Tuesday, July 12, 2011

The contraction with "expansionary fiscal consolidation"!

The big macroeconomic debate of our times is over whether economies facing the Great Recession should indulge in more fiscal and monetary expansion or should embrace fiscal austerity and monetary contraction.

Advocates of more stimulus point to dismal economic conditions - aggregate demand slump, lack of business confidence, idle capacity, depressed business investments, high unemployment rates etc - and argue that the economy would remain in a deep recession in the absence of expansionary policies. The zero-bound in interest rates, they say, only exacerbates the problems.

The Austerians point to the huge build up of public debts across most developed economies and demand immediate steps to bring them down to sustainable levels. They also see dangers of an inflationary spiral and even asset bubbles unleashed by the extended expansionary monetary policy. They also fret at bond-vigilantes driving up interest rates.

In recent months, they have pointed to the work of Alberto Alesina and Silvia Ardagna (pdf here, earlier version here) who examined episodes of all large fiscal policy stances, both stimuli and adjustments, in OECD countries from 1970-2007. They found,

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

This has repeatedly been invoked to justify "expansionary fiscal contraction" or "expansionary austerity", where fiscal consolidation will result in increased growth. It is argued that fiscal consolidation by way of spending cuts or tax increases today will, by reducing the expectations of the need for a larger and disruptive fiscal adjustment later, raise household and business expectations about their future incomes and thereby stuimulate private consumption and business investments.

They also argue that if current fiscal policy can influence agents' expectations about interest rates by signalling to them about the government's resolve, by way of fiscal stabilization, to rein in public debt, "they can ask for a lower premium on government bonds". Further, aggregate demand components sensitive to real interest rates too get a boost if such credible expectations about fiscal stabilization and lower future interest rates are conveyed. They forecast a possible consumption/investment boom if such expectations can be credibly conveyed. This study has also been used to justify the preference of tax cuts over government spending if stimulus is deployed.

A recent paper by IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori have examined the dataset used by Alesina and Ardagna and find that their findings may have been compromised by the bias within the examples used. The IMF economists drew a distinction between fiscal consolidations motivated by a desire to reduce budget deficit and those responding to prospective economic conditions. They focussed on the impact of short-term fiscal consolidation arising out of only the former and found

"Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects...

Based on the fiscal actions thus identified, our baseline specification implies that a 1 percent of GDP fiscal consolidation reduces real private consumption by 0.75 percent within two years, while real GDP declines by 0.62 percent... Our main finding that fiscal consolidation is contractionary holds up in cases where one would most expect fiscal consolidation to raise private domestic demand. In particular, even large spending-based fiscal retrenchments are contractionary, as are fiscal consolidations occurring in economies with a high perceived sovereign default risk."

As Paul Krugman writes, the Alesina and Ardagna findings are muddled by reverse causation - they mistake the rise in revenues and/or fall in expenditures that generally follows fiscal consolidation (since safety-net spending falls or government prunes down expenditures) to claim that economic expansion follows all spending cuts and/or tax increases.

1 comment:

KP said...

Dear Gulzar,

Thanks for a timely post.