Joint estimates of automatic and discretionary fiscal policy for the OECD

Official calculations of automatic stabilizers are seriously flawed since they rest on the assumption that the only element of social spending that reacts automatically to the cycle is unemployment compensation. This puts into question many estimates of discretionary fiscal policy. In response, we propose a simultaneous estimate of automatic and discretionary fiscal policy. This leads us, quite naturally, to a tripartite decomposition of the budget balance between revenues, social spending and other spending as a bare minimum. Our headline results for a panel of 20 OECD countries in 1981-2003 are .59 automatic stabilization in percentage-points of primary surplus balances. All of this stabilization remains following discretionary responses during contractions, but arguably only about 3/5 of it remains so in expansions while discretionary behavior cancels the rest. We pay a lot of attention to the impact of the Maastricht Treaty and the SGP on the EU members of our sample and to real time data.Fiscal stabilization, automatic stabilizers, discretionary policy.

TRADE COSTS, TRADE BALANCES AND CURRENT ACCOUNTS: AN APPLICATION OF GRAVITY TO MULTILATERAL TRADE

In this paper we test the well-known hypothesis of Obstfeld and Rogoff (2000) that trade costs are the key to explaining the so-called Feldstein-Horioka puzzle. Our approach has a number of novel features. First, we focus on the interrelationship between trade costs, the trade account and the Feldstein-Horioka puzzle. Second, we use the gravity model to estimate the effect of trade costs on bilateral trade and, third, we show how bilateral trade can be used to draw inferences about desired trade balances and desired intertemporal trade. Our econo-metric results provide strong support for the Obstfeld and Rogoff hypothesis and we are also able to reconcile our results with the so-called home bias puzzle.Feldstein-Horioka puzzle; trade costs; gravity model; home bias puzzle; current account; trade balance

Trade Costs, Trade Balances and Current Accounts: An Application of Gravity to Multilateral Trade

In this paper we test the well-known hypothesis of Obstfeld and Rogoff (2000) that trade costs are the key to explaining the so-called Feldstein-Horioka puzzle. Using a gravity framework in an intertemporal context, we provide strong support for the hypothesis and we reconcile our results with the so-called home bias puzzle. Interestingly, this requires a fundamental revision of Obstfeld and Rogoff’s argument. A further novelty of our work is in tying bilateral trade behavior to desired aggregate trade balances and desired intertemporal trade.Feldstein-Horioka puzzle, trade costs, gravity model, home bias puzzle, current account, trade balance

Five minutes with Jacques Melitz: “The discontented members of the Eurozone should consider very seriously the creation of a second euro”

Since the height of the Eurozone crisis, a number of reforms have been pursued to stabilise the economic situation in states using the single currency. In an interview with EUROPP’s editor Stuart Brown, Jacques Melitz outlines why the Eurozone is still suffering from two key problems – the European Central Bank’s inability to engage in proper open market operations and the lack of joint-responsibility for the banking system. He argues that, given the inflexibility of Germany, the discontented Eurozone members should give serious consideration to the possibility of creating a ‘second euro’ as an alternative

Pigou and the "Pigou Effect": Rendez-Vous with the Author

This article attempts to show that Pigou does not rely on the "wealth effect" in his attack on the doctrine of "unemployment equilibrium" with flexible money wages (a doctrine which, incidentally, he never considers clearly Keynesian). Instead, he depends on a form of "substitution effect," hinging on a change in the "convenience yield" on money relative to the yield on physical capital. This particular line of thought is much closer than the "wealth effect" to the sort of reasoning concerning stock adjustments to differences in yields which has become popular today. In this view of Pigou's position, the principal mechanism in his work for restoring full employment under flexible wages is the "substitution" rather than the "wealth effect" of wage-price reductions. The "substitution effect" requires a mere rise in the ratio of real money to real wealth, while the “wealth effect” requires a rise in real wealth

Friedman and Machlup on the Significance of Testing Economic Assumptions

This article questions Milton Friedman’s methodological position in a famous essay dating to 1948 where he questions the validity of tests of the assumptions of economic theory. Valid tests, he maintains, by and large, concern the empirical implications of hypotheses derived from the theory. The truth or falsehood of assumptions is “largely irrelevant.” In response, this article argues that Friedman’s position is questionable but for different reasons depending on the nature of the assumptions. “Auxiliary assumptions” concern the environment in which the test is supposed to take place. “Generative assumptions” concern the postulates or theorems from which the hypothesis is derived. If auxiliary assumptions are false, all test results bear less weight, whether are confirmatory or disconfirmatory. If generative assumptions are false, positive results confer less confirmation on the hypothesis. The article further questions Friedman’s famous proposal to treat the assumptions of economic theory as “as if” statements, which are not really supposed true but simply taken for granted. The article goes on to question a related one by Fritz Machlup agreeing with Friedman about the irrelevance of tests of “generative assumptions.” Unlike Friedman, however, Machlup stands on the authority of philosophers of science, who, he claims, maintain that theoretical postulates in science should be regarded as “rules” that must be followed

Sidgwick's Theory of International Values

Henry Sidgwick (1838-1900) is generally believed to have rejected the classical theory of comparative costs. He supposedly maintained, contrary to the classical view, that transportation costs instead of international factor immobilities were the primary basis for a special theory of international values. It is argued in this article that Sidgwick did not contest the classical theory of international values. He merely opposed John Stuart Mill's case for introducing the "equation of reciprocal demand" in international trade theory. Whereas Mill believed that the use of the "equation" was required by international factor immobilities, Sidgwick attributed the need for it mainly to transportation costs

Non-Discretionary and Automatic Fiscal Policy in the EU and the OECD

Official adjustments of the budget balance to the cycle merely assume that the only category of government spending that responds automatically to the cycle is unemployment compensation. But estimates show otherwise. Payments for pensions, health, subsistence, invalidity, child care and subsidies of all sorts to firms respond automatically and significantly to the cycle as well. In addition, it is fairly common to borrow official figures for cyclically adjusted budget balances, divide by potential output, and then use the resulting ratios to study discretionary fiscal policy. But if potential output is not deterministic but subject to supply shocks, then apart from anything else, those ratios are inefficient estimates of the cyclically-independent ratios of budget balances divided by potential output. (A fortiori, they are inefficient estimates of the cyclically adjusted ratios of budget balances to observed output.) Accordingly, the paper provides separate estimates of the impact of the cycle on the levels of budget balances and the ratios of budget balances to output. In addition, it discusses the relation between the two sorts of estimates. When the focus is on ratios of budget balances to output, the cyclical adjustments depend more on inertia in government spending on goods and services than they do on taxes (which are largely proportional to output). But they depend even still more on transfer payments. Besides calling for different series for discretionary fiscal policy if ratios serve, these results also raise questions about the general policy advice to 'let the automatic stabilizers work.

Sidgwick's Theory of International Values

Henry Sidgwick (1838-1900) is generally believed to have rejected the classical theory of comparative costs. He supposedly maintained, contrary to the classical view, that transportation costs instead of international factor immobilities were the primary basis for a special theory of international values. It is argued in this article that Sidgwick did not contest the classical theory of international values. He merely opposed John Stuart Mill's case for introducing the "equation of reciprocal demand" in international trade theory. Whereas Mill believed that the use of the "equation" was required by international factor immobilities, Sidgwick attributed the need for it mainly to transportation costs