Chapter 4. Fiscal Multipliers: How Will Consolidation Affect Latin America and the Caribbean? Regional Economic Outlook: Western Hemisphere May 2018

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1 Regional Economic Outlook: Western Hemisphere May 2018 Chapter 4 Fiscal Multipliers: How Will Consolidation Affect Latin America and the Caribbean? Yan Carrière-Swallow, Antonio David, Daniel Leigh & Jorge Restrepo 1

2 Outline Motivation Method Results Implications 2

3 Motivation Public revenue from commodities fell sharply during Primary deficits currently exceed debt-stabilizing levels causing rising public debt and eroding fiscal space ARG BOL CHL COL ECU MEX PER TTO Primary balance, 2017 (% GDP) Peru Colombia Debt-stabilizing primary balance LAC Gross Public Debt (% of GDP) (% GDP) Sources: IMF, World Economic Outlook database; and IMF staff calculations. Note: LAC aggregate corresponds to US dollar nominal GDP-weighted 3 average of 14 LAC countries. Chile Mexico Uruguay Brazil

4 Motivation How painful will the adjustment be? Intrinsically related to question of the size of fiscal multipliers. Theory provides an ambiguous guide on relative size of multipliers in emerging economies (structural characteristics). Some factors suggest higher multipliers. Ex: larger share of financially constrained agents. Other factors point to lower multipliers. Ex: higher sovereign default risk perceptions; Flexible exchange rates. 4

5 Motivation Empirical studies have typically found small multipliers for LAC 1.6 Latin America and the Caribbean Other EMDE Advanced economies Sources: IMF staff estimates of density functions based on a survey of 132 empirical estimates in the literature. Note: EMDE = emerging market and developing economies. 5

6 Method Identify fiscal shocks in LAC using three methodologies: i. SVAR (Blanchard & Perotti, 2002) Requires good quarterly fiscal data: 8 LAC countries from mid-1990s. ii. Narrative approach (Romer & Romer, 2010) David & Leigh (2018) build for 14 LAC countries since iii. Real-time forecast errors (Auerbach & Gorodnichenko, 2012 & 2013) Most WEO countries since 1990; 19 from LAC. 6

7 Method Estimate cumulative multipliers using a common machinery that will generate comparable results across sets of fiscal shocks. Local projections panel specification: tt+h yy cc,tt+h yy cc,tt 1 = αα cc + γγ tt + ββ h ss=tt SSSSSSSSS cc,ss + δδxx cc,tt + εε cc,tt h yy cc,tt+h : Log real GDP αα cc : Country fixed effects γγ tt : Time fixed effects SSSSSSSSS cc,ss : Identified fiscal shock ββ h Cumulative GDP multiplier at horizon h. Following fiscal actions worth 1% of GDP over t to t+h, how much does real GDP change over the same period? XX cc,tt : Vector of country-specific controls: Lagged real GDP growth Lagged fiscal shocks Growth rate of commodity export value (and lags) 7

8 Macro effects of fiscal consolidation Narrative consolidations: LAC real variables respond in line with advanced economies Output falls by about 1% unemployment rises the real exchange rate depreciates and the current account balance adjusts t 1 t t + 1 t + 2 t 1 t t + 1 t + 2 t 1 t t + 1 t + 2 t 1 t t + 1 t + 2 LAC Advanced economies Note: Based on panel estimations where fiscal shocks are identified externally using the narrative approach (David & Leigh, 2018). +/- 1 HAC standard error. 8

9 Macro effects of fiscal consolidation Narrative consolidations: Are they more painful during recessions or periods of slack? Impact on real GDP; negative output gap LAC: Slump Impact on real GDP; positive output gap LAC: Boom percent percent Year Year Note: Based on panel estimations where fiscal shocks identified externally using the narrative approach (David & Leigh, 2018). +/- 1 HAC standard error. 9

10 Macro effects of fiscal consolidation Narrative consolidations: Signs of confidence effects? Impact on real GDP; by level of perceived sovereign risk High risk Low risk t 1 t t + 1 t + 2 Note: Based on panel estimations where fiscal shocks identified externally using the narrative approach (David & Leigh, 2018). +/- 1 HAC standard error. 10

11 Macro effects of government spending Comparing identification strategies: Range of estimates for LAC expenditure multiplier Estimates of expenditure multipliers across methods are in line with multipliers for tax hikes (unlike in AEs) Forecast errors SVAR Narrative t 1 t t + 1 t Spending range Tax 1.5 t 1 t t + 1 t + 2 Note: Identification of shocks to primary expenditure using forecast errors in WEO vintages (Furceri & Li, 2017), country-by-country SVAR models (Blanchard & Perotti, 2002), and the narrative approach (David & Leigh, 2018). 11

12 Macro effects of government spending Forecast error surprises: Are spending multipliers affected by the composition of cuts? Primary expenditure Public investment 2.0 t 1 t t + 1 t + 2 Note: Estimates based on identification of fiscal actions using forecast errors for a sample of 19 LAC countries. Shaded area indicates +/- 1 HAC standard error. 12

13 Likely impact of fiscal adjustment on GDP Most countries expected to improve their CAPB during and this is expected to hurt output over this period MEX CRI DOM PER URY BRA LAC COL CHL ARG ECU MEX Range for typical composition If all through cuts to public investment CRI DOM PER URY BRA LAC COL CHL ARG ECU Sources: IMF, World Economic Outlook database; and IMF staff calculations. Note: LAC aggregate corresponds to US dollar nominal GDP-weighted average of 14 LAC countries. For Ecuador, we exclude petroleum revenue and a oneoff payment to Occidental Petroleum in

14 Implications for Debt Dynamics dd tt = 1 + rr(pppp tt) 1 + gg(pppp tt ) dd tt 1 pppp tt dd tt cc = 1 + rrcc 1 + gg cc dd tt 1 pppp tt cc When does the Debt/GDP increase with a contractionary fiscal shock (dd tt cc dd tt >0)? 14

15 Implications for Debt Dynamics Assume pppp cc tt = pppp tt +εε tt ; εε tt = 1% of GDP; and rr gg, for a bad outcome (dd cc tt dd tt >0) we need: 1 ββ > 1 + rr cc 1 + gg cc dd tt 1 εε tt dd tt 11 Multiplier LAC Aggregate Low debt case

16 Implications A range for fiscal multipliers in Latin America and the Caribbean is between 0.5 and 1.1: Somewhat larger than what has been found in previous work. Multipliers in LAC look similar across states of the business cycle (recession, expansion) Periods of high-sovereign default risk are opportune moment for consolidation: Contractionary effects are mitigated. Expenditure multipliers vary by composition: Multiplier is larger for public investment; near zero for public consumption. For LAC parameters, multiplier estimates suggest that self-defeating short-run debt dynamics are very unlikely. 16

17 Regional Economic Outlook: Western Hemisphere May 2018 Chapter 4 Fiscal Multipliers: How Will Consolidation Affect Latin America and the Caribbean? Yan Carrière-Swallow, Antonio David, Daniel Leigh & Jorge Restrepo 17

18 Additional Slides 18

19 Narrative Consolidations (% of GDP) density

20 Identified Shocks Pairwise Correlations Packages Spending Tax Narrative Packages 1.00 Spending Tax Forecast errors Narrative Forecast errors SVAR CAPB Primary Primary Expenditures Consumption Investment Expenditures Change Primary expenditures Consumption Investment SVAR Primary expenditures CAPB Change

21 Impact on Inequality Change in Gini coefficient following fiscal action t 1 t t + 1 t + 2 t + 3 t + 4 t + 5 Market income Disposable income 21