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Fiscal Policy after the Financial Crisis

Fiscal Policy after the Financial Crisis

by Alberto Alesina (Editor), Francesco Giavazzi (Editor)

The recent recession has brought fiscal policy back to the forefront, with economists and policy makers struggling to reach a consensus on highly political issues like tax rates and government spending. At the heart of the debate are fiscal multipliers, whose size and sensitivity determine the power of such policies to influence economic growth.

Fiscal Policy


The recent recession has brought fiscal policy back to the forefront, with economists and policy makers struggling to reach a consensus on highly political issues like tax rates and government spending. At the heart of the debate are fiscal multipliers, whose size and sensitivity determine the power of such policies to influence economic growth.

Fiscal Policy after the Financial Crisis focuses on the effects of fiscal stimuli and increased government spending, with contributions that consider the measurement of the multiplier effect and its size. In the face of uncertainty over the sustainability of recent economic policies, further contributions to this volume discuss the merits of alternate means of debt reduction through decreased government spending or increased taxes. A final section examines how the short-term political forces driving fiscal policy might be balanced with aspects of the long-term planning governing monetary policy.

A direct intervention in timely debates, Fiscal Policy after the Financial Crisis offers invaluable insights about various responses to the recent financial crisis.

Editorial Reviews

“The financial crisis illuminated gaps in economists’ understanding of both fiscal and monetary policy. This work, a National Bureau of Economic Research conference report, addresses fiscal policy gaps. . . . The articles, particularly William Easterly’s article on governments’ inability to adjust current spending to a new, slower growth path provide a valuable discussion of many key issues facing policy makers today. Recommended.”

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University of Chicago Press
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Fiscal Policy after the Financial Crisis

By Alberto Alesina, Francesco Giavazzi


Copyright © 2013 National Bureau of Economic Research
All rights reserved.
ISBN: 978-0-226-01844-7



Government Spending and Private Activity

Valerie A. Ramey

1.1 Introduction

The potential stimulus effects of fiscal policy have once again become an active area of academic research. Before the Great Recession, the few researchers who estimated the effects of government spending did so in order to understand which macroeconomic models were the best approximation to the economy. Rather than analyzing differences in estimated multipliers, most of the literature debated whether the movements of key variables, such as real wages and consumption, were more consistent with Keynesian or neoclassical views of fiscal policy (e.g., Rotemberg and Woodford 1992; Ramey and Shapiro 1998; Blanchard and Perotti 2002; Burnside, Eichenbaum, and Fisher 2004; and Perotti 2008). Starting with the stimulus debate, however, the focus shifted to empirical estimates of multipliers. In Ramey (2011b), I surveyed the growing recent literature that estimates government spending multipliers in aggregate national data as well as in state panel data. Reviewing that literature, I found that the range of estimates of the GDP multiplier is often as wide within studies as it is across studies. I concluded that the multiplier for a deficit-financed temporary increase in government spending probably lies somewhere between 0.8 and 1.5, but could be as low as 0.5 or as high as 2.

Two of the key questions for deciding whether policymakers should use government spending for short-run stabilization policy are: (1) Can an increase in government spending stimulate the economy in a way that raises private spending? and (2) Can an increase in government spending raise employment and lower unemployment? With respect to the first question, if an increase in government spending raises GDP without raising private sector spending, then private welfare does not necessarily rise. With respect to the second question, most economists and policymakers would agree that job creation is at least as important a goal as stimulating output. In theory, one can use Okun's law to translate GDP multipliers to unemployment multipliers. However, because of variations in the parameters of this "law" over time, the advent of jobless recoveries, and the frictions involved in creating and filling jobs, the translation of output multipliers to employment or unemployment multipliers is not straightforward. Thus, it makes sense to devote as much attention to the employment effects of government spending as to the output effects.

This chapter empirically studies the effect of government spending on private spending, unemployment, and employment. I define private spending to be GDP less government spending. I show that whether one uses structural vector autoregressions (SVARs) or expectational vector autoregressions (EVARs), whether the sample includes World War II and Korea or excludes them, an increase in government spending never leads to a significant rise in private spending. In fact, in most cases it leads to a significant fall. These results imply that the government spending multiplier is more likely below one rather than above one.

These estimates are based on samples in which part of the increase in government spending is financed by an increase in tax rates, so the multipliers are not necessarily the ones applicable to current debates on deficit-financed stimulus packages. I thus explore two different ways to adjust for the increase in taxes in order to determine a deficit-financed government spending multiplier. One method uses the VARs to create counterfactuals and the other uses more structural instrumental variables estimates. Surprisingly, both methods suggest that the behavior of marginal tax rates does not have a significant effect on the size of the spending multiplier.

In the final part of the chapter I investigate the effects of government spending on unemployment and employment. I begin by conducting a case study of labor markets during the World War II period. I then use the VAR methods on various samples and find that an increase in government spending lowers unemployment. However, I find the surprising result that in the great majority of time periods and specifications, all of the increase in employment after a positive shock to government spending is due to an increase in government employment, not private employment. There is only one exception. These results suggest that the employment effects of government spending work through the direct hiring of workers, not stimulating the private sector to hire more workers.

1.2 Background

1.2.1 Output Multipliers

There has been a dramatic increase in research on the output multiplier in the last few years. The aggregate studies that estimate the multiplier fit in two general categories. The first are the studies that use long spans of annual data and regress the growth rate of GDP on current and one lag of defense spending, or government spending instrumented by defense spending (e.g., Hall 2009; Barro and Redlick 2011). These studies tend to find multipliers that are less than one. The second type are the VARs estimated on quarterly data, such as those used by Ramey and Shapiro (1998), Blanchard and Perotti (2002), Mountford and Uhlig (2009), Fisher and Peters (2010), Auerbach and Gorodnichenko (2012), and Ramey (2011c). Some of these papers calculate the multipliers based on comparing the peak of the government spending response to the peak of the GDP response. Others compare the area under the two impulse response functions. As I discuss in my forum piece for the Journal of Economic Literature (Ramey 2011b), the range of multiplier estimates are often as wide within studies as across studies. An interesting, but unnoticed, pattern arises from this literature. In particular, the Blanchard-Perotti style SVARs yield smaller multipliers than the expectational VARs (EVARS), such as the ones used in my work. This result is intriguing because the SVARs tend to find rises in consumption whereas the EVARs tend to find falls in consumption in response to an increase in government spending. Overall, most output multiplier estimates from the aggregate literature tend to lie between 0.5 and 1.5.

There are also numerous papers that use cross-sections or panels of states to estimate the effects of an increase in government spending in a state on that state's income. These papers typically find multipliers of about 1.5. However, translating these state-level multipliers to aggregate multipliers is tricky, as discussed in Ramey (2011b).

While the explicit instrumental variables frameworks with few dynamics provide statistical confidence bands around the implied multipliers, the VAR-based literature does not. Typically, the VAR literature provides separate impulse responses of government spending, GDP, and the spending subcomponents, and then calculates an implied multiplier by either comparing the peak response of GDP to the peak response of government spending, or comparing the integral under the two impulse response functions. As I will show later, a simple permutation of the VAR makes it easy to provide confidence intervals of the multiplier relative to unity.

1.2.2 Labor Market Effects of Government Spending

A few of the older papers and a growing number of recent papers have studied government spending effects on labor markets. Most of the studies that exploit cross-state or locality variation focus on employment as much as income. For example, Davis, Loungani, and Mahidhara (1997) and Hooker and Knetter (1997) were among the first to study the effects of defense spending shocks on employment in a panel of states. Nakamura and Steinsson (2011) study similar effects in updated data. Fishback and Kachanovskaya (2010) analyze the effects of various New Deal programs during the 1930s on states and localities. Chodorow-Reich et al. (2012) and Wilson (2012) estimate the effects of the recent American Recovery and Reinvestment Act (ARRA) on employment using cross-state variation. As summarized by Ramey (2011b), on average these and related studies produce estimates that imply that each $35,000 of government spending produces one extra job. However, some of these studies, such as by Wilson (2012), find that the jobs disappear quickly.

At the aggregate level, the recent paper by Monacelli, Perotti, and Trigari (2010) analyzes the effects of government spending shocks on a number of labor market variables. In particular, they use a standard structural VAR to investigate the effects of government spending shocks on unemployment, vacancies, job-finding rates, and separation rates in the post-1954 period. Their point estimates suggest that positive shocks to government spending lower the unemployment rate and the separation rate, and increase vacancies and the job finding rate. However, their estimates are imprecise, so most of their points estimates are not statistically different from zero at standard significance levels. On the other hand, Brückner and Pappa (2010) study the effects of fiscal expansions on unemployment in a sample of Organization for Economic Cooperation and Development (OECD) countries using quarterly data. Whether they use a standard SVAR, sign restrictions, or the Ramey-Shapiro military dates, they find that a fiscal expansion often increases the unemployment rate. In most cases, these increases are statistically significant at the 5 percent confidence level.

In sum, the studies using state or local panel data find more robust positive effects of government spending on employment than the aggregate studies. As discussed earlier, translating state-level multipliers to the aggregate is not straightforward.

1.2.3 The Distinction between Government Purchases and Government Value Added

To understand why there is not a one-to-one correspondence between output multipliers and private employment multipliers, it is useful to consider the distinction between government spending on private goods versus government output. In the National Income and Product Accounts (NIPA), government purchases (G) includes both government purchases of goods from the private sector, such as aircraft carriers, and government value added, which is comprised of compensation of government employees, such as payments to military and civilian personnel, and consumption of government capital. Rotemberg and Woodford (1992) made this distinction in their empirical work by examining shocks to total defense spending after conditioning on lags of the number of military personnel. Wynne (1992) was the first to point out the theoretical distinction between government spending on purchases of goods versus compensation of government employees. He used comparative statistics in a neoclassical model to demonstrate the different effects. Finn (1998) explored the issue in a fully dynamic neoclassical model. She showed that increases in G resulting from an increase in government employment and increases in G resulting from an increase in purchases of goods from the private sector have opposite effects on private sector output, employment, and investment. Other authors exploring this distinction include Cavallo (2005), Pappa (2009), and Gomes (2010).

Figure 1.1 shows the two ways of dividing the output of the economy. The top panel shows the usual way of dividing goods and services according to which entity purchased the goods. Variable G is the usual NIPA category of "Government Purchases of Goods and Services." The rest of the output is purchased by the private sector, either as consumption, investment, or net exports. The middle panel divides the economy according to who produces the goods and services. Production by the government occurs when it directly hires workers and buys capital stock. The value added is counted as production by this sector. Examples include education services, police services, military personnel services, and other general government activities. All other production is done by the private sector. The third panel superimposes these two ways of dividing the economy. As the panel illustrates, government purchases (G) consist of the value added of government (YGov), which the government itself produces and essentially "sells" to itself, and government purchases of goods and services from the private sector (GPriv). During the typical military buildup, the government hires more military personnel, resulting in more government production, and buys tanks from the private sector. Thus, both components of G rise.

To see why different types of government spending can have different effects, consider the following key equations from an augmented neoclassical model. Consider first the production function for private value added:

(1) YPriv = F(NPriv, KPriv),

where YPriv is private value added, NPriv is private employment, and KPriv is the private capital stock. The number of workers available for private employment is determined by the labor resource constraint:

(2) NPriv = [bar.T] - NGov - L,

where [bar.T] is the time endowment, NGov is government employment, and L is leisure. Thus, one way that the government draws resources from the private sector is through the labor resource constraint. Another way that the government draws resources from the private sector is through its purchases of private goods. In this case, the affected resource constraint is the one for private output, given by:

(3) YPriv = C + I + NX + GPriv,

where GPriv is government purchases from the private sector. Total G from the NIPA is:

(4) G = GPriv + YGov,

where YGov is government value added, created by combining government employment with government capital as follows:

(5) YGov = H(NGov, KGov).

Under reasonable assumptions about labor markets and production functions, the relative price of private and government output is one, so total GDP is given by:

(6) Y = YPriv + YGov.

In the context of this type of model, an increase in government spending raises total employment. However, the extent to which government spending raises private employment depends on whether the increase in G is due more to an increase in purchases of private sector output or more to an increase in government output and employment. We would expect private sector employment to rise in the first case but to fall in the second case. Thus, a rise in overall employment does not necessarily imply a rise in private sector employment, so it is important to distinguish private versus government employment in the data.

1.3 The Effects on Private Spending

In most studies using aggregate data and VARs, government spending multipliers are usually calculated by comparing the peak of the output response to the peak of the government spending response or by comparing the integral under the impulse response functions up to a certain horizon. Usually, no standard errors are provided, but given the wide standard error bands on the output and government spending components, the standard error bands on the multipliers are assumed to be large. Studies of the subcomponents of private spending, such as nondurable consumption or nonresidential fixed investment, often give mixed results with wide error bands.

As I will now show, a simple permutation of the variables in a standard VAR can lead to more precise estimates for the relevant policy question: on average does an increase in government spending raise private spending? To answer this question, I will use a standard set of VAR variables employed by many in the literature with one modification: I will use private spending (Y - G) rather than total GDP. Since previous VAR studies have shown that the peak of government spending and the peak of total GDP are roughly coincident in the impulse response functions, I do not distort the results by considering only the contemporaneous multiplier.

Excerpted from Fiscal Policy after the Financial Crisis by Alberto Alesina. Copyright © 2013 by National Bureau of Economic Research. Excerpted by permission of The University of Chicago Press.
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Meet the Author

Alberto Alesina is the Nathaniel Ropes Professor of Political Economy at Harvard University, and a research associate and director of the Political Economy Program at the NBER. Francesco Giavazzi is professor of economics at Bocconi University, Italy, and visiting professor of economics at the Massachusetts Institute of Technology. He is a research associate of the NBER.

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