What Have We Learned About Austerity Since the Great Recession?

8/12/2019 What Have We Learned About Austerity Since the Great Recession?

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1 Center for American Progress | What Have We Learned About Austerity Since the Great Recession?

What Have We Learned About

Austerity Since the Great Recession?By Michael Madowitz May 30, 2014

Te global collapse o ax revenues was one o he major challenges ha policymakers

conroned during he Grea Recession. Te Bush and Obama adminisraions boh

responded o recessions early in heir erms by simulaing he economy. Governmens

ypically couner he shorall o demand ha occurs during a recession by reducing

axes or increasing spending, an approach ha ormer Presiden John F. Kennedy once

deended by asking, Don you remember your Economics 101?1

Oher governmens, however, had made budge commimens ha gave hem less

laiude in heir fiscal policy approaches. Insead o simulaing he economy, hey

implemened auseriy measures, including slashing spending and raising axes in he

ace o he Grea Recession.

Mos prominenly, EU member saes had heir hands ied by fiscal goals hey com-

mited o as a condiion o joining he European Economic and Moneary Union. Less

prominenly, sae and local governmens across he Unied Saes duiully cu spending

and raised axes o mee balanced budge rules and ride ou he recession.

FIGURE 1

Premature austerity in the United States

U.S. federal, state, and local government consumption expenditures and

gross investment (percent of potential gross domestic product), 19992014

Source: Bureau of Economic Analysis.

1999 2000 2001 2003 2005 2007 2009 20112002 2004 2006 2008 2010 2012 2013

25%

20%

15%

10%

5%

0%

State and local

Federal

RecessionRecession


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In Washingon, poliicians were quick o disance hemselves rom he simulus package;

a he same ime, mos o he simulus was negaed by all o he orced auseriy a he

sae level. By 2010, boh American and European poliicians o every major pary were

burnishing heir auseriy credenials.

Meanwhile, academic economiss began o seriously revisi how o measure he effec-

iveness o fiscal simulus or he firs ime in a generaion. Researchers have devoedmore atenion o sudying he effeciveness o fiscal policy in he wake o he Grea

Recession han a any oher poin in he pas 50 years. Expers in he field have cre-

aed richer daases, more-precise measures o policy changes, and new heoreical and

empirical echniques. Inormed exper opinion has moved in he opposie direcion

rom poliicians in boh paries: In academic deparmens across he Unied Saes,

economiss have come o he conclusion ha simulus is acually more poweruland

auseriy more harmulhan even many simulus proponens hough a decade ago.

Economiss have also significanly shifed heir hinking abou wha happens o he U.S.

economy afer recessions, and many have come o he conclusion ha ailure o simu-

lae he economy and push ou o recessions has irreversible, negaive, long-erm effecson he economy.

Tere are hree major lessons or policymakers rom his research:

1. Direc governmen inervenion during recessions, eiher hrough defici-financed ax

cus or defici-financed increases in governmen spending, is a more powerul ool or

fighing recessions han we realized beore he Grea Recession.

2. In a slack economy, or one ha is operaing below is poenial, auseriyaking

money ou o he economy o balance governmen budgesis especially bad policy.Wheher via ax hikes or cus in governmen spending, conracing he governmens

budge during a recession reduces gross domesic produc, or GDP, by more han he

size o he cuspossibly as much as hree imes more.

3. Te coss o doing nohing can be permanen and much higher han we previously

hough: U.S. GDP is currenly 10 percen below is prerecession 2014 projecion,

and many economiss believe ha we have reached a new normal. I his is rue, aus-

eriy could cos he U.S. economy more han $1 rillion in economic aciviy every

year, even afer we have ully recovered rom he Grea Recession.2


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Te mos imporan developmen in economic research during his recession has been

a beter undersanding o how shor-erm labor markes affec he long-run size o he

economy. I is simply no he case ha recessions have only ransiory effecs on an

economy. Tis is a proound, i counerinuiive, lesson or policymakers: Te pruden

approach during a recession may be much more aggressive fiscal and moneary acivism

han we are used o.

Tis issue brie is an atemp o bring policymakers up o speed wih he laes academic

research on how policy should broadly respond o economic downurns. Te firs secion

begins wih a brie discussion o he challenges o sudying fiscal simulus. Tis is ollowed

by a discussion o research on srucural changes in he U.S. economy, including he increas-

ingly acceped finding ha auseriy in he wake o he Grea Recession has permanenly

reduced boh U.S. employmen and GDP. We also look a how our new undersanding

o he way he U.S. economy recovers rom recessions suggess ha here are ewer risks

o fiscal acivism han previously hough. Te brie concludes wih a summary o how

recen heoreical work on macroeconomics has helped our undersanding o fiscal policys

effeciveness during recessions, as well as a survey o some o he empirical work ha hasinormed he emerging consensus view ha acivis fiscal policy is an imporan policy ool.

How economists think about stimulus and austerity

Te logic o fiscal simulus is sraighorward: When he economy is no operaing a

ull speed, workers and capial are siting idle; here is slack in he economy. Tis is a

shor-run problem. In he long run, he economy makes use o is resources, bu i can

ake ime or aggregae demand o adjus enough o equal aggregae supply. One way o

reurn hese idle resources o producive use more quickly is or he governmen secoro pu hese resources o work and increase aggregae demand. Te governmen can

eiher do his direclyby spending moreor indireclyby cuting axes, so ha he

privae secor has more money o spend and inves.

In the simplest terms, stimulus and austerity represent opposite reactions, typically to a

recession. Recessions result in lower tax revenues, and a government can respond by either

doing nothingin which case it runs a budget deficitor by engaging in stimulus orausterity. Stimulus, the prescription of the Keynesian economic view, involves deliberately

issuing more debt today to finance tax cuts and/or additional spending in a depressed

economy to raise aggregate demand and GDP. Austerity is responding to a short-run de-

cline in the economy by raising taxes and/or cutting spending to balance a budget during a

depressed economy.

Austerity and stimulus


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How well his simulus works is a crucial quesion or economiss. Unorunaely, i is

difficul o precisely measure he effecs o hese policy changes in a depressed economy.

Chrisina Romer, Presiden Barack Obamas firs chair o he Council o Economic

Advisers and a Universiy o Caliornia, Berkeley, proessor, has used he analogy o

evaluaing reamen or vicims o car accidens based on precrash and pos-reamen

repors o how well he paien eels.3Paiens always eel worse afer a procedure han

hey did beore he crash, bu ha is hardly inormaive abou how he procedureworked, as i is likely he discomor is rom he effecs o he acciden. Likewise, i is

difficul o measure he effeciveness o fiscal inervenion in he economy precisely

because he relevan fiscal inervenions are only recommended i he economy is expe-

riencing severe negaive shocks.

Here, Romer is geting a he issue o couneracuals. In perec scienific experi-

mens, researchers recrui and rea a conrol group and a reamen group so hey can

know he effec o doing everyhingbu he procedure hey are sudying, as well as he

effec o everyhing and he procedure hey are sudying. Economiss do no ge o do

ha. Tere is only one economy, so i is no moral o experimen on i. Consequenly,economic researchers only ge o ry hings ha are believed o be likely o work,

and hey have o be clever abou finding ways o separae ou he effecs o he policy

hey wan o sudy rom everyhing else ha happens in he economy. Tis problem

is endemic o economic research, and i is a uniquely difficul challenge in sudying

acivis fiscal policy.

Tis is an acive area o academic debae, so consensus does no imply cerainy or uni-

ormiy o opinion, bu here have been hree major shifs in our undersanding o fiscal

policy since he end o World War II. Te firs is he original rise o Keynesian econom-

ics, which lased hrough he 1960s and held ha he governmen should ake a veryacive role in sabilizing he economy.

Te second is he raional-expecaions revoluion ha rose o prominence in he 1970s

and was he consensus view in academic economics unil airly recenly.4Under his

view, sabilizaion o he economy was cerainly no a ask or fiscal policy. wo o he

more sriking findings rom his work were he ideas ha he coss o recessions are quie

small5and ha even i he governmen ried o simulae he economy, raional ciizens

would increase heir own privae savings during any shor-erm increase in public deb

in anicipaion o uure ax increases, negaing any atemp a fiscal simulus.6Alhough

policymakers have never ully convered o his view, i has been he dominan paradigm

in academic circles or a generaion.


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Te slow recovery rom he Grea Recession, amid auseriy on boh sides o he

Alanic, has coincided wih new research in economics and generaed a srong heo-

reical and empirical oundaion or he work ha policy economiss have been doing

all along. Tis researchhe hird shif in our fiscal policy undersandinghas won

imporan convers in academia and he research deparmens o many o he worlds

major macroeconomic insiuions.

This school of thought believes that governments should actively manage the economys ag-

gregate demand to minimize fluctuations in unemployment and economic output. In most

instances, these interventions are best conducted through monetary policy. During large

recessions, however, managing fiscal policy is often deemed superior because the economy

is more responsive to monetary contractions than to expansions. Also, in a sufficiently deep

recession, the interest rates needed to stimulate the economy can be negative. 7

Keynesian economics

Long-term economic health is not independent of the short-term

economy

Macroeconomics exbooks have long subscribed o he view ha here are differen

approaches and echniques ha we should use when sudying shor-erm flucuaions

and long-erm growh in an economy and ha he wo are driven by disinc, indepen-

den acors. In he shor erm, Keynesian models have been used o jusiy and designfiscal ando a greaer exenmoneary inervenions ha keep he economy wihin

accepable parameers by managing demand. In he long erm, he proper undersand-

ing is ha invesmen, capial accumulaion, and he size and skill level o he labor orce

are he key drivers o economic growh and ha demand is assumed o mee oupu.

Under his convenion, long-run changes in he growh rae o he real economy mus be

he resul o shocks, or policy changes, ha change aggregae supply.


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Te growing role o human capial in he economy has called his approach ino

quesion. Jus as physical capial depreciaes over imeconsider wha a five-year-

old compuer is worh, or exampleso can human capial, especially i workers loseconac wih he laes developmens in heir fields o experise. I he long-run speed

limi o he economyypically called poenial GDPdepends on human capial

accumulaion, and i recessions produce prolonged periods o unemploymen ha

cause a counrys sock o human capial o decline, hen shor-erm demand shoralls

could reduce long-erm GDP.

Since he onse o he Grea Recession, he shif in exper opinion on his opic has been

more dramaic han on any oheri only because he exising consensus was so srong.

Beore he recession, he acceped wisdom was ha macroeconomic shocks could eiher

affec aggregae supply or aggregae demand. Supply shockssuch as a spike in oil

priceswould move he poenial GDP o he economy, and demand would evenually

adjus, balancing a he new level o supply.

Economists make strong distinctions between the short run and the long run. In the

long run, demand is assumed to meet supply, but in the short run, this need not hold.

Governments and central banks can affect aggregate demand, but aggregate supply is

driven by long-term fundamentals that are difficult to actively manage. In the short run,most economists believe that either the government or the central bank can raise the

economys real output by increasing demand when it falls short of supply. In the long

run, when supply and demand are balanced, raising demand has no effect on output and

only increases prices.

Economists recognize that sharp distinctions between the short run and the long run are

a bit artificial, but until this recession, the idea that long-run supply is independent of

short-term demand was widely accepted. New research since the recession reveals that

insufficient demand alone over a long-enough period of time can actually cause aggregate

supply to fall. This reduces the speed limitor potential GDPof the long-run economy.

Potential GDP

Potential GDP is the level of GDP that it is possible to achieve for a given aggregate supply

without increasing the rate of inflation beyond an acceptable range.8

Short run vs. long run


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Our previous undersanding o demand shocks was ha hey could cause a emporary

increase or decrease in GDP bu would have no effec on long-run aggregae supply or

poenial GDP. Consequenly, any effec o a demand shock would have o be empo-

rary, and only supply-side shocks could cause long-erm changes in he poenial GDP

o he economy. Olivier J. Blanchard and Lawrence H. Summers firs suggesed a shor-

erm o long-erm demand-side ineracion in heir 1986 examinaion o pos-1970

growh in European unemploymen.9A he ime, he ac ha he problem exised orEuropean economies and no he Unied Saes led he auhors o suspec ha less-flex-

ible European labor markes were ranslaing shor-erm shocks ino long-erm growh

slowdowns, because higher long-erm unemploymen reduces he sock o human

capial. Te auhors used he erm hyseresis o describe he long-run eedback effecs

o persisenly high unemploymen, bu eurosclerosis became he erm o ar or wha

he auhors were describing. A generaion laer, here is now alk o Amerisclerosis in

he wake o he 2007 recession.10

As recenly as 2011, J. Bradord DeLong and Summers presened research ha poined

ou he possibiliy ha a similar dynamic may be a play in he Unied Saes during heconinued slow recovery rom he Grea Recession.11Teir cenral argumen was ha i

we accep he possibiliy ha fiscal inervenion can affec long-run aggregae supply, he

coss o fiscal simulus are much lower han previously hough, and acivis fiscal poli-

cies should be pursued more ofen. ypical esimaes implicily assume he economy

will reurn o is previous rend and poenial GDP, bu our experience over he slow

recovery shows his is no always he case.

Tis finding was quie conroversiala poin ha is unusually clear because he pub-

lished paper includes a summary o a skepical discussion ha immediaely ollowed

he papers presenaion. As 2013 drew o a close, his view gained considerable valida-ion, wih a paper by hree economiss in he research division o he Federal Reserve

BoardDave Reischneider, William L. Wascher, and David Wilcoxsuggesing ha

he coss o he prolonged slump could be very large, permanenly reducing GDP by as

much as 7 percen per year.12

Empirically demonsraing ha recessions can produce long-run effecs in labor markes

was a much ougher ask given he daa requiremens, bu his oo has been a producive

avenue or research since he beginning o his recession. As daa qualiy has improved

over he pas 20 years, his quesion has become one ha can be answered, and i

increasingly appears as i shor-erm shocks do have long-erm coss o individuals. Tis

is imporan because i upends he convenional wisdom ha he long-erm cos o

doing nohing is essenially zero. Tis new research indicaes ha even a fiscal muliplier

o less han 1 may sill correspond wih a pruden policy, due o he long-erm downside

risks o GDP rom hyseresis.


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Pairing longiudinal Social Securiy records wih he relaively new Job Openings and

Labor urnover Survey, or JOLS, Seven J. Davis and ill von Wacher show ha work-

ers who are displaced rom employmen during he mass layoff episodes ofen associ-aed wih recessions experience significan, permanen losses in lieime earnings.13A

worker who is laid off when he unemploymen rae is more han 8 percen can expec o

lose wice as much in lieime earnings as one who loses a job when he unemploymen

rae is less han 6 percen. More recenly, Alan B. Kreuger, Judd Cramer, and David Cho

have presened research suggesing ha a disurbingly large racion o workers who are

unemployed or long periods o ime never ully regain sabiliy in he labor orce, pos-

sibly due o individual specific acors, saisical discriminaion agains he long-erm

unemployed, or a combinaion o he wo.14

Anoher srucural change in U.S. recessions since he early 1980s is he rise o he job-less recovery. Unil 1990, recoveries rom recessions ended o involve rapid increases

in GDP and employmencolloquially called V-shaped recoveries because mos daa

series exhibied a rapid all and rapid reurn o baselinebu he 1990, 2001, and 2007

recessions all broke rom his patern wih rapid alls ollowed by slow recoveries. Tis

ormed he patern ha gives rise o he so-called L-shaped recovery. Olivier Coibion,

Yuriy Gorodnichenko, and Dmiri Kousas ound significan evidence o Amerisclerosis

in a rerospecive look a he U.S. labor marke, hough hey rejeced he simple conclu-

sion ha moneary and fiscal policies could explain he slowdown.15Insead, heir lesson

or policymakers is orward looking: Te srucure o he U.S. economy has changed,

and he V-shaped recoveries o he 1950s o 1980s, when growh and employmen

increased rapidly in he period immediaely afer a recession, seem o be a hing o he

pas. I ha is rue, hen ensuring ha simulus does no las oo longone o he pri-

mary pracical problems o devising such a programis ar less worrisome.

This term is used to describe how large an effect on the entire economy we can expect for a

given fiscal intervention. If the government provides $100 in tax cuts or spending increases

and GDP then increases by $200, the fiscal multiplier would be 2, which is likely during a re-

cession when the multiplier is typically greater than 1. If the same $100 in cuts or spending

only increases GDP by $70, the fiscal multiplier would be 0.7a typical outcome when the

economy is operating at capacity and the multiplier is less than 1. A fiscal multiplier of less

than 1 is the mathematical condition that defines crowding out, where public spending

simply displaces private spending and produces no additional economic growth.

Fiscal multiplier


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Tese researchers sugges ha he imely, argeed, and emporary rule o humb used

by policymakers may be ou o dae in our curren economy.16Longer-lasing fiscal sim-

ulus programs are more appropriae i L-shaped recoveries coninue, as hey pose boh

less risk o inflaion due o misiming and are less likely o end oo soon, induce prema-

ure auseriy, and harm long-erm growh prospecs. One addiional benefi o such a

program is ha he Federal Reserves moneary policy ools are much beter a slowing a

recovery han speeding one up, so a fiscal policy ha creaes oo much demand will norequire unconvenional policy measures rom he Federal Reserve.

Toward a state-dependent understanding of fiscal intervention

Reurning o Chrisina Romers medical analogy, he mos imporan componen

o successul reamen is a correc diagnosis. Removing an appendix ha is abou

o burs prevens a lie-hreaening inecion and is a useul reamen, bu removing

a healhy appendix will leave he paien in pain and wih unnecessary holes in he

abdomen. Te effeciveness o he reamen is sae dependen: Is benefi can beposiive or negaive depending on he healh o he appendix. Te radiional esimae

o he effeciveness o fiscal policy is a fiscal muliplier ha is no sae dependen,

equivalen o esimaing he benefis o arbirarily aking ou an appendix wihou firs

checking o see i he appendix is abou o burs. I we assume ha policymakers have

no abiliy o discern wheher he economy is healhy, his is he opimal approach, bu

ha is a prety exreme assumpion. Since 2000, boh governmens and cenral banks

have been relaively successul a diagnosing economic crises in real ime. Ye unil

he Grea Recession, mos mainsream macroeconomic models did no allow or sae

dependency o fiscal mulipliers.

Economiss used o model he fiscal muliplierhe percen by which GDP would

increase given an addiional 1 percen o GDP in spending or ax cusas i i were

more or less consan across business cycles.17Boh simple inuiion and complex eco-

nomic models show ha his is no he righ way o hink abou shor-erm fiscal policy,

wih much o ha progress in modeling coming over he course o he Grea Recession.

In good imes, fiscal policy is no very effecivein ac, i is ofen counerproducive.

Te simplified explanaion is ha in normal imes, pruden moneary policy couneracs

much o he inended simulus o avoid an overheaed economy. Bu during recessions

when he cenral banks moneary policy is also expansionary, fiscal policy is useul, and

in severe recessions, when cenral banks canno cu raes any urher, fiscal simulus is a

crucial, very powerul ool.


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Te radiional Keynesian view, as laid ou by Johnahan A. Parker, is ha fiscal policy

has beneficial effecs when here is slack in he economy, bu no when he economy

is operaing normally.18Unorunaely, as Parker goes on o explain, here are very

ew rigorous macroeconomic simulaion models ha are mahemaically compaible

wih he idea o slack in he economy. In echnical erms, he models do no allow or

sae dependency. In oher words, hey are unable o esimae differen mulipliers or

recessions and or normal imes. For a variey o reasons, esimaing hese wo differenmulipliers is much more han wice as hard as esimaing one.

Developing rigorous estimates of fiscal multipliers is a technical challenge, and state-de-

pendent multipliers are even more difficult to estimate. Theoretical estimates of multipliers

come from simulating policy in a model. These models abstract from the economy by leav-

ing out some detail, but they rigorously specify how people and firms behave to maximize

their own benefits in major sectors of the economy. The model is then calibrated to match

the behavior of historical data in the U.S. economy.

Such a model is already a mathematical approximation of the real world, and solving for

simultaneous equilibriums in the policy simulations of a model often requires further ap-

proximation. Most of these simulations start with the model in equilibrium, then introduce

a shock and solve for the new equilibrium. The vast majority of solution techniques used

represent the model as a continuous function, often one that is nearly linear near the previ-

ous solution.

This implicitly makes it much harder to represent a state-dependent multiplierone

that jumps from a value of less than 1 when the economy is at equilibrium to a value ofsignificantly more than 1 in a recessionbecause it does not behave like a continuous

function. This means that even a correctly structured model may give incorrect or imprecise

estimates of the size of fiscal multipliers in the conditions where policymakers are most

likely to use fiscal policy.

Estimating multipliers

Forunaely or us bu unorunaely or our models, recessions are rare, and large reces-

sions are even more rare. More flexible models require more daa o make esimaes.

A model ha has more srucure can make use o a greaer variey o macroeconomic

daa in every ime period and use heory o ease ou more inormaion when here are

limied daa available. Par o he reason we have made so much progress in modeling

sae-dependen mulipliers since he Grea Recession is ha we now have more daa

abou how he U.S. economy perorms in severe recessions.


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In VAR and DSGE models, he mahemaical echniques used o solve he modelsrely on absracing an addiional level rom hem. ypically, hese resricions on he

complexiy o he models soluions are an accepable rade-off because hey can show a

significan level o deail abou he linkages beween economic variables. Tis is paricu-

larly imporan o macroeconomic modelers because o he relaive pauciy o relevan

daa, even i i comes a he cos o being able o precisely model he exac dynamics

o rare evens. Te rade-off, however, is ha he condiions ha mus be saisfied or a

soluion mehod o work may no be an accurae descripion o how markes uncion

during he early sages o a recession. In a review o relevan lieraure, Valerie A. Ramey

provides a airly complee axonomy o how he mechanisms in boh classical and

Keynesian models drive he esimaes abou he size o hese models mulipliers.19

Tis is no o say ha i is impossible o build advanced models ha incorporae sae

dependency. Indeed, some o he more ineresing recen work in macroeconomic

modeling has addressed his challenge. Alan J. Auerbach and Yuriy Gorodnichenko

use a VAR approach and come up wih much larger esimaes or mulipliers when he

economy is depressed.20Lawrence Chrisiano, Marin Eichenbaum, and Sergio Rebelo

likewise consruced one o he firs examples o a DSGE model economy where agens

ace differen incenives when ineres raes run up agains he zero lower boundhe

poin a which he cenral banks policy calls or negaive ineres raesand find ha in

his conex, a 1 percen increase in governmen expendiures can generae as much as a

3 percen increase in GDP.21

Macroeconomics is very hard to study because there are a relatively small number of data

points, so macroeconomic modelers rely on economic theory to extract as much insight

from these data as possible. Two of the most commonly used techniques are vector

autoregression, or VAR, and dynamic stochastic general equilibrium, or DSGE, models. In

VARs, relationships between data points can be flexibly established over time. We know, for

example, that tomorrows investments must depend on todays savings, so we can estimate

these internal linkages and maximize the information that each time series provides in the

context of other data to estimate how an economy responds to shocks. In a DSGE model,

a series of equations defines economically rational behavior in individual markets, and

individual, random shocks hit parts of the economy. Their effects then decay over time due

to linkages in the model economy.

Modeling techniques: DSGE and VAR


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Tere is sill reason o rea all o hese esimaes wih cauion, as Parker poins ou.22

Tere are wo major ailings o he mahemaical models ha generae hese esimaes

o fiscal mulipliers. No only is sae dependency difficul o model mahemaically, is

inerpreaion is no sraighorward even when one does ge a reasonable esimae o he

sae-dependen muliplier. We can use models o esimae he effec o he firs dollar o

simulushe marginal muliplierbu no he effec o an enire simulus programhe

average muliplier, which is more useul or developing policy soluions. For a small simu-lus program, his marginal muliplier is a reasonable approximaion o he enire programs

effecs. Bu or precisely he kind o simulus ha heory suggess we should be sudying

large programs in he ace o significan economic downurnshe size o he marginal

muliplier can differ significanly rom he average muliplier. Tis makes i difficul or

policymakers who are fighing recessions o gauge he effecs o heir policy choices.

One area o research in which considering he effecs o expansionary policy vs. auseriy

policy in he ace o a depressed economy has no changed in he pas decade is he idea

ha no every dollar o simulus is alike. Tere remains broad agreemen ha fiscal mul-

ipliers vary dramaically based on how spending and ax cus are direced.23

I remainsrue ha he bang or he buck is smalles when governmen cus axes or high-income

earners. Inuiion is helpul here, as wealhy people are mos likely o behave as opimiz-

ers, saving emporary cus o finance uure axes or consumpion. In oher words, giv-

ing someone wih a seady job and los o cash on hand a $1,000 ax cu is likely o resul

in approximaely $0 in increased demand or oupu. In conras, giving an unemployed

worker $1,000 in exended benefis is likely o resul in nearly he enire amoun being

spen, as hese workers lack he addiional asses or income o save more or secure a loan

o finance heir consumpion during unemploymen.

One o he less explored aspecs o his debae is ha he acual benefi o he inves-mens he addiional spending generaes is largely irrelevan or hese economic mod-

els. Te ypical assumpion is ha public invesmens are analogous o hrowing he

money in he ocean. Ta is, mos macroeconomic models generally assume ha public

invesmen has zero producive benefi. Tis assumpion is obviously a caricaure, bu

i reflecs boh he fields desire or comparable measuremens across sudies and is

general belie ha privae markes are more efficien a allocaing capial han are public

officials. Tis approach is ofen counerproducive in assessing fiscal simulusi allows

researchers o isolae he effecs o he iming o spending rom is producive effecs bu

obviously undervalues any public invesmen wih posiive reurns.

Acual economic work on he effeciveness o public invesmens is rare, bu one iner-

esing source is a 1993 paper by Marianne Baxer and Rober G. King. Tis is a well-

known work among academics, and he auhors are broadly skepical o he effeciveness

o fiscal policy. Ye hey noe ha a $1 invesmen in producive public capial could

produce beween $4 and $13 in overall long-run GDP increases, wih he range coming

rom differences in assumpions abou how much less producive public invesmen is

han privae invesmen.24


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Again, some cauion is warraned here. Tese resuls do no sugges ha governmen

spending is he righ response o every hiccup in he economy. In ac, he lieraure

is quie consisen in is suggesion ha his kind o micromanaging o he macro-

economy is unlikely o be successul. However, wih considerable slack remaining in

he U.S. economy five years afer he Grea Recession, i is clear ha he premaure

moves oward auseriy ha ook hold on boh sides o he Alanic have been bad

policy, and i may now be oo lae o preven a large, permanen decline in boh U.S.and EU GDP.

Evolution of techniques for measuring fiscal policy

Te hardes par o sudying fiscal inervenion is deermining appropriae counerac-

uals. Tis means ha good economic research has o be clever abou finding ways o

separae ou he effecs o he policy we wan o sudy rom everyhing else ha happens

in he economy. Tis is an especially challenging problem in he sudy o fiscal policy or

wo reasons:

1. Tere are very ew o he righ kind o evens o sudyperiods in which he govern-

men aced wih fiscal policy o counerac a negaive economic shock.

2. Te examples where his does happen include, by definiion, an unusually large nega-

ive economic shock, which usually has an even larger effec on he economy han he

acual policy abou which we care.

Wih hese caveas, i is imporan o poin ou how ar research on fiscal policy has

come over he pas 20 years and how much beter i is now han he research haormed he consensus among academics and policymakers in he decades leading up o

he Grea Recession.

The cyclically adjusted budget balance is a measure of what the budget deficit or surplus

of a government would look like, when changes in tax revenue and need-based spending

driven by the business cycle are taken into account.

Cyclically adjusted budget balance


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Unil surprisingly recenly, he dominan mehod o sudying fiscal policy was o look

a he cyclically adjused budge defici o a counry. Recall ha fiscal expansion can

ake he orm o defici-financed ax cus or increases in governmen spending, so i is

reasonable o look a he budge defici as a measure o fiscal simulus in he ace o daa-

gahering consrains.25

Unorunaely, los o hings ha are no ax cus or governmen spending affec he bud-ge defici. On he expendiure side, means-esed programssuch as he Supplemenal

Nuriion Assisance Program, or SNAP, ormerly known as ood samps, and unem-

ploymen insuranceauomaically become more expensive as recessions make people

worse off and a larger share o he populaion qualifies or hem. On he ax side, as

firms profis and individuals incomes are reduced by he recession, income and capial

gains ax revenues auomaically all.26A recession ha causes boh o hese hings o

happen a he same ime will produce a large budge defici, bu ha defici is no a grea

measure o how much he governmen is rying o simulae he economy. Researchers

have correced or hese effecs on budges by using a cyclically adjused measure ha

atemps o ake ino accoun he sae o he economy and is effec on budge deficis.Bu because cyclical acors have a srong and persisen effec on he budge defici, i is

very difficul o esablish wheher growh happens because o or in spie o he policies

pursued. Consequenly, i is a poor measure or drawing conclusions abou wheher or

no fiscal policy caused changes in economic condiions.27

A new approach, pioneered by Valerie Ramey and Mathew D. Shapiro in 1998, is o

examine a narraive hisorical recordreading aricles rom he pas o deermine

when governmen spending was unexpeced and on wha i was spen. Because his

spending was unanicipaed, i was less likely o be subjec o mismeasuremen due o

oher economic acors.28

A similar approach was aken in 2009 by Chrisina Romerand David H. Romer, who used narraive records no only o ideniy he iming o

hisorical ax changes bu also o divide he inended effecs o hese changes ino

our caegories: simulaing he economy, reducing deficis, inducing higher long-run

growh, or oher goals.29

Ramey, working wih muliple co-auhors and using a variey o srucural predicions o

models o analyze macroeconomic policy, has consisenly ound ha mulipliers in he

Unied Saes are small. Some o hese mechanisms include spillovers rom increased

governmen spending in one secor o oher secors30and he cyclical behavior o firms

pricing markups.31In conras, he Romer and Romer approach finds ha he muliplier

on ax cusespecially hose explicily mean o simulae a depressed economyis

quie large. Tis is somewha surprising because heory is very clear ha he muliplier

on ax cus should be weakly smaller han on governmen purchases.


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As hese more inormaive, labor-inensive mehods gain racion, i is imporan o noe

ha simple empirics have become much more powerul in he pas five years, largely

because o policies pursued in response o he Grea Recession. I is sill rue ha here

is a pauciy o relevan daa poins rom advanced economies, bu researchers are awash

in daa compared wih 10 years ago. While here may have been some debae abou

he size o fiscal mulipliers beore he recession, a broad consensus would have pre-

vened economiss rom recommending he auseriy policies pursued in Europe andhe Unied Saes since he Grea Recession. Te daa rom hese policy acions have

demonsraed ha auseriy has been counerproducive across he globe or he levels

o slack seen in he afermah o he Grea Recession. Olivier Blanchard and Daniel

Leigh use relaively simple echniques o show ha auseriy in Europe has consisenly

resuled in lower GDP growh han was orecased during he pas five years.32

Tis is ar rom he las word on he quesion o fiscal simulus. Daa will be revised and

improved, and heoreical and empirical echniques will advance, boh o which will give

us an even clearer picure o wha effecs fiscal policy can have in a depressed economy.

Overall, economic researchers are in much sronger agreemen abou he useulness ofiscal policy han hey were a decade ago. Ironically, much o he daa ha have made

he empirical work ha suppors his consensus possible are he resul o policymakers

going agains he exising economic consensus.

Conclusion

Since he onse o he Grea Recession, fiscal policy has become a much more widely sud-

ied opic in academic circles. Te broad conclusions o recen work are surprisingly consis-

en or he field. Fiscal mulipliers are larger han we hough, a leas in slack economies.Even some o he sharper criics o acivis fiscal policy have concluded ha he US aggre-

gae muliplier or a emporary, defici financed increase in governmen purchases is

probably beween 0.8 and 1.5. Reasonable people can argue ha he daa do no rejec 0.5

and 2.33Supporers sugges ha mulipliers as large as 3 are possible in a slack economy34

and ha fiscal policy is perhaps even more imporan in ligh o he new undersanding o

how he long-erm poenial GDPs o advanced economies are affeced by recessions.35

Tis research does no indicae ha deficis do no mater or ha simulus is always he

answer. Insead, he greaer consensus around larger fiscal mulipliers suggess ha fis-

cal simulus has ewer risks han we hough and is a very powerul and imporan ool

or boosing shor-erm economic growh in a way ha moneary policy canno repli-

cae. urning o auseriy beore robus economic growh occurs can be sel-deeaing,

depressing economic growh and increasing budge deficis in boh he shor erm and

he long erm. Considering fiscal policy in a vacuum is a misake, and i is imporan o

consider he role o he cenral bank, which has beter ools o address oo much simu-

lus han i does o address oo much auseriy.


16/18


More imporanly, economic research has developed a new undersanding ha

prolonged, shor-run unemploymen decreases long-run GDP. Te consensus on he

coss o inacion has changed dramaically wihin he field: While many academic

researchers hough o he coss o recessions as a rounding error a generaion ago, he

emerging view is ha ailing o lif an economy ou o recession could permanenly

reduce is size. In he Unied Saes, his could reduce GDP by somehing on he order

o $1 ri llion each year.36

Te akeaway or policymakers is simple. Fiscal simulus is a much more powerul ool

in odays economy han we previously hough, and he auseriy policies we have been

pursuing are even more cosly. Mos imporanly, he comoring belie ha policymak-

ers can, wihou causing harm, do nohing while hey wai or he economy o rebound

is misaken. Te ailure o break ou o he deep recession and he anemic growh sill

engulfing Wesern economies has resuled in significan long-erm damage o hem.

Ta damage coninues o pile up as policymakers ignore he need o ge heir respecive

economies back o ull employmen.

Michael Madowitz is an Economist at the Center for American Progress.


17/18


18/18

30 Ramey and Shapiro, Costly Capital Reallocation and theEffects of Government Spending.

31 Christopher J. Nekarda and Valerie A. Ramey, The CyclicalBehavior of the Price-Cost Markup. Working Paper 19099(National Bureau of Economic Research, 2013), available athttp://www.nber.org/papers/w19099.pdf.

32 Olivier Blanchard and Daniel Leigh, Growth Forecast Errorsand Fiscal Multipliers. Working Paper WP/13/1 (Interna-tional Monetary Fund, 2013), available athttp://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf.

33 Ramey, Can Government Purchases Stimulate theEconomy?

34 Christiano, Eichenbaum, and Rebelo, When is the govern-ment spending multiplier large?

35 DeLong and Summers, Fiscal Policy in a DepressedEconomy.

36 Authors calculations using estimates from Reifschneider,Wascher, and Wilcox, Aggregate Supply in the UnitedStates.
http://www.nber.org/papers/w19099.pdfhttp://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdfhttp://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdfhttp://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdfhttp://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdfhttp://www.nber.org/papers/w19099.pdf

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What Have We Learned About Austerity Since the Great Recession?

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