Timing the fiscal exit

What’s at stake: Timing the withdrawal of macroeconomic stimulus poses a difficult tradeoff. Unwinding public intervention too early could jeopardise progress in securing a sustained economic recovery, but continuing deficits are spooking markets. According to the OECD, every developed country except Norway ran a deficit last year. But if everyone tightens simultaneously, the contraction in demand will be large and needs to be offset by higher spending elsewhere or rapid underlying growth. Otherwise, deficient global demand will undermine both the economic prospects of the OECD, the world and the fiscal consolidation plans.

Olivier Blanchard, Carlo Cottarelli and José Viñals argue that on balance, fiscal consolidation should take priority over monetary tightening. In general, fiscal and monetary stimulus may need to be maintained well into 2010 for a majority of the world’s economies, including several of the largest, although the timing of exit is likely to differ substantially across countries. Maintaining an expansionary fiscal stance has a clear and direct impact on the build-up of debt, while maintaining an accommodative monetary policy stance has no obvious direct downside, other things remaining unchanged (e.g. the absence of price pressures in goods, labour, and asset markets). Moreover, while monetary tightening will contribute to a worsening of the fiscal position, a tightening of the fiscal stance does not necessarily complicate monetary management. Hence, on balance, fiscal consolidation should take priority, all else given.

Carlo Cottarelli argues that stabilising the debt-to-GDP ratio is not enough. Governments need to do whatever they can to lower debt ratios as they need space for fiscal responses to possible future crises and high debt pushes up real interest rates. In a recent paper, Cottarelli shows that raising government debt ratios by 40 percentage points (exactly what is projected to happen on current trends) would increase real interest rates by a sizable 2 percentage points. James Hamilton argues that the concern should not be the 2011 deficit, but the deficits in 2015 and beyond. And Paul Krugman reacts to John Lipsky, the #2 man at the IMF, calling for early fiscal retrenchment in the beginning of 2011 if the recovery occurs at the projected pace. Comparing the IMF projected pace to what would have happened if growth were to continue at its average pace from 2000 to 2007, Krugman argues that Lipsky apparently accepts the losses in output during the crisis as permanent. Although this would leave us on a drastically lower trend, Lipsky apparently considers this an acceptable result, good enough to pull back stimulus.

Fred Bergsten argues that the straightforward way to resolve the timing dilemma is to adopt policy changes in 2010 that will phase in over the medium term, beginning in 2012 or so and accelerating thereafter to ultimately reach the fiscal target. Bergsten proposes three specific policies for the US – cost controls under the new health care reform program, which should start kicking in after two or three years and become quite substantial over the course of a decade or more; Social Security reform, including further increases in the retirement age and rebasing of the indexation formula on wage rather than price levels, which would of course apply with increasing impact over a considerable period of time; and gradual phase-in of the new taxes, preferably a gasoline or broad-based national consumption tax, that will inevitably be required to raise the needed revenues for eventual budget balance in a way that will not undermine continued growth of the economy.

Tim Besley and Andrew Scott call for independent fiscal committees. With high levels of debt likely to persist for a long time, governments urgently need a way to commit to credible and sustainable long-run fiscal plans. The authors argue that a new device is needed to restore credibility to governments’ long-term public finances. This requires independent fiscal policy committees to institutionalise fiscal transparency and restore credibility to governments’ long-term public finances. The aim of this Fiscal Policy Committee would be merely to assess and comment on the Budget, not to set policy. A key role for the new independent body would be to check the Government’s policy, budget projections, and growth assumptions for consistency. But the committee should avoid detailed commentary on the structure of taxation and spending, except where it is germane to the overall fiscal risks. Fiscal councils already exist in Belgium, Denmark, and Sweden and seem to have contributed to fiscal discipline in those countries during the crisis.

Giancarlo Corsetti, André Meier and Gernot Müller argue that anticipated spending cuts would enhance the effectiveness of today’s fiscal stimulus. The anticipation of a future spending reversal generally raises the expansionary impact of today’s fiscal stimulus through its effect on long-term real interest rates. Prospective spending cuts reduce expected inflationary pressures, allowing the central bank to set lower nominal (and, effectively, real) short-term interest rates in the future. Anticipated policy rate cuts, in turn, immediately reduce long-term real interest rates today, as these capture market expectations for the entire path of future short-term rates. Consequently, the future spending cuts boost current demand. But if monetary policy is constrained by the zero lower bound on policy rates, the spending cuts should not come too early as anticipated spending cuts enhance the short-term expansionary impact of fiscal stimulus only insofar as their future deflationary effect, all else equal, leads to lower expected real rates. With short-term nominal rates at the zero lower bound, lower inflation (caused by the public spending cut) instead raises real rates. As a result, the prospect of fiscal adjustment via spending cuts might actually weaken current demand and prolong the recessionary dynamics.

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