Announced changes in US public spending on defence have a significant impact on the economic behaviour of firms and households, according to research by Nadav Ben Zeev and Evi Pappa, which is published in the August 2017 issue of the Economic Journal. Their study finds that anticipated increases in defence spending induce a significant and persistent increase in output, hours worked, the interest rate and inflation, as well as significant impact responses for consumption and investment.
In the light of these findings, the researchers comment that policy-makers should be cautious about announcing policy changes that can affect people''s expectations about future government spending. Policy-makers can also use policy announcements as a tool for responding to the business cycle.
The researchers note that there has recently been renewed interest in theories of expectation-driven business cycles, focusing in particular on the effects of news shocks: shocks that are realised and observed before they materialise. These types of shocks are of particular importance for fiscal variables, where there is a natural lag between policy decisions and implementation.
Studies that attempt to measure the effects of news shocks empirically have to date used narrative identification of expectational shocks, which is particularly time-consuming to implement and requires the availability of detailed historical records. The new study proposes an alternative methodology to identify fiscal news in the data, one that is easier to implement and which can be used in situations where narrative evidence is unavailable.
By its nature, measuring news in the data can be difficult, but in recent years some studies have identified news using the timing of specific events, in particular in the context of fiscal changes. A 2011 study by Valerie Ramey constructs two measures of news about changes in defence spending:
• The first uses narrative evidence, based on information in Businessweek and other newspapers, to construct an estimate of the change in the expected present value of government spending.
• The second is constructed using the Survey of Professional Forecasters: changes in government spending are measured as the difference between actual government spending growth and the one-quarter-ahead forecast of government spending growth.
The new study uses an alternative approach and identifies defence news shocks as the shocks that best explain future movements in defence spending over a horizon of five years, and that are orthogonal to current defence spending.
In other words, using the defence spending series, which are assumed to be exogenous to the state of the economy, the researchers characterise defence spending news shocks as disturbances that can forecast defence spending movements in five years but do not relate to current movements in defence spending.
Clearly, defence spending is largely exogenous, and the new methodology can be applied to it. Yet this is not true for other types of fiscal spending such as government employment or consumption, for which reason the researchers do not apply their methodology to other non-defence components of government spending.
The identified defence news shocks are correlated with the news shocks of Ramey (2011), but explain a much larger fraction of the variability in all real variables at business cycle frequencies. They also generate more significant demand effects. Anticipated increases in defence spending induce a significant and persistent increase in output, hours worked, the interest rate and inflation, and significant impact responses for consumption and investment.
Moreover, the shock identified using this methodology significantly increases the excess returns of large defence contractors while Ramey''s news shock does not. According to the estimates, news about future changes in defence spending account for a non-negligible share of output fluctuations at business cycle frequencies.
These results are useful to both academics and policy-makers. Since anticipation effects are estimated to be significant and economically important, it is important to include them in empirical studies of the effects of fiscal changes.
Moreover, policy-makers should be cautious about announcing policy changes that can affect people''s expectations about future government spending. Or, reversing this argument, policy-makers can use policy announcements as a tool for responding to the cycle when constrained by budgetary or other types of restrictions.
''Chronicle of a War Foretold: The Macroeconomic Effects of Anticipated Defence Spending Shocks'' by Nadav Ben Zeev and Evi Pappa is published in the August 2017 issue of the Economic Journal. Nadav Ben Zeev is at Ben-Gurion University of the Negev. Evi Pappa is at the European University Institute.
