Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement. The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP. A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks. In other words, the target is cyclically adjusted. The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.read more
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.read more
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.read more