Redis­cov­er­ing fis­cal pol­icy at the G7

Financial Mirror (Cyprus) - - FRONT PAGE -

As G7 lead­ers con­vene in Ise-Shima, Ja­pan, the global econ­omy’s fragility is a top concern. But in­stead of fo­cus­ing on cur­rency wars, the lead­ers of the ma­jor de­vel­oped economies should be dis­cussing fis­cal pol­icy, which un­der cur­rent con­di­tions would be a more pow­er­ful tool than mone­tary pol­icy for boost­ing eco­nomic ac­tiv­ity. Af­ter all, to­day, un­like in nor­mal times, the ef­fects of fis­cal pol­icy would not be lim­ited by too-high in­ter­est rates, in­ad­e­quate pri­vate de­mand, strict ca­pac­ity con­straints, or ex­ces­sive in­fla­tion.

Econ­o­mists dis­miss fis­cal pol­icy largely be­cause it is “po­lit­i­cally con­strained.” But that is not a good rea­son to give up on it. On the con­trary, if the po­lit­i­cal process is pro­duc­ing prob­lem­atic fis­cal poli­cies, as it is to­day, that is all the more rea­son for econ­o­mists to voice their con­cerns.

The heyday of ac­tivist fis­cal pol­icy was a half-cen­tury ago. Most ad­vanced coun­tries pur­sued a coun­ter­cycli­cal ap­proach, rein­ing in spend­ing or rais­ing taxes dur­ing pe­ri­ods of eco­nomic ex­pan­sion and en­act­ing stim­u­lus poli­cies dur­ing re­ces­sions. The say­ing “we are all Key­ne­sians now,” at­trib­uted to Mil­ton Fried­man in 1965 and Richard Nixon in 1971, cap­tured the eco­nomic zeit­geist.

But, af­ter 2000, some be­gan to pur­sue pro-cycli­cal bud­getary poli­cies. When the econ­omy was boom­ing, they im­ple­mented fis­cal stim­u­lus, thereby re­in­forc­ing the up­swing. When the econ­omy ex­pe­ri­enced a down­turn, they pur­sued fis­cal aus­ter­ity, ex­ac­er­bat­ing the re­ces­sion.

Among those who acted pro-cycli­cally were some US politi­cians. At the begin­ning of this cen­tury, Pres­i­dent Ge­orge W. Bush threw away the large fis­cal sur­pluses that he had in­her­ited from Bill Clin­ton, en­act­ing large tax cuts and rapid spend­ing in­creases even from 2003 to 2007, as the econ­omy neared its peak. He was aided and abet­ted by Fed Chair­man Alan Greenspan, who bizarrely con­sid­ered the sur­pluses a threat. It was dur­ing this pe­riod that Vice Pres­i­dent Dick Cheney re­port­edly de­clared that for­mer Pres­i­dent Ron­ald Rea­gan had proved that “deficits don’t mat­ter.”

Sad­dled with debt, US lead­ers felt less able to en­act badly needed fis­cal stim­u­lus when the Great Re­ces­sion hit in 2007. Democrats un­der­stood that it was nec­es­sary, but Repub­li­cans de­cided, at pre­cisely the wrong time, that deficits were bad, af­ter all.

In Jan­uary 2009, when the econ­omy was tank­ing, the Repub­li­cans voted against Pres­i­dent Barack Obama’s fis­cal stim­u­lus plan. For­tu­nately, the pol­icy was en­acted nonethe­less, mak­ing a ma­jor con­tri­bu­tion to re­vers­ing the free-fall. But once the Repub­li­cans took over the House of Rep­re­sen­ta­tives in 2010, they were able to block Obama’s fur­ther at­tempts to stimulate the still-weak econ­omy.

Then there is the poster child for the post­mil­len­nial turn to pro-cycli­cal fis­cal pol­icy: Greece. Like Bush, the coun­try ran ex­ces­sive bud­get deficits while the econ­omy was ex­pand­ing, from 2003 to 2008. Then, in 2010, con­fronting a mas­sive debt cri­sis, Greece ac­qui­esced to its Euro­pean cred­i­tors and adopted strict aus­ter­ity, which ex­ac­er­bated eco­nomic con­trac­tion. As a re­sult, far from restor­ing a sus­tain­able debt bur­den as in­tended, the pol­icy caused the debt-to-GDP ra­tio to rise rapidly.

Euro­pean coun­tries in general base their bud­get plans on un­nec­es­sar­ily bi­ased of­fi­cial fore­casts, which can push them to­ward pro­cycli­cal pol­icy. Be­fore 2008, all euro­zone mem­bers, not only Greece, “un­ex­pect­edly” ex­ceeded the 3%-of-GDP ceil­ing for bud­get deficits at times. And, af­ter 2008, the pat­tern of pro-cycli­cal fis­cal con­trac­tion, lead­ing to fall­ing in­come and ris­ing debt-to-GDP ra­tios, played out not just in Greece, but in Ire­land, Italy, Por­tu­gal, and Spain as well.

Aus­ter­ity’s lead­ing cham­pion is, no sur­prise, Ger­many. The Ger­mans had re­luc­tantly agreed, at the April 2009 G20 sum­mit in Lon­don, that the US, China, and other ma­jor coun­tries would ex­pand de­mand to help pull the world out of re­ces­sion. But when the Greek cri­sis erupted at the end of that year, the Ger­mans re­verted to their deeply held be­liefs in fis­cal rec­ti­tude.

At first, the In­ter­na­tional Mone­tary Fund went along with the claim by Greece’s cred­i­tors that aus­ter­ity could work. But in Jan­uary 2013, the IMF’s then-chief economist, Olivier Blan­chard, pub­lished a pa­per con­clud­ing that fis­cal mul­ti­pli­ers were much higher than the IMF had thought, and thus that the aus­ter­ity pro­grams in the strug­gling coun­tries of the euro­zone’s pe­riph­ery might have been ex­ces­sive. To­day, IMF Man­ag­ing Di­rec­tor Christine La­garde well recog­nises that, for Greece to achieve a sus­tain­able debt-to-GDP ra­tio, it needs more debt re­lief, not de­mands for sur­pluses of 3.5% of GDP.

Ja­pan, host of this week’s G7 meet­ing, has also made fis­cal mis­takes. In April 2014, even with the Bank of Ja­pan hav­ing pur­sued ag­gres­sive quan­ti­ta­tive eas­ing to kick-start eco­nomic growth, Prime Min­is­ter Shinzo Abe fol­lowed through on a planned con­sump­tion-tax hike, from 5% to 8%. As many had pre­dicted, Ja­pan fell back into re­ces­sion.

Very soon, Abe must de­cide whether to raise the con­sump­tion tax again, to 10%. While Ja­panese of­fi­cials are not be­ing un­rea­son­able in wor­ry­ing about the coun­try’s huge na­tional debt, near-zero in­ter­est rates show that cred­it­wor­thi­ness is not the prob­lem to­day. What Ja­pan needs is a stronger econ­omy. This clearly in­di­cates that Ja­pan should not pro­ceed with an­other large in­crease in the con­sump­tion tax. What it could do in­stead is pur­sue a pre-set path of small an­nual in­creases in the con­sump­tion tax over the next 20 years.

To be sure, there are also ex­am­ples of coun­tries that have used coun­ter­cycli­cal fis­cal pol­icy to their ad­van­tage since 2000. Some de­vel­op­ing coun­tries – in­clud­ing Chile, Botswana, In­done­sia, Malaysia, and South Korea – took ad­van­tage of the boom years to run bud­get sur­pluses, pay down debt, and build up re­serves. As a re­sult, they had enough fis­cal space to re­lax such poli­cies when the 2008-2009 cri­sis hit.

Un­for­tu­nately, some that es­caped pro­cycli­cal­ity in the last decade have since been back­slid­ing. Thai­land is one ex­am­ple. An­other is Brazil, whose fail­ure to take ad­van­tage of the re­newed com­mod­ity boom of 2010-2011 to elim­i­nate its bud­get deficit con­trib­uted sub­stan­tially to the mess it is in to­day.

Politi­cians vir­tu­ally ev­ery­where would do well to re-read the fis­cal pol­icy chap­ter in their in­tro­duc­tory macro­eco­nomics text­books.

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