Guest Contribution: “Fiscal Education for the G-7”

Today, we are pleased to present a guest column written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. This is an extended version of a column appearing at Project Syndicate.

As the G-7 Leaders gather on May 26-27 in Ise-Shima, Japan, the still fragile global economy is on their minds. They would like a road map to address stagnant growth. Their approach should be to talk less about currency wars and more about fiscal policy.

Fiscal policy vs. monetary policy

Under the conditions that have prevailed in most major countries over the last ten years, we have reason to think that fiscal policy is a more powerful tool for affecting the level of economic activity, as compared to monetary policy. The explanation can be found in elementary macroeconomics textbooks and has been confirmed in recent empirical research: the effects of fiscal stimulus are not likely to be limited, as in more normal times, by driving up interest rates, crowding out private demand, running into capacity constraints, provoking excessive inflation, or overheating in other ways. Despite the power of fiscal policy under recent conditions, economists continue to lavish more attention on monetary policy. Why?

Sometimes I think the honest reason we economics professors are attracted to monetary policy is that central bankers tend to be like us, with PhDs, and to hold nice conferences.

The answer that one usually hears is that fiscal policy is “politically constrained.” This is an accurate statement, but not a good reason for us to give up on it. Indeed, if the political process gets fiscal policy wrong, which it does, that is all the more reason for economists to offer their contributions.

Of course if one is a central banker, or is advising a central banker, then one must concentrate on the job at hand, which is monetary policy. But precisely because there is a limit to what central bankers can say about fiscal policy, there is more need for the rest of us to do it.

The heyday of activist fiscal policy was 50 years ago. The position “we are all Keynesians now” was attributed to Milton Friedman in 1965 and to Richard Nixon in 1971. In the late 20th century, most advanced countries managed to pursue countercyclical fiscal policy on average: generally reining in spending or raising taxes during periods of economic expansion and enacting fiscal stimulus during recessions. The result was generally to smooth out the business cycle (as Keynes had intended). It was the developing countries who tended to follow procyclical or destabilizing policies.

Advanced country leaders forget how to do counter-cyclical fiscal policy

After 2000, however, some countries broke out of their familiar patterns. Too many political leaders in advanced countries pursued procyclical budgetary policies: they sought fiscal stimulus at times when the economy was already booming, thereby exaggerating the upswing, followed by fiscal austerity when the economy turns down, thereby exacerbating the recession.

Consider mistakes in fiscal policy made by leaders in three parts of the world — the US, Europe, and Japan. US President George W. Bush began the century by throwing away the large fiscal surpluses that he had inherited from Bill Clinton, and then continued with big tax cuts and rapid spending increases even during 2003-07, as the economy reached its peak. It was during this period that Vice President Cheney reportedly said “Reagan proved that deficits don’t matter.” Predictably, the rising debt left the government feeling less able to enact fiscal stimulus when it was really needed, after the Great Recession hit in December 2007. At precisely the wrong time, Republicans “got religion” deciding that deficits were bad after all. Thus when President Obama took office in January 2009, with the economy in freefall, the opposition party voted against his fiscal stimulus. Fortunately they failed then, and the stimulus made a big contribution to reversing the freefall in the economy in 2009. But having regained the Congress in 2011, they did succeed in blocking Obama’s further attempts to stimulate the still-weak economy for three years. The Republicans appear to be consistently procyclical.

Greece is the “poster boy” of an advanced country that unhappily switched to a systematically procyclical fiscal policy after the turn of the current century. Its first mistake was to run excessive budget deficits during the expansionary period 2003-08 (like the Bush Administration). Then, as if operating under the theory that “two wrongs make a right,” Greece was induced after its crisis hit to adopt tight austerity in 2010, which greatly worsened the fall in GDP. The goal was to restore its debt/GDP ratio to a sustainable path; but instead the ratio rose at a sharply accelerated rate, because of the fall in GDP.

Europeans suffer even more than other countries from basing their budget plans on official forecasts that are unnecessarily biased, which can lead to procyclical fiscal policy. Before 2008, not just Greece, but all euro members were overly optimistic in their forecast and so at times “unexpectedly” exceeded the 3% ceilings on their budget deficits. After 2008, qualitatively similar stories of procyclical fiscal contraction, leading to falling income and accelerating debt/GDP, also held in Ireland, Portugal, Spain and Italy.

The native land of austerity philosophy is, of course, Germany. The Germans had (reluctantly) gone along with an agreement at the London G-20 Leaders Summit of April 2009 that the US, China, and other major countries would expand demand in order to address the Great Recession. But when the Greek crisis hit at the end of that year, the Germans reverted to their deeply held beliefs in fiscal rectitude.

At first the IMF went along with the other members of the troika in believing — or at least pretending to believe — that fiscal discipline in the European periphery countries would not greatly damage their GDPs and thus could restore their debt/GDP ratios to sustainable paths. But in January 2013, Fund Chief Economist Olivier Blanchard released a paper that was widely interpreted as a mea culpa. It concluded that fiscal multipliers were much higher than the IMF (among other forecasters) had thought, suggesting that the austerity programs might have been excessive. This conclusion was based on a statistical finding that the countries which had attempted the biggest fiscal retrenchment in response to the crisis turned out to experience the most damage to GDP relative to what the IMF forecasters had expected. Today, IMF Managing Director Christine Lagarde explains to the Germans that Greece cannot achieve the elusive path of a sustainable debt/GDP ratio if it is not given further debt relief and is instead told to run primary budget surpluses of 3 ½ percent of GDP.

Now to Japan, host of this week’s G-7 meeting. In April 2014, even though the economy had been so weak that the Bank of Japan had been pursuing aggressive quantitative easing, Prime Minister Abe went ahead with a planned increase in the consumption tax (from 5% to 8%). As many had predicted, Japan immediately went back into recession. Even though the first arrow of Abenomics, the monetary stimulus, had been fired appropriately, it was evidently less powerful than the second arrow, fiscal policy, which unfortunately had been fired in the wrong direction.

Very soon now, Prime Minister Abe must decide whether to go ahead with a further rise in the consumption tax (to 10%), currently scheduled for April 2017. It is easy to see why Japanese officials worry about the country’s huge national debt. But, as near-zero interest rates signal, creditworthiness is not the current problem; weakness in the economy is. A more effective way of addressing the long-run sustainability of the debt is to announce a 20-year path of very small annual increases in the consumption tax, calculated so as to demonstrate to investors that the ratio of debt to GDP will come down in the long term.

Developing countries

Not all is bleak on the country scoreboard of cyclicality. Some developing countries did achieve countercyclical fiscal policy after 2000. They took advantage of the boom years to run budget surpluses, pay down debt and build up reserves, which allowed them the fiscal space to ease up when the 2008-09 crisis hit. Chile is the poster boy of those who “graduated” from procyclicality. Others include Botswana, Malaysia, Indonesia, and Korea.

Unfortunately some, like Thailand, who achieved countercyclicality in the last decade have suffered backsliding since then. Brazil, for example, failed to take advantage of the renewed commodity boom of 2010-11 to eliminate its budget deficit, which explains much of the mess it is in today now that commodity prices have fallen. Politicians everywhere might improve their game if they re-read their introductory macroeconomics textbooks.

This post written by Jeffrey Frankel.

22 thoughts on “Guest Contribution: “Fiscal Education for the G-7”

  1. Paul Mathis

    “It is easy to see why Japanese officials worry about the country’s huge national debt.”

    No, it is not easy at all. Japan’s interest rate on its 10 yr. government bond is negative, so Japan’s lenders are paying it to take on more debt.
    OTOH, increasing the consumption tax to reduce the debt would reduce consumption and therefore, as any Keynesian knows, would reduce GDP growth.
    Japan’s greatest need is to increase domestic consumption by imposing a tax on savings and giving tax credits to incentivize consumption spending.

    There is no reason whatsoever for worry about Japan’s debt but there is every reason to worry about its slow economic growth.

  2. Joseph

    Frankel: “But precisely because there is a limit to what central bankers can say about fiscal policy, there is more need for the rest of us to do it.

    But why should central bankers be restrained from telling the truth?

    For that matter, Alan Greenspan recognized no such constraints when he heartily endorsed the Bush tax cuts in 2001 in order to prevent the “disaster” of fiscal surpluses.

  3. Peter K.

    “The answer that one usually hears is that fiscal policy is “politically constrained.” This is an accurate statement, but not a good reason for us to give up on it. Indeed, if the political process gets fiscal policy wrong, which it does, that is all the more reason for economists to offer their contributions.”

    Then why are all of the prominent economists backing Hillary whose fiscal plan is inadequate? An economic spokesman of hers was on MSNBC the other night and mentioned her plan of $500 billion over five years. Combined with the trade deficit, this will force the central bank to lean more on monetary policy to achieve full employment which may cause future asset bubbles depending on the quality of regulations.

    1. Jeffrey Frankel

      The answer is simple. Hillary Clinton’s fiscal proposals are vastly more realistic than those of Bernie Sanders, Donald Trump, and the many Republican candidates whom Trump defeated for the presidential nomination (including even supposed responsible moderates like Jeb Bush).

  4. Genauer

    1. Multiplier
    The IMF multiplier paper in October 2012 was a politically motivated last minute hoax desparately trying to topple other majorities by surprise
    Last updated: October 12, 2012 11:00 pm Robustness of IMF data scrutinised
    By Chris Giles in London

    The artifically inflated multiplier dependen on just one outlier, Greece and would have been ZERO without it

    2. Ireland
    Several IMF people, especially certain US based individuals, also went on rampage, using very ugly, downright hate mongering words against Germany, demanding a debt write down for Ireland, because “they could never pay it down”.

    Ireland has now a dept of 89% GDP, lower than the average of its creditors in the EuroArea, and much lower than the US 107%. Therefore they also enjoy 1.1% lower interest rates than the US.

    Another example of gross incompentence, megalomaniac individuals at the IMF and politically driven statements

    3. Greece
    The IMFs “debt sustainability analysis” (DSA) is another purely politically motivated publicity stunt, just before the EuroGroup meeting on 23th May 2016.

    a “preliminary draft DSA”, “was neither discussed nor approved by the IMF’s Executive Board.”

    Their “sensitivity analysis” (page 15) is a joke, e.g. the discussion of long term interest rate changes.

    The IMF assumption that Greece would borrow at a 6% risk premium (page 19) in the markets over the German bunds, instead of Bund + 0.5% as now from the ESM, 1% lower than the US has to pay is just hilarious. Even Italy and Spain pay now less than the US, and there is little reason for substantially larger risk premium, after Greece is turned around. And we will see to that.

  5. Genauer

    4. IMF consistently wrong
    a) When you read the IMF Chapter IV consultations in Spring 2008, you would get the impression that
    and not

    was the sick man at that time. The IMF is now hiding the embarrassing Germany pdf a little bit in their usual lists : – )

    b) It was the IMF plan drawn up in May 2010, which failed. After all they were called in as the “experts” while Europe provided about 90% of the money.

    c) it was the supposedly “tough IMF” folks, who failed again and again to get things done.

    d) only when Schäuble and Juncker got really tough in July 2015, without the IMF, showing the Greeks the instruments, that we were prepared to let them go, that all others are completely prepared for a Grexit

    did the left-wing Syriza get (financial) Religion.

    5. Germany
    – has spent in the last 25 years about 100% GDP on rebuilding east Germany.
    – finances the rest of the Euro by about 25% GDP with Target 2 loans at negative rates
    – took in last year over 1 million refugees (1.5% of population), financing them to the tune of 20 000 per capita, some 3 star hotel housing around my corner
    – still balances the budget
    – expects to hit 60% debt in 3 years

    Maybe the other G-7 take their financial education from people who obviously know something about long term successful financial policies, the German finance ministry, Wolfgang Schäuble

    not based on “deeply held beliefs in fiscal rectitude” but plain evidence of success.

  6. PeakTrader

    Bush didn’t “throw away” the surplus. Clinton failed to cut taxes before the stock market crash that began in March 2000. Bush’s timely tax cuts made the 2001 recession so mild, real per capita GDP didn’t fall in 2001. The 1982-00 economic boom was over. Yet, the country again reached full employment with up to $800 billion trade deficits, or 6% of GDP, which subtract from GDP.

    The Republicans got half of Congress back – the Senate – in 2015. The budget deficit shrunk to $162 billion in 2007 and Bush’s timely tax cut in early 2008 put the country on a path to another mild recession, until Lehman failed in September 2008. It should be noted, the Fed was behind the curve easing the money supply and the Bush tax cut gave the Fed time to catch-up. The Obama stimulus proved to be a failure.

    1. A nonymous

      Moreover, the phrasing that Bush “threw away” the surplus is rather condescending. When the government runs a surplus, it means it is taking more money from the people than is necessary to fund the government. But the surplus is the people’s money in the first place. Bush simply returned the people’s money to them. In no way is that “throwing away” money.

  7. PeakTrader

    And, we don’t know the counterfactual of leaving Saddam and his two sons in power – sitting on trillions of dollars of oil – before oil prices soared – perhaps seeking revenge someday, e.g. acquiring a dirty bomb, using chemical weapons, burning oil wells in Kuwait, defying U.N. resolutions over and over, along with the world community, etc.. The world knew Bush meant business – and built credibility. Bush shouldn’t be blamed for the failures in the Middle East under the Obama Administration.

    1. Zinsky

      PeakTrader – There is not a shred of evidence that Saddam would have done anything to the U.S. had we not invaded Iraq under false pretenses (a clear war crime under the Geneva Conventions). Not. One. Shred. In fact, there is evidence Hussein destroyed his nuclear program after Gulf War I in 1991 and never spent another dime on it. Your statement about Bush “built credibility” is delusional and so far from the truth, that I have to ask whether you are drunk or something. George W. Bush, the unelected alcoholic coke-sniffing, draft-dodging loser from Texas was an unmitigated disaster for the U.S. and our relations with almost every other country on the face of this planet. Obama’s biggest failure in the Middle East was not pulling out sooner and exiting Afghanistan completely!

      1. PeakTrader

        Of course, there’s no evidence. Bush sent Saddam and his two sons to Allah.

        Thanks to Obama, now Russia, China, Iran, etc. don’t even think twice about pushing the U.S. around.

        1. baffling

          obama had to deal with the lost credibility from the bush administration. bush policies on war and economics were a verifiable disaster-there is no denying this fact. and enormously expensive to clean up. now we have another spoiled rich brat running for office-imagine the mess to be cleaned up if he gets to office.

  8. sherparick

    It is amazing how Bushies on this blog are rewriting history.

    Also, regarding Germany, The Germans lower their real wages while the periphery boom between 2001-2007, then they enjoyed the Euro depreciation from 2010-2015 that resulted from the Greek crisis. Germany’s immense current-account surplus – the excess savings generated by suppressing wages to subsidize exports – has been both a cause of the eurozone crisis and an obstacle to resolving it. Before the crisis, it fueled German banks’ bad lending to southern Europe and Ireland. Now that Germany’s annual surplus – which has grown to €233 billion ($255 billion), approaching 8% of GDP – is no longer being recycled in southern Europe, the country’s depressed domestic demand is exporting deflation, deepening the eurozone’s debt woes.

    Regarding the 2009 stimulus, the last I checked President Bush was still President in September 2008, and Secretary Paulson was his Treasury Secretary. In the spring of 2009, the economy was losing 500,000 jobs a month and then the stimulus started being spent, allowing states to hold off on their procyclical austerity for one year and slowly returning the economy to growth. Unemployment peaked in November 2009 and job growth continues from then to the present at a steady rate with the exception of the austerity panic of summer of 2011. The stimulus should have been bigger and a second stimulus requested sooner than December 2010. But it was a law that helped end the Great Recession and did significant, if limited permanent good for country. (To keep millions of children from being malnourished is a permanent good in itself, although our right wing friends believe an occasional famine or episode of starvation encourages the work ethic of the poor.)

    1. PeakTrader

      I see you’re not ready to dump the biased political view of history.

      Bush should’ve been much more aggressive overturning bad economic policies by Congress to prevent the financial crisis.

      1. baffling

        funny how an ex banker, who lost his job because of the financial crisis he helped create, continues to find blame with everybody other than his own poor behavior.

  9. David Olsen

    Who did Bush build credibility with?

    He spend a trillion dollars in Iraq, wasted it basically. That is money no longer available to spend on the current military. He forgot about Afghanistan in the process. He covered up for his Saudi backers. He lied about the reason for going into Iraq.

    He left a trail of destruction behind him that the US is still having to clean up. Iraq is still a mess. At least the Kurds have gained something from the situation. That would be some recompense for the gassing of Kurdish villages that George Bush senior enabled.

    What was Iraq all about? The lust for oil? Money? Creating a string of small warring states in the area to protect Israel? Just plain old showing who’s boss?

    What credibility? Where?

    1. PeakTrader

      That’s the narrative some factions want you to believe. In reality, most of the defense spending would’ve taken place anyway without Operation Iraqi Freedom and neutralizing our enemies Afghanistan. Hillary, our allies, and the U.N. accepted the intelligence reports. The world knew Bush meant what he said, unlike Obama, who wasted our credibility.

      Bush defended the world order created under the Nixon Admistration, i.e. the Saudis make sure OPEC exchanges oil for dollars. So, oil importers exchange their goods for dollars, in the U.S., raising U.S. living standards, and OPEC invests those dollars in the U.S. to further raise our living standards in exchange for a powerful U.S. military to defend the innocent. Don’t be so selfish.

      1. baffling

        “That’s the narrative some factions want you to believe.”
        its less of a narrative, and more of the truth. bush and his policies have been the single largest sink of us tax dollars the country has ever seen. his middle east policy was short sighted, and ultimately he accomplished very little. his economic policies have been equally disasterous.

        “Bush defended the world order created under the Nixon Administration”
        perhaps that is your problem right there. what makes you think the nixon world order is acceptable in the least? there is no rational person who would relive the last 40 years promoting an oil centric world. oil has been our root problem for decades.

        1. PeakTrader

          Yeah, I know, Bush bad, Obama good. Small government bad, big government good. Oil bad, wind good.

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