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

• Published date: 01 January 2019
• Author: Richard McManus,Gulcin Ozkan,Dawid Trzeciakiewicz
• DOI: http://doi.org/10.1111/sjoe.12269
• Date: 01 January 2019

Scand. J. of Economics 121(1), 32–54, 2019

DOI: 10.1111/sjoe.12269

Expansionary Contractions and Fiscal Free

Lunches: Too Good To Be True?*

Richard McManus

Canterbury Christ Church University, Canterbury CT1 1QU, UK

richard.mcmanus@canterbury.ac.uk

Gulcin Ozkan

University of York,YorkYO10 5DD, UK

gulcin.ozkan@york.ac.uk

Dawid Trzeciakiewicz

Loughborough University,Loughborough LE11 3TU, UK

d.g.trzeciakiewicz@lboro.ac.uk

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. Wepropose a new metric quantifying the budgetary implications of

fiscal action, a key aspect of fiscal policy particularly at the monetary zero lowerbound. 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.

Keywords: Austerity versus stimulus; fiscal policy; zero lower bound

JEL classification:E65; H2; H3

I. Introduction

The 2008 global financial crisis and subsequent economic downturn led to

a deterioration in fiscal balances, resulting in widespread fiscal austerity in

a large number of countries. Within this climate, it was suggested by some

that fiscal contractions could be expansionary, especially those conducted

through spending cuts, as agents anticipate efficiency gains and lower future

taxes as a result of a smaller public sector (Alesina and Ardagna,1998).

*Weare grateful to an anonymous referee for valuable comments and suggestions. Wewould also

like to thank the participants at the 2014 Money, Macro and Finance Annual Conference, the

2015 Royal Economic SocietyAnnual Conference and the 2016 York Fiscal PolicySymposium,

and the members of the MacroeconomicsAnalysis and Application Research Group at Newcastle

University for their helpful comments.

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The editors of The Scandinavian Journal of Economics 2017.

R. McManus, G. Ozkan, and D. Trzeciakiewicz 33

Others, however, indicated that fiscal multipliers are potentially much larger

in recessions than during normal times (e.g., Auerbach and Gorodnichenko,

2012), and hence austerity would be even more contractionary in post-

crisis periods. This is argued to be the case in the current climate in

particular, with monetary policy being constrained to its nominal zero lower

bound (ZLB; e.g., Eggertsson,2011;Woodford,2011). Furthermore, it is

argued that under the ZLB, fiscal effectiveness is greatly amplified such

that interventions become fiscal free lunches (Erceg and Lind´e,2014)–

expansionary policy stimulates output and resulting tax revenues to such

an extent that there is a reduction in government debt.

The contribution of this paper is to develop a formal framework which

encompasses the possibilities of both expansionary contractions and fiscal

free lunches. The former are defined as fiscal contractions leading to an

increase in output, and the latter as expansions which reduce debt. We test

for expansionary contractions by using traditional output multipliers, and we

investigate fiscal free lunches by introducing a bond multiplier metric which

measures the response of government debt to fiscal interventions. A fiscal

free lunch is observed when either spending increases or tax cuts lead to a

decrease in government debt. We find that austerity needs to be permanent

and credible in order to yield expansionary effects. Agents observe a

potential increase in their lifetime earnings if they predict lower future

taxes, but they only act on this if they perceive the spending cuts to be

credibly long lasting; without this expectation and credibility, expansionary

contractions are not possible. In the case of fiscal expansions, we show

that fiscal action improves budgetary outcomes when it is temporary,

well-targeted, and supported by accommodative monetary policy (or the

ZLB). We conclude that, given the political costs associated with prolonged

austerity, as well as those of reversing stimulus, neither extreme outcome

is likely, and therefore policy-makers are unlikely to benefit from either

expansionary contractions or fiscal free lunches.

This paper builds on existing literature which finds that fiscal policy,

especially with respect to government spending, becomes more effective

under a period of the ZLB (Christiano et al., 2011; Eggertsson, 2011;

Woodford, 2011). Under such conditions, interest rates are not raised by

the central bank, who would otherwise respond to increased inflation and

output when government spending increases. Furthermore, higher inflation

with a fixed nominal interest rate leads to a fall in the real interest rate,

subsequently fuelling further increases in consumption. Indeed, fiscal policy

can become so effective that spending increases lead to substantial rises in

the tax base, reducing government debt (Erceg and Lind´e,2014).

We extend the work of Erceg and Lind´e(2014) in two important

ways. First, we extend the results to many fiscal instruments: our model

incorporates government spending on consumption goods, investment

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The editors of The Scandinavian Journal of Economics 2017.