The Relationship between Large Fiscal Adjustments and Short-Term Output Growth Under Alternative Fiscal Policy Regimes

I. INTRODUCTION During the past quarter century, nearly all Organisation for Economic Co-operation and Development (OECD) countries undertook at least one large fiscal contraction to deal with high levels and rapid growth of public debt. Although such fiscal contractions did curb the growth of public debt, significant concern emerged that such actions could weaken economic growth in the short run. Those concerns seemed justified when growth slowed in many cases, sometimes resulting in recessions. But in others--most notably the fiscal contractions in Denmark (1983-86) and Ireland (1987-89)--growth accelerated. Those experiences, as well as the contractionary fiscal expansion in Sweden in the early 1990s, raised questions concerning the conventional wisdom on the effect of fiscal actions meant to stabilize cyclical fluctuations. They also generated a small but growing body of empirical literature looking for evidence of so-called non-Keynesian effects on short-term growth (e.g., Giavazzi and Pagano, 1990, 1996; Alesina and Pe rotti, 1995, 1997; McDermott and Wescott, 1996; Perotti, 1999; Giavazzi et al., 2000). That literature concluded that under certain conditions large fiscal contractions stimulate rather than retard short-term growth. Those studies frequently distinguish between normal and unusual times--where fiscal regimes, as measured by the change in the cyclically adjusted primary deficit, change dramatically. In some cases, the idea of a fiscal crisis also comes into play. In large part, however, differences in fiscal policy regimes were determined on an ad hoc basis. Although the adopted definitions of regime changes are generally reasonable, the results regarding non-Keynesian effects may depend on the definition of a regime change. The authors use more statistically based methods for determining changes in fiscal regimes and empirically test for the significance of more types of fiscal crises--or so-called trigger points. After considering Hamilton's (1994) procedure for empirically determining regime changes, the authors use a procedure previously employed by Miller (1986, 1989) in his study of short-run money demand shifts because of sample size limitations. After identifying different fiscal policy regimes and associated trigger points in 19 OECD countries, the authors use that information in three alternative regression equations, explaining economic activity with pooled time-series, cross-section data. First, the authors estimate a St. Louis equation similar to Batten and Hafer (1983). Second, the authors estimate a Martingale equation for consumption similar to those estimated by Hall (1978) and Flavin (1981). Finally, the authors estimate a growth accounting equation similar to Levine and Renault (1992), Barro (1991), and Miller and Russek (1997). The existing empirical literature that searches for non-Keynesian outcomes generally estimates a consumption function. The authors provide similar estimates based on Hall's specification as well as on a St. Louis equation specification. The third empirical analysis is based on a growth accounting specification that offers the first test of the Bertola and Drazen (1993) hypothesis that unusual fiscal events may turn neoclassical outcomes into Keynesian outcomes. With few exceptions, the authors' findings do not provide overwhelming support for strong unusual fiscal outcomes. Unusual fiscal outcomes fall into two categories--non-Keynesian outcomes within a Keynesian model and Keynesian outcomes within a neoclassical model. Moreover, the authors find mixed evidence that non-Keynesian outcomes occur more for government spending cuts than for tax hikes. Finally, the evidence does not indicate that trigger points matter much empirically. In sum, the evidence on unusual fiscal outcomes exhibits idiosyncratic rather than systematic results. II. THEORY The standard textbook Keynesian model implies that government tax hikes and spending cuts both reduce the pace of short-term economic activity through their adverse effects on aggregate demand. …