New Evidence for Greece’s Fiscal Multiplier Debate

In this unstable global economic environment, the effectiveness of fiscal policy in stimulating the real economy is very crucial. But these effects are still under question in both theoretical and empirical perspectives. The most important issue is what determines the size and the sign of the fiscal impact, i.e the exchange rate regime, the phase of the business cycle, the openness of the economy, the level of debt to GDP ratio or even the method of fiscal policy, that is, government spending versus lower taxes. The transmission mechanism determines the final impact, which differs depending on the issues of flexibility of prices, forward looking consumers, small open economies and perfect or monopolistic competition among others. Keynesian economics assuming sticky prices and perfect competition, argue that an expansionary fiscal policy will increase the output and the income. As the demand for money balances is an increasing function of income this will increase the interest rate resulting in a partial crowding out of private investments. The overall impact will be an increase in output, in investment and in consumption. The transmission mechanism differs in the case of an open economy. Under a floating exchange rate regime and perfect capital mobility, the increased interest rate appreciates the nominal and the real exchange rate deteriorating net exports, thus crowding out private investment. As a result, total output, private consumption and investment remain unchanged. It is worth noticing that monetary policy is expected to be more accommodative under a fixed exchange rate than under a float. Nonetheless, this is debatable depending on the credibility of the peg. Imperfect credibility of a peg may induce a government to raise the interest rate after an increase in government spending, in order to defend the peg. The overall fiscal impact is expected to be larger under a peg.

In more stylized economic models with forward looking consumers, as the Real Business Cycles models, fiscal expansion has different results than the standard Keynesian model. Through the negative wealth effect as a result of a fiscal expansion, consumption will decrease but output will increase as well as private investment. The real exchange rate will appreciate reducing the overall first positive impact on output. Under a new Keynesian perspective (DSGE models) and assuming imperfect competition, consumption will decrease after an increase in government spending as a result of the negative wealth effect. Furthermore, private investment is crowded out as a result of the higher interest rates and of the appreciation of the exchange rate. Once again, under pegged exchange rate regime the fiscal policy is expected to be more effective.

Empirical results although are still mixed regarding the transmission mechanism of a fiscal policy under different exchange rate regimes, are more clear over the final impact. This is of great importance since the countries of the South in the European Union having most of their trade partners being members of the E.U are facing a fixed exchange rate regime. The fiscal multiplier is larger under a pegged exchange rate while there is a zero response of output to fiscal expansion under a floating exchange rate regime and a pronounced crowding out effect of private investment. Contradicting theory, most empirical studies do not detect any negative effects to net exports and second, they find that the exchange rate depreciates rather than appreciating. Gogas and Pragidis (2013), examining U.S data find that under a peg the fiscal multiplier is larger than under a float, concluding that the fiscal policy is by far more effective in the first case.

This results cast doubt in the chosen policy of extreme fiscal contraction chosen by E.U for it’s highly debted South members. These countries and especially Greece are facing a fixed exchange rate regime since most of their trade partners are E.U countries. That is, even if the IMF had calculated the impact of the recession at the height of the multiplier for Greece, the effective multiplier would still be higher due to the influence of the fixed exchange rate. This means that the undeniably real need to reduce public expenditure is very expensive in terms of growth in the Greek economy. So the “budget targets” that have at their base the fiscal multiplier it is natural not to be achieved almost never when the actual multiplier is significantly higher.

Thus, Greece needs the increased public expenditure but yet in an environment where private initiative has the dominant role. The state should create the conditions for a competitive market without cartels or monopolies for the benefit of consumers and the public. The rapid structural changes can lead to the development assistance of public spending. Otherwise the increased government spending will just exacerbate the existing problem as has been demonstrated by the recent experience. In an environment where deleveraging is the issue with interest rates at historic lows which generate reasonable expectations for growth in the future, the non-financial cost reforms are the key to development. With the acceleration of these reforms alone can use the weapon of increased public spending.

2 Responses to "New Evidence for Greece’s Fiscal Multiplier Debate"

  1. Tom   July 17, 2013 at 7:11 pm

    It's pointless to debate the pros and cons of austerity vs countercyclical stimulus for Greece without facing head on Greece's dependence on foreign public funding. The question is ultimately to German politicians and voters, whether to commit more aid to Greece would be mutually beneficial or throwing good money after bad. The usual models are not only tweak and tired but irrelevant to Greece as they presume a self-funding government. Of course Greece would have higher GDP in the near term with more aid no one doubts that. The reluctance is that of a creditor to an insolvent debtor, trying to judge whether more credit would hurt or help solvency in the longer run.

    • Perry   July 17, 2013 at 10:07 pm

      Precisely Tom. But the creditors need to evaluate tyhe pros and cons of more funding or the effects of the austerity measures employing more accurate and realistic models.