The Financial and Economic Crisis Lecture Four: The implications for fiscal policy Mike Kennedy

Some definitions Budget balance = Total revenues less spending and interest payments on outstanding debt Primary balance = Revenues less spending on goods and services (excludes net interest payments) Structural balance = Budget balance adjusted for cyclical effects CAPB = Primary balance adjusted for cyclical effects

Rational for fiscal activism At the heart of the rationale is the IS-LM model, suitably modified. “Discretionary fiscal stimulus is playing an important role in OECD countries’ policy response to boost demand in the wake of the financial crisis. This reflects the severity of the downturn, both in terms of depth and duration, combined with the limits of monetary policy, both because the room for additional interest rate cuts is becoming increasingly slim in many OECD countries and especially because monetary transmission channels may be impaired.” For the average OECD country carrying out a stimulus package, their cumulated budget impact over the period amounts to more than 2½ per cent of GDP, with the United States having the largest fiscal package at about 5½ per cent of 2008 GDP.

The response of fiscal policy

Fiscal responses in problem countries

Fiscal responses in the major euro area countries

Rational for fiscal activism (con’t) The great moderation led to low inflation and low interest rates. As noted, the shock was sufficiently large to push the economy to a point where monetary policy was thought to be ineffective. The importance of the three “Ts” is a standard which can be used to judge policy effectiveness: – Timely – Targeted – Temporary.

Evaluating/measuring the effectiveness of fiscal actions Factors that affect fiscal effectiveness Automatic stabilisers Discretionary actions but sometimes subject to lags Interest rates External leakage Ricardian effects as well as uncertainty likely increased savings by households Tax cuts, to be effective, should be aimed at liquidity- constrained households Can be offset by sub-national/junior levels of government

Evaluating fiscal measures (con’t) A review of the available evidence suggests that, under normal circumstances, fiscal multipliers may be around unity for government spending and about half that for tax measures, although with lower multipliers for more open economies. However, in the current conjuncture the propensity of households and businesses to save has likely increased, reducing multipliers, particularly for tax cuts.

Evaluating fiscal measures (con’t) For the average OECD country, such multipliers suggest that the level of support from discretionary stimulus to GDP both in 2009 and 2010 will be of the order of 1⁄2 per cent. Only for the United States and Australia will the estimated multiplier effect clearly exceed 1% of GDP in both 2009 and These effects do not include cross-border spillovers. There is an inverse correlation between the size of discretionary fiscal packages announced/implemented among OECD countries and the strength of automatic stabilisers.

Evaluating fiscal measures (con’t) Whether a more ambitious fiscal stimulus than currently planned is appropriate depends on country- specific circumstances. Evidence shows that adverse reactions in financial markets are likely in response to higher government debt and that such reactions may depend on the initial budget situation. For countries which are identified as having a weak initial fiscal position (as measured by high debt-to-GDP ratios) -- including Japan, Italy, Greece, Hungary, Iceland and Ireland -- the room for fiscal expansion is limited.

Government debt levels are generally high in some problem countries

Government debt levels are generally high

Euro area problem countries have seen large back-ups in interest rates

Evaluating fiscal measures (con’t) Other countries differ in terms of the costs and benefits of further stimulus. – For some, further action to cushion the projected downturn seems warranted. – Countries with most scope for fiscal manoeuvre appear to be Germany, Canada, Australia, Netherlands, Switzerland, Korea and some Nordic countries. – For others, action would only be warranted in case activity looks to turn out even weaker than projected.

Government debt levels are generally high

Evaluating fiscal measures (con’t) The design of additional fiscal packages in terms of individual components will be crucial in maximising their effectiveness. The largest short-run impact on aggregate demand is likely to come from government spending measures. But where tax cuts are implemented they are most effective if targeted at households that are likely to be liquidity-constrained.

Evaluating fiscal measures (con’t) Complementary criteria for selecting individual measures are those which are both most likely to raise aggregate demand in the short run as well as aggregate supply in the long run, including: – increased public spending on infrastructure; – increased spending on active labour market policy, including on compulsory training courses; and – reduction of personal income taxes, notably on low-income earners.

Evaluating fiscal measures (con’t) In practice, and outside the G7, a majority of countries have given priority to tax cuts over boosting spending. G7 countries are more balanced in this respect. The reason for the relative weight on tax cuts may be the ease of implementation of such measures. Timing issues are also key in respect of the fiscal stimulus. – To the extent that the output gap widens further, those countries that have scope for further action, should consider boosting the stimulus in 2010.

Evaluating fiscal measures (con’t) Fiscal stimulus will have international spillovers both through trade and interest rate channels. Smaller countries perceive only part of the global benefit provided by their action; larger countries perceive only part of the costs involved. This suggests a possible role for international co- ordination, while taking into account each country’s scope for fiscal action.

Unwinding the imbalances Fiscal stimulus is likely to be more cost effective if accompanied by credible commitments to scale it back or even reverse it as the recovery gains traction. Scaling back will depend on: – starting points, – credibility of government commitments, and – horizon that is chosen to stabilise debt-to-GDP ratio. This underlines the importance of strengthening medium-term fiscal frameworks for ensuring fiscal sustainability.

A useful framework for analysing stabilisation efforts The government’s balance:  (D t ) = – PB t + iD t-1 Manipulate the expression (see notes on website) to get:  (D t /Y t ) = D t /Y t – D t-1 /Y t-1 = D t /Y t – (D t-1 (1 + g)/ Y t ) = (D t – D t-1 )/Y t – g(D t-1 /Y t ) = – PB t /Y t + ((i –g)/(1 + g))(D t-1 /Y t-1 ) Shows the factors that drive the fiscal balance and what is needed to restore overall balance

The problem: growth and interest rate differences

Unwinding the imbalances (con’t) Timing Will depend on the size of the problem The state of the economy The size of multipliers The scope for monetary policy to offset the negative effects Potential confidence effects by reducing risk premiums

Unwinding the imbalances (con’t) Instruments Arguments for using both spending cuts as well as tax increases, although past evidence suggests that spending cuts tend to be more permanent Give size, cuts should be considered to all major components with priority to: – pension reform; – expenditures categories where there is scope for efficiency gains (education and healthcare); – reducing distortions caused by subsidies and tax expenditures; and – social spending as well as employment laws. If hikes needed, could use consumption taxes or taxes on immovable property or environmental taxes.

Unwinding the imbalances (con’t) Structural reform – OECD estimates that 1 percentage point drop in the UR would boost revenues by ¼ to ¾ a per cent of GDP. Institutional arrangements Fiscal rules tend to be associated with lasting consolidations Other considerations Is there such a thing as expansionary fiscal contractions?

Unwinding the imbalances (con’t) Stylised facts on consolidations: Bad initial conditions will trigger consolidations – the more negative the CAPB the larger the consolidation – likely reflecting necessity as well as public support Most consolidations were of short duration with only modest gains In general, those that were sizeable also lasted longer (and vice-versa) Longer consolidation periods also involved lower intensity (measured by total size) – low-hanging fruit as well as lessening need as the process continued

Unwinding the imbalances (con’t) Stylised facts on consolidations (con’t): A number of arguments and empirical studies suggest that spending restraint (notably with respect to government consumption and transfers) is more likely to generate lasting fiscal consolidation and better economic performance. Composition is important for growth and saving; however while spending cuts are favoured, a lot was done by increasing taxes Success is measured as enough to stabilize debt-to- GDP ratio; on this basis about half were successful. Fiscal rules helped.