Blog Post

The abandonment of counter-cyclical fiscal policy

What’s at stake: The reluctance to use fiscal policy as a stabilizing tool in the current deflationary environment has been puzzling to many and a number of authors are now putting forward possible explanations.

By: Date: May 30, 2016 Topic: Global Economics & Governance

The move from counter-cyclicality to procyclicality

In its 2015 Fiscal Monitor, the IMF writes that to be stabilizing, the fiscal balance needs to increase when output rises and to decrease when it falls. That way, fiscal policy generates additional demand when output is weak and subtracts from demand when the economy is booming.

Jeffrey Frankel writes that 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 was generally to smooth out the business cycle (as Keynes had intended). It was the developing countries who tended to follow procyclical or destabilizing policies. After 2000 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.

Alesina and al. (2014) show in the Figure reproduced below how the fiscal policy of Euro Area economies changed overtime, in relation to the economic cycle. For every year we show the change in the cyclically adjusted primary balance and the level of the output gap. The first and third quadrants represent episodes of counter-cyclical fiscal policy where governments squeeze the public budget while the economy is overheating, and vice versa. On the contrary, the second and fourth quadrants include years in which fiscal policy was pro-cyclical. The majority of the countries in the sample adopted counter-cyclical fiscal policies at the beginning of the recession (2008-09) but turned pro-cyclical after 2009, namely fiscal consolidations started when recessions were not over yet.

bebr 28 may

A general theory of austerity

Simon Wren-Lewis writes that there was no good macroeconomic reason for austerity at the global level over the last five years, and austerity seen in periphery Eurozone countries could most probably have been significantly milder. As austerity could have been so easily avoided by delaying global fiscal consolidation by only a few years, a critical question becomes why this knowledge was not applied.

Simon Wren-Lewis writes that one set of arguments point to an unfortunate conjunction of events: austerity as an accident if you like. Basically Greece happened at a time when German orthodoxy was dominant. This explanation cannot play more than a minor role: mainly because it does not explain what happened in the US and UK, but also because it requires us to believe that macroeconomics in Germany is very special and that it had the power to completely dominate policy makers not only in Germany but the rest of the Eurozone.

Simon Wren-Lewis writes that austerity was instead the result of right-wing opportunism, exploiting instinctive popular concern about rising government debt in order to reduce the size of the state. This opportunism, and the fact that it was successful, reflects a failure to follow both economic theory and evidence. This failure was made possible in part because the task of macroeconomic stabilization has increasingly been delegated to independent central banks, but these institutions did not actively warn of the costs of premature fiscal consolidation, and in some cases encouraged it.

Larry Summers write that despite the overwhelming case for infrastructure investment, there is great resistance from those who think it will be carried out ineptly. It is understandable to doubt about the government’s ability to do big things when it fails in executing some of its routine responsibilities. In an era when public trust in government remains near all-time lows, every public task is freighted with consequence. The relationship is cyclical — if government can start being more effective, it will win more trust, leading to more effectiveness.

Josh Bivens notes that in the US the federal budget season came and went this year without any budget proposal hitting the floor of the U.S. House of Representatives. For Germany, Brad Setser writes that nothing appears to trump the commitment to balanced budgets right now. The long tradition of viewing public investment as different from public consumption and more amenable to debt financing has been forgotten as Germany’s governing coalition has made the black zero (the schwarze Null) the central goal of economic policy.

Emerging economies graduating from procyclicality

Otaviano Canuto, Francisco Carneiro, and Leonardo Garrido write that evidence on the procyclical pattern of fiscal policy in developing countries was first found by Gavin and Perotti (1997), who showed that Latin American was much more expansionary in good times and contractionary in bad times. Talvi and Vegh (2000) then showed that such behaviour was far from being a trademark of Latin America alone as many other developing countries across the world espoused a procyclical fiscal policy stance. There are a number of different explanations as to why developing countries tend to behave in this way vis à vis industrialised economies. Some of the reasons most commonly found in the literature include credit constraints and political economy considerations.

Jeffrey Frankel writes that some developing countries did achieve countercyclical fiscal 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. 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.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

Hong Kong’s Economy is in Danger of Further Contraction

Approaching the end of a volatile year, Hong Kong continues to face the triple whammy of slower growth in mainland China, the trade war uncertainty and social unrest.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: November 21, 2019
Read article More on this topic More by this author

Opinion

Why investors should temper optimism over a China trade rally

The economy is in worse shape than in 2015 and policies to boost growth are not as effective as they once were

By: Alicia García-Herrero Topic: Global Economics & Governance Date: November 6, 2019
Read article More on this topic More by this author

Blog Post

A Fear of Regime Change is Slowing the Global Economy

Why did such a sharp and steady slowdown occur against a background of loose monetary policy, supportive fiscal policy, low inflation and absence of evident large imbalances? As argued in the IMF’s World Economic Outlook report issued last week, the evidence points to uncertainty over trade tensions as a major contributor.

By: Uri Dadush Topic: Global Economics & Governance Date: October 25, 2019
Read article More by this author

Podcast

Podcast

How to Spend it

Can governments make their fiscal policy go further? And are they trusted enough to try? This week The Sound of Economics asks if the quality of public spending is as important as the quantity.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Global Economics & Governance Date: October 23, 2019
Read about event More on this topic

Past Event

Past Event

Public finance - time for a quality check

Is the quality of fiscal expenses and revenues more important than the budget deficit?

Speakers: Maria Demertzis, Boris Cournede, Sven Langedijk and Francesco Papadia Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 16, 2019
Read article More by this author

Blog Post

It’s hard to live in the city: Berlin’s rent freeze and the economics of rent control

A proposal in Berlin to ban increases in rent for the next five years sparked intense debate in Germany. Similar policies to the Mietendeckel are currently being discussed in London and NYC. All three proposals reflect and raise similar concerns – the increase in per-capita incomes is not keeping pace with increases in rents, but will a cap do more harm than good? We review recent views on the matter.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: July 1, 2019
Read article More on this topic More by this author

Blog Post

The June Eurogroup meeting: Reflections on BICC

The Eurogroup met on June 13th to discuss the deepening of the economic and monetary union (EMU) and prepare the discussions for the Euro Summit. From the meeting came two main deliverables: an agreement over a budgetary instrument for competitiveness and convergence and the reform of the European Stability Mechanism (ESM) treaty texts. We review economists’ first impressions.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 24, 2019
Read article More on this topic More by this author

Blog Post

Uncertainty over output gap and structural-balance estimates remains elevated

The EU fiscal framework strongly relies on the structural budget balance indicator, which aims to measure the ‘underlying’ position of the budget. But this indicator is not observed, only estimations can be made. This post shows that estimates of the European Commission, the IMF, the OECD and national governments widely differ from each other and all estimates are subject to very large annual revisions. The EU should get rid of the fiscal rules that rely on structural balance estimates and use this opportunity to fundamentally reform its fiscal framework.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: June 17, 2019
Read article More on this topic More by this author

Blog Post

The campaign against ‘nonsense’ output gaps

A campaign against “nonsense” consensus output gaps has been launched on social media. It has triggered responses focusing on the implications of output gaps for fiscal policy under EU rules, especially for Italy. But the debate about the reliability of output-gap estimates is more wide-ranging.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: June 17, 2019
Read article More on this topic More by this author

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Read article More on this topic More by this author

Blog Post

The 'seven' ceiling: China's yuan in trade talks

Investors and the public have been looking at the renminbi with caution after the Trump administration threatened to increase duties on countries that intervene in the markets to devalue/undervalue their currency relative to the dollar. The fear is that China could weaponise its currency following the further increase in tariffs imposed by the United States in early May. What is the likelihood of this happening and what would be the consequences for the existing tensions with the United States, as well as for the global economy?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 3, 2019
Load more posts