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Premature fiscal tightening endangers global recovery

Sep 8, 2011 5:32:06 PM - www.ft.lk

UNCTAD report warns of consequences of fiscal tightening; says best strategy for dealing with public debt is to promote growth

UNCTAD´s Trade and Development Report 2011 (TDR 2011) released this week warns that fiscal tightening only addresses the symptoms of the problem, leaving the basic causes unchanged. Higher public debt ratios are a consequence of the crisis, not its cause. A fiscal policy that supports growth is more likely to reduce fiscal deficit and to curb public debt ratios than a restrictive fiscal policy is.

The Trade and Development Report 2011: Post-Crisis Policy Challenges in the World Economy, released today, argues that a shift from fiscal stimulus towards fiscal tightening is self-defeating, especially in the most developed economies which were severely hit by the financial crisis. In such a situation, a restrictive fiscal policy may reduce GDP growth and fiscal revenues, and is therefore counterproductive in terms of fiscal consolidation.
The TDR 2011 shows that fiscal imbalances were not a driving factor of the crisis, but were, rather, a result of the crisis. Between 2002 and 2007, fiscal balances had improved significantly in most developed and developing economies, as a result of growth in output, lower interest rates, and, in some countries, the price boom in commodities. The crisis caused a significant deterioration in public sector accounts, as automatic stabilizers and fiscal stimulus packages were put in place. In several developed countries, public bailouts of financial institutions accounted for a large portion of the deficit, reflecting a conversion from private into public debt.
As a result, the median public debt-to-GDP ratio in developed countries almost doubled, to more than 60 per cent of GDP, between 2007 and the end of 2010. Economic growth in developing countries, as a group, suffered less impact from the financial crisis, partly thanks to active countercyclical fiscal policies; as a result, fiscal balances improved in 2010 and debt-to-GDP ratios remained in check.
The main argument that is usually advanced in support of fiscal tightening is that it is indispensable in order to restore the confidence of financial markets, which is perceived as being key to economic recovery. But in light of the irresponsible behaviour of many private financial market actors, which has required costly government intervention to prevent the collapse of the financial system, public opinion and policymakers should not trust again those institutions, including rating agencies, to judge what constitutes sound macroeconomic policies and sound management of public finances.  The reduction in growth-promoting fiscal expenditure may lead to a decline in future government revenues that will be larger than the fiscal savings obtained by retrenchment – with negative consequences for long-term fiscal and debt sustainability.
Countries that put fiscal tightening packages in place during the 1990s and 2000s as part of IMF-supported programmes have failed to consider these dynamic effects. In countries where fiscal tightening was expected to reduce the budget deficit and restart growth, deficits actually became worse while GDP growth stalled. In the present situation, the current fiscal tightening policies adopted by some countries are likely to deliver similar negative results. There is a widespread perception that space for a continuation of fiscal stimuli is already exhausted, especially in developed countries. But fiscal space is not a static variable. An expansionary fiscal policy can have strong effects on demand, increase private-sector incomes, and generate higher fiscal revenues. It is possible to extend the economic impact of fiscal policies by changing the composition of public expenditure or structuring public revenues in a way that maximizes their multiplier effects without necessarily modifying the total amount of expenditure or the fiscal balance.
The TDR 2011 shows that the way the public sector spends and taxes is not neutral. Increases in spending on infrastructure, social transfers, or targeted subsidies for private investors tend to be more effective in stimulating the economy than tax cuts, because they directly lead to job creation, purchases, and demand.
Often, the proceeds of reduced tax payments for higher-income groups are not injected back into the economy. History has shown that if tax cuts are the preferred instrument, cuts for the lower-income groups are more effective in raising demand and national income than tax cuts for higher-income groups. Out of necessity, lower-income groups tend to spend their earnings in the local economy. The challenge for highly indebted developed countries is how to grow out of debt, with growth-enhancing fiscal, monetary and income policies. GDP growth combined with low interest rates is the best strategy for reducing public debt ratios over time. If these cannot be attained because of an external constraint or outright fiscal insolvency, priority should be given to resolving the balance of payments or restructuring the debt, rather than to introducing austerity measures. Furthermore, developing countries should preserve and enlarge their fiscal space, and conduct countercyclical policies, in order to protect themselves from potential negative external shocks.

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