Accepted wisdom on fiscal policy has shifted remarkably over the last couple of years, although too late to support the feeble global recovery from the 2008 crisis. Now the consensus is that there is a good case for fiscal stimulus in countries still with sub-par growth (i.e. almost all), provided they have 'fiscal space'.
There are implications in this global debate for Australia. Perhaps the last hold-outs for the Old View of fiscal policy are the credit rating agencies, which are currently threatening to downgrade Australia’s AAA rating because the budget deficit does not look likely to be reduced as fast as they would like.
In the immediate aftermath of the 2008 crisis, budget deficits increased in all the crisis economies, as the automatic stabilisers kicked in and discretionary expenditure supported failing sectors, especially finance. G20, meeting in London in 2009, supported this budget expansion. Within a year, however, governments started worrying about the prospect of higher debt and began 'budget consolidation'; austerity aimed at winding back deficits. The US, for example, cut its budget deficit by 5% of GDP in the four years 2010-2014. The 2010 Toronto G20 meeting urged countries to 'at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016'. The OECD and BIS argued the same line.
There can hardly be any doubt that this austerity retarded recoveries everywhere. At the time the academic and policy consensus was that fiscal policy was not a counter-cyclical instrument: at most, automatic stabilisers might be allowed to operate but this had to be reversed quickly and discretionary budget policy was to be avoided. The consensus view has now shifted substantially.
Reflecting this change at a high policy level, Jason Furman, chair of the influential US Council of Economic Advisors, covered the topic in a recent speech.
The Old View held that:
- Fiscal policy response-lags are too long. Monetary policy was more flexible and powerful. It should be left to do the cyclical stabilisation job alone.
- Even if the timing of fiscal policy was right, policy is ineffectual because the public anticipates later tax increases (so cuts back on expenditure) and the budget stimulus increases interest rates, dampening private expenditure.
- Priority should be to maintain fiscal balance because of concerns about the sustainability of government debt. At the time, high-profile economists were citing widely-based empirical evidence that if debt exceeded a critical level a bit below 100% of GDP, growth would be significantly reduced.
In addition, there was an influential argument that budget consolidation would boost public confidence so much that the consolidation would actually be expansionary; what Paul Krugman called the ‘confidence fairy’ argument. Others argued that economies had strong self-equilibrating forces, so there was no need for policy to interfere.
Furman sets out the New View of fiscal policy this way:
- With interest rates close to zero, monetary policy has become ineffective and needs the support of active fiscal policy. This is not a short-term cyclical problem, but reflects secular stagnation and excess global savings.
- Fiscal policy is, in fact, effective in most circumstances. The IMF had initially backed fiscal consolidation because the staff thought that the fiscal multiplier was very low and consolidation would do little harm. They revised this view in 2013.
- The amount of fiscal room is greater than had been thought. Excessive government debt was clearly a cause of crisis in Greece, but higher debt levels in Spain and Ireland are now seen as a result of the crisis, not the cause.
As well, the earlier projections of US debt/GDP have been revised downward dramatically. The Reinhart/Rogoff econometric work demonstrating a sharp break-point in growth as government debt rose turned out to be careless analysis.
Looking ahead, unusually low interest rates on long-term debt are reducing the burden of government debt. There are even some prominent economists arguing that fiscal stimulus improves the debt ratio, thanks to the boost to growth. Slow growth does more damage to the debt ratio than extra budget spending. Well-designed expenditure adds not only to demand, but to supply as well (e.g. infrastructure).
The IMF’s evolving position reflects this shift. In 2008 the Fund supported the need for fiscal stimulus. Within a year it was arguing for budget consolidation, backed up by model-based forecasts showing that this would not damage the recovery. The ongoing need for fiscal consolidation remained the main message from the Fund.
By 2013 Fund research staff were reassessing this view, although other staff were still promoting the old hard line. By 2015, Fund research staff were doubting the general need to reduce debt quickly.
IMF Managing Director Christine Lagarde is now firmly articulating the New View: 'Now fiscal policy needs to play a bigger role in countries that have additional spending headroom.' This New View is not advocating universal massive stimulus. Lagarde says:
… as for fiscal policies, few would dispute that better roads and airports, more power grids, and high-speed internet are essential components of modern public infrastructure. The current low-interest environment provides an historic opportunity to make these necessary investments - and to boost growth. Unlike in 2008, we are not calling for broad-based fiscal stimulus today. The basic principle is that countries with fiscal space should use it
From his new home at the Peterson Institute, former IMF chief economist Olivier Blanchard strongly supports the New View. The head of the OECD is a vocal proponent. The G20 economic leaders endorsed it in Chengdu in July.
Who are the hold-outs in this near-universal shift in fiscal thinking? The credit rating agencies, whose false ratings of mortgage-backed securities were a key factor in causing the 2008 crisis, are threatening to lower Australia’s AAA rating because the budget deficit is not consolidating as quickly as they would like. For good measure, Moody’s is also eyeing the Australian banks (which came through the 2008 crisis in good shape and have since been strengthened further) for a downgrade. In terms of fiscal space, the IMF ranks Australia as sixth best among the 30 top countries, above Germany, Canada, Switzerland, Sweden, Netherlands, Denmark and Singapore, all AAA-rated. As well, Australian government debt is low by global comparison.
The rating agencies were caught out badly by the 2008 financial crisis and missed the impending Greek implosion in 2009. In their eagerness to show how vigilant they are now, they are encouraging Australia to mimic the failed macro-policies which gave the world such a slow recovery over the past eight years.
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