Will It Hurt? Who Will it Hurt? Will It Hurt? Who Will it Hurt? Macroeconomic and Distributional Effects Macroeconomic and Distributional Effects of Fiscal Consolidation of Fiscal Consolidation Prakash Loungani Prakash Loungani Research Department, IMF Research Department, IMF Views expressed are those of the author and should not be Views expressed are those of the author and should not be ascribed to the IMF. ascribed to the IMF. I thank Jair Rodriguez for outstanding research assistance. I thank Jair Rodriguez for outstanding research assistance.
Outline Outline Will it Hurt? (IMF Fall 2010 WEO chapter 3) Will it Hurt? (IMF Fall 2010 WEO chapter 3) Who Will it Hurt? (ongoing work with Larry Ball Who Will it Hurt? (ongoing work with Larry Ball and Daniel Leigh) and Daniel Leigh) Impact on Long- -term Unemployment term Unemployment Impact on Long Who Will it Hurt? (review of the literature) Who Will it Hurt? (review of the literature) Changes in Wage and Profit Shares Changes in Wage and Profit Shares Changes in Inequality Changes in Inequality
Setting the Scene Setting the Scene Advanced economies face challenge of fiscal consolidation. Advanced economies face challenge of fiscal consolidation. What are the macro effects of tax hikes and spending cuts? What are the macro effects of tax hikes and spending cuts? Role of monetary policy, international trade, tax- -spending spending Role of monetary policy, international trade, tax composition, perceived sovereign risk. composition, perceived sovereign risk. Fiscal Balance/GDP Government Debt/GDP 0 110 -1 -2 100 -3 -4 90 -5 -6 80 -7 -8 70 -9 -10 60 2005 10 15 2005 10 15 Source : IMF World Economic Outlook database. Note : Advanced economy weighted average. General government.
Identifying Fiscal Consolidation Identifying Fiscal Consolidation Conventional approach: outcome outcome- -based (CAPB). based (CAPB). Conventional approach: expansionary effects. Sample selection bias expansionary effects. Sample selection bias Alesina and Ardagna (2010), many others. Alesina and Ardagna (2010), many others. Action- -based based definition: historical accounts and records Action definition: historical accounts and records ( OECD Economic Surveys OECD Economic Surveys , IMF documents, budgets). , IMF documents, budgets). ( 15 OECD countries 1980- -2009: 173 cases of fiscal consol 2009: 173 cases of fiscal consol 15 OECD countries 1980 G7, AUS, BEL, DNK, FIN, IRL, PRT, ESP, SWE. G7, AUS, BEL, DNK, FIN, IRL, PRT, ESP, SWE. Mean size of 173 cases: 1% of GDP. Mean size of 173 cases: 1% of GDP.
Episodes of Fiscal Consolidation: Episodes of Fiscal Consolidation: Action- -based vs. Standard Approach based vs. Standard Approach Action DEU 1996 JPN 2006 (change in cyclically adjusted primary balance) JPN 1999 BEL 1984 FIN 2000 Standard approach FIN 1993 ITA 1993 IRL 1982 FIN 1992 IRL 2009 Action-based approach
Macroeconomic Effects Macroeconomic Effects Estimation approach: Romer- -Romer Romer- -style. style. Estimation approach: Romer g : growth rate of real GDP. : growth rate of real GDP. g FC : action : action- -based consolidation in % of GDP. based consolidation in % of GDP. FC Cumulate responses to estimate GDP level. level. Cumulate responses to estimate GDP 2 2 g g FC u , , it j i t j s i t s it 1 0 j s u v it i t it Robustness: different lag lengths (up to 4), no lags of growth. Similar results.
Fiscal Consolidation is Contractionary Fiscal Consolidation is Contractionary Impact of 1% of GDP fiscal consolidation. Impact of 1% of GDP fiscal consolidation. ⅓ GDP down ½ ½ percent. Unemployment rate up ⅓ point. GDP down percent. Unemployment rate up point. Note : Consolidation in year t =1. Point estimates and one standard error bands.
Usually: Monetary Mitigation Usually: Monetary Mitigation Monetary conditions ease in response to fiscal consol. Monetary conditions ease in response to fiscal consol. Interest rates fall. Interest rates fall. Currency looses value (both real and nominal). Currency looses value (both real and nominal). Interest Rate Exchange Rate (Basis points) (Percent) Note : Impact of 1% of GDP consolidation in year t =1. Point estimates and one standard error bands.
Transmission Channel: Net Exports Transmission Channel: Net Exports ↑ NX increase plays key offsetting role. Contribution ↑ 0.5%. NX increase plays key offsetting role. Contribution 0.5%. ↓ 1%. Domestic demand ↓ 1%. Domestic demand ↑ Exports rise 1%, imports fall 1%. CA/GDP ↑ 0.6pp. Exports rise 1%, imports fall 1%. CA/GDP 0.6pp. Note : Impact of 1% of GDP consolidation in year t =1. Point estimates and one standard error bands.
Does Composition Matter? Does Composition Matter? Tax- -based vs. spending based vs. spending- -based consolidation. based consolidation. Tax Both are contractionary, but spending- -based less so. based less so. Both are contractionary, but spending Unemployment Rate GDP Tax-based Spending-based Note : Impact of 1% of GDP consolidation in year t =1. Point estimates and one standard error bands.
Role of Perceived Sovereign Default Risk Role of Perceived Sovereign Default Risk Low perceived risk “ “Keynesian Keynesian” ” contraction. Low perceived risk contraction. milder contraction. High risk milder contraction. High risk Denmark/Ireland = outliers. Denmark/Ireland = outliers. Denmark (1983) and Ireland (1987) High risk Low risk Note : Impact of 1% of GDP consolidation in year t =1. Point estimates and one standard error bands.
Contrast with the Literature Contrast with the Literature Our sample using AA (2010) episodes expansionary effects. expansionary effects. Our sample using AA (2010) episodes Interpretation: sample selection bias. Interpretation: sample selection bias. Action-based approach (large > 1.5%) Standard approach ( ∆ CAPB/GDP > 1.5%) GDP Unemployment Rate Note : Impact of additional 1% of GDP consolidation in year t =1. Point estimates and one standard error bands.
Lessons for Today Lessons for Today Fiscal consolidations are contractionary contractionary in short- -term. term. Fiscal consolidations are in short ↓ , R ↓ ) + NX boom = key Monetary easing (ER ↓ , R ↓ ) + NX boom = key Monetary easing (ER cushioning role. But less today (zero R, synchronized). cushioning role. But less today (zero R, synchronized). Less contractionary contractionary for high risk than for low risk. Less for high risk than for low risk. Reforms needed: retirement age, entitlement programs. Reforms needed: retirement age, entitlement programs. Long- -term gains. Lower interest rates, lower taxes. term gains. Lower interest rates, lower taxes. Long
Fiscal Consolidation and Fiscal Consolidation and Unemployment Unemployment
Tax Hikes and Unemployment Tax Hikes and Unemployment
Spending Cuts and Spending Cuts and Unemployment Unemployment
Wage and Profit Shares Wage and Profit Shares (based on Alesina Alesina and Ardagna Ardagna (1998) (based on and (1998)
Wage and Profit Shares Wage and Profit Shares (based on Alesina Alesina and Ardagna Ardagna (1998) (based on and (1998)
Wage and Profit Shares: Wage and Profit Shares: Case Studies Case Studies
Wage and Profit Shares: Wage and Profit Shares: Case Studies (continued) Case Studies (continued)
Wage and Profit Shares: Wage and Profit Shares: Case Studies (continued) Case Studies (continued)
Wage and Profit Shares: Wage and Profit Shares: Case Studies (concluded) Case Studies (concluded)
Fiscal Policy and Growth Fiscal Policy and Growth (Based on Carlos Mulas Mulas- -Granados, 2005) Granados, 2005) (Based on Carlos
Fiscal Policy and Inequality Fiscal Policy and Inequality (Based on Carlos Mulas (Based on Carlos Mulas- -Granados, 2005) Granados, 2005)
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