Tag: Fiscal Consolidation

In an attempt to prevent recession following the financial crisis of 2007–8, many countries adopted both expansionary monetary policy and expansionary fiscal policy – and with some success. It is likely that the recession would have been much deeper without such policies

But with growing public-sector deficits caused by the higher government expenditure and sluggish growth in tax receipts, many governments soon abandoned expansionary fiscal policy and relied on a mix of loose monetary policy (with ultra low interest rates and quantitative easing) but tight fiscal policy in an attempt to claw down the deficits.

But such ‘austerity’ policies made it much harder for loose monetary policy to boost aggregate demand. The problem was made worse by the attempt of both banks and individuals to ‘repair’ their balance sheets. In other words banks became more cautious about lending, seeking to build up reserves; and many individuals sought to reduce their debts by cutting down on spending. Both consumer spending and investment were slow to grow.

And yet government and central banks, despite the arguments of Keynesians, were reluctant to abandon their reliance solely on monetary policy as a means of boosting aggregate demand. But gradually, influential international institutions, such as the IMF (see also) and World Bank, have been arguing for an easing of austerity fiscal policies.

The latest international institution to take a distinctly more Keynesian stance has been the Organisation for Economic Co-operation and Development (OECD). In its November 2015 Economic Outlook it had advocated some use of public-sector investment (see What to do about slowing global growth?. But in its Interim Economic Outlook of February 2016, it goes much further. It argues that urgent action is needed to boost economic growth and that this should include co-ordinated fiscal policy. In introducing the report, Catherine L Mann, the OECD’s Chief Economist stated that:

“Across the board there are lower interest rates, except for the United States. It allows the authorities to undertake a fiscal action at very very low cost. So we did an exercise of what this fiscal action might look like and how it can contribute to global growth, but also maintain fiscal sustainability, because this is an essential ingredient in the longer term as well.

So we did an experiment of a two-year increase in public investment of half a percentage point of GDP per annum undertaken by all OECD countries. This is an important feature: it’s everybody doing it together – it’s a collective action, because it’s global growth that is at risk here – our downgrades [in growth forecasts] were across the board – they were not just centred on a couple of countries.

So what is the effect on GDP of a collective fiscal action of a half a percentage point of GDP [increase] in public investment in [high] quality projects. In the United States, the euro area, Canada and the UK, who are all contributors to this exercise, the increase in GDP is greater than the half percentage point [increase] in public expenditure that was undertaken. Even if other countries don’t undertake any fiscal expansion, they still get substantial increases in their growth rates…

Debt to GDP in fact falls. This is because the GDP effect of quality fiscal stimulus is significant enough to raise GDP (the denominator in the debt to GDP ratio), so that the overall fiscal sustainability [debt to GDP] improves.”

What is being argued is that co-ordinated fiscal policy targeted on high quality infrastructure spending will have a multiplier effect on GDP. What is more, the faster growth in GDP should outstrip the growth in government expenditure, thereby allowing debt/GDP ratios to fall, not rise.

This is a traditional Keynesian approach to tackling sluggish growth, but accompanied by a call for structural reforms to reduce inefficiency and waste and improve the supply-side of the economy.

Articles

Osborne urged to spend more on infrastructure by OECD Independent, Ben Chu (18/2/16)
OECD blasts reform fatigue, downgrades growth and calls for more rate cuts Financial Review (Australia), Jacob Greber (18/2/16)
OECD calls for less austerity and more public investment The Guardian, Larry Elliott (18/2/15)
What’s holding back the world economy? The Guardian, Joseph Stiglitz and Hamid Rashid (8/2/16)
OECD calls for urgent action to combat flagging growth Financial Times, Emily Cadman (18/2/16)
Central bankers on the defensive as weird policy becomes even weirder The Guardian, Larry Elliott (21/2/16)
Keynes helped us through the crisis – but he’s still out of favour The Guardian, Larry Elliott (7/2/16)
G20 communique says monetary policy alone cannot bring balanced growth
Reuters (27/2/15)

OECD publications
Global Economic Outlook and Interim Economic Outlook OECD, Catherine L Mann (18/2/16)
Interim Economic Outlook OECD (18/2/16)

Questions

  1. Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
  2. Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
  3. Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all OECD countries rather than being the only country to pursue such a policy?
  4. What determines the size of the multiplier effect of such policies?
  5. How might a new classical/neoliberal economist respond to the OECD’s recommendation?
  6. Why may monetary policy have ‘run out of steam’? Are there further monetary policy measures that could be adopted?
  7. Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
  8. Should quantitative easing be directed at financing public-sector infrastructure projects? What are the benefits and problems of such a policy? (See the blog post People’s quantitative easing.)

It is one year since the election of Shinzo Abe in Japan. He immediately embarked on a radical economic policy to stimulate the Japanese economy, which had suffered from years of stagnation. There have been three parts (or three arrows) to his policy: fiscal policy and monetary policy to stimulate aggregate demand and supply-side policy to increase productivity.

As the previous post explains:

“The first arrow is monetary policy. The Bank of Japan has engaged in extensive quantitative easing through bond purchases in order to drive down the exchange rate (see A J-curve for Japan?), stimulate expenditure and increase the rate of inflation. A target inflation rate of 2% has been set by the Bank of Japan. Part of the problem for the Japanese economy over the years has been stagnant or falling prices. Japanese consumers have got used to waiting to spend in the hope of being able to buy at lower prices. Similarly, Japanese businesses have often delayed stock purchase. By committing to bond purchases of whatever amount is necessary to achieve the 2% inflation target, the central bank hopes to break this cycle and encourage people to buy now rather than later.

The second arrow is fiscal policy. Despite having the highest debt to GDP ratio in the developed world, Japan is embarking on a large-scale programme of infrastructure investment and other public works. The package is worth over $100bn. The expansionary fiscal policy is accompanied by a longer-term plan for fiscal consolidation as economic growth picks up. In the short term, Japan should have no difficulty in financing the higher deficit, given that most of the borrowing is internal and denominated in yen.

The third arrow is supply-side policy. On 5 June, Shinzo Abe unveiled a series of goals his government would like to achieve in order to boost capacity and productivity. These include increasing private-sector investment (both domestic and inward), infrastructure expenditure (both private and public), increasing farmland, encouraging more women to work by improving day-care facilities for children, and deregulation of both goods, capital and labour markets. The prime minister, however, did not give details of the measures that would be introduced to achieve these objectives. More details will be announced in mid-June.”

In the webcast and article below, Linda Yueh, the BBC’s Chief Business Correspondent, considers how effective the policies are proving and the challenges that remain.

Webcast

Has Abenomics fixed Japan’s economic fortunes? BBC News, Linda Yueh (16/12/13)

Articles

Why Abenomics holds lessons for the West BBC News, Linda Yueh (13/12/13)
Japanese business confidence hits six-year high, Tankan survey shows The Guardian (16/12/13)

Data

World Economic Outlook Database IMF (Oct 2013)
Bank of Japan Statistics Bank of Japan
Economic Outlook Annex Tables OECD
Country statistical profile: Japan 2013 OECD (15/11/13)

Questions

  1. Demonstrate on (a) an aggregate demand and supply diagram and (b) a Keynesian 45° line diagram the effects of the three arrows (assuming they are successful) in meeting their objectives.
  2. Why has Japan found it so hard to achieve economic growth over the past 20 years?
  3. How has the Japanese economy performed over the past 12 months?
  4. What lessons can be learnt by the UK and eurozone countries from Japan’s three arrows?
  5. Why is the second arrow problematic, given the size of Japan’s general government debt? Does the proportion of Japanese debt owed overseas affect the argument?
  6. In what ways do the three arrows (a) support each other; (b) conflict with each other?
  7. Why is the structure of the labour market in Japan acting as a break on economic growth? What policies are being, or could be, pursued to tackle these structural problems?

Since coming to office in December 2012, Shinzo Abe’s government has been determined to revive the Japanese economy. For the past 20 years, Japan’s growth has averaged only 0.8% per annum. This compares with 1.3% for Germany, 2.3% for the UK, 2.6% for the USA, 4.9% for South Korea and 10.4% for China.

Japanese real GDP per capita was only 14.5% higher in 2012 than 20 years earlier. This compares with figures for Germany, the UK, the USA, South Korea and China of 27%, 45%, 34%, 126% and 497% respectively.

So what has the Japanese government done to boost both short-term and long-term growth after years of stagnation? There are ‘three arrows’ to the policy, targeted at reviving and sustaining economic growth.

The first arrow is monetary policy. The Bank of Japan has engaged in extensive quantitative easing through bond purchases in order to drive down the exchange rate (see A J-curve for Japan?), stimulate expenditure and increase the rate of inflation. A target inflation rate of 2% has been set by the Bank of Japan. Part of the problem for the Japanese economy over the years has been stagnant or falling prices. Japanese consumers have got used to waiting to spend in the hope of being able to buy at lower prices. Similarly, Japanese businesses have often delayed stock purchase. By committing to bond purchases of whatever amount is necessary to achieve the 2% inflation target, the central bank hopes to break this cycle and encourage people to buy now rather than later.

The second arrow is fiscal policy. Despite having the highest debt to GDP ratio in the developed world, Japan is embarking on a large-scale programme of infrastructure investment and other public works. The package is worth over $100bn. The expansionary fiscal policy is accompanied by a longer-term plan for fiscal consolidation as economic growth picks up. In the short term, Japan should have no difficulty in financing the higher deficit, given that most of the borrowing is internal and denominated in yen.

The third arrow is supply-side policy. On 5 June, Shinzo Abe unveiled a series of goals his government would like to achieve in order to boost capacity and productivity. These include increasing private-sector investment (both domestic and inward), infrastructure expenditure (both private and public), increasing farmland, encouraging more women to work by improving day-care facilities for children, and deregulation of both goods, capital and labour markets. The prime minister, however, did not give details of the measures that would be introduced to achieve these objectives. More details will be announced in mid-June.

The following videos and articles look at the three arrows of Abenomics and the effects they are having on confidence and attitudes as well as on expenditure, output and the exchange rate. They also look at the crucial third arrow: at whether supply-side reforms will be enough to achieve a sustained increase in economic growth.

Videos

Abenomics an uncertain future for most Financial Times on YouTube, Ben McLannahan (30/5/13)
Assessing Abenomics NHK World (3/6/13)
Adam Posen on Abenomics NHK World (30/5/13)
Japanese concerned over ‘Abenomics’ AlJazeera on YouTube (30/5/13)
Abenomics – the cure for deflation? BBC News, Rupert Wingfield-Hayes (10/5/13)
Japan PM’s economic speech ‘short on detail’ BBC News, Rupert Wingfield Hayes (5/6/13)
Pretty Positive on Abenomics Bloomberg, Jan Hatzius, Goldman Sachs (5/6/13)
Why Abenomics is Bonkers: Pro CNBC, Graeme Maxton, (27/5/13)
‘Abe’nomics Not About BOJ Printing Money Bloomberg, Derek Halpenny (31/5/13)
Abenomics Aims `Third Arrow’ at Business Rules Bloomberg, Willie Pesek (5/6/13)
Analysis on Abe’s Growth Plan NHK World (5/6/13)

Articles

Will three arrows find their target? On Line Opinion, Andrew Leigh (6/6/13)
Japan Fires ‘Third Arrow,’ but Will It Work? CNBC, Dhara Ranasinghe (5/6/13)
Japan’s ‘3 Arrows’ May Run Into German Wall CNBC, Michael Ivanovitch (19/5/13)
Japan’s recovery – the power of Abe’s three arrows Commonwealth Bank, Australia, Melanie Timbrell (31/5/13)
So Far, the Battery Charger Is Working in Japan The New York Times, Jeff Sommer (18/5/13)
Abenomics Could Light A Fire Under The Japan Trade Again Business Insider, Matthew Boesler (4/6/13)
Japan’s New Prime Minister Unveils The ‘Most Important’ Plank Of Abenomics Business Insider (5/6/13)
Japan PM pledges to boost incomes by 30% Channel NewsAsia (5/6/13)
Abe’s growth strategy disappoints economists, investors The Asahi Shimbun (6/6/13)
Abenomics Won’t Be ’Magic Bullet’ for Japan, Says Johnson of MIT Bloomberg, Cordell Eddings (5/6/13)
Too soon to call time on Abenomics BBC News, Stephanie Flanders (19/6/13)
Abenomics: The objectives and the risks BBC News, Puneet Pal Singh (19/7/13)

Data

World Economic Outlook Database IMF
Bank of Japan Statistics Bank of Japan
Economic Outlook Annex Tables OECD
Country statistical profile: Japan 2013 OECD

Questions

  1. Demonstrate on (a) an aggregate demand and supply diagram and (b) a Keynesian 45° line diagram the effects of the three arrows (assuming they are successful) in meeting their objectives.
  2. What will determine the effectiveness of the first two arrows in boosting short-term economic growth?
  3. Would you characterise the policies of the third arrow as interventionist or market-orientated, or as a mixture? Explain.
  4. What are the dangers in ‘Abenomics’?
  5. Find out what has been happening to Japanese bond rates. What are the implications of this for monetary policy?
  6. What are the ‘markets telling Abe’?
  7. In what ways will expectations influence the effectiveness of Abenomics?

At the start of 2013, the USA faces a ‘fiscal cliff’. By this is meant that, without agreement by Congress on new fiscal measures, the USA will be forced into tax rises and expenditure cuts of around $650 billion (over 4% of GDP). This would probably push the economy straight back into recession. This in turn would have a serious dampening effect on the global economy.

But why would fiscal policy be automatically tightened? The first reason is that tax cuts given under the George W. Bush administration during 2001–3 (largely to the rich) are due to expire. Also a temporary cut in payroll taxes and an increase in tax credits given by President Obama are also due to end. These tax increases would form the bulk of the tightening. The average US household would pay an extra $3500 in taxes, reducing after-tax income by around 6%.

The second reason is that various government expenditure programmes are scheduled to be reduced. These reductions in expenditure amount to around $110 billion.

It is likely, however, that Congress will agree to delay or limit the tax increases or expenditure cuts; politicians on both sides want to avoid sending the economy back into recession. But what the agreement will be is not at all clear at this stage.

Republicans are taking a tougher line than Democrats on cutting the budget deficit; they are calling for considerably less restraint in implementing the government expenditure cuts. On the other hand, they are likely to be less willing to raise taxes.

But unless something is done, the consequences for 2013 could be dire. The fiscal cliff edge rapidly approaches.

Articles
Nearly 90 percent of Americans would see taxes rise if ‘fiscal cliff’ hits Washington Post, Lori Montgomery (1/10/12)
Fiscal cliff a serious threat, but unlikely CNN Money, Chris Isidore (1/10/12)
“Fiscal cliff” fears may impede faster job growth Chicago Tribute, Lucia Mutikani (1/10/12)
Avert Fiscal Cliff With Entitlement Cuts, Tax Increases Bloomberg (2/10/12)
‘Fiscal cliff’ to hit 90% of US families Financial Times, James Politi (1/10/12)
Investors don’t want the US to fall off the fiscal cliff The Telegraph, Tom Stevenson (22/9/12)
Gauging the fiscal cliff BBC News, Stephanie Flanders (27/9/12)
The US fiscal cliff – and the fiscal chasm BBC News, Stephanie Flanders (2/10/12)
US fiscal cliff threat fails to galvanise policymakers Guardian Economics blog, Mohamed el-Erian (1/10/12)
Multiplying Europe’s fiscal suicide (technical) The Telegraph, Ambrose Evans-Pritchard (1/10/12)
Q&A: The US fiscal cliff BBC News (7/11/12)
US election: Four more years… of what? BBC News, Stephanie Flanders (7/11/12)

Background
United States fiscal cliff Wikipedia

Questions

  1. Explain what is meant by the ‘fiscal cliff’ and what is its magnitude.
  2. What would be the multiplier implications of the USA ‘falling off the cliff’ both for the USA and for the rest of the world?
  3. What factors determine the size of the government expenditure and tax multipliers? What would be the problems of (a) underestimating and (b) overestimating the size of these multipliers?
  4. How can a fiscal stimulus be reconciled with a policy of reducing the size of the budget deficit as a proportion of GDP over the longer term?
  5. In what ways can the actions of Democrats and Republicans be seen as game playing? What are the possible payoffs and risks to both sides?
  6. Is relying on export growth to bring the world economy out of recession a zero sum game?
  7. Explain which is likely to be more effective in stimulating short- and medium-term economic growth in the USA: fiscal policy or monetary policy.

In the third and final part of this blog, we look at the G8 summit at Camp David on 18 and 19 May 2012. Ways of averting the deepening global economic crisis were top of the agenda.

In terms of the global economy, the leaders agreed on three main things. The first was that they supported Greece remaining in the euro. According to the communiqué:

We agree on the importance of a strong and cohesive eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the eurozone while respecting its commitments. We all have an interest in the success of specific measures to strengthen the resilience of the eurozone and growth in Europe

The second was a commitment to ‘fiscal responsibility’ and the clawing down of public-sector deficits.

We commit to fiscal responsibility and, in this context, we support sound and sustainable fiscal consolidation policies that take into account countries’ evolving economic conditions and underpin confidence and economic recovery.

The third was commitment to boosting economic growth. (Click on chart for a larger image.) On the supply side this would be through measures to stimulate productivity. On the demand side this would be through policies to stimulate investment.
(For a PowerPoint of the chart, click on the following link: Quarterly Growth.)

To raise productivity and growth potential in our economies, we support structural reforms, and investments in education and in modern infrastructure, as appropriate. Investment initiatives can be financed using a range of mechanisms, including leveraging the private sector. Sound financial measures, to which we are committed, should build stronger systems over time while not choking off near-term credit growth. We commit to promote investment to underpin demand, including support for small businesses and public-private partnerships.

But the communiqué was short on details. How will fiscal consolidation be achieved? Does this mean a continuation of austerity measures? And if so, what will be the impact on aggregate demand? Or if fiscal consolidation is slowed down, what will be the impact on financial markets?

If a growth in investment is central to the policy, what will be the precise mechanisms to encourage it? Will they be enough to combat the deflationary effect on demand of the fiscal measures?

And how will productivity increases be achieved? What supply-side measures will be introduced? And will productivity increases be encouraged or discouraged by continuing austerity measures?

Lots of questions – questions raised by the articles below.

Articles

Capitalism at a crossroads Independent (19/5/12)
Barack Obama warns eurozone to focus on jobs and growth The Telegraph (20/5/12)
G8 Summit: World leaders push for Greece to stay in the eurozone The Telegraph, Angela Monaghan (19/5/12)
Obama sees ’emerging consensus’ on crisis Sydney Morning Herald, Ben Feller and Jim Kuhnhenn (20/5/12)
G8 leaders tout economic growth, fiscal responsibility CNN (20/5/12)
G8 focuses on Eurozone Gulf News (20/5/12)
G8 leaders back Greece amid tensions France 24 (20/5/12)
G8 splits over stimulus versus austerity Financial TimesRichard McGregor and Kiran Stacey (19/5/12)
Cameron is consigning the UK to stagnation Financial Times, Martin Wolf (17/5/12)
Time to end ‘Camerkozy’ economics Financial Times, Ed Miliband (18/5/12)
Obama: Eurozone ‘must focus on jobs and growth’ BBC News (20/5/12)
World leaders back Greece, vow to combat financial turmoil Reuters, Jeff Mason and Laura MacInnis (19/5/12)
Germany isolated over euro crisis plan at G8 meeting in Camp David Guardian, Patrick Wintour (19/5/12)
G8 leaders end summit with pledge to keep Greece in eurozone Guardian, Ewen MacAskill (19/5/12)
G8 summit ends with few tangible results Xinhua, Sun Hao (20/5/12)

Final communiqué
Camp David DeclarationG8 (19/5/12)

Questions

  1. To what extent are economic growth and fiscal consolidation (a) compatible; (b) incompatible objectives? How might a Keynesian and a new classical economist respond to these questions?
  2. What supply-side measures could be introduced by the EU?
  3. Why might dangers of protectionism increase in the coming months?
  4. What would be the impact of a Greek default and exit from the eurozone on other eurozone economies?
  5. What monetary policy changes could be introduced by the eurozone governments and the ECB in order to ease the sovereign debt crisis of countries such as Grecce, Spain, Portugal, Italy and Ireland?