Fiscal Policy and the “Great Recession”in the Euro Area

G. CoenenEuropean Central Bank

R. StraubEuropean Central Bank

M. TrabandtFederal Reserve Board of Governors

The views expressed are those of the authors and should not be interpreted as reflecting the views of the ECB or the Board of Governors of the Federal Reserve System.

2

Motivation

• Great Recession triggered large-scale fiscal policy response in the euro area: – Automatic stabilizers– Discretionary fiscal policy

• EERP of 2% of GDP in 2009-10• Financial market support measures

– Consequence: strong deterioration of euro area public finances

• This paper: model-based accounting exercise – What did fiscal policy actually do to euro area GDP

in the Great Recession, quantitatively?

3

What we do

• Point of departure: estimated version of ECB’s New Area-Wide Model (NAWM)

– Small open economy version of CEE (2005) and SW (2003, 2007)

– Stylized fiscal sector:• constant taxes, balanced budget, exogenous

government consumption (only fiscal observable)

4

What we do

• NAWM Fiscal: extension of baseline NAWM to allow for broader scope of fiscal policy

– Empirical extensions:• measure in total 8 fiscal time series

– Theoretical extensions:• rule-of-thumb consumers, public capital, time-to-

build, complementarities, fiscal rules, automatic stabilizers, pre-announcement, …

• Estimate model and study contributions of fiscal policy to real GDP growth

5

Preview: Baseline NAWM

2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1

−12

−10

−8

−6

−4

−2

0

2A

nnua

lized

Qua

rterly

Gro

wth

Rat

esHistorical Decomposition of Real GDP Growth (demeaned)

Real GDP GrowthGov. Consumption ShockNon−Fiscal Shocks

6

Preview: NAWM + Enhanced Fiscal Sector

2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1

−12

−10

−8

−6

−4

−2

0

2A

nnua

lized

Qua

rterly

Gro

wth

Rat

esHistorical Decomposition of Real GDP Growth (demeaned)

Real GDP GrowthFiscal ShocksNon−Fiscal Shocks

7

Outline

• Motivation

• NAWM Fiscal: Theoretical Extensions

• NAWM Fiscal: Empirical Extensions

• Results

• Conclusions

8

NAWM Fiscal: Rule-of-Thumb Consumers

• Gali/Lopez-Salido/Valles (2007); Coenen/Straub (2005)

• Share ω of non-optimizing consumers J– Identical wage and labor supply across groups– Rule-of thumb consumption:

• Aggregate consumption:

9

NAWM Fiscal: Public capital

• Public capital stock for intermediate goods production:

• Composite capital stock (CES):

• Government maintains public capital stock

• Gov. investment subject to time-to-build constraint

10

NAWM Fiscal: Valued Gov. Consumption

• Households utility function:

• Composite consumption (CES):

• Private consumption response after gov. consumption shock depends on degree of complementarity

11

NAWM Fiscal: Fiscal feedback rules

• Feedback rules for fiscal instruments– gov. consumption, investment, transfers, – distortionary taxes on labour income, employer

and employee SSC and lump-sum taxes

• Example:

with

Lagged response

Debt Stabilization, Automatic Stabilizers

Discretionary policy (possibly pre-announced)

<

12

Outline

• Motivation

• NAWM Fiscal: Theoretical Extensions

• NAWM Fiscal: Empirical Extensions

• Results

• Conclusions

13

NAWM Fiscal: Empirical Extensions

• Macro Data:– 17 euro area macro time series of baseline NAWM – Area-Wide model database

• Fiscal Data:– Newly available quarterly fiscal database– 8 euro area fiscal time series

• Government consumption, investment, transfers• Direct and indirect tax revenues• Employee and employer SSC• Government debt

14

NAWM Fiscal: Empirical Specification

• Sample period: 1980Q2 to 2010Q2

• Data treatment:– Expenditure and debt data in real terms– Revenue data as a ratio to consumption or wages

and salaries– Linear- resp. HP-trends removed

• Bayesian estimation

15

Outline

• Motivation

• NAWM Fiscal: Theoretical Extensions

• NAWM Fiscal: Empirical Extensions

• Results

• Conclusions

Selection of Calibrated Parameters

A Selection of Estimated Parameters

18

Historical Decomposition: NAWM Fiscal

2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1

−12

−10

−8

−6

−4

−2

0

2A

nnua

lized

Qua

rterly

Gro

wth

Rat

esHistorical Decomposition of Real GDP Growth (demeaned)

Real GDP GrowthFiscal ShocksNon−Fiscal Shocks

Historical Decomposition: Effects of fiscal shocks on GDP taking parameter uncertainty into account

Ann

ualiz

ed Q

uarte

rly G

row

th R

ates

20

Contribution of Individual Fiscal Shocks

2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1−1

−0.5

0

0.5

1

1.5

Ann

ualiz

ed Q

uarte

rly G

row

th R

ates

Contribution of Fiscal Shocks to Real GDP Growth (demeaned)

Total Contribution to Real GDP GrowthGov. ConsumptionGov. TransfersCons. TaxEmployer SSCEmployee SSCLabor TaxGov. InvestmentLump−sum Tax

21

Inspecting the Mechanism I: Effects of valued/non-separable government consumption (CES)

22

Cross-Check I: Standardized Fiscal Multipliers

23

Cross-Check II: Estimated Fiscal Multipliers

Cross-Check II: Estimated Fiscal MultipliersTaking Parameter Uncertainty into Account

Cross-Check III: Historical DecompositionImportance of Fiscal Rules

Cross-Check IV- Evaluation of European Economic Recovery Package (EERP)

Cross-Check IV: Sensitivity of EERP -Present Value Fiscal Multipliers

28

Cross-Check IV: Effects of Fiscal Shocks vs. EERP

29

Cross-Check IV: Effects Fiscal Shocks vs. EERP (II)

Cross Check V: Nominal Interest Rate, Taylor Ruleand ZLB

31

Outline

• Motivation

• NAWM Fiscal: Theoretical Extensions

• NAWM Fiscal: Empirical Extensions

• Results

• Conclusions

32

Conclusions

• Great Recession triggered large-scale fiscal policy response in the euro area

• Question: How much did expansionary fiscal policy contribute to GDP growth?

• Answer: Up to 1.6p.p. annualized quarterly real GDP growth

• Important:– Incorporate (lots of) fiscal data – Detailed modelling of the fiscal sector

33

Annex

34

Baseline New Area-Wide Model (NAWM)

• Micro-founded estimated DSGE model for euro area– Small open economy version of CEE and SW

• Four types of agents:– Optimizing private households & firms– Monetary and fiscal authority (balanced budget)

• Wealth of nominal and real rigidities (habit preferences, adjustment costs, sticky prices and wages….)

• Estimated on 18 euro area time series– Government consumption only fiscal observable

35

Inspecting the Mechanism II: Share of Rule-of-Thumb Consumers (ω)

0 1 2 3 4 5 6 7 80

0.02

0.04

0.06

0.08

0.1

Priv. Consumption After Lump−Sum Gov. Transfer Shock

Quarters

Per

cent

Dev

. Fro

m S

tead

y S

tate

ω=0.35ω=0.18 (estimate)ω=0.00

36

Inspecting the Mechanism III: Effects of government investment (CES private-public capital)

0 1 2 3 4 5 6 7 8

−0.04

−0.03

−0.02

−0.01

0

0.01

0.02

0.03

0.04

Priv. Investment After Gov. Investment Shock

Quarters

Per

cent

Dev

. Fro

m S

tead

y S

tate

υK=0.25,αK=0.85

υK=0.25

υK=0.84 (estimate)

υK=1.00 (Cobb-Douglas)

υK=1000

Public/private capital substitutes

Public/private capital complements

37

Contribution of Non-Fiscal Shocks

38

Data SHOW ALSO LEVEL DATA

1985 1990 1995 2000 2005 2010−2

0

2

Government ConsumptionP

erce

nt

1985 1990 1995 2000 2005 2010

−10

0

10

Government Investment

Per

cent

1985 1990 1995 2000 2005 2010−5

0

5

Government Debt

Per

cent

1985 1990 1995 2000 2005 2010−5

0

5

Government Transfers

Per

cent

1985 1990 1995 2000 2005 2010−1

0

1

Indirect Tax Revenue / Consumption

Per

cent

1985 1990 1995 2000 2005 2010−0.5

0

0.5

Employer SSC / Wages and Salaries

Per

cent

1985 1990 1995 2000 2005 2010

−0.5

0

0.5

Employee SSC / Wages and Salaries

Per

cent

1985 1990 1995 2000 2005 2010

−2

0

2

Direct Tax Revenue / Wages and Salaries

Per

cent

39

The Great Recession and Euro Area Public Finances