Hysteresis and Fiscal Policy Philipp Engler (DIW Berlin) and Juha Tervala (University of Helsinki)

Motivation Model Simulations Conclusions Overview Results without hysteresis Results with hysteresis Conclusions

Motivation Recessions may have a permanent effect on output Ball (2014): most countries suffered from a hysteresis effect after the global recession of 2008-2009 (23 OECD countries) Blanchard et al. (2015): Two thirds of countries suffered from hysteresis over past 50 years (sample: 23 OECD countries)

Motivation

Motivation Summers (2015) criticizes DSGE models and New Keynesian macroeconomics because they ignore hysteresis Yellen (2016): hysteresis and the possibility it might be reversed can have important implications for the conduct of fiscal policy Blanchard and Summers (1986): Hysteresis in unemployment Fatas and Summers (2016): we need a broader concept of hysteresis that allows a temporary downturn to affect productivity and capital accumulation dynamics

Motivation Anzoategui et al. (2016): in the recent productivity slowdown, labor productivity declined by 7 percentage points relative to the trend TFP declined by roughly 5 percentage points relative to the trend Weak demand explains 4.75 percentage points of the TFP slowdown and most of the 7 percentage points decline in labor productivity A drop in capital intensity after 2009 mainly accounts extra the drop in labor productivity relative to TFP This suggests that endogenous changes in TFP caused by a weak demand is the most important factor of hysteresis

Persistent TFP changes at the core of our analysis Motivation Substantial TFP declines relative to pre-recession trends Persistent TFP changes at the core of our analysis

% change relative to the initial steady state Motivation Our approach: Endogenous TFP in otherwise standard DSGE model The production function with and TFP Learning by doing % change relative to the initial steady state

Motivation Consequences: A temporary recession has a long-lasting effect on output Fiscal policy has a long-lasting effect on output through TFP Preview of Results: Output multipliers significantly larger Hysteresis has profound implications for the conduct of fiscal policy

The model Standard New Keynesian DSGE model of two countries: Home and Foreign countries of equal size A 2-country model to have an entirely demand-driven source for a recession Representative households maximizing utility Imperfect competition in the goods market Sticky prices, à la Calvo (1983) Central Banks follow Taylor rules Government spending financed by lump-sum taxes, balanced budget

The model The domestic household maximizes Time preference shock The domestic household maximizes subject to with Our scenario: a foreign time preference shock causes a global recession (roughly 1% drop in domestic output)

The model Firm z has profits and produces with Maximizes profits s.t. demand function and the Calvo constraint.

The model Fiscal policy: The government pays public consumption with lump-sum taxes: Monetary Policy: Balanced budget Public spending: an exogenous AR (1) process a pure inflation targeting rule with interest rate smoothing

The model: Parameters

The model: Parameters A foreign shock drives the home economy into a recession and the home government implements a fiscal expansion of 0.5% of GDP Rawdanowicz et al. (2014): the hysteresis parameter, the effect of one percentage point of the negative output gap on reducing potential output, is 0.1 for the U.S. and 0.3 for the euro area DeLong and Summers (2012): the hysteresis parameter, a proportional reduction in potential output from a temporary downturn, is 0-0.2 Our model: the proportional reduction in output in the 20th period to first-period output is 0.13

Simulations: Results without hysteresis Model mechanics A foreign recession reduces domestic exports and output A temporary demand shock, a temporary recession Economies return to the initial steady state Fiscal expansion limits the size of a recession

Simulations: Results without hysteresis

Simulations: Results WITH hysteresis Model mechanics: Same as above + a long-lasting TFP decline → a long-lasting fall in potential and actual output Fiscal policy: Much more effective! Additional channel: public spending ↑: employment today ↑: TFP in the next period ↑: output ↑: lifetime consumption ↑

Simulations: Results WITH hysteresis

Fiscal output multipliers Cumulative multiplier (16 quarters): Net present value multiplier (a long-term view): Fiscal output multipliers measure the increase in output caused by fiscal policy, over the change of fiscal policy WITHOUT Fiscal Expansion

Welfare multipliers Welfare measure: The welfare multiplier of fiscal policy as the change in aggregate welfare, in consumption equivalent terms, for a one unit change in public spending If the welfare multiplier is 0.5 One euro spent by the government raises domestic welfare by the equivalent of 0.5 euros of private consumption Households are willing to pay 0.5 euros for a one euro rise in public spending

Fiscal multipliers Without hysteresis Output multipliers are small Welfare multipliers are always negative: No reason for a fiscal expansion in a recession

Fiscal multipliers Hysteresis changes the effects of fiscal policy Output multipliers rise significantly Welfare multipliers are positive

Hysteresis in the Euro area recession of 2012-2013

Fiscal consolidation measures in the euro area in 2011-2013 Data: TFP fell in the recession of the 2010s and it was 1.1% below trend in 2013 Data: Output was 4.8% below the trend in 2013 Gechert et al. (2015): cumulative discretionary fiscal consolidation in the euro area in 2011-2013 were 3.9% of output Our results: this reduced output and TFP by 4.0% and 0.9%, respectively, relative to the no-consolidation baseline by 2013 Fiscal consolidation may explain the majority of TFP's and output's deviation from the trend in 2013 Hysteresis implies that the damage of fiscal consolidation is not limited to the short term because of its substantial medium- and long-term effects. Fiscal consolidation may have been a mistake, but mono-causal explanations that austerity can be blamed for everything is wrong

Conclusions Yellen (2016): hysteresis and the possibility it might be reversed can have important implications for the conduct of monetary and fiscal policy Reifschneider et al. (2015): optimal monetary policy becomes more accommodative in the presence of hysteresis Our findings: Accommodative fiscal policy is not desirable in the absence of hysteresis Accommodative fiscal policy becomes desirable in the presence of hysteresis Hysteresis has more profound implications for the conduct of fiscal policy than to monetary policy