Several of my colleagues on the Harvard faculty have recently been casualties in the cross-fire between fiscal austerians and stimulators.   Economists Carmen Reinhart and Ken Rogoff have received an unbelievable amount of press attention, ever since they were discovered by three researchers at the University of Massachusetts to have made a spreadsheet error in the first of two papers that examined the statistical relationship between debt and growth.   They quickly conceded their mistake.

Then historian Niall Ferguson, also of Harvard, received much flack when — asked to comment on Keynes’ famous phrase  ”In the long run we are all dead” — he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.”  

There is a lot more to be said about each of the two cases.  (i) Reinhart and Rogoff’s 2010 estimates had already been superseded by a subsequent 2012 paper of theirs written along with Carmen’s husband, Vincent, which used a more extensive data set where the error does not appear.  (ii) The debt-growth causality is debated.  (iii) “Some of Ferguson’s best friends are gay.”   (iv) Keynes was actually bi-sexual.  (v) He tried to have children.  And so forth.  Most of this has already been said many times by now.  Apparently people are even more fascinated by Harvard than they are by macroeconomic theory.

But what does it all have to do with the debate between austerians and stimulators?   Not much.  But the battle lines of the austerians have been wavering lately under the continuing onslaught of facts (most notably the recessions in Europe and Japan’s recent conversion to stimulus), and the stimulators find the missteps of Reinhart-Rogoff and Ferguson to be convenient stones to throw into the attack as well.   But they are barking up the wrong tree.  Sorry;  they are throwing the wrong stones.

The Reinhart-Rogoff controversy is not in fact relevant to the question whether governments should expand or contract at a given point in time.  The basic finding in their papers continues to hold up, that subsequent growth tends to be lower among countries with debt/GDP ratios above 90% than below 90%; but neither that finding nor their policy advice was designed so as to support the proposition that a recession is a good time to undertake fiscal contraction. 

The Ferguson controversy is even less relevant, because the phrase “in the long run we are all dead” was neither about fiscal policy when Keynes wrote it nor an argument against deferred gratification.   Nor was Keynes in favor of uninhibited fiscal stimulus regardless of economic conditions;  he argued, rather, “the boom, not the slump, is the right time for austerity at the Treasury.”     Fix the hole in the roof when the sun is shining, not when it is raining.

Neither of the controversies bears on the policy proposition that is important at the moment, which is the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (the conditions that hold in rich countries today, as in the 1930s), fiscal expansion is expansionary and fiscal contraction is contractionary.

Some research by yet another highly valued colleague at Harvard does bear much more directly on this important proposition.   Alberto Alesina has not been receiving his “fair share of abuse.”  His influential papers with Roberto Perotti  (1995, 1997) and Silvia Ardagna (1998, 2010) found that cutting government spending is not contractionary and that it may even be expansionary.  

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other euro members.  But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that academic research finds fiscal austerity to be expansionary in general.  Nevertheless, the conclusions are clear:  “Even major successful adjustments do not seem to have recessionary consequences, on average” (1997).  And “several fiscal adjustments have been associated with expansions even in the short run” (1998).   And “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions” (2010, p.3).   Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi finds “that spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”  

Alesina’s recent policy advice is that the US should cut spending “right away.”  By contrast, the advice of Reinhart and Rogoff seems to favor inflation and financial repression and, if anything, postponing fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today).  In more far-gone cases like Greece, they favor restructuring the debt.   If the thunderstorm is too severe and the roof is too far-gone to be fixed, it may be necessary to rebuild from scratch.

A new attack on Professor Alesina’s econometric findings comes from an unlikely source:   Perotti, the co-author of the first two of the five articles, has now recanted (2013a, b).    He points out some problems with the methodology (including the papers that Alesina wrote with Ardagna).  Under the dating scheme, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year.   It turns out that some of what have been treated as large spending-based consolidations, though announced by the governments, were in fact never implemented.  Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth, for example, the touted stabilizations of Denmark and Ireland in the 1980s.  His conclusions:  “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth” and so “the fiscal consolidations implemented by several European countries could well aggravate the recession” (2013b, p.10).   To me, this is a more powerful indictment of the reasoning behind recent attempts at fiscal discipline during recession than is a spreadsheet error or a too-flippant line about Keynes’ sexuality.

References
    Alberto Alesina, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy Vol.13, no, 27, October, 487-545.
     Alberto Alesina, and Silvia Ardagna, 2010,  ”Large Changes in Fiscal Policy: Taxes versus Spending,” in Tax Policy and the Economy, Volume 24 (University of Chicago Press).
     Alberto Alesina, Carlo Favero and Francesco Giavazzi, 2013, “The Output Effect of Fiscal Consolidations,” IGIER, May.
     Alberto Alesina and Roberto Perotti. 1995, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, October.  NBER WP 5214.
   Alberto Alesina and Roberto Perotti, 1997, “Fiscal Adjustments In OECD Countries: Composition and Macroeconomic Effects,”  International Monetary Fund Staff Papers, vol.44, no.2, June, 210-248.
     Francesco Giavazzi and Marco Pagano, 1990, “Can Severe Fiscal Contractions be Expansionary?” NBER Macroeconomics Annual 1990, Vol.5, Olivier Blanchard and Stanley Fischer, editors (MIT Press) p. 75 - 122.
    Thomas Herndon, Michael Ash, and Robert Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute WP Series 322,University of Massachusetts Amherst, April.
     Roberto Perotti, 2013a,”The ‘Austerity Myth’: Gains Without Pain?” A. Alesina and F. Giavazzi, eds.: Fiscal Policy After the Financial Crisis (University of Chicago Press). BIS WP 362.  NBER WP no 17571.
     Roberto Perotti, 2013b, “The Sovereign Debt Crisis in Europe: Lessons from the Past, Questions for the Future,” Academic Consultants Meeting , Federal Reserve Board , Washington DC , May 6 , 2013.  Bocconi University.
     Carmen Reinhart and Ken Rogoff, 2010, “Growth in a Time of Debt,” AER, 100, May, 573-578.
     Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, 2012, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol.26, No.3-Summer, 69-86.

 [Comments can be posted at On Deck of Project Syndicate or on the site of the shortened op-ed version.]

     Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12^th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

    Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.  

     There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

    Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

     Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

    Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

   Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

    It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).  

   Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent. 

   Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

     [The original of this post appears at Project Syndicate.  Comments may be posted there.]