The Agenda

Alberto Alesina on the Case for Fiscal Consoliation

The latest issue of The Economist includes an Economics Focus column that draws heavily on Chapter 3 of the IMF’s “World Economic Outlook.” The chapter criticized “Large Changes in Fiscal Policy: Taxes Versus Spending,” a paper written by political economists Alberto Alesina and Sylvia Ardagna that has been cited by many advocates of fiscal consolidation. Alesina has responded at his website, arguing that the gap between the WEO analysis and his paper with Ardagna is far smaller than The Economist suggests:

The Economist tries to portray our paper and the WEO Chapter as polar opposites. In reality they agree on many points. In particular, they find the same critical result, and potentially the most important one: tax increases are much worse for the economy than spending cuts. The WEO Chapter argues that this effect comes mainly from different reactions of monetary policy, but their claim of having identified separately all of these channels is overstated because interest rates, current and expected, and exchange rates are endogenous to both fiscal and monetary policy. In addition, our paper and the WEO Chapter also agree that after a few years, even large (but spending based) fiscal adjustments create growth for the economy. Our paper and the WEO Chapter achieve the same results using very different methodologies. We use simple statistics and econometric analysis, they use a complex dynamic general equilibrium model. Our time framework of comparison before and after the fiscal consolidation is a five-year window (from two years after, to two years before the adjustment). This is exactly the same window around which the WEO Chapter finds that a reduction of the debt has positive effects on growth, as long as taxes are not raised.

And Alesina goes on to observe that the IMF uses a potentially problematic approach to identify episodes of fiscal consolidation:

The imperfections of cyclical adjustments are well known, and we carefully discuss them in our paper. We never claimed that these corrections are without flaws, and in our paper, we perform a variety of sensitivity tests. The WEO chapter simply dismisses this methodology. It claims to have found a better way of identifying when a fiscal adjustment really occurs. How? By reading IMF and OECD historical reports and checking what countries were intending to do at the time of publication. There are pros and cons in this approach. First, it involves many judgment calls. Second, and more importantly, the idea that this procedure would eliminate endogeneity (i.e., fiscal policy responding to the economy and not the other way around) is highly questionable.

The Economist observes that the IMF “looks at intent and action rather than outcomes,” without underlining the judgment calls involved. And that’s not where the judgment calls stop:

Using this method, the IMF reckons that on average a rich country attempted a fiscal contraction of more than 1.5% of GDP about once a decade. (There were also many smaller consolidations; see left-hand chart.) It finds that the typical such episode is clearly contractionary: a fiscal consolidation equivalent to 1% of GDP leads on average to a 0.5% decline in GDP after two years, and to an increase of 0.3 percentage points in the unemployment rate. Spending cuts do less damage than tax rises. This is mainly because they seem to be associated with bigger declines in interest rates. The fund’s economists reckon that this may be because central banks view spending cuts as a stronger signal of a commitment to fiscal prudence and so are more willing to provide some monetary stimulus to soften the blow.

My guess is that other economists might weigh the possibilities differently. Regardless, it’s certainly a very interesting back-and-forth.

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