In its Sep 30th 2010 print edition, The Economist suggests that a paper by Silva Ardagna and me  is “seriously flawed.” The Economist bases this view upon a chapter from the recently released Chapter 3 of the World Economic Outlook (WEO) of the IMF. While the Chapter of the WEO offers interesting observations, to be further analyzed and all the underlying material disclosed, the drastic judgment of the Economist is unfounded.
The Economist tries to portray our paper and the WEO Chapter as polar opposites. In reality they agree on many points. In particular, they find the same critical result, and potentially the most important one: tax increases are much worse for the economy than spending cuts. The WEO Chapter argues that this effect comes mainly from different reactions of monetary policy, but their claim of having identified separately all of these channels is overstated because interest rates, current and expected, and exchange rates are endogenous to both fiscal and monetary policy. In addition, our paper and the WEO Chapter also agree that after a few years, even large (but spending based) fiscal adjustments create growth for the economy. Our paper and the WEO Chapter achieve the same results using very different methodologies. We use simple statistics and econometric analysis, they use a complex dynamic general equilibrium model. Our time framework of comparison before and after the fiscal consolidation is a five-year window (from two years after, to two years before the adjustment). This is exactly the same window around which the WEO Chapter finds that a reduction of the debt has positive effects on growth, as long as taxes are not raised.
There are some differences arising from methodological choices which have implications for the definition of an adjustment, and its immediate impact on the economy. Our methodology is the following. We analyze how a country during the year of the adjustment, and in the two following years, was growing. Then we define a fiscal adjustment as “expansionary” if in the year of the adjustment, and in the two following years, growth was above the average in the sample. In fact, our definition is more stringent. We define as “expansionary” as an episode in which growth is not only above average, but also it is in the top 25 per cent of the sample. To correct for the world business cycle, we consider the growth of each country in difference from average G7 countries’ growth. The Economist incorrectly characterizes our results as if we had implied that most fiscal adjustments cause economic booms. Instead, what we demonstrate is that fiscal adjustments based mostly on spending cuts sometimes are associated with levels of growth well above sample average, even on impact. We certainly agree that various accompanying policies, such as monetary easing, supply side reforms and, devaluations may help.
The key difference between the WEO Chapter and our paper is on how we define a fiscal adjustment and how we adjust the deficit for the business cycle. Our definition of fiscal adjustment uses the cyclically adjusted primary balance; this is the standard methodology used in the literature to date. That is, we define an adjustment when there is a large fall in the primary deficit (more than 1.5 per cent of GDP) after taking out the effect of the cycle on the primary deficit. The idea is that such a sharp reduction of cyclically adjusted deficits in virtually all cases has to be the result of some policy action and not “business as usual.” Our cyclical adjustment does indeed leave out what would be “incorrect” selections of episodes. For example, in the nineties in the US, there were no discretionary fiscal contractionary policies despite the sharp reduction of the deficit. In fact, the latter was due only to sustained growth of the economy. The deficit went down quickly, but our methodology does not define the US as a case of fiscal adjustment because the cyclical correction reveals that it was the sustained growth of the economy that reduced the deficit, not policy actions. Our methods for cyclical adjustment are standard and widely used.
The imperfections of cyclical adjustments are well known, and we carefully discuss them in our paper. We never claimed that these corrections are without flaws, and in our paper, we perform a variety of sensitivity tests. The WEO chapter simply dismisses this methodology. It claims to have found a better way of identifying when a fiscal adjustment really occurs. How? By reading IMF and OECD historical reports and checking what countries were intending to do at the time of publication. There are pros and cons in this approach. First, it involves many judgment calls. Second, and more importantly, the idea that this procedure would eliminate endogeneity (i.e., fiscal policy responding to the economy and not the other way around) is highly questionable. Certainly various governments were cutting taxes or spending programs (or the other way around) for a reason, such as how the economy was doing. Note also that their approach differs from the one by Romer and Romer, who indentify exogenous tax policy changes by carefully analyzing congressional documents. This detailed and voluminous process was intended to genuinely disentangle the motivation of the US policymakers, and even then, one can quibble on whether the problem of endogeneity is really solved. The WEO Chapter uses descriptive IMF and OECD reports. These reports usually describe what happens to the deficit in a particular period; they do not go into the details of policy makers’ intentions, discussions and congressional records. In any event, we will happily compare which episodes they capture, and which we do not and vice versa.
Many other papers using different methodologies, have identified cases of expansionary fiscal adjustments, thereby drawing similar conclusions to our paper. For example, in a previous paper (Alesina and Ardagna, 1998) we also investigate, at length, nine specific episodes of fiscal adjustments. We analyzed fiscal policy actions and their motivations in detail, including accompanying policies and verified that some of them were expansionary even on impact. Giavazzi and Pagano (1990) had already discovered two expansionary episodes. In his published comments on that paper, Olivier Blanchard argued that expansionary fiscal adjustments can indeed occur and he also showed why. He argued that a fiscal adjustment by removing fear of future harsher ones, and future taxes, can stabilize expectations, increase consumers’ expected disposable income, and increase confidence of investors and therefore can stimulate private demand.
Many others have also studied the effects of fiscal adjustments. From detailed case studies, to regression analysis, to vector auto regressions. Below we show a (possibly incomplete) list, including work done at the IMF. There is an additional recent and large fiscal policy literature (including work by Robert Barro) that consistently finds very small multipliers for government spending, much less than one. That is: a one-dollar cut in spending stimulates private demand that compensates partially for the cut in public demand.
Below, however, we list only the papers more directly related to fiscal adjustments. All of these analysis, find what we confirm in our most recent paper. These previous papers use different samples, different set of countries, and different methodologies. This body of work show two results: 1. that spending cuts are less recessionary than tax increases when deficit are reduced, and 2. that sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns.
In any event, the brand new Chapter of the WEO is a welcome addition to this list. When all the data are made available, and the analysis is replicated by others, we will see how to fit its results into the large preceeding literature. We already know that one conclusion is in line with many of the previous papers-- namely, that spending cuts are better than tax increases to reduce a budget deficit.
From IMF research department
IMF World Economic Outlook 1996, Ch. III.
McDermott J., and R. Wescott, 1996, An Empirical Analysis of Fiscal Adjustments, IMF Staff papers, vol. 43, n.4, 723-753.
From OECD research department
Cournede B, F. Gonand (2006), “Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending”?, OECD Economics Department Work- ing Papers no.520.
Guihard S., M. Kennedy, E. Wurzel, and C/ Andre, (2007), “What Promotes Fiscal Consolidation: OECD Country Experience”, OECD Economics De- partment Working Papers no. 553.
From Goldman Sachs
Ben Broadbent, Kevin Daly, 2010, Limiting the fall-out from fiscal adjustment, Goldman Sachs, Global Economics Paper 195, April 2010.
In referred academic pubblications
Alesina A., and R. Perotti, 1995, Fiscal Expansions and Adjustments in OECD Countries, Economic Policy, n.21, 207-247.
Alesina A., S. Ardagna, R. Perotti, and F. Schiantarelli, 2002, Fiscal Policy, Profits, and Investment, American Economic Review, vol. 92, no. 3, June 2002, 571-589.
Alesina A., R. Perotti, and J. Tavares, 1998, The Political Economy of Fiscal Adjustments, Brookings Papers on Economic Activity, Spring 1998.
Alesina and Ardagna (1998), Tales of Fiscal Adjustments, Economic Policy, no. 27, October 1998, pp. 489-545.
Ardagna Silvia (2004), “Fiscal Stabilizations: When Do They Work and Why”, European Economic Review, vol. 48, No. 5, October 2004, pp. 1047- 1074.
Giavazzi F., and M.Pagano,1990, Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries, NBER Macroeconomics Annual, MIT Press, (Cambridge, MA), 1990, 95-122.
Olivier B.1990 comments on Giavazzi and Pagano NBER Macroeconomic Annual
Giavazzi F., and M. Pagano, 1996, Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience, Swedish Eco- nomic Policy Review, vol. 3, n.1, Spring, 67-112.
Lambertini, L. and J. Tavares, 2005, Exchange rates and fiscal adjustments: Evidence
from the OECD and implications for the EMU. Contributions to Macroeconomics 5, 11.
Tavares, J. 2004, Does right or left matter? Cabinets, credibility and fiscal adjustments.
Journal of Public Economics 88, 2447-2468.
von Hagen J., R. Strauch, (2001), “Fiscal Consolidations: Quality, Economic Conditions, and Success, Public Choice, vol. 109, no.3-4, pp 327-346
von Hagen J., A. H. Hallett, R. Strauch, (2002), “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence”, Journal of the Japanese and International Economics, vol. 16, pp. 512-535.
 Alberto Alesina and Silvia Ardagna (2010) “Large changes in fiscal policy taxes versus spending” in Tax policy and the economy, NBER and University of Chicago Press