Expansionary Austerity and Reverse Causality: A Critique of the Conventional Approach

Abstract

In this paper we methodologically review and criticize a broad literature of empirical work on the effects of fiscal policy (the ‘conventional approach’). Beyond previous critiques of this approach, we show that the cyclical adjustment strategy as used in this literature entails erroneous assumptions that necessarily produce flawed results in support of expansionary austerity. Specifically, the cyclically-adjusted primary balance (CAPB) strategy this literature employs fails to correct for cyclical effects in the expenditure-GDP-ratio, so that the estimates of the results of expansionary fiscal consolidation are affected by reverse causality, i.e. increasing GDP causally decreases expenditure-GDP-ratios, rather than vice versa. We provide suggestions on how to fix this incomplete cyclical adjustment problem with a new approach. After replicating two famous articles of the conventional literature and controlling for this bias, the expansionary effects of fiscal adjustments disappear or turn into their opposites.

Keywords: Austerity; Fiscal adjustment; Conventional approach; Blanchard method; Cyclical adjustment; Reverse causality

JEL Classification: E60, E62, E65