A New Evaluation of Current Fiscal Policy

     During a recession, there are few things a government can do to raise output that do not ultimately depend on consumption. Increasing government spending or transfer payments, reducing taxes, cutting interest rates−all of these tactics yield outcomes whose utility hinges on the consequent change in consumer expenditures. Thus, as the U.S. government ponders giving a second tax rebate to millions of households, it is important to consider the potential effects of such measures on consumption in order to fully evaluate their impact on the economy.

     In their recent paper “International Evidence on Sticky Consumption Growth,” economists Christopher Carroll of John Hopkins University, Jiri Slacalek of the German Institute for Economic Research and Martin Sommer of the IMF indicate that consumption in the United States, as well as twelve other countries, may not be as elastic as policymakers hope. After analyzing quarterly measures of total personal consumption expenditures from the past forty years for all thirteen economies, the authors conclude that consumption presents an approximate excess smoothness coefficient of 0.7. This means that consumption expenditures only increase by about 30% of what macroeconomic models that do not consider this excess smoothness predict. Thus, contrary to the “random walk” hypothesis, past consumption growth is the most accurate predictor of current consumption growth.

     In order to explain these results, the authors introduce two distinct theories. The first argues that consumers develop strong consumption habits such that their expenditures do not change significantly, even with increases in income. Such consumers derive utility both from the level and the stability of their consumption, otherwise known as “smoothing.” The second theory argues that far from being informed about current and future economic conditions, many consumers do not stay up-to-date with economic trends, and thus are unable to fully respond to improving economic conditions.

The findings presented in this paper shed light on the limited ability of monetary and fiscal policy to bolster consumer spending- a worrisome fact in light of the current economic difficulties. Moreover, although the paper states that consumers are not usually aware of the country’s macroeconomic situation, this is less true today given the magnitude of the financial crisis. Despite their desire to smooth their consumption over time, the pervasive uncertainty about the economic future forces consumers to restrict spending today. Current solutions for the financial crisis assert the importance of regaining lost consumer confidence so that prices increase and stabilize. However, this paper suggests that this measure can only do so much. Even if consumer confidence is regained, consumer expenditure will only increase up to its long run average levels, and this might not be enough to single-handedly resolve the crisis. Measures that do not rely heavily on consumer expenditure should be carefully assessed, as they may be the ones that ultimately prove the most helpful.