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Transmission of fiscal policy in open economies

Final Activity Report Summary - FPMPEMU (Transmission of fiscal policy in open economies)

Public debt is on the cards again. The United States is facing huge outlays, Japan is still struggling with an enormous public debt and European Union countries regulate the control of public debt with the stability and growth pact (SGP).

I reconsidered the short-term effects of fiscal policy in case both government spending and taxes were allowed to respond to the level of public debt. I embedded the long-term government budget constraint in a vector autoregression (VAR) model and applied this common trends model to United States quarterly data. The main finding was that debt consolidation had expansionary effects on output. The expectation of policy adjustments with future tax rises or spending cuts contracted output today. Current rising trends in debt were rather worrying for the long term economic growth. It also did not exclude using fiscal policy for stabilising the economy in the short term. We related the cyclical components of total revenues and expenditures and the budget balance in four European Union countries. Fiscal slippages of the deficit were mainly due to reversals in tax policies, which were unmatched by expenditure adjustments. Consequently, deficits rose when economic conditions worsened but caused a ‘ratcheting’ in booms. Such bad policies in good times also contributed to aggregate macroeconomic instability. Moreover, the growth effects of fiscal policy probably outweighed the short term cyclical effects.

Thus, the policy question was how to maintain sustainability in the long term through the maintenance of growth, while stabilising the economy in the short run. Fiscal rules could be useful in constraining debt and preserving long term growth and short term stabilisation. Fiscal rules should be refined, involving adjustment of tax and spending policies. A country like Sweden developed its own combination of procedural and numerical rules in response to a severe fiscal crisis. I applied Markov switching models to characterise Swedish fiscal policy. Spending was not sufficiently kept under control. Taxes were procyclically set, in order only to keep debt in check. Controls on debt sustainability required tighter spending rules, linked to taxation levels.

Adjustments in fiscal policy are big events, with their effects being also felt in other countries. Theoretical models pay little attention to this spillover, for want of empirical evidence. Recently, spatial econometrics made large strides to encompass multiple channels of spillover. Spillover affects many countries contemporaneously in a variety of ways, depending on their economic structure and linkages. I applied these techniques to check spillover of fiscal policy across borders and quantify its magnitude. The common belief was that a fiscal expansion raises interest rates. However, these crowding out effects were found to be small. One explanation was that financial integration offset interest rate differentials on globalised bond markets. We tested this spillover on financial markets and the residual crowding out effect, finding that the crowding out effect on domestic interest rates was indeed significant, however reduced by spillover. This spillover was especially important in major crises, in periods of coordinated policy actions.

Fiscal policies decisions were also more closely linked in a monetary union. Control on the regional government budgets was important as lower tiers of government had fewer incentives to consolidate. We tested fiscal rules on a new database for Germany. The results showed that German Länder bore a relatively smaller part of the burden of debt consolidation. Most was carried out by the central government. The central bank was not then without defense in the presence of a federal government. By internalising spillover effects of non-Ricardian fiscal policies, a federal government could compensate for unsustainable regional fiscal policies so as to keep fiscal policy Ricardian on aggregate. Following Canzoneri et al. (2001), we tested the validity of the fiscal theory of the price level for both federal and regional governments in Germany. We found evidence of a spillover effect of unsustainable policies on the price level for other Länder. However, the German federal government offset this effect on the price level by running Ricardian policies.