giving flagging economies a fiscal boost is back in fashion
A stimulating notion
Feb 14th 2008 | WASHINGTON, DC
From The Economist print edition
The idea of giving flagging economies a fiscal boost is back in fashion
Illustration by Satoshi Kambayashi
“I AM a Keynesian now,” Richard Nixon declared in 1971. With the benefit of hindsight, his quip marked the high point of fiscal fine-tuning. Inspired by John Maynard Keynes's “General Theory”, many economists in the 1960s and early 1970s viewed government tax and spending decisions as the prime tool for smoothing the economic cycle. That confidence was later shattered by stagflation and rising budget deficits. The modern consensus has been that monetary policy, administered by an independent central bank, makes a better first weapon against recession than the whims of politicians.
But now, after more than three decades in the wilderness, Keynesian-style fiscal policy seems to be staging a comeback. On February 13th George Bush signed into law individual tax rebates and temporary investment incentives worth $152 billion (just over 1% of GDP) this year, and $168 billion in total. Passed in record time by the normally sluggish Congress—and before recession is even a certainty—the stimulus is aimed at cushioning America's downturn by getting cash into consumers' pockets and encouraging firms to invest.
Meanwhile debate has begun on the merits of a fiscal boost well beyond America. The IMF, traditionally a fierce guardian of budget probity, is pushing for broad fiscal loosening if the global economic outlook darkens. Monetary policy may be less effective in this downturn, argues the fund's managing director, Dominique Strauss-Kahn, and many countries are in unusually strong fiscal positions. At the G7 finance ministers' gathering in Tokyo on February 9th, he said that, in addition to America, countries making up a quarter of global GDP had the potential to cut taxes or increase spending—and urged them to begin contingency planning now.
A few non-American politicians are already thinking along those lines. Spain's government is putting together a fiscal-stimulus package as its economy slows in the wake of a construction bust. Alistair Darling, Britain's chancellor, has said his budget will be aimed at raising growth.
But many others are sceptical. Jean-Claude Trichet, president of the European Central Bank, has said bluntly that discretionary fiscal policy should be “avoided”. Joaquín Almunia, the European Commission's top man on economic matters, has given warning against “succumbing to the Sirens' songs”. Ken Rogoff, the IMF's former chief economist, says Mr Strauss-Kahn's plan seems “dubious”. A fair few economists within the fund agree.
Who is right depends on the answer to two questions. Do countries have more room to use counter-cyclical fiscal policy than they used to? And what is the evidence that it works?
Bold or barmy?
Many of the world's rich economies have healthier budgets than before other recent downturns. In 2007 almost half of the countries within the OECD ran structural fiscal surpluses (that is, adjusted for the state of the business cycle). The euro zone's public finances have improved dramatically, from a combined structural deficit of 2.1% of GDP before the 2001 recession to a deficit of only 0.7% of GDP in 2007. Germany's budget is now virtually in balance. Spain, Ireland and Finland are all running surpluses.
Judging by fiscal deficits alone, it is America and Britain that should fret. In 2000 America ran a structural surplus; in 2007 it had an underlying deficit of 3% of GDP. At 3.1% of GDP, Britain's was slightly bigger (see chart).
Although cyclically adjusted budget positions give a better picture of a country's fiscal health than headline surpluses or deficits, they tell only a partial story. Countries have varying underlying debt burdens and face differing pressures from ageing populations. Japan has a big deficit, a large debt and the oldest population in the OECD. Britain has a bigger structural budget deficit than Italy, but much less debt (43% of GDP versus 105%).
Outside the OECD the fiscal situation has vastly improved. Thanks to better economic management and the boom in commodity prices, several emerging economies have enviably strong public finances. Measured properly, China's budget is in surplus (see article). High oil revenues have brought double-digit budget surpluses to the Gulf oil producers and pushed Russia's surplus over 6% of GDP. Brazil and Mexico both have deficits of less than 2% of GDP, a far cry from the fiscal laxness of a few years ago.
The news is not all good: India's budget deficit is still large. Countries such as Turkey and Hungary have large current-account deficits that would make fiscal expansions risky. But no longer is the option of countering a downturn with fiscal tools confined to rich countries.
But should that option be exercised? Sceptical economists argue that counter-cyclical stimulus often does more harm than good. Politicians traditionally fail to recognise recessions in time, and then take too long to enact stimulus. By the time tax cuts and spending increases arrive, the downturn is often over, and the extra stimulus simply adds inflationary pressure. Moreover, since politicians are usually unwilling to tighten fiscal policy enough in a boom, any loosening of the budget reins tends to result in permanently higher debt. Others argue that temporary stimulus, even if well timed, will not work because people will hardly adjust their spending in response to a one-off tax cut.
There is evidence to support all these worries. Most analyses of America's stimulus efforts in the 1970s conclude that they were badly timed. In continental Europe, the record suggests that activist fiscal policy brought permanently higher public spending and debt—a point Mr Trichet has been quick to note. Japan's experience is salutary. It tried to break deflationary stagnation in the 1990s with several fiscal packages. Debt soared but the country did not recover for a decade. Milton Friedman famously used Japan to argue that fiscal pump-priming didn't work.
But not all the evidence is negative. An influential study in 2001 by Adam Posen of the Peterson Institute and Ken Kuttner, now at Oberlin College, argued that Japan's debt burden stemmed from its stagnant economy not the stimulus packages. Stimulus appeared to fail because it was fitfully implemented. When tax cuts and spending boosts were enacted properly, their analysis suggests, they worked.
More recently, the post-mortems on America's 2001 fiscal boost have been positive. By luck more than design, the income-tax rebate was well timed (Mr Bush had promised to cut taxes long before the recession hit). It also seemed to work. One study suggested that people spent between 20-40% of their rebate in the quarter in which it was received, and over 60% of it within six months. Poorer, more credit-constrained people spent a higher share of their rebates.
Such studies have informed America's recent debate. Politicians have been urged to act quickly and keep the stimulus “targeted and temporary”. Two-thirds of the boost will come from tax rebates, which 130m American families are due to receive starting in May. If people spend roughly the same share of their rebate as they did in 2001, Morgan Stanley reckons output could grow at an annual rate of more than 4% in the third quarter of 2008.
That is a big boost but it will not last long. By the beginning of 2009, Morgan Stanley's economists expect GDP growth to slip back to 1.3%. A growing group of forecasters is now fretting about a “W” shaped, or double-dip, recession.
To Keynesian converts that outcome would simply call for more stimulus. Even before Mr Bush had signed this week's package, some Congressmen were talking about a second round, focused on extending unemployment insurance. Laurence Seidman of the University of Delaware says America has had “an excellent first dose” of stimulus and should be planning for a second if necessary. Traditionally, such talk would have sent shudders though the IMF. Now at least some within the fund's upper ranks seem to agree.
Less clear, however, is how far America's experience is applicable elsewhere. With stingier unemployment benefits and a lower federal tax take, America has fewer “automatic stabilisers” than other rich countries do. Since many American states are forced, by law, to run balanced budgets they cut spending or raise taxes in a downturn—the opposite of Keynesian pump-priming. Federal-stimulus packages, in part, counter those trends. With higher tax burdens and more generous jobless benefits, European countries get a bigger fiscal boost without any change in policy.
A few euro-zone economies, notably Spain and Ireland, may use the fiscal lever. But others seem content to rely on automatic stabilisers. Germany's finance minister has ruled out new counter-cyclical measures. France and Italy have headline deficits that could soon nudge against the 3% of GDP limit prescribed by the European Union's stability and growth pact.
Nor, for now, is there much enthusiasm for action in emerging markets. The economies with the strongest fiscal positions, such as China, need to worry about overheating more than slumping. But what if the outlook darkens? Many emerging economies, often at the IMF's behest, have limited their fiscal flexibility by introducing clear budget rules.
Nor are the mechanisms for swift stimulus obvious. Emerging economies, in general, have fewer automatic stabilisers than rich ones do. In China, for instance, personal income tax will be paid by only 30% of workers this year and accounts for just 7% of government revenue. Some poor countries, particularly those with excess household saving, could do with a better social safety net. But revamping health, education and pension systems takes time.
In many developing countries, infrastructure spending may be the most promising way for governments to support output—and boost the economy's long-term potential. Keynes argued that governments, in extremis, could boost demand by digging holes. Until now, few emerging economies had the luxury to contemplate his advice. Now that they do, roads, bridges and electricity grids would be a better bet. |
