TWN Info Service on Finance and Development (Sept11/03)
26 September 2011
Third World Network

Fiscal tightening could be self-defeating, warns UNCTAD
Published in SUNS #7215 dated 12 September 2011

Geneva, 7 Sep (Kanaga Raja) - The shift towards fiscal tightening appears to be premature in many countries where demand has not yet recovered on a self-sustaining basis, and where government stimulus is still needed to avoid a prolonged stagnation, the United Nations Conference on Trade and Development (UNCTAD) has said.

In its Trade and Development Report 2011, UNCTAD cautioned that premature fiscal tightening could be self-defeating if it weakens the recovery process, hampers improvement in public revenues and increases the fiscal costs related to the recession and bailouts. Hence, by hindering economic growth, such a policy would fail to achieve fiscal consolidation.

The current obsession with fiscal tightening in many countries, the report said, is misguided as it risks tackling the symptoms of the problem while leaving the basic causes unchanged. In virtually all countries, the fiscal deficit has been a consequence of the global financial crisis, and not a cause.

According to UNCTAD, between 2002 and 2007, fiscal balances had improved significantly in most developed and developing economies, as a result of growth in output, lower interest rates, and, in some countries, the price boom in commodities.

The crisis caused a significant deterioration in public sector accounts, as automatic stabilizers and fiscal stimulus packages were put in place. In several developed countries, public bailouts of financial institutions accounted for a large portion of the deficit, reflecting a conversion from private into public debt.

As a result, notes UNCTAD, the median public debt-to-GDP ratio in developed countries almost doubled, to more than 60 per cent of GDP, between 2007 and the end of 2010. Economic growth in developing countries, as a group, suffered less impact from the financial crisis, partly thanks to active counter-cyclical fiscal policies: as a result, fiscal balances improved in 2010 and debt-to-GDP ratios remained in check.

According to the UNCTAD report, the global financial crisis has once again brought fiscal policies and, more generally, the role of the State to the forefront of the economic policy debate.

Public sector accounts have been dramatically affected by the global crisis. In addition to policy-driven fiscal stimulus packages, which typically involved a discretionary increase in public spending and/or tax cuts to counter the macroeconomic impact of the crisis in the financial sector, the crisis itself affected fiscal balances and public debt through several channels.

One reason for the increasing public deficits and debts was the operation of automatic stabilizers, in particular reduced tax revenues, which reflected the downturn in economic activity, and, in countries with well-developed social security systems, increasing social expenditure, especially higher unemployment allowances.

Clearly, therefore, the crisis was not the outcome of excessive public expenditure or public sector deficits; rather, it was the cause of the high fiscal deficits and/or high public-debt-to-GDP ratios in several countries.

Nevertheless, says the report, some governments have already changed their policy orientation from providing fiscal stimulus to fiscal tightening, while others are planning to do so, in an effort to maintain or regain the confidence of financial markets which is viewed as key to economic recovery. This policy reorientation comes at a time when private economic activity is still far from being restored to a self-sustained growth path.

Although it is universally recognized that the crisis was the result of financial market failure, little has been learned about placing too much confidence in the judgement of financial market actors, including rating agencies. Many of the financial institutions that had behaved irresponsibly were bailed out by governments in order to limit the damage to the wider economic system.

It is therefore surprising that, now that "the worst appears to be over" for those institutions, a large body of public opinion and many policy-makers are once again putting their trust in those same institutions to judge what constitutes correct macroeconomic management and public finance.

"In any case, the shift towards fiscal tightening appears to be premature in many countries where private demand has not yet recovered on a self-sustaining basis, and where government stimulus is still needed to avoid a prolonged stagnation. Premature fiscal tightening could be self-defeating if it weakens the recovery process, hampers improvement in public revenues and increases the fiscal costs related to the recession and bailouts. Hence, by hindering economic growth, such a policy would fail to achieve fiscal consolidation."

The report argues that the recent global financial and economic crisis was not due to profligate fiscal policies, and that the increase in public debt in a number of developed countries was the result of the Great Recession.

Primary deficits caused by discretionary fiscal policies were a much smaller contributory factor to higher debt ratios than the slower (or negative) GDP growth and the banking and currency crises. Therefore, any policy that seeks to reduce public debt should avoid curbing GDP growth; without growth, any fiscal consolidation is highly unlikely to succeed.

According to the report, a review of a number of systemically important countries (including developed and emerging market economies) shows that the evolution of government savings is not the main factor behind external imbalances.

In the United States, the current-account balance fell steadily, from equilibrium in 1991 to a deficit of 6 per cent of GDP in 2006, in the build-up to the crisis. Government savings can hardly explain this trend: they first increased significantly between 1992 and 2000, as a result of strong growth of GDP and tax revenues as well as what was then called the "peace dividend"; they subsequently fell due to slower growth and policy shifts that reduced taxes and increased military expenditure, but this shift had no noticeable impact on the current account.

The progressive decline of household savings would be a better explanation for the widening current-account deficit, but this alone could not have been sufficient. Rather, the trade and current-account deficits were more likely the result of a combination of rising consumption - by incurring ever-increasing private debt (which lowers household savings rates) - and the loss of industrial competitiveness.

However, the lower household savings were less of a contributory factor than the greater consumption of imported rather than domestically produced goods, which slowed down growth of domestic income, corporate profits and tax revenue for the state and federal governments.

Another major developed economy, Japan, has run a current-account surplus every year over the past three decades, with a rising trend from 1.5 per cent of GDP in 1990 to 4.8 per cent in 2007. During that period, government savings plunged by 8 percentage points of GDP, and household savings also fell by an equal amount. Thus, the country's current-account surplus was clearly not because the Government or households decided to save more.

The report summarises that external imbalances in the countries reviewed were not caused by government dis-savings, firstly, because in several countries government savings were positive before the crisis, and secondly, because government (and corporate) savings behaved basically as endogenous variables.

The main factors contributing to their current-account deterioration were the loss of international competitiveness of their domestic firms and the decline in household savings, both of which were linked to massive capital inflows and financial deregulation that spurred credit-financed household expenditure and led to real appreciation of their currencies.

Between 2002 and 2007-2008, fiscal balances improved significantly in many countries, although some governments continued to run relatively large deficits. On the eve of the crisis, fiscal accounts were balanced, on average, in East, South and South-East Asia, and Latin America; and in Africa, the transition economies and West Asia, governments were achieving sizeable surpluses.
In developed economies, fiscal deficits had fallen, on average to less than 1.5 per cent of GDP. However, the crisis caused fiscal accounts to turn into deficit in all the regions.

In general, says the report, the improvement of fiscal balances in the years preceding the crisis did not result from fiscal retrenchment and expenditure cuts; in most countries, government revenues and expenditures increased together, although at different rates.

With the exception of developed countries, where they remained flat as a percentage of GDP, government revenues expanded significantly in all regions from 2002-2003 onwards. This was supported by broad-based acceleration of growth and increased earnings from commodity exports.

The declining share of interest payments in public expenditure has been a widespread trend. It resulted from the reduction of public debt ratios in most developing and emerging economies, as well as from lower real interest rates in most countries. In Africa, Latin America and East, South and South-East Asia, interest payments fell by 1 to 2 percentage points between the periods 1998-2000 and 2008-2010. In the transition economies, there was a similar reduction between 2002 and 2008-2010.

"Such expansionary adjustments of fiscal balances, with higher revenues and primary expenditure, implied a structural change in many developing and transition economies, and served to enlarge their policy space which they were able to use when hit by the financial crisis."

In developed countries with well-established social security systems and a comparatively high share of direct taxes in fiscal revenues, changes in government revenues and expenditure are partly related to automatic stabilizers.

Between 2007 and 2010, spending on social security benefits increased by 3 per cent of GDP in Japan and the United States, and by between 1.5 and 4.3 per cent of GDP in most European countries, with the highest increases in those countries where unemployment rose the most, such as Greece and Spain.

Financial crises - such as those that struck many emerging-market economies in the past - typically create fiscal costs through interest rate hikes, currency devaluation that increases the burden of public debt denominated in foreign currencies, and public-funded bailouts. This is in addition to the direct effects of slower growth or recession on current revenues and expenditures, and on discretionary fiscal stimulus measures.

In the context of the latest crisis, bailout operations have been taking place mainly in developed economies. Developing countries were generally able to avoid this kind of fiscal cost, because most of them did not experience banking crises, and therefore did not need to bail out any of their banks.

In contrast, says the report, fiscal accounts in several developed countries were severely affected by the financial crisis. In these countries, the authorities gave top priority to preventing the collapse of the financial system, making available the financial resources necessary to achieve this objective.

"The current obsession with fiscal tightening in many countries is misguided, as it risks tackling the symptoms of the problem while leaving the basic causes unchanged. In virtually all countries, the fiscal deficit has been a consequence of the global financial crisis, and not a cause," the report stresses.

Today's fiscal deficits are an inevitable outcome of automatic stabilizers and measures aimed at countering the effects of the crisis, including policy-driven stimulus packages that involved increased government spending, lower tax rates and public-funded bailouts of financial institutions.

Empirical evidence from different countries and regions shows that the crisis was caused by underlying changes in national competitiveness and private sector imbalances, which were closely related to a malfunctioning financial sector in developed countries.

"These fundamental causes are not being addressed in the current focus on fiscal tightening in some countries."

Worse still, the diversion of attention away from the underlying causes and towards so-called fiscal profligacy in other countries, which in turn could eventually lead to fiscal tightening, increases the risk of stalling, or even reversing, economic recovery.

The level of a country's fiscal deficit (or surplus) needs to be viewed from a more holistic and dynamic perspective, in the context of its position and on its economic stability and growth prospects. From this perspective, the composition of fiscal revenues and expenditures and many other variables that have an impact on a country's fiscal space are also important.

According to the report, after an initial wide consensus on the necessity of proactive macroeconomic policies to support demand, many policy-makers have now shifted their focus from fiscal stimulus to fiscal tightening. The policy debate today is about what measures should be taken to achieve the widely agreed objectives of recovery from the crisis and an improvement in fiscal accounts, as well as the sequencing of those measures.

An argument frequently advanced in support of fiscal retrenchment is that there is no more fiscal space available for further fiscal stimulus, even if it is acknowledged that such policies were useful at the initial stages of the crisis. However, this argument overlooks the fact that fiscal space is not a static variable. It would be a mistake to consider this policy space as exogenously determined rather than a largely endogenous variable.

Despite the lack of solid conceptual foundations, most developed economies have embarked on fiscal tightening, concentrating on the expenditure side. Spending cuts on welfare, health care and pensions have been the most frequently used measure in OECD (Organisation for Economic Cooperation and Development) countries, occurring with up to 60 per cent frequency.

When the crisis erupted, a number of European and transition economies that were among the most seriously affected turned to the IMF for emergency financing. Although at the time the IMF approved of counter-cyclical fiscal policies, in most of these countries the programmes it supported entailed fiscal adjustment, as has been typical of its conditionality.

Hence, fiscal restraint was required without a previous injection of fiscal stimulus aimed at limiting the impact of a crisis that, in general, was not caused by fiscal deficits. Given the pressure on financial markets, no fiscal space was assigned to those countries by creditors. In order to obtain IMF support, countries are expected to adjust their current-account deficits by reducing domestic absorption (including fiscal retrenchment), which normally slows GDP growth.

"Misjudging the effects of fiscal tightening seems to be the rule rather than the exception in IMF-backed programmes," says the report.

A detailed examination of fiscal adjustment in 133 IMF-supported programmes in 70 countries carried out by the IMF's Independent Evaluation Office (IEO) notes that there was "a tendency to adopt fiscal targets based on over-optimistic assumptions about the pace of economic recovery leading inevitably to fiscal under performances" and "over-optimistic assumptions about the pace of revival of private investment."

That report observes that "a more realistic assessment in certain circumstances could have justified the adoption of a more relaxed fiscal stance on contra-cyclical grounds".

According to UNCTAD, in country after country where fiscal tightening was expected to both reduce the budget deficit and boost investment and economic growth, the opposite happened. Private sector demand and investment, in particular, responded much more sluggishly than the IMF had expected.

In addition, fiscal balances, on average, failed to improve during the first two years of the fiscal adjustment programmes, even though this was an explicit goal of those programmes.

The UNCTAD report also highlights the need for a dynamic definition of fiscal space, while showing that other factors, such as monetary policy and the international financial environment, might also be relevant for creating that space.

The crisis has created higher levels of public debt in many developed economies. However, it is not clear that these levels are unsustainable, and whether fiscal policy should become contractionary if economic recovery and low real interest rates are sufficient to maintain the debt-to-GDP ratio on a stable path.

To a large extent, central banks around the world control the rate of interest, and there is no justifiable reason for raising interest rates when global recovery is still fragile. If inflationary pressures not directly associated with excess demand develop, there are alternative policies that might be used to deal with the problem, such as an incomes policy.

The report summarises that monetary policy is an essential instrument, not just to promote the level of activity while maintaining stability, but also to create the necessary space for fiscal policy. There are good reasons to believe that monetary policy should continue to create fiscal space by maintaining low interest rates in a two-speed global recovery in which developed countries such as Japan, several European countries and the United States face a sluggish recovery, and developing countries remain steadfast on their catching-up path.

However, particularly when interest rates are low, or at the lower zero bound level, and demand for credit remains weak, as is normally the case after a financial crisis, fiscal policy should bear full responsibility for promoting output growth. In that respect, the way the public sector spends and collects revenue becomes an essential ingredient.

The report underscores that fiscal space depends not just on how fiscal policies are implemented, but also on how well those policies are supported by monetary policy and by the national and international financial environment.

This is in addition to considerations of the political viability of the policy changes. If fiscal space is an issue in the design of counter-cyclical macroeconomic policies, this should be taken into account not when it has allegedly reached its limit, but at the outset (i.e. when decisions are taken on fiscal stimulus measures), because demand and fiscal feedback effects differ widely depending on which specific expenditures or taxes are changed.

"An optimal combination of such changes would achieve a maximum expansionary effect, as there would be a minimum drain of demand in the income circulation process on savings and imports, and a maximum encouragement of additional private spending."

As a result, there may be a debt paradox in the sense that the income effects of stimulus measures would lead to full compensation, or even overcompensation, of the initial deficit through additional tax incomes. Moreover, to the extent that it accelerates GDP growth, the debt-to-GDP ratio may fall.

In other words, as a result of multiplier and accelerator effects on income, which increase the tax revenue at constant tax rates, a deficit can finance, and, under favourable conditions, even over-finance its own debt service, so that an expansionary fiscal policy may be more likely to reduce the deficit and the debt ratio than a restrictive one.

Although public debt crises often do not have a fiscal origin, some are indeed caused by unsustainable fiscal policies, while others are caused by irresponsible lending for purposes that do not increase the overall productivity but amount to zero sum games over the medium term. However, even when a debt crisis has a fiscal origin, it may well be necessary to undertake expansionary fiscal policies to promote growth, which may lead to increasing public debt in the short run in order to forestall even worse consequences later.

Since banking crises are often followed by sudden increases in public debt, associated with policy decisions to rescue financial institutions in distress, policies aimed at reducing the risk of debt crises need to include measures to keep in check private sector debt, both domestic and external.

There are a number of useful instruments for limiting excessive risk-taking by the private sector, such as: tighter financial regulation, including guarantees that borrowers have income streams compatible with the accumulated debt; restrictions on certain types of predatory lending which misinform borrowers about payment conditions; caps on interest rates charged by certain types of credit lines; higher capital requirements for banks; and capital controls.

Although debt crises do not always have a fiscal origin, the standard response to a sudden jump in public debt is often fiscal retrenchment. "This appears to be a misguided policy, because the appropriate response should relate to the nature of the crisis."

If a crisis originates from the bursting of an asset bubble, the response should be financial reform, and even quite the opposite of fiscal retrenchment, namely, counter-cyclical policies to absorb private sector de-leveraging so as to reduce the macroeconomic slump created by asset deflation.

If the crisis originates from excessive foreign currency lending and excessive real appreciation, the appropriate response at the national level might be to improve the debt structure and introduce policies aimed at avoiding misalignments of the real exchange rate as well as introducing controls on capital inflows.

Debt restructuring may be part of a strategy to resolve a debt crisis, not just for the borrowing country but also for creditors, since the possibilities for renewed economic growth and the ability to repay increase. If debt renegotiation frees up resources for growth-enhancing activities it may allow a country to better finance its own reduced debt service. However, sovereign default or debt restructuring are no panacea, and their risks have to be weighed carefully against the risk of contagion, which is a major hazard in the European monetary union.

The report goes on to suggest that the best strategy for reducing public debt is to promote growth-enhancing fiscal policies. Moreover, it would seem from the evidence that fiscal expansion tends to be more effective if spending takes precedence over tax cuts, if spending targets infrastructure and social transfers, and if tax cuts, in turn, target lower income groups, which generally have a higher propensity for spending.

Fiscal expansion, by increasing the level of activity and income, raises the revenue stream and reduces the debt-to-GDP ratio, in particular if interest rates are relatively low compared with GDP growth.

In this sense, problems associated with the growth of public debt, particularly when that debt is not primarily related to fiscal problems, are best resolved by a strategy of fiscal expansion. Further, if it is argued that, for economic and/or political reasons there is little space for fiscal expansion, there is always the possibility to redirect spending and taxes to support more expansionary measures. Again, this suggests that spending should be given precedence over tax cuts, and that both measures should benefit low-income groups in particular.

"A more equitable distribution of income would make economic recovery more self-sustaining and improve the chances of achieving fiscal consolidation. In this sense, increasing real wages in line with productivity, and, especially in developing countries with large informal sectors, government transfers to the low-income segments of society, are important complements to fiscal expansion."

Beyond the notion that growth is the best solution to reduce public-debt-to-GDP ratios, it is important to emphasize that higher ratios of public debt per se, particularly in developed countries after the crisis, do not pose a threat to fiscal sustainability.

The public debt today is much more sustainable than the private debt before the crisis. As long as interest rates are low and unused capacities exist, there is no crowding out of private investment, and the globally higher public debt ratios do not pose a problem for recovery, the report stresses.

"For the world as a whole, and for the big economies, the only strategy warranted is one of consolidation through growth. Growth, combined with low interest rates, will bring an increase in revenues and a fall in debt ratios over time. This implies that monetary policy should continue to maintain low interest rates in order to keep the burden of interest payments for the public sector bearable."

If inflation is perceived to be a serious threat to economic stability, and given that in most economies the pressures on prices have originated largely from the financialisation of commodity markets, the subsequent, second round effects (such as a price-wage spiral) need to be dealt with by an incomes policy rather than by adopting restrictive macroeconomic measures.

There are instances when an external constraint (e.g. when lack of competitiveness brings about current-account deficits) prevents fiscal expansion because it would aggravate the external imbalance. In such cases, priority should be given to resolving the balance-of-payments problem rather than introducing austerity measures, the report concludes.