I. Rethinking Fiscal Activism
The challenge of raising aggregate demand is now a global phenomenon. To get an understanding of the underlying processes, take the case of the US. Here, the fall in the stock market and owner occupied real estate led to an erosion of household wealth by over $10 trillion by June 2009. This led to an estimated decrease in aggregate demand by about $600 annually, or about 3% of GDP, due to a fall in household spending by about $400 billion and production by $200 billion. Automatic stabilizers like a decrease in personal and corporate taxes cushion the fall in aggregate demand by about a third, but still leaving a net GDP gap of about $400 billion annually1. So the present challenge in the US alone lies in policies that could potentially raise aggregate demand by about $400 billion annually.
In many advanced countries, including the United States, the scope of monetary policy to forcefully affect demand is limited to interest rates. However, interest rates in many of these countries are already at historically very low levels, leaving little leverage for further use of this instrument. In many emerging and developing economies, though central banks have lowered interest rates, they have done so cautiously so as to maintain incentives for capital inflows and external stability. Given the extent of the downturn and the limits to monetary policy action, fiscal policy is regarded as being crucial in providing short and medium term support to the global economy. However, while a fiscal response across many countries may be needed, not all countries have sufficient fiscal space to implement it since expansionary fiscal actions may threaten the sustainability of fiscal finances. This note discusses the possible fiscal policy goals, options and the potential long term impacts.
In short, during a recession, both consumers and investors are uncertain about the short to medium term. The private sector is in a ‘wait and see’ approach and therefore both decline. Consumption declines during a recession following a crisis due to:
- Decreases in income or wealth (write down mortgages) and tighter credit – tax cuts or transfers? Suggest: cash transfers, temporarily extend and increase unemployment benefits, reduce VAT.
- Increase in precautionary savings as individuals try to save more for a ‘rainy day.’ For example, within six months during October 2008 and March 2009, US consumers went from negative savings of about 3% of GDP to positive 5% of GDP in savings.
Therefore there is a need for Government interventions to shore up aggregate demand, but it should be pro-poor stimulus, which may not occur in practice as the stimulus is politicized. Not everyone is convinced about fiscal activism during a downturn. For example, John Taylor (2009) and others point to the ineffectiveness of $150 billion first stimulus package provided through tax rebates during Summer of 2008 under President George Bush. This did not prevent recession, which began in December 2007, from exacerbating during 2008 and beyond. They also believe that Government intervention could worsen and prolong the recession. Others such as Rogoff and Reinhart (2009) based on eight centuries of financial crises across the world, worry about fiscal activism leading to large deficits, debts and defaults that invariably seems to have occurred following a financial panic. Moreover, they also point out that on an average, public debt of over 60% of GDP is likely to lead to a sovereign debt crisis. For example, in February 2010 Greece Government was under pressure to default on its debt payments and needed EU support as a contingency measure.
II. Goals of Fiscal Policy
Fiscal measures today are aimed at getting the financial system back to health, increasing aggregate demand, raising consumer confidence and improving economic growth. As many as 40 countries have responded to the global crisis by announcing fiscal stimulus packages. The IMF (2008) recommends that for the fiscal stimulus package to be effective, it should be:
- Timely as there is an urgent need for action. But, there is a trade-off between timeliness and quality of a fiscal program. For example, in a rush to implement a fiscal stimulus package, project cost-benefit analysis and procurement procedures may be ignored.
- Temporary so that fiscal sustainability is not jeopardized and unintended consequences of programs is avoided. In practice, politics makes it difficult for programs to be unwound once economic recovery takes hold because vested interests for continued funding of programs would have taken hold.
- Targeted so the resources go to areas and people who are affected the most. This would require very good data for formulation of programs and for monitoring on the impact of the programs. In developing countries, inadequate data availability constrains effective use of resources. For example, there are several episodes of mis-match between where unemployment is high and where public works programs are put in place.
- Large as the drop in demand is large; but countries with limited fiscal space, as in several Eastern European countries, India, etc quickly run into issues of fiscal sustainability in face of large fiscal deficits. Largeness could also lead to mis-allocation of resources within the government, encouragement of corruption at all levels of government. The bulk of resources of may end-up protecting industries and jobs not for efficiency reasons but for political reasons.
- Lasting in terms of its economic impact as the recession will likely last for some time.
- Diversified as there is uncertainty regarding which measures will be most effective.
- Contingent so as to indicate that further action will be taken, if needed.
- Collective as all countries that have the fiscal space should use it given the severity and global nature of the downturn. This is aimed at avoiding a free-rider problem among major countries of the world; and
- Sustainable to avoid debt explosion in the long run and adverse effects in the short run.
These recommendations have also been emphasized by Larry Summers, who succinctly said that fiscal packages have to be timely, temporary and targeted. The stimulus should not be withdrawn too early (because it could prematurely abort economic recovery and lead to a double-dip recession). Neither should the fiscal expansion be continued for long, because inflationary pressures can gain momentum and fiscal sustainability may be jeopardized in countries that are already saddled with a high debt burden, Moreover, the global scale of the financial crisis makes it more important than ever for international co-ordination and cooperation to avoid measures that distort international competition or effectively shift the problem to other countries while some countries benefit at the expense of others (i.e. the free rider problem).
Needless to say, the challenge to fiscal policy is finding a way to balance competing goals of stimulating economic recovery and growth while protecting the poor and the vulnerable. It will also involve several trade-offs -- for example going in for large and lasting actions versus fiscal sustainability. The following chart identifies the various fiscal options.
The following social protection measures are usually considered by governments as part of fiscal stimulus programs:
- Safety Nets, on which on average governments in developing countries spend about 1% of GDP per year.
• unconditional or conditional cash transfers,
• similar food transfers, school feeding;
• public works;
• waivers for fees for essential services;
- Labor Programs: Industrial policies and protectionist policies to protect jobs in large corporations?
• expanding coverage or length of benefit for unemployment benefits;
• training programs with income stipends.
- Programs to avoid
• general food or fuel price subsidies;
• general wage increases for civil servants;
• early retirement programs.
III. Potential Long-Term Impacts
One of the most visible spinoffs of the gargantuan fiscal stimulus packages is growing public debts and fiscal sustainability. High levels of debt compromise three important long-term objectives of fiscal policy: intergenerational equity, economic performance (through “crowding out”, higher future tax rates to cover revenue shortfall and inflation), and fiscal sustainability.
There is also the potential risk of an era of heavy government. Acemoglu (2009) is of the opinion that the current “expectational gap” in which consumers delay purchases of durable goods would lengthen the recession and force liquidation of businesses. This would lead to more government spending to get out of the deepening recession as well as a shift to anti-market protectionist industrial policies. However, a slide toward trade and financial protectionism would have cross border ramifications and be hugely damaging to the global economy as learnt from the experience of 1930s beggar-thy-neighbor policies.
Then, there is the larger risk. If the calculations regarding how much time is required by the financial markets to thaw out turns out to be wrong, a deeper and more persistent recession with severe effects on spending, output and employment is more likely. This has adverse consequences for government revenues through the operation of automatic stabilizers. In a prolonged recession, the impact for the sustainability of public finances would be far more severe.
In this time of crisis, policymakers will have to balance two opposing risks. One is the risk of prolonged depression and stagnation if efforts to boost aggregate demand are not large enough. The other is the risk of a loss of confidence in government fiscal solvency and the larger long-term impacts of rising debt burden. The trade-off between these two risks will depend on country-specific circumstances. Not all countries can afford big fiscal stimulus packages, and in this respect, projected debt levels and indicators of fiscal vulnerability will be less relevant in making policy choices. However, in countries with more fiscal room, such tradeoffs can exist and can be improved if governments clarify, in a credible way, their strategy to ensure fiscal solvency. The IMF (2008) suggests a fiscally sustainable and credible path could be achieved by following some key principles:
- Fiscal stimulus packages should consist, as much as possible, of temporary measures or that have clear sunset clauses contingent on the economic situation
- Pre-commitment to unwinding stimulus measures either at a specific date (like lowering VAT for just two years as the U.K. recently did) or on a contingent basis (reversing the VAT cut once GDP growth has risen above a certain level)
- Increasing the scope of automatic stabilizers such as unemployment benefits that, by their nature, are countercyclical
- Improving procurement and expenditure procedures to ensure that stepped-up public works spending is well directed to raise long-term growth potential
- Policies to be cast within medium-term fiscal frameworks supported by fiscal responsibility laws, fiscal rules, or independent fiscal councils. These should cover a period of 4–5 years and should ideally include accurate and timely projections of government revenues and expenditures; a government balance sheet reporting data on government assets and liabilities and a statement of contingent liabilities and other fiscal risks
- Strengthening fiscal governance by increasing fiscal transparency to reduce the public’s perception of possible political biases; and
- Avoid general wage increases in public sector and general price subsidies as such measures are distortionary.
Some of the good examples of fiscal stimulus programs include:
- Front loading shovel-ready, maintenance and repair, small projects – projects government will do anyway. For example, why not green projects as public works schemes? Such projects should be identified and designed before the onset of crisis.
- India’s National Rural Employment Guarantee Scheme under which government funds work of upto 100 days per family at low wages. A key issue that needs to be considered is whether such public works should be labor-intensive. Here one is reminded of an incident in an Asian country where Milton Friedman upon arrival to a public works program finds that workers are using only shovels and not any earth-moving equipment. Upon questioning about this lack of use of heavy equipment, Friedman is told that this was a public works program and the aim is to employ as many workers as possible. Friedman then quips, “why not give them spoons to dig?” In practice, work-fare faces a number of problems, such as the implications for capital-labor substitution if wages are not set right. Similarly, is it a good idea for government to pay workers to train and re-tool during a period of high-unemployment?
- While there is a need to improve targeting of programs, this will reduce financial resources to programs just when the crisis leads to more poor. More this global crisis impacted adversely not only on the poor but middle-classes as well. There is uncertainty about the impact of a financial crisis, particularly about which income groups and geographical areas are affected. Further, Governments are organized to formulate policies and provide public goods and services and are not well-equipped for implementation of targeted programs. There is a need for a flexible system of safety nets that is capable of being scaled up rapidly when a crisis strikes, and then scaled down when the crisis passes. This flexibility has both technical and political economy elements. For all these reasons, there is a need for some flexibility and laxity in social programs.
Baunsgaard, Thomas, and Steven A. Symansky, 2009, “Automatic Fiscal Stabilizers,” IMF Staff Position Note SPN/09/23.
Elmendorf, Doug, 2009, “Implementation Lags of Fiscal Policy,” presentation at the
FAD/RES Conference on Fiscal Policy, June.
———, and Jason Furman, 2008, “If, When, How: A Primer on Fiscal Stimulus,” The
Feldstein, Martin 2009. “Re-thinking the Role of Fiscal Policy” paper presented at the American Economic Association, January 2009.
Spilimbergo, A., S. Symansky, O. Blanchard, and C. Cottarelli, 2008, “Fiscal Policy For the Crisis,” IMF Staff Position Note No. 08/01.
Antonio Spilimbergo, Steve Symansky, and Martin Schindler, 2009, “Fiscal Multipliers”, IMF Staff Position Note SPN/09/11, May 20, 2009