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Output spillovers from fiscal policy

Output spillovers from fiscal policy

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It's tough out there for policymakers seeking to stabilise economies, and shocks from abroad aren't helping. This column argues that for countries hit by recession, fiscal stimulus in another country might significantly stimulate demand back at home, softening the worse effects of the current crisis. The evidence suggests that transnational coordination of fiscal policy may well be more valuable than previously thought.

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Policymakers seeking to stabilise the economy face many challenges. A recent set of challenges is shocks from abroad. Such shocks can come from many directions: trade channels as during the Great Trade Collapse of 2009; financial linkages as during the 2008 Global Crisis; and capital flows (Crucini et al. 2008). Foreign fiscal policy is one shock that has been especially prominent during the Eurozone crisis and the US fiscal cliff discussion. Indeed, a common justification for fiscal agreements like the Stability and Growth Pact and successive measures adopted by Eurozone countries is that, having relinquished independent monetary and exchange rate policies, individual countries need some protection from the shocks of uncoordinated fiscal policies.

Fiscal spillovers

Economic observers long appreciated the importance of fiscal spillovers. The current economic environment consists of ever-increasing globalisation and conflicting demands for fiscal austerity and fiscal stimuli. This calls for clear and robust evidence with which policymakers can navigate through the Great Recession and its aftermath. Specifically, there are at least three key questions to be addressed:

  • What is the effect of fiscal austerity/stimulus in one country on economic conditions in another?
  • Can countries short of fiscal ammunition (e.g. Greece) be supported by positive fiscal stimulus in other countries?
  • Does the strength of fiscal spillovers vary over the business cycle?

What should be the scope of coordinated fiscal policies in recession? Our recent research (Auerbach and Gorodnichenko 2012c) sheds new light on these questions, with results that have immediate policy implications.

Fiscal shocks

The key ingredient in our analysis is a measure of fiscal spillover shocks. Building on our earlier work (Auerbach and Gorodnichenko 2012a, 2012b), we construct these shocks as follows:

  • First, we compute real-time, one-period-ahead forecast errors for government spending in each country from the OECD’s "Outlook and Projections Database".

This step helps to purify the series from predictable changes in government spending.

  • Second, to further purify the series from predictable movements in government spending, we project the forecast error on that country’s lagged macroeconomic variables (output, government spending, exchange rate, inflation, investment, and imports) as well as a set of country- and period-fixed effects.

The residual from our regression captures innovations in government spending orthogonal to professional forecasts and lags of macroeconomic variables. We take this residual as a measure of unanticipated government spending shocks.

  • Third, to construct the fiscal spillover shock affecting a given country, we aggregate fiscal shocks across source countries with bilateral trade weights.

Thus, the strength of the fiscal spillover is affected by the intensity of trade between countries as well as the overall openness of countries to trade.

Empirical framework

To model the effects of fiscal spillovers, we extend our approach (Auerbach and Gorodnichenko 2012b) and use data for a panel of OECD countries to estimate fiscal spillover multipliers using direct projections. We can use the same approach to study the effects of fiscal spillovers on a number of other macroeconomic variables in addition to output, hence painting a more detailed picture of how fiscal shocks propagate across countries.

We also wish to allow the impact of shocks to vary over the business cycle, given the findings in our earlier work that multipliers vary over the cycle and are larger in recessions.

Results

We find that fiscal spillovers are significant in both statistical and economic terms.

  • Depending on the sample of countries and measures of fiscal spillover shocks, the average real GDP multiplier of fiscal spillovers over the three-year horizon window is between one and two.

These multipliers are larger than those we found previously for domestic government spending shocks. Given that our spillover shocks are scaled by the level of imports from the affected country, this result