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The fiscal arithmetic of a slowdown in trend growth

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How does a slowdown in trend growth affect fiscal policy sustainability and household welfare?

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This video discusses a paper examining the fiscal policy implications of slow economic growth in advanced economies, particularly in the context of Australia. The authors began their study around 2018-2019, recognizing a persistent slow recovery post-global financial crisis, which raised concerns about the long-term growth trends.

They aimed to explore whether this slowdown was evident in the data and to develop a framework to analyze the consequences for fiscal authorities. The paper also references historical theories of secular stagnation and incorporates insights from contemporary literature examining productivity growth and innovation.

The initial analysis employs a basic neoclassical model in which households adjust their expectations of future income in response to diminished productivity growth, leading them to save more and eventually increase capital accumulation, which could stabilize the economy in the long term.

As the study progresses, the authors introduce a government sector into their model, comparing two fiscal approaches: one where government spending per capita is fixed and another where it is tied to GDP ratio. They find that the implications of slow growth diverge significantly based on the chosen fiscal policy approach.

The research emphasizes the dangers of maintaining fixed growth rates for government spending during slow growth periods, which can lead to increasing fiscal imbalances and unsustainable debt levels. They argue that fiscal policies need to adapt to these changing economic conditions to avert destabilization.

The application of their findings to the Australian economy reveals that despite favorable conditions post-global financial crisis, a slowdown in growth was still evident, and the study suggests that fiscal authorities must be responsive to structural changes in growth trends to ensure stable economic transitions.

This video also identifies areas for further research, including exploring endogenous growth models and considering the possibility of imperfect information among agents regarding economic changes. Overall, the main takeaway is the critical relationship between growth trends and fiscal policy formulation in maintaining economic stability.

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Context for this paper, came about, like

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around 20 18, 20 19 before Covid hit.

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So, you know, a number of policy institutions

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and EE economies have noticed that,

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following the global financial crisis, the pace of recovery

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of many of these economies of advanced economy was,

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lower than, than than expected or weak.

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So, you know, you could see that in forecasts,

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of the a MF in forecast all productivity growth

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of the Congressional Budget Office

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and, policymakers in Australia.

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Also, note is that GDP growth, seemed to have,

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you know, found a new normal.

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So in, in, in that context, what we, you know, said to,

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study in the question was, well, first to try

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to see whether our, you know, this load and was in the data,

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but that that wasn't our main focus.

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We wanted to first see what the data had to say,

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but then basically we wanted a framework to be able

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to think about what the consequences would be

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for a fiscal authority facing, a slowing economy.

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There was an HHR, back.

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Mean one goes back to the 1930s.

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There was a, a famous paper by Hansen proposing the secular,

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stagnation, story.

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So, you know, that was following, the,

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the Great Depression, in, in the US

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and the anime growth at the time.

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Uh, then, you know, more recently, there's a number

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of papers that you could view, some which have, you know, re

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yeah, re relooked at the,

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secure stagnation, hypothesis, summers and others,

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and then others, which have taken more

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of a supplied side view,

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looking at productivity growth on the pace of innovation

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and how that innovation was trickling down,

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to other industries.

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So there, there, there are, there, you know,

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name that comes to mind is Gordon, you know, looking at,

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at the history of, American productivity

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and, you know, I think most of those studies.

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And then there's a, a range

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of other econom econometric studies that have used

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statistical models to see if they would detect,

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the slowdown, in, in economic activity.

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Uh, so, you know, we we're gonna take, do papers

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and the bulk of the evidence are

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as saying there is a slowdown,

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but there wasn't much literature on assessing

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what the implications of the slowdown

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were for fiscal policy.

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There's a couple of papers that have looked at the impact

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of the slowdown on monetary policy,

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because what you find in, in most, mainstream models is

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that a slow in productivity growth translates into a

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slowdown, sorry, a, a decrease of the rearer, right?

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And as a result, monetary policy ends up operating kind

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of closer to a zero, lower one.

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There were papers, doing that,

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but there wasn't much on, on fiscal policy.

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So that's where, you know, kind of our contribution,

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comes in to understand kind of what happens,

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when there is a slow learning trend growth.

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We start with the, you know, simplest textbook,

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neoclassical framework.

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So that's a very simple framework in which households,

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you know, they, they care about, maximizing utility

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by, by maximizing the path of, of consumption.

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And, and in, in that model, productivity growth,

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growth at a constant rate, governed by, you know,

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a parameter called Z.

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So in that model, what we can do is we, we start, you know,

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in, in, in an economy that actually does not have a

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government, so just households

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and firms, there is a low in productivity.

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And what happens is when households see

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that productivity growth will slow down,

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they revise their expectations of the path of future wages,

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and as a result of the path of future income.

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So basically, future income is lower when productivity

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growth is lower, but that's not the end of the story.

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What happens is households cut consumption

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because they feel poorer,

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but when they cut consumption, they increase savings.

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And all of these savings make their way into increased

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capital accumulation,

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which over time increases the productivity of, of labor.

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So wages do go up.

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And you know what, what, what we find in that model is

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that there is a, an what we call an indulgent of response

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to a slow trend growth that, you know, operates,

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in a way as an automatic stabilizer

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because it, it increases capital accumulation

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and wages, which will then serve

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as tax basis for the government.

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So that's kind of what we first identify in a simple,

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framework.

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What we do next is in this simple framework,

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we add a very simple government sector.

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So they go on sector, all they do is a spend,

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and they collect lump sum taxes to finance that spending.

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And, and then we distinguish, two cases,

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one in which the government or, or,

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or one in which you can think of fiscal policy

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as the government deciding on the provision

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of public goods per capita, right?

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And another case in which

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what the government decides is what's the size

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of government relative to the economy.

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So they, they would say, well, we want government spending

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to be say, 25% of GDP, for example.

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Now, those two, if you wish, fiscal approaches

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have very different implications when there is a

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slow on in trend growth.

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Because what happens is, as if we go back to

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what we just described, the slow on happens,

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capital accumulation increases, and as

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A result, income per capita goes up

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because capital accumulation is increasing.

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But if then one takes the case in which the,

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government sector is just keeping the provision

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of public goods per capita fixed, what's going to happen is

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that this increasing income per capita is just going

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to pull down the government,

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the government spending to, to GDP ratio in the economy.

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In the other case, well, the government will have maintained

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a fixed, government spending to output ratio.

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But if output is going up,

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then the government is also increasing the provision

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of public goods, per capita.

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So, you know, we do distinguish these two cases,

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and then we, we take those two cases to the data with the,

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more, yeah, realistic or, or,

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or, appropriate model for the Australian economy.

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So what we do is from, from there, we, from

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that simple model, we get the intuition.

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But in that simple model, there are many,

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important elements which are missing,

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like importantly, public debt.

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So there's no government debt,

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and, we were only considering lump sum taxes in the

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richer model, if we have a model in which the government can

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collect taxes from labor income, from capital income,

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from consumption expenditures,

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and, they also have access to, to public debt,

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the long term, government debt.

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So then you, there's a richer, set of possibilities

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that, that the government has, in that,

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richer framework I describe were two fiscal approaches in

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which, basically fiscal policy responds in a way

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that the economy, has an equilibrium

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after the slowdown in trend growth.

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What we, what became clear in the study,

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and for me it's one of the important messages

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for policymakers of our paper, is that if one thinks

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of fiscal policy rules in terms of growth rates, so

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that say the government would be cha chosen, a growth rate

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for, government spending or,

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or a growth rate for tax revenues,

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those rules are potentially dangerous if the economy's

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experiencing these regime changes in trend growth.

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So there's a slowdown in trend growth,

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and the government insists on a path of government spending

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that is inconsistent with this lower growth rate.

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What we find is that, you know, there is no, stable,

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equilibrium because those policies imply

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of an ever increasing, fecal imbalance

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that translates into explosive debt dynamics.

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But the model is good in telling you those are things you

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shouldn't do.

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Um, sorry, having said that, to, to your other question

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of how we apply this to a, Australia is an open economy,

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and, it's a small open economy that basically,

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takes the real world interest rates are given.

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So what we do is we set up a version of this stochastic,

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of this new classical, growth economy.

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Uh, we take a, an open economy version in which there's,

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capital and labor, just like in the, in the textbook case,

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as I said, the fecal authority there has a range

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of, tax rates.

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And what we do is then estimate the model on,

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believe 11,

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of observable s So we have consumption growth,

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believe GDP growth, real interest rates, net exports

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to GDP gold spending

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to GDP tax revenues from the different sources

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and the foreign, real interest rate.

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And on that data, what we do is we allow,

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the estimation to pick up if the data so wanted,

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as, a decrease in trend growth.

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We don't impose it, but we have the data either a decrease

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and the data detects a decrease prior

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to the global financial crisis.

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I think the num precise numbers are in the paper,

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but it's a bit before, 8, 0 7,

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which is also consistent with, findings

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that other authors have found for the US economy.

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So now we thought that, that part of the paper, well,

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let's establish what the magnitude is,

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from Australian data.

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And we also think that Australia,

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now we're showing the paper that the, the, the pattern

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of slowing growth has also been a feature of the uk,

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New Zealand, Canada,

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and a number of other advanced, small open economies.

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But what we thought was also compelling

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of the Australian case is

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that Australia did very well following the

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global financial crisis.

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It was an economy that didn't, fall into recession.

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At the same time,

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the economy benefited from an increase in, in its terms

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of trade through, increased demand from China.

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So it had a lot of favorable, conditions,

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and still we detected, a slow down.

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I think one of the main, implications is that, you know,

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if the economy experiences this, structural shifts

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or these changes in, in regime, like, you know,

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moving from a high growth to, to allow growth, you know,

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the first, implication is

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that the fecal authority must respond to

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that change somehow.

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And, and,

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and then the way it responds will determine, you know,

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what the transition from one equilibrium

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to a new equilibrium is

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and what the properties of that,

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new equilibrium looks like.

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So in our baseline estimation, you know,

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we take the case in which,

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e essentially we allow the government spending

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to output ratio to fall.

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And then what we detected is that that comes hand in hand

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with, a, a a a cut in in labor income taxes.

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So this, this happened in the late,

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and also an increase in, in capital income taxes.

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So there were a number of, you know, changes

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to the superannuation concessions

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and, other changes to the treatment of depreciation

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that our model would pick up

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as an increasing in capital taxes.

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So those are baseline,

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but in that baseline, you know, we keep the debt

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to GDP ratio, as a constant target.

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So essentially, as the economy travels from one state state

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to the next, what happens is that government spending

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to output falls by, over one percentage point,

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but then this implies tax cuts for, labor income

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and some increases for, capital income taxes.

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Now, then we compare that baseline to other,

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possibilities that the, government could have, used.

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And one, which is very, striking is that

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what the government could have done is increase the,

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debt to output ratio.

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So when the governments, governments pending

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to GP falls, you know, a, a, a possibility to use the,

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the, the extra surplus just to finance increasing,

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interest rates on a higher level of public debt.

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But then that transition looks very different

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because if the government is going to change its target

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to output ratio, then it needs to open up in a transition,

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a much larger deficit to get the date up.

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Uh, so now what's interesting in that case is that,

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you know, what might, yeah,

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or at least what I've learned, from the paper was my,

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my initial, my preconceptions

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as I was getting into this study was,

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clearly a slow entering growth has

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to be very bad, for the economy.

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And the first thing that comes out is that it is bad

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for measures of household welfare.

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Clearly, everyone's worse off if productivity grows

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as a slower way.

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But from the perspective of fiscal policy,

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this indu Indogenous response that we were talking about

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operates as an automatic stabilizer,

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and it can give rise to what in the paper we call a,

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a plea fecal arithmetic

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because it comes hand in hand with the need to cut taxes,

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or if you're increasing public debt

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and you don't cut taxes,

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then the government has a period in which

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to increase the public debt, it can run,

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higher deficits.

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So I said we, we've done this in the context of,

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of the standard or mainstream neoclassical model in which

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productivity growth is exogenous.

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And you were asking me about, areas for future research.

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So one interesting area would be to consider a, a similar,

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similar question,

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but in the context of models of, so-called models

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of indogenous growth in which the growth rate

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of the economy is not just, you know, pinned down

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by a single parameter that is exogenous,

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but it's a function of ma many parameters, you know, the

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fraction of the population that does research

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and development and, patterns of human capital

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accumulation as well.

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So I think that's an open area, which is, well,

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in those malls, the growth rate is a function of many

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other features of the economy

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that in principle could interact

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with fiscal policy in interesting ways.

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So I think that's clearly, an important, area

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where more research, would be useful.

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The other, important assumption of our study is

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that when this changes in the regime happen,

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the agents in the economy know what's happening.

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So there is a slow down,

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and households revise their expectations of future income.

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They cut consumption, and these triggers the

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forces we were discussing.

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Now, in reality, it's possible that, you know,

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there's a period in which agents are learning what's going

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on, and that maybe they're not fully rational

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or completely informed about these changes.

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And in those cases, you could have situations in which,

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you know, these, the faults in consumption and, and,

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and, and,

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and the triggering

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of the automatic stabilizer may take a while

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until agents realize what's going on.

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But again, we started this under the standard assumption of,

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full information, rational expectations.

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So I think that could be another, interesting avenue

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for future research.

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