Fiscal policy is back. In the United States, intellectual and policy leaders have called for a heavy use to fiscal measures to counteract the coming economic slowdown in 2008. President George W. Bush drafted a plan committing resources for up to one percent of US GDP to transfers to households. The IMF joined with a call for a global fiscal expansion. As regards Europe, many observers actually expressed their concern about the constraints on fiscal policy in Europe due to the Stability and Growth Pact.
The new proposals mark an important shift in attitude. In fact, for several years a number of arguments have been feeding a diffuse scepticism on the mere effectiveness of fiscal policy as an instrument to stabilise the business cycle. This does not mean that fiscal policy was not heavily used (or abused). After the Clinton years, the new administration engineered an unprecedented reversal in the fiscal stance of the US. But it is difficult to find analyses celebrating the anti-cyclical merits of such a reversal.
In the past, fiscal scepticism has been fed by at least two leading arguments, stressing trade integration and financial globalisation. Are these arguments losing shine in the context of the much-feared 2008 global slowdown?
Globalisation and openness to trade
In conventional policy models, increasing openness to trade means that an increasing share of a given fiscal stimulus benefits employment and output abroad, rather than in the country sustaining the cost of the fiscal expansion. In the traditional jargon, the problem consists of the ‘leakages’ that reduce the additional output one can stimulate with a given amount of government spending or tax cut. The argument is not new: what is new is the extent to which the pace of globalisation has raised economic linkages. A large and increasing share of domestic consumption and investment fall on imported goods or indirectly on imported inputs.
With globalisation – the argument goes – fiscal policy may still be effective at the global level, if all governments expand at the same time. But from the vantage point of a single country, large fiscal programs may just translate into an increase in their trade deficit. Most importantly, there is little incentive to take fiscal initiatives, when by doing nothing a country can eventually benefit from fiscal expansions by its trade partners, on a cost-free basis. As is well understood, this generates a global deficit of expansionary policy.
In practice, budget expansion is comparatively more effective in the US than in countries that are smaller and more open to trade. While Europe would be comparable to the US in size and openness, not many people would attach a significant probability to a strong global expansion, given the constraint on fiscal policy in the euro area. Similar considerations apply to Japan, given the scant records of fiscal policy in that country.
A concern with an asymmetric strong expansion in the US is that, exactly because of demand leakages abroad, this is likely to interfere with the ongoing process of correction of global imbalances. This outcome cannot be welcomed by people who see excessive spending in the US as one of the main roots of the large US current account (see the exchange between Willem Buiter and Lawrence Summers in the Financial Times, January 6, 2008). Raising both the budget and the external deficits clearly magnifies the scale and therefore the costs of the macroeconomic correction to fix the current account imbalance down the road. It may also increase the likelihood of a much-feared disorderly adjustment, above and beyond the financial turmoil we have been experiencing so far.
Empirically, it is very hard to find evidence that the effect of a US fiscal expansion worsens the US current account by more than 20 cents to the dollar, if at all – a feature of the United States that can be attributed to the fact that it is a large and relatively closed economy (Corsetti and Mueller 2006). However, these average estimates may not provide good guidance in a situation where financial markets work quite differently than in the past (as argued below) and fiscal measures are designed to prevent a fall in consumption in response to a strong negative shock: the external effects of a budget expansion can be much stronger in the present circumstances, reinforcing concerns about external imbalances. Moreover, even if the external deficit response remains subdued, adjustment may involve a downturn in domestic investment, which is not necessarily good news regarding the ability of a country to service its external debt over time.
In conclusion, it seems that the reasons for ‘fiscal scepticism’ rooted in trade- or openness-related considerations remain quite strong. Unless one finds it plausible that we will experience strong setbacks in the process of trade liberalisation in the next few quarters, the reason for the ‘shift in attitude’ must lie with financial-market-related considerations.
Financial development and distress
Financial globalisation is a second powerful argument that has progressively strengthened doubts of the effectiveness of fiscal policy. The process of liberalisation and deregulation of financial markets – the argument goes – has relaxed credit constraints on households and firms. Because of the enhanced opportunities to smooth consumption vis-à-vis temporary fluctuations in income and diversify income risks, households demand is less and less dependent on current income, shaking the foundations of fiscal ‘multipliers’.
While there is a considerable controversy on how exactly fiscal policy works, econometric and quantitative studies provide some empirical backing to this view. An important instance is the work by Roberto Perotti (2005) documenting that the size of consumption multipliers appears to be declining since the 1980s. One could argue that the world after 1980 is different in exactly the two dimensions mentioned above: openness and financial liberalisation and deregulation.
In the current slowdown, however, it seems that this argument can be run in reverse. As the real estate crisis is propagating across the United States and other regions of the world, and the financial turmoil from August 2007 is still shaking money markets, the main fear is that credit and liquidity constraints on households and firms are now considerably tighter than they were just a few months ago. If the worst-case scenarios with diffuse distress in credit and financial markets materialise, many categories of households and firms will be cut off from the liquid and cheap financial markets characterising our economies through 2007. Hence, spending patterns would become much more dependent on current income.
Moreover, even ruling out the worst-case scenario, the correction of housing prices has obviously lowered the value of the collateral that households in the US and elsewhere can count on to borrow. The crisis has also meant that a number of financial arrangements that made real estate very much liquid in the past are now used with much more caution. At the time of the writing, the evidence on the US slowdown is still mixed, although signals are increasingly negative. Nonetheless markets appear to share a strong pessimistic feeling about the risk of a severe disruption.
So, it is the specific nature of the current slowdown – with financial market standards changing drastically from perhaps too lax in the recent past to excessively strict – that provides the ground for the current rediscovery of fiscal policy. Once again: fiscal policy must be more effective at times when credit and liquidity constraint are tighter, because firms and households spending decision are more dependent on current income – this is a good rationale for temporary fiscal measures of the kind recently proposed by Larry Summers or, proposed a few years ago (in a comparable situation) by Alan Blinder in the aftermath of 9-11.1 In normal times, these proposals would make very little sense, because only a tiny fraction of the transfer would concretely affect households’ behaviour.
Using fiscal policy wisely
But note that the above considerations simply re-affirm the effectiveness of fiscal policy as an instrument to stabilise the economy. They do not necessarily justify its use on a massive and indiscriminate scale. First, as is well understood, the problem of financial distress is not uniform across groups in the economy. The effect of income support may be vastly different across groups of households, depending on their initial debt level and their equity losses in the crisis. Moreover, as the uncertainty about future income has arguably become much higher in the current crisis, some groups may have even raised their propensity to save out of current income.
Consistently, fiscal support should be targeted to specific groups of households and firms that are more likely to suffer from the market distress. Concentrating income support may maximise its insurance value for the population, while at the same time guaranteeing a relative strong stimulus to the economy – creating more output for a given deterioration of the budget.
Fiscal policy does not come for free. Current benefits should be assessed against the future costs of a higher stock of public and arguably ‘twin’ foreign liabilities. The trade-off between these two may be quite sensitive to the size of the policy measure. A specific risk should in fact moderate the over-enthusiasm in the ‘rediscovery of fiscal policy’ at times of financial turmoil. In the last few years, credit spreads have been extremely low. Countries with vastly different ratios of debt and deficits to their GDP have been able to borrow at essentially the same interest rate. Would countries undertaking substantial fiscal expansion been granted the same treatment in the near future?
Corsetti, G. and Mueller, G. J.: 2006, Twin deficits: Squaring theory, evidence and common sense, Economic Policy 48, 598–638.
Perotti, R.: 2005, Estimating the Effects of Fiscal Policy in OECD Countries, CEPR Discussion Paper 4842.
1 See New York Times Sept. 28, 2001