My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern: supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time. Procyclicalists exacerbate the magnitude of the swings in the business cycle. This is not just an American problem. A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years. Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time. Historically, developing countries used to be the ones where dysfunctional political systems produced procyclical fiscal policies. Almost all of them showed a positive correlation between government spending and the business cycle during the period 1960-1999. But things have changed. Remarkably, during the decade 2000-2010, about a third of emerging market governments - in countries such as China, Chile, Malaysia, Korea, Botswana, and Indonesia - managed to reverse the historical correlation. They took advantage of the boom years 2003-2007 to strengthen their budget positions, saving up for a rainy day. They were thus in a good position to ease up when the global recession hit them in 2008-09. In fact a majority of the governments that have followed countercyclical spending policies since 2000 are in emerging market or developing countries. They figured out how to achieve countercyclicality during the last decade, precisely the decade when so many politicians in “advanced countries” forgot how to.
Posts Tagged ‘countercyclical’
The world is in the grip of a debate between fiscal austerity and fiscal stimulus. Opponents of austerity worry about contractionary effects on the economy. Opponents of stimulus worry about indebtedness and moral hazard.
Is austerity good or bad? It is as foolish to debate this proposition as it would be to debate whether it is better for a driver to turn left or right. It depends where the car is on the road. Sometimes left is appropriate, sometimes right. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
True, it is hard for politicians to get the timing of countercyclical fiscal policy exactly right. This is the reason, more than any other, why Keynesian policy lost its luster. “Fine-tuning” it was called. Sometimes the fiscal stimulus would kick in after the recession was already over.
But this is no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilizing, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.
Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by procyclicality. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak. Exactly backwards.
Consider the positions taken over the last three decades by some American politicians.
First cycle: During a recessionary period, President Ronald Reagan in his 1980 campaign and in his 1981 Inaugural Address urged immediate action to reduce the national debt “beginning today.” (Recession: austerity.) But in 1988, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level it had been when Reagan had given his speeches. “Read my lips, no new taxes,” Bush famously said. (Boom: profligacy.)
Second cycle: Predictably, the first President Bush and the Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment, that is, just as the US was entering another recession in 1990. (Recession: austerity.) Although the timing of the legislation was poor, the action was courageous. The Pay as You Go Rule and other reforms switched government finances back onto a path that eventually was to eliminate the deficits by the end of the decade.
But three years later — and even though the most robust recovery in American history had begun — every Republican congressman voted against Clinton’s 1993 legislation to continue Bush’s spending caps, PAYGO, and tax increases. Nor did they change their minds in response to the subsequent success of the policy. Even after seven years of strong growth, with unemployment at the peak of the business cycle dipping below 4% for the first time since the 1960s, George W. Bush based his 2000 campaign on a platform of large long-term tax cuts. (Boom: profligacy.)
Third cycle: Even after the Bush fiscal expansion had turned the inherited record budget surpluses into record deficits, the Administration went for a 2nd round of tax cuts in 2003, and continued a rate of growth of spending that was triple the rate under Clinton (both national security and domestic spending). Vice President Richard Cheney said “Reagan proved that deficits don’t matter.” These policies were maintained for five more years, as another $ four trillion was added to the national debt. (Boom: profligacy.)
Predictably, when the worst recession since the Great Depression hit in 2007-09, politicians felt constrained from an adequate fiscal response due to the big deficits and debts the government had already been running. Republicans suddenly re-discovered the evil of budget deficits and decided that retrenchment was urgent. They opposed Obama’s initial fiscal stimulus in February 2009, even though GDP growth and employment were much worse than they had been when Reagan and Bush had launched their tax cuts and spending increases. (Recession: austerity.) Subsequently, with a new majority in the House, they succeeded in blocking further efforts by Obama when the stimulus ran out in 2011. The government spending cutbacks of the last two years are the most important reason, in my view, why the economic recovery which began in June 2009 subsequently stalled in 2011.
Three cycles. Three generations of politicians who favored expansionary fiscal policies during a boom and then decided after a recession had hit that budget deficits were bad after all. (See the graph below.)
This is not to say that the procyclicalist politicians have always succeeded in getting their policies adopted. Clinton had a strong enough congressional majority in August 1993 that he was able to pass his budget balancing legislation (Omnibus Budget Reconciliation Act) — even though every Republican in Congress voted “no” at a time when the economy was expanding. Similarly, Obama had a strong enough majority in January 2009 that he was able to pass some initial fiscal stimulus (the American Recovery and Reinvestment Act), without a single Republican vote, at a time when the economy was in freefall. But too often the countercyclicalists are overpowered by the procyclicalists.
Trying to turn left or right at precisely the wrong points in the road is a worse record than one would get by switching policies randomly. To explain this perverse pattern, let us switch metaphors in mid-stream. It is the old problem of needing to fix the hole in the roof when the sun is shining, rather than waiting for a storm to realize that it is necessary. When the economy is booming, there is no political support for painful spending cuts or tax increases. After all, everything seems fine; why make a change? Then when the deluge comes, sinners suddenly see the evils of their ways and proclaim the necessity of reforming. Of course it is very difficult to fix the roof in the middle of a thunderstorm.
Procyclical Politicians: Support for fiscal contraction (down-arrows) and fiscal expansion (up-arrows)
- The Obama Recovery. The U.S. economy was in free fall in late 2008, whether measured by GDP statistics, the monthly jobs numbers, or inter-bank spreads. Was the end of the recession in mid-2009 attributable to policies adopted by President Obama? A full evaluation of that question to economists’ standards would require delving into the complexity of mathematical models. The public generally has a simpler standard: was the impact big enough to be visible to the naked eye? Amazingly, the answer is “yes.” Whichever of those statistics one looks at, and whether it is coincidence or not: the economic free-fall ended almost precisely the month that Obama took office, January 2009.
- Emerging markets have generally had much better economic fundamentals over the last decade than advanced economies. For example, one third of developing countries have succeeded in breaking the historical syndrome of procyclical (destabilizing) fiscal policy. For the first time, they took advantage of the boom of 2003-08 to strengthen their budget balances, which allowed a fiscal easing when the global recession hit in 2008-09.
- The 15-year cycle in EMs. Market swings that start out based firmly on fundamentals can eventually go too far. Some emerging markets like Turkey look vulnerable this year. A crash would fit the biblical pattern: seven fat years, followed by seven lean years. Here are the last three cycles of capital flows to developing countries:
- 1975-81: 7 fat years (”recycling petrodollars”)
- 1982: crash (the international debt crisis)
- 1983-1989: 7 lean years (the “Lost Decade” in Latin America)
- 1990-1996: 7 fat years (Emerging Market boom)
- 1997: crash (the East Asia crisis)
- 1997-2003: 7 lean years (currency crises spread globally)
- 2003-2011: 7 fat years (the triumph of the BRICs)
- 2012: ?
Everywhere one looks, problems of fiscal policy are now center stage. Among advanced countries, the news is bad: Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles. But in the rest of the world there is better news: In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.
In the past, developing countries tended to follow procyclical fiscal policy: they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.) Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.
Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999. More precisely, it shows the correlation between the cyclical components of spending and GDP; the longer term trends are taken out. The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars. A positive correlation indicates government spending that is procyclical, that is, destabilizing. A negative correlation indicates countercyclical spending, that is, stabilizing.
There is no missing the message. Yellow bars lie overwhelmingly on the right hand side: more than 90 percent of developing countries show positive correlations (procyclical spending). Black bars dominate the left hand side: around 80 per cent of industrial countries show negative correlations (countercyclical spending).
Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world. Figure II updates the statistics, showing the period 2000-2009. The number of yellow bars on the left side of the graph (negative correlations) has greatly increased. Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.
Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis. The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy. The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.
The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy: debt/GDP ratios, rankings by rating agencies, and sovereign spreads. Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years. [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent. The financial markets have ratified the historic turnaround. Spreads are now lower for many emerging markets than for some “advanced countries.” Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece. Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.
Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.
What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions. In new research we 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). The relationship holds also when instrumental variables are used.
Although one thinks of institutions as slow-moving, they can change over time. Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical. A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions. Chile did it with the structural budget reforms of 2000 and 2006. Chile’s approach could be emulated by others.
Fiscal rules, such as euroland’s Stability and Growth Pact, may accomplish little in themselves. Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance. Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.
Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South. Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09. Otherwise there may be no way out but to adjust at the worst possible time.
During much of the last decade, U.S. fiscal policy has been procyclical, that is, destabilizing. We wasted the opportunity of the 2003-07 expansion by running large budget deficits. As a result, in 2010, Washington now feels constrained by inherited debts to withdraw fiscal stimulus at a time when unemployment is still high. Fiscal policy in the UK and other European countries has been even more destabilizing over the last decade. Governments decide to expand when the economy is strong and then contract when it is weak, thereby exacerbating the business cycle.
Meanwhile, some emerging market and developing countries have learned how to run countercyclical fiscal policy - saving in the boom and easing in the recession - during the same decade that we advanced countries have forgotten how to.
The frenetic debate at any moment for or against “fiscal conservatism” is artificial. It is not the right answer always to shrink any more than it is the right answer always to expand. Americans should take a perspective longer than the annual budget cycle or the bi-annual electoral cycle, let alone the daily news cycle. When the United States was able to take advantage of the long 1992-2000 boom to eliminate its budget deficit, the key legislation had been enacted in 1990 and 1993. Similarly, the big deficits of the last ten years were created by the legislation of 2001 and 2003. Bringing back far-sighted fiscal policy would mean taking steps today to lock in long-term progress toward fiscal responsibility (such as enacting social security reform) but at the same time extending last year’s short-term fiscal stimulus so long as the economy is still weak.
It might help to have ways to insulate fiscal policy from some of the wilder vagaries of politics. I came away from a conference in Chile recently, impressed anew by that country’s accomplishments. It has achieved countercyclical fiscal policy over the last ten years by means of some innovative institutions. Chile has a rule that targets the structural budget balance. In other words, it can only run a deficit to the extent that GDP and the price of copper are below their long-run trends. But a structural budget rule is not enough in itself. Who is to say which deficits are structural and which are temporary? Chile’s key innovation ten years ago was to vest responsibility for determining the long-run trends in GDP and copper prices in two panels of independent experts. Why does this matter? One reason that politicians spend too much in booms is that they convince themselves that deficits are temporary even when they are really structural. Officials in the US and Europe made overly-optimistic forecasts of future growth rates and tax revenues during the 2001-07 expansion. Research shows that this is a systematic pattern. The biased forecasts contributed to unaffordable tax cuts and accelerated spending, which in turn spelled excessive deficits and debts. Today we are living with the consequences of this procyclicality.
[For comments, go to SeekingAlpha.]