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Alan Taylor: "The Boom, Not the Slump, Is the Time for Austerity at the Treasury"

Alan Taylor:

When is the time for austerity?: Is… evidence-based macroeconomics possible?… Experimental techniques drawn from medicine have been fruitfully incorporated in other fields of economics. Helpful, for some, since more clarity on fiscal impacts might be welcome, given the uproar over European and UK austerity programs…. In a new paper we exploit a treatment-control design using statistical techniques designed for situations, experimental or otherwise, where underlying allocation [of cases to treatment and control] bias may prevail (Jordà and Taylor 2013). This turns out to be a serious problem here, as in many other macroeconomic contexts where endogenous policy actions epitomise the “insufficient randomisation” problem….

We use the very same OECD annual panel dataset (17 economies; 1978–2009) common to… the influential “expansionary austerity”… Alesina and Ardagna (2010); but an IMF study reached the opposite conclusion of “contractionary austerity” (Guajardo et al. 2011)…. We use local projection methods (Jordà 2005) to estimate output impacts of fiscal policy up to four years out….

As a first step we estimate linear-projection impacts of fiscal policy using the Alesina-Ardagna measure of policy, the change in the cyclically-adjusted primary balance from year 0 to year 1. These first estimates suggest, consistent with Alesina-Ardagna, that austerity is expansionary… we stratify the results by the state of the cycle (2 bins, boom and slump, based on the sign of HP-filtered log output, yC) at time 0; we see that the result is entirely driven by what happens in booms. It is only in booms that we find a significant response of real GDP to fiscal tightening….

As a next step we therefore replace our linear-projection estimator with an instrumental-variable linear-projection estimator… [using] the IMF set of potential 'narrative' instruments…. Austerity appears contractionary. The significant coefficients here have a negative sign. However, stratification shows that this result is now largely driven by what happens in slumps….

Table 3 presents probit models of the IMF treatment variable (a consolidation from year 0 to year 1). In column 1 the austerity treatment is more likely when public debt is higher. Governments pursue austerity when debt is elevated. In column 2, when output is further below potential or growing more slowly, there is an increase in the likelihood of treatment. Finally, columns 3 and 4 add the lag of treatment. Being in treatment today is a good predictor of being in treatment tomorrow. Austerity programs persist.

We offer a new take in a third and final step. If the IMF’s austerity treatment variable has a significant forecastable component this could induce allocation bias in estimated responses. To address this we use local projections again, but with an inverse probability weight regression-adjustment method to calculate average treatment effects. The inverse probability weight regression-adjustment estimator uses a saturated first-stage probit model to predict treatment probability based on observables, getting as close as possible to a quasi-randomised experiment…. Table 4 shows that austerity has a mostly negative effect, all years, in both bins. It has larger and more statistically significant negative effects in the slump…

Our results contrast with the expansionary austerity view of Alesina and Ardagna, and even amplify the opposing view of the IMF…. In recent times austerity has been systematically applied in weak economic conditions: plus ça change. But in a bad current state the economy is more likely to grow faster than trend going forward. By failing to allow for the endogeneity of treatment we could end up with a far too rosy view of the aftermath of fiscal consolidations. A dead cat bounces, regardless of whether it jumped or was pushed.

Using ordinary-least-squares estimation we would walk away believing in expansionary austerity, or no effect when the economy is weak. Using 'narrative' instrument variables we might believe in contractionary austerity except when the economy is strong…. Using our two-stage method to deal with allocation bias, we find stronger evidence of contractionary austerity in the weak economy with much more precise estimates. These results suggest that only a strong economy can bear a fiscal consolidation without significant output losses….

Fiscal consolidations are not exogenous events, even those identified by the narrative approach. By reweighting observational data to approximate an experiment where treatment is 'as if' at random (based on a first-stage model), we estimate policy responses in a way that corrects for allocation bias…. Keynes is still right, after all: “The boom, not the slump, is the right time for austerity at the Treasury.”