Expansionary Fiscal Contraction

The February exchequer returns combined with ongoing default risk perceptions mean the government has little choice but to bring forward its fiscal adjustment.  I have doubts, however, about one argument for front-loading the adjustment that seems to be gaining currency – that it will be expansionary.  

The classic argument for an expansionary fiscal contraction focuses on cuts to government spending.  Permanent cuts in government spending lead to expectations of permanent cuts in taxes.   The expenditure effect of the latter can outweigh the former (especially if starting from a large and distorting tax burden).   In contrast, the current Irish debate is focused on adjustment through tax increases.   With apologies for oversimplifying, the argument seems to be that households and businesses already expect higher taxes, but uncertainty about the precise nature of those taxes is causing increased precautionary savings and investment delays.  Eliminating this uncertainty would lead to increased domestic demand.   

Two comments:  First, if the economy contains a significant share of myopic/liquidity-constrained individuals as well as forward-looking Ricardians, the reduced precautionary savings effect of the latter would have be very strong to offset the reduced spending of the former.  Second, and less speculatively, the empirical work of Alberto Alesina, Roberto Perotti and co-authors finds that fiscal adjustments based on tax increases tend to be less durable and more likely to be contractionary.

I draw two tentative lessons.   The first is that a cautious approach should be taken to front-loading until we understand better the role of discretionary fiscal contraction in the extremely sharp slowing of the economy.  The second is that a narrow intertemporal macro perspective suggests a significant part of any adjustment burden should fall on expenditure.   I would be very interested to hear views on the relevance of the expansionary fiscal contraction hypothesis to the current Irish situation.

3 thoughts on “Expansionary Fiscal Contraction”

  1. John,

    These are very important questions and I certainly don’t have the answers.

    What if the forward-looking Ricardians are operating in a fog of confusion and fear, and are placing probabilities on very very bad potential states of the world that are perhaps bigger than they need to be? In particular, what if they are placing a non-zero probability on government default, and perhaps on associated banking crises — I guess then the issue for them is, what would such a state of the world look like? I guess they are making assumptions about that based on zero historical evidence in the Irish context, and perhaps in this sort of context a successful fiscal consolidation is likely to have positive effects.

    But aside from that, I don’t think you need sell a fiscal consolidation on the basis that it will be expansionary — I am not convinced myself, any more than you seem to be, and view wage cuts as the policy most likely to preserve jobs. The issue for me is: what is the counterfactual? I’m pretty sure it would be even uglier.

    The final point is that all of this is showing up huge design flaws in EMU. Instead of one FDR, we have 16 Herbert Hoovers (OK, a bit of an exaggeration, but still..) and an excessively cautious ECB. Irishmen are of course not well positioned right now to point all this out on the EU stage.

  2. Thanks Kevin. Great points. Your first point is in line with a key idea behind Olivier Blanchard’s neat model in his comment on Giavazzi and Pagano (1990) (the paper in which the expansionary fiscal contraction idea is introduced). Individuals fear a very rough adjustment once a debt limit is reached. In advance of this limit there can be high precautionary saving as well as anticipations of large tax distortions. Perhaps I have underestimated how debilitating these fears can be.

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