Expansionary Austerity and Reverse Causality

Empirical studies on the effects of fiscal policy using the conventional or data-based approach and the Blanchard-method of cyclical adjustment or the Blanchard Fiscal Impulse (BFI) discovered that fiscal consolidations can be expansionary, particularly in the case of spending-cuts. In this paper, it is stated this finding is affected by reverse causality, i.e. increasing GDP causally decreases expenditure-GDP-ratios if the cyclical adjustment strategy fails to correct for cyclical effects. It is also illustrated that the BFI as used in the literature does not appropriately control for cyclical effects in the case of expenditure-GDP-ratios and the resulting BFI is endogenously correlated with the economic cycle. This might explain why previous studies based on the BFI pointed to counter-intuitive findings when examining cuts in government expenditure. Replicating one prominent example of literature on expansionary austerity and comparing both the results based on the BFI and the results based on standard cyclical adjustment strategies, only the BFI-based results show expansionary effects of fiscal consolidations, while these effects disappear after applying standard methods of cyclical adjustment