London skyline. Policymakers met in London in 2009 to coordinate fiscal policy efforts to combat the effects of the crisis (Photo: Mark Fairhust/Newscom)
Deficits & Debt
A new paper by IMF staff looks at lessons from the recent crisis on the role of fiscal policy in advanced economies.
“Our research has some interesting implications for policymakers, especially on the use of fiscal policy as a tool to help stabilize the economy and on how to deal with fiscal risks and high public debt,” said Bernardin Akitoby, division chief in the IMF’s Fiscal Affairs Department. “For one, we see that fiscal policy can have powerful short-run effects on the economy when economic conditions resemble those that have prevailed in many advanced economies over the last few years. We also see that advanced economies are exposed to larger–than–expected shocks and need bigger fiscal buffers than we thought,” said Akitoby, who led the team of economists from the Fiscal Affairs and Research Departments.
Fiscal policy to fight recessions
The paper reviews what economists have learned from the crisis about the effectiveness of fiscal policy as a tool to stabilize the economy. Recent evidence shows that some of the precrisis concerns about the effects of fiscal policy and implementation issues related to discretionary fiscal stimulus were overblown.
The study finds that, under certain conditions, fiscal policy can have powerful effects on the economy in the short run. Its effects are larger when central banks are unable to reduce interest rates below zero, when the financial sector is weak, or when the economy is producing at significantly below its potential. New research has also raised doubts about the precrisis evidence that fiscal contractions can have an expansionary effect on output.
The crisis also showed that economic stimulus measures need not take too long to design and implement, as most advanced economies quickly enacted fiscal stimulus efforts when the crisis erupted. Moreover, most temporary stimulus measures were allowed to lapse or were rolled back after the initial phase of the crisis had passed, countering the view that politicians are unwilling to roll back stimulus measures once economies recover. Nevertheless, some of the earlier concerns about whether discretionary stimulus measures will be timely and reversible remain valid, especially during less severe recessions.
The findings also raise a critical question that has implications for the Fund’s policy advice, according to Daniel Leigh, of the IMF’s Research Department and co-author of the paper. “When we look at the use of fiscal stimulus during the recent crisis and ask whether from now on governments should use discretionary fiscal stimulus to fight recessions, the answer depends on whether countries face circumstances in the future similar to those that led governments to resort to discretionary tax cuts and spending increases—monetary policy constrained by near-zero interest rates, for instance,” he said. “One should not underestimate the likelihood of such conditions persisting or reoccurring.”
Fiscal risks and debt sustainability
The paper also looks at the fiscal risks that advanced economies face and how they can better prepare themselves to handle such risks in the future.
While a full-blown fiscal crisis in an advanced economy had generally been considered a remote possibility before the crisis, events since 2008 have proven otherwise. The evidence shows that most advanced economies’ fiscal buffers were not big enough to allow them to easily absorb the severe economic shocks they suffered, with several countries experiencing sovereign debt crises as a result.
One lesson the paper draws from these experiences is that governments should take a “risk-based” approach to analyzing the sustainability of their public debt—including risks from the financial sector and other fiscal vulnerabilities specific to each country. In turn, the level of debt that might be considered “safe” for each country will depend on the potential risks it faces. Generally speaking, as they rebuild their buffers, prudent policymakers will want to aim for a long-run debt level that is lower than what was considered reasonable before the crisis.
Designing fiscal adjustments
Given the need to bring down public debt levels, the paper goes on to examine the appropriate pace of fiscal tightening and what constitutes the best revenue and expenditure mix for fiscal adjustment programs.
Economists are increasingly questioning the merits of always doing the bulk of the fiscal adjustment upfront. Instead, how fast a country should adjust depends on the state of the economy, the condition of public finances, and the extent of financial market pressures.
The paper finds that most advanced economies today should adjust at a gradual pace, within a credible medium-term plan, to limit the short-run impact of fiscal tightening on growth. But excessively delaying the adjustment would be unwise. The risk is that investors lose confidence in a government’s willingness to put fiscal policy on a sound footing and begin to demand higher interest rates, which, at high debt levels, can quickly lead to debt dynamics that spiral out of control. Countries that are under pressure from financial markets, or have lost market access, may have little choice but to “frontload” their adjustments. Even for these countries though, there may be a “speed limit” on the pace of adjustment, beyond which faster adjustment may be counterproductive.
While evidence on the best mix of adjustment measures is less clear cut, the paper highlights the importance of taking into account equity considerations, such as through better targeting of revenue and spending measures. The paper also argues that raising taxes further when the tax burden is already high can undermine a country’s potential growth, so countries with a relatively high tax burden should focus on reducing spending. Countries with lower spending and revenue levels would have more scope to boost revenues.
Fiscal institutions and transparency
The crisis highlighted how important it is to have well functioning fiscal institutions, including tools like medium-term budget frameworks and fiscal rules, to ensure fiscal policy remains sustainable.
Medium-term budget frameworks and fiscal rules need to be credible, but the IMF economists find that they also need to be sufficiently flexible to respond to economic fluctuations. These tools can be designed to avoid overspending in good economic times (by targeting the structural fiscal balance, for example), and can also include “escape clauses” that allow countries more freedom to use fiscal policy to support the economy when it is hit by large economic shocks. Independent fiscal agencies can help to monitor adherence to the rules and make sure greater flexibility is not abused.
Shortcomings in fiscal transparency have also been revealed by the crisis. The paper concludes that further efforts are needed to improve the timeliness and institutional coverage of fiscal reporting. Moreover, countries should publish fiscal risk assessments to raise awareness about potential sources of fiscal risks.
