A word on the US  Over stimulus?  The beginning of negotiations  Ryan proposal: consistent with the traditional “American exceptionalism” regarding g the welfare state  Obama would like to have a more European welfare state but has not told us how to finance it

Conclusions  Fiscal adjustments mostly on the spending side have a better chance of not creating large recessions even on impact.  Fiscal rectitude is sometimes rewarded by the voters.  Finally (possibly too late) US and some European countries are moving in the right direction

Fiscal Policy After the Great Recession | Barcelona GSE Lecture XXI

by Barcelona Graduate School of Economics (GSE) on May 09, 2011

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