Olivier Blanchard, the IMF’s Chief Economist who is stepping down from that position at the end of September gave an interesting interview on his term at the IMF which focused, among other things, on the issue of fiscal multipliers as one of the main topics where the IMF had to update its beliefs and change its assumptions on the relationship between fiscal consolidation and growth. Given this opportunity I would like to use this space as a small reference on the existing literature on the topic.
Up until the crisis, fiscal multipliers were calculated usually through an SVAR system IRFs based on a methodology pioneered by Blanchard himself (Blanchard and Perotti 2002) . Based on that research, fiscal multipliers were considered to be rather small with estimates ranging between 0.3 and 0.6 for tax multipliers and 0.3 and 1 for spending multipliers. The large (and persistent) output gaps since the crisis, the presence of the ZLB which limited monetary accommodation as well as the inability to devalue at least in the Eurozone countries changed the focus of the research away from a roughly balanced growth path where fiscal effects are only temporary (and Ricardian equivalence holds) and towards a methodology focused on regime-switching models, usually implemented through Smooth-Transition VARs. Early and significant contributions to this literature were made by Auerbach and Gorodnichenko whose work is still the primary reference on the subject.
Under this kind of framework, fiscal multipliers are different in downturns and upturns measured by a state variable such as the output gap. Moreover, in order to avoid bias problems, fiscal shocks were not specified using the cyclically adjusted primary balance approach (as originally used by Alesina in his ‘expansionary austerity’ papers) but rather using either the ‘narrative approach’ where fiscal shocks are determined based on the examination of policy documents to identify episodes of exogenous fiscal measures or where shocks are identified as forecast errors based on professional forecasts of fiscal policy.
Fiscal multipliers in the G-7
One of the earliest research notes on the subject was during 2012 by the IMF (which was also presented in the Fiscal Monitor of that year) on the fiscal multipliers in G-7 countries. The paper used a TVAR methodology to calculate spending and tax multipliers for six G7 countries.The results showed that multipliers are significantly different between regimes with spending shocks having a substantially higher effect on output:
Growth forecast errors and multipliers
Following the strong Greek disappointment the IMF and its Chief Economist published significant research on its WEO 2012 and as a separate paper on the fiscal multipliers during the fiscal consolidation period. The idea was actually rather simple and elegant:
regress forecast error for real GDP growth on forecasts of fiscal consolidation. Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors
The results indicated that forecasters had significantly underestimated the impact of fiscal consolidation on economic growth and especially on consumption and investment (in other words, on internal demand):
Our forecast data come from the spring 2010 IMF World Economic Outlook (IMF, 2010c), which includes forecasts of growth and fiscal consolidation—measured by the change in the structural fiscal balance—for 26 European economies. We find that a 1 percentage point of GDP rise in the fiscal consolidation forecast for 2010-11 was associated with a real GDP loss during 2010-11 of about 1 percent, relative to forecast. Figure 1 illustrates this result using a scatter plot. A natural interpretation of this finding is that multipliers implicit in the forecasts were, on average, too low by about 1.
Table 1 reports our baseline estimation results. We find a significant negative relation between fiscal consolidation forecasts made in 2010 and subsequent growth forecast errors. In the baseline specification, the estimate of β, the coefficient on the forecast of fiscal consolidation, is –1.095 (t-statistic = –4.294), implying that, for every additional percentage point of GDP of fiscal consolidation, GDP was about 1 percent lower than forecast. Figure 1 illustrates this result using a scatter plot. The coefficient is statistically significant at the 1% level, and the R² is 0.496.
As Table 1 reports, when we remove the two largest policy changes (those for Germany and Greece), the estimate of β declines to –0.776 (t-statistic = –2.249) but remains statistically significant at the 5 percent level.
As Table 6 reports, when we decompose the effect on GDP in this way, we find that planned fiscal consolidation is associated with significantly lower-than-expected consumption and investment growth. The coefficient for investment growth (–2.681) is about three times larger than that for private consumption growth (–0.816), which is consistent with research showing that investment varies relatively strongly in response to overall economic conditions.
Overall, we find that, for the baseline sample, forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation.
Expansionary austerity? Not so fast
Another important piece of research by the IMF is a paper which focused on the ‘expansionary austerity’ narrative championed mainly by Alesina. The paper argued that using the cyclically adjusted primary balance (CAPB) suffered from serious bias problems and using instead a narrative approach (focusing on historical data of discretionary fiscal consolidation measures) changed the impact on growth significantly, especially compared to the CAPB estimation:
The conventional approach is to identify discretionary changes in fiscal policy using a statistical concept such as the change in the cyclically-adjusted primary balance (CAPB). As this paper explains, changes in cyclically-adjusted fiscal variables often include non-policy changes correlated with other developments affecting economic activity. For example, a boom in the stock market improves the CAPB by increasing capital gains and cyclically-adjusted tax revenues. It is also likely to reflect developments that will raise private consumption and investment. Such measurement error is thus likely to bias the analysis towards downplaying contractionary effects of deliberate fiscal consolidation. Moreover, a rise in the CAPB may reflect a government’s decision to raise taxes or cut spending to restrain domestic demand and reduce the risk of overheating. In this case, using the rise in the CAPB to measure the effect of fiscal consolidation on economic activity would suffer from reverse causality and bias the analysis towards supporting the expansionary fiscal contractions hypothesis.
To address these possible shortcomings, we examine the behavior of economic activity following discretionary changes in fiscal policy that historical sources suggest are not correlated with the short-term domestic economic outlook. In particular, we consult a wide range of contemporaneous policy documents to identify cases of fiscal consolidation motivated not by a desire to restrain domestic demand in an overheated economy, but instead by a desire to reduce the budget deficit.
A comparison of our measure of fiscal consolidation with the change in the CAPB reveals large differences between the two series, and suggests that, in these cases, the CAPB based approach tends to misidentify deficit-driven fiscal consolidations.
Based on our new dataset, Section III estimates the short-term effect of fiscal consolidation on economic activity. Our estimates imply that a 1 percent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 percent, while real GDP declines by 0.62 percent. In contrast, repeating the analysis using the change in the CAPB to measure discretionary policy changes provides evidence consistent with the expansionary austerity hypothesis. On average, a rise in the CAPB-to-GDP ratio is associated with a mild expansion in private consumption and GDP. The large difference in these estimates also arises for a subset of large fiscal adjustments––those greater or equal to 1.5 percent of GDP. These results suggest that the biases associated with using cyclically-adjusted data may be substantial.
Meta-Regression: Effects on Eurozone and Greece
Apart from presenting the results of specific papers it is also interesting to note the conclusions of a large meta-regression on the available literature on the topic. This research was also used in order to determine the actual effects of fiscal consolidation within Europe and in Greece. Its main results are:
The meta-analysis finds that the fiscal multiplier estimates are significantly higher during economic downturns than in average economic circumstances or in booms.
For example, the multiplier of unspecific government expenditures on goods and services robustly rises by an average of 0.6 to 0.8 units during a downturn. And for some specific instruments, for instance fiscal transfers, the multiplier increases by much more, turning transfers from the second least effective expenditure instrument into the most effective one. Part of the strong increase of the transfer multiplier might be explained by an increase in the share of liquidity constrained private households in downturns.
Importantly, and by contrast, there does not appear to be any such regime dependence in the impacts of tax changes. In fact, the spending multipliers exceed tax multipliers by about 0.3 units across the board in normal times and even more so in recession periods. Furthermore, during average economic times and in boom periods, the fiscal multipliers are not only lower than in downturns but also tend to vary less across different fiscal instruments.
Gechert and Rannenberg (2014) find that for all expenditure categories other than increases in unspecified government spending, the cumulative multipliers robustly exceed one in the downturn regime.
Spending multipliers tend to be larger than tax multipliers,
More open economies have significantly lower multipliers than more closed economies, and
The multipliers generally vary significantly across spending and tax categories, so that studies which look at the strength of general fiscal multipliers (or deficit multipliers) on average can produce very misleading results.
Looking into the effects of Euro wide fiscal consolidation the authors find that:
the fiscal consolidation in the Eurozone reduced GDP by 4.3% relative to a no-consolidation baseline in 2011, with the deviation from the baseline increasing to 7.7% in 2013. Thus, the austerity measures came at a big cost. By far the biggest contribution to this GDP decline comes from transfer cuts
This is especially evident in Greece where austerity can explain more or less the full extent of the loss of output since 2009, as well as the return to growth during 2014 (since that was the time when fiscal consolidation was largely put on hold) :
We estimate that austerity almost entirely explains the collapse of Greek GDP after 2009. This result suggests that ceteris paribus in the absence of austerity, the Greek economy would have entered a prolonged period of stagnation, rather than a depression.
We find that the fiscal consolidation in Greece reduced GDP by more than 10% in 2010, with the cumulative GDP decline increasing to 28% in 2013, after which it decreases to about 26% in 2014, as – according to our estimates – fiscal austerity was relaxed somewhat on the expenditure side in 2014.
Fiscal multipliers: Monetary accommodation and medium-term effects
I will end this post with a look at two more papers on the subject that do not attempt to just re-estimate fiscal multipliers for specific countries but rather to answer some important policy questions. Mainly whether monetary accommodation plays a role on the impact of fiscal consolidation (economic theory and common logic suggests it does) and how fiscal consolidation affects economic growth in the medium-term (which can have negative effects on potential output through lower growth of the capital stock and hysteresis effects on the labour market).
The first paper finds that fiscal policy is much more effective when monetary policy is accommodative. This also answers the crowding-in/out question of government spending since controlling for the stance of monetary policy can determine to a large extent the effects of fiscal measures.
Clearly, the response of output is conditional on the state of monetary policy: output increases to a large extent following a federal spending shock when monetary policy accommodates, while it falls, albeit not significantly, when monetary policy does not accommodate. This result holds over time and is consistent with the findings in Auerbach and Gorodnichenko (2012). The authors find that government spending tend to be slightly recessionary during expansions when expectations are controlled for.
Estimation results suggest that output increases by 2.5 dollars within a year for a dollar increase in federal spending when monetary policy is accommodative and decreases by 1.6 dollars when monetary policy is non-accommodative. The peak multiplier when the accommodative state prevails is equal 5.5 and only equals 2.8 under non-accommodative monetary policy.
The second paper tries to study the effects of fiscal consolidation on output and employment over a 5-year period for a sample of OECD countries during periods of deep recession defined as economic contractions lasting at least two consecutive years. It Fiscal shocks are identified using the narrative approach while separate expenditure and tax multipliers are calculated. An important contribution of this paper is the fact that it also tries to estimate employment and unemployment multipliers.
Its findings suggest that multipliers are indeed significantly larger during prolonged recessions while the asymmetry between long and ‘normal’ recessions exists mainly for expenditure based adjustments:
Our empirical findings suggest that the medium-term fiscal multiplier on output is significantly larger during PRs. Specifically, the medium-term multiplier is approximately -2 at a five-year horizon during PRs, compared to -0.6 during normal times. This means that during PR episodes a cumulative increase in the primary surplus of 1 dollar leads to a cumulative decrease in output of 2 dollars over a five-year horizon. We also find that the employment ratio persistently declines after a fiscal consolidation during periods of PR, resulting in a medium-term employment multiplier above -3 compared to -0.5 on average. The unemployment rate also persistently increases with an estimated medium-term multiplier of around 1.5, indicating that a cumulative increase in the primary surplus of 1 percent of GDP leads to a cumulative rise in the unemployment rate by 1.5 percentage points at a five-year horizon.
Our empirical results show that the asymmetry in the size of multipliers between PR and non-PR only exist for expenditure-based (EB) adjustments for which medium-term multipliers on output, employment or unemployment, are significantly higher during PR episodes compared to the average response in non-PR periods. Our results for tax-based (TB) consolidations are in line with previous literature, which finds large and symmetric effects of TB consolidations on output (Romer and Romer, 2010). These results are robust to several alternative specifications, including different definitions of the cycle, credit growth, and exclusion of countries with financial crises or with constrained monetary policy.
It is also highly significant that protracted recessions appear to have a serious impact on variables such as the capital stock, the NAIRU and (as a direct result) on potential output. Consumption, investment and private-sector employment are also seriously affected.
Overall I think it is quite clear that fiscal multipliers (especially expenditure multipliers) are high and significant during times of recession and negative output gap. They are able to explain the largest part of the output losses and stagnation in the Eurozone since 2010. The ‘confidence fairy’ does not seem to exist while continued consolidation during a deep and prolonged recession can have very serious effects not only on current output but also on potential output and future growth due to its impact on structural unemployment and the capital stock. Monetary policy accommodation (which is even more important in times when the ZLB has been hit or inside the Eurozone) determined to a large extent whether fiscal policy will have expansionary results or not and answers the crowding-in/out question.