Permanent Effects of Fiscal Consolidations or Permanent Effects of Monetary Crashes?

From the abstract of Fatás and Summers “The Permanent Effects of Fiscal Consolidations”:

The global financial crisis has permanently lowered the path of GDP in all advanced economies. At the same time, and in response to rising government debt levels, many of these countries have been engaging in fiscal consolidations that have had a negative impact on growth rates. We empirically explore the connections between these two facts by extending to longer horizons the methodology of Blanchard and Leigh (2013) regarding fiscal policy multipliers. Using data seven years after the beginning of the crisis as well as estimates on potential output our analysis suggests that attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their negative impact on output. Our results provide support for the possibility of self-defeating fiscal consolidations in depressed economies as developed by DeLong and Summers (2012).

In early 2012, I commented on Summers and DeLongs “Self-financing deficits:

Interestingly, when he was number two to Rubin (and later top Treasury honcho) during the Clinton Presidency (1993 – 2000), Larry Summers peddled “stimulative austerity”, the idea that to cut deficits would lower interest rates by enough to produce stronger growth.

There was certainly a lot of consolidation, although real interest rates rose instead of fall. That excessive attention to the level of interest rates is, according to market monetarism precepts, highly misleading. So Summers had his “wish come true”, but not from the reasons he advanced.

Now Summers argues that fiscal consolidation has had a permanent negative effect on the level of RGDP. From the conclusion:

The global financial crisis has permanently lowered the path of GDP in all advanced economies. In none of these countries GDP is expected to return to its pre-crisis levels. At the same time, many of these countries have been engaging in fiscal consolidations in response to rising government debt levels that had a negative impact on growth rates. In this paper we use the methodology of Blanchard and Leigh (2013) to show that fiscal consolidations had long-term effects on GDP, at horizon much longer than the traditional analysis of fiscal policy multipliers.

As the charts below show, it is more likely that what has “permanently” lowered the path of RGDP is the “permanent” monetary crash that took place in 2008 (both in the US and Europe).

Summers Permanent Effects_1

During the Great Inflation NGDP was growing on a rising trend, with RGDP remaining much of the time above trend (“potential”). During the Great Moderation, with NGDP evolving very close to the trend path, RGDP was also very close to trend. The monetary crash (that was never offset) has doomed RGDP to a permantly lower level!

3 thoughts on “Permanent Effects of Fiscal Consolidations or Permanent Effects of Monetary Crashes?

  1. Re fiscal policy: Whether FP has a beneficial impact on long term growth or not is dependent on the flow
    of net “economic” benefits from policy actions over that term. There is minimal evidence, if any, that typical,
    so-called, “stimulative” actions of today’s governments will have any material net positive impact
    on real long-term growth. At best, these are low-value-added actions with a tiny short-term benefit. The
    long-term benefit from “austerity” is likely to be much higher.

  2. Great post Marcus, but only pu to the conclusion. If money is neutral in the long run, NGDP growth, regardless or the growth rate (if 4, 5 or 7), as long the rate is stable, should not have real effects. We have seen from your data and others that when NGDP growth rate changes, it has real effects. The 2008 crisis came when NGDP growth rate came from 5.5 to 3.5 in the US, Unemployment in Australia rose a lot when NGDP growth came from 5% to 2% along 2013. RGDP in Japan increased when in the first 4 quarters of Abenomics, but then came back to trend afterwards. To me, the conclusion is very simple, and very clear: money is not superneutral. But it is neutral fairly quickly after NGDP growth stabilization. This means that stable NGDP growth at 4% is the same as gowth at 5.5%, when real effects are concerned, only inflation will be different.

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