In the 80 years since Keynes published his General Theory, few questions have been as controversial as whether or not government spending can stimulate a weak economy. New research shows that stimulus spending indeed does work, even for countries facing high debt burdens, unemployment and inflation.
The research appeared in a paper, Fiscal Stimulus and Fiscal Sustainability, by Alan Auerbach and Yuriy Gorodnichenko, both of the University of California at Berkeley. It was published August 29.
Their key finding, stated in the paper’s abstract, was that, “For a sample of developed countries, we find that government spending shocks do not lead to persistent increases in debt-to-GDP ratios or costs of borrowing, especially during periods of economic weakness.”
This amounts to a validation of the counter-cyclical measures advocated by John Maynard Keynes in the 1930s as a way to escape from the Great Depression. Those measure have since become a central component of what is known as Keynesian economics.
In earlier work, researchers have found that economies respond more in terms of GDP growth and other measures of economic activity to fiscal stimulus in a weak economy than in a strong economy. Basically, the Keynesian prescription works when you expect it to work – when there is a lot of slack in the economy.
This research goes further to show that fiscal spending in a weak economy does not lead to higher debt levels, higher interest rates or wider CDS spreads. It was the first research to look directly at the effect of spending on the debt-to-GDP ratio.
I spoke to Auerbach on September 12 and we discussed the relevance of his findings to fiscal policies under the Obama and Trump administrations, as well as to other countries. I’ll come back to that later, but, first, let’s look at the research he and Gorodnichenko published.
Does fiscal spending drive up debt?
To look at the effect of fiscal spending on an economy, Auerbach and Gorodnichenko first had to define what they considered to be a fiscal “shock.” The difficulty is isolating those spending measures that are not part of a country’s current policies. Certain spending changes are expected, such as gearing up for a war, but the authors needed to identify those changes that weren’t anticipated.
The conventional way is to do this is credited to Olivier Blanchard and Roberto Perotti, and looks at all observable economic variables and calculates the difference between actual and projected spending. But their method is limited, for example, because it can categorize spending as unanticipated in cases where it was planned, but moved from one period to another. To control for those and other situations, Auerbach and Gorodnichenko used their own approach, which incorporates projections from professional forecasters.
Auerbach and Gorodnichenko looked at how those spending shocks affected a country’s debt-to-GDP ratio, interest rates and credit-default swap (CDS) spreads, in order to determine whether stimulus spending impairs a country’s ability to borrow in the future.
Auerbach and Gorodnichenko looked at the data for weak and strong economies, based on the business cycle (whether an economy was in a recession or expansion) and on the level of unemployment. They defined “weak” and “strong” based on how significantly the variables deviated from their historical trends.
They looked at approximately two dozen large, developed countries using historical data as far back as 1980.
Key findings
In weak economies, unexpected increases in government spending lead to a favorable outcome; they lead to decreases in the debt-to-GDP ratio, the fiscal gap, CDS spreads and interest rates.
In strong economies the opposite happens. Auerbach and Gorodnichenko found that unexpected spending increases debt-to-GDP, worsens the fiscal gap and leads to higher CDS spreads and interest rates.
“In weak economies, countries should be more strongly encouraged to adopt expansionary fiscal policies, even if they have concerns about fiscal sustainability,” Auerbach said.
That feeds into the results for debt, according to Auerbach. A stimulus increases economic activity, which leads to greater tax revenues and lower spending needs, and lessens pressure on the system.
If a country is already in a very high-debt situation, Auerbach cautioned that there is some indication that the reduction in debt-to-GDP is weaker. But he said, those results were not sufficient to conclude that spending isn’t the right prescription.
One of the caveats, he said, is that the research is based on historical periods. Most countries in his sample had high debt levels, but not as high as they have now. Auerbach cautioned against too bold an extrapolation of the historical data to future scenarios.
Another caveat is that each country has its idiosyncrasies. Japan, he said, is able to support its high debt-to-GDP level because there is a widespread belief that it will “figure it out,” as well as the fact that much of its debt is internally held.
“There are subtle differences that are hard to control for,” Auerbach said.
Most of the countries in the sample were in the European Union (E.U.) and therefore did not have control over their own currencies. Auerbach said he wouldn’t expect being in a common currency to reduce the effects of fiscal policy. To the contrary, fiscal stimulus would normally be expected to cause a country’s currency to appreciate, which weakens the stimulus, so being in a common currency is a good thing. There are other reasons why individual European countries pursuing individual policies might face difficulties, in particular the fact that they have very open economies and so much of the increased demand for goods and services would be for products produced in other countries.
But, he said, his past research on similar topics had found that there weren’t consistently big differences between E.U. and non-E.U. countries. If he had excluded the E.U. countries, he said it would have made his sample size too small.
Implications for the Obama and Trump administrations
Auerbach and Gorodnichenko’s research has received a great deal of attention, most of it reflecting the attitude that their findings were unexpected. Business Insider ran the story with the headline, “Everything you thought you knew about budget deficits is wrong.”
I asked Auerbach why his findings, which represent what mainstream economists have been teaching for decades, came as such a surprise.
“The field of economic research has evolved to be skeptical of the value of counter-cyclical fiscal policies,” he said. “That has become a particular concern when debt-to-GDP is high.”
He noted that a school of thought has even supported “expansionary fiscal consolidation” – reducing spending when the economy is weak – otherwise known as austerity.
The pendulum has swung back in last five years to a more traditional Keynesian view, Auerbach said, “but by no means is this generally accepted in the economic community.”
During the Obama years, he said “the push to pivot from stimulus to fiscal conservatism was undertaken too early.”
But under Trump there is not a lot to argue for fiscal expansion, according to Auerbach, because we are near full employment.
“Now would be a really good time to get our fiscal house in order,” Auerbach said. “Now is not the time for fiscal stimulus, which would worsen our long-run fiscal condition.”
“This is not the green light for government spending growth,” Auerbach said.
Read more articles by Robert Huebscher
