Reconciling Fiscal Stimulus with Fiscal Responsibility?

There is today in many countries a crying need for fiscal stimulus. At the same time, the need for fiscal consolidation is equally compelling in the medium and longer term. How can these two imperatives be reconciled? How can fiscal stimulus be managed so that it does not become an excuse for a renewed bout of the type of fiscal irresponsibility which has led so many OECD countries into difficulties? This is a key issue facing both fiscal policy formulation and public financial management today. It is a multi-faceted issue which does not have simple answers. But let’s start at the start by considering the macroeconomic policy context.

With the limited and halting recovery of the world economy since the global financial crisis (GFC), calls for fiscal stimulus are growing louder. Monetary stimulus alone has clearly proven inadequate for the job – indeed, excessive reliance on monetary policy has created new financial fragility risks for the world economy.

In this context, economists have put forward two important propositions. The first is that fiscal stimulus can be self-financing: it can, over time, increase government revenues by more than it costs. This can be achieved if the main vector of fiscal stimulus is infrastructure spending, which is particularly effective in boosting the economy, thereby increasing tax revenue. Not only does infrastructure spending have a large multiplier effect when the economy is depressed, but it also directly supports private sector investment and growth (DeLong and Summers, 2012; IMF, 2014).

The second proposition is that a partnership of fiscal and monetary policy, with the central bank (CB) matching the fiscal stimulus with an equivalent permanent monetary expansion, will work effectively to stimulate the economy in a way that neither monetary nor fiscal policy alone are capable of doing (Buiter, 2014). This is the ‘helicopter money’ idea, also referred to as ‘overt money financing’ (Turner, 2013).

A stimulus package may be self-financing over time, but it is not in the short-run. In the short run, it means higher deficits and increased debt. But in many countries debt has, in the wake of the GFC, reached dizzy heights not seen since the Second World War. Deficits in many cases also remain high. The majority of OECD nations require major fiscal consolidation in the medium to long term if they are to be able to cope with emerging age-related spending pressure (e.g. old-age pensions) (European Commission, 2015; Office for Budget Responsibility, 2014; Congressional Budget Office, 2015), not to mention potentially large future increases in interest expenditure when interest rate increase. Even prior to the GFC, fiscal policy was in many countries unsustainable. Now the position is much worse.

In recent decades, an important part of the framework for addressing unsustainable public finances has been fiscal rules, and in particular numerical limits on government debt and deficits such as the EU’s 60 percent debt limit and 3 percent deficit limit. Even when breached in the aftermath of the GFC, these limits have an important role to play as targets to move back towards.

What then should governments do about their fiscal rules during the implementation of fiscal stimulus? Should debt and deficit limits simply be suspended? Perhaps, but a number of concerns arise. One is political resistance from leaders (and voters) wedded to simplistic balanced budget doctrine. Another is the possibility that even higher debt may damage market confidence. In addition, there is the danger that the suspension of debt and deficit limits might be used to provide camouflage for a renewed outbreak of fiscal irresponsibility, with some governments implementing measures which permanently raising current expenditures or reducing tax revenues, increasing structural deficits.

This question will be discussed in a series of blog pieces. The first question examined in this series will be that of whether it is possible and/or desirable to circumvent the conflict between fiscal rules and fiscal stimulus by using the central bank to finance stimulus spending without recourse to borrowing. The idea of “debt free” financing of fiscal stimulus spending is – as will be discussed in the next blog piece – surprisingly widespread these days. It is an idea which draws from a centuries-old tradition of “monetary populism”.

The argument presented in the following three pieces is as follows: It is, firstly, an illusion to believe that the fiscal position of government can be improved if the government avoids borrowing by tapping grants from the central bank (CB). Other things being equal, the sole effect of ‘debt-free’ CB finance is to defer deficits to the future. If the CB provides grants to government, this relaxes the financial constraints facing government only because of the monetary expansion implicit in the grant. But systematically exploiting money creation as a major source of government revenue is a sure path to damagingly high inflation.

The potential benefits of a self-financing fiscal stimulus supported by accommodating monetary policy are entirely unrelated to whether the package is funded by borrowing or CB grants. It is therefore a mistake to confuse the case for a Keynesian alternative to austerity policies with notions derived from monetary populism.

The use of CB grants does, however, result in the appearance of lower deficits and debt in the short run. The limited use of such grants could therefore help in overcoming the short-term obstacles to fiscal stimulus. However, this comes with the risk of creating a precedent for dangerous large-scale exploitation of CB funding. Fiscal transparency also suffers.

Finally, an alternative proposition often put forward today by monetary populists – that CB loans to government amount to the cancellation of public debt – is also incorrect, as is also the companion notion that government debt is correctly measured by netting off the CB’s holdings of government bonds.


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