5/4/19: Does Government Debt Matter? The Reality of Fiscal Multipliers

There has always been a lot of debate in economics about the effects of debt (especially sovereign debt) on growth and fiscal dynamics. And, despite numerous papers on the subject, the debate is far from settled.

Here is an interesting new study that looks at the effect high levels of government indebtedness have on the effectiveness of fiscal policy stimulus. The reason this topic is important is simple: fiscal policy can and is used to offset or smooth out recessionary shocks. The extent to which fiscal policy is effective in doing so (the impact expansionary fiscal policy may have on unemployment and output) can be varied across different economies and under different crises conditions. But, does this extent vary under different debt conditions?

In theory, the debt levels carried by a given sovereign can impact the size of fiscal multipliers (the effectiveness of fiscal policy) through two main channels:

1. The so-called Ricardian channel: a government with a weak fiscal position (high debt) deploying fiscal stimulus (an increase in public spending) can cause households to expect future tax increases. The result is that in economies with high public debt levels, deploying fiscal stimulus can trigger increased savings by households, reducing consumption, and lowering the size of fiscal policy multiplier.
2. An interest rate channel: when the government debt is high, so that the government fiscal position is weak, fiscal stimulus can increase concerns about sovereign credit risk amongst government bond holders and buyers. This can increase bond yields, raise borrowing costs, lower liquidity of bonds for the sovereign, but also increase cost of capital across the private sector. The result is the crowding out effect, whereby public spending crowds out private investment and credit-finance consumption.

In theory, both channels imply that fiscal policy is less effective when fiscal stimulus is implemented from a weak initial fiscal position (position of high starting government debt levels).

A new World Bank paper, authored by Huidrom, Raju and Kose, M. Ayhan and Lim, Jamus Jerome and Ohnsorge, Franziska, and titled "Why Do Fiscal Multipliers Depend on Fiscal Positions?" (March 2019, World Bank Policy Research Working Paper No. 8784: https://ssrn.com/abstract=3360142) considers the two theoretical channels operating simultaneously. Using data for 34 countries (19 advanced economies and 15 developing economies),  over 1Q 1980 through 1Q 2014, the authors show that "the fiscal position helps determine the size of the fiscal multipliers: estimated multipliers are systematically smaller when the fiscal position is weak (i.e. government debt is high).

Looking at the longer run panel in the chart above, fiscal multipliers rapidly reach into negative territory as Government debt rises to around 37-40 percent of GDP. Over a medium term horizon, of 2 years, multipliers hit negative values for debt levels above 75 percent of GDP.

Similar dynamics are confirmed in the chart below:

The authors subsequently "show that when a government with weak public finances conducts expansionary fiscal policy, the private sector scales back on consumption in anticipation of future tax pressures (Ricardian channel) and risk premia rise on mounting concerns about sovereign risk (interest rate channel)." In other words, high starting debt position does trigger both theoretical effects to reinforce each other.

This is an unpleasant arithmetic for uber-Keynesians who hold that fiscal policy is always effective in stimulating economic growth during periods of economic crises. The findings also support the view that the 'fiscal policy space' is indeed bounded by the reality of pre-crisis fiscal policy paths: there is no free lunch when it comes even to sovereign financing.

12/9/16: Fiscal Policy in the Age of Debt

In recent years, there has been lots and lots of debates, discussions, arguments and research papers on the perennial topic of fiscal stimulus (aka Keynesian economics) on the recovery. The key concept in all these debates is that of a fiscal multipliers: by how much does an economy expand it the Government spending rises by EUR1 or a given % of GDP.

Surprisingly, little of the debate has focused on a simple set of environmental factors: fiscal stimulus takes place not in a vacuum of environmental conditions, but is coincident with: (a) economies in different stages of fiscal health (high / low deficits, high/low debt levels etc) and (b) economies in different stages of business cycle (expansion or contraction). One recent paper from the World Bank decided to correct for this glaring omission.

“Do Fiscal Multipliers Depend on Fiscal Positions?” by Raju Huidrom, M. Ayhan Kose, Jamus J. Lim and Franziska L. Ohnsorge (Policy Research Working Paper 7724, World Bank) looked at “the relationship between fiscal multipliers and fiscal positions of governments” based on a “large data-set of advanced and developing economies.” The authors deployed methodology that “permits tracing the endogenous relationship between fiscal multipliers and fiscal positions while maintaining enough degrees of freedom to draw sharp inferences.”

The authors report three key findings:

“First, the fiscal multipliers depend on fiscal positions: the multipliers tend to be larger when fiscal positions are strong (i.e. when government debt and deficits are low) than weak.” In other words, fiscal expansions work better in case where sovereigns are in better health.

“For instance, our estimates suggest that the long run multiplier can be as big as unity when the  fiscal position is strong but it can turn negative when the fiscal position is weak. A weak fiscal position can undermine fiscal multipliers even during recessions. Consistent with theoretical predictions, we provide empirical evidence suggesting that weak  fiscal positions are associated with smaller multipliers through both a Ricardian channel and an interest rate channel.”

By strong/weak fiscal position, the authors mean low/high sovereign debt to GDP ratio. And they show that fiscal expenditure uplift for higher debt ratio states results in economic waste (negative multipliers) in pro-cyclical spending cases (when fiscal expansion is undertaken at the times of growing economy). Which is important, because most of the ‘stimuli’ take place in such conditions and majority of the arguments in favour of fiscal spending increases happen on foot of rising economic growth (‘spend/invest while you have it’).

“Second, these effects are separate and distinct from the impact of the business cycle on
the fiscal multiplier.” Which means that debt/GDP ratio has an impact in terms of strengthening or weakening fiscal policy impact also regardless of the business cycle. Even if fiscal expansion is counter-cyclical (Keynesian in nature, or deployed at the time of a recession), fiscal multipliers (effectiveness of fiscal policy) are weaker whenever the debt/GDP ratio is higher. In a way, this is consistent with the issues arising in the literature examining effects of debt overhang on growth.

“Third, the state-dependent effects of the fiscal position on multipliers is attributable to two factors: an interest rate channel through which higher borrowing costs, due to investors’ increased perception of credit risks when stimulus is implemented from a weak initial fiscal position, crowd out private investment; and a Ricardian channel through which households reduce consumption in anticipation of future fiscal adjustments.”

What this means is that low interest rates (accommodative monetary policy) may be supporting positive effects of fiscal expansion, but at a cost of reducing private investment. In a sense, public investment, requiring lower interest rates, crowds out private investment. Now, no medals for guessing which environment we are witnessing today.

Some charts

First, median responses to increased Government spending

Once you control for debt/GDP position with stimulus taking place during recessions:

“Note: The graphs show the conditional fiscal multipliers during recessions for different levels of fiscal position at select horizons… Government debt as a percentage of GDP is the measure of fiscal position and the values shown on the x-axis correspond to the 5th to 95th percentiles from the sample. …Fiscal position is strong (weak) when government debt is low (high). Solid lines represent the median, and dotted bands are the 16-84 percent confidence bands.”

In the two charts above, notice that the range of public debt/GDP ratios for positive growth effect (multiplier > 1) of fiscal policy is effectively at or below 25%. At debt levels around 67%, fiscal expansion turns really costly (negative multipliers) in the long run. How many advanced economies have debt levels below 67%? How many below 25%? Care to count? Five  economies have debt levels below 25% (Estonia, Hong Kong, Macao, Luxembourg and San Marino). For 67% - nineteen out of 39 have debt levels above this threshold. Not exactly promising for fiscal expansions...

Overall, the paper is important in: (1) charting the relationship between fiscal policy effectiveness, and debt position of the sovereign; (2) linking coincident fiscal and monetary expansions to weaker private investment; and (3) showing that in the long run, fiscal expansion has serious costs in terms of growth and these costs are more pronounced for countries with higher debt levels. Now, about that idea that Greece, or the rest of PIGS, should run up public investment to combat growth crisis…

24/10/2013: Fiscal Policy: To Bail Directly or Via Project Finance?

New paper "Macro Fiscal Policy in Economic Unions: States as Agents" by Gerald Carlino, and Robert P. Inman (NBER Working Paper No. 19559 published October 2013) argues that ARRA (the American Recovery and Reinvestment Act) was the US government’s fiscal policy (as opposed to monetary policy QEs programmes) response to the Great Recession. "An important component of ARRA’s $796 billion proposed budget was $318 billion in fiscal assistance to state and local governments."

The study "reaches three conclusions.

1. "First, aggregate federal transfers to state and local governments are less stimulative than are transfers to households and firms. It is important to evaluate the two policies separately." Note: I have argued that in the current extreme case of debt overhang on household side, monetary policy can act directly to monetize debt (effectively cover household debt write downs) instead of attempting tod sliver support for deleveraging via traditional channels (banks --> firms & households, or government --> firms & households).
2. "Second, within intergovernmental transfers, matching (price) transfers for welfare spending are more effective for stimulating GDP growth than are unconstrained (income) transfers for project spending. Matching aid is fully spent on welfare services or middle-class tax relief; half of project aid is saved and only slowly spent in future years." Again, direct injections to households will work better than indirect stimulus via 'infrastructure projects' or neo-Keynesian 'digging of the trenches'… However, this effect for the US is obviously linked to the less open nature of the US economy than say in the case of smaller economies of Europe.
3. "Third, simulations using the SVAR specification suggest ARRA assistance would have been 30 percent more effective in stimulating GDP growth had the share spent on government purchases and project aid been fully allocated to private sector tax relief and to matching aid to states for lower-income support."

From the paper: Federal Aid, Federal Purchases, and Federal Net Revenue: 1947 - 2010*
(Per Capita, 2005 Dollars)

Now, look at the above and give a thought to the fact that Paul Krugman still thinks there was not enough stimulus...

30/10/2012: Not all austerity is equal

August 2012 paper (link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2153486 ) "The Output Effect of Fiscal Consolidations by Alberto F. Alesina , Carlo A. Favero and Francesco Giavazzi published by CEPR (Discussion Paper No. DP9105) looked at "whether fiscal corrections cause large output losses." Italics are mine:

The authors "find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions.

The difference cannot be explained by different monetary policies during the two types of adjustments. Studying the effects of multi-year fiscal plans rather than individual shifts in fiscal variables we make progress on question of anticipated versus unanticipated policy shifts: we find that the correlation between unanticipated and anticipated shifts in taxes and spending is heterogenous across countries, suggesting that the degree of persistence of fiscal corrections varies."

"Estimating the effects of fiscal plans, rather than individual fiscal shocks, we obtain much more precise estimates of tax and spending multipliers". And "the key result is that while expenditure-based adjustments are not recessionary, tax-based ones create deep and long lasting recessions." The reason for this that "the aggregate demand component which reflects more closely the difference in the response of output to ECB and [tax-based] adjustments is private investment. The confidence of investors proceeds with the economy and therefore recovers much sooner after a spending-based adjustment than after a tax-based one. ...These results are consistent with the descriptive statistics presented in Alesina and Ardagna (2012) who show that the fiscal stabilizations which have the mildest effect on output are those that are accompanied by a set of structural reforms which signal a "decisive" policy change. They [like the present study] do not find any difference in the monetary pol- icy stance between spending-based and tax-based adjustments, but mostly differences in the policy packages regarding supply side reforms and liberalizations."

21/7/2012: Sunday Times July 1, 2012 - Not a 'stimulus' again...

An unedited version of my Sunday Times article from July 1.

One of the points of contention in modern economics is the role of fiscal spending shocks on economic growth. Various empirical estimates suggest Irish fiscal multiplier at 0.3-0.4, implying that for every euro of additional Government spending we should get a €1.30-€1.40 in GDP uplift. However, these are based on models that do not take into the account our current conditions. Despite this fact, Irish policymakers continue talking about the need for Government to stimulate the economy, while various think tanks continue to argue that Ireland should abandon fiscal stabilization or more aggressively tax private incomes to deliver a boost to our spending.

International research on this matter is more advanced, although it too leaves much room for a debate.

June 2012 IMF working paper titled “What Determines Government Spending Multipliers?” by Giancarlo Corsetti, Andre Meier and Gernot Muller (June 2012) studied the effects of government spending on the economy under the variety of macroeconomic conditions.

What IMF researchers did find is that the initial conditions for stimulus do matter in determining its effectiveness – an issue generally ignored in the domestic debates about the topic.

Under a pegged exchange rate regime, similar to Ireland’s but still allowing for some exchange rate and interest rates adjustments, trade balance is likely to worsen in response to a fiscal stimulus, while output can be expected to rise. Domestic investment and consumption will decline in response to the positive stimulus shock. These factors are likely to be even more pronounced in the case of Ireland’s currency ‘peg’ that permits no adjustment in real exchange rate except via domestic inflation.

The role of weak public finances in determining the effectiveness of fiscal spending stimulus is also revealing. The study defines fiscally constrained conditions as the gross government debt exceeding 100 percent of GDP and/or government deficit in excess of 6 percent of GDP. Both of these are present in the case of Ireland. On average, the study shows that consumption response to fiscal stimulus is negative-to-zero following the stimulus, but becomes positive in the medium term. Impact on output and investment is negative. The core reasons for the adverse effects of fiscal expenditure on economic performance are losses from stimulus through increased imports of goods and services by the State, internal re-inflation of the economy through inputs prices, plus the expectation from the private sector consumers and producers of higher future taxes required to cover public spending increases.

In the case when financial crisis is present, increase in Government spending results in a positive and strong output expansion, rise in consumption and, with some delay, rise in investment. However, net exports still fall sharply and the stimulus leads to the inflationary loss of external competitiveness in the economy.

The problem with the above results is that the IMF study still does not consider what happens to a fiscal stimulus in a country like Ireland, combining a strict currency peg, exclusive reliance on trade surplus for growth generation and characterized by historically high levels of fiscal imbalances and financial system collapse. In other words, even the IMF research as imprecise as it is, is far from conclusive.

These are non-trivial problems in the case of Ireland. Official estimates for fiscal policy multiplier in this country range between 0.38 (European Commission) and 0.4 (Department of Finance).  These are based on relatively simplistic models and are, therefore, likely to be challenged by the reality of our current conditions. A more recent study from the Deutsche Bank cites Irish fiscal multiplier of 0.3 without specifying the methodology used in deriving it. Either way, no credible estimate known to me puts the fiscal multiplier above 0.4 for Ireland.

In short, Government stimulus is not exactly an effective means for raising output, even at the times when the economy can take such stimulus without demolishing the Exchequer balancesheet. And lacking precision in estimating the fiscal multiplier, the entire argument in favor of fiscal stimulus is an item of faith, not of scientific analysis.

In my opinion, Ireland does not need a Government expenditure boost. Instead we need a policy shift toward stimulating domestic and international investment, plus the public expenditure rebalancing away from current spending toward some additional capital investment.

Quarterly National Accounts clearly show that the problem with the Irish economy is not the fall off in private or public consumption, but a dramatic collapse in private investment. While private consumption expenditure in Ireland has declined 13.6% relative to the economy’s peak in 2007, net expenditure by Government is down 12.0% (including a decline in public investment). However, overall private investment in the economy is down 67%. 2011 full year capital investment was, unadjusted for inflation, at the level last seen in 1997, while consumption is down ‘only’ to 2005-2006 levels and Government spending is running at around 2006 levels. With nominal GDP falling €33.5 billion between 2007 and 2011, our investment declined €32.6 billion over the same period, personal consumption dropped €12.8 billion, while net Government expenditure on goods and services is down a mere €3.4 billion. Between 2007 and 2011, total voted current expenditure by the Government rose 12%, while total net voted capital expenditure fell 44%.

Adding a Government investment stimulus of €2 billion would have an impact of raising net capital expenditure by the Exchequer in 2012-2014 to the levels 22.4% below those in 2007 and will lift our GDP by under 1.8% according to the EU measure of fiscal multiplier. However, factoring in deterioration in the current account as estimated by the IMF, the net effect might be closer to zero. Based on IMF model re-parameterized to our current conditions, the net result can be as low as 0.1% increase in GDP.

Again, the problem here is the effect of capital spending on our imports. As a highly open economy, Ireland imports most of what it consumes. This includes Government and private capital investment goods – machinery, materials and know-how relating to construction, assembly, installation and operation of modern transport systems, energy and ICT, etc. Some of these imports will continue well beyond the period of actual investment. In other words, using fiscal stimulus to finance public capital investment risks providing some short-term supports for lower skilled Irish labour and few professionals with the lion’s share of expenditure going to the multinational companies supplying capital goods and services into Ireland from abroad.

The fiscal cost of such a stimulus, however, would be exceptionally high. Between 2008 and 2011, Irish Government has managed to cut €4.3 billion off the annual capital spending bill while increasing current spending by €662 million. This resulted in total voted spending reduction of only €3.6 billion. A stimulus of €2 billion on capital investment side will throw the state back to 2009 levels of expenditure, erasing two years worth of consolidation, unless it is financed out of cutting current spending and transferring funds to capital programmes. The extra capital spending will lead to further retrenchment in private consumption and investment, as households and businesses will anticipate relatively rapid uplift in tax burdens to recover the momentum to the fiscal consolidation. This, coupled with already committed €8.6 billion in further fiscal adjustments in the next three years, will further reduce growth effects of the stimulus and shorten its positive effects duration.

Overall, the right course of policies to pursue today requires restructuring of the debt burden carried by the real economy, starting with household debts and stimulating, simultaneously domestic and foreign investment into small and medium enterprises and start-ups. Instead of focusing on the less labor-intensive MNCs’ investments, we need to put in place tax and institutional incentives to increase inflow of equity capital, not new debt, to Irish businesses. Such incentives must target two areas of investment: investment into activities associated with new jobs creation by the SMEs, plus investment into strategic repositioning and restructuring of Irish SMEs to put them onto exporting path.

Lastly, if we really do want to have a stimulus debate, the discussion should not be focusing on creating a net increase in the public expenditure, but on the potential for reallocating some of the funds from the current expenditure side of the Exchequer balancesheet to capital investment.

  

Box-out:

The latest Index of Failed States published this week ranks Ireland the 8^th best state in the world. Our overall score in the league table was helped by extremely high performance in some specific indicators. Surprisingly, according to the Index authors, we are having a jolly good time throughout the crisis. Allegedly, Ireland’s problem in terms of emigration is relatively comparable to that found in New Zealand and Germany. Our economy, heavily dominated by MNCs exports in pharma, medical devices and ICT sectors ranks higher in terms of the balance of economic development than majority of the advanced economies that have more diversified and domestically anchored sources of growth. Our ‘balanced development’ model, having led us into the current crisis, is allegedly more sustainable, according to the Index, than that of Canada – a country that escaped the Great Recession. In terms of poverty and economic decline we are better off than France, Japan and New Zealand, which had a much less severe recession than Ireland over the last 5 years. In quality of public services, we are better than Belgium and the UK, and are ranked as highly as Canada. And our elites are less factionalized than those in the vast majority of the states of the Euro area. In short, according to the Foreign Policy, index publisher, Ireland is a veritable safe haven within a tumultuous euro zone, comparable to New Zealand, Luxembourg, Norway and Switzerland. We rank well ahead of Canada, Australia, the UK and the US, as well as all other states that currently receive tens of thousands of Irish emigrants.