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).

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!