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

55 Pages Posted: 15 Jul 2019

See all articles by Christian Breuer

Christian Breuer

CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute

Date Written: June 1, 2019

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

Suggested Citation

Breuer, Christian, Expansionary Austerity and Reverse Causality: A Critique of the Conventional Approach (June 1, 2019). Institute for New Economic Thinking Working Paper Series No. 98, June 2019, Available at SSRN: https://ssrn.com/abstract=3419588 or http://dx.doi.org/10.2139/ssrn.3419588

Christian Breuer (Contact Author)

CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

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