Fiscal adjustments and the recession

Alberto Alesina, 12 November 2010

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Many European countries are engaged in large fiscal adjustments. The standard Keynesian view is that these adjustments will cause deep recessions especially if they occur on the spending side (see for example Krugman 2010). A lively literature initiated by a paper by Giavazzi and Pagano (1990) has uncovered “non-Keynesian” effects of large fiscal adjustments. The latest instalment of this line of research is a paper that I co-authored with Silvia Ardagna (Alesina and Ardagna 2010).

This literature reaches three conclusions.

  • First, fiscal adjustments on the spending side are more likely to lead to a permanent stabilisation of the budget.
  • Second adjustments on the spending side have lower cost in terms of lost output.
  • Third, some, not all, adjustments on the spending side are not followed by a downturn even on impact.

This may be due to a confidence effect on consumers and investors or because monetary policy can be more expansionary when a fiscal adjustment is credible. Another reason may be that raising taxes would have negative supply-side effects on labour costs, labour supply, and investments. These supply-side effects do not apply to spending cuts, which, on the contrary, imply lower taxes in the future.

A recent chapter of the IMF's September 2010 World Economic Outlook (WEO) argues that these results are incorrect. Yet the rhetoric of the IMF study exaggerates the differences in their results and claims.

The WEO focuses on the second and third result, and it does not deal with the first. On the second result the WEO chapter agrees that tax increases are much worse for the economy than spending cuts. It says that this effect comes mainly from different reactions of monetary policy, but their claim of having identified separately all of these channels is overstated because interest rates, current and expected, and exchange rates are endogenous to both fiscal and monetary policy.

Regarding the third result, the WEO chapter in particular criticises a paper I co-wrote with Silvia Ardagna. In it we analysed how countries grow during the year of a fiscal adjustment, and in the two following years. The study covers a sample of 21 countries from 1970 to the most recent period and defines a fiscal adjustment as “expansionary” if GDP growth in the year of the adjustment, and in the two following years, is in the top 25% of the sample. To correct for the world business cycle, our study considers the growth of each country in difference from average G7 countries’ growth. The main finding is that about one fifth of fiscal adjustment episodes are expansionary and these are based mostly on spending cuts.

Our definition of a fiscal adjustment relies on the cyclically adjusted primary balance; this is the standard methodology used in the literature to date. That is, the paper defines an adjustment when there is a large fall in the primary deficit (more than 1.5% of GDP) after taking out the effect of the cycle on the primary deficit. The idea is that such a sharp reduction of cyclically adjusted deficits in virtually all cases has to be the result of some policy action and not “business as usual”. Indeed, such a measure leaves out what would be “incorrect” selections of episodes. For example, in the nineties in the US, there were no discretionary fiscal contractionary policies despite the sharp reduction of the deficit. In fact, the latter was due only to sustained growth of the economy. The deficit went down quickly, but the US is not defined as a case of expansionary fiscal adjustment because the cyclical correction reveals that it was the sustained growth of the economy that reduced the deficit, not policy actions. This method for cyclical adjustment is standard and widely used.

The imperfections of cyclical adjustments are well known, and this is shown in the vast literature on this subject experiments with many sensitive tests. Yet the WEO chapter simply dismisses this methodology. It claims to have found a better way of identifying when a fiscal adjustment really occurs. How? By reading IMF and OECD historical reports and checking what countries were intending to do at the time of publication. There are pros and cons in this approach. First, it involves many judgment calls. Second, and more importantly, the idea that this procedure would eliminate endogeneity (i.e., fiscal policy responding to the economy and not the other way around) is non tenable.

Certainly various governments cut taxes or spending programmes (or the other way around) for a reason, such as how the economy was doing or expected to be doing. The WEO chapter claims to have mirrored the methodology of Romer and Romer for the US economy. But this is not quite right. Romer and Romer examined a voluminous documentation of Congressional proceedings to disentangle “exogenous” tax changes, i.e. exogenous to the economic cycle. The WEO Chapter uses descriptive IMF and OECD reports which state what happens to the deficit in a particular period; these reports do not go into the details of policymakers’ intentions, discussions and congressional records.

It is worth pointing out that many other papers using different methodologies have identified cases of expansionary fiscal adjustments. For example, in a previous paper we investigate, at length, nine specific episodes of fiscal adjustments, some of which expansionary and others contractionary (Alesina and Ardagna 1998). Giavazzi and Pagano (1990) had already discovered two expansionary episodes. In his published comments on that paper, Olivier Blanchard (the IMF’s Chief Economist) argued that expansionary fiscal adjustments can indeed occur and he also showed why. He argued that a fiscal adjustment, by removing fear of future harsher ones and future taxes, can stabilise expectations, increase consumers’ expected disposable income, and increase confidence of investors and therefore can stimulate private demand.

Below is an incomplete list of papers consistent with the possibility of expansionary fiscal adjustments. All of these analyses find two results:

  • Spending cuts are less recessionary than tax increases when deficits are reduced, and;
  • Sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns.

I don’t believe that, despite its rhetoric, the WEO chapter proves that either of these two conclusions regarding the history of fiscal adjustments is incorrect.

What will happen to the current cases of budget cuts in an especially difficult situation for the world economy remains to be seen. But one thing is certain: Several European countries had no choice but to initiate fiscal adjustment programmes. Let’s hope for the best.

Literature on possibly expansionary fiscal adjustments

Alesina A., and R. Perotti (1995), "Fiscal Expansions and Adjustments in OECD Countries, Economic Policy, n.21, 207-247.

Alesina A., S. Ardagna, R. Perotti, and F. Schiantarelli (2002), "Fiscal Policy, Profits, and Investment", American Economic Review, vol. 92, no. 3, June 2002, 571-589.

Alesina A., R. Perotti, and J. Tavares (1998), "The Political Economy of Fiscal Adjustments", Brookings Papers on Economic Activity, Spring 1998.

Alesina and Ardagna (1998), "Tales of Fiscal Adjustments", Economic Policy, no. 27, October 1998, pp. 489-545.

Ardagna Silvia (2004), “Fiscal Stabilizations: When Do They Work and Why?”, European Economic Review, vol. 48, No. 5, October 2004, pp. 1047- 1074.

Blanchard, Olivier (1990), “Comments on Giavazzi and Pagano”, NBER Macroeconomic Annual.

Broadbent, Ben and Kevin Daly (2010), “Limiting the fall-out from fiscal adjustment”, Goldman Sachs, Global Economics Paper 195, April.

Cournede B and F Gonand (2006), “Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?”, OECD Economics Department Working Papers no.520.

Giavazzi F., and M.Pagano (1990), Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries, NBER Macroeconomics Annual, MIT Press, (Cambridge, MA), 1990, 95-122.

Guihard S, M Kennedy, E Wurzel, and C/ Andre (2007), “What Promotes Fiscal Consolidation: OECD Country Experience”, OECD Economics Department Working Papers no. 553.

Giavazzi F., and M. Pagano (1996), Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience, Swedish Economic Policy Review, vol. 3, n.1, Spring, 67-112.

McDermott J and R Wescott (1996), “An Empirical Analysis of Fiscal Adjustments”, IMF Staff papers, 43(4):723-753.

Lambertini, L and J Tavares (2005), “Exchange rates and fiscal adjustments: Evidence from the OECD and implications for the EMU”, Contributions to Macroeconomics,5, 11.

Tavares, J (2004), “Does right or left matter? Cabinets, credibility and fiscal adjustments”, Journal of Public Economics, 88:2447-2468.

von Hagen J and R Strauch, (2001), “Fiscal Consolidations: Quality, Economic Conditions, and Success, Public Choice, 109,3-4:327-346

von Hagen J, AH Hallett, R Strauch (2002), “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence”, Journal of the Japanese and International Economics, 16:512-535.

References

Alesina, A. and S. Ardagna (2010) “Large changes in fiscal policy taxes versus spending” in J.R. Brown (ed) Tax policy and the economy, NBER and University of Chicago Press.

IMF(2010, World Economic Outlook, Ch. III.

Krugman, Paul (2010), “British Fashion Victims”, The New York Times, 21 October.

 

Topics: Macroeconomic policy
Tags: budget cuts, Fiscal crisis, Fiscal retrenchment

Nathaniel Ropes Professor of Political Economy, Harvard University; and Research Fellow, CEPR