The Financial and Economic Crisis Lecture Four: The implications for fiscal policy and structural reform Mike Kennedy

The Financial and Economic Crisis

Lecture Four: The implications for fiscal policy and structural

reformMike Kennedy

Some definitions

• Budget balance = Total revenues less spending and interest payments on outstanding debt

• Primary balance = Revenues less spending on goods and services (excludes net interest payments)

• Structural balance = Budget balance adjusted for cyclical effects

• CAPB = Primary balance adjusted for cyclical effects

Rational for fiscal activism • At the heart of the rationale is the IS-LM model, suitably

modified. “Discretionary fiscal stimulus is playing an important role in OECD

countries’ policy response to boost demand in the wake of the financial crisis. This reflects the severity of the downturn, both in terms of depth and duration, combined with the limits of monetary policy, both because the room for additional interest rate cuts is becoming increasingly slim in many OECD countries and especially because monetary transmission channels may be impaired.”

• For the average OECD country carrying out a stimulus package, their cumulated budget impact over the period 2008-10 amounted to more than 2½ per cent of GDP, with the United States having the largest fiscal package at about 5½ per cent of 2008 GDP.

The response of fiscal policy

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0-15

-10

-5

0

5

10

Budget balance as % GDP

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesOECD - Total

The situation in the euro area

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

20132015

-15

-10

-5

0

5

10 Budget balance as % GDP

RecessionFinlandFranceGermanyItalyNetherlandsSpainEuro area (15 countries)OECD - Total

Fiscal responses in problem countries

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0-35

-30

-25

-20

-15

-10

-5

0

5

10Budget balance as % GDP

RecessionGreeceIrelandEuro area (15 countries)

Rational for fiscal activism (con’t)

• As noted in previous lectures, the shock was sufficiently large to push the economy to a point where monetary policy was thought to be ineffective.

• The importance of the three “Ts” is a standard which can be used to judge policy effectiveness: – Timely – Targeted – Temporary.

Evaluating/measuring the effectiveness of fiscal actions

Factors that affect fiscal effectiveness• Automatic stabilisers• Discretionary actions but sometimes subject to lags• Interest rates• External leakage• Ricardian effects as well as uncertainty likely increased

savings by households• Personal tax cuts, to be effective, should be aimed at

liquidity-constrained households• Can be offset by sub-national/junior levels of government

Evaluating fiscal measures (con’t)

• A review of the available evidence suggests that, under normal circumstances, fiscal multipliers may be around unity for government spending and about half that for tax measures, although with lower multipliers for more open economies.

• However, in the current conjuncture the propensity of households and businesses to save has likely increased, reducing multipliers, particularly for tax cuts.

• This may be especially true for countries with highly indebted households


• For the average OECD country, such multipliers suggest that the level of support from discretionary stimulus to GDP both in 2009 and 2010 will be of the order of 1⁄2 per cent.

• Only for the United States and Australia will the estimated multiplier effect clearly exceed 1% of GDP in both 2009 and 2010. These effects do not include cross-border spillovers.

• There is an inverse correlation between the size of discretionary fiscal packages announced/implemented among OECD countries and the strength of automatic stabilisers.


• Whether a more ambitious fiscal stimulus than implemented was appropriate depends on country-specific circumstances.

• Evidence shows that adverse reactions in financial markets are likely in response to higher government debt and that such reactions may depend on the initial budget situation.

• For countries which are identified as having a weak initial fiscal position (as measured by high debt-to-GDP ratios) -- including Japan, Italy, Greece, Hungary, Iceland and Ireland -- the room for fiscal expansion is limited.

Government debt levels are generally high in some countries

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

20132015

-50

-30

-10

10

30

50

70

90

110

130

150

Net government liabilities

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesOECD - Total

Government net debt in the euro area

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

20132015

-75

-55

-35

-15

5

25

45

65

85

105

125Net government liabilities

RecessionFinlandFranceGermanyItalyNetherlandsSpainEuro area (15 countries)

Net in debt in problem euro area countries

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

20132015

-20

0

20

40

60

80

100

120

140

Net government liabilities

RecessionGreeceIrelandEuro area (15 countries)

Euro area problem countries have seen large back-ups in interest rates


• Other countries differ in terms of the costs and benefits of further stimulus. – For some, further action to cushion the projected

downturn seems warranted. – Countries with most scope for fiscal manoeuvre

appear to be Germany, Canada, Australia, Netherlands, Switzerland, Korea and some Nordic countries.

– For others, action would only be warranted in case activity looks to turn out even weaker than projected.


• The design of additional fiscal packages in terms of individual components will be crucial in maximising their effectiveness.

• The largest short-run impact on aggregate demand is likely to come from government spending measures.

• But where tax cuts are implemented they are most effective if targeted at households that are likely to be liquidity-constrained.


• Complementary criteria for selecting individual measures are those which are both most likely to raise aggregate demand in the short run as well as aggregate supply in the long run, including: – increased public spending on infrastructure;– increased spending on active labour market policy,

including on compulsory training courses; and– Reductions in personal income taxes, notably for

low-income earners.


• In practice, and outside the G7, a majority of countries have given priority to tax cuts over boosting spending.

• G7 countries are more balanced in this respect. • The reason for the relative weight on tax cuts may be

the ease of implementation of such measures. • Timing issues are also key in respect of the fiscal

stimulus.– To the extent that the output gap widens further, those

countries that have scope for further action, should consider boosting the stimulus.

Unwinding the imbalances

• Fiscal stimulus is likely to be more cost effective if accompanied by credible commitments to scale it back or even reverse it as the recovery gains traction.

• Scaling back will depend on: – starting points, – credibility of government commitments, and – horizon that is chosen to stabilise debt-to-GDP ratio.

• This underlines the importance of strengthening medium-term fiscal frameworks for ensuring fiscal sustainability.

A useful framework for analysing stabilisation efforts

• The government’s balance:(Dt) = – PBt + iDt-1

• Manipulate the expression (see notes on website) to get:

(Dt/Yt) = Dt/Yt – Dt-1/Yt-1 = Dt/Yt – (Dt-1(1 + g)/ Yt)

= (Dt – Dt-1)/Yt – g(Dt-1/Yt)

= – PBt/Yt + ((i –g)/(1 + g))(Dt-1/Yt-1)• Shows the factors that drive the fiscal balance and what

is needed to restore overall balance

The problem: growth and interest rate differences

Stimulus is being unwound

19861987

19881989

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016

-12

-10

-8

-6

-4

-2

0

2

4

6

8

Underlying primary balance

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesEuro area (15 countries)OECD - Total

Fiscal policy is now restrictive in the euro area …

19861987

19881989

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-10

-8

-6

-4

-2

0

2

4

6

8 Underlying primary balance

RecessionFinlandFranceGermanyNetherlandsSpainEuro area (15 countries)

…particularly in some problem countries

19861987

19881989

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-12

-10

-8

-6

-4

-2

0

2

4

6

8

Underlying primary balance

RecessionGreeceIrelandItaly

Why debt levels must be addressed in the euro area

Unwinding the imbalances (con’t)

Timing• Will depend on the size of the problem• The state of the economy• The size of multipliers• The scope for monetary policy to offset the

negative effects• Potential confidence effects by reducing risk

premiums

Unwinding the imbalances (con’t)Instruments

• Arguments for using both spending cuts as well as tax increases, although past evidence suggests that spending cuts tend to be more permanent

• Give size, cuts should be considered to all major components with priority to: – pension reform; – expenditures categories where there is scope for efficiency gains

(education and healthcare); – reducing distortions caused by subsidies and tax expenditures; and – social spending as well as employment laws.

• If tax hikes needed, could use consumption taxes or taxes on immovable property or environmental taxes.


• Structural reform – OECD estimates that 1 percentage point drop in the UR would boost revenues by ¼ to ¾ a per cent of GDP.

Institutional arrangements• Fiscal rules tend to be associated with lasting

consolidationsOther considerations• Is there such a thing as expansionary fiscal

contractions?


Stylised facts on consolidations:• Bad initial conditions will trigger consolidations – the more

negative the CAPB the larger the consolidation – likely reflecting necessity as well as public support

• Most consolidations were of short duration with only modest gains

• In general, those that were sizeable also lasted longer (and vice-versa)

• Longer consolidation periods also involved lower intensity (measured by total size) – low-hanging fruit as well as lessening need as the process continued


Stylised facts on consolidations (con’t):• A number of arguments and empirical studies suggest that

spending restraint (notably with respect to government consumption and transfers) is more likely to generate lasting fiscal consolidation and better economic performance.

• Composition is important for growth and saving; however, while spending cuts are favoured, a lot was done by increasing taxes

• Success is measured as enough to stabilize debt-to-GDP ratio; on this basis about half were successful.

• Fiscal rules helped.

Fiscal consolidation plans include both spending and revenue measures

Debt levels pose a challenge

Measuring the extent of product market regulation

At the same time, potential growth has been negatively affected, pointing to a need to tackle structural problems

AUS USA CAN OECD GBR FRA DEU EUR ESP JAP ITA0

0.5

1

1.5

2

2.5

3

3.5 Potential growth rates*

Average 1989-1998

Average 1990-2008

2014-15

* OECD estimates from Economic Outlook 95 June 2014

Assessing progress on product market reform…

Greece

Hungary

Portuga

l

Korea

Switz

erland

Spain Ita

ly

France

Belgium

Japan

German

y

Austria

Icelan

d

Finlan

d

Sweden

Norway

Irelan

d

Canad

a

Netherla

nds

Australi

a

Denmark

United St

ates

New Zeala

nd

United Kingd

om

0

0.5

1

1.5

2

2.5

3Product market regulation

1998

2003

2008

2013

… which has slowed since the recession

1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8-0.2

0

0.2

0.4

0.6

0.8

f(x) = 0.285578421304642 x − 0.169161890447386R² = 0.469280224762346

PMR 1998

∆PM

R 19

98-2

003

1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8-0.2

0

0.2

0.4

0.6

0.8

f(x) = 0.397294538788349 x − 0.471991252986053R² = 0.338189031955204

PMR 2003

∆PM

R 20

03-2

008

0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6-0.2

5.55111512312578E-17

0.2

0.4

0.6

0.8

GRCPOR

KOR

f(x) = 0.32365803512357 x − 0.380041114034888R² = 0.333148329117482

PMR 2008

∆PM

R 20

08-2

013

Is pursuing product market reform worth the effort?

1 1.2 1.4 1.6 1.8 2 2.2 2.4-0.5

0

0.5

1

1.5

2

2.5

3

3.5

f(x) = − 2.78657661353589 ln(x) + 2.74802218871749R² = 0.370573888544874

The case for product market reform(a very simple result)

PMR 2003

Pote

ntial

gro

wth

201

4-15

Duration of unemployment has risen or remains high in several cases …

Irelan

d

Greece

Portuga

lIta

ly

Hungary

Spain

Belgium

German

y

France

United Kingd

om

Netherla

ndsOEC

D

Switz

erland

United St

ates

Finlan

d

Denmark

Icelan

d

Australi

a

Sweden

Japan

New Zealn

ad

Canad

a

Norway

Korea

0

10

20

30

40

50

60

70

80

Duration of unemployment (men)

2008

2013

Mon

ths

… as has long-term unemployment

Greece

Irelan

dIta

ly

Portuga

lSp

ain

Hungary

Euro

area

Belgium

German

y

France

Japan

Netherla

nds

United Kingd

omOEC

D

Switz

erland

Denmark

United St

ates

Finlan

d

Norway

Icelan

d

Australi

a

Sweden

New Zeala

nd

Canad

aKore

a0

10

20

30

40

50

60

70

80 Long-term unemployment(more than one year)

2008*

2013*

*Note: Data are 4th quarter

Per c

ent o

f tot

al u

nem

ploy

men

t

Measuring Employment Protection Legislation (EPL)

Unfortunately progress on this measure of structural reforms in labour markets has slowed

or stopped

German

y

Belgium

Netherla

nds

France Ita

ly

Portuga

l

Mexico

Sweden

Turke

y

Icelan

d

Austria

Greece

Poland

Denmark

Norway

OECD

Spain

Finlan

dKore

a

Switz

erland

Japan

Hungary

Irelan

d

Australi

a

United Kingd

omCan

ada

United St

ates

New Zeala

nd0

0.5

1

1.5

2

2.5

3

3.5

4Strictness of employment protection

2008

2013

Is pursuing labour market reform worth the effort?

2 4 6 8 10 12 14 16 18 20 22

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

f(x) = − 1.00691718313878 ln(x) + 3.3952635667638R² = 0.318209332728992

Strutural unemployment rate (2014-15)

Pote

ntial

gro

wth

(201

4-15

)

Political economy of structural reform: Lessons from experiences

• Electoral mandate


• Electoral mandate• Effective communication


• Electoral mandate• Effective communication• Solid research and analysis


• Electoral mandate• Effective communication• Solid research and analysis• Reforms take time to prepare


• Electoral mandate• Effective communication• Solid research and analysis• Reforms take time to prepare• Cohesion of government and leadership


• Electoral mandate• Effective communication• Solid research and analysis• Reforms take time to prepare• Cohesion of government and leadership• Conditions of policy regime to be reformed

Political economy of structural reform: Lessons from country experiences

• Electoral mandate• Effective communication• Solid research and analysis• Reforms take time to prepare• Cohesion of government and leadership• Conditions of policy regime to be reformed• Reform requires persistence

Literature referenced

• Auerbach, A and W Gale (2009), “Activist fiscal policy to stabilize economic activity”, Financial Stability and Macro Policy, Jackson Hole, available at http://www.kc.frb.org/publicat/sympos/2009/papers/auerbach-gale.09.30.09.pdf

• OECD (2009), “The effectiveness and scope of fiscal stimulus”, Chapter 3 in OECD Economic

Outlook: Interim Report, available at http://www.oecd.org/dataoecd/3/62/42421337.pdf

• Guichard, S, M Kennedy, E Wurzel and C André, “What promotes fiscal consolidation: OECD country experiences”, OECD Economics Department Working Papers, No 553, available at http://www.olis.oecd.org/olis/2007doc.nsf/LinkTo/NT000029DA/$FILE/JT03227897.PDF

• Haugh, D, P Olivier and D Turner (2009), “What drives sovereign risk premiums? An analysis

of recent evidence from the euro area” OECD Economics Department Working Papers, no 781, available at http://www.olis.oecd.org/olis/2009doc.nsf/LinkTo/NT00004ACE/$FILE/JT03268157.PDF

• The Political Economy of Structural Reform, OECD 2009

http://www.kc.frb.org/publicat/sympos/2009/papers/auerbach-gale.09.30.09.pdf

http://www.oecd.org/dataoecd/3/62/42421337.pdf

http://www.olis.oecd.org/olis/2007doc.nsf/LinkTo/NT000029DA/$FILE/JT03227897.PDF

http://www.olis.oecd.org/olis/2009doc.nsf/LinkTo/NT00004ACE/$FILE/JT03268157.PDF

Documents

The Financial and Economic Crisis Lecture Four: The implications for fiscal policy and structural reform Mike Kennedy