Thursday, June 7, 2012

The Difficulty in Accepting "Discretionary Stabilizers"

As the debate on the appropriateness of doing more fiscal and monetary stimulus continues, here is a reflection on something that I never understood in that debate: even those who strongly oppose the idea of additional stimulus rarely question the workings of automatic stabilizers. This is surprising because under most economic models, a change in taxes or fiscal spending has a similar effect on GDP and unemployment whether this is built into the tax code or it is a discretionary decision of the government (this is even more true if everyone expects the government to react like that during recessions). Somehow, automatic stabilizers are seen as normal and effective (here is a 2008 WSJ piece by John Taylor arguing that automatic stabilizers should be allowed to work). But discretionary changes are ineffective and can only do harm.

The moment one admits that there is a good reason to have automatic stabilizers, then the discussion on how large they should be and how they should be complemented with discretionary fiscal policy is a natural one and cannot be avoided. Automatic stabilizers are not equal across countries and there is strong evidence that countries with smaller automatic stabilizers use discretionary fiscal policy more aggressively to compensate for this (which makes sense from an economic point of view). A few months ago we wrote a paper on this: the similarities between automatic stabilizers and discretionary fiscal policy. In addition to presenting evidence of how automatic stabilizers and discretionary policy can be seen as substitutes, we also show that among OECD economies the largest automatic stabilizer comes from stable government spending in the presence of falling GDP. In particular, in countries where government spending is large (and stable) we see strong automatic stabilizers. Finally, we also estimate fiscal policy multipliers but we do so by taking into account our argument that automatic stabilizers and discretionary policy are part of the same policy.

Antonio Fatás