A2 The Efficacy of Public Investment as a Counter-Cyclical Measure

With regard to a normal business cycle, output fluctuations cause recessions temporally and repeatedly. As long as the macroeconomic condition is sustainable, a recession should be temporary. Thus, the government may still attain the potential growth path in the long run. Although expansionary fiscal measures may be needed in a recession, built-in stabilizers can achieve macroeconomic stabilization faster than discretionary fiscal measures if we consider the problem of policy lags seriously, as explained in Sect. 4 of the main text of this chapter.

It is usually desirable to have a small deficit during a recession in the event of ordinary fluctuations. This policy implication holds for both the Keynesian and neoclassical models, as explained in Chap. 6. Whereas the Keynesian model utilizes fiscal deficits as a tool for stabilizing measures, the neoclassical model utilizes fiscal deficits as a tool for smoothing out tax revenues over time.

To sum up, an automatic built-in stabilizer must be primarily used for ordinary fluctuations, whereas an expansionary discretionary policy must be implemented for severe fluctuations. Moreover, the discretionary policy measure should be consistent with long-run fiscal sustainability. From the viewpoint of fiscal consolidation, it may also be useful to impose automatic fiscal stabilizing mechanisms on the budgetary system; thus, if deficits increase, public spending automatically decreases and taxes automatically increase. Moreover, it is desirable to improve the fiscal condition before another recession occurs.

Considering the above developments, many studies on Japan’s public investment empirically examine the macroeconomic effects of public investment policy as a tool of discretionary fiscal measures. There are competing arguments regarding the efficacy of such policy. One is that the effects of public investment policy were highly significant in 1990s; hence, the recession would have deepened without fiscal expansion.

In contrast, another argument is that public investment policy did not have an adequate expansionary effect to increase macroeconomic activity; hence, unlimited public investment expenditure simply worsened the fiscal crisis.

These opposing arguments, which lead to different policy implications, originate from different understanding of the macroeconomic analytical framework. Namely, the former argument is based on the conventional Keynesian model of liquidity- constrained agents, whereas the latter is based on the neoclassical model of rational agents.

Using the vector autoregression (VAR) method, Ihori et al. (2002) showed that fiscal policies generated limited effects on output in Japan. Namely, tax policies did not have a stronger effect on output than changes in government expenditure. Further, the effect of public investment policies was too marginal to recover macroeconomic activities, which is consistent with the latter view based on the neoclassical model of rational agents. In this study, we showed that the multiplier effect of public works has considerably reduced in recent years; hence, its efficacy in stimulating aggregate demand is controversial.

Some recent studies, including those of Kato (2010), Watanabe et al. (2010), and Hirai and Nomura (2012), estimated fiscal multipliers using recent data in Japan and found the limited effects of public investment.

When the fiscal situation becomes severe, fiscal reconstruction may stimulate private consumption and investment because of the “non-Keynesian” effect (see Chap. 4 for a detailed explanation of this effect). Contrary to the conventional “Keynesian effect,” this effect implies that if public investment spending is wasteful or if the fiscal condition is adverse, fiscal consolidation measures such as a reduction in public investment spending and/or an increase in taxes tend to stimulate private demand. If a non-Keynesian effect actually occurs, the government can attain fiscal sustainability and economic recovery simultaneously.

This argument is consistent with the analytical understanding that fiscal conditions and the usefulness of public investment influence the effectiveness of counter-cyclical policies. The deteriorating fiscal situation in Japan and the declining benefit of public works may suggest that the “non-Keynesian” effect has had some relevance in recent years.

According to Nakazato (2002) and Kameda (2008), among others, during sustainable periods in Japan, when the ratios of fiscal deficit and debt outstanding to GDP were smaller than a certain level, the standard Keynesian effect could be observed. However, during unsustainable periods, when both ratios were significantly higher than a certain level, a non-Keynesian effect occurred. In these situations, expansionary fiscal measures such as increasing public investment spending and/or decreasing tax revenues depressed private demand, thereby deteriorating the fiscal situation. Chapter 4 explains the non-Keynesian effect to some extent.

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