Page 64 - ES 2020-21_Volume-1-2 [28-01-21]

Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa! 47

(iii) Through expectation multiplier by building confidence in tough times: Governments adopting
counter-cyclical fiscal policy are able to credibly exhibit their commitment to sound fiscal
management. As a result, rational agents in the economy would expect the economy not to
fluctuate as much and therefore their private actions would reinforce this, in turn enabling
stronger macroeconomic fundamentals (Konstantinou and Tagkalakis (2011), Alsina et al.
(2014)).

Numerous studies in economic literature establish this relationship both theoretically and
empirically. Ozkan and McManus (2015) study the impact of cyclicality of fiscal policy on
macroeconomic outcomes for 114 countries over 1950–2010 and establish that following a pro-
cyclical fiscal stance leads to lower economic growth, higher volatility in output and higher levels
of inflation. In contrast a counter-cyclical fiscal policy stance with policy actions against the cycle
acts as a stabiliser by reducing output volatility and keeping growth on a steady path. Similarly
a study by Kharroubi and Aghion (2008) shows that industries have grown faster in economies
where fiscal policy has been more countercyclical, both in terms of output and productivity.

For India, in the current scenario, when private consumption, which contributes to
54 per cent of GDP is contracting, and investment, which contributes to around 29 per cent is
uncertain, the relevance of counter-cyclical fiscal policies is paramount. In fact as Krugman
prescribed, a sustained, productive program of permanent stimulus directed towards public
investment, in both physical and human capital, is the need of the hour (Krugman 2020).

Box 2: Higher Fiscal Multipliers During Economic Slowdown

Most studies aimed at estimating the variation in effects of fiscal policies with country’s
position in the business cycle, concur that the fiscal policies are considerably more effective in
recessions than in expansions (Barro and Redlick (2011), Auerbach and Gorodnichenko (2012),
Fazzari et al. (2015), Ramey and Zubairy (2015)). Auerbach and Gorodnichenko (2012(i), (ii)) in
their seminal paper show large differences in the size of spending multipliers in recessions and
expansions for the OECD countries and the US, with higher fiscal multipliers during recessionary
regimes. These results are maintained after allowing for different multipliers for different
components of government spending. They derive the point estimates of the maximum output
multiplier (over the first 20 quarters) is estimated to be 0.57 during expansions and 2.48 during
recessions in the US.

Riera-Crichton, Vegh and Vuletin (2014) condition the fiscal policy on both the state of
the business cycle, and the sign/size of the fiscal intervention, and find that fiscal expansions
in recessions are much more expansionary than fiscal expansions in booms. Jorda and Taylor
(2016) use the propensity-score based methods for time series data to show that a one per cent
of GDP fiscal consolidation translates into a loss of 4 per cent of real GDP over five years
when implemented in a slump, and just 1 per cent in a boom.

Different studies attribute this phenomenon of counter-cyclicality of the fiscal multipliers to
different channels. Some of these are: