Alberto Alesina May 2011

Fiscal Policy after the Great Recession

The problem   Major Fiscal Expansion during the recessions in the US and

many European countries   Several countries already entered the recession with the fiscal

house not in order, which made the problem worse   Now is the time to rein in the deficits both in the US and in

Europe   Have we waited too long?

Conventional wisdom is gloomy   Fiscal adjustment lead to recessions, particularly those on the

spending side.   Fiscal adjustments lead to electoral defeats and therefore this

is why they are postponed

Conventional wisdom wrong?   Most likely.   Fiscal adjustments on the spending side are less costly in

terms of short run recessions than tax based adjustments.

  The short run cost of fiscal adjustment are often overemphasized

  Many governments which have implemented large fiscal adjustments have been reappointed. No systematic relationship between deficit reduction policies and electoral results.

A methodological point   As economists we should be very clear about how little we

know   Anti economic profession reaction is due to our self

aggrandizing attitude

Basic Keynesian Ec 101 model   Spending multiplier (much) bigger than one.   Spending multiplier (much) bigger than tax multiplier.

Identification problem   Co-movements of G T and GDP. What causes what?

  Are there third factors? What are we holding constant? Monetary Policy, exchange rates, labor regulations?

What do people do?   Dynamic general equilibrium models (real business cycle

theorists)   Vector auto regression analysis (Blanchard Perotti)

  Isolate episodes of exogenous changes in tax rates(Romer and Romer)

  Isolate exogenous changes in spending, military spending (Barro Ramey)

Spending Multipliers   People find spending multipliers at most equal to one, many

find them much smaller   Possibly a bit larger during recessions

  Much smaller than Keynesian standard model would predict (much larger than 1)

Tax multipliers   Romer and Romer: size of 3!!!   Too large? Most likely   Jury still out

  All serious research find them larger than spending multipliers (a non Keynesian result)

Large episodes   Long list if papers since 1990 on “episodes” if fiscal

adjustments (and expansions).   First paper, Giavazzi and Pagano (1990)

  Latest one Alesina and Ardagna (2010)   These papers look at episodes of large changes in fiscal policy

in OECD countries from 1970 to today

Identifying assumption   A fiscal stimulus or contraction is needed given the state of

the economy and or public finances   Decision about what side of the budget act upon is mostly

political

Results

  Fiscal contractions: those based upon spending cuts are less contractionary (or even in some cases expansionary) than those based upon tax increases.

  Fiscal contractions: those based upon spending cuts leads to a more long lasting adjustment of deficit and debt reduction

Data description

  21 OECD countries 1970-2007 (Economic Outlook database)   Fiscal contractions = year in which the cyclically adjusted

primary balance improves by at least 1.5 per cent of GDP

  107 episodes of fiscal contractions (15.1% of observations in sample) 65 episodes last 1 year,13 episodes last 2 years, 4 episodes last 3 years, 1 episodes (Denmark 1983-1986) lasts 4 years

Why?   Supply side effects of tax increases.   Demand side effect (positive) effect of future lower taxation

if spending goes down.

  Confidence credibility effects. An adjustment today eliminates the need of a bigger one tomorrow

  If you don’t stop automatic spending growth taxes can never catch up!

Fiscal deficits and elections   There is not evidence that larger budget deficits increase

changes of reelection.   Brender and Drazen (AER 2008) find the opposite: larger

deficits are (weakly) associated with less success at the polls.

How about large fiscal adjustments?   Many large fiscal adjustments have been followed by re-

election of government which implemented them.   Especially when the adjustment occurred early in the term

Reverse causality?   Could it be that only those governments which know they

are strong engage in fiscal adjustment?   Thus government are reelected despite not because of fiscal

adjustments.   Difficult to test. How do you define “strong”?   No obvious evidence of this effect.

A word on Europe   Some countries seem to have gotten the message above (UK

Spain, Greece)   Some positive sign of attacking overgrown government

spending   Greece, Portugal and (possibly) Ireland will probably

restructure   Big question marks: Italy and Spain   Can the EU taker over fiscal policy?

  Domestic fiscal rules?

A word on the US   Over stimulus?   The beginning of negotiations   Ryan proposal: consistent with the traditional “American

exceptionalism” regarding g the welfare state   Obama would like to have a more European welfare state but

has not told us how to finance it

Conclusions   Fiscal adjustments mostly on the spending side have a better

chance of not creating large recessions even on impact.   Fiscal rectitude is sometimes rewarded by the voters.

  Finally (possibly too late) US and some European countries are moving in the right direction