September 7, 2012
The austerity debate hangs on the question of how fiscal policy affects economic output – but answering that question is no easy task. This column presents a paper that, it argues, overcomes some of the problems with identifying cause and effect.
The austerity debate turns on a central economic logic – how does fiscal policy affect output? This is a tricky question since declining output can affect fiscal policy just as much as fiscal policy can affect growth. Governments, after all, don’t make policy in a vacuum.
The key to estimating the effects of fiscal policy on output is this identifying shifts in fiscal policy that are 'exogenous'. Policy changes that are not a response to the state of output – as would be the case, for instance, of a fiscal expansion induced by a fall in output.
Following the approach pioneered by Romer and Romer (2010), Devries at al. (2011) have collected and described – using the records available in official documents – the multi-year fiscal consolidation plans announced (and then implemented or revised) by 17 OECD countries over a quarter of a century (1980-2005). Among all these stabilisation plans the authors have selected those that were designed to reduce a budget deficit and to put the public debt on a sustainable path, which should guarantee their 'exogeneity'.
Using the Devries et al (2011) data, we find that it matters crucially how the consolidation occurs (Alesina et al. 2012).
- Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones.
- The heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth.
Read the Paper