The Permanent Scars Of Fiscal Consolidation
Antonio Fatas | Oct 02, 2014 04:59AM ET
The effect that fiscal consolidation has on GDP growth has probably generated more controversy than any other economic debate since the start of the 2008 crisis. How large are fiscal multipliers? Can fiscal contractions be expansionary?
Last year, Oliver Blanchard and Daniel Leigh at the IMF produced a paper that claimed that the IMF and other international organizations had here ). So what is the evidence?
If we include all European countries that are part of the Advanced Economics group as defined by the IMF we get the relationship depicted in the graph above. There is a strong correlation between the two variables: fiscal consolidations have led to a large change in our views on potential output. The coefficient (strongly significant from a statistical point of view) is around -0.75.
Just for comparison, and going back to the original work of Blanchard and Leigh, the coefficient using output growth (not potential) is around -1.1. Because the forecast for output growth already included a multiplier of about 0.5, Blanchard and Leigh's interpretation was that the IMF had been underestimating multipliers and instead of 0.5 the true number was 1.6. In my regression, the theoretical multiplier built into the IMF model must be zero, which means that the true long-term multiplier is just the coefficient on the regression, about 0.7. But this number is very large and it provides supporting evidence of the arguments made by DeLong and Summers regarding the possibility of fiscal contractions leading to increases in debt via the permanent effects they have on potential output.
There are many interesting questions triggered by the correlation above: What are the mechanisms through which potential output is affected? Is potential output really changing or is just our perception about long-term growth that is changing? These are all interesting questions that I hope to address as I translate the analysis into a proper draft for a paper. To be continued.
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