Discussion of “The Austerity Myth”- Gain without Pain by Roberto Perotti* Roland Straub

1. Discussion of “The Austerity Myth”- Gain without Pain by Roberto Perotti* Roland Straub European Central Bank Budapest, 16 September 2011 *The views expressed in this presentation are mine and do not necessarily reflect those of the ECB or the Eurosystem

2. What is the paper about? • Expansionary fiscal consolidation (EFC) hypothesis • Controversy between AAP and IMF studies • AAP: fiscal consolidation (CAPB measure) may be expansionary if implemented by cutting government spending • IMF study: effects are biased; new estimates (action based using historical records as in Romer and Romer, 2010) suggest that fiscal consolidation has contractionary effects • Perotti (2011): IMF criticism is correct in principle, but has its own limitations • Case studies of fiscal consolidation episodes • Denmark, Ireland, Finland and Sweden provides some evidence on the existence of EFC • Though unlikely in the current environment

3. What is the paper about? • General problems in identifying the impact of fiscal shocks on output • Countercyclical response problem: policy maker might implement systematic, countercyclical changes to policy parameters (e.g. tax rates) to react to the current states of the economy • Imperfect cyclical adjustment: surplus reacts automatically to asset prices, because their effects on tax revenues (standard CAPB do not correct for that) • IMF: AAP study using CAPB is subject to both, which can explain the differences between the two studies • Perotti (2011): IMF study might also be subject to the countercyclical response problem, so coefficients might be biased towards zero.

4. IMF vs. AAP vs. Perotti (2011) • Perotti (2011) : IMF and AAP agree that on average fiscal consolidations are associated with a recession in the short-run. • Main issue of contention: spending based consolidation • IMF (contractionary) vs. AAP (expansionary) • Arguments used by the IMF study to explain differences are incorrect • Both effects create a positive bias between revenue based increases in surplus and GDP growth. • But the AAP estimates are actually negative, so removing this effect would reinforce the main finding of AAP. • Censoring bias of the IMF approach, as only positive values of fiscal shocks are recorded • Omitting the countercyclical response

5. Comments: CAPB vs. Action Based approach • Do IMF and AAP agree that, on average, fiscal consolidations are associated with the recessions in the short-run?

6. Comments: censoring bias • To test whether these effects matter, set all negative changes also in the CAPB-to-GDP ratio to zero

7. Comments: omitting the countercyclical response • Quote: “While omitting the countercyclical response of fiscal policy has an obvious motivation for the purpose of estimating the multiplier of fiscal policy actions, it can provide the wrong picture of the actual fiscal policy stance when trying to gather the size of fiscal consolidations” • True motivation is indeed difficult to identify, even in an action based approach. • Tough call…

8. Case studies: main findings • Discretionary fiscal consolidations are often smaller than estimated in the past • All stabilization were associated with expansions in GDP. • Except in Denmark, all stabilization were driven by exports • Denmark: internal devaluation using nominal exchange rate as a nominal anchor. • Wage restraints and income policies as a substitute of a devaluation • The expansion was followed by a slump that lasted for several years

9. Case studies: main findings Quote from Perotti ( 2011), page 5: “Some of the conditions made these consolidations expansionary - (i) a decline in interest rates from very high levels, (ii) wage moderation relative to other countries, perhaps supported by income policies- seem not to be applicable in the present circumstances. “

10. The Question of the Day Quote: “To be sure fiscal multipliers depend on the state of the economy and can change overtime. But can they change sign in a little over a year? Does any model exist to show that 18 months ago it made sense for the United Kingdom to expand fiscal policy, while now it makes sense to implement the recently announced 25 percent nearly across-the-board budget cuts.”

11. The Question of the Day Quote: “To be sure fiscal multipliers depend on the state of the economy and can change overtime. But can they change sign in a little over a year? Does any model exist to show that 18 months ago it made sense for the United Kingdom to expand fiscal policy, while now it makes sense to implement the recently announced 25 percent nearly across-the-board budget cuts.” Leeper (2010), Jackson Hole Symposium

12. Decomposing Euro Area GDP Coenen , Straub and Trabandt (2010):

13. Expansionary Fiscal Contraction • Theoretical Studies • Under some conditions can be successful • Bertola/Drazen, 1993; Perotti, 1999; Sutherland, 1997; • Fiscal consolidation generate economic contraction • Erceg and Linde, 2010 • Angeloni, Faia, Winkler, 2010

14. Expansionary Fiscal Contraction (i) Are we in a low interest rate environment? (ii) Is wage moderation relative to other countries, perhaps supported by income policies, applicable in the present circumstances?

15. Comments: • Are we in a low interest rate environment?

16. Comments: • Are we in a low interest rate environment?

17. Comments: • CDS spreads

18. Risk premia and fiscal consolidation • Coenen-Mohr-Straub: “Fiscal Consolidation in the Euro Area: Long-Run Benefits and Short-Run Costs” • New Keynesian DSGE Model • A wealth of nominal and real rigidities • Detailed modelling of the fiscal sector • Standard Taylor Rule –zero lower bound is not binding • Link between real interest rates and government debt

19. Risk premia and fiscal consolidation: Long-run effects

20. Expenditure Based Consolidation

21. Revenue Based Consolidation

22. Risk premia and fiscal consolidation at a zero lower bound • Corsetti, Kuester, Meier, Mueller (2011): Identifying conditions under which fiscal retrenchment may actually stimulate economic activity. • Key features • Sovereign risk channel ( responsiveness of interest rate spread to expected deficit) • Expected duration of ZLB • IS curve (see also Cúrdia and Woodford, 2009)

23. Impact of fiscal consolidation is state dependent • Expansionary fiscal contraction if • Fiscal strain is pervasive and • And monetary policy is constrained at the ZLB

24. Risk Premium in an Open Economy • Similar results hold in an open-economy version of the model with monetary union

25. Wage Moderation: Is it unlikely?

26. Wage Moderation: Is it unlikely?

27. Conclusion • Very interesting paper. • I agree with most of the conclusions. • But, I would argue that there is potentially a case for having expansionary effects of fiscal contractions even (or especially) in the current environment.

28. Fiscal Limits and Monetary Policy • Leeper and Walker (2011) • Unresolved fiscal stress raises the possibility that the economies hit fiscal limits • Monetary Policy might loose its ability to control inflation and influence the economy in a usual ways.

29. Comments: • CDS spreads