From the BRICs to Southern Europe, economic analysts are beginning to discuss the conditions for a negative fiscal multiplier.
In other words, in spite of the famous identity Y = C(p) + I(p) + C(g) + I(g) + X – M, one might have many situations where an increase in C(g) financed by government bond issues has a negative impact on the other variables of the identity, including private consumption, private investment, Government investment and the current account balance surplus.
During the early Keynesian discussions, such a hypothesis was not even considered, but nowadays with open economies, free capital markets, flexible exchange rates, huge government déficits and debts, etc., the role of fiscal policy seems to have changed dramatically. An increase in current government expenditures tends to reduce real GDP through many different sources and channels, with an emphasis of course on financial variables such as the interest rate, the availability of internal and external credit for the private sector, the exchange rate, expectations of inflation, and the risk of government default.
Some names have been used in the past to develop theories related to this subject, including the concept of the “crowding-out” of the private sector through higher interest rates and less credit, and the old Ricardian theory that one should not differentiate after all debt from taxes, leading to private savings to pay for future taxes. Some in the past have even discussed a consumption function within the government sector.
The fact is that a negative fiscal multiplier suggests that in order to get out of a recession, what you need to do nowadays is to cut current government spending in order to bring interest rates down, liberate credit for the private sector, devalue the exchange rate, avoid inflation and minimize Government default risks. And vice-versa, of course: in 2010, a raise in current government spending does not necessarily work as a way out of recession, as a fiscal stimulus.
Although hyper-Keynesians continue to argue that you need to raise Government spending in order to avoid recession through the standard positive fiscal multiplier, we are becoming more and more convinced that such fiscal stimulus does not work anymore, because of the impact on the financial sector through government bond financing. At the end of the day, a pure fiscal policy without monetary expansion tends to be negatively compensated by the crowding-out of credit, interest rates and exchange rates.
We were all Keynesians in the fifties and sixties, all monetarists (or Friedmanites) in the seventies and eighties, and now we are becoming Ricardians (from David Ricardo) in the new century: when the general public sees more government debt being issued, it begins to save more to pay for future taxation and – worse – begins to fear inflation and/or government default. The so-called positive fiscal multiplier tends to disappear without private consumption, due to a major decline in the marginal propensity to consume on the private sector.
This is perhaps the major macroeconomic debate of the day, which is behind the present discussion about increasing or reducing government déficits and government debts. On one side, we still hear hyper-Keynesian views, always talking about what happened in the thirties. On the other side, based on recent empirical work by Alberto Alesina and others, there is evidence from the last three or four decades, showing that the new globalized world is perhaps more prone to negative fiscal multipliers, due to financial globalization and to the international capital markets who penalize excessive government debt.
Although markets in 2010 have concentrated their attention in Southern European countries, it is important to point out some new worrisome trends in countries such as Brazil, where ratios such as government deficit to GDP or government debt to GDP are still considered low, but are unfortunately showing negative dynamics with a rapid deterioration.
Perhaps economists should begin to pay more attention to statistics such as the ratio of current government expenditures to GDP. When these rates of growth begin to move with different velocities, one can expect in the near future fiscal negative multipliers and in the longer term, default risks.
In spite of excellent Brazilian macroeconomic statistics regarding inflation and GDP growth in 2010, analysts have to worry about three things: overvalued exchange rates, high real interest rates, and dangerous trends on the fiscal policy side related to huge increases in current government spending and current government jobs.
In particular, what’s happening with government jobs might represent a major blow to one of the things that made Brazil a very dynamic country in the last century; the animal spirits of the young entrepeneurial population are slowly being replaced by the laziness of government job opportunities.