Economic policy basically consists of fiscal policy, that is, spending and taxation decisions from the government, and monetary policy, which refers to the policy decisions of the central bank. Ever since the Great Recession began, the effectiveness of fiscal policy has been a hot topic of debate. This issue has become even more relevant as monetary policy reached its conventional limit when interest rates effectively hit zero. Moreover, a lot of western governments have also embarked on austerity that is still ongoing. Thus, it has become critical to ascertain the effect of fiscal policy on economic growth when monetary policy is conventionally constrained.
The IMF has been at the forefront of this important work (see here and here), but a research paper from 2002 adds yet more evidence into this domain. The paper is from Kenneth Kuttner and Adam Posen (hereafter K&P), formerly of the UK Monetary Policy Committee, and it took a detailed look at fiscal policy in Japan. To preview the main results, the paper found that expansionary fiscal policy, whether in the form of tax cuts or public spending works, had significant stimulative effects. The multiplier on these policy options were both well in excess of one and they also found little evidence of Ricardian equivalence.
K&P preface their work with a quote from Milton Friedman, who said that Japan’s experience in the 90s with stimulative fiscal policy was a failure, resulting in ‘stagnation at best, depression at worst’. But the authors caution against this conclusion, as the bulk of the debt increase in Japan was due to falling tax revenue from a depressed economy, rather than the increase in expenditures.
From a theoretical standpoint, open economy theory such as Mundell-Fleming states that some of the impact of expansionary fiscal policy will be reduced via an increase in interest rates. This may be so, but perhaps only under more normal cirumstances when monetary policy is not constrained by the zero lower bound of interest rates. This is the liquidity trap scenario that is so relevant to today’s policy decisions, which implies that fiscal policy can be more effective than normal as interest rates are unlikely to be raised in the current circumstances.
How they did it
K&P used a structural VAR framework, similar but not identical to that of this IMF paper (see here). The SVAR is designed to identify the impact of fiscal policy while explicitly allowing for contemporaneous independence among taxes, spending and output. As is customary with an SVAR approach, K&P had to make identifying assumptions to allow the model to solve. Some of these assumptions are as follows:
- Real GDP is allowed to have a contemporaneous effect on tax receipts, but not on expenditure
- Taxes do not depend contemporaneously on expenditure, or vice versa
- The elasticity of tax revenue to real GDP is set to 1.25
What they found
The chart shown below from the paper shows the effects of a tax shock, being a tax cut, as well as an expenditure shock on real GDP. As can be seen, both of these shocks are stimulative and the effects were found to be statistically significant. The results of this SVAR analysis showed the impacts of discretionary fiscal policy that were predicted in standard macroeconomic analysis. K&P reiterate the main point that the view of the ineffectiveness of fiscal policy stems from the failure to recognise the dependence of tax receipts on GDP.
To get estimates of the multipliers at work here, K&P use a linear combination of taxes and spending shocks to generate a cumulative 1% change in the variable of interest. The logic for this approach is that there is a correlation between taxes and expenditures, so this needs to be taken into account in an attempt to find a ‘pure’ multiplier. Using this innovative technique, K&P calculate a multiplier on tax cuts of 2.5 and on expenditures of 2.0.
What about monetary policy?
This is really the key point of this paper, as it relates to macro-economic conditions today. It is true that K&P do not have monetary policy explicitly controlled for in their model. This is due to the use of annual data, making an assumption that monetary policy does not effect output contemporaneously untenable. However, the influence of monetary policy is implicit, as these shocks would also involve the possibility of a response from monetary policy. Using standard ISLM analysis, the most likely response of the LM curve (the monetary response) to an increase in government expenditure is a movement to offset some of the expansionary impact. This implies that these multipliers could be understated, rather than overstated.
The key point, in the case of Japan, is that monetary policy exhibited limited movement during this time, before hitting the zero lower bound. The result of this is that it is safe to assume that monetary policy did not react to fiscal policy in any systematic way.
Savings and Ricardian Equivalence
If there were ever a perfect experiment for Ricardian equivalence, it was Japan in the 1990s. Ricardian equivalence (RE), generally speaking, is the idea that government tax and spending decisions will be offset by households, due to forward looking expectations. For example, a tax cut will not lead to increased spending by households, as they will view this tax cut leading to a future tax rise, so will save money instead, thus offsetting any positive impact of the tax cut.
Japan had the right conditions for RE to hold: rapid ageing of the population, the rapid rise in public debt, household connections across generations and constant talk of budget problems. Consequently, K&P examine this concept by looking at a long run (error-correcting) model, involving savings, the old-age dependency ratio and fiscal variables. These regressions find little evidence of RE, as there was only a moderate influence of tax cuts on savings.
Coming back to the main conclusion, the relevance of this paper from K&P is its estimates of fiscal multipliers when an economy is stuck at the zero lower bound. The effects of fiscal policy in these circumstances are likely to be larger than under more normal circumstances where monetary policy could offset some of the fiscal stimulus. Critically, given the current wave of austerity at a time when monetary policy is conventionally constrained, policymakers should not underestimate the large negative impacts of cuts on economic growth.
 Fiscal Policy effectiveness in Japan. Kuttner & Posen (2002).