Expansionary Fiscal Contractions: The Empirical Evidence

Policymakers, particularly in Europe, are having to delicately balance the need to reassure the financial markets and credit rating agencies against the danger of jeopardizing the fragile recovery of their economies or of pushing their economies further into recession.

Abstract

Policymakers, particularly in Europe, are having to delicately balance the need to reassure the financial markets and credit rating agencies against the danger of jeopardizing the fragile recovery of their economies or of pushing their economies further into recession.

Rina Bhattacharya and Sanchita Mukherjee

Policymakers, particularly in Europe, are having to delicately balance the need to reassure the financial markets and credit rating agencies against the danger of jeopardizing the fragile recovery of their economies or of pushing their economies further into recession.

Achieving and maintaining a sustainable level of public debt over the medium term will require a major and sustained fiscal adjustment in most advanced economies. The precise magnitude of primary balance adjustment required is quite sensitive to assumptions—for example, on interest rates and growth rates. Nevertheless, the scale of the fiscal problem is large for almost all reasonable sets of parameter values. IMF staff carried out baseline simulations to determine the improvement required in the structural primary balance in advanced economies to either achieve a debt-to-GDP ratio of 60 percent by 2030, or to stabilize the debt-to-GDP ratio at the end-2012 level for those countries where the ratio is below 60 percent (Abbas and others, 2010). These simulations suggest that the required adjustment in the structural primary balance amounts to 8 percentage points of GDP over the period 2011 to 2020, implying a fiscal effort of ¾ percentage points of GDP per year. Not surprisingly, however, the required fiscal adjustment varies considerably across countries, ranging from just under a ½ percentage point of GDP for Switzerland to over 13 percentage points of GDP for Japan, Ireland, and Greece.

Countries such as Canada and Ireland have managed in the past to significantly reduce their fiscal deficits—by around 10 percent of GDP—over a relatively short period of time. However, countries that are currently undertaking fiscal adjustment are in a unique situation from a historical perspective in at least two ways. First, rarely have so many major economies faced the need to cut their budget deficits at the same time. Second, many countries that undertook fiscal consolidation in the past were able to offset the adverse impact on output through expansionary monetary policy and/or by devaluing their exchange rates. Today most advanced countries have little or no scope to further loosen their monetary policies or, in the case of the euro zone economies, to devalue.

The traditional presumption that short-term fiscal multipliers are always positive has been challenged on both theoretical and empirical grounds. From a theoretical viewpoint it has been noted that, once the impact on risk premiums and expectations are taken into account, the negative demand impact of lower fiscal deficits may be more than offset by an increase in private domestic demand. A growing empirical literature has also critically reassessed the short-term and long-term effects of fiscal policy among different countries and time periods. One of the more striking findings of this literature has been the possibility of negative fiscal multipliers connected to strong fiscal consolidations. The famous adjustment episodes in Ireland and Denmark in the 1980s—where consolidation was followed by a sharp upturn in growth—led to several studies that implied negative multipliers may in fact be more widespread than suggested by conventional wisdom (Giavazzi and others, 2000).

“Not surprisingly, however, the required fiscal adjustment varies considerably across countries.”

There are primarily two mutually non-exclusive views to explain why fiscal adjustments can be expansionary. The first one, proposed by Giavazzi and Pagano (1990) and Blanchard (1990) and further explored by Bertola and Dra-zen (1993) and Sutherland (1997), emphasizes wealth effects on consumption and expectations of future tax liabilities. In addition, private demand reacts to the perceived credibility of the adjustment. The second view, proposed by Alesina and Perotti (1997a, 1997b) and Alesina and Ardagna (1998), emphasizes the supply-side effects of fiscal adjustment measures operating through the labor market.

Fiscal adjustments operate through both the demand side and the supply side. Two mechanisms may be at work on the demand side: (1) wealth effects on consumption, and (2) credibility effects on interest rates. When spending cuts are perceived as permanent, consumers anticipate a reduction in the tax burden and a permanent increase in their lifetime disposable incomes. Thus, in contrast to the Keynesian case, the wealth effect predicts that private consumption increases when government spending is cut. The size of the increase in private consumption depends on the absence of liquidity-constrained consumers and on the efficiency of financial markets. Similarly, while a tax increase should reduce private demand and be contractionary, in some cases it can be expansionary. This may be the case if tax hikes today imply a change of fiscal regime, so that consumers believe that previously anticipated larger tax increases will not be necessary in the future.

The second source of expansionary effects of fiscal consolidations is the credibility argument on interest rates. At high or rapidly increasing levels, public debt may face a significant interest rate premium due to inflation or default risks. A fiscal consolidation, if perceived as permanent and successful, can bring about a discrete reduction in real interest rates. Here too initial conditions are important. Risk premia are likely to be significant only when the level of the debt/GDP ratio crosses some relatively high threshold (Ale-sina and others, 1992). Recent research by IMF staff suggests that the frequently cited cases of Ireland and Denmark could be stand-alone cases and that the “credibility” effect of fiscal consolidation on interest rates may not apply more generally (IMF, 2010).

The macroeconomic impact of fiscal adjustment measures will also depend on the stance of monetary policy. In the standard Keynesian model, a fiscal contraction can be expansionary or neutral if it is accompanied by a sufficiently lax monetary policy, which in a small open economy may take the form of devaluation. In particular, a devaluation at the onset of fiscal adjustment can help to maintain (or even increase) aggregate demand by giving a boost to exports, thereby offsetting—at least to some extent—the contractionary impact of any fall in domestic demand arising from the fiscal consolidation measures.

Finally, as Giavazzi, Jappelli, and Pagano (2000) note, a common finding of the empirical studies on non-Keynesian effects of fiscal policy is that the response of private sector demand may be non-linear: both the magnitude and the sign of the response appear to change depending on the conditions under which the impulse occurs and on its characteristics.

Bhattacharya and Mukherjee (2010) explore the hypothesis that the propensity to consume out of income varies in a non-linear fashion with fiscal variables, and in particular with government debt per capita. Using data from 18 OECD countries, the authors first apply a Kalman Filter to derive time-varying estimates of the marginal propensity to consume for each of these countries. They go on to use standard panel data estimation methods to see if there is a non-linear relationship between the estimated marginal propensities to consume and the ratio of government debt to household income. The ratio of government consumption to GDP is included as an additional explanatory variable to empirically examine the evidence that private consumption and government consumption are complements/substitutes in the household utility function. Their empirical results lend strong support to the hypothesis that households move from non-Ricardian to Ricardian behavior as government debt reaches high levels and as uncertainty about future taxes increases.

Recent studies by IMF staff (IMF, 2010 and Guajardo and others, 2011) have forcefully argued that fiscal austerity is unlikely to trigger faster growth, at least in the short term. While this may indeed be the case, the empirical evidence presented in Bhattacharya and Mukherjee (2010) strongly suggest that the contractionary impact of fiscal consolidation in heavily indebted advanced economies may be offset, at least in part, by higher private consumption.

More specifically, in Australia, Belgium, Canada, and Spain, their estimates of the private marginal propensity to consume show a trend rise over the past decade at the same time that the government net debt to gross household income ratio fell. This indicates that the relationship between these two variables can become negative during periods of high government indebtedness once economic agents are convinced about the authorities’ commitment to fiscal consolidation. The policy implication, at least for these countries, is that the direct negative impact of fiscal consolidation measures may be offset, at least in part, by increases in private consumption. The same may be true for other highly indebted countries that have witnessed large increases in public debt in the period since the onset of the global financial crisis in 2008, such as the United Kingdom and the United States. However, in these countries the offsetting impact of higher private consumption is likely to be much more muted due to the current high levels of debt of households relative to their disposable incomes.

References

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