The effects of austerity: recent research.

AuthorAlesina, Alberto
PositionResearch Summaries

What are the costs in terms of output losses of so-called "austerity" policies designed to reduce large government deficits and mounting public debt? The debate on this issue is raging, especially after the latest round of austerity in Europe.

The question is difficult to answer for at least three reasons. The first is "endogeneity," the two-way interaction between fiscal policy and output growth. Suppose you observe a reduction in the government deficit and an economic boom. It would be highly questionable to conclude that deficit reduction policies generate growth, since it could be easily the other way around. Second, major episodes of austerity are often accompanied by changes in other policies: monetary policy, exchange rate movements, labor market reforms, regulation or deregulation of various product markets, tax reforms, and so on. In addition, they are sometimes adopted at times of crisis due to runaway debts, not in periods of "business as usual." Third, virtually all austerity programs are based upon multi-year plans announced in advance and then revised along the way. To the extent that expectations matter, the multi-year nature of these plans cannot be ignored.

An early literature started by Francesco Giavazzi and Marco Pagano (1) and reviewed and summarized by Alberto Alesina and Silvia Ardagna (2) reached two conclusions regarding austerity policies in advanced industrial economies. First, expenditure-based adjustments, namely those based upon cutting spending and not raising taxes, or relying less on tax increases than on spending cuts, were found to be much less costly in terms of output losses than tax-based approaches. Second, expenditure-based adjustments accompanied by an appropriate set of related policies can sometimes be expansionary, even in the short run.

This literature was well aware of the three problems discussed above. The first was initially addressed by considering cyclically adjusted deficit over GDP ratios as measures of fiscal policy. This variable, in principle, should eliminate the effects on deficits of output fluctuations. The second and third problems were addressed in a variety of ways, including case studies. (3)

In some recent research, we and our coauthors have revisited these questions, and tried to go deeper (4) than previous work. In order to address the endogeneity problem, we adopt the "narrative method" proposed by Christina Romer and David Romer. (5) This approach attempts to solve the endogeneity problem by identifying through direct consultation of the relevant budget documents only changes in fiscal policy not implemented to achieve cyclical stablization, but for other goals. Implementing this technique, Romer and Romer identified episodes of tax changes in the U.S. (6) Using a similar methodology, Pete Devries, Jaime Guajardo, Daniel Leigh, and Andrea Pescatori identified "exogenous" increases in taxes and spending cuts motivated by the explicit desire to reduce deficits for 17 OECD economies over the period 1980-2007. (7) Guajardo, Leigh, and Pescatori (8) analyzed these data and found results broadly consistent with those summarized by Alesina and Ardagna, (9) although with some variation on the size of the difference between tax increases and spending cuts, depending on monetary policy.

In the previously cited work with Carlo Favero, we address the third problem mentioned above, namely that fiscal adjustments are typically carried out through multi-year plans in which announcements and revisions deeply affect the expectations of economic agents. To begin, we checked the episodes of exogenous fiscal consolidations identified by Devries, et al, and corrected a few inconsistencies. More importantly, we constructed "plans." By going back to the original sources (National Budget Reports, EU Stability Programs, IMF documents, OECD Economic Surveys, etc.), we reconstructed actions taken at the time an austerity plan was adopted, announcements made at the time of adoption regarding future periods of up to three years, and revisions of these announcements in the actual policies then carried out.

To be more precise, a fiscal plan implemented at time t typically contains three components:

* Unexpected shifts in fiscal variables, announced upon implementation at time t

* Shifts implemented at time t but which had been announced in previous years

* Shifts announced at time t, to be implemented in future years

Each year of a fiscal plan is fully characterized by these three components, which we allow to have different effects on macroeconomic variables.

To study the potentially heterogeneous effects of plans depending on their nature, we distinguish between Tax-Based (TB) and Expenditure-Based (EB) plans. A plan is labeled TB if the sum of all the tax measures (unexpected, announced in the past and currently implemented, and announced at t for future implementation) measured as a fraction of year t GDP is greater than the sum of the corresponding expenditure measures.

Consider as an example the Australian fiscal plan implemented between 1985 and 1988. The plan was announced in 1985 and consolidation lasted until 1988 with subsequent revisions of the original plan. In 1985 the government announced a sequence of...

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