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World World Economic Economic Outlook Outlook Fall 2010 Will It Hurt? Macroeconomic Effects of Fiscal Consolidation Daniel Leigh, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton, and Andrea Pescatori with support from Murad Omoev, Min Song and Jessie Yang. Setting the Scene Advanced economies face challenge of fiscal consolidation. What are the macro effects of tax hikes and spending cuts? Role of monetary policy, international trade, tax-spending composition, perceived sovereign risk. Fiscal Balance/GDP 0 Government Debt/GDP 110 -1 -2 1 00 -3 -4 90 -5 -6 80 -7 -8 70 -9 -10 2005 10 15 60 2005 10 Source: IMF World Economic Outlook database. Note: Advanced economy weighted average. General government. 15 Main Results Fiscal consolidations are contractionary : GDP falls, unemployment rate rises in the short term. Monetary easing (ER↓, R↓) + NX boom = key cushioning role. Contractionary for both spending cuts and tax hikes but more for tax hikes. Key: R↓ more for spending cuts. Contractionary for both high sovereign default risk and low risk but more for low risk. Long-term gains. Roadmap Looking at History (Empirical Analysis) New approach for identifying episodes. Fresh evidence: short-term effects. Model Simulations: GIMF Zero lower bound, synchronized adjustment. Long-term effects. Identifying Fiscal Consolidation Conventional approach: outcome-based (CAPB). Sample selection bias expansionary effects. Alesina and Ardagna (2010), many others. Action-based definition: historical accounts and records (OECD Economic Surveys, IMF documents, budgets). 15 OECD countries 1980-2009: 173 cases of fiscal consol G7, AUS, BEL, DNK, FIN, IRL, PRT, ESP, SWE. Mean size of 173 cases: 1% of GDP. Example: Fiscal Consolidation in Japan in 1997 Fiscal consolidation totals 1.8 % of GDP. Tax hikes: of 1.2 % of GDP, spending cuts of 0.6 % of GDP. Part of medium-term strategy of fiscal consolidation (Fiscal Structural Reform Act) in response to large structural fiscal deficit and future demographic pressures. Sources: 1997 IMF Staff Report for Japan. Macroeconomic Effects Estimation approach: Romer-Romer-style. g: growth rate of real GDP. FC: action-based consolidation in % of GDP. Cumulate responses to estimate GDP level. 2 2 j 1 s 0 git j gi ,t j s FCi ,t s uit uit i t vit Robustness: different lag lengths (up to 4), no lags of growth. Similar results. Fiscal Consolidation is Contractionary Impact of 1% of GDP fiscal consolidation. GDP down ½ percent. Unemployment rate up ⅓ point. Note: Consolidation in year t=1. Point estimates and one standard error bands. Usually: Monetary Mitigation Monetary conditions ease in response to fiscal consol. Interest rates fall. Currency looses value (both real and nominal). Interest Rate (Basis points) Exchange Rate (Percent) Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Transmission Channel: Net Exports NX increase plays key offsetting role. Contribution ↑ 0.5%. Domestic demand ↓ 1%. Exports rise 1%, imports fall 1%. Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Does Composition Matter? Tax-based vs. spending-based consolidation. Both are contractionary, but spending-based less so. Unemployment Rate GDP Tax-based Spending-based Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Does Composition Matter? (Cont.) Domestic Demand Tax-based Spending-based Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Composition and Monetary Policy Spending-based: interest rate cuts, currency loses value. Tax-based: interest rate hikes. Policy Rate (Basis points) Real Effective Exchange Rate (Percent) Tax-based Spending-based Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Role of Perceived Sovereign Default Risk Low perceived risk “Keynesian” contraction. High risk milder contraction. Denmark/Ireland = outliers. Denmark (1983) and Ireland (1987) High risk Low risk Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Contrast with the Literature Our sample using AA (2010) episodes expansionary effects. Interpretation: sample selection bias. Action-based approach (large > 1.5%) Standard approach (∆CAPB/GDP > 1.5%) GDP Unemployment Rate Note: Impact of additional 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. GIMF: Zero Interest Rate Floor Canada and Rest of the World. With zero interest rate floor contractionary effect doubles. ZIRF + synchronized adjustment effect doubles again. Impact of Fiscal Consolidation of 1% of GDP on GDP With zero interest rate floor Without zero interest rate floor Canada-only fiscal consolidation Global fiscal consolidation GIMF: Long-term Effects G3 debt/GDP ↓ 10pp interest rate ↓ 30 bps. Interest payments ↓ taxes ↓ (or spending ↑) GDP ↑ range of outcomes: Minimum: 0.5% (savings used to raise general transfers) Maximum: 1.5% (savings used to cut capital income taxes) Rest of world benefits (lower interest rate). Lessons for Today Fiscal consolidations are contractionary in short-term. Monetary easing (ER↓, R↓) + NX boom = key cushioning role. But less today (zero R, synchronized). Less contractionary for high risk than for low risk. Reforms needed: retirement age, entitlement programs. Long-term gains. Lower interest rates, lower taxes. Appendix Episodes of Fiscal Consolidation: Action-based vs. Standard Approach JPN 1999 FIN 2000 JPN 2006 BEL 1984 FIN 1993 IRL 1982 ITA 1993 FIN 1992 IRL 2009 Action-based approach Standard approach (change in cyclically adjusted primary balance) DEU 1996 Tax vs. Spending: Additional Results Tax-based GDP Domestic Demand Contribution Spending-based Unemployment Rate Net Exports Contribution Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands. Composition and Monetary Policy (cont.) Why do monetary conditions ease less for tax-based? Central banks view spending cuts favorably (signal discipline)? Inflation impact of (indirect) tax hikes. Policy Rate (Basis points) Tax-based (indirect) Tax-based (direct) Spending-based GDP (Percent) Note: Impact of 1% of GDP consolidation in year t=1. Spending Composition Transfers cuts more benign than cuts to government consumption or investment. Confidence effects? Results only suggestive. Cuts to government transfers Cuts to public consumption Cuts to public investment Note: Impact of 1% of GDP consolidation in year t=1. Long-Term Effects (GIMF)