Download Fiscal Policy in the Global Financial and Economic Crisis First, I

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Fiscal Policy in the Global Financial and Economic Crisis1
First, I should say that this lecture is my own personal view. I mean this in two ways. Of
course, it is not necessarily the view of the OECD or its member countries. But beyond that,
some of what I say is certainly not obvious and would be disputed by others. In particular, I
am going to offer a pretty mainstream “Keynesian” analysis, which stresses the effects of
fiscal policy on the economy in a period of recession. This is for two reasons. First, I think it is
the best analytical framework we have at the moment, although I admit that it is not
satisfactory. Second, it is the framework used by policy makers and people like me at
international institutions.
I should also say that this it is a disturbing state of affairs that the best models available were
developed mainly more than 50 years ago. Although large advances were made in many areas
of economics in the past half century, it is as if the part of economics dealing with deficientdemand business cycles—the issue addressed by Keynes—has been in suspended animation.
This lecture may leave the impression that fiscal policy is a mechanical operation, an issue of
computing the cyclical position of the economy, applying a “multiplier” and turning on the fiscal
tap. This impression is wrong, for at least two reasons. First, things like the cyclical position of
the economy and the multipliers are not very well known, and there is therefore not so much
certainty how fiscal policy can affect the economy. I will return to this point near the end of my
lecture. Second, there is no such thing as just “fiscal policy”: any practical policy involves
changes to taxes or spending which affect not just the aggregate economy, but also sectors,
industries, social groups, and even individuals. This means that fiscal policy is necessarily
political, not just technocratic.
1. The Keynesian perspective
Multipliers
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Robert Ford, Deputy Director of Country Studies, Economics Department, Organisation for Economic Cooperation
and Development. The views expressed are those of the author, and not necessarily those of the OECD or of its
member countries. Preliminary: please do not quote.
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This viewpoint is summarised at the beginning of any macroeconomics textbook. In its simplest
form it assumes that real GDP is determined by aggregate demand, and that aggregate demand
also enters into things like consumption, imports, government activity and even investment. In
this slide, it is assumed to enter only into consumption and taxes. In this equation: Y is both
GDP and household income, T is taxes less transfers, G is government consumption and
investment (which is much smaller than government spending in the public accounts or the
national accounts), I is investment, X is exports and M is imports. The small letters, c and t, are
the marginal propensity to consume and the response of taxes (less transfers) to income. Quick
manipulation yields Keynesian multipliers for government spending and for taxes/transfers. In
what follows, when I use the term “multiplier”, this is the sort of thing I will mean. Because
prices are assumed to be stable, or inflation to be zero, all this should be understood in real
terms, not nominal terms (there is, as it were, no difference).
To give you a feel for the numbers, if the marginal and average propensities to consume are the
same, then c=.6; if t=.5 (t is the effect of a change of Y on the deficit, and a rule of thumb is that
that is about equal to the size of government, in the national accounts sense, which for most
OECD countries is around .4 or .5, so I pick .5), then the formulas gives, more or less, dy/dg=1.5
and dy/dt=7. For an open economy, import leakages would lower these multipliers.
Note that the deficit, which is G-T, depends on Y; in our little model through the tY term. This
observation gives rise to a number of familiar and closely related concepts: the automatic
stabilisers (when Y falls, taxes also fall and this reduces the multiplier, as you can see: in the
numbers I gave before, the automatic stabiliser effect (the difference between the multiplier
with and without the tax term) is about 1); and the cyclically adjusted deficit (an estimate of
what the deficit would be if Y were at full employment).
These concepts, and especially the automatic stabilisers, will return from time to time.
The multiplier is not the same thing as the effect on Y of a change in G or T, because there are
other effects.
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First, there is the effect of asset markets. The IS-LM-BP model includes asset markets, which
react to the fiscal impulse to change interest rates and exchange rates to clear the money
market and the foreign exchange market. Since the IS-LM model underlies much of our intuition
about economies in depression, it is worth explaining a bit more. An increase in G raises
aggregate demand. Since money demand depends on aggregate demand, if the money supply
doesn’t change the real interest rate needs to go up to reduce money demand again. This
increase in the interest rate offsets some (but not all) of the effect of the fiscal impulse. Higher
aggregate demand also raises imports and so disturbs the balance of payments. BoP
equilibrium requires a higher real exchange rate to lower imports again. This also reduces the
effect of the fiscal shock, via lower exports. These effects are called interest rate and exchange
rate “crowding out” or, if we are talking about a fall in G, “crowding in”.
A famous result is that with perfectly elastic capital flows—as would be the case in a small
country with no capital controls—and a flexible exchange rate, a change in G has no effect at all
on Y. Exchange rate crowding out is complete in this case.
Another famous result is that with a fixed exchange rate monetary policy has no effect.
A relevant result is that when interest rates are constant—today, they are trapped at the zero
lower bound—there will be no interest rate crowding out or crowding in.
Second, near full employment, there are supply-side effects. If we think of supply as being
more or less fixed—given by K, L and technology—then expansionary fiscal policy can have no
effect on Y either. All it does is shift the composition of output from the private to the public
sector, or if it is a question of taxes or transfers, moves activity around within the private
sector. Real business cycle models are constructed such that the economy is always at full
employment, and fluctuations in Y therefore arise from supply shocks, not demand shocks.
Fiscal policy cannot stabilise output in this case.
Third, there is an important intertemporal dimension to fiscal policy, and I want to dwell on
this for a while because they have become very important in understanding and analysing the
effects of fiscal policy.
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This intertemporal dimension stems essentially from the interactions of expectations with the
intertemporal budget constraints of firms, households and the government itself. There are
many examples, and their effects are hard to gauge. An announced increase in the VAT rate
leads to an expectation that prices will be higher in the near future, and households move
consumption forward in time to escape that. Announced changes in corporate taxation might
similarly shift investment decisions.
For the purposes of discussing the fiscal response to the global economic and financial crisis,
perhaps the most important is the government budget constraint. Because of this, to a first
approximation Keynesian fiscal policy does not raise or lower GDP: rather it is best thought of
as shifting GDP through time. To ensure fiscal sustainability, an increase in the public deficit
today must in some sense be paid for tomorrow. The sense usually used is in present values
stretching off into infinity, but basically we can think of an expansionary fiscal policy being
offset by an equal contractionary one later on.
Ricardian equivalence
This logic is driven to its ultimate conclusion in the so-called Ricardian Equivalence theorem,
popularised by a famous article by Barro some30 years ago. This has been attacked on many
grounds. In empirical settings, it is fair to say that Ricardian equivalence seems to hold partially,
but not fully.
As Ricardian equivalence has been the most prominent and, in many ways, persuasive
challenge to Keynesian fiscal policy, I want to dwell on it for a while.
First, it is not about government spending, but about how that spending is financed. The
proposition is that for a given flow of government spending through time, aggregate demand
will be the same whether it is financed by taxes (a balanced budget) or by issuing government
debt (deficit spending).
There are many ways of describing how it works. Probably the most common is: households see
fiscal stimulus—tax cuts—today, but they realise that this means fiscal contraction—tax
increases—tomorrow. As a result, they save, rather than spend, the tax cuts. In terms of
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multipliers, their marginal propensity to consume from the tax cuts is zero, even if their
marginal propensity to consume in general is positive. A closely related way of thinking about
this is that consumption depends on permanent income, and permanent income does not
change as taxes are shifted over time.
This slide shows the situation in very simplified form, the most simplified form I could think of.
The first equation is a two-period household budget constraint. In the first period, the
household receives income (y1), pays its taxes and receives government transfers (t1), and
consumes (c1). If it has anything left over, this is savings and it earns interest (r). If it is short,
then it borrows and pays interest. In the second period, it receives more income (y2), pays
more taxes (t2) and consumes more (c2). I have assumed there are no bequests, which I will
talk about in a minute. The second equation is the government budget constraint: the
government spends money (g1) and raises taxes or provides transfers (t1). It either borrows or
lends (positive or negative national debt), and does the same thing in the second period, except
it must, like the household, end up with balance over the two periods.
The second set of equations is the same as the first set, except written so that Ricardian
equivalence is obvious: taxes can be substituted out of the household budget constraint, which
depends only on its own variables and government spending. This budget constraint is the
household’s permanent income, which is not affected by taxes. It is, however, affected by g,
because g absorbs real resources.
But wait a minute. There is a lot hidden in these equations. All of these hidden things chip away
at Ricardian equivalence.
- The government lasts much longer than an individual. To get around this, Barro talked
about the “dynastic family”, arguing that bequests linked generations in a way that they could
be treated as an infinitely lived household. Note that this means that Ricardian equivalence is
more than just a budget constraint issue, because it also needs to assume that the utility of the
living includes the utility of those yet to be born.
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- Households may not realise fully that taxes must increase. That is, the t2 terms in the
household budget constraint are lower than the t2 terms in the government constraint, and so
you cannot make the substitution. In this case, a tax cut (deficit finance) can be thought of as
working because it fools households into thinking that their lifetime income is bigger than it
really is. This is an uncomfortable foundation for economic policy.
- My favourite is credit constraints on households. These can be modelled different
ways. For example, the interest rates faced by households may differ than those faced by the
government. Or some households may be shut out of credit markets. These households face
two budget constraints, one for each period. Again the substitution cannot be made. In this
case, deficit financing can be thought of working because governments borrow on behalf of
credit constrained households, and thereby increase aggregate demand. It also suggests that
fiscal multipliers are likely to be larger in large recessions, because more households will be
credit constrained.
2. The run-up and response to the Great Economic and Financial Crisis
Let’s begin by looking at fiscal policy during the 2000s, starting with the boom years leading up
to the crisis.
I will focus on two indicators of the fiscal position: the deficit/GDP ratio and the debt/GDP ratio.
Why these? Two reasons.
The level of public debt and projections on how it will evolve in the future is an indicator of the
sustainability of the fiscal position. Of course it has to be scaled by some measure of the
government sector’s ability to service that debt, and in most cases we use GDP, on the grounds
that that, ultimately, is the tax base. For some countries, like Ireland, arguably GNP is better,
because a significant slice of GDP is dedicated to foreigners and is probably not, in practice,
taxable.
In what follows, almost always when I say “debt” I will almost always mean the debt-GDP ratio.
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Turning to deficits, they play two roles as an indicator of fiscal position. First, of course, they
drive the debt. Apart from various capital operations, the deficit is the change in the debt.
Second, the change in the deficit is a measure of fiscal stimulus that is being applied or
withdrawn from the economy. A more refined indicator is the change in the cyclically adjusted
deficit, because this removes the effect of changes in output on the deficit itself. A still more
refined indicator is the change in the cyclically adjusted primary deficit, which can also be
thought of as an indicator of “fiscal effort” (on the grounds, increasingly dubious these days,
that debt default is not an imaginable fiscal policy).
This chart shows the evolution of debt, as a ratio of GDP, for several countries in the run up to
the crisis. As you can see, there was no wild increase in public debt during this period, and
therefore no obvious indication of anything wrong.
But is that really true?
This was a period of extended economic boom. You will recall from the multiplier calculations
that higher income automatically reduces the deficit, mainly by raising taxes and reducing some
transfers (unemployment insurance, for instance). If the boom is unsustainable, so are the tax
revenues, and so is the fiscal position. So, to correct for this, you want to cyclically adjust
deficits.
How is this done? Cyclical adjustment amounts to estimating potential, or full employment,
output and using the multiplier-type calculations to adjust the deficit for the difference
between actual output and potential output. That deficit is the cyclically adjusted deficit. For
example, if actual output is higher than potential output, as it was in most countries in 2006,
then the cyclically adjusted deficit will be larger than the actual deficit.
Cyclical adjustment is not easy. Potential output is not observable, and must be estimated. In
practice, you use some sort of trend of actual output. There are many more-or-less complicated
ways to do this. But it has, for our purposes, on important implication: a long boom will raise
estimates of potential output, because high actual output will pull up the trend. And this is
what happened. At the time, we at the OECD, along with everyone else, developed an
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increasingly sanguine view of things like sustainable productivity and unemployment rates. As a
result, we developed an optimistic view of budget positions: we thought the cyclically adjusted
deficit was smaller than it turned out to be. And the countries themselves developed the same
optimistic views.
So if you adjusted the debt paths for the large boom that was occurring, you would conclude
that they were not so good as they seemed at the time. Another way of putting this is that, with
hindsight at least, most governments didn’t do enough to reduce deficits and debt during the
long boom. This is one of the reasons we are where we are?
2. Response to the crisis
It’s worth mentioning that the fiscal response to the crisis could have taken several forms.
One orthodox response would be to try to contain the deficit increase. Remember, even if
policy doesn't change, the automatic stabiliser effect will increase the deficit. This is called procyclical. It was the response in the Great Depression and, for very specific reasons, also in
Estonia in the Great Recession. It is thought that, in both cases, such policy aggravated the
depression. Another would to let the automatic stabilisers work, but not change policy. We
would characterise this as neutral fiscal policy. And a third would be to let the automatic
stabilisers work and change policy to increase the deficit still further. This is counter-cyclical
fiscal policy.
The big difference between the Great Depression and the Great Recession is Keynes, and so
practically all countries implemented pro-cyclical fiscal policy.
And where are we? This slide shows deficits and debt just before the global crisis. Remember,
these are not cyclically adjusted, so in that sense they look better than they really were. But
some countries had surpluses, some had small deficits, and a couple had pretty big deficits.
Most countries had debt close to or below the Maastricht ceiling of 60% of GDP. The next slide
shows the position in 2010, after the crisis was in full swing. Now, almost all countries have
fiscal deficits, quite a few close to 10% of GDP. Debt has also gone up: four countries are over
100% of GDP and about 8 countries are above or almost at 100%.
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And so in a way these two charts summarise the fiscal response to the crisis.
Let’s focus on the deficits. In almost all countries, two things happened: discretionary fiscal
policy; and the automatic stabilisers. In a few countries—on this chart Ireland is the spectacular
example—deficits and debt were also pushed up by bank bailouts. Also, of course, there may
have been changes that were neither discretionary nor the automatic stabilisers. One example
might be pensions.
There are two ways of separating these two, neither of which are perfect.
The first way is to examine budgets for fiscal policy changes in response to the crisis. In our
June, 2009 Economic Outlook we have an annex of such changes, and planned changes, for
2008-10. I won’t bore you with the numbers, but on this basis, the countries with the largest
stimulus packages were the US (5.6), Australia (5.4), Japan (4.7), Turkey (4.4) and Canada (4.1).
A few countries were tightening: Ireland (8.3), Hungary (7.7), Iceland (7.3) and Greece (0.8). The
OECD average discretionary fiscal expansion, weighted by country size, was 3.9 (1.7
unweighted). On average, fiscal expansion was divided half-and-half between tax cuts and
spending increases, although this is not true for each country.
What is left is “non-discretionary”. This is not quite the same thing as cyclical, of course.
There are two main problems with this methodology. The first is deciding which measures are
in fact a response to the crisis. This may seem straightforward, but it has turned out to be
surprisingly difficult and required quite a bit of judgment on the part of our country desks.
Different judgments would have yielded different results. The second is that you have to
estimate the effect on the deficit of each of these measures. This can also be pretty hard.
The second way is to cyclically adjust the deficits. What is left is non-cyclical, which, again, is
not quite the same thing as discretionary. The main problem with this methodology is that, as I
just described, cyclical adjustment is pretty hard. This is particularly the case now, because the
crisis has been unprecedented and so we have little prior experience to go on.
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The key issue is: what did the crisis do to potential output? One way of answering this question
is to break output into three components: capital, labour and productivity. This is the so-called
“production function approach” to estimating potential.
Capital is the easiest, because we have good data on investment. Investment collapsed, and
therefore the growth of capital collapsed, and capital has even fallen because of depreciation.
We have assumed depreciation has not changed because of the crisis, but one could argue that
it has gone up.
Labour is harder, because it is difficult to estimate the NAIRU. What we did was look at history,
estimated so-called “hysteresis effects” for each OECD country—they are high in Europe and
zero in the US—and applied them to actual unemployment rate increases.
Productivity is the hardest, because we have no data at all. Total factor productivity is just an
unexplained residual. Anyway, we assumed that underlying productivity growth was not
affected by the crisis, even though measured productivity went down, as in all cycles. [WHAT
ABOUT LEVEL EFFECTS?]
The bottom line of our estimates is that, on average across the OECD, potential output fell by
about 2% between 2008-10. Some of that will come back quickly if investment picks up. Some
of it will come back much more slowly, as it is due to hysteresis effects in employment.
Did the fiscal expansion work?
A reasonable question to ask is whether all this fiscal expansion worked. By that, I mean: How
much did it support activity during the crisis in 2008-09?
The short answer is that we really don’t know.
For most practical purposes, the answer is given by the multiplier. And this is probably the
simple multiplier that I put on the first slide. Why? Because monetary policy cut interest rates
quickly, and is not letting them rise in response to a fiscal expansion. So there is no interest rate
crowding out. The financial shock was global and almost all countries expanded fiscal policy, so
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there may be no exchange rate crowding out. And there are obviously no supply constraints.
So, maybe the G multiplier is around 1.5.
This is ultimately an empirical question. Multipliers have been estimated for decades, and yet
there is a surprising amount of controversy over the size of the multiplier.
During the Great Moderation of the 1990s-2006, estimates of the fiscal multiplier were quite
low, on the order of 0.3. So fiscal policy seems relatively ineffective. But, this may not be a very
good estimate for the Great Recession, because: (i) during the Great Moderation we were
largely at full employment, so supply-side effects dampened the effect of fiscal policy; and (ii)
inflation targeting central banks systematically offset fiscal policy shocks (and other shocks)—
the LM curve moved to offset the IS curve.
As I mentioned, neither of these factors is relevant today.
Last year, the IMF issued a very influential paper arguing that multipliers were more like 1 to
1.5 in the Great Recession. This is not so far from the multiplier I calculated from the basic little
model.
[It is an ingenious paper: it correlated their forecast errors during the Great Recession with the
amount of fiscal consolidation to derive the error in their multiplier estimate. The advantage of
this is that it squarely addresses the issue of what the multiplier is right now. The disadvantages
are that the result appears to depend on a couple of countries at the extremes (Germany and
Greece); and that the Fund forecasts were probably not constructed in any mechanical way
using a multiplier of 0.3, so it is not clear that the errors are due to an understatement of the
multiplier.]
This means that fiscal policy was pretty effective. Going back to the estimate of discretionary
policy of about 4% of GDP, this is how much was shaved off the recession (about 1 1/3 percent
of growth each year). And then there’s the automatic stabiliser effect. You also could throw in
things like confidence effects—the economic collapse might have been worse if governments
had been perceived to be doing nothing—but that is fairly speculative, especially since
confidence has been pretty low anyway.
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Was it worth it?
Another, more interesting and difficult question is: Was the fiscal expansion worth it? Again, I
will tell you now that the short answer is we don’t know, and it is too early to say. And I
certainly will not give you a cost-benefit analysis of the issue today.
The benefit we just talked about. Fiscal expansion helped shave off the bottom of the Great
Recession.
The costs, which at this point are much harder to identify, boil down to the very large public
debt that was the consequence of the fiscal expansion.
This chart shows debt-GDP ratios as of 2012. They are in almost all cases even higher than they
were in 2010. All this is to show that, as a result of the crisis and the fiscal response to it, many
countries are now in big fiscal trouble. Which is to say that they eventually need fiscal
consolidation to narrow deficits and bring down their debt levels. For many countries it will
take many years of fiscal consolidation to make up for the stimulus that was provided after the
crisis.
An important issue here is how much fiscal contraction is really needed, By this I mean how
much discretionary spending cuts or tax increases are needed? The answer is uncertain, but it is
probably less than this chart suggests. Why? Because some of the fiscal expansion was the
action of the automatic stabilisers, and this will be reversed all by itself when economies
recover.
To illustrate the issue, consider two extremes. If potential output was not affected at all, then
output gaps—the difference between actual and potential output—are now very large in most
countries and the cyclically adjusted deficits are quite low. That is, the automatic stabiliser
effect is quite big. In a way, this would be good news, because it means that once the
economies return to potential, the deficits will largely disappear. At the other extreme, suppose
potential and actual output are the same. Then, the output gap is zero, and all the deficits are
“structural”, that is non-cyclical. This would be bad news: practically none of the deficits will go
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away just because of growth, but instead it will require large policy measures such as
permanent tax increases or spending cuts.
This next chart is more difficult to interpret, but it is a measure of how much fiscal
consolidation needs to be done taking into account such things as the automatic stabilisers and
the implications of fiscal policy as it stands . There are other measures, such as the EC’s “S”
measures, and all involve a fair amount of arbitrary assumptions to reduce a long path of fiscal
consolidation down to one number.
In this case, the number depends on some baseline projection of deficits and debt, some
assumed path of primary deficits (because front loaded consolidations get more traction than
back loaded ones) and, because it is in terms of primary deficit consolidation, it depends on
projections of interest rates and GDP growth. Given all that, both the bars and the triangles are
differences between the baseline deficits and the deficits needed to stabilise the debt-GDP
ratio at 60%, in 2060. The triangles are the easiest to understand. This is the difference in 2060
between the baseline deficit and the stabilising deficit (which, given assumptions, is a small
primary surplus). The three worst countries are Japan, the US and the UK. All have large deficits
and Japan, in particular, has a huge debt. Note that Greece is in pretty good shape. That’s
because its primary deficit is already quite small. The bars measure the peak difference
between the baseline primary deficit and the same debt stabilising path. For most countries, in
this simulation this happens fairly soon, before 2020. But it’s highly dependent on the path
chosen, and so is maybe less interesting.
Indeed, almost all OECD countries are now in the fiscal consolidation phase. As I said earlier,
fiscal policy doesn’t raise income, it redistributes income over time. We added income in 200809, and we are now subtracting it again.
The typical rate of fiscal consolidation—as measured by the change in the cyclically adjusted
primary deficit—is roughly 1% of GDP a year. There are exceptions: countries like Greece and
Ireland are doing much more; the US, with the sequestration, might do as much as 2% of GDP
this year. As an exception, Japan has recently announced more fiscal expansion, even though it
has the largest public debt in the OECD by far.
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As you are doubtless aware, the fiscal policy debate is not about whether to consolidate, but
how fast or slow. These days, the pendulum seems to be swinging towards less short-term
consolidation. There are two competing and conflicting concerns:
(i) The weak recovery. Faster fiscal contraction reduces domestic demand and growth in the
short term. The amount is given by the multiplier. Slower fiscal consolidation allows for faster
short-term growth. This reasoning argues for delaying fiscal contraction until growth and
income levels are stronger, unemployment has fallen back to its natural rate, and so on. Then,
the fiscal contraction can be used as counter-cyclical policy
(ii) The dangers of high debt. If high public debt is a problem, then fiscal consolidation should
be faster, not slower. This is more controversial because it is unclear how much debt might be a
problem. It has recently become quite controversial because of the errors that were found in
the celebrated Reinhard Rogoff paper, which argued that debt above 90% of GDP sharply
reduced growth.
There is no level of the debt-GDP ratio that is known for sure to be unsustainable, and there is
no known optimal debt-GDP ratio. The literature on government budget constraints imposes a
so-called “no ponzi game”, or “transversality” condition, which requires the present value of
debt to go to zero. While technically elegant, this provides zero policy guidance in the real
world.
High debt may hurt growth. There is a long tradition of believing this, mainly arguing that high
government debt crowds out private sector debt and impedes capital formation. Recently, an
empirical literature has grown up on the growth-debt relationship. This is still very much in flux,
but the position at the moment seems to be that: high debt is associated with low growth, that
there is no obvious threshold, and that the causality of the relationship is still unclear.
High debt has also become associated with financial market attacks on sovereigns and
banking systems, especially in the euro area. Examples are Greece, Portugal, Italy and Ireland,
all of which have debt exceeding 100% of GDP. But Belgium has debt of about 100% of GDP,
and has not come under attack. France has debt of over 90% of GDP and has not come under
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attack. Spain in 2011 had debt of about 75% of GDP, and came under attack anyway. The
likelihood of attack appears to depend also on the state of the banking system (bad in Ireland
and Spain) and on some perception of fiscal credibility (bad in Italy and Spain). In any case, the
fear of markets has become a serious concern, and in many countries has become a powerful
incentive for fiscal consolidation.
Finally, there is an “insurance argument”. High debt will restrict the room for fiscal expansion
should another crisis arise. This is obviously dependent on debt being a problem somehow,
because otherwise debt could just be pushed higher.
4. The Future of Fiscal Policy
Exit
One way or another, public debt levels will be brought down. How far and how fast is difficult
to predict. What will this take?
In various studies for various countries, we have done simple simulations—spreadsheet
operations, really—to assess the path of debt under different growth and deficit paths. Two
major conclusions emerge:
(i) for most countries, reducing debt to 60% of GDP with the sort of deficits envisaged in
national fiscal plans—typically budget balances or surpluses of around 1% of GDP—will take
many years. Typical years for hitting 60% are 2030 or, for a country like Italy, 2037. These paths
assume growth at what we estimate to be potential, and that there will be no major needs for
fiscal stimulus over the next couple of decades. The bottom line is that we will need many years
of fairly strict fiscal discipline to hit such targets.
(ii) In one sense, growth doesn’t matter very much. If the budget balance is achieved, then the
target will be hit, more or less, on time. But in another sense, growth matters a great deal.
Higher growth will make it much easier to raise taxes and meet spending needs, while hitting
the target.
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(iii) During these years, population aging will take place in OECD countries. This will reduce
growth, but we have already taken that into account in our potential output numbers. It will
also raise spending on things like pensions and health care. That will make maintaining fiscal
discipline harder.
Lessons from the Crisis
In many ways it is too early to be drawing lessons from the crisis for fiscal policy. We are still in
the crisis in many ways, and the result is still uncertain. For example, if growth returns soon and
deficits and debts begin to fall rapidly, then the whole fiscal exercise of expansion then
contraction will be judged, on the whole, a success. The Keynesians and the use of fiscal policy
as a stabilisation tool will have been vindicated. But if growth doesn’t return, debt keeps rising,
and more governments are forced to default, then the lesson may be drawn that the attempt to
stabilise the economy in 2008-09 via fiscal expansion was bad policy that ultimately made
things worse. The Great Recession may come to be seen as a cautionary tale about the limits of
fiscal policy.
It may not be too early to draw lessons from the run-up to the crisis. As I noted at the beginning
of this lecture, this period was characterised by an over-optimistic view of countries’ fiscal
positions; or, put differently, insufficient effort by countries to get their fiscal house in order. In
many countries, even though fiscal positions didn’t deteriorate, or even improved, it was, in
retrospect, pro-cyclical, in the sense that the cyclically adjusted fiscal deficits deteriorated; or,
the automatic stabilisers accounted for more than all of the improvements in fiscal positions.
This realisation has led to calls in many quarters—the OECD and the EC among them—to
implement stronger fiscal institutions.
The argument here is the following. Standard budget procedures at the time typically involved
annual budgets, prepared by Finance Ministries with little outside input, that focused on
headline deficits rather than cyclical effects. The question is: can these processes be improved
to avoid such cyclical slippages in the future?
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That is still an open question. But a number of suggestions have been made, and some have
been implemented in a number of countries.
(i) multi-year budgets. The idea here is to base annual budgets in the framework of a target
path that stretches out a few years. An example is the Dutch system: at the beginning of each
government a fairly detailed fiscal plan is agreed for the next four years. It sets deficit, spending
and revenue paths. The US tried this several years ago with the Budget Enforcement Act, which
required a 10 year budget outlook. In my view, multi-year budgeting is good practice, although I
am not sure how well it enforces fiscal discipline in boom times.
(ii)debt and deficit ceilings. A number of countries have either legislated such ceilings or built
them into their constitutions. This can either be thought of as a virtuous government imposing
restraint on future, perhaps less virtuous ones; or as a cure for time inconsistency, because at
any time governments have an incentive to try to boost growth through fiscal stimulus even
though, as we have seen, they are really just moving around through time. A well known
example is the Swiss debt brake: it requires correction of excessive deficits, which are defined
in cyclical terms and in a pretty detailed way. Germany now has a similar set-up. Another
example are the debt ceilings, as in Poland and Slovakia. As debt approaches or reaches these
ceiling, a combination of legislation and the constitution requires fiscal action.
I am somewhat dubious of all this for two reasons. First, such constitutional provisions cannot
possibly build in all possible contingencies, and so realistically need escape clauses. Second,
deficit rules must adjust for the cycle, but this is very difficult to do accurately, even for the
past, and for budgeting it needs to be done for the future. The result may be bad policy forced
by the rule.
(iii) fiscal councils. These are, ideally, authoritative bodies that assess fiscal policy and provide
advice and analysis to governments. Quite a few countries have them in one sort or another,
although they remain controversial and their effectiveness in terms of improving fiscal policy
has yet to be proved. Examples include the Dutch CPB, the US CBO and the recent UK OBR.
They vary quite a lot in terms of precise mandate. For example, the CPB and the OBR do the
macro forecasts for the budgets, but the CBO does not. EU countries are required to have some
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sort of fiscal council arrangement—or at least an independent look at fiscal policy, but these
will probably vary quite a lot in terms of institutional arrangements.
I am quite a big fan of these institutions, notwithstanding their limited track record and the lack
of evidence about their effectiveness. Some have certainly been effective, given their
mandates: I would cite the CPB and the CBO. Others, it is too early to tell.
That said, there is clearly some tension between the role of these institutions and the
traditional role of governments and their Finance Ministries to set fiscal policy. You may recall
that at the very beginning of the lecture I noted that fiscal policy is, by nature, intensely political
in many respects. Therefore, it will not do to have a non-elected group setting fiscal policy.
That, in a nutshell is why the analogy between a fiscal council and a central bank breaks down.
In the central bank model, the government typically sets a target (and inflation rate, for
instance) and leaves it to the central bank to hit it. The analogy with a fiscal council would be
that the government sets a target (the national debt, say) and lets the council hit it. This is
absurd.
That leaves fiscal councils in a bit of no-mans land. They are supposed to be independent and
critical, but they have no executive power. We will see how that works out.