Interaction of Government Tiers and Central Banks in a Federation: An Empirical Test

Fiscal rules are necessary to protect monetary policy from the consequences of unsustainable or active fiscal policy for inflation. Monetary unions, such as the Economic and Monetary Union (EMU), require even stronger fiscal rules to avoid free riding by regional fiscal authorities on the common monetary policy. By contrast, in a fiscal federation, the federal government internalises the effect of active regional policies on the overall price level. Federal fiscal policy contributes to price stability either by enforcing fiscal rules or by adjusting its own stance. Following Canzoneri, Cumby and Diba (2001), we test whether federal and regional governments in Germany behave in an active or passive way. We find evidence of a spillover effect of unsustainable policies on other regions. The German federal government offsets the effect on the price level by running passive policies. The Bundesbank's prime objective of price stability is therefore endorsed by fiscal policy. The results have implications for the regulation of fiscal policies in the EMU.     

Fiscal Policy Shocks in the Euro Area and the US: An Empirical Assessment*

We analyse the impact of fiscal policy shocks in the euro area as a whole, using a newly‐available quarterly data set of fiscal variables for the period 1981–2007. To allow for comparability with previous results on euro‐area countries and the US, we use a standard structural vector autoregressive (VAR) framework, and study the impact of aggregated and disaggregated government spending and net‐tax shocks. In addition, to frame euro‐area results, we apply the same methodology for the same sample period to US data. We also explore the sensitivity of the results to the inclusion of variables aiming to control for underlying financial and fiscal conditions. The main new findings are that: expansionary fiscal shocks have a short‐term positive impact on GDP and private consumption, with government spending shocks entailing, in general, higher effects on economic activity than (net) tax reductions; output multipliers to government expenditure shocks are of similar size in the euro area and in the US; the persistence of a fiscal spending shock is higher in the US than in the euro area, which appears to be related to military spending in the US; and fiscal multipliers have increased over the recent past in both geographical areas.     

Long‐Term Effects of Fiscal Policy on the Size and Distribution of the Pie in the UK*

This paper provides a joint analysis of the output and distributional long‐term effects of various fiscal policies in the UK, using a vector autoregression (VAR) approach. Our findings suggest that the long‐term impact on GDP of increasing public spending and taxes is negative, and especially strong in the case of current expenditure. We also find significant distributional effects associated with fiscal policies, indicating that an increase in public spending reduces inequality while a rise in indirect taxes increases income inequality.     

Macro‐Fiscal Volatility and the Composition of Public Spending*

Earlier empirical literature has examined some long‐ and medium‐term aspects of macro‐fiscal volatility while leaving its short‐term fiscal impact unexplored. To help fill that gap, we examine the impact of macro‐fiscal volatility on the composition of public spending. To that end, we analyse a panel of 10 EU countries during 1991–2007. Our results suggest that increases in the volatility of regularly‐collected and cyclical revenues such as the VAT and income taxes tend to tilt the expenditure composition in favour of public investment. In contrast, increases in the volatility of ad hoc taxes such as capital taxes tend to favour public consumption spending, albeit only a little. We interpret such volatility innovations as conveying news to the fiscal policymaker about the underlying economic conditions, with especially regularly‐collected and cyclical taxes prompting short‐term cyclical fine‐tuning.     

Fiscal Rules and Government Financing Costs

This paper assesses the effect of fiscal rules on sovereign bond spreads over the short and medium term, for 34 advanced countries and 19 emerging market economies, over the period 1980–2016. Our results, based on impulse response functions, show that the dynamic impact of fiscal rules on sovereign yield spreads is negative and statistically significant, at around 1.2–1.8 percentage points, implying lower government borrowing costs. This result stems essentially from the advanced economies subsample. We also find that more fiscally responsible countries are the ones for which a fiscal rule reduces the government's borrowing costs. Moreover, in times of recession, a fiscal rule leads financial markets to reduce the risk premiums on government bonds. Finally, when it comes to design features of fiscal rules, independent monitoring of compliance to the rule, done outside government, also reduces sovereign spreads.     

Cross‐Country Spillovers from Fiscal Consolidations

In the aftermath of the global financial crisis, many OECD countries adopted fiscal consolidation strategies to reduce their debt‐to‐GDP ratios. This paper investigates the effects of fiscal consolidation on trading partners’ growth through trade linkages. Using a measure of exogenous fiscal shocks in export markets, fiscal consolidation spillovers are found to slow down domestic growth and decrease employment. To the extent that fiscal consolidations are synchronised, fiscal policies have large spillover effects on output. Spillovers of fiscal consolidations on growth are found to be initially larger between countries belonging to currency unions, though this larger impact vanishes over the medium term. Larger spillovers of fiscal consolidation coincide with lower bilateral exports, higher bilateral imports and relative increases in unit labour costs in currency unions. Spillovers of fiscal consolidation are also found to be more detrimental to domestic growth during economic downturns in export markets.     

Fiscal Consolidations and Economic Growth

The aim of this paper is to deepen the understanding of the macroeconomic consequences of fiscal consolidations. In particular, there is evidence in the literature of fiscal consolidation episodes producing (non‐Keynesian) expansionary effects in the short run. We replicate this result for a panel of OECD countries under exogeneity of the fiscal consolidation. However, we provide some evidence that output growth might affect the fiscal tightening process so that fiscal consolidations are not exogenous to economic growth. Once we allow for feedback effects from economic growth to fiscal adjustments, we find that expansionary effects disappear and recover the typical Keynesian effect of fiscal adjustments. This finding points to the need to take these short‐term negative implications into account in the design of fiscal consolidations.     

Public Investment in Europe: Evolution and Determinants in perspective*

We describe the evolution of public investment and public capital stocks in Europe over the past three decades. Against this background, we analyse the macroeconomic determinants of public investment, with a special focus on its long‐term trend. We find that public investment has been determined by national income, the stance of budgetary policies and fiscal sustainability considerations. Neither the cost of financing nor the fiscal rules embodied in EMU have had a systemic impact on public investment. The significant downtrend that characterises the evolution of public investment in non‐cohesion countries is chiefly determined by drawn‐out episodes of fiscal consolidation, unrelated to EMU.     

Strengthening Post‐Crisis Fiscal Credibility: Fiscal Councils on the Rise – A New Dataset

Institutions that aim to constrain policy discretion in order to promote sound fiscal policies are once again at the forefront of the policy debate. Interest in fiscal councils – independent watchdogs active in the public debate – has grown rapidly in recent years. In this paper, we present the first cross‐country dataset summarising key characteristics of fiscal councils among International Monetary Fund members. The data document a surge in the number of fiscal councils since the 2008–09 economic and financial crisis, and also illustrate that well‐designed fiscal councils are associated with stronger fiscal performance and better macro‐economic and budgetary forecasts. Key features of effective fiscal councils include operational independence from politics, the provision or public assessment of budgetary forecasts, a strong presence in the public debate and the monitoring of compliance with fiscal policy rules.     

International Differences in Fiscal Outcomes during the Global Crisis

We examine the cross‐country dispersion in fiscal outcomes during 2008–09. Controlling for output, we find that the declines in the overall and structural fiscal balances were larger for those countries experiencing larger increases in unemployment and where credit growth during the pre‐crisis period was more rapid. However, controlling for output and unemployment, there is no systematic covariation between fiscal outcomes and a wider range of initial conditions and country characteristics that have been cited as possible drivers of fiscal outcomes during this episode.     

Estimating the Equity Risk Premium and Expected Equity Rates of Return: The Case of Canada

It is common to use the average excess return of equities over bonds estimated over long time periods as an expected equity risk premium on the grounds that going back far enough covers most possible economic scenarios. But although this data is useful in guiding the exercise of judgment, it cannot substitute for judgment. Adding more years of data to the near century of Canadian stock and bond returns that inform today's estimate of the equity risk premium will not produce a “random walk” for a simple reason: the historic bond series is the result of a specific historic monetary policy. This is particularly true of and important for the case of Canada, where today's very low current bond yields reflect the emergence of the Canadian dollar as a reserve currency as well as the impact of unconventional monetary policy elsewhere. After analyzing the historic record of the Canadian equity risk premium and noting the need for adjustments when this premium is applied to the current anomalously low Canadian long‐term bond yields, the author reaches the following conclusions:

• The historic Canadian equity risk premium is approximately 5.0% (based on arithmetic returns), which is slightly lower than the roughly 6.0% value for the U.S.
• The historic equity risk premium has not been constant because of obvious changes in the Canadian bond market. To some extent, the huge cycle in which bond yields began their increase from the 4.0% level starting in 1957, when markets were liberalized, and then fell back to the 4.0% level in 2007‐2008 completed an adjustment to changes in fiscal versus monetary policy. However, in 2016, average long Canada bond yields dropped to an anomalously low 1.8%, which is below the long‐term inflation target of the Bank of Canada, and have barely recovered since. It is difficult to view this as an equilibrium rate determined by private investors.
• Of the drop in bond yields, about 0.50% is unique to Government of Canada bonds as they became attractive to sovereign investors as a rare AAA‐rated issuer.
• Using an indicator variable for the post‐2010 years, a simple regression analysis indicates that current long Canada bond yields should be about 2.75% higher but for the recent changes. And for 2018, this means that the 2.35% average long Canada bond yield should have been about 5.0%. Apart from the impact of higher government deficits, this is consistent with average yields before the 2008 financial crisis.
• Adding an adjusted 5.0% long Canada bond yield to the historic equity risk premium in Canada of 4.50% gives 9.50% for the cost of the overall equity market or, given the Bank of Canada's target inflation rate of 2.0%, a real equity return of 7.5%, both slightly higher than the long‐run averages.

In sum, the conventional practice of adding a historic market risk premium to the current low Canada long bond yields would impart a sharp downward bias to current equity cost estimates; use of this method would not be appropriate until long Canada bond yields increase to at least the 4.0% level.     

Fiscal and Monetary Policy Coordination,Macroeconomic Stability,and Sovereign Risk Premia

In standard macroeconomic models, equilibrium stability and uniqueness require monetary policy to actively target inflation and fiscal policy to ensure long‐run debt sustainability. We show analytically that these requirements change, and depend on the cyclicality of fiscal policy, when government debt is risky. In that case, budget deficits raise interest rates and crowd out consumption. Consequently, countercyclical fiscal policies reduce the parameter space supporting stable and unique equilibria and are feasible only if complemented with more aggressive debt consolidation and/or active monetary policy. Stability is more easily achieved, however, under procyclical fiscal policies.     

Macroeconomic Effects of Government Spending: The Great Recession was (Really) Different

We estimate the effect of government spending shocks on the U.S. economy with a time‐varying parameter vector autoregression. The recent Great Recession period appears to be characterized by uniquely large impulse responses of output to fiscal shocks. Moreover, the particularity of this period is underlined by highly unusual responses of several other variables. The pattern of fiscal shock responses neither completely fits the predictions of the New Keynesian model of an economy subject to the zero lower bound on nominal interest rates, nor does it suggest regular variation of fiscal policy effects depending on the state of the business cycle. Rather, the Great Recession period seems special in that government spending shocks had a strongly negative effect on the spread between corporate and government bond yields and a strongly positive effect on consumer confidence and private consumption spending.     

Borrowing to Finance Public Investment? The ‘Golden Rule of Public Finance’ Reconsidered in an Endogenous Growth Setting*

In this paper, we look for long‐run and short‐run effects of fiscal deficits on economic growth and welfare in a standard endogenous growth model. We show that, under very general hypotheses, the ‘golden rule of public finance’, which allows a government to run public‐investment‐oriented fiscal deficits, leads to a lower balanced‐growth path in the long run, and eventually in the short run, compared with balanced‐budget rules. Welfare effects are more difficult to assess, and depend on the form of the utility function. Our model shows that debt rules such as the golden rule may improve (if the consumption elasticity of substitution is ‘low’) or weaken (if the consumption elasticity of substitution is ‘high’) intertemporal welfare. Consequently, a balanced‐budget rule does not necessarily dominate debt rules from the point of view of welfare, while it does from the point of view of long‐run economic growth.     

Austerity and Private Debt

This study provides empirical evidence that the costs of austerity crucially depend on the level of private indebtedness. In particular, fiscal consolidations lead to severe contractions when implemented in high private‐debt states. Contrary, fiscal consolidations have no significant effect on economic activity when private debt is low. These results are robust to alternative definitions of private‐debt overhang, the composition of fiscal consolidations, and controlling for the state of the business cycle and government debt overhang. I show that deterioration in household balance sheets is important to understand private debt‐dependent effects of austerity.     

Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates

I characterize optimal monetary and fiscal policy in a stochastic New Keynesian model when nominal interest rates may occasionally hit the zero lower bound. The benevolent policymaker controls the short‐term nominal interest rate and the level of government spending. Under discretionary policy, accounting for fiscal stabilization policy eliminates to a large extent the welfare losses associated with the presence of the zero bound. Under commitment, the gains associated with the use of the fiscal policy tool remain modest, even though fiscal stabilization policy is part of the optimal policy mix.     

Quantitative Easing in the 1930s

During the 1934–39 recovery from the U.S. Great Depression, overnight interest rates were usually at a lower bound. Meanwhile, American monetary authorities followed policies related to today's debates on quantitative easing: they tried to stabilize yields on Treasury bonds with open market operations; they created rapid growth in high‐powered money; and they allowed transitory factors to affect high‐powered money. Effects of these policies on bond yields reveal a portfolio effect of short‐duration asset supply on term premiums. This portfolio effect helps explain why high‐powered money growth was associated with recovery of real activity over 1934–39.     

Panel Data Evidence on the Effects of Fiscal Policy Shocks in the EU New Member States

We identify fiscal policy shocks in the EU new member states using four different methods. We use panel data techniques to estimate the output response to these shocks. We find that investment and export growth increase after fiscal consolidation and decelerate after fiscal stimulus when the shocks are expenditure‐based. In contrast, private consumption does not respond to fiscal policy shocks. Expenditure‐based fiscal consolidations reduce wages, supporting the view that fiscal consolidation of such composition enhances the competitiveness and profitability of domestic enterprises. In contrast, we do not find evidence of fiscal shocks affecting households' confidence.     

Fiscal Stimulus in Times of High Debt: Reconsidering Multipliers and Twin Deficits

We investigate the impact of fiscal stimuli at different levels of the government debt‐to‐GDP ratio for a sample of 17 European countries from 1970 to 2010. This is implemented in an interacted panel VAR framework in which all coefficient parameters are allowed to change continuously with the debt‐to‐GDP ratio. We find that responses to government spending shocks exhibit strong nonlinear behavior. While the overall cumulative effect of a spending shock on real GDP is positive and significant at moderate debt‐to‐GDP ratios, this effect turns negative as the ratio increases. The total cumulative effect on the trade balance as a share of GDP is negative at first but switches sign at higher levels of debt. Consequently, depending on the degree of public indebtedness, our results accommodate long‐run fiscal multipliers that are greater and smaller than one or even negative as well as twin deficit and twin divergence behavior within one sample and time period. From a policy perspective, these results lend additional support to increased prudence at high public debt ratios because the effectiveness of fiscal stimuli to boost economic activity or resolve external imbalances may not be guaranteed.     

Identifying Discretionary Fiscal Policy Reactions with Real‐Time Data

We propose a method of identifying discretionary fiscal policy reactions using real‐time data. Automatic stabilizers should depend on true GDP, while discretionary fiscal policy is contingent on the information that policy makers have in real time. We can compute a real‐time measurement error by comparing the first release of GDP data with later revisions. Discretionary fiscal policy is influenced by this measurement error, whereas automatic fiscal policy is not. We use this identification approach to test the central identifying assumption of Blanchard and Perotti’s (2002) seminal structural vector autoregression (VAR). According to this assumption, fiscal policy makers do not react to GDP developments contemporaneously in a discretionary fashion. We find that government expenditure is adjusted upward if GDP growth in real time is lower than true GDP. This suggests that fiscal policy makers use short‐term funds to buy goods and services in response to their perception of GDP dynamics.