Download Short-Run and Long-Run Effects of Fiscal Austerity

Economics 134
Spring 2013
Christina Romer
David Romer
LECTURE 26
Short-Run and Long-Run Effects of
Fiscal Austerity
April 30, 2013
Announcements
• Hand in Problem Set 4.
• We will hand back graded essays at the end of
Thursday’s lecture
• Final Exam is Thursday, May 16, 8-11 a.m., in 220
Hearst Gym.
• Extra office hours and Q&A sessions will be posted
on the course website.
About the Final Exam
• Coverage: Whole semester. But:
• There will be more emphasis on Sections VI to IX of the
syllabus.
• There won’t be any multiple choice questions that are
specifically about the readings from before the midterm.
• Format: Broadly similar to last year’s final (which is posted on
the course website).
• Multiple choice
• True/False/Uncertains
• Problems
• Essay
• Students with DSP accommodations: You will receive an email
from us.
I. OVERVIEW
Fiscal Austerity
• Deliberate measures to get the government budget
deficit down.
• Other terms: fiscal consolidation, fiscal reform,
deficit reduction, fiscal contraction.
Fiscal Consolidation in Advanced Countries
Source: IMF Fiscal Monitor, 2013.
Impacts of Fiscal Austerity
• Near-term: Does contractionary fiscal policy lower
or raise short-term GDP growth?
• Long-term: Is high government debt bad for growth?
II. ORIGIN OF THE IDEA OF EXPANSIONARY FISCAL
CONTRACTIONS
Effect of a Fiscal Contraction in the IS-MP Model
r
MP
r1
r2
IS2 IS1
Y2 Y1
Y
Empirical studies largely confirm the IS-MP result.
• Hall and Nakamura and Steinsson find cuts in
government spending lower output.
• Romer and Romer find that tax increases are
contractionary.
Giavazzi and Pagano
• Look at two countries that seem to have had
expansionary fiscal contractions.
• Ireland in the late 1980s and Denmark in the mid1980s.
Ireland and Denmark appear to have had expansionary fiscal contractions.
How could fiscal contractions be expansionary?
• Severe budget problems could be damaging
confidence; getting deficit under control improves
confidence.
• Severe budget problems are raising all interest rates
and hurting the financial system. Fiscal reform
lowers rates and allows firms and consumers to
borrow at reasonable rates.
• Budget problems are a symptom of dysfunctional
government. Fiscal consolidation is a sign that the
government is functioning, and so may be correlated
with other measures that are good for growth.
What might be unusual about these two cases?
• Countries are small.
• Fiscal and economic problems are localized.
• Episodes predate the creation of the euro, so could
use country-specific monetary and exchange rate
policy.
Looking at More Countries:
Alesina and Ardagna’s Approach
• Look at many advanced economies over the past 30
years.
• Identify fiscal consolidations mechanically as times
when the cyclically-adjusted budget deficit falls by
1.5% of GDP.
The standard approach found that fiscal consolidation, particularly
through spending cuts, raised GDP.
III. WEO: WILL IT HURT? THE
MACROECONOMIC EFFECTS OF FISCAL
CONSOLIDATION
Why might the standard approach tend to find
that fiscal consolidations are expansionary?
• It may identify as consolidations times when revenues
rose because of asset price booms (which are also times
when output tends to rise).
• It may include consolidations that were followed by
growth, but exclude consolidations that were followed by
recessions (because the consolidations followed by
recessions were reversed).
• It may identify as consolidations the end of one-time
dramatic actions that may be associated with other
factors aiding growth (such as the reunification of
Germany).
Action-based approach (WEO)
• Identify fiscal consolidations from narrative sources.
• When did policymakers say they were trying to
reduce the budget deficit?
• WEO finds that the action-based approach yields
very different observations.
What makes the impacts of consolidation
smaller?
• Monetary expansion.
• Currency depreciation.
Why are spending cuts less contractionary than
tax increases?
• Monetary policy isn’t used to counteract tax
increases?
• Why?
Is there a confidence effect when default risk is
high?
• Somewhat. Consolidation is less painful if you start
with high risk of default.
• But Ireland and Denmark (Giavazzi and Pagano’s two
expansionary contractions) are still unusual.
Evaluation of the WEO study:
• Very carefully done.
• Identification of consolidations from narrative
sources is difficult and involves judgment.
• More work is still needed.
Implications of the WEO study:
• Deficit reductions will be painful.
• Particularly painful at the zero lower bound and
when a country can not depreciate relative to its
trading partners.
• Confidence effects appear to be small.
IV. IMPACT OF HIGH PUBLIC DEBT ON GROWTH
Reasons Why High Government Debt/GDP May
Lower Growth:
• Large deficits and debt may raise interest rates and
crowd out private investment.
• High debt and high interest payments may require
large distortionary taxes.
• High debt may eventually lead to a fiscal crisis, which
in turn, may trigger a financial crisis and require
painful adjustments.
What do Reinhart and Rogoff do?
• Get data on Debt/GDP and real GDP growth annually
for 20 countries since 1946.
• Put data by country by year into 4 bins based on
Debt/GDP: 0-30%; 30-60%, 60-90%, over 90%.
• Get average GDP growth in a country for each bin.
• Average countries in each bin.
Source: Reinhart and Rogoff, “Growth in a Time of Debt”
Critique by Herndon, Ash, and Pollin
• Background
• Replicability of results is a big issue in economics.
• Paper generated a lot of news coverage.
Data and Calculation Issues
• Spreadsheet coding mistake
• Reinhart and Rogoff left out 5 countries.
• Selective omission
• Data for New Zealand, Australia, and Canada
for late 1940s left out. NZ had very high debt
and high growth in the omitted years.
• Weighting
• Each country in a bin gets the same weight
regardless of number of years with debt/GDP in
that range.
Source: Herndon, Ash, and Pollin, “Does High Public Debt Consistently Stifle Economic Growth?”
Source: Herndon, Ash, and Pollin, “Does High Public Debt Consistently Stifle Economic Growth?”
Evaluation of Herndon, Ash, and Pollin
• Raise some significant data and statistical issues.
• The most important differences involve judgment
calls.
• May not be focusing on the most important issue:
causation.
Is Reinhart and Rogoff’s Relationship Causal?
• Could there be reverse causation?
• Low growth leads to high debt/GDP.
• Japan is a case where that seems to be true.
• Reinhart and Rogoff’s response.
Debt and Growth by Country
Source: Krugman, “Reinhart-Rogoff, Continued”
Source: Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800”
Is Reinhart and Rogoff’s Relationship Causal?
• Could there be omitted variable bias?
• Countries mess up in multiple ways: Bad
policies lead to low growth and high debt.
• In the case of the U.S.: World War II led to high
debt, and end of war led to negative growth.
120.0
80.0
0.0
Debt-to-GDP Ratio
Real GDP Growth
60.0
40.0
20.0
10
5
0
-5
-10
-15
-20
-25
Real GDP Growth
100.0
1940
1943
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
Debt-to-GDP Ratio
Debt and GDP Growth in the U.S., 1946-2012
25
20
15
Is there a better way to look for a relationship
between debt and growth?
• Clever instruments?
• Narrative evidence?
• Focus on transmission mechanism, such as interest
rates or financial crises?
• Rely on theory?
V. CONCLUSIONS