Post-crisis Fiscal Policy

Post-crisis Fiscal Policy

Carlo Cottarelli
Philip Gerson
Abdelhak Senhadji
Copyright Date: 2014
Published by: MIT Press
Pages: 576
https://www.jstor.org/stable/j.ctt9qf72g
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  • Book Info
    Post-crisis Fiscal Policy
    Book Description:

    Fiscal policy makers have faced an extraordinarily challenging environment over the last few years. At the outset of the global financial crisis, the International Monetary Fund (IMF) for the first time advocated a fiscal expansion across all countries able to afford it, a seeming departure from the long-held consensus among economists that monetary policy rather than fiscal policy was the appropriate response to fluctuations in economic activity. Since then, the IMF has emphasized that the speed of fiscal adjustment should be determined by the specific circumstances in each country. Its recommendation that deficit reduction proceed steadily, but gradually, positions the IMF between the fiscal doves (who argue for postponing fiscal adjustment altogether) and the fiscal hawks (who argue for a front-loaded adjustment). This volume brings together the analysis underpinning the IMF's position on the evolving role of fiscal policy. After establishing its analytical foundation, with chapters on such topics as fiscal risk and debt dynamics, the book analyzes the buildup of fiscal vulnerabilities before the crisis, presents the policy response during the crisis, discusses the fiscal outlook and policy challenges ahead, and offers lessons learned from the crisis and its aftermath. Topics discussed include a historical view of debt accumulation; the timing, size, and composition of fiscal stimulus packages in advanced and emerging economies; the heated debate surrounding the size of fiscal multipliers and the effectiveness of fiscal policy as a countercyclical tool; coordination of fiscal and monetary policies; the sovereign debt crisis in Europe; and institutional reform aimed at fostering fiscal discipline.ContributorsAli Abbas, Nate Arnold, Aqib Aslam, Thomas Baunsgaard, Nazim Belhocine, Dora Benedek, Carlo Cottarelli, Petra Dacheva, Mark De Broeck, Xavier Debrun, Asmaa ElGanainy, Julio Escolano, Lorenzo Forni, Philip Gerson, Borja Gracia,, Martine Guerguil, Alejandro Guerson, Laura Jaramillo, Jiri Jonas, Mika Kortelainen, Manmohan Kumar, Suchitra, Kumarapathy, Douglas Laxton, Pablo Lopez-Murphy, Thornton Matheson, Jimmy McHugh, Uffe Mikkelsen, Kyung-Seol Min, Aiko Mineshima, Marialuz Moreno, John Norregaard, Ceyla Pazarbasioglu, Iva Petrova, Tigran Poghosyan, Marcos Poplawski-Ribeiro, Anna Shabunina, Andrea Schaechter, Jack Selody, Abdelhak Senhadji, Baoping Shang, Mauricio Soto, Bruno Versailles, Anke Weber, Jaejoon Woo, Li Zeng

    eISBN: 978-0-262-32411-3
    Subjects: Economics, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-viii)
  3. Acknowledgments
    (pp. ix-x)
  4. Foreword
    (pp. xi-xii)
    Christine Lagarde

    For many countries the global financial crisis also turned into a fiscal crisis. Policy makers had to confront an extraordinarily challenging environment with fewer than usual economic weapons in their arsenals. In particular, monetary policy—the main traditional stabilization tool—was constrained, leaving fiscal policy to shoulder an unusually large burden. A combination of fiscal stimulus, collapse in output and fiscal revenues, along with, in some cases, expensive packages to rescue the financial system, strained public finances and resulted in higher government debt.

    The unprecedented magnitude and scope of the crisis led to a broad rethinking of policy advice, including...

  5. Introduction
    (pp. 1-12)
    Carlo Cottarelli, Philip Gerson and Abdelhak Senhadji

    Fiscal policy makers have had to operate in an extraordinarily challenging environment over the last few years. First, they were confronted with an exceptionally large output shock, the biggest since the 1930s. Second, reflecting in large part the size of the shock but also the relatively weak fiscal position in many advanced economies in the period before the financial crisis, they quickly found their policy options constrained by spiraling deficits and a rapid buildup of public debt, which rose in some advanced economies to dizzying levels not seen since the end of the Second World War. Before long, policy options...

  6. Part I
    • 1 Fiscal Sustainability and Fiscal Risk: An Analytical Framework
      (pp. 15-30)
      Carlo Cottarelli

      Developments over the last few years have evidenced the damaging effects of fiscal crises on economic activity. The term “fiscal crisis” here refers to the difficulty the government experiences in rolling over its debt. This difficulty shows up in forms of varying intensity, from the need to pay higher interest rates on government paper to a complete loss of market access. These difficulties reverberate through the economy, as higher risk premia are applied also to private sector borrowers and as increased uncertainty on future prospects discourages investment and consumption. Inevitably, economic growth suffers as evidenced by the experience of several...

    • 2 Debt Dynamics and Fiscal Sustainability
      (pp. 31-48)
      Carlo Cottarelli and Julio Escolano

      This chapter presents the analytical relationships that describe government debt dynamics and underpin the sustainability of fiscal policies. A fiscal policy plan is understood here as a plan for revenue and expenditure, or more succinctly, for the resulting primary balances. Sustainability of fiscal policy plans underlies the discussion of debt dynamics. In loose terms, a fiscal policy plan is sustainable if it can be implemented without the government becoming unable to roll over its debt and having to resort to extreme measures such as default or hyperinflation.¹ In more technical terms, a fiscal policy plan can be defined as sustainable...

    • 3 The Determinants of the Interest-Rate–Growth Differential
      (pp. 49-66)
      Julio Escolano

      The interest-rate–growth differential (IRGD) is a key determinant of the dynamics of the ratio of government debt to GDP (the debt ratio, for short). Essentially, the IRGD is the difference between the interest rate paid on government debt and the growth rate of GDP.¹ The IRGD drives the inertial or “snowball” dynamics of the debt ratio. For any given primary balance, higher interest rates result in larger rollover refinancing needs, while higher growth reduces the ratio of debt to GDP by increasing the latter.² Thus the IRGD represents the rate at which the debt ratio would increase (or decrease,...

    • 4 Determinants of the Primary Fiscal Balance: Evidence from a Panel of Countries
      (pp. 67-96)
      Li Zeng

      The primary fiscal balance is a key determinant of public debt dynamics. Together with the level of the public debt stock and the differential between the interest rate on public debt and GDP growth, it forms the basis for projecting the future path of a country’s public debt. This chapter first reviews some stylized facts about the primary fiscal balance. It then tries to empirically identify the most important underlying determinants of the primary fiscal balance, using cross-country panel data. The final section of the chapter provides an illustrative example showing how to apply the empirical findings to predict a...

    • 5 The Relationship between Debt Levels and Growth
      (pp. 97-126)
      Manmohan S. Kumar and Jaejoon Woo

      This chapter empirically investigates a critical policy question of the extent to which large public debts are likely to have an adverse effect on investment, productivity, and growth. From a theoretical point of view, this can occur through a variety of channels including higher long-term interest rates, possibly higher future distortionary taxation, higher inflation, greater uncertainty, vulnerability to crises, and reduced scope for countercyclical fiscal policies. Despite the importance of the issue, there is little systematic evidence in the literature.

      The chapter provides empirical evidence on the impact of high public debt on subsequent growth of real per capita GDP...

  7. Part II
    • 6 Fiscal Trends and Fiscal Stress prior to the Crisis
      (pp. 129-160)
      Jiri Jonas and Iva Petrova

      This chapter traces the evolution of fiscal aggregates in advanced and emerging economies prior to the crisis. The long-term trend of public finances in the advanced economies illustrates gradual buildup of vulnerabilities over time. In the postwar period until the early 1990s, the long-term fiscal picture shows steadily expanding expenditures, initially paid for by increasing revenues, but eventually accommodated by wider deficits and growing debt. During the 1950 and 1960s, unanticipated postwar inflation and negative interest-rate–growth differential contributed to a rapid reduction in public debt, even as expenditure growth picked up in the 1960s. However, in the mid-1970s, the...

    • 7 Current Debt Crisis in Historical Perspective
      (pp. 161-192)
      S. Ali Abbas, Nazim Belhocine, Asmaa El-Ganainy and Anke Weber

      The simultaneity and scale of debt accumulations in a number of advanced countries in the wake of the global financial crisis and the accompanying so-called Great Recession have renewed attention and interest in the historical behavior of public debt in advanced economies, and first research on this topic has already emerged, such as Reinhart and Rogoff (2011), Abbas et al. (2011), IMF (2012), and Reinhart et al. (2012).

      These studies have indicated, consistent with figure 7.1, that the current debt buildup is certainly not unique in its scale if the entire past century is considered.¹ Debt ratios in 19 advanced...

    • 8 The Other Crisis: Sovereign Distress in the Euro Area
      (pp. 193-226)
      S. Ali Abbas, Nathaniel Arnold, Petra Dacheva, Mark De Broeck, Lorenzo Forni, Martine Guerguil and Bruno Versailles

      The sovereign crisis that has engulfed the euro area (EA) since 2009 was largely unexpected. In early fall 2008, before the collapse of Lehman triggered what is now known as the Great Recession, the EA appeared to be in a relatively sheltered position. The area’s macroeconomic indicators were faring well compared to those of other advanced economies. Its banks looked relatively less exposed to the worst effects of the subprime or other toxic assets. And an institutional framework was in place to facilitate cross-border policy coordination. However, once Greece, a member with a relatively small economic weight in the EA,...

    • 9 Has Taxation Contributed to the Crisis?
      (pp. 227-252)
      John Norregaard, Aqib Aslam, Dora Benedek and Thornton Matheson

      A broad consensus has emerged on the view that tax policy was not a direct cause of the financial meltdown during 2008.¹ Yet tax distortions—by providing incentives for higher leverage, risk taking, and the use of tax arbitrage through complicated financial instruments—may well have exacerbated its severity and prolonged its duration.² Recently, implemented and planned policy initiatives also point to the fact that tax policy reform is an essential part of the broader macroeconomic strategy for addressing the adverse consequences of the crisis in several countries.

      This chapter surveys and discusses the different, and often very complex, channels...

  8. Part III
    • 10 Fiscal Policy Response in Advanced and Emerging Market Economies
      (pp. 255-286)
      Elif Arbatli, Thomas Baunsgaard, Alejandro Guerson and Kyung-Seol Min

      This chapter discusses the fiscal response to the sharp decline in global growth following the financial crisis that erupted in August 2007. The policy response to the financial crisis and economic recession was unprecedented, befitting the exceptional nature of the shock. The average fiscal deficit across all countries increased by 6.3 percent of GDP between 2007 and 2009, with a larger deterioration in advanced economies (figure 10.1). This reflected fiscal stimulus packages—the cyclically adjusted deficit increased by over 3 percent of GDP, the automatic stabilizers, the rescue packages for the financial sector, and a structural decline in revenues as...

    • 11 Fiscal Policy Response during the Crisis in Low-Income African Economies
      (pp. 287-314)
      Martine Guerguil, Marcos Poplawski-Ribeiro and Anna Shabunina

      Fiscal policy has traditionally been procyclical in emerging market and developing economies; that is, government spending increases in good times but declines in bad times, possibly exacerbating the business cycle. A large and growing body of literature has linked this outcome to three main (and not inconsistent) factors: financial constraints, political distortions, and technical weaknesses.¹ Because of their limited access to financial markets, governments have no choice but to cut spending and raise revenues in bad times, while in good times, inadequate political and fiscal institutions make it difficult to resist pressures to increase expenditure and lower taxes. Growth forecast...

    • 12 Size of Fiscal Multipliers
      (pp. 315-372)
      Aiko Mineshima, Marcos Poplawski-Ribeiro and Anke Weber

      The Great Recession has refocused attention on the effectiveness of fiscal policy. In the economic policy paradigm prevalent before the crisis, there was little room for fiscal policy activism. Monetary policy was considered more effective in managing short-run fluctuations, with fiscal policy contributing through automatic stabilizers. This implied that fiscal policy focused mainly on the medium and longer terms, enhancing potential growth through structural reforms, including reducing distortions in the economy, ensuring debt sustainability, and safeguarding the most vulnerable.

      The reasons why fiscal policy took a backseat as a stabilization tool during the pre-crisis era are manifold.¹ First, there was...

    • 13 Coordination of Fiscal and Monetary Policies
      (pp. 373-392)
      Mika Kortelainen, Douglas Laxton and Jack Selody

      In this chapter we use the International Monetary Fund’s Global Integrated Monetary and Fiscal Model (GIMF) to illustrate the increased effectiveness of expansionary fiscal policy when monetary policy accommodates the shock, such as was the case in the 2008 to 2009 coordinated fiscal expansion. To accomplish this, we introduce simple fiscal policy and monetary policy rules into the model to show the dynamics of policy coordination. We also show how features like financial accelerators affect the dynamics of policy coordination.

      The chapter starts with a review of the literature on activist monetary and fiscal policies, describes the key features of...

    • 14 Financial Sector Support: Why Did Costs Differ So Much?
      (pp. 393-406)
      Ceyla Pazarbasioglu, Uffe Mikkelsen and Suchitra Kumarapathy

      The global financial crisis continues to impose significant strains on public finances. Extensive public support has been provided to restore confidence in the financial system. As the crisis unfolds its fiscal costs remain uncertain but so far they have differed widely across countries; and differences are likely to remain significant going forward. Crisis management strategies that rely on containment at the expense of upfront restructuring tend to shift fiscal costs into the future, and ultimately increase them. Compared with previous crises, governments to date have relied more on containment (central bank liquidity provision and guarantees of bank liabilities) and less...

    • 15 Impact of the Crisis and Policy Response at the Sub-national Level
      (pp. 407-428)
      Borja Gracia, Jimmy McHugh and Tigran Poghosyan

      The global crisis had an adverse effect on public finances at all levels of government. The impact of the crisis ongeneral governmentfinances has been documented widely (e.g., see International Monetary Fund 2010a; International Monetary Fund 2010b; OECD 2009 ; European Commission 2009 ), while evidence onsub-national government(SNG) finances is scarce. The existing small literature has largely focused on the impact of the crisis on aggregate SNG indicators (OECD 2011; Blöchliger et al. 2010 ; Dexia 2011 ; Ter-Minassian and Fedelino 2010 ), but aggregate data mask substantial regional variation and do not allow disentangling the impact...

  9. Part IV
    • 16 Fiscal Outlook in Advanced and Emerging Markets
      (pp. 431-454)
      Laura Jaramillo and Pablo Lopez-Murphy

      The financial crisis left many countries, especially advanced economies, with a dangerous combination of high debt to GDP ratios not seen since World War II (figure 16.1) and overall deficits unheard of in at least thirty years (figure 16.2). While overall balances are expected to improve over the medium term as economic activity recovers and countries implement ambitious structural reforms, this improvement is expected to make only a small dent in the debt stock, as countries struggle to address the enduring legacies of the crisis. These legacies include a tepid recovery of revenues as potential GDP is not expected to...

    • 17 Escaping High Debt: The Narrow Path Ahead
      (pp. 455-484)
      Lorenzo Forni and Marialuz Moreno Badia

      Previous chapters have highlighted the challenges faced by advanced economies with gross public debt increasing by more than 30 percent of GDP in the wake of the financial crisis. Although progress has been made since 2010 in adjusting fiscal balances, weak growth and downside risks restrict the room for maneuver of policy makers. Moreover some countries have been subject to market pressures leading to spikes in sovereign risk premia. Market confidence in these economies is indeed being currently sapped by what is perceived as an unsustainable level of public debt. In these countries the path to fully restore market confidence...

    • 18 Institutional Reforms and Fiscal Adjustment
      (pp. 485-514)
      Xavier Debrun and Andrea Schaechter

      As current debt dynamics call for significant fiscal retrenchment over the medium term, present governments must credibly anchor future fiscal policy in some trajectory deemed consistent with a sustainable debt. Absent credibility, a vicious cycle of large frontloaded consolidations followed by financial market bets on the self-defeating nature of these adjustments is a real possibility (IMF 2012a). This is where a central lesson from the 2008 to 2009 crisis meets the precondition to a successful exit from crisis policies: sound fiscal governance must ensure that fiscal policy is predictable, stabilizing, and

      financially sustainable.

      Clearly, the institutional arrangements governing fiscal policy...

    • 19 Long-Term Fiscal Challenges
      (pp. 515-534)
      Baoping Shang and Mauricio Soto

      Reforming age-related spending, including both pension and health care spending, will be a key policy challenge in both advanced and emerging economies over coming decades. A large share of government budgets is devoted to public pension and health care systems. Spending in these two areas has been growing rapidly, driven by population aging and excess cost growth¹ in health care spending, and is projected to increase by 3.5 percentage points of GDP in advanced economies and by 2 percentage points of GDP in emerging economies over the next two decades, with a greater contribution coming from projected increases in health...

    • 20 Fiscal Adjustment, Growth, and Global Imbalances
      (pp. 535-550)
      Mika Kortelainen, Douglas Laxton and Jack Selody

      Over the medium term, significant fiscal consolidation seems inevitable in much of Europe and the United States in order to counter rising public-sector indebtedness. Fiscal consolidation is usually associated with shrinking current-account deficits and a slowdown in growth as demand for foreign goods falls along with demand for domestically produced goods. In this chapter we illustrate how combining fiscal consolidation with structural reform and coordinated fiscal policy can result in lower public-sector indebtedness, stronger growth, and a lessening of global imbalances for all participating countries.

      The chapter starts with a high-level discussion of the virtuous circle that can be generated...

    • 21 Policy Lessons from the Crisis and the Way Forward
      (pp. 551-556)
      Carlo Cottarelli, Philip Gerson and Abdelhak Senhadji

      The analysis in previous chapters makes clear that the global financial crisis has reshaped our understanding of the role of fiscal policy and has refocused the attention of the economics profession on fiscal sustainability issues. Had such a focus existed prior to the crisis, many countries might have been better prepared to deal with its impact than has turned out to be the case: fiscal policy, particularly in advanced economies, was far from optimal prior to the crisis due in part to gaps in fiscal frameworks. As a result many advanced economies’ fiscal position was relatively weak even before the...

  10. Contributors
    (pp. 557-558)
  11. Index
    (pp. 559-562)