Monday, 10 September 2012

Recovery paradigms: Fiscal consolidation or infrastructure spending?

Note: This blog post was published as an article for the Adam Smith Institute, on 13th September 2012. For all my other ASI writings see here.

A new research paper by Alesina, Favero and Giavazzi focuses on measuring the output effect of fiscal consolidations. Basically, the paper repeats some of the points Alesina made in his previous (2009) paper co-written with Silvia Ardagna, and in his numerous texts on VoxEU. Favero and Giavazzi summarize some of the main findings here

The idea is that fiscal consolidations tend to have much more favourable effects on the economy if they are done via spending cuts alone, not via increased taxation (see the graph below), which is actually what austerity is supposed to be.

Here's the abstract:
"This paper studies whether fiscal corrections cause large output losses. We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions.  
The difference cannot be explained by different monetary policies during the two types of adjustments. Studying the effects of multi-year fiscal plans rather than individual shifts in fiscal variables we make progress on question of anticipated versus unanticipated policy shifts: we find that the correlation between unanticipated and anticipated shifts in taxes and spending is heterogenous across countries, suggesting that the degree of persistence of fiscal corrections varies. Estimating the effects of fiscal plans, rather than individual fiscal shocks, we obtain much more precise estimates of tax and spending multipliers."
Source: Alesina, Favero, Giavazzi (2012) "The output effect of fiscal consolidations" Figure 3, pg. 40.
The figure shows the results they got when comparing tax-based and expenditure-based fiscal consolidations, using a sample of 17 OECD economies, over 25 years (1980-2005). It is clear that for every country in the sample, tax increases resulted in a negative or stagnant output, whereas expenditure cuts resulted in an increase of output 2 years after the adjustment. They have also found (not shown in the graphs) that business confidence picks up immediately after the expenditure-based adjustments, unlike consumer confidence for which it takes longer to recover. Finally, the most important finding, in my opinion, is that the "heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth". 

The findings of the paper are important in trying to explain the process of "right" or "wrong" fiscal adjustments. Using an increased taxation burden combined with spending cuts is a wrong approach since it depresses the economy (loss of public sector jobs leads to a loss of consumption before these people are reemployed), and doesn't offer incentives for it to grow. All the laid off public sector workers that are supposed to find jobs in the private sector are unable to do so since the private sector isn't hiring due to the many existing constraints it is facing. Unemployment starts to go up, supported by an increasing number of graduating youths for whom finding a job is now even more difficult, making the situation look bad for the politicians in power. This means that the politicians, under even more pressure to close the budget deficit, now need to cease spending cuts and stop firing more civil servants and bureaucrats, since they don't want to make the unemployment picture even worse than it already is. In addition, more unemployed would depress consumption even further. So the government then relaxes the spending cuts and public sector reforms and focuses mostly on increasing taxes to close the budget deficit. The government starts running out of options, as further spending cuts become politically unfavourable while increased taxation is needed to continue closing the budget deficit. 

Are public investments the key to recovery? 

This got me thinking further on one of the most popular policies aimed at kick-starting a recovery, one that is especially being advocated in the UK - infrastructure spending. The idea is as follows; the government is suppose to kick-start growth via infrastructure spending by two ways; (1) directly creating jobs, and (2) cutting costs to businesses through improved infrastructure. The first idea implies that hiring more workers in construction who will use their new wages to increase spending, will ultimately boost consumption (the classical demand-side story, followed by a Keynesian government spending multiplier). However, if the idea is to hire more workers to start a demand-side increase in consumption, why not have the government hire 100,000 workers (or more), give them all a job to dig holes around the country, and then fill them up? That's a perfectly meaningless job, but as long as the workers get paid, they will begin the cycle of recovery, right? Wrong! Expectations of temporary income aren't the same as expectations on permanent income: "If people anticipate a rise in tax rebates or any other form of stimuli (this is true for companies as well, not just consumers) to be temporary, they will save this money instead of spend or invest it. But when they anticipate a permanent rise in income (like getting a new or better paid job) they are much more likely to spend or invest now as they anticipate a certain future stream of income." (This was from the text on tax rebates, but the idea is essentially the same.)

The second way is having the newly build infrastructure lower the costs of businesses and help them grow. But how long does it take to build major infrastructure projects like motorways or railways? A long time! Much longer than the average bankruptcy rate for businesses in the UK. And much longer than the current recovery is going to last (hopefully). Full benefits won't be visible in another 10 years, during which time the very same businesses advocating the project will be using old roads and old railways. 

This isn't to say that infrastructure projects aren't important - they are, for long term growth almost definitely, but they cannot be the priority in starting up a recovery. One can argue that major infrastructure projects and things like the New Deal made a big difference during the Great Depression, but the world is much different today than it was 80 years ago. For starters back then information was being distributed either through the radio or word of mouth. In that case the people hearing that the government is ready to do something to help them out was enough to get confidence going. Their knowledge of possible negative effects on public finances was very limited. In the modern age of vast informational availability this is certainly not the case anymore. Particularly among investors, but that's another story. 

To start up a recovery, the priority should be on supply-side reforms aimed primarily at resolving labour market inefficiencies and at reducing the regulatory and taxation burden on businesses. These will decrease costs much faster and much more efficient than any new road or rail-link, no matter how good or fast they could be. 

11 comments:

  1. All of this is really just common sense. The Austerity programs currently in effect in most of Europe are exactly wrong because they contain only nominal spending reductions and lots of tax hikes. That takes money right out of production and depresses investment levels.

    The program used by The United States is also bad because it included a vast expansion of debt(almost none of which was infrastructure) and on the Tax side it offered only temporary tax cuts and no reduction to long range marginal, capital, or corporate rates.

    There is no substitute for low marginal tax rates and a reduced cost of business regulation. In addition, sound money policy, and lowering barriers to trade will also help create a growing economy.

    I have seen no modern theories which offer any real substitute for the tried and true.

    Infrastructure spending must succeed or fall upon it's own merits. If a project makes sense then do it. If not, do not fund it. At the best I would say you might move some projects forward a little in a downturn in order to take advantage of lower labor costs, but that is it.

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  2. as soon as the policymakers learn that the government cannot start a recovery, growth will be released.
    When entrepreneurs realize that the government is ceasing burdensome taxation and extensive regulation, they will get the confidence to start hiring and investing.
    We don't need public sector investments; we need private sector investments. Cameron did make a brief hint towards that option back in March before the budget, but now I see that was nothing more than a political trick to appeal to his (lost) voters..
    Osborne is back to his old Keynesian solutions. The UK has tried old Keynesian solutions during Gordon Brown. What we have today is an effect of these policies.

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    1. What I can’t understand is the persistent nagging of conservatives that gordon brown messed up and that this is the reason your economic policies are failing. Why can’t you admit that osborne and co. don’t know what they’re doing and that this coalition is nothing than a mere political circus of bad decisions and even worse outcomes?

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    2. @Charlie, I was also saddened by the UK government not going forward with its road privatization plans, which I though was a fine idea, but as I said back in March, the decision took me by surprise so it's no wonder they decided to drop it (although I don't know when or why this decision came about).

      @Garry, I understand your anger towards the coalition and its misguided and mismanaged policies offering at best half-baked solutions, but if you look at the program of the opposition, they argue for essentially the same thing, only with a two year lag. This tells me that, unfortunately, no political option currently knows what they are doing (both in the UK and abroad).

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    3. Garry, whatever they come up with, I'm sure it's better than anything labour can come up with at the moment.
      And the reason everyone attacks gordon brown (even within the labour party), is because it WAS his fault that everything went from bad to worse for the UK. This is no 'nagging' as you suggest, these are pure facts. The deficit rose to unprecedented levels and it was up to the next government to solve this problem. If we did nothing and continued with brown's policies the UK could have had the same fate as Spain, Italy or even Greece.

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  3. On another note, infrastructure spending does create jobs. Even if they are temporary it will get the economy started and that way increase confidence among consumers and businesses. Whenever investors, banks, or businessowners see poor growth data they hold back their money. If they would see positive movements, that would cause them to increase their optimism, no matter how they feel on the government’s role in the economy.

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    1. It isn't that simple I'm afraid. Observing better growth data is far from enough to increase business confidence and make business owners re-invest their money. You're probably thinking of a signaling game where better growth numbers indirectly imply higher confidence. But it doesn't work that way. A more realistic signaling game between the government and the entrepreneurs is the one where the government signals that it is willing and able to reform the existing constraints facing businesses.
      Upon receiving that signal the private sector reacts through increasing confidence and investment.

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    2. Amazing that you persist in this myth in spite of all of the evidence to the contrary. There has been zero stimulus either in the USA, Europe or Japan, and Japan has been priming the pump for a long time.

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  4. It looks like my prediction was correct, the German court refused to block the bailout deal.

    Just like in the USA, the courts will never side with their citizens against the government elites.

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    1. "the courts will never side with their citizens against the government elites"

      Yes, that is rather unfortunate..

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  5. thanks for this, it'll come in handy..

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