WORLD BANK, DECEMBER 10, 2008, AART KRAAY AND LUIS SERVÉN

PRESENTED BY : ALYAA EZZAT

Fiscal Policy Responses to the Current Financial Crisis:

Issues for Developing Countries

Overview

This note first reviews the state of the empirical evidence on the effectiveness of discretionary countercyclical fiscal policy in developing countries.

The note also reviews briefly a few contrasting experiences of success and failure in industrial and developing countries.

It concludes with several recommendations motivated by past experience that policymakers should consider before adopting any fiscal responses to the current crisis.

Lessons from the Past

There is strong evidence that fiscal policy is procyclical.

1)tend to take place in good times2)not during bad times when they might play

some role in smoothing output declines3)This applies to a variety of measures of fiscal

policy.

Lessons from the Past

Fiscal procyclicality in developing countries arises from both the weakness of automatic stabilizers and the procyclical bias of discretionary policies.

1)In industrial countries countercyclical discretionary policy contributes to dampen aggregate fluctuations.

2)In developing economies discretionary policy is usually procyclical.

3)In most developing countries automatic fiscal stabilizers - such as income taxes and transfer programs built into the fiscal system - are too small to have a significant smoothing effect on aggregate fluctuations

Lessons from the Past

The procyclical bias in fiscal policy reflects underlying fundamental challenges facing developing countries.

- Research suggests that two main sets of factors account for this procyclicality of discretionary fiscal policy: 

1)the inability of developing countries to access external finance to pay for fiscal expansions during downturns

2)political economy problems that contribute to an overspending of public revenues when they are abundant in good times.

- Such fundamental factors are difficult to overcome in the short run, suggesting deep underlying limits on the ability of most countries to generate successful fiscal responses to the current crisis.

Lessons from the Past

Regardless of whether they occur in booms or recessions, the evidence is mixed that fiscal expansions can actually stimulate aggregate demand and output in developing countries in the short run. 

- Most studies also find that the expansionary effect of fiscal policy tends to be much smaller in developing countries than in developed ones.

Lessons from the Past

To the extent that fiscal expansions do boost output, the procyclicality of fiscal policy means that discretionary fiscal interventions tend to increase output volatility rather than reduce it. 

- This finding suggests that fiscal policy has been very unsuccessful as a tool for stabilization.  In fact, the additional volatility induced by procyclical fiscal policy has been found to undermine & weaken growth in the long run as well.

Lessons from the Past

Fiscal expansions are difficult to reverse- If governments commit to unsustainably large

spending programs during recessions as a countercyclical device, these may be very difficult to reverse when times improve, threatening fiscal sustainability in the long run.

- This is why automatic stabilizers in the form of lower tax rates and larger transfer payments during recessions are viewed as a more sustainable approach to countercyclical fiscal policy in industrial countries.

- The difficulty for developing countries is that most of them have very weak tax and transfer schemes and so the effectiveness of automatic stabilizers is limited.

Conclusion

Developing countries expecting fiscal policy responses to the current crisis should learn lessons from past experience.

Successful episodes of countercyclical discretionary fiscal policy in developing countries have been rare. 

Too often fiscal responses are too late and too difficult to reverse, with the perverse effect of increasing volatility and contributing to unsustainable debt accumulation.

Cont. Conclusion

Overall, empirical evidence from the past 30 years suggests that developing countries have not been overly successful in using discretionary fiscal policy to stabilize output fluctuations -- although some successes do exist.

US

In the early 1930s of great depression, the U.S. government adopted a broad set of policies including:

1) deposit insurance2) abandoning the gold standard3) monetary expansion4) a discretionary fiscal expansion- In cyclically-adjusted terms, the budget went from a

surplus of 1 percent of GNP under the Hoover administration, to a deficit of around 2 percent under Roosevelt’s. (DeLong 1998). While the magnitude of the change may seem modest, it has to be compared with the very small size of the budget at the time (around 5% of GNP).

- Under the New Deal policies, the expenditure increases consisted mainly in federal grants for work relief associated with public works, and transfers to farmers.

Cont. US:

Most observers agree that the fiscal expansion helped the recovery substantially, although the extent of its contribution - as opposed to that of other policy changes - remains debated.

Closer analysis reveals that the two major spending items had quite different effects:

1)public works grants probably raised income almost one-for-one.

2)transfers to farm owners – intended to compensate them for taking land out of production – had little or no effect on spending and income, owing partly to their regressive redistributive impact on rural incomes (Fishback et al 2005).

China

China's response to the East Asian financial crisis of 1997-1998 is viewed as an unusual example of a successful countercyclical intervention by a developing country in the face of an external shock.

China's fiscal response was prompt, with the cyclically-adjusted budget deficit increasing quickly from 1% of GDP prior to the crisis to 1.9% in 1999 and 2.4% in 2000, and remaining in the area of 2% through 2003 (Kuijs and Xu 2008). 

This period of expanded deficits coincided with a growth slowdown from 9.5% per year in the five years before the crisis to an average of 7.9% in the five years following the crisis.  Unusually relative to the experience of most developing countries, the fiscal stimulus was reversed, with cyclically-adjusted budget deficits returning to 1% of GDP after 2003. 

Finally, the fiscal stimulus was achieved primarily through increases in infrastructure spending.

Cont. China

Several unique factors contributed to China's ability to carry out this policy response.

1) China entered the East Asian crisis with very low public debt, and so there was considerable scope to engage in deficit spending

2) China's prohibition on subnational government borrowing combined with many years of very rapid growth ensured that local governments had strong demand for infrastructure investment projects but were effectively credit-constrained from carrying them out.

3) Although the budgetary size of the fiscal stimulus was modest at around 1% of GDP, it was leveraged into significantly larger investment spending

4) This fiscal expansion was implemented during a period of still-very-rapid growth - even during growth slowdowns growth in China is faster than almost any other developing country! 

Argentina

In contrast to the case of China, the risks of a mistimed expansionary change in fiscal policy are illustrated by the experience of Argentina in the mid-1990s. After undergoing a recession in 1995, largely due to the spread of Mexico’s Tequila crisis, a recovery took hold in 1996 and strengthened in 1997

The modest growth effects of the fiscal expansion quickly dissipated, and eventually the authorities were forced to abandon it and adopt a fiscal austerity package in 1983.