Accueil / Nouveau ! New !

Paper - Should We Forsake Automatic Stabilisers ?

In Government Size and Output Volatility : Should We Forsake Automatic Stabilization ?, Bruegel Working Paper 2008-01 (also available as DG ECFIN Economic Paper-> 316), April 2008, joint we Xavier Debrun and André Sapir, we revisit the relationship between government size and output volatility.

Prior to the launch of the euro, academics and policymakers were concerned that the loss of the monetary policy instrument would deprive participating countries of a vital tool to respond to country-specific economic shocks. This concern was rooted in the generally accepted proposition that market-based adjustment channels-i.e. labor mobility and capital flows-tended to be weaker among euro area countries than among regions of existing monetary unions such as the United States.

Against this background, it was hoped that European countries could rely on the stabilizing role of large government sectors to smooth fluctuations -the so-called automatic stabilizers. Those stabilizers were generally considered as having contributed significantly to the decrease of output volatility witnessed in Europe and in the United States after World War II, when the size of governments increased substantially on both sides of the Atlantic. This view was supported by a seemingly robust and well-documented stylized fact : that countries with large governments tended to exhibit more macroeconomic stability.

However in the 1980’s and the 1990’s the US and most European countries experienced a sharp slowdown in output volatility - the so-called great moderation - without having experienced any significant increase in the size of government. In this paper, we start by reviewing and bringing together the two strands of the literature. This highlights that while government size contributes to macroeconomic stabilization, it can be substituted by monetary policy and financial development. Indeed, what accounts for the great moderation (apart from luck) seems to be a combination of monetary policy improvements and financial developments.

We therefore look at both the cross-section and time-series evidence and find that although in the 1970’s and the 1980’s output volatility was larger in big-government countries, this relationship seems to have vanished in the 1990’s, especially in relatively closed economies. Bivariate analysis confirms that the correlation does not hold anymore after 1995 because the decline in volatility was especially pronounced for small-government countries. An analysis of which components of spending account for the decline in aggregate volatility in the US and four major European economies confirms that reduction in the variance of primary income, rather than government transfers, played the main role.

The next step is to proceed with econometric analysis. We start by replicating previous estimates and find again that the negative relationship between government size and output volatility was strong prior to 1990 but vanishes afterwards. We next introduce financial development and the quality of monetary policy as two other determinants of output volatility and find that they do contribute to reducing it. We also find evidence of substitutability between automatic stabilization and monetary policy. Our next step is to check how these alternative determinants interact with government size, that is, whether for example the quality of monetary policy is more important as a determinant of aggregate volatility when the government is small. We do find that this is the case, especially for monetary policy. This supports the idea that other channels of stabilization can be found (and have been found) in small-government countries. Finally, we provide an estimate of the stabilization gain from an increase in government size and find that it decreases as the size of government grows. Specifically, we find that a one percentage point increase in the size of government is unlikely to yield a reduction in output volatility exceeding 0.1 percentage point once public expenditures reaches around 40% of GDP. This suggests that the impact of a marginal change in the size of government is bound to be very small for most countries in the euro area.