Should we rethink fiscal policy?

Ángel Ubide makes the case for active fiscal policy. The pre-crisis consensus on the use and scope of fiscal policy was that the business cycle would be managed by monetary policy, while fiscal policy would focus solely on debt sustainability. In that world, fiscal policy was asymmetric. That was a world of growth near potential, inflation at or above target, and positive nominal and real interest rates, which created economic rules like the Eurozone’s Stability and Growth Pact. But we don’t live in that world anymore: we live in a world of persistent insufficiency of demand, too-low inflation, and neutral real interest rates that are likely to be zero or even negative. In this world, fiscal policy has to contribute to supporting aggregate demand and protecting against deflationary risks because monetary policy alone cannot do it. If we apply the old framework to today’s reality, if we fail to stimulate the economy, we risk that hysteresis transforms persistent weakness in demand into lower potential growth.

Ubide argues that a well-designed expansionary fiscal policy stance can contribute to better economic outcomes in three ways. First, it can boost potential growth with multi-year public investment packages that raise productivity. Second, it can help monetary policy become more effective by increasing the supply of government bonds and raising the equilibrium real interest rate. Third, it can contribute to reducing income inequality. A typical criticism of this call for active fiscal policy is that there is no fiscal policy space, especially in the Eurozone. This is a debatable statement, given the very strong demand for government bonds that is pushing long-term interest rates to record low levels.  And, in any case, it is time to create the fiscal space by accelerating the creation of a European fiscal policy, including Eurobonds.

Lawrence Summers and Antonio Fatas have a new paper out on the permanent effects of fiscal consolidation. Their question is whether cyclical (demand) shocks can have permanent effects through hysteresis effects. The presence of hysteresis was originally discussed in the context of labour markets: Blanchard and Summers (1986) argued that cyclical unemployment could turn into long-term unemployment, making a cyclical shock persistent or even permanent. Fatas and Summers argue that we can think about a broader concept of hysteresis, one that includes the effects on productivity and capital accumulation dynamics and establishes a much stronger connection between economic crises and long-term growth trends. A reasonable hypothesis is that the forces that drive long-term growth slow down during recessions, so that a temporary slowdown results in a permanent impact on GDP levels, leading to hysteresis.

The global financial crisis has permanently lowered the path of GDP in all advanced economies. The Eurozone is a good example: relative to the 1999-2007 trend, Eurozone GDP today is about 15% below that level and potential has been revised downwards by a similar magnitude. In response to rising government debt levels, many countries have been engaging at the same time in fiscal consolidations that have had a negative impact on growth rates. Fatas and Summers’ paper empirically explores the connections between these two facts, and results provide support for the presence of strong hysteresis effects of fiscal policy. The large size of the effects points in the direction of self-defeating fiscal consolidations: attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their long-term negative impact on output.

Brad DeLong has a write up of a recent IMF conference on “fiscal Policy in the new normal”, essentially revolving around the role for fiscal policy in a world where the global recovery has been anemic and monetary policy has been stretched to extremes. In a “new normal” of prolonged slow growth, should we rethink fiscal policy in terms of both its countercyclical role and its effectiveness in boosting productivity and catalyzing longer-term inclusive growth?

Brad DeLong also looks in depth at the role of fiscal policy in the (post-2009) US recovery. The near-consensus policy rule for fiscal policy’s countercyclical role back in 2008 was simple: it had none. Automatic stabilizers were allowed to function, were even encouraged, but an opinion crystallized that fiscal policy should be set according to “classical” principles: rightsizing the state, levying taxes efficiently, and achieving long run fiscal balance, with countercyclical fiscal policy was to be restricted to automatic stabilizers. Why? For three reasons: discretionary fiscal policy was unnecessary as a countercyclical policy tool, because monetary policy could do the job; discretionary fiscal policy was ineffective as a countercyclical policy tool, because decision and implementation lags were just too long; discretionary countercyclical policy was counterproductive as a countercyclical fiscal policy tool, because legislators and their staffs were not competent to choose appropriate policies even when they wished to do so.

Jason Furman on the FT also argues that too many policymakers have abandoned expansionary fiscal policy as a tool for supporting growth, placing the burden on monetary policy, and he  lays down five principles to follow for a new fiscal policy. First, at a time when conventional monetary policy faces limitations in a world of lower interest rates, fiscal policy can be a particularly effective complement. Second, in today’s conditions fiscal policy may be more effective than previously understood, by “crowding in” private investment through stronger growth, which gives private companies an inducement to invest, and higher expected inflation, which lowers real interest rates and the cost of capital. Third, advanced economies have more room to expand fiscal policy than generally appreciated, as under today’s economic conditions, effectively crafted investments could raise output by more than they raise debt. Fourth, prolonged lower interest rates and economies operating below potential suggest that fiscal expansion should be more sustained, especially if it results in investment in areas that boost long-term growth. Fifth, fiscal policy is even more beneficial if co-ordinated more across countries, due to cross-border spillovers via trade and capital flows. But Furman argues that eurozone fiscal policy faces obstacles at the national level and that despite recent improvements to the EU’s stability and growth pact, it remains opaque and has become increasingly complex, capable of forcing faster deficit reduction but not co-ordinated fiscal expansion. He thinks active fiscal policy and mechanisms such as eurozone-wide unemployment insurance, better co-ordination between countries or a simplified pact that allows an emphasis on near-term growth are all worth considering.

Meanwhile, Igor Masten and Ana Grdović Gnip stress test the EU fiscal framework, to see if the cyclically adjusted budget balance (CABB) is a good measure of discretionary fiscal policy. Their results show that the official EC methodology performs poorly when it is asked to determine the fiscal policy stance. On average, it wrongly signals either the expansive or restrictive fiscal policy stance roughly 40% of the time. This is because the EC methodology mis-attributes much of the cyclical variation in the budget balance to discretionary fiscal policy. They also argue that the provisions of the SGP seem to be too stringent for compliance with the Maastricht 3% deficit-to-GDP limit. The stringency of the SGP provisions, combined with a weak capacity of the CABB to capture discretionary fiscal policy measures, yields suboptimal conditions for macroeconomic stabilisation: the official EC methodology mis-signals the violation of the SGP structural deficit limit in about 25% of cases. Masten and Grdović Gnip conclude that the CABB estimation methodology needs revision - explicitly incorporating a structural description of discretionary fiscal policy -  and that the SGP limits are too tight for effective fiscal stabilisation. According to the prediction of the model they set up, allowing for a bigger role for discretionary policy could enhance the stabilisation efficiency of fiscal policy without jeopardising compliance with the Maastricht Treaty.