Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies

Carlo Cottarelli, Laura Jaramillo
2013 Review of Economics and Institutions  
Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalize long-term growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt, and financing costs. Revenue and expenditure policies are also critical in affecting
more » ... ical in affecting productivity and employment growth. This paper discusses the complex relationships between fiscal policy and growth both in the short and in the long run. JEL classification: E43; E62; H30; O40 GDP ratio, which has reached a historical peak seen only once in the last 130 years (Figure 1 ). This paper discusses the feedback loops between fiscal policy and growth. It argues that stabilizing public debt-to-GDP at current levels penalizes potential growth, which in turn would make it more difficult to sustain high public debt over the longer run. Therefore, it is imperative to lower public debt over time. However, in the short-run, front-loaded fiscal adjustment is likely to hurt growth prospects, which would delay improvements in fiscal indicators, including deficits, debt, and financing costs. A measured, although not trivial, pace of adjustment, based on a clear medium-term plan, is therefore preferable, if market conditions allow it. The recognition that, other conditions being the same, fiscal adjustment will slow down growth, makes it important to ensure that other policies (monetary, financial, and structural policies) are used to support growth when fiscal policy is tightened. The paper goes on to discuss the importance of strong medium-term growth for a successful fiscal consolidation. Reforms in goods, service, and labor markets that improve economic efficiency will boost potential growth, in turn serving as important tools in the fiscal adjustment process. Section II discusses the short-term interactions between growth and fiscal policy. Section III focuses on the longer-term interactions. Section IV draws policy conclusions for both the short and the long term. Fiscal adjustment affects growth in the near term through two main channels. First, by strengthening the fiscal accounts, fiscal adjustment enhances fiscal sustainability, thereby reducing the risk of a fiscal crisis. The turbulence recently faced by euro area countries with weak fiscal accounts is a reminder of the importance of this channel. A weak fiscal position is certainly not a sufficient condition to be under market pressure, but it is a necessary condition. This is confirmed by recent studies looking at sovereign bond yields since the onset of the global crisis, which find that, while global risk aversion is a key determinant, fiscal fundamentals have played an increasingly important role. Sgherri and Zola (2009) suggest that, while euro area sovereign risk premium differentials tend to commove over time and are mainly driven by a common time-varying factor, markets have become progressively more concerned about fiscal fundamentals. Similarly, Haugh, Ollivaud, and Turner (2009) find that the increase in global risk aversion has magnified the importance of fiscal performance in several euro area countries, and these effects are non-linear, so that the incremental deteriorations in fiscal performance lead to even larger increase in the spread. Schuknecht et al. (2010) also find that markets penalize fiscal imbalances much more strongly after the Lehman default in 2008. In addition, Caceres et al. (2010) show that earlier in the crisis the surge in global risk aversion was a significant factor influencing sovereign bond spreads, while more recently public debt and deficits have started playing a more important role. The second channel through which fiscal adjustment affects growth is its negative effect on aggregate demand. Consensus around the standard Keynesian view that fiscal policy has an important role to play in mitigating the business cycle had developed in the aftermath of the Great Depression (and was illustrated in the standard IS-LM and Mundell-Fleming models). 1 However, by the 1990s many economists rejected discretionary fiscal policy as an effective stabilization tool, largely based on Ricardian equivalence arguments where agents are forward looking and have rational expectations (Barro, 1974). 2 Some have even argued that "expansionary fiscal contractions" exist (implying that large fiscal consolidations improve confidence, lead to a revision in expectations about the future tax burden, and may also induce a supply-side response if taxes are distortionary), especially if fiscal tightening is focused more on spending cuts rather than tax increases (Bertola and Drazen
doi:10.5202/rei.v4i2.113 fatcat:67hvv5zbxzb3ngcyfpkxapw5lq