Spillovers: Why macro-fiscal policy should be coordinated in economic unions

Gerald Carlino, Robert Inman

24 June 2013

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The recent Great Recession in the US and Europe has generated renewed interest in the management of macro-stabilisation fiscal policy in economic unions. The received wisdom among economists is that such fiscal policies can only be managed efficiently by an overarching central government. Oates, in his classic treatise on fiscal federalism, concludes:

“The case for having the central government assume primary responsibility for the stabilisation function appears, therefore, to rest on a firm economic foundation … local government cannot use conventional stabilisation tools to much effect and must instead rely mainly on beggar-thy-neighbor policies, which from a national standpoint are likely to produce far from the desired results. The central government, on the other hand, is free to adopt monetary policies and fiscal programs involving deficit finance; consequently, the stabilisation problem must be resolved primarily at the central government level” (1972: 30).

Deficits and employment

Deficits by lower-tier governments may stimulate local demand for goods and services, but because those goods and services are produced and traded within the wider union, the impact on local employment is thought to be modest at best. Even if there are increases in local employment opportunities, they may be ‘diluted’ by the entry of workers from another state or country. Because of demand spillovers or worker mobility, therefore, any employment benefits derived from the deficit will accrue to other members of the union, while all future tax costs of the deficit will remain the responsibility of the original local jurisdiction. If so, we have a fiscal-policy spillover and a need for policy coordination managed by the union’s central government.

That’s the theory, but what’s the evidence? Three recent studies of fiscal policy spillovers among countries in the EU and our new work looking for spillovers from state deficit policies among US states reach the same conclusion: Fiscal spillovers from local macroeconomic fiscal policies are significant, both statistically and quantitatively.

In their study of the impact of government purchases on country GDP for a sample of 14 EU countries for the period 1970-2004, Beetsma and Giuliodori (2011) find, first, that an unanticipated shock of €1 to government spending increases GDP in the spending country by €1.2 initially rising to €1.5 in the second year after the shock. Second, these local GDP gains then spill over to benefit their trading partners through increased demand for the traded goods. For the larger EU countries (France, Germany, Italy, Spain and the UK), for every €1 gain in income in the country adopting the fiscal policy leads to a €0.35 gain in income for their trading partners.

Auerbach and Gorodnichenko (2013) find similar fiscal spillovers among a sample 30 OECD economies over the period 1984-2007. They estimate that for a €1 expansionary spending policy by one large economy, the country’s trading partners’ incomes will rise by as much as two to four times a partner’s share in the imports of the original country adopting the expansionary policy. Expansionary fiscal policies raise incomes in the original country and then in those countries from whom it imports goods and services. For example, an import share of 10% will imply a beneficial spillover onto the incomes of a trading partner of between €0.2 and €0.4 for each €1 of original fiscal stimulus.

Hebous and Zimmermann’s (2013) study of 12 EU economies uses a different policy benchmark but reaches the same conclusion: spillovers are important. Their analysis answers the question: does a country benefit by sitting on its hands? The answer is ‘yes’. It is better to let your neighbours run deficits and pay required future taxes and for you to wait for your GDP to rise in response to their expanding economies. If a country’s trading partners increase their deficits by a collective total of €1, then the no-deficit country’s GDP will rise by from €1 to €2.

Recent research

Our recent research of the impact of US state deficit policies on state economies (2013) reaches very similar conclusions. We study the effect of states’ deficits on states’ economies and find that a $1 increase in a state’s deficit implies an average increase of $1.85 in the state’s gross state product (the regional measure for GDP), a fiscal multiplier comparable to that found by Beetsma and Giuliodori for the EU.1 As in the three EU studies, we also find statistically and quantitatively significant spillovers between states from their deficit policies, most importantly between states in each of eight distinct economic regions defined by coincident business cycle movements. Energy states impact other energy states; manufacturing states impact other manufacturing states; farming states impact other farming states; service states impact other service states. Like Beetsma-Giuliodori and Auerbach-Gorodnichenko, the largest economy in the region has a significant effect on the economies of its smaller neighbours. When the largest state in a region increases its own deficit by $1, it stimulates about a $0.9 increase in the combined gross state products of its smaller economic neighbours.2 Like Hebous-Zimmermann, we find that the largest state benefits when its smaller neighbours work in concert and all increase their deficits. An aggregate $1 increase in the deficits of the large state’s neighbours will increase the gross state product in the large state, not increasing its deficit, by $0.6.3 The large state therefore has an incentive to sit on its hands, hoping its smaller neighbours will do the deficit financing.

Which level of government manages macroeconomic stabilisation?

This EU and supportive US evidence finding significant positive spillovers from expansionary fiscal policies by economic neighbours raises the important institutional question of which level of government should manage fiscal policy for macroeconomic stabilisation. When there are important spillovers, the incentive for each lower-tier government in an economic union is to let its important trading partners adopt, and pay for, expansionary deficits. Though larger economies may find it beneficial to run their own fiscal stabilisation policies, they will ignore the job and income benefits those programmes create for their economic neighbours. Thus too little stimulus will be provided relative to a best union-wide policy. Germany rightly asks: why should we pay for fiscal deficits beyond what is best for Germany? If all states, provinces, or Eurozone countries think this way, there will be too little use of beneficial stabilisation policies.

What is needed, then, are coordinated fiscal stabilisation policies decided by an overarching central government. In the case of a full fiscal and political union such as the US this would be central government deficit financing of temporary tax cuts, increased transfer payments, expanded unemployment insurance, and perhaps added infrastructure spending.4 In the case of Europe, the best strategy may be to move more slowly, one well-defined program at a time. One possibility might be a Eurozone-wide unemployment-insurance trust fund specified by the European Parliament and the Council of Finance Ministers and supervised by the European Commission; see for example, Fahri and Werning (2012). Payments into the fund would be from firms, experience-rated by industry and country. Payments from the fund would be to unemployed individuals, limited to a fixed period for benefits. This more modest programmatic approach has the virtue of avoiding all the complications sure to arise in specifying a full fiscal and political union.

Conclusions

The received wisdom has it right. We now have a growing body of empirical evidence that there are important positive spillovers between an economic union’s lower-tier governments in the management of macro-stabilisation policies. As a consequence, coordinated policies will be preferred. Finding programmes and institutions that can best facilitate this coordination is the important next step, both for new and established economic unions.

Disclaimer: The views expressed here are solely those of the authors and do not represent the official position of the Federal Reserve Bank of Philadelphia, the Federal Reserve System, or the University of Pennsylvania.

References

Auerbach, A and Y Gorodnichenko (2013), “Output Spillovers from Fiscal Policy”, The American Economic Review Papers and Proceedings 103, May, 141-146.

Ball, L M, D Leigh, and P Loungani (2013), “Okun’s Law: Fit At Fifty?”, NBER, Working Paper, 18668.

Beetsma, R and M Giuliodori (2011), “The Effects of Government Purchase Shocks: Review and Estimates for the EU”, Economic Journal 121, F4-F32. 

Carlino, G A and R P Inman (2013), “Local Deficits and Local Jobs: Can US States Stabilize Their Own Economies?”, Journal of Monetary Economics (forthcoming), also available as NBER Working Paper 18930.

Farhi, E and I Werning (2012), “Fiscal Unions”, NBER, Working Paper 18280.

Gramlich, E (1979), “Stimulating the Macro Economy Through State and Local Governments”, The American Economic Review Papers and Proceedings 69, May, 180-185.

Hebous, S and T Zimmerman (2012), “Estimating the Effects of Coordinated Fiscal Actions in the euro Zone”, European Economic Review 58, 110-121.

Oates, W (1972), Fiscal Federalism, New York, Harcourt, Brace, Jovanovich.


1 While most US states face balanced budget rules, those rules only apply to the general fund. Our analysis uses a measure of aggregate deficits including the general fund, but also the capital fund and all insurance trust funds. This is the most appropriate definition for evaluating the macroeconomic effects of states budgets on state economies. Also our formal analysis focuses on job growth as it responds to state deficits, but Okun’s Law relating job growth to income growth allows us to estimate the impact of state deficits on state GDP (measured as gross state product, GSP). By Okun’s Law, growth in income equals twice the growth in jobs; see Ball, Leigh, and Loungani (2013). Our estimates suggest a state deficit of $390/person will increase state job growth by 1.2%, implying an increase of 2.4% in GSP. The mean level of GSP in our sample period is $30,000/person. Thus incomes are estimated to rise by $720/person. The implied fiscal multiplier is therefore 1.85 (= $720/$390 = ΔGSP/ΔDeficit).

2 For a $390/person increase in the deficit of the region’s largest state, we predict a gain in job growth of all other states of 3/10 of 1% implying a 6/10's of 1% increase in GSP/person in the smaller states or about $180/person. Aggregating this income gain over all residents in the smaller states and dividing by the aggregate deficit from the one large state implies a spillover income multiplier of .90.

3 If all the neighbors of the largest state raise their state deficits by $390/person, then our analysis predicts a gain in job growth in the largest state of 8/10's of 1%, implying an income gain for the largest state (again by Okun’s Law) of 1.6%. Assuming the large state’s average GSP is $30,000/person implies an income gain of $480/person. Aggregating this income gain over all the residents of the largest state and dividing by the aggregate deficits across all the smaller states implies a spillover multiplier for small state deficits of about .60.

4 The emerging US evidence strongly favors transfers to households as the best means for stimulating the aggregate economy. Infrastructure spending takes time, and if transfers are given to lower-tier governments for such spending, the US experience is that those funds are saved, not spent, by the states. See Gramlich (1979).

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Topics:  Europe's nations and regions Macroeconomic policy

Tags:  fiscal policy, Eurozone crisis

Senior Economic Adviser and Economist in the Research Department, Federal Reserve Bank of Philadelphia

Richard King Mellon Professor of Finance and Economics at the Wharton School, University of Pennsylvania.

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