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 ‘procyclical’
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)
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.
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