Expansionary Contractions and Fiscal Free Lunches: Too Good To Be True?

Abstract

This paper builds a framework to jointly examine the possibilities of both expansionary fiscal contractions (austerity increasing output) and fiscal free lunches (expansions reducing government debt), arguments which in recent debates have been supported by the austerity and stimulus camps, respectively. We propose a new metric quantifying the budgetary implications of fiscal action, a key aspect of fiscal policy particularly at the monetary zero lower bound. We find that austerity needs to be highly persistent and credible in order to be expansionary, and stimulus needs to be temporary, responsive, and well-targeted in order to lower debt. We conclude that neither is likely, especially during periods of economic distress.

Fiscal Trade‐Offs: The Relationship Between Output and Debt in Policy Interventions

“…Stronger elasticities between debt and output multipliers at the monetary zero lower bound are observed (which is consistent with Erceg and Lindé ; McManus et al. ; who find fiscal free lunches at output multipliers of approximately 2) which is as a result of lower interest rates arising from (for example) expansionary policy, as interest rates are temporary fixed to zero. Although lower average output multipliers are observed in an open economy where some of domestic incomes are spent on imports, the elasticity between output and debt multipliers remains consistent with those observed in Figure .…”

“…This intuition does not uniformly follow to tax output multipliers as fiscal expansion at the zero lower bound can have deflationary impacts which can lead to a rising real interest rate; these results are in line with Eggertsson () and McManus et al. ().…”

“…This way, changes in output as a result of fiscal policy only impact the the numerator of (10) which allows multiplier values to be comparable between those coming from changes to government spending and those from changes in taxation; this is the approach taken in McManus et al. ()…”

“…There are two main objections to this: first, the relationship between policy and debt is not frequently analysed in the literature, where discussions tend to centre around the impact of policy on output; and second, there is a small literature suggesting that such trade‐offs may not exist under certain circumstances. For example, some find empirical evidence that fiscal contractions can be expansionary to output (see, for example, Alesina, Favero and Giavazzi ), with theoretical transmission mechanisms coming from private agents’ expectations about future government policy (see, for example, Blanchard ; McManus, Ozkan and Trzeciakiewicz ). Others find the potential for ‘fiscal free lunches’ where the economic environment is so conducive to fiscal stimulus that tax bases are increased to such a magnitude that there is no increase in debt as a result of fiscal stimuli (see for example Erceg and Lindé ; McManus et al.…”

“…Others find the potential for ‘fiscal free lunches’ where the economic environment is so conducive to fiscal stimulus that tax bases are increased to such a magnitude that there is no increase in debt as a result of fiscal stimuli (see for example Erceg and Lindé ; McManus et al. ) . These literatures investigate two outcomes where the trade‐off between output and debt with respect to fiscal policy does not exist.…”