Monday, November 24, 2014

Fiscal Closing Time?

BRUSSELS – Is it time for fiscal consolidation or stimulus? Should governments cut or increase spending? Once again the issue is a matter of dispute among policymakers and economists. Citizens, having been told in 2008-2009 that the imperative was to stimulate the economy, and in 2010-2011 that the time had come for retrenchment, are understandably confused. Should priorities once again be reversed?

At the International Monetary Fund’s annual meeting in October, the Fund’s chief economist, Olivier Blanchard fueled the controversy by pointing out that in recent times governments have tended to underestimate the adverse growth consequences of fiscal consolidation. They have typically assumed that to cut public spending by a dollar would reduce GDP by 50 cents in the short term; according to Blanchard, the true outcome in current conditions is a decline by between $0.90-1.70. That is a big gap, but also a perplexing finding: how can there be so much uncertainty?

Contrary to what such forecasting disparities may suggest, economists actually know a lot about the consequences of fiscal policy, at least much more than they used to know. Until the 1980’s, it was routinely assumed that the so-called “multiplier” – the ratio of change in GDP to the change in government spending – was stable and larger than one. A one-dollar spending cut was believed to reduce GDP by more than one dollar, so that fiscal retrenchment was economically costly (while, conversely, stimulus was effective).

Then came the counter-revolution, which advanced a long list of reasons why the multiplier was likely to be much lower. Cut spending, it was said, and inflation would fall. The central bank would lower interest rates; households would spend in anticipation of lower taxes; and business confidence would rise. In the end, there would be little, if any, damaging impact on output.

Economists are a fractious lot, but they are also stubborn investigators, so the controversy prompted new research into the effects of budgetary retrenchments. New methods were developed to measure their impact; new approaches were introduced to account for the possibility that the multiplier could vary over time; and new data were compiled to incorporate better actual budgetary decisions.

All of this effort paid off. There is now convincing evidence that the same decision to cut public spending can have very different consequences, depending on economic conditions. This may seem like Paradise for policy wonks, but it also has significant implications for government choices.

The adverse short-term growth effects of a spending cut are likely to be largest when the economy is already in a recession, trade partners are also cutting spending or raising taxes, the central bank’s interest rate is already near zero, and markets have no particular worries about the state’s ability to repay its debt. In such conditions, like those of 2009, the multiplier can be close to two. So it would have been lethal to embark on fiscal consolidation back then. It was right to stimulate.

But when the economy is booming, the effects of fiscal retrenchment are unlikely to be damaging. So it was right to start planning for a change of gear when the recovery started to materialize.

Things are trickier when public finances are under acute stress and markets are worried about sovereign solvency, as is the case in southern Europe. There is scant empirical evidence for this set of conditions, because such cases were rare until recently. But it is logical to consider that restoring the sustainability of public finances can have strongly positive effects on confidence and bond rates. At the same time, if the economy is already contracting sharply, as it often does in such situations, a spending cut is bound to have serious negative effects on domestic demand.

The best way out of the dilemma is to undertake measures that improve long-term public finances without producing negative short-term effects, such as public pension reform. Increasing the retirement age, for example, improves the perspective for public finances, but it does not weigh on short-term demand.

More generally, measures that credibly signal stronger public finances in the future are desirable – assuming, obviously, that governments still have some credibility. When it is squandered, as in Greece, promises have no value, and governments have no choice but to cut spending immediately.

Understanding which conditions are being met when and where helps to set the agenda for today. The global economy currently is slowing; several European countries – and the eurozone as a whole – are in recession; central banks’ interest rates are exceptionally low, and unlikely to rise soon; and most advanced countries are cutting public spending. This calls for caution with consolidation efforts. At the same time, public-debt ratios are still rising, and several countries have lost market access or are at risk of losing it, owing to the precarious state of their public finances. This, by contrast, implies a need for retrenchment.

The prescription for policymakers is thus fourfold:

·         Whenever public-finance sustainability is at stake (which is pretty much everywhere in the advanced world, except Australia, Canada, and a few northern European countries, including Germany), governments should continue consolidating, but at a moderate pace.

·         Governments should not increase consolidation efforts just because the slowdown reduces tax revenues, and should not aim at headline deficit targets for next year.

·         In acute fiscal stress, governments cannot afford to slow down consolidation. But they should place as much emphasis as possible on spending reforms that credibly improve the outlook while having limited adverse short-term effects.

·         Finally, officials everywhere should invest in institutions that help to convince markets of their commitment to public-finance sustainability.

In hazardous conditions, officials should not rely on rosy scenarios and hope that they will be believed. Rather, they should communicate clearly to markets and citizens how they reason and what they intend to do.

Read more from our "The Great Debt Debate" Focal Point.

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    1. CommentedNathan Coppedge

      It seems to me that this is a focus on macro-scale economics, which isn't typically regrettable. But it may be that the 'allocative-ness' of businesses is what is at stake, and a source of policy scrutiny like the bank scandals.

      Perhaps there is a benefit in focusing on middle-interests as a basis for economic security. Perhaps this is a lesson that has already been learned, but I suspect there are parties who might benefit by some creative thinking about middle-interest scenarios.

      For example, there may be resources that only work at a mid-interest level of meso economics (a kind of material economics), by this I mean to refer to economics in a modular fashion, e.g. 'what is functional starvation' and 'just what embodies a permanent resource/ are all material resources transient / expendable'; The general idea however, is a combination of factors, not just meso economics, but some sort of tactical knowledge on the role of citizens, psychology, and the aforementioned starvation and permanence. Although on one level the concern is how to "simulate" not "stimulate" the economy, on another level simulation is entirely separate from the material highly contingent organization of meso economics.

    2. CommentedBrett Blake

      The world has altered drastically since the sea-change of economic thought of the 80's occurred. Regulators and central bankers now have a much reduced ability to influence domestic markets and a vacuum exists at the top, among nations, where some common understandings and agreements are woefully lacking. Which tends to make the stability theorized by convergence unreachable. The Eurozone today is ample illustration of this.

      The problems coming out of the current crisis are only a tiny subset of the economic, political and social weaknesses revealed today, and any direction undertaken which fails to address the greater problems will offer, at best, only fleeting relief restricted to the financial sector. We've all seen this demonstrated. While I grant that stimulus is unsustainable, consolidation offers no guarantees that greater public and private financial health will provide either recovery or longer term stability in a chaotic global economy where destructive tax and regulatory competition among nations predominates.

      We might start with recognizing that fiscal "health" may be unrealizable and under these circumstances, even sound fiscal planning hit-or-miss at best, and go from there.

    3. CommentedJean-Pierre Dumas

      It is amazing to see how new-born Keynesians are able to write articles without considering the specific situation of each country. Let's take ex. France has a public expenditure ratio of 56% of GDP and a tax ratio of 50%. US has an expenditure ratio of 42% and a tax ratio of 31%. It seems that a practical Economist will recommend, front end, decrease public expenditure and taxes in France, to give more space to the private sector which is the engine of growth, the actual socialist President (Hollande) is doing the opposite, so all this Keynesian discussion on the multiplier is completely out of reality. As a matter of facts, this is ideology which has a clear objective to prevent any cuts in public expenditure in a socialist country.

      I guess the US should do the opposite increase the low tax ratio (31% of GDP) and not decrease public expenditure (42% of GDP). This has nothing to do with short-term, simplistic Keynesianism, it has to do with "bon sens" which is missing in this debate.

    4. CommentedJean-Pierre Dumas

      why 2? where is the demonstration? Of course not valid for all countries, exaggerated. Who can say seriously that m=2 for country as France which has the highest expenditure ratio in the world and a structural deficit every year, where is the growth? Germany had a low fiscal deficit in 2009 & 10, France very high fiscal deficit, economic growth in Germany, no growth in France. The multiplier does not exist for country with a high debt burden.

    5. CommentedCarol Maczinsky

      Who pays the pipers decides the tune. It is utopian to imagine up domestic growth policies financed by your creditor states when you can't restore trust and demonstrate fiscal discipline. The rating and the interest rates show. So here it goes, the self-inflicted downwards spiral for those unwilling to comply. We need actually to better control the investment banks and reduce systemic risks. We need Kantian rationality, then nations could recover and do recover.

    6. CommentedPaul A. Myers

      I think this is an excellent summary of Keynesian demand management. Politicians find it easy to borrow money to sustain demand during a contraction, but they do not follow the flip side of the coin during a health expansion when public finances should be strengthened for the inevitable slowdown.

    7. CommentedMatt Stillerman

      It is posts like this that give economics a bad reputation!

      After discussing evidence that the fiscal multiplier under current conditions is much greater than one, Mr. Pisani-Ferry goes on to prescribe a policy of austerity. With a large multiplier, such a policy will directly harm the economy of any nation that tries it. The resulting depression will only make the fiscal situation worse. And, those who invest in sovereign debt understand all of this very well.

      After two years, the evidence is clear: The more firmly the policy of austerity has been followed, the worse the results. The myth of the "confidence fairy" has been thoroughly debunked.

      Are we supposed to simply not notice that the discussion of economics in this article is exactly at odds with its policy prescription?

    8. CommentedProcyon Mukherjee

      The ‘convincing evidence’ for the fiscal multiplier belies the rhetoric around fiscal retrenchment (to be abhorred) during times of boom, something which implemented would have stymied the excessive building of capacities that was not based on the economy’s inherent potential demand. The same rhetoric returns to allow the fiscal retrenchment when the economy has nowhere to go and monetary policy is stuck at the zero lower bound.
      This apparent contradiction was much in evidence in the run up towards the financial crisis, where neither monetary hardening nor fiscal hardening was thought necessary (almost like Taleb’s brilliant example of the Turkey’s weight graph, which only comes crashing down to zero on Thanksgiving Day).

      Procyon Mukherjee

    9. CommentedMichael Booth

      Excellent summary of current thinking, but with one caveat. There is one country currently in stress minor or major willing to say clearly how they reason and what they intend to do. First because politics know no reason. Second because politics is the 'art of the possible', not the 'art of the necessary'. One need only observe Washington, DC to understand the first point. One need only observe the tangled chaos in Europe to understand the second.

    10. CommentedAvraam Dectis

      It all sounds good except for the assertion that countries in Depression must continue to cut if they lack credibility.

      I understand where this assertion comes from. Given the set of orthodox monetary/fiscal tools, cutting is the only one in the bag that might work.

      Perhaps we once again should seek unorthodox tools, much as FDR sought news ways to deal with the Depression.

      The eurozone is currently characterized by a lack of a true central government, high unemployment, high debt, low inflation, recessionary influences and unused capacity. For such an environment, we should consider Central Bank Dividends ( CBD ).

      CBD exhibits both a rationalization and a structure. The rationalization is that the true owners of a Central Bank are the citizens, and, as an incorporated entity may do, can declare a dividend to be given to its owners.

      The structure of CBD is simple. It consits of two mandatory values and one optional value. The mandatory value is a sum and a target. The optional value is a constraint.

      If the ECB declared a CBD with a sum of 10,000 euros, a target of the national governments and a constraint of debt, the following would occur:

      1) The ECB would open an account for each euro country that contained 10,000 euros times the number of citizens in that country.

      2) The accounts would only be available to pay debts as they became due. No country would be forced to use the money.

      The effect would be a couple of years of freedom from the euro crisis, giving time for restructuring.

      The political advantage of CBD is that all governments ( or targets ) are treated the same. One entity is not called upon to support another.

      There would not be an inflationary effect because the money would be slowly paid out to bond holders as debt became due. We have seen through QE that this is not inflationary. It would also not be inflationary in an economy with the attributes described above.

      Those who control the monetary and fiscal levers should not ignore the screams of millions of suffering people. They have a duty to be creative when standard tools are inadequate. There is no reason to inflict a continued Depression on a country merely to adhere to economic orthodoxy.

      Thank you.

      Avraam J. Dectis