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GOVERNMENT SIZE AND OUTPUT VOLATILITY: SHOULD WE FORSAKE AUTOMATIC STABILISATION?
By XAVIER DEBRUN, JEAN PISANI-FERRY and ANDRÉ SAPIR
Non Technical Summary
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. labour 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 stylised fact: that countries with large governments
tended to exhibit more macroeconomic stability.
However in the 1980s and the 1990s 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 stabilisation, 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
1970s and 1980s output volatility was larger in big-government countries, this relationship seems
to have vanished in the 1990s, 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. That reduction in the variance of
primary income, rather than government transfers, played the main role is confirmed by an
analysis of which components of spending account for the decline in aggregate volatility in the
US and four major European economies.
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 stabilisation
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 stabilisation
can be found (and have been found) in small-government countries. Finally, we provide
an estimate of the stabilisation 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.
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