Sunday, January 31, 2010

Fiscal contraction during recessions?

It is widely agreed that an economy facing a deep recession and massive unemployment has to indulge in fiscal stimulus expenditures by way of direct government spending and/or tax cuts to stimulate the economy out of the trough. Accordingly, economies of the world, both developed and emerging, have resorted to generous fiscal stimulus spending during the current Great Recession.

Spain, one of the worst hit by the property bubble, has apprently decided to take a contrarian route. Spain's economy is staring deep down the barrel, as this Times report indicates

"The International Monetary Fund said this week that it expected Spain to be the only country in the euro zone to remain in recession this year. It forecast a contraction of 0.6 percent in 2010, then growth of 0.9 percent in 2011. The national statistics office in Madrid said that unemployment was 18.8 percent in the fourth quarter, up from 17.9 percent in the previous period. According to Eurostat, the European Union’s statistics agency, 44.5 percent of people under 25 in Spain were without work at the end of 2009."

In order to combat the deep recession and unemployment, what has the Spanish government decided

"The Spanish government said that it would cut spending by almost 50 billion euros, or $70 billion, to help bring its budget deficit down to 3 percent of gross domestic product by 2013, from 11.4 percent last year. Lowering the deficit to 3 percent would be in line with European Union’s limit on national deficits... the spending cuts would spare only a few areas — education, antiterrorism, research and development, pension payments and unemployment assistance. Total spending cuts for public employees will amount to a reduction equivalent to 0.3 percent of G.D.P. through 2013, taking into account reduction measures like hiring freezes."

This contrarian budget balancing approach is what economists like John Cochrane and Eugene Fama have been advocating. Spain's path towards recovery with this contrarian approach is an experiment to be evaluated. Let us wait for 2013 or 2014 to judge who was right!

Spain's problems is only the latest manifestation of the need to bring in some form of flexibility to the EU's very rigid (on macroeconomic parameters) Stability Pact given the wide diversity among member economies. One way of accomodating the rigid norms of the Pact is to have an EU-wide fiscal balancing fund that bails out economies like Spain and Greece which face severe debt crisis.

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