Rediscovering fiscal policy at the G7
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.