The imperfections of cyclical adjustments are well known, and this is shown in the vast literature on this subject experiments with many sensitive tests. Yet 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 non tenable.
Certainly various governments cut taxes or spending programmes (or the other way around) for a reason, such as how the economy was doing or expected to be doing. The WEO chapter claims to have mirrored the methodology of Romer and Romer for the US economy. But this is not quite right. Romer and Romer examined a voluminous documentation of Congressional proceedings to disentangle “exogenous” tax changes, i.e. exogenous to the economic cycle. The WEO Chapter uses descriptive IMF and OECD reports which state what happens to the deficit in a particular period; these reports do not go into the details of policymakers’ intentions, discussions and congressional records.
Ultimately, Alesina wants to enlist the opposition in his own camp:
Giavazzi and Pagano (1990) had already discovered two expansionary episodes. In his published comments on that paper, Olivier Blanchard (the IMF’s Chief Economist) 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 stabilise expectations, increase consumers’ expected disposable income, and increase confidence of investors and therefore can stimulate private demand.
Below is an incomplete list of papers consistent with the possibility of expansionary fiscal adjustments. All of these analyses find two results:
I don’t believe that, despite its rhetoric, the WEO chapter proves that either of these two conclusions regarding the history of fiscal adjustments is incorrect.
- Spending cuts are less recessionary than tax increases when deficits are reduced, and;
- Sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns.
Alesina dismisses from his mind the possibility that "fiscal adjustment" may undermine rather than bolster confidence by putting thousands of people into the streets (think of the striking Greek policemen earlier this year or this week's rioting British students). One hopes that someone in power is reading historians as well as economists.
