Why we should hope fiscal multipliers are large

One of the frustrating things about doing macroeconomics during the crisis is that it is so hard to pin down key empirical parameters.    The size of fiscal multipliers is probably the main case in point.   The combination of short time series and a wide range of conditioning factors – confidence effects, the state of credit markets, import leakages, etc. – make it hard to identify the causal impacts of changes in taxes and government spending.  

While there is a widespread view that Irish fiscal multipliers are small (mainly due to the openness of the economy), I have always believed this is exaggerated given offsetting factors such binding credit constraints, an almost completely accommodating monetary policy and a large negative output gap.  At a time when I thought Ireland could retain its creditworthiness, this led me to believe we should pursue as gradual a fiscal adjustment as the State creditworthiness constraint would allow.    But with creditworthiness proving more fragile than expected, there is now little choice but to move expeditiously to close the deficit. 

With significantly more fiscal adjustment to come – probably at a minimum the €9 billion planned for in the EU/IMF programme – there is an obvious reason to hope fiscal multipliers are small.   But there is also a reason to hope they are large.   With the IMF reducing its growth estimate for 2011 and the exchequer returns hinting at a weaker than expected recovery, we would be better off if the fiscal adjustment is a significant source of the observed weakness in domestic demand.  

It is the underlying rate of potential output growth that really matters for Ireland’s debt sustainability.   Uncertainty about this rate is a significant part of our creditworthiness problem.    As others have pointed out, there are competing narratives about Ireland’s medium-term growth potential.   On the positive side is the strong growth in net exports (which added about 3.5 percentage points to Ireland’s real GDP growth in 2010).  On the negative side is the combined impact of the fiscal austerity and the drag from impaired balance sheets (which subtracted about 4.5 percentage points from growth in 2010).  

While unfortunately we are in for a good deal more austerity, it will eventually end; the more of the current drag on domestic demand that is coming from the austerity, the higher is the implied underlying potential growth rate.   Even if the fiscal adjustment is making less headway now in reducing the deficit due to relatively high multipliers, the large changes in taxes and social welfare rates should allow for a rapid improvement in the deficit once the austerity ends and decent overall growth returns.    The hoped for growth narrative – which I think we have good reason to believe is true – is that Ireland has an economy with a strong underlying export-driven growth potential that is being temporarily held back by unavoidable fiscal adjustment. 

How Big (Small?) are Fiscal Multipliers?

Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Végh provide new empirical evidence (using a different method to the recent IMF study). The paper is here and the abstract is below.

Abstract: We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.

Effects of Fiscal Stimulus in Structural Models

This new IMF working paper provides interesting analytical insights into the determinants of fiscal multipliers.  Also striking is the set of co-authors: it represents a joint collaborative effort across the IMF, ECB, European Commission, Federal Reserve, OECD and Bank of Canada.