Dr. Periklis Gogas is a frequent contributor to The Business Thinker magazine. He is an Assistant Professor of Economic Analysis and international Economics, Department of International Economics and Development, Democritus University of Thrace, Greece
Dr. Ioannis Pragidis is a co-author for the Business Thinker magazine. He is a Lecturer of Economic Analysis at the Department of Business Administration, Democritus University of Thrace, Greece
The “rescue plan” for Greece and other economies in trouble in the recent European fiscal crisis was designed by the IMF based on one very important factor: the fiscal multiplier. The latter is a measure of the total decline of GDP after a reduction in government spending or a tax increase. The IMF assumed that the fiscal multiplier for Greece was 0.5. Thus, a €1 reduction in government spending would ultimately decrease GDP by €0.5. But both economic theory and empirical evidence suggest that depending on the case and the phase of the cycle the fiscal multiplier may be well above unity. Even the IMF admitted that they were wrong and the actual multiplier may be between 0.9 and 1.7 in an economy in a recession and in the middle of a fiscal crisis. This suggests that the final effect of the austerity measures to the Greek GDP was surprisingly at first 2 or 3 times higher that was assumed. The result of this austerity program based on wrong assumptions is evident: a cumulative 25%-30% real GDP decline in the past 4 years and an unemployment rate that reaches 28%! It is embarrassing that the IMF used a value totally inappropriate for Greece’s case. Finding empirical evidence that the fiscal multiplier is 0.5 in the U.S. or Japan does not necessarily mean that this value is appropriate for Greece too and especially in the midst of a crisis! The fiscal multiplier increases as the economy enters a recession. Thus, a contractionary fiscal policy during recession time could have much larger contractionary results than in a boom time.
In a Keynesian model and under a closed economy (an economy with no international trade) economic theory predicts that the fiscal multiplier is large and above unity and there is a crowding out effect of private investment. This means that when government spending is increased, private investment falls as a result of a rise in the interest rate. In an open economy (an economy with international trade): the fiscal multiplier is larger when we have a fixed exchange rate regime (peg) than under floating exchange rates. The crowding out effect is larger under a floating exchange rate regime than under a peg. In a classical model on the other hand, the fiscal multiplier is near zero and the crowding out effect of government spending on private investment is large.
Empirical Evidence so Far
In the empirical evidence found so far in economics literature, the exchange rate regime and its effect on the fiscal multiplier is not exploited in depth. So far, the empirical papers have found that:
• The fiscal multiplier is larger under a peg than under a float.
• The crowding out effect is larger under a float than under a peg.
• However, the differences in the crowding out effect between the two regimes is not found to be very large as well as the differences in net exports
• There is no consensus about net exports: some find that they increase and some others that they decrease.
• The same ambiguity in empirical evidence exists for the interest rate as well.
Evidence from the Long Run Derivative
In our current study (Gogas-Pragidis, June 2013) we use data spanning both the fixed exchange rates regime of Bretton-Woods and the recent floating exchange rate period. We use data on several macroeconomic variables from the U.S. economy and we employ for the first time in the empirical literature and in this context the Long Run Derivative methodology of Fisher and Seater (1993). This methodology allows us to explore the evolution from the short to the long run of the effect of government spending on several macroeconomic variables of interest that are in the heart of the relevant policy debate. Our empirical findings are summarized in the following:
• The fiscal multiplier is positive in the short run and neutral in the long run under a peg but negative under a float.
• The crowding out holds for both regimes, although under a peg there is no crowding out in the long run. Nevertheless, the difference in the results between the two regimes is quite large.
• Net exports deteriorate in both regimes after a fiscal expansion. Under a float though this turns to positive in the long run.
• Private consumption increases under a peg in the short run and returns to its initial value in the long run. Under a float, private consumption decreases in the long run confirming Ricardian equivalence.
• We also confirm the decrease of gross savings in both regimes
Thus, we confirm the very large differences in the fiscal multipliers and the crowding out effects with respect to the exchange rate regime. We also confirm the transmission mechanism predicted by economic theory: under a float, an increase in government spending will increase the interest rate, so the exchange rate will appreciate, crowding out both net exports and private investments. Due to Ricardian equivalence, the private consumption will decrease as well as the total output. Thus, under a float the expansionary fiscal policy can have contractionary results. The inverse holds in the case of a peg. An expansionary fiscal policy will have expansionary results. In this case the transmission mechanism works differently. The interest rate is accommodative and the crowding out effect in both net exports and in private investments are smaller. Private consumption increases resulting to an increase in total output.
From our analysis it is evident that the exchange rate regime plays an important role with respect to the effects of government spending on key macroeconomic variables. Following this, we may bring into the multiplier’s debate the fact that Greece is an economy operating in a de facto peg: it cannot use the monetary policy as a tool to stimulate its economy in this crisis. This has significant implications to the fiscal multiplier as under a peg, as the evidence suggests, the multiplier should be large and positive. Thus, government spending cuts and tax increases have a large and negative effect on real GDP irrespective of the phase of the economic cycle. Going back to the miscalculation by the IMF, It is not only the crisis and the recession that is the main driver of the large fiscal multiplier; the fixed exchange rate regime that Greece faces in terms of the euro is another issue that was not considered and properly included in the models. So the IMF used wrong fiscal multipliers not only because it failed to take into account the recession phase of the Greek economy but also it failed to incorporate the exchange rate regime, the fact that Greece is a member of the Eurozone, into its calculations.