Download Fiscal Policy Responses to the Current Financial Crisis: Issues for

Fiscal Policy Responses to the
Current Financial Crisis:
Issues for Developing Countries
WORLD BANK, DECEMBER 10, 2008, AART
KRAAY AND LUIS SERVÉN
PRESENTED BY :
ALYAA EZZAT
Overview
 This note first reviews the state of the empirical
evidence on the effectiveness of discretionary
countercyclical fiscal policy in developing countries.
 The note also reviews briefly a few contrasting
experiences of success and failure in industrial and
developing countries.
 It concludes with several recommendations
motivated by past experience that policymakers
should consider before adopting any fiscal responses
to the current crisis.
Lessons from the Past
 There is strong evidence that fiscal policy is
procyclical.
1) tend to take place in good times
2) not during bad times when they might play some
role in smoothing output declines
3) This applies to a variety of measures of fiscal policy.
Lessons from the Past
 Fiscal procyclicality in developing countries
arises from both the weakness of automatic
stabilizers and the procyclical bias of
discretionary policies.
1) In industrial countries countercyclical discretionary
policy contributes to dampen aggregate fluctuations.
2) In developing economies discretionary policy is usually
procyclical.
3) In most developing countries automatic fiscal
stabilizers - such as income taxes and transfer
programs built into the fiscal system - are too small to
have a significant smoothing effect on aggregate
fluctuations
Lessons from the Past
 The procyclical bias in fiscal policy reflects
underlying fundamental challenges facing
developing countries.
- Research suggests that two main sets of factors account for
this procyclicality of discretionary fiscal policy:
1) the inability of developing countries to access external
finance to pay for fiscal expansions during downturns
2) political economy problems that contribute to an
overspending of public revenues when they are abundant in
good times.
Such fundamental factors are difficult to overcome in the
short run, suggesting deep underlying limits on the ability of
most countries to generate successful fiscal responses to the
current crisis.
Lessons from the Past
 Regardless of whether they occur in booms
or recessions, the evidence is mixed that
fiscal expansions can actually stimulate
aggregate demand and output in developing
countries in the short run.
- Most studies also find that the expansionary effect of
fiscal policy tends to be much smaller in developing
countries than in developed ones.
Lessons from the Past
 To the extent that fiscal expansions do boost
output, the procyclicality of fiscal policy
means that discretionary fiscal
interventions tend to increase output
volatility rather than reduce it.
- This finding suggests that fiscal policy has been very
unsuccessful as a tool for stabilization. In fact, the
additional volatility induced by procyclical fiscal
policy has been found to undermine & weaken
growth in the long run as well.
Lessons from the Past
 Fiscal expansions are difficult to reverse
- If governments commit to unsustainably large spending
programs during recessions as a countercyclical device,
these may be very difficult to reverse when times
improve, threatening fiscal sustainability in the long run.
- This is why automatic stabilizers in the form of lower tax
rates and larger transfer payments during recessions are
viewed as a more sustainable approach to countercyclical
fiscal policy in industrial countries.
- The difficulty for developing countries is that most of
them have very weak tax and transfer schemes and so the
effectiveness of automatic stabilizers is limited.
Conclusion
 Developing countries expecting fiscal policy
responses to the current crisis should learn
lessons from past experience.
 Successful episodes of countercyclical
discretionary fiscal policy in developing
countries have been rare.
 Too often fiscal responses are too late and
too difficult to reverse, with the perverse
effect of increasing volatility and
contributing to unsustainable debt
accumulation.
Cont. Conclusion
 Overall, empirical evidence from the past 30
years suggests that developing countries have
not been overly successful in using
discretionary fiscal policy to stabilize output
fluctuations -- although some successes do
exist.
US
 In the early 1930s of great depression, the U.S. government adopted
a broad set of policies including:
1) deposit insurance
2) abandoning the gold standard
3) monetary expansion
4) a discretionary fiscal expansion
In cyclically-adjusted terms, the budget went from a surplus of 1
percent of GNP under the Hoover administration, to a deficit of
around 2 percent under Roosevelt’s. (DeLong 1998). While the
magnitude of the change may seem modest, it has to be compared
with the very small size of the budget at the time (around 5% of
GNP).
Under the New Deal policies, the expenditure increases consisted
mainly in federal grants for work relief associated with public
works, and transfers to farmers.
Cont. US:
 Most observers agree that the fiscal expansion helped the
recovery substantially, although the extent of its
contribution - as opposed to that of other policy changes
- remains debated.
 Closer analysis reveals that the two major spending items
had quite different effects:
1) public works grants probably raised income almost
one-for-one.
2) transfers to farm owners – intended to compensate
them for taking land out of production – had little or no
effect on spending and income, owing partly to their
regressive redistributive impact on rural incomes
(Fishback et al 2005).
China
 China's response to the East Asian financial crisis of 1997-1998 is
viewed as an unusual example of a successful countercyclical
intervention by a developing country in the face of an external
shock.
 China's fiscal response was prompt, with the cyclically-adjusted
budget deficit increasing quickly from 1% of GDP prior to the crisis
to 1.9% in 1999 and 2.4% in 2000, and remaining in the area of 2%
through 2003 (Kuijs and Xu 2008).
 This period of expanded deficits coincided with a growth slowdown
from 9.5% per year in the five years before the crisis to an average of
7.9% in the five years following the crisis. Unusually relative to the
experience of most developing countries, the fiscal stimulus was
reversed, with cyclically-adjusted budget deficits returning to 1% of
GDP after 2003.
 Finally, the fiscal stimulus was achieved primarily through increases
in infrastructure spending.
Cont. China
 Several unique factors contributed to China's ability to carry out this
policy response.
1) China entered the East Asian crisis with very low public debt, and
so there was considerable scope to engage in deficit spending
2) China's prohibition on subnational government borrowing
combined with many years of very rapid growth ensured that local
governments had strong demand for infrastructure investment
projects but were effectively credit-constrained from carrying
them out.
3) Although the budgetary size of the fiscal stimulus was modest at
around 1% of GDP, it was leveraged into significantly larger
investment spending
4) This fiscal expansion was implemented during a period of stillvery-rapid growth - even during growth slowdowns growth in
China is faster than almost any other developing country!
Argentina
 In contrast to the case of China, the risks of a
mistimed expansionary change in fiscal policy are
illustrated by the experience of Argentina in the mid1990s. After undergoing a recession in 1995, largely
due to the spread of Mexico’s Tequila crisis, a
recovery took hold in 1996 and strengthened in 1997
 The modest growth effects of the fiscal expansion
quickly dissipated, and eventually the authorities
were forced to abandon it and adopt a fiscal austerity
package in 1983.