Download This PDF is a selection from a published volume from... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

This PDF is a selection from a published volume from the National
Bureau of Economic Research
Volume Title: NBER International Seminar on Macroeconomics
2011
Volume Author/Editor: Jeffrey Frankel and Christopher Pissarides,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-26035-6; 978-0-226-26034-1 (cloth);
978-0-226-26035-8 (paper)
Volume URL: http://www.nber.org/books/fran11-1
Conference Date: June 17-18, 2011
Publication Date: May 2012
Chapter Title: Comment on "The Fiscal Stimulus of 2009-2010:
Trade Openness, Fiscal Space, and Exchange Rate Adjustment"
Chapter Author(s): Menzie Chinn
Chapter URL: http://www.nber.org/chapters/c12499
Chapter pages in book: (p. 343 - 347)
Comment
Menzie Chinn, University of Wisconsin and NBER
I.
Introduction
This is a very interesting and relevant paper. The authors examine a
mix of advanced and emerging market economies’ policy response to
the Great Recession of 2007–2009. Unlike other treatments, the novelty of the approach is that it links the strength of fiscal and exchange
rate responses to the extent of fiscal space and trade openness. In other
words, they marry the insights of public finance and open economy
macroeconomics.
The authors find, using simultaneous equations estimation, that
countries rely more on the former when there is more fiscal space (in
2006) and are less open in terms of international trade. They find that
this pair of findings is robust to a variety of modifications of the specification and estimation approaches. I think these findings make a lot of
sense, and I expect them to be established as stylized facts in the literature. Nonetheless, these findings inspire some additional questions, as
well as avenues for further research.
II.
What Is Fiscal Space?
The key determinant in their finding that countries tend to substitute
exchange rate depreciation for fiscal stimulus when constrained by a
shortage of fiscal space is the fiscal space variable. They focus on their
preferred measure—debt-to-tax-base—mainly on the basis of their previous work (Aizenman, Hutchison, and Jinjarak 2011).
In fact, the concept of fiscal space, while intuitively appealing, is not
easily operationalized. Ostry et al. write: “The term ‘fiscal space’ is used
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344
Chinn
variously in the literature—for example, to refer to the scope for financing the deficit tout court or for financing the deficit without either a
sharp increase in funding costs or undue crowding out of private investment” (Ostry, Ghosh, Kim, and Qureshi 2010, 6). How does one
judge this, however? Ostry et al. (2010) argue that one needs to take
historical behavior into account. Hence, for them, “fiscal space is the
difference between the current level of public debt and the debt limit
implied by the country’s historical record of fiscal adjustment.”
So conceptually, what goes into fiscal space is the tax revenue capacity and spending restraint capacity, as well as the level of current debt.
What motivates Aizenman and Jinjarak’s reliance on solely the former?
First, there is the fact that, as Ostry et al. (2010) find, it is hard to precisely estimate the reaction function linking the primary budget balance
to lagged debt to GDP ratio. This point is illustrated in their figure 2,
reproduced as figure 1 below.
Second, market-based indicators of default risk, namely CDS spreads
on government debt, seem to be much more closely linked to debt / tax
revenue ratios than to other measures of fiscal space, such as the commonly used debt / GDP ratio. Hence, on purely pragmatic grounds,
measuring fiscal space using debt / tax revenues seems plausible, even
if it is somewhat unsatisfying from a theoretical perspective.
Fig. 1. Primary balance and lagged public debt, 1970–2007 (in percent of GDP)
Source: IMF’s World Economic Outlook database and staff estimates.
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Comment
345
It is of interest to speculate why it is so hard to estimate primary balance reaction functions; such reaction functions incorporate the ability
to restrain spending, and this might be a more difficult to measure “political” factor than the ability to tax. Hence, a debt / tax revenue measure
empirically works better.
III.
Reinterpreting the Results
The authors estimate the relationship between fiscal stimulus and fiscal
space and trade openness, controlling for a number of other variables,
using OLS, Tobit, and instrumental variables. The basic results can be
found in table 5, wherein the higher the debt / tax revenue and the
higher the trade openness, the smaller the fiscal stimulus. A 1 percentage point increase in the debt / tax revenue induces a 0.004 percentage
point reduction in the stimulus size (0.026 percentage point reduction if
endogeneity is accounted for). A 1 percentage point increase in trade
openness, measured as (X + M)/GDP, induces a 0.09 percentage point
reduction in fiscal stimulus.
These results are plausible, but I have one major concern. One can
think of a trade- off between fiscal stimulus, and stimulus induced by
exchange rate depreciation, for a given amount of desired stimulus. In an
open economy Keynesian model, the trade- off in terms of economic
effects is determined by the degree of trade openness (actually, the marginal propensity to import). That is a constraint of sorts. Governments
have quasi-preferences over fiscal stimulus versus exchange rate depreciations, and those preferences depend critically on the degree of fiscal
space. Hence, for a given amount of target stimulus, both trade openness
and fiscal space matter.1
In the conference version of the paper, conditioning on the target
amount of stimulus was omitted; the authors addressed this concern
in the published version by adding in a measure proxying for trade
and financial exposure to the United States. The fact that the results
pertaining to fiscal space and trade openness remain largely unchanged
is reassuring.
IV.
Some Additional Points
While the original version of the paper merges public finance and open
economy aspects, in some regards it omits some aspects of international
finance that might be important. For instance, is trade openness corre-
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346
Chinn
lated to capital account openness? How does the exchange rate regime
fit in? And is the ability (or inability) to borrow in the domestic currency
of importance to the use of fiscal policy? These are avenues for further
research.
A more specific concern relates to the use of the dollar as the reference currency in calculating the extent of depreciation. This is a strange
choice; the effective exchange rate is surely a better measure of macroeconomic competiveness in almost all cases, and its success makes one
wonder if the results are an artifact of the data.
In the published version of the paper, the results are checked using
a trade- weighted exchange rate instead of the dollar exchange rate.
Unfortunately, as an explanation of exchange rate depreciation, the coefficient on trade openness is no longer as large—and as statistically
significant—in this case. Perhaps the statistical nonsignificance is due
to the reduced sample size, or the composition of the smaller sample,
but this is one point that clearly calls for further investigation. On the
other hand, the fiscal space variable retains its statistical significance as
a determinant of fiscal stimulus.
V.
Concluding Thoughts
This is an interesting and incredibly relevant paper, which links together fiscal space and open economy macro. There are a wealth of
empirical results, most of which validate widely held, but previously
untested, views regarding the efficacy of fiscal policy versus exchange
rate depreciation. That being said, I think it might be useful to interpret
the results in a slightly more structural fashion, highlighting the effects
emanating from economically determined trade- offs and policy preferences.
Endnotes
For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http: // www.nber.org / chapters / c12499
.ack.
1. One can couch this argument in terms of the following framework. Consider isostimulus curves in fiscal- depreciation space; the slope of these iso- stimulus curves depends on the stimulus per unit of fiscal impulse and per unit of depreciation. There would
be a corresponding indifference curve for government policy, where preferences for fiscal
versus exchange rate induced effects depends on the degree of fiscal space and the importance of exporter and importer profits to the government. The outcome depends on
equating of marginal conditions so the trade- offs in terms of preferences matches that of
the constraint implied by the economic structure.
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Comment
347
References
Aizenman, Joshua, Michael J. Hutchison, and Yothin Jinjarak. 2011. “What Is
the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads
and Market Mispricing of Risk.” University of California, Santa Cruz.
Ostry, Jonathan D., Atish R. Ghosh, Jun I. Kim, and Mahvash S. Qureshi. 2010.
“Fiscal Space.” IMF Staff Position Note SPN / 10 / 11. Washington, DC: International Monetary Fund, September.
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