What’s the impact of fiscal policy on GDP growth? That’s one of the most contentious questions in economics. A lot of economists regard economic stimulus packages as completely useless. New empirical evidence shows that they are wrong. Amazingly, we know this partly thanks to the Italian mafia.
It was one of the most expensive signatures in American history. Barack Obama had flown to Denver, Colorado, to give it. On 17 February 2009, the American president signed the “American Recovery and Reinvestment Act“, an economic stimulus package worth $787 bn. It was the biggest single piece of fiscal policy in the history of mankind.
Governments all across the globe acted accordingly. In their fight against the most severe economic crisis for decades they spent billions on fiscal policy.
Did this debt-financed policy avert a second Great Depression? Or was it just massively expensive and futile?
The answers economists are giving to these questions vary a lot. For several decades the mainstream consensus has been that fiscal policy just does not work. Recently, however, the views in the profession have begun to change. There is growing empirical evidence that fiscal policy is better than its reputation.
“The last decade has produced a substantial improvement in economists’ understanding of the empirical orders of magnitude of a number of fiscal impacts,” wrote Norman Gemmell recently in the “Economic Journal” (“Can a Fiscal Stimulus Boost Economic Growth Rates?“).
Gemmell is the Chief Economist of the New Zealand Treasury and a former Professor of Economics of the University of Nottingham. “Consensus”, Gemmell stressed, “could not yet be said to have been reached.”
What seems to be clear, however, is that the complete dismissal of fiscal policy is based on few empirical facts.
Theoretically, it’s quite clear cut…
Theoretical considerations suggest that government purchases crowd out private activities. If humans were fully rational and if all markets worked perfectly, we would smooth our lifetime consumption. Temporary income gains would not influence our current spending. We would anticipate that debt-financed tax cuts imply higher taxes in the future.
Hence, we would not spend the extra money but save it. Therefore, apart from the higher public deficit, such tax cuts would not have any impact on the economy.
Economists call this phenomenon “ricardian equivalence”. It is a unifying feature of the most modern macro models. It is, therefore, small wonder that theoretical simulations based on these models come to the conclusion that the stimulus packages won’t do much good. (see: John Cogan, Tobias Cwik, John Taylor and Volker Wieland: “New Keynesian versus Old Keynesian Government Spending Multipliers”)
How the Mafia helps economists
However, real life seems to be different. According to a bunch of empirical papers, “fiscal injections can boost output and consumption levels in the short-run”, writes Norman Gemmell.
The scientific evaluation of fiscal policy is quite a task. The mere observation that the world economy has recovered quickly from the recession of 2009 does not say anything. Nobody knows how things would have panned out without the economic stimulus packages. Economists also often struggle to disentangle cause and effect: Does growth accelerate because government spending increases, or is it the other way round?
Thanks to the Italian mafia, three economists have recently been able to solve this problem. In a fascinating paper entitled “Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi-experiment”, Antonio Acconcia, Giancarlo Corsetti and Saverio Simonelli analysed the effects of fiscal policy inItaly. They did not look at the whole country but focused on small regions.
Organised crime is a nightmare inItalybut it is a blessing for economists because it causes significant changes in government expenditures that are completely unrelated to the current economic environment. If a politician is arrested because of his connections to the mafia, all public investments in infrastructure and construction are put on hold immediately until the investigators have checked if the mafia had been able to channel money into their pockets.
“Public work and projects are started again only after investigation and scrutiny of previous tender procedures and decisions to establish that the contractors are not effectively mafia Associations,” the economists explain. “The dismissal of elected administrators is thus associated with sizeable fiscal retrenchment.”
Acconcia, Corsetti and Simonelli looked at more than 100 cities where local politicians were forced to resign because they were Mafia figureheads. Afterwards, local government expenditures declined on average by 20 percent.
It’s all about the multiplier
According to the paper, this was highly detrimental for the local economy. When the government expenditures were slashed by one Euro, the economic activity immediately shrank 1.40 Euro. In the medium term, the output losses accumulated to 2 Euro. Hence, the so called government multiplier was between 1.4 and 2.
These estimates are in line with a number of empirical studies on the macro level. In a very influential paper, Olivier Blanchard and Roberto Perotti in 2002 analysed American fiscal policy after 1947. Their paper had a rather clumsy title (“An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output”) and was published in the “Quarterly Journal of Economics”.
Their conclusion was as follows:
“We consistently find a positive effect of government spending on private consumption, a straightforward implication of virtually all Keynesian models but a result that is difficult to reconcile with the neoclassical approach.”
According to Blanchard and Perotti, the fiscal multipliers were rather small, often close to one.
Five years later, other researchers published estimates that were even higher. In their paper “Understanding the Effects of Government Spending on Consumption,” Jordi Gali, Javier Vallés and J. David López-Salido came to the conclusion that one Dollar of higher government spending in the U.S. increases GPD by 1.74 Dollars after two years. Private consumption had risen by 0.95 Dollar. In a different paper, Jordi Gali concluded:
“Keynes and his followers got it right.”
Roel Beetsma and Massimo Giuliodori, two economists with the Universityof Amsterdam, have recently published similar estimates of the impact of fiscal policy for Europe. With regard to EU member states , they came to the conclusion that a 1% increase in government expenditure leads to a GDP increase of around 1.5% after one year.
“The multiplier is quite large, but not out of line with findings by others,” wrote Beetsma and Giuliodori in their paper entitled “The Effects of Government Purchases Shocks: Review and Estimates for the EU.”
The devil is in the details
However, the effects of fiscal policy vary quite significantly from country to country. The more internationally interconnected a country is, the smaller the effects of fiscal policy, the economists observe. In open economies, the fiscal stimulus partly leaks overseas.
Similar results are obtained by Ethan Ilzetzki (London School of Economics), Enrique Mendoza and Carlos Végh (both: Universityof Maryland). In their paper entitled “How Big (Small?) are Fiscal Multipliers?” they conclude:
“The medium to long-run effects of increases in government consumption vary considerably. In particular, in economies closed to trade or operating under fixed exchange rates we find a substantial long-run effect of government consumption on economic activity. In contrast, in economies open to trade or operating under flexible exchange rates, a fiscal expansion leads to no significant output gains.”
A lot hinges on the nitty gritty details of the stimulus packages. For example, “cash for clunkers programmes” seem to be egregiously inefficient, Atif Mian and Amir Sufi show in a paper entitled “The Effects of Fiscal Stimulus: Evidence from the 2009 ‘Cash for Clunkers’ Program.” They conclude:
“Our results reveal a swift reversal in auto purchases at the expiration of [the 2009 Cars Allowance Rebate System] which highlights a strong inter-temporal substitution that quickly “crowds out” the initial effect. Our evidence suggests that the ‘cash for clunkers’ program, a program that cost $2.85 billion, had no long run effect on auto purchases.”
Handle with care
Hence, fiscal policy is no golden bullet and should be used with thorough consideration by governments. Probably deficit spending should only be done in very rare and extraordinary occasions: when severe recessions threaten economic stability. Even though economic stimulus packages are able to thwart a total economic collapse in the short term, from a medium to long term perspective the assessment is different, the economists Norman Gemmell, Richard Kneller and Ismael Sanz conclude in a paper entitled “The Timing and Persistence of Fiscal Policy Impacts on Growth: Evidence from OECD Countries”:
“We find that positive growth effects associated with ‘productive’ public spending changes have often been approximately counteracted by tax changes with negative effects. Furthermore, growth-affecting fiscal policy changes are often reversed, so growth effects in practice are expected to be short-lived.”
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