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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