My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern: supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time. Procyclicalists exacerbate the magnitude of the swings in the business cycle.
This is not just an American problem. A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years. Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time.
The world is in the grip of a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard.
Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
The Obama Recovery. The U.S. economy was in free fall in late 2008, whether measured by GDP statistics, the monthly jobs numbers, or inter-bank spreads. Was the end of the recession in mid-2009 attributable to policies adopted by President Obama? A full evaluation of that question to economists’ standards would require delving into the complexity of mathematical models. The public generally has a simpler standard: was the impact big enough to be visible to the naked eye? Amazingly, the answer is “yes.” Whichever of those statistics one looks at, and whether it is coincidence or not: the economic free-fall ended almost precisely the month that Obama took office, January 2009.
Emerging markets have generally had much better economic fundamentals over the last decade than advanced economies. For example, one third of developing countries have succeeded in breaking the historical syndrome of procyclical (destabilizing) fiscal policy. For the first time, they took advantage of the boom of 2003-08 to strengthen their budget balances, which allowed a fiscal easing when the global recession hit in 2008-09.
The 15-year cycle in EMs. Market swings that start out based firmly on fundamentals can eventually go too far. Some emerging markets like Turkey look vulnerable this year. A crash would fit the biblical pattern: seven fat years, followed by seven lean years. Here are the last three cycles of capital flows to developing countries:
1975-81: 7 fat years (“recycling petrodollars”)
1982: crash (the international debt crisis)
1983-1989: 7 lean years (the “Lost Decade” in Latin America)
1990-1996: 7 fat years (Emerging Market boom)
1997: crash (the East Asia crisis)
1997-2003: 7 lean years (currency crises spread globally)
Everywhere one looks, problems of fiscal policy are now center stage. Among advanced countries, the news is bad: Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles. But in the rest of the world there is better news: In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.
In the past, developing countries tended to follow procyclical fiscal policy: they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.) Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.
During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing. We wasted the opportunity of the 2003-07 expansion by running large budget deficits. As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high. Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade. Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.