Fiscal policy defined

Horton and El-Ganainy explain the basics of fiscal policy, a topic of much discussion in recent days especially relating to fiscal stimulus in almost all countries in the world. A very basic explanation that gives a taste of intro to macro econ, chapter one!

Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty. The role and objectives of fiscal policy have gained prominence in the current crisis as governments have stepped in to support financial systems, jump-start growth, and mitigate the impact of the crisis on vulnerable groups. […] Fiscal policy that increases aggregate demand directly through an increase in government spending is typically called expansionary or “loose.” By contrast, fiscal policy is often considered contractionary or “tight” if it reduces demand via lower spending.

Besides providing goods and services, fiscal policy objectives vary. In the short term, governments may focus on macroeconomic stabilization—for example, stimulating an ailing economy, combating rising inflation, or helping reduce external vulnerabilities. In the longer term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply side to improve infrastructure or education. Although these objectives are broadly shared across countries, their relative importance differs depending on country circumstances. In the short term, priorities may reflect the business cycle or response to a natural disaster—in the longer term, the drivers can be development levels, demographics, or resource endowments. The desire to reduce poverty might lead a low-income country to tilt spending toward primary health care, whereas in an advanced economy, pension reforms might target looming long-term costs related to an aging population. In an oil-producing country, fiscal policy might aim to moderate procyclical spending—moderating both bursts when oil prices rise and painful cuts when they drop.

Many countries can afford to run moderate fiscal deficits for extended periods, with domestic and international financial markets and international and bilateral partners convinced of their ability to meet present and future obligations. Deficits that grow too large and linger too long may, however, undermine that confidence. Aware of these risks in the present crisis, the IMF is calling on governments to establish a four-pronged fiscal policy strategy to help ensure solvency: stimulus should not have permanent effects on deficits; medium-term frameworks should include commitment to fiscal correction once conditions improve; structural reforms should be identified and implemented to enhance growth; and countries facing medium- and long-term demographic pressures should firmly commit to clear strategies for health care and pension reform.

Does South Asia need a counter-cyclical fiscal policy?

Yes, yes, says that World Bank as the fear of inflation is now replaced (Nepal has over 12% inflation rate right now???) by declining growth and the impact of global slump on poverty.

South Asian countries do not have automatic stabilizers or social safety nets to counter the negative effects of economic slump. So, the only option left is Keynesian fiscal policies (as expected). However, the WB argues that the extent to which this can be used is constrained by the bloc’s high public debt. This should be least of the worries because right now all that matters for countries like Nepal (which has over 12% inflation rate) is how to balance a rise in general price level and ensure economic growth. As is popular right now, the WB recommends investment in public infrastructure such as roads, schools, and hospitals.

South Asian countries may have missed the opportunity to strengthen their fiscal position during good times, which would have enhanced their capacity to counter downturns. Timing is of the essence. Any counter-cyclical policy needs to be tailored to conditions in individual countries. The capacity of a country to undertake counter-cyclical fiscal policy depends on its ability to finance the resulting fiscal deficit, which is easier when public debt is low and external balances are in good shape.

It is essential to protect core public spending in social and physical infrastructure in the face of declining revenues. Spending targeted at vulnerable groups may need to increase. This would require reallocation of expenditures from other areas, as well as greater reliance on borrowing or grants. However, it will always be a risky proposition especially for countries with a weak track record of controlling spending and where there are fears of inflation. Once introduced such spending may be hard to reverse.

According to a number of Economists, a fiscal stimulus program for countering an economic downturn needs to fulfill the 3-Ts; it needs to be timely, targeted, and temporary in order to be effective.

When will people read Keynes correctly?

Robert Skidelsky writes a very interesting article about the cycle of ideological debates and what Keynes actually meant (I wonder why people are still not (trying) understanding the simple, common sense concept put forth by Keynes in the 1930s). The beauty of classical economics and its different variations is that their models can be proved mathematically in a very slick and convincing fashion (ceteris paribus). This does not mean that they represent reality cent percent. Economics is a social science and not all things can be simplified without missing some stuff. What matters is good judgment arising from some sort of economic model (may or may not be comprehensive). This is what Keynesians do!

And remember, when resources are idle, economy is not in full employment, and market forces hesitate to function as they should (due to, say, crisis of confidence arising from self-fulfilling and reinforcing prophesy of some speculators/investors), government can turn the tide around by managing demand/using fiscal policies to put idle resources to work. Things could go awfully wrong even in a stable market economy, when then needs an escort to safety. Isn’t this a common sense?

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

Can additional funding to the developing countries through the IMF be helpful?

Economists at the CEPR say, No unless…! The $108 billion in new funds for the IMF approved by the US Senate is not going to counter the world recession, they say. Why? Because without reforms in the IMF itself, additional funding injections would not be helpful. (The G20 pledged $500 billion for the IMF to lend to struggling economies)

Contrary to remarks by IMF Managing Director Dominique Strauss-Kahn that rich country contributions to the IMF make "this…the most coordinated stimulus ever," the IMF has been mandating economic conditions for countries receiving new loans, including deficit reduction, monetary tightening, and inflation-targeting measures that run counter to the worldwide need for an increased economic stimulus.

"Throwing $108 billion at the IMF without any reforms is a mistake, and one that Americans will later regret."

"There's little evidence that the IMF has actually helped boost GDP growth in developing countries over the past 30 years, and a lot of evidence to the contrary," Weisbrot said. "Giving the IMF this money without reform conditions is a mistake, and one that will come back to haunt us in the future."

Also, see this one:

Almost all of the agreements that the IMF has concluded since the global economic crisis began have included the opposite of stimulus programs: for example spending cuts or interest rate increases. The amount of money that will help poor countries is tiny. And it is difficult to see why the IMF would need hundreds of billions of dollars to help governments with balance of payments support: for sixteen Standby Arrangements negotiated since the crisis intensified last year, the total has been less than $46 billion.

And, here is Kevin Gallagher:

Kevin Gallagher argues that the IMF, in its emergency assistance plans for developing countries, is still imposing harsh conditionalities that limit rather than expand government spending. “If the IMF is to receive significantly higher lending authority, it should be forced to abandon its draconian austerity policies, which are more inappropriate than ever in the current crisis,” he argues.

Some Keynesian stuff

Keynesianism works in Australia

Australia went early and hard with a substantial cash handout to households in December 2008, followed by another round of cash stimulus delivered a month or two ago, and then a large-scale infrastructure program. The national accounts for the March quarter (which should include the effects of the first round of stimulus) have just come out, and show growth of 0.4 per cent, compared to a 0.6 per cent contraction in the December 2008 quarter

 

IMF loves to apply Keynesian principles in Africa

The main focus of fiscal stimulus should be on the expenditure side, particularly infrastructure and social spending given pressing needs, as reducing tax rates may be inequitable and the scope for doing so is limited given low revenue ratios. Other countries will have to adjust, in a way that will not affect critical spending. Additional donor support would reduce the need for adjustment. In all cases, countries should give priority to expanding social safety nets as needed to cushion the impact of the crisis on the poor.

And, this is very interesting-- The Phillips machine: Using water to predict the economy

Industrial policy in the US

Any doubts that the ongoing series of bail outs of financial institutions and key industries in the West is not an industrial policy. Well, it is definitely an industrial policy (under different trade regimes) of a different form that somewhat resembles the policies of South Korea, Japan, Taiwan and China, writes Gallagher. This is not necessarily protectionism. And yes, the government can fill up the gap where the private sector cannot. The best way to do it: go for PPP but with more accountability.

Many will cry that industrial policy – government fostering of specific sectors, industries or firms – is protectionism. It certainly can be. These policies are justifiable only to the extent they correct for market failures in the economy. Of course we all know that the free market is failing to supply credit to firms in the real economy. There is also an underproduction of green technologies, because firms are not compensated for the environmental benefits they bring. This is accentuated because dirty producers don't have to pay for their environmental sins.

If US policy rectifies market failures, these policies should be seen as correctionism rather than protectionism. Asian countries such as Japan, South Korea, Taiwan and China have all successfully experimented with industrial policy. Conventional economic theories would have told these nations to produce rice, fish and perhaps some clothing for the world economy. However, over time governments enabled firms like Toyota, Kia, Hyundai, Acer and Lenovo to become household names across the world.

When countries succeed at industrial policy they usually form public-private partnerships, put conditions on favoured recipients and have systems for government accountability. Public-private partnerships help alleviate the problem of governments picking winners by creating mechanisms whereby governments get important input from the private sector. Enforceable conditions are also important, such as performance requirements to export a certain percentage of output before receiving additional support. Government accountability needs to be ensured as well.

New op-ed about the Nepali economy under the Maoist-led government

This op-ed is the same as the blog post published earlier.

 

 

 

In the last day of his role as prime minister, the Maoist premier Pushpa Kamal Dahal claimed that his administration gave “utmost importance to economic transformation” and made “major contribution to economic revolution”. Unlike his boss, former Finance Minister Dr. Baburam Bhattarai was a bit modest in laying claims about economic progress achieved under his leadership. In assessing the economic policies and progress under the Maoist administration, it is unclear how the dismal performance, especially in encouraging private sector and utilizing development expenditures, amounts to or leads to “economic revolution”.

[…]

The economy is far from being transformed. There were some successes in revenue collection and welfare programs. However, there were even more problems-- industrial relations deteriorated, allocated development money remained unspent, investors and donors remained skeptical of Maoists policies, price level spiraled upwards, and there was a severe shortage of energy, which further crippled the industrial sector, among others.

Unfortunately and mistakenly, I emailed the same article to two (rival) dailies in Nepal. I have no desire to publish the same op-ed in two dailies (Republica and The Kathmandu Post) on the same day. I bear responsibility for the confusion (and tension) it created there! This should not have happened.