Friday, September 7, 2012

Output effects of fiscal consolidations

by Carlo Favero and Francesco Giavazzi


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 difference is remarkable in its size and it cannot be explained by different monetary policies during the two types of adjustments. We find instead that:
  • 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.
Interestingly, the responses of business and consumers’ confidence to different types of fiscal adjustment show the same asymmetry as investment and consumption: business confidence (unlike consumer confidence) picks up immediately after expenditure-based adjustments.


Read the Paper

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