The expansionary fiscal contraction that worked
Despite the International Monetary Fund/World Bank Spring Meetings, as well as a G20 get-together, the biggest economic news of the past two weeks was the mistake in an influential economic study.
Here is the intro. to my latest Hurriyet Daily News (HDN) column. The study is of course the Reinhart/Rogoff (R^2) paper. I am sure most Economonitor readers are familiar with the matter at hand, as it has been a trending topic in Economonitor for the past few days. But for those of you who just landed from a Mars mission:) and are unaware of what’s going on, I provided a short summary, with a few useful hyperlinks, on the issue in the column. If that is not sufficient, Bloomberg has a nice FAQ.
Most of the articles posted at Economonitor and others in the media/blogosphere are harshly criticizing the paper. I love to be contrarian, and so the second part of the paper is devoted to a successful case of expansionary fiscal contraction: Turkey during 2003-2005. This way, I may help R^2 to get back on their feet. Not that they need my help: The duo are respected international macroeconomists. Rogoff was the IMF’s chief economist from 2001 to 2003. But when they published the paper, R&R were famous because of their recent book, This Time Is Different: Eight Centuries of Financial Folly (highly recommended). Besides, they just published a column defending their paper in the New York Times, along with a complementary technical appendix paper (I am not kidding; this is how they described it- this has to a first), so they don’t need my help at all:). Anyway, I read both of their columns carefully; I agree with some of their points, not others, but I am not going to spend the next 10,000 words boring you with my views on their points- I am sure someone else more qualified than me, probably Paul KrugTron, defender of the Keynesian universe, will do that, especially since his home home planet New York Times was attacked by the Robeasts Reinhart and Rogoff. Edit: I just checked his NYT blog and saw that he has answered first thing in the morning🙂
Instead, I would like to raise a more general point: As I mention in the column, R^2 do not argue that there is a causal relationship between debt and growth; they couldn’t do that with the descriptive statistics in the paper anyway. There have been earlier papers, most notably one by Harvard University’s Alberto Alesina and Slivia Ardagna, who have argued for a causal relationship- and got their share of criticism, from the IMF and others and more recently from KrugTron . But austerity proponents chose to deduce causality from the R^2 paper because it was in their interest to do so! As I mentioned above, R^2 were already famous because of their book, and so they were turned into reluctant heroes of the austerity movement.
What do I make of all this? Simply put, as Ugo Panizza and Andrea F Presbitero noted at Vox: “The debt-growth link is more complex than commonly thought. While there is evidence that public debt is negatively correlated with economic growth, there is no study that makes a strong case for a causal relationship going from debt to growth.” The Fuhrer could not have said it better himself!:)… And if you want to make the counter argument with a somewhat compelling case against fiscal stimulus, Matthew Yglesias has a political argument.
This has indeed been a long introduction. Turning to my column, you can read the whole thing in the HDN website. As for an addendum, I would like to start by noting that you should not make too much of the Turkish result. After all, as I mentioned int the column as well, the previous fiscal consolidation efforts in 1994-1995 and 2000 were unsuccessful. Before writing the column, I did a bit of research and stumbled upon a paper that has looked at Turkey from 1987 to 2009 and concluded that fiscal contractions are in general not expansionary in Turkey. It is not in a refereed journal, and I did not have a chance to read it, so I would not take the result as iron-clad at this stage, but for now, I would see the Turkish 2003-2005 episode as the exception rather than the rule.
So that brings us to the next question: What makes a fiscal consolidation successful? My short answer is I don’t know. I think research is lacking in this area. IMHO, it seems a few fiscal contractions work, while most end up with the usual Keynesian effect. Therefore, other than discussing whether fiscal contractions can be expansionary or not, research should focus on the conditions that make fiscal consolidations expansionary. As I mentioned in the column, I see the bank balance sheet clean-up as the key aspect of the 2003-2005 Turkish consolidation. The 2000 episode had a problematic real exchange appreciation, and rather than clean up the banks, the 1994-1995 episode sowed the seeds of banking problems that led to the 2001 crisis. As you can see, even for a particular country, each successful or unsuccessful fiscal contraction has certain specifics that caused that effort to succeed or fail. So I am not sure if much could be gained from regression analysis, but I am just your average econ. columnist- it is up to real academics to tackle this issue.
The next question is whether the debate of the last few weeks will put an end to austerity? Capital Economics does not think so. In a short note they published yesterday, they argue that “fiscal austerity will be a major drag on growth for some years to come, particularly in advance economies”:
The IMF’s latest numbers show that advanced G20 countries are planning to tighten fiscal policy by a total of 2.7% of GDP over the three year period from 2013 to 2015, following significant tightening during the previous two years. What’s more, as the IMF acknowledged in its October World Economic Outlook, in current conditions the impact of this austerity on growth may be much larger than was previously supposed. Although most countries are tightening fiscal policy, the scale of the squeeze varies considerably. The biggest contraction this year is likely to be in the US, largely because of the impact of the automatic “sequester” which came into effect on 1st March. At the other end of the spectrum, Germany should escape austerity more or less completely. In the euro-zone as a whole, however, austerity will continue for some time yet and we think policymakers have underestimated its impact on the economy.
I don’t want to delve too much into the debate itself; there are so many columns/posts/arguments/counterarguments that I would not know where to start. Instead, I would like to touch upon a more general point: What does this debate tell about the future of economics? Mark Thoma argues standard economic models don’t work in episdoes of crises, but KrugTron asserts, on the other hand, that the simplest model, IS/LM, does a good job in explaining the last few years.
No good story should be perfect without a good drama: In this case, while everyone is discussing the idea, some have opted to bring forward the man behind the idea: The UMass Amhert graduate student who found the error in R&R’s Excel sheet. While his story is quite interesting, so is the economics department he is working towards his Ph.D. at. UMass Amherst has long been known as the bastion of leftist economics- you may want to use the term unorthodox/heterodox if you want to be more P.C.:) In fact, well-known (at least in Turkey) leftist Turkish economist Erinc Yeldan (formerly of Bilkent University, currently at Yasar University in Izmir) has close relations with them and has been a visiting professor there a couple of times, if I’m not mistaken.
BTW, hopefully, my HDN column and this post rose your interest in the Turkish 2001 crisis and 2003-2005 fiscal consolidation. I could hardly do full justice to the program in a couple of paragraphs, and I know of a study by Fatih Ozatay and Guven Sak on the 2001 crisis. While I did find their paper, I also stumbled upon another paper by Ozatay on the 2003-2005 Turkish fiscal consolidation. He makes more or less the same points as in my column. There is a longer/more detailed version of the paper as well. And I even found a short book, but I have not tried to get a hold of it.
Shifting gears a bit, this column has given me a chance to let out my usual complaints/lamentations about the econ. columnist profession in Turkey. Although the R^2 debate was by far the leading economic agenda of the past 10 days or so, I saw very few columns on it in Turkish papers. A notable exception was my preferred daily Radikal: Their columnists Guven Sak and Ugur Gurses mentioned the issue early on (both in Turkish), and Fatih Ozatay, the author of the Turkish fiscal consolidation paper I mentioned above, also writes there, so we maybe he’ll have something in the next couple of days. This lack of interest reflects, IMHO, that most Turkish columnists are not following global developments well. After all, for any Turkish economist, or anyone moderately familiar with the Turkish economy, the first thing that comes to mind when hearing about the R^2 debate should be the Turkish 2003-2005 fiscal consolidation.
Finally, I would like to conclude with a little bit of humor. Apparently, this is not the first time Excel has wrecked havoc on the economy; it may even be the quiet villain of global finance🙂 FT Alphaville takes the joke seriously and argues that this is a gross exaggeration.
2 Responses to “The expansionary fiscal contraction that worked”
Thanks. What people don't realize about R&R is that they developed their point as analysts mainly of emerging markets, where the fiscal consolidators have generally done far better than the fiscal stimulators.
Part of the reason is that in emerging markets stimulus tends to lead very quickly to inflation, so it just isn't possible for them to pursue the high-deficit route a la US, UK, Japan without suffering either high inflation or high interest costs. Most of the fiscal consolidators, Turkey being a great example, tried everything else first, and everything else failed for them.
Turkey also had the fortune to pursue its austerity when bigger neighbors were doing the opposite, which makes it a whole lot easier.
Good points. The global environment, especially, what your peers and trading partners are doing, indeed matters a lot as well…