Wednesday, June 29, 2011

Automatic fiscal stabilizers and counter-cyclical fiscal policy

I have blogged extensively about the utility of fiscal policy in combating aggregate demand slumps, especially when the economy is facing the zero-bound in nominal interest rates.

However, unlike the more rules-based monetary policy, fiscal policy is subjective and deeply political. The classic fiscal policy alternatives like direct government spending on infrastructure face the problem of implementation lags. In contrast, automatic stabilizers kick-in immediately, being targeted on those most likely to spend any money provided to them. It no surprise that automatic stabilizers - unemployment insurance, food stamps etc - have among the highest fiscal multipliers.

The WSJ points to the apparent success of Sweden in managing its recovery from the Great Recession and attributes it to successful expansionary policies by both the government and the Riksbank. The Swedish economy grew 5.5% in 2010 and unemployment rate has fallen from its peak of 9% to 7%. Instead of high-profile direct spending and tax cuts, the Swedish government responded swiftly with automatic stabilizers to provide income, health care and other services to people who are unemployed. The Riksbank, initially lowered rates aggressively to zero, even taking it to minus 0.25% (savers had to pay 0.25% for the privilege of keeping deposits). Its quantitative easing program was more expansionary than even the Fed - the Riksbank's balance sheet was more than 25% of GDP in the summer of 2009, compared to 15% for the Fed.

Further, unlike many other developed economies, Sweden entered the recession in excellent fiscal health - its budget had a 3.6% of GDP surplus in 2007, to 3% deficit in the US. This gave the government enough cushion to indulge in extended fiscal expansion when recession struck. This was a result of a strong commitment, borne out of the bitter experience of its banking and economic crisis in early 1990s, to maintain a counter-cyclical fiscal policy.

Clice Crook points to the example of the US, where though the Obama administration came up with a large fiscal stimulus in 2009, mostly with tax cuts and direct spending, its impact was offset by the severe fiscal tightening by the local governments. He also writes about the relative lack of influence of fiscal stabilizers in the US,

"Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession."

The acrimonious debates surrounding fiscal expansion in the US underlines the need for a much greater role for automatic fiscal stabilizers. However, it is also important that these automatic stabilizers have automatic sunset clauses that ensure exit from fiscal expansion when the economy recovers. Mark Thoma makes an excellent case for greater use of automatic fiscal stabilizers during recessions.

In this context, Jeffrey Frankel, Carlos A. Vegh, and Guillermo Vuletin (pdf here) examined long-term fiscal policy in 94 countries (73 developing and 21 developed countries) over the 1960-2009 period and found that "the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions".

They examined the correlation between government spending and GDP for these countries over two periods, 1960-1999 and 1999-2009, and found a significant increase in countries with negative correlation (or counter-cyclical spending) over the two periods. In fact, among developing countries, those following counter-cyclical policies increased four-fold to 35% over the two periods. The graphic below indicates the correlation between spending and GDP for these countries in the 2000-09 period, with yellow and black bars representing developing and developed countries respectively.

The increase in counter-cyclicality in the conduct of fiscal policy by developing countries is evidence of greater maturity by policy makers and policy institutionalization in these countries. This maturity is corroborated by other indicators like reduced debt-to-GDP ratios in many developing countries. The authors "find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment". They highlight the success of Chile with counter-cyclical fiscal policy and attributes it to institutional strengthening reforms since 1980s.

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