Two decades ago, Sweden undertook a significant fiscal expansion to counter a growing recession. The cyclically adjusted primary balance went from a surplus of 3.5% of gross domestic product (GDP) to a deficit of 6.5% of GDP in three years. Government debt trebled to 70% of GDP. Conventional Keynesian theory would suggest that a large fiscal expansion would stimulate growth, and have a positive multiplier effect on private demand.
Exactly the opposite happened. Private consumption and investment crashed in response to the fiscal expansion. The magnitude of their collapse swamped the initial fiscal stimulus, resulting in a contraction of output. The fiscal multiplier was negative, and Sweden experienced a contractionary fiscal expansion.
Illustration: Jayachandran / Mint
A few years before, Denmark and Ireland engaged in sharp fiscal consolidations. Far from depressing private economic activity, both consolidations led to a sharp boom in private consumption and investment. In each case, private demand reacted in the opposite direction to the fiscal impulse—contrary to Keynesian theory—resulting in a highly muted or negative fiscal multiplier.
These episodes are not unique or anomalous. Several industrialized countries have experienced negative fiscal multipliers. More importantly, International Monetary Fund (IMF) studies have documented the growing existence of non-Keynesian outcomes even in low- and middle-income countries. What’s driving these outcomes? And why should Indian policymakers care?
Econometric studies have demonstrated that non-Keynesian outcomes typically appear under certain conditions: First, fiscal policy’s impact on growth is highly non-linear. Small, intermittent fiscal impulses generate Keynesian impacts, but large and persistent ones often generate non-Keynesian outcomes. Second, initial conditions matter. Fiscal impulses initiated during “adverse times” (that is, when public debt-to-GDP is high) often have a non-Keynesian impact. Why? There are two primary transmission mechanisms.
The first works through the interest rate. A fiscal expansion typically drives up interest rates (including by increasing default risk premiums on public debt). Higher interest rates typically crowd out private investment and also reduce asset prices— which, in turn, dampens private consumption through a negative wealth effect. Initial conditions, therefore, matter: fiscal expansions in “adverse times” disproportionately push up risk premiums and interest rates.