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 re- election 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