Scarring Effects of Major Economic Downturns: The Role of Fiscal Policy and Government Investment

Long shunned as slow and often ill timed, the response to the Covid-19 pandemic initiated a reassessment of fiscal policy as stabilisation tool. At the same time, there is ample evidence that major economic downturns produce lasting effects on real GDP in spite of active fiscal policy interventions. This paper takes a fresh look at economic scarring in 26 OECD countries since 1970 and examines the role played by fiscal policy including government investment. We find that fiscal expansions mitigate the lasting impact of major economic downturns on real GDP. However, scarring effects remain significant confronting governments with higher debt levels, which in turn weigh on the room for manoeuvre in subsequent downturns. While automatic stabilisers help, the limited impact of fiscal expansions on scarring goes along with the tendency to rely on discretionary increases in current expenditure rather than boosting public investment. In sum, fiscal policy makers face two difficulties in the event of a major economic downturn: (i) adopt the right type of fiscal expansion, and (ii) find the right time to pivot from short-term stabilisation to fiscal consolidation. Both challenges are fraught with political economy issues.

Working Paper