Article Review The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence?

27 September 2013

The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence? Chowdhury and Islams article explores the variables of concern in employing fiscal consolidation and examines the feasibility of, and impediments to, implementation of such a stance. The authors also utilize empirical evidence to dismiss the notion that fiscal consolidation yields expansionary effects. The following review provides the economic rationale underlying the authors assertions, and critique arguments that contradict traditional economic theory. Chowdhury and Islam propose that varying fiscal compositions yield asymmetric effects on output, income and employment. The authors proclaim that productivity enhancing investment expenditure (i.e., education and infrastructure) facilitates longrun income growth, decreasing the debt/GDP ratio and improving the budget balance. This caveat can be applied to the following model proposed by Smith (2013), which examines the differences in effectiveness of fiscal expansion relative to consolidation in terms of attempting to reduce debt/GDP and budget deficits. Assuming taxes are an increasing function of income, fiscal expansion directly increases national income and creates flow-on effects, increasing consumption, investment and net-exports, which further enhances output. Implementation generates income from increased output in the economy, and thus positively affects the government finances via amplified tax receipts. Conversely, consolidation causes falling output, income and taxes, resulting in budget degradation, which offsets the initial gain from reduced expenditure. Consistent with the authors claim, productivity increasing fiscal outlays has greater long-run effects for government budget metrics than consolidation, as displayed in the following figures:

Income and employment growth following implementation of fiscal austerity measures cannot, as the authors correctly warn, be attributed solely as a function of fiscal consolidation. Instead, they advocate that subsequent growth is a function of bundled variables comprising monetary policy, exchange-rate policy and structural reforms. This is consistent with the empirical findings that economies who enjoyed successful expansionary fiscal consolidations are the exception, not the rule (Boyer 2012 p. 298) whereby subsequent growth was the combined effect of simultaneously varying other variables such as price devaluation promoting export booms, credibility effects and income effects. Chowdhury and Islam postulate that fiscal expenditure should be curtailed in order to stimulate confidence in the economy via the credibility effect (Heylen and Everaert 1998), facilitating increased investment, and ultimately improvement of the budgetbalance. This is akin to a downward shift in the tail of the yield curve, lowering longterm risk premia and inducing interest sensitive components of aggregate demand (AD) (Gordon 2013). However, the authors make no allowance for subdued economic conditions canvassed worldwide, which have pushed cash rates (and via relation, interest rates) toward their zero lower-bound, creating a liquidity trap (Benhabib, Evans and Honkapohja 2012). This moderates the assumption that an indirect confidence multiplier would have more pronounced effects on national income than a direct expansionary fiscal injection. In addition, the asymmetric nature of monetary policy albeit indirectly via changes in the yield curve - further constrains any indirect increase to AD (Gordon 2013).

Assuming the authors claim eventuates, and increased confidence induces private investment there would be a rightward shift the AD curve owing to increased output, countering to an extent (the magnitude of which is dependent on the interest-elasticity of demand) a significant initial leftward shift stemming from an adverse shock to AD during the GFC. However, the accelerator mechanism is unaccounted for, whereby the fall in AD emanating from constrained government expenditure, results in further contractionary momentum attributable to adverse responses in private investment and consumption (Heylen and Everaert 1998). The effect of this policy lowers output below that of the initial AD shock, further decreasing output and employment. This lower income level adversely affects the budget balance via falling tax receipts and increased transfer payments, ultimately increasing debt/GDP (Boyer 2012). The authors position does however gain momentum as government debt becomes excessive, which, according to Sutherland (1996) results in anti-Keynesian effects, forming contractionary momentum via diminished consumption (assuming the Ricardian Equivalence Principal of future distributional taxation concerns (Boyer 2012)). The authors present a flawed argument with respect to crowding out concerns in an underperforming economy, by proposal that government expenditure aimed at increasing AD will manifest partial crowding out and thus diminish private investment, constraining fiscal expansion. This point is employed in support of austerity as an alternative to fiscal expansion, and under the assumption that there is exogenous money in the economy, whereby the central banks monetary policy tool is the quantity of money. With identification that the quantity of money is endogenous, crowding out concerns are unsubstantiated until the full-employment level of output is reached. The authors assumption that an economy is in a depressed state further establishes crowding out infeasibility, given that an adverse shock to AD would ensure that the economy be positioned at a lower short run equilibrium level of output. Assuming that the economy were in a diminished state of output, and that the short run price level was beneath expected prices, expansionary monetary measures would tend to yield crowding in effects (Heylen and Everaert 1998), independently of either fiscal stance. Chowdhury and Islam challenge the robustness of expansionary fiscal consolidation, and hi-light composition of fiscal policy and the causality as key variables in evaluation of optimal policy responses. However, deviation from traditional Keynesian theories (employing a mix of Ricardian and Neoliberalism methodologies), and contradictory or understated analyses compromise the legitimacy of certain assertions.

References: Benhabib, J., Evans, GW. and Honkapohja, S. 2012, Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?, CEPR Discussion Papers, vol. DP9176. Boyer, R. 2012, The four fallacies of contemporary austerity policies: the lost Keynesian legacy, Cambridge Journal of Economics, vol. 36, pp. 283-312. Chowdhury, C. and Islam, I. 2012, The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence?, The Economic and Labour Relations Review, vol. 23, no. 3, pp. 13-38. Gordon, Robert J. 2012, Macroeconomics, 12th ed., Pearson Addison Wesley, Boston Heylen, F. and Everaert, G. 1998, Success and failure of fiscal consolidation in the OECD: A multivariate analysis, Public Choice, vol. 105, pp. 103-124. IMF (2010b) From stimulus to consolidation: Revenue and expenditure policies in advanced and emerging economies, IMF Policy Paper, 30 April, IMF. Smith, M. 2013, Intermediate Macroeconomics (ECOS2002), The University of Sydney, Sydney, 14 August 2013, viewed 24 September 2013, <http://blackboard.econ.usyd.edu.au> Sutherland, A. 1996, Fiscal crises and aggregate demand: can high public debt reverse the effects of fiscal policy?, Journal of Public Economics, vol. 65, pp. 147162.