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In Times of Consecutive Crises, Is Fiscal Policy the Answer?

Otaviano Canuto's picture

By flickr user prawnpieIn recent weeks, fiscal policy – once the domain of policy wonks – has become part of dinner-table conversations. As Washington attempts to put its fiscal house in order, catchy metaphors from "fiscal cliff" to "fiscal calamity" to "austerity bomb" (and even "hostage crisis") permeate the media.  Amidst the media spin and misnomers however, there lies a crucial debate. After all, fiscal policy, both through public spending and taxes, has a critical impact on long-run growth.

Common wisdom is straightforward. Investments in capital goods spur economic growth. Public infrastructure in sectors such as electric power and roads make private equipment, such as machinery and vehicles, more productive. A recent book, Is Fiscal Policy the Answer? A Developing Country Perspective (prepared by several PREM colleagues under the leadership of Blanca Moreno-Dodson), presents a comprehensive assessment of the trade-offs faced by policy makers (see video of the book launch discussion here), particularly as countries reacted to the 2008-2009 global crisis.

At its core, fiscal policy is a balancing act. Increases in public spending must be offset with increases in tax revenue, deficits or grants. These are not only politically difficult in most countries and circumstances, but can also act as a drag on the economy, particularly when certain levels of risk and distortions have been reached. Unsustainable public debt does endanger macroeconomic stability, and therefore undermines the credibility of the country, inhibiting private investment and growth. "The net effect of fiscal change on growth therefore depends on the way it is offset," one of the chapters of the book notes. "The direct and indirect growth effects of the offsetting element may have similar or opposite impacts on the economy."

Furthermore, when it comes to public spending, it is not the quantity but the quality that matters. As the book stresses, "it is not just accumulation of public capital. Rather, through affecting private productivity, certain types of public spending potentially raise the returns to investment, and thereby productivity of total (private and public) production factors." Those "growth-enhancing" expenditures often lead to the creation of assets in education, health, transport and communication.

But public spending does not occur in a vacuum. Tweaking the levels or composition of public spending can be pointless if governance is poor. Translating the spending into public service delivery is when rubber hits the road. If teachers don't perform their duties in school and students don't learn, or roads are actually not constructed properly, fiscal policy will have little traction when it comes to growth and social welfare.  In fact, surveys that trace the flow of public resources suggest that low government accountability and public-spending leakages are the primary concern of policy makers.

In addition to diving into the institutional dimensions of fiscal policy making, the book takes the discussion on the impact of fiscal policy to another level. In their chapter, Eduardo Ley and Kirk Hamilton argue that in resource-rich settings, measuring growth rates alone could be deceiving if the wealth of the country (defined to include the depletion of natural resources and other assets) is deteriorating.  Therefore, policy makers must pay attention to such developments and use fiscal policy tools, mainly taxes and expenditures, to preserve and expand their wealth in the long run so that their populations can benefit from it.

Although this book focused entirely on developing countries – with a special chapter dedicated to Africa, where the diverse reactions to the latest global crisis offer numerous lessons – many of the book findings, I believe, can illustrate the current fiscal policy debates in the USA and Europe, as we are witnessing them these days.

Follow the latest from Otaviano Canuto at twitter.com/OCanuto and keep up with the World Bank's efforts to help countries fight poverty and close gaps in income and opportunity at twitter.com/WBPoverty. For more Economic Premise notes, go to worldbank.org/economicpremise.

Photo by flickr user prawnpie, reproduced under a Creative Commons license.