As the G-7 Leaders gather in Ise-Shima, Japan, on May 26-27, the still fragile global economy is on their minds. They would like a road map to address stagnant growth. Their approach should be to talk less about currency wars and more about fiscal policy.
Fiscal policy vs. monetary policy
Under the conditions that have prevailed in most major countries over the last ten years, we have reason to think that fiscal policy is a more powerful tool for affecting the level of economic activity, as compared to monetary policy. The explanation can be found in elementary macroeconomics textbooks and has been confirmed in recent empirical research: the effects of fiscal stimulus are not likely to be limited, as in more normal times, by driving up interest rates, crowding out private demand, running into capacity constraints, provoking excessive inflation, or overheating in other ways. Despite the power of fiscal policy under recent conditions, economists continue to lavish more attention on monetary policy. Why?
Sometimes I think the honest reason we economics professors are attracted to monetary policy is that central bankers tend to be like us, with PhDs, and to hold nice conferences.
The reason that one usually hears, however, is that fiscal policy is “politically constrained.” This is an accurate statement, but not a good reason for us to give up on it. Indeed, if the political process gets fiscal policy wrong, which it does, that is all the more reason for economists to offer their contributions.
Of course if one is a central banker, or is advising a central banker, then one must concentrate on the job at hand, which is monetary policy. But precisely because there is a limit to what central bankers can say about fiscal policy, there is more need for the rest of us to do it.
The heyday of activist fiscal policy was 50 years ago. The position “we are all Keynesians now” was attributed to Milton Friedman in 1965 and to Richard Nixon in 1971. In the late 20th century, most advanced countries managed to pursue countercyclical fiscal policy on average: generally reining in spending or raising taxes during periods of economic expansion and enacting fiscal stimulus during recessions. The result on average was to smooth out the business cycle (as Keynes had intended). It was the developing countries that tended to follow procyclical or destabilizing policies.
Leaders forget how to do counter-cyclical fiscal policy in the US, Europe and Japan
After 2000, however, some countries broke out of their familiar patterns. Too many political leaders in advanced countries pursued procyclical budgetary policies: they sought fiscal stimulus at times when the economy was already booming, thereby exaggerating the upswing, followed by fiscal austerity when the economy turns down, thereby exacerbating the recession.
Consider mistakes in fiscal policy made by leaders in three parts of the world — the US, Europe, and Japan.
US President George W. Bush began the century by throwing away the large fiscal surpluses that he had inherited from Bill Clinton, and then continued with big tax cuts and rapid spending increases even during 2003-07, as the economy reached its peak. It was during this period that Vice President Cheney reportedly said “Reagan proved that deficits don’t matter.”
Predictably, the rising debt left the government feeling less able to enact fiscal stimulus when it was really needed, after the Great Recession hit in December 2007. At precisely the wrong time, Republicans “got religion” deciding that deficits were bad after all. Thus when President Barack Obama took office in January 2009, with the economy in freefall, the opposition party voted against his fiscal stimulus. Fortunately they failed then, and the stimulus was able to make a big contribution to reversing the freefall in the economy in 2009. But having regained the Congress in 2011, they did succeed in blocking Obama’s further attempts to stimulate the still-weak economy for three years. The Republicans appear to be consistently procyclical.
Greece is the “poster boy” of an advanced country that unhappily switched to a systematically procyclical fiscal policy after the turn of the current century. Its first mistake was to run excessive budget deficits during the expansionary period 2003-08 (like the Bush Administration). Then, as if operating under the theory that “two wrongs make a right,” Greece was induced after its crisis hit to adopt tight austerity in 2010, which greatly worsened the fall in GDP. The goal was to restore its debt/GDP ratio to a sustainable path; but instead the ratio rose at a sharply accelerated rate, because of the fall in GDP.
Europeans suffer even more than other countries from basing their budget plans on official forecasts that are unnecessarily biased, which can lead to procyclical fiscal policy. Before 2008, not just Greece, but all euro members were overly optimistic in their forecast and so at times “unexpectedly” exceeded the 3% ceilings on their budget deficits. After 2008, qualitatively similar stories of procyclical fiscal contraction, leading to falling income and accelerating debt/GDP, also held in Ireland, Portugal, Spain and Italy.
The native land of austerity philosophy is, of course, Germany. The Germans had (reluctantly) gone along with an agreement at the London G-20 Leaders Summit of April 2009 that the US, China, and other major countries would expand demand in order to address the Great Recession. But when the Greek crisis hit at the end of that year, the Germans reverted to their deeply held beliefs in fiscal rectitude.
At first the IMF went along with the other members of the troika in believing — or at least pretending to believe — that fiscal discipline in the European periphery countries would not greatly damage their GDPs and thus could restore their debt/GDP ratios to sustainable paths. But in January 2013, Fund Chief Economist Olivier Blanchard released a paper that was widely interpreted as a mea culpa. It concluded that fiscal multipliers were much higher than the IMF (among other forecasters) had thought, suggesting that the austerity programs might have been excessive. This conclusion was based on a statistical finding that the countries which had attempted the biggest fiscal retrenchment in response to the crisis turned out to experience the most damage to GDP relative to what the IMF forecasters had expected. Today, IMF Managing Director Christine Lagarde explains to the Germans that Greece cannot achieve the elusive path of a sustainable debt/GDP ratio if it is not given further debt relief and is instead told to run primary budget surpluses of 3 ½ percent of GDP.
Now to Japan, host of this week’s G-7 meeting. In April 2014, even though the economy had been so weak that the Bank of Japan had been pursuing aggressive quantitative easing, Prime Minister Abe went ahead with a planned increase in the consumption tax (from 5% to 8%). As many had predicted, Japan immediately went back into recession. Even though the first arrow of Abenomics, the monetary stimulus, had been fired appropriately, it was evidently less powerful than the second arrow, fiscal policy, which unfortunately had been fired in the wrong direction.
Prime Minister Abe has indicated that he is sticking with his plan to go ahead with a further rise in the consumption tax (to 10%), scheduled for April 2017. It is easy to see why Japanese officials worry about the country’s huge national debt. But, as near-zero interest rates signal, creditworthiness is not the current problem; weakness in the economy is. A more effective way of addressing the long-run sustainability of the debt is to announce a 20-year path of very small annual increases in the consumption tax, calculated so as to demonstrate to investors that the ratio of debt to GDP will come down in the long term.
Not all is bleak on the country scoreboard of cyclicality. Some developing countries did achieve countercyclicalfiscal policy after 2000. They took advantage of the boom years to run budget surpluses, pay down debt and build up reserves, which allowed them the fiscal space to ease up when the 2008-09 crisis hit. Chile is the poster boy of those who “graduated” from procyclicality. Others include Botswana, Malaysia, Indonesia, and Korea. China’s 2009 stimulus was very countercyclical.
Unfortunately some, like Thailand, who achieved countercyclicality in the last decade, have suffered backsliding since then. Brazil, for example, failed to take advantage of the renewed commodity boom of 2010-11 to eliminate its budget deficit, which explains much of the mess it is in today now that commodity prices have fallen.
Politicians everywhere might improve their game if they re-read their introductory macroeconomics textbooks.