Fiscal Policy Ineffectiveness in the Interwar Period

Gregor Smith forwards me this paper (coauthored with Nicolas-Guillaume Martineau) that estimates the impact of government spending growth on real GDP growth, using data from a cross-section of countries during the interwar period 1920-1939. Here is their abstract:

Differences across countries or decades in the countercyclical stance of fiscal policy can help identify whether the growth in government spending affects output growth and so speeds recovery from a recession. We use the heterogeneity in the government-spending reaction functions across twenty countries in the interwar period to identify this effect. The main finding is that the growth of government spending did not have a significant effect on output growth, so that there is little evidence that this central aspect of fiscal policy played a stabilizing role from 1920 to 1939.

As usual, a lot depends on the plausibility of the identifying assumptions employed.

The limitations of the data, in frequency and coverage, may prevent us from reaching a precise answer about the efficacy of fiscal policy, but it is still of interest to know whether that is the conclusion. Of course, the answer and its precision depend on an identification scheme. This paper adopts a new one: the main identifying assumption is that countercyclical fiscal policy could have worked in any country but was not tried to the same extent in every country. Identification relies on differences across countries (or over time) in fiscal reaction functions that capture the response of government spending to national income. We use these differences to estimate the effect of this government spending on the growth of income in turn.

The authors conclude (in a rather provocative and un-Canadian manner, I might add), that the evidence over this period fits better the infamous “Treasury view.”

If you have some thoughts to share on their identification scheme and/or interpretation of their results, please feel free to comment. I’m sure the authors would appreciate your feedback.

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About David Andolfatto 95 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

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