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Are Countercyclical Fiscal Policies Counterproductive?

  • David B. Gordon
  • Eric M. Leeper

Economists generally believe that countercyclical fiscal policies have stabilizing effects that work through automatic stabilizers and discretionary actions. Analyses underlying this conventional wisdom focus on intratemporal margins: how employment and personal income respond in the short run to changes in government expenditures and taxes. But in economic downturns, countercyclical policies increase government indebtedness, raising future debt service obligations. These new expenditure commitments must be financed by some mix of higher taxes, lower spending, or higher money growth in the future. Expectations of how future policies will adjust change current savings rates and the efficacy of countercyclical policies. It is thus possible for responses to expected future policies to exacerbate and prolong recessions. This paper highlights these expectations effects. Connecting the theory to U.S. data we find: (1) through this expectations channel, countercyclical policies may create a business cycle when there would be no cycle in the absence of countercyclical policies; (2) nontrivial fractions of variation in investment and velocity can be explained by variation in macro policies alone---without any nonpolicy sources of fluctuation; and (3) persistence in key macro variables can arise solely from expectations of policy.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11869.

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Date of creation: Dec 2005
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Handle: RePEc:nbr:nberwo:11869
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