Fiscal policy and the economy – The evidence

Reading time: 3 minutes

The arguments presented in the articles up to now have shown us that when it comes to fiscal policy, economists are generally divided into two opposing camps. The question that naturally follows is: what does the evidence say?

As it often happens in economics, clear-cut answers are not that easy to reach. Two recent papers by Alesina, Favero and Giavazzi (AFG), and by Batini, Callegari and Melina (BCM) provide us with a case in point. Both groups of authors try to shed light on the impact of an event of fiscal consolidation on GDP growth. After reading the papers, however, one cannot but be puzzled by the striking contradiction of the results they obtain: while AFG predict that a fiscal consolidation is less recessionary if implemented through spending cuts, BCM reach the exact opposite conclusion. This contradiction originates from the different methodologies employed in the two papers, including the choice of sample and econometric model. Since clearly both papers provide profound and accurate analyses, we can infer that their results are not robust to a change in the methodology.[1]

The example presented above emphasizes the difficulties economists have to face when dealing with one of the major challenges in empirical research – endogeneity. In simple terms, endogeneity is closely related to the idea that correlation does not automatically imply causation.  In the context of our analysis, the fact that the GDP increases after an expansionary fiscal policy is not by itself a proof of the efficacy or of the desirability of such a policy.  In fact, one could hardly deem public spending completely independent of the state of the business cycle. That is, it is not clear at all whether it is the direction of fiscal policy that causes changes in national income or vice versa. Moreover, there could be other unknown factors that account both for the performance of the economy and for the level of public expenditures.

Having said that, going back to the two papers, we can also identify two of the major approaches that have been employed by economists in order to determine the direction of causality between fiscal policy and GDP growth. The first one is the “narrative approach”, applied by AFG, which requires a careful analysis of each single episode of fiscal consolidation or expansion, and the interpretation of the results through the prism of economic theory. The second approach, followed by BCM, relies on an econometric technique that has recently gained popularity, known as vector autoregression. Here the basic idea is to try to compare simultaneously many economic variables in subsequent periods in search of “structural breaks” in the time series that might be a signal of the effects of public expenditures.

Since there is no widespread agreement on the superiority of one of the two methodologies, both regarded as valid instruments of empirical analysis, neither of them can generate definitive conclusions for policy. Then, should governments follow the prescriptions of AFG or those of BCM?

What we tried to show in this article is that conclusive evidence on the effects of fiscal policy is yet to be found and that, all in all, empirical support for any argument presented regarding fiscal policy and the economy should be interpreted with caution by policymakers and researchers alike.


Michele Fornino

[1] This post by Giulio Zanella on the blog NoiseFromAmerika provides a careful and accurate assessment of the two papers.

Leave a Reply

Your email address will not be published. Required fields are marked *