Fiscal Policy after the Financial Crisis
December 12-13, 2011
Valerie A. Ramey, University of California at San Diego and NBER
Ramey asks whether increases in government spending stimulate private activity, in the form of either private spending or private employment. She first studies private spending. Using a variety of identification methods and samples, she finds that in most cases private spending falls significantly in response to an increase in government spending. These results imply that the average GDP multiplier lies below unity. In order to determine whether concurrent increases in tax rates dampen the spending multiplier, she uses two different methods to adjust for tax effects. Neither method suggests perceptible effects of current tax rate changes on the spending multiplier. Next she explores the effects of government spending on labor markets and finds that increases in government spending lower unemployment. However, most specifications and samples imply that virtually all of the effect is through an increase in government employment, not private employment. She concludes that on balance government spending does not appear to stimulate private activity.
Alan J. Auerbach and Yuriy Gorodnichenko, University of California at Berkeley and NBER
Auerbach and Gorodnichenko extend their previous analysis of fiscal multipliers in two important ways. First, they estimate multipliers for a large number of OECD countries, rather than just for the United States, again allowing for state dependence and controlling for information provided by predictions. Second, they adapt their previous methodology to use direct projections rather than the SVAR approach to estimate multipliers, to economize on degrees of freedom and to relax the assumptions on impulse response functions imposed by the SVAR method. They confirm the findings of their earlier paper. In particular, multipliers of government purchases are larger in recession, and controlling for real-time predictions of government purchases tends to increase the estimated multipliers of government spending in recession.
Francesco Giavazzi, and Michael McMahon, University of Warwick
Giavazzi and McMahon provide new evidence on the effects of fiscal policy by studying, using household-level data, how households respond to shifts in government spending. They find that there is no such thing as a single "fiscal multiplier": the effects on households of a shift in government spending vary over time depending, among other factors, on the state of business cycle and, at a lower frequency, on the composition of employment (such as the share of workers in part-time jobs). Shifts in spending also have important distributional effects that are lost when estimating an aggregate multiplier. Heads of households working relatively few (weekly) hours, for instance, suffer from a spending shock of the type we analyzed: their consumption falls, their hours increase and their real wages fall.
Mathias Trabandt, European Central Bank, and Harald Uhlig, University of Chicago and NBER
Trabandt and Uhlig seek to understand how Laffer curves differ across countries in the United States and the EU-14, thereby providing insights into fiscal limits for government spending and the service of sovereign debt. As an application, they analyze the consequences for the permanent sustainability of current debt levels, when interest rates are permanently increased for example because of default fears. The authors build on the analysis in their earlier paper and extend it in several ways. To obtain a better fit to the data, they allow for monopolistic competition as well as partial taxation of pure profit income. They update the sample to 2010, thereby including recent increases in government spending and their fiscal consequences. They provide an analysis for the pessimistic case that the recent fiscal shifts are permanent. They include a cross-country analysis on consumption taxes as well as a more detailed investigation of the inclusion of human capital considerations for labor taxation.
William Easterly, New York University and NBER
Easterly points out that according to the well-known arithmetic of debt dynamics, a growth slowdown results in rising debt ratios if fiscal policy does not adjust. This mechanical effect plays a role in a surprisingly wide variety of public debt crises, from the Latin American debt crisis of the 1980s and 1990s to the low income HIPC crisis of the same period to the current Eurozone debt crisis and U.S. debt crisis. Growth slowdowns often result in growth projections by fiscal authorities that are too optimistic, one of the possible reasons for which fiscal policy fails to adjust. Sound forecasting practices of projecting mean reversion and being more conservative the worse the debt situation are ignored in some major debt crises.
Richard Evans and Kerk Phillips, Brigham Young University, and Laurence J. Kotlikoff, Boston University and NBER
Evans, Kotlikoff, and Phillips study the effects of a fiscal transfer program on the probability and timing of the insolvency of that program. They use an overlapping generations model with aggregate uncertainty in which households have rational expectations to show how the size of the fiscal transfer program affects the expected time in which the economy will reach its fiscal limit. They look at two results of insolvency. The first is a catastrophic government shut down in which the current economy ceases to function. The second is a less-severe permanent regime shift to a high proportional tax rate regime. In their example calibrated to the U.S. economy, they show that the expected time until the fiscal limit is about 100 years. But they also find that there is a roughly 35 percent chance that the economy could hit its limit in 30 years. They also calculate measures of the fiscal gap and the equity premium. Their model with potential fiscal insolvency generates equity premia that are close to those observed in the data.
Charles Wyplosz, University of Geneva
Eric M. Leeper, Indiana University and NBER, and Todd B. Walker, Indiana University
The Great Recession and worldwide financial crisis have exploded fiscal imbalances and brought fiscal policy and inflation to the forefront of policy concerns. Those concerns will only grow as aging populations increase demands on government expenditures in coming decades. It is widely perceived that fiscal policy is inflationary if and only if it leads the central bank to print new currency to monetize deficits. Monetization can be inflationary. But it is a misperception that this is the only channel for fiscal inflations. Nominal bonds, the predominant form of government debt in advanced economies, derive their value from expected future nominal primary surpluses and money creation; changes in the price level can align the market value of debt to its expected real backing. This introduces a fresh channel, not requiring explicit monetization, through which fiscal deficits directly affect inflation. Leeper and Walker describe various ways in which fiscal policy can directly affect inflation and explain why these fiscal effects are difficult to detect in time-series data.
Ruud de Mooij and Michael Keen, International Monetary Fund
Tax design faces unparalleled difficulties in many advanced economies, to restore credible and sustainable fiscal positions and enhance growth-and doing so, in some cases, with great urgency and in circumstances of considerable social stress. de Mooij and Keen focus on the redesign and rebalancing of core instruments that, ultimately, must bear much of the brunt in meeting these challenges. They assess the merits of the VAT in this context, including by developing and beginning to apply a methodology for diagnosing weaknesses in design and implementation so as to find revenue in ways likely to be less distortionary and fairer than raising the standard rate from levels that are in many cases already very high. They then explore the currently fashionable idea of a "fiscal devaluation" -- a shift from social contributions to the VAT-which advocates see as one of the few options available to troubled eurozone countries. They find that in countries with fixed exchange rates this may improve the trade balance, with quite sizable short-run effects. As theory predicts, the effects appear disappear in the long run, so that the case for such shifts rest largely on their potential to accelerate adjustment to deeper underlying problems.
Pierre Cahuc, Ecole Polytechnique, and Stephane Carcillo, OECD
Cahuc and Carcillo analyze the relation between public wage bills and public deficits in the OECD countries from 1995 to 2009. They show that fiscal drift episodes, characterized by simultaneous increases in the GDP shares of public wage bills and budget deficits, are more frequent during booms and election years, but not during recessions, except for the 2009 exceptionally strong recession. The emergence of fiscal drift episodes during booms and election years is less frequent in countries with more transparent government, more freedom of the press, as well as in countries with presidential regimes and less union coverage. Inversely, fiscal tightening episodes, characterized by simultaneous decreases in the GDP shares of public wage bills and budget deficits, occur less often during booms than during recessions. The emergence of fiscal tightening episodes during recessions and election years is less frequent in countries with more union coverage.
Axel H. Boersch-Supan, Max Planck Institute for Social Law and Social Policy and NBER
Many European countries have begun (or have announced) programs intended to reduce the growth of entitlement programs, in particular of public pensions. Current costs are high, and the pressures will increase due to population aging and negative incentive effects. Boersch-Supan focuses on the pension reform process in Europe. He links the causes for current problems to the cures required to make the pay-as-you-go entitlement programs in Continental Europe sustainable above and beyond the financial crisis. He then discusses examples which appear, from a current point of view, to be the most viable and effective options to achieve successful changes in the entitlement system. There is no single policy prescription that can solve all problems at once. Reform elements include a freeze in the contribution and tax rates, an indexation of benefits to the dependency ratio, measures to stop the current trend towards early retirement, an adaptation of the normal retirement age to increased life expectancy, and more reliance on private savings –- elements of a sustainable but complex multi-pillar system of pensions and similar entitlement programs.
Roberto Perotti, Universita' Bocconi and NBER
As governments around the world contemplate slashing budget deficits, the "expansionary fiscal consolidation hypothesis" is back in vogue. Perotti argues that, as a statement about the short run, it should be taken with caution. He presents four detailed case studies, two - Denmark and Ireland - undertaken under fixed exchange rates (the most relevant case for many Eurozone countries today) and two - Finland and Sweden - after floating the currency. All four episodes were associated with an expansion; but only in Denmark was the driver of growth internal demand. However, after three years a long slump set in as the economy lost competitiveness. In all the others for a long time the main driver of growth was exports. In Ireland this occurred because the sterling coincidentally appreciated. In Finland and Sweden the currency experienced an extremely large depreciation after floating. In all consolidations interest rate fell fast, and wage moderation played a key role in generating a gain competitiveness and a decline in interest rates. These results cast doubt on at least some versions of the "expansionary fiscal consolidations" hypothesis.
Alberto F. Alesina; Dorian Carloni, University of California, Berkeley; and Giampaolo Lecce, Bocconi University
The conventional wisdom regarding the political consequences of large reductions of budget deficits is that they are very costly for the governments that implement them: they are punished by voters at the following elections. Alesina finds no evidence that governments that quickly reduce budget deficits are systematically voted out of office in a sample of 19 OECD countries from 1975 to 2008. He also takes into consideration issues of reverse causality, namely the possibility that only "strong and popular" governments can implement fiscal adjustments and thus they are not voted out of office despite having reduced the deficits. In the end he concludes that many governments can reduce deficits decisively while avoiding an electoral defeat.