Expansionary Austerity and Reverse Causality

Breuer, Christian (2017): Expansionary Austerity and Reverse Causality.

Abstract

Empirical studies on the effects of fiscal policy using the conventional or data-based approach and the Blanchard-method of cyclical adjustment or the Blanchard Fiscal Impulse (BFI) discovered that fiscal consolidations can be expansionary, particularly in the case of spending-cuts. In this paper, it is stated this finding is affected by reverse causality, i.e. increasing GDP causally decreases expenditure-GDP-ratios if the cyclical adjustment strategy fails to correct for cyclical effects. It is also illustrated that the BFI as used in the literature does not appropriately control for cyclical effects in the case of expenditure-GDP-ratios and the resulting BFI is endogenously correlated with the economic cycle. This might explain why previous studies based on the BFI pointed to counter-intuitive findings when examining cuts in government expenditure. Replicating one prominent example of literature on expansionary austerity and comparing both the results based on the BFI and the results based on standard cyclical adjustment strategies, only the BFI-based results show expansionary effects of fiscal consolidations, while these effects disappear after applying standard methods of cyclical adjustment.

• Item Type: MPRA Paper
• Language: English
• Keywords: fiscal policy; fiscal adjustment, cyclical adjustment; reverse causality
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy ; Stabilization ; Treasury Policy; H - Public Economics > H5 - National Government Expenditures and Related Policies > H50 - General

References

Alesina, A. and S. Ardagna (1998), “Tales of Fiscal Adjustment”, Economic Policy 13, 489-585.

Alesina, A. and S. Ardagna (2011), “Large Changes in Fiscal Policy: Taxes vs. Spending”, in: Brown, J. R. (ed.), Tax Policy and the Economy 24, Chicago: University of Chicago Press, 35-68.

Alesina, A. and S. Ardagna (2013), “The Design of Fiscal Adjustments”, in: Brown, J. R. (ed.), Tax Policy and the Economy 27, Chicago: University of Chicago Press, 19-67.

Alesina, A. and R. Perotti (1995), “Fiscal Expansions and Adjustments in OECD Countries”, Economic Policy 10, 205-248.

Alesina, A. and R. Perotti (1997), “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects”, NBER Working Paper 5730.

Ardagna, A. (2004), “Fiscal stabilizations: When do they work and why”, European Economic Review, 48, 1047-1074.

Ardagna, A. (2009), “Financial markets’ behavior around episodes of large changes in the fiscal stance”, European Economic Review, 53, 37-55.

Blanchard, O. (1990), “Suggestions for a new set of fiscal indicators”, OECD Economics Department Working Paper No. 79.

De Cos, P. H. and Moral-Benito, E. (2013), “Fiscal Consolidations and Economic Growth”, Fiscal Studies, 34, 491-515.

De Coz, P. H. and Moral-Benito, E. (2016), “On the predictability of narrative fiscal adjustments”, Economics Letters, 143, 69-72.

Fedelino, A., Ivanova, A., Horton, M. (2009), “ Computing Cyclically Adjusted Balances and Automatic Stabilizers”, International Monetary Fund, Technical Notes and Manuals, 09/05.

Giavazzi, F. and M. Pagano (1990), “Can Severe Fiscal Contractions be Expansionay? Tales of Two Small European Countries”, NBER Macroeconomics Annual, 1990.

Giavazzi, F. (1995), “Comment on Fiscal Expansions and Adjustments in OECD Countries”, Economic Policy, 1995, 240-241.

Girouard, N and C. André (2005), “Measuring cyclically-adjusted budget balances for OECD countries”, OECD Economics Department Working Paper 434.

Guajardo, J., D. Leigh, and A. Pescatori (2014), “Expansionary Austerity? International Evidence”, Journal of the European Economic Association, 12, 949-968.

Holden, S., Midthjell, N. L. (2013), „Successful Fiscal Adjustments – Does the Choice of Fiscal Instruments Matter?”, CESifo Working paper Series 4456.

Jayadev, A. and M. Konczal (2010), “The Boom Not the Slump: The Right Time for Austerity”, New York: Roosevelt Institute.

Jordà, Ò. and Taylor, A. (2015), “The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy”, Economic Journal, 2016, 126, 219-255.

Joumard, I., M. Minegishi, C. Andre, C. Nicq, and R. Price (2008), “Accounting for one-off operations when assessing underlying fiscal positions”, OECD Economics Department Working Papers, 642.

Kollintzas, T. (1995), “Comment on Fiscal Expansions and Adjustments in OECD Countries”, Economic Policy, 1995, 241-243.

Leigh, D., P. Devries, C. Freedman, J. Guajardo, Laxton, D. and A. Pescatori (2010), “Will It Hurt? Macroeconomic Effects of Fiscal Policy Consolidation”, in: IMF World Economic Outlook October 2010, 93-124.

Morris, R., and L. Schuknecht (2007), “Structural balances and revenue windfalls: the role of asset prices revisited”, European Central Bank Working Paper, 737.

Perotti, R. (2013), “The “Austerity Myth”: Gain Without Pain?”, NBER Chapters, in: Fiscal Policy after the Financial Crisis, NBER.

Yang, W., Fidrmuc, J., Ghosh, S. (2015), “Macroeconomic effects of fiscal adjustments: A tale of two approaches”, Journal of International Money and Finance, 57, 31-60.