6 fiscal policy

8/14/2019 6 Fiscal Policy

1/790

Fiscal Policy: Lessons from the CrisisSeminari e convegniWorkshops and Conferences

number

6February

2011


2/790

Fiscal Policy: Lessons from the CrisisSeminari e convegniWorkshops and Conferences

PUBLIC FINANCE WORKSHOPPapers presented at the Banca dItalia workshopheld in Perugia, 25-27 March, 2010


3/790

Earlier versions of the papers in this volume were presented at the Banca dItalia workshopon Fiscal Policy: Lessons from the Crisis held in Perugia, S.A.Di.Ba., on 25-27 March, 2010.We wish to thank the staff of S.A.Di.Ba. for their assistance in all aspects of the organization of theworkshop.

Previous Public Finance workshops have addressed the following topics:

Indicators of Structural Budget Balances (1998)

Fiscal Sustainability (2000)

Fiscal Rules (2001)

The Impact of Fiscal Policy (2002)Tax Policy (2003)

Public Debt (2004)

Public Expenditure (2005)

Fiscal Indicators (2006)

Fiscal Policy: Current Issues and Challenges (2007)

Fiscal Sustainability: Analytical Developments and Emerging Policy Issues (2008)

Pension Reform, Fiscal Policy and Economic Performance (2009)

The proceedings may be requested from:

Banca dItaliaBibliotecaVia Nazionale, 9100184 RomaItaly

They are also available at the Banca dItalia website:

http://www.bancaditalia.it/studiricerche/convegni/atti;internal&action=_setlanguage.action?LANGUAGE=enand:http://www.bancaditalia.it/pubblicazioni/seminari_convegni;internal&action=_setlanguage.action?LANGUAGE=en

The contents of this book do not commit Banca dItalia.Responsibility for the ideas and opinions expressed rests with the authors of the papers.Printed by the Printing Office of Banca dItalia, Rome, March 2011

2010 Banca dItalia


4/790

CONTENTS

Foreword

Daniele Franco(Banca dItalia)......................................................................................................... p. 11

Introduction

Marika Cioffi, Daniele Franco and Maria Rosaria Marino(Banca dItalia)......................................................................................................... p. 13

Session 1

AUTOMATIC STABILISERS AND DISCRETIONARY FISCAL POLICY

1. Government Fiscal and Real Economy Responses to the Crises: Automatic

Stabilisers Versus Automatic StabilisationJonas Fischer and Isabelle Justo

(European Commission) ........................................................................................... p. 29

2. Are the Effects of Fiscal Changes Different in Times of Crisis and Non-crisis?

The French Case

Carine Bouthevillain*and Gilles Dufrnot**( *Banque de France)( **Universit dAix-Marseille andBanque de France) ........................................... p. 49

3. Fiscal Activism in Booms, Busts and Beyond

Ludger Schuknecht(European Central Bank).......................................................................................... p. 75

4. The Reaction of Fiscal Policy to the Crisis in Italy and Germany: Are They

Really Polar Cases in the European Context?

Britta Hamburg,*Sandro Momigliano,**Bernhard Manzke*and Stefano Siviero**( *Bundesbank)( **Banca dItalia) .................................................................................................... p. 99

5. Fiscal Policy in the United States: Automatic Stabilizers, Discretionary

Fiscal Policy Actions, and the Economy

Glenn Follette and Byron Lutz

(Federal Reserve Board)........................................................................................... p. 125


5/790


6/790

12. Short-term Macroeconomic Effects of the Fiscal Stimulus Measures in

AustriaSerguei Kaniovski and Margit Schratzenstaller(Austrian Institute of Economic Research, WIFO) ...................................................p. 347

13. Getting It Right:

How Fiscal Response Can Shorten Crisis Length and Raise Growth

Emanuele Baldacci,*Sanjeev Gupta*and Carlos Mulas-Granados**( *IMF)( **Universidad Complutense de Madrid) ................................................................ p. 365

14. Fiscal Policy and Growth: Do Financial Crises Make a Difference?

Antnio Afonso,*Hans Peter Grner**,***and Christina Kolerus**

(*

ECB and ISEG/TUL Technical University of Lisbon)( **University of Mannheim)( ***Centre for Economic Policy Research)..............................................................p. 383

15. Tax Policies to Improve the Stability of Financial Markets

Jason McDonald and Shane Johnson(Australian Treasury)................................................................................................ p. 405

Comments

Yngve Lindh(Ministry of Finance, Sweden).................................................................................. p. 427

CommentsDaniela Monacelli

(Banca dItalia)......................................................................................................... p. 433

CommentsGalen Countryman

(Department of Finance, Canada)............................................................................ p. 443

Session 3

FISCAL POLICY AND FISCAL RULES

16. The Great Crisis and Fiscal Institutions in Eastern and Central Europe and

Central Asia

Luca Barbone, Roumeen Islam and Luis lvaro Sanchez(World Bank)............................................................................................................. p. 447

17. Fiscal Policy in Colombia and a Prospective Analysis After the 2008 Financial

Crisis

Ignacio Lozano(Banco de la Repblica de Colombia) ......................................................................p. 473


7/790

18. Fiscal Institutions in New Zealand and the Question of a Spending Cap

Tracy Mears, Gary Blick, Tim Hampton and John Janssen(New Zealand Treasury) ........................................................................................... p. 495

19. Fiscal Multipliers in the Euro Area

Pablo Burriel*, Francisco De Castro*, Daniel Garrote*, Esther Gordo*,Joan Paredes**and Javier J. Prez*

( *Banco de Espaa)( **European Central Bank) ..................................................................................... p. 519

20. The Crisis, Automatic Stabilisation, and the Stability Pact

Jrme Creel*and Francesco Saraceno**( *ESCP Europe andOFCE/Sciences Po)

(**

OFCE/Sciences Po) ............................................................................................ p. 535

21. EU Fiscal Consolidation After the Financial Crisis Lessons from Past

Experiences

Salvador Barrios, Sven Langedijk and Lucio Pench(European Commission) ........................................................................................... p. 561

22. Impact of the Global Crisis on Sub-national Governments Finances

Teresa Ter-Minassian*and Annalisa Fedelino**( *formerly IMF)( **IMF) .................................................................................................................... p. 595

CommentsDavid Heald

(University of Aberdeen Business School)................................................................ p. 613

Comments

Christian Kastrop(Ministry of Finance, Germany) ............................................................................... p. 619

Comments

Jana Kremer(Bundesbank) ............................................................................................................ p. 621

Session 4

THE LEGACY OF THE CRISIS AND THE EXIT STRATEGY

23. The Consequences of Banking Crises for Public Debt

Davide Furceri*and Aleksandra Zdzienicka**( *OECD)( **GATE-CNRS,University of Lyon) ...................................................................... p. 627


8/790

24. Implications of the Crisis for Public Finances: The Case of Austria

Lukas Reiss and Walpurga Khler-Tglhofer(sterreichische Nationalbank)................................................................................ p. 649

25. The First Time You Never Forget: The Success of Brazil in the 2009 Crisis

and the Need for Third-generation Reforms

Joaquim Vieira Levy(formerly State of Rio de Janeiro)............................................................................. p. 671

26. Structural Aspects of the Japanese Budget

Michio Saito(Ministry of Finance, Japan) .................................................................................... p. 693

27. Cyclical and Structural Components of Corporate Tax Revenues in JapanJunji Ueda*, Daisuke Ishikawa**and Tadashi Tsutsui**

( *University of Kyoto)( **Ministry of Finance, Japan)................................................................................ p. 705

28. Optimal Fiscal Policy in the Post-crisis World

Francesco Caprioli, Pietro Rizza and Pietro Tommasino(Banca dItalia)......................................................................................................... p. 727

29. A Note on Optimal Fiscal Rule for Turkey

Mehmet Yrkolu

(Central Bank of the Republic of Turkey) ................................................................. p. 747

30. The New Medium-term Budgetary Objectives and the Problem of Fiscal

Sustainability After the Crisis

Paolo Biraschi,*Marco Cacciotti,*Davide Iacovoni*and Juan Pradelli**( *Ministero dellEconomia e delle Finanze)( **The World Bank andUniversit degli Studi di Roma Tor Vergata) ................... p. 761

Comments

Carlo Cottarelli(IMF)......................................................................................................................... p. 783

CommentsRichard Hemming

(Duke University)...................................................................................................... p. 787

Comments

Thomasz Jdrzejowicz(Narodowy Bank Polski) ........................................................................................... p. 789


9/790

Contributors

Antnio Afonso (ECB andISEG/TUL Technical University of Lisbon)Emanuele Baldacci (IMF)Luca Barbone (World Bank)Salvador Barrios (European Commission)Paolo Biraschi (Ministero dellEconomia e delle Finanze)Gary Blick (New Zealand Treasury)Carine Bouthevillain(Banque de France)Adi Brender (Bank of Israel)Pablo Burriel (Banco de Espaa)Marco Cacciotti (Ministero dellEconomia e delle Finanze)

Francesco Caprioli (Banca dItalia)Marika Cioffi (Banca dItalia)Carlo Cottarelli (IMF)Galen Countryman (Department of Finance, Canada)Jrme Creel (ESCP Europe andOFCE/Sciences Po)Christian Daude (OECD)Xavier Debrun (IMF)Fabia A. De Carvalho (Banco Central do Brasil)Francisco De Castro (Banco de Espaa)Gilles Dufrnot (Universit dAix-Marseille andBanque de France)Annalisa Fedelino (IMF)

Jonas Fischer (European Commission)Glenn Follette (Federal Reserve Board)Daniele Franco (Banca dItalia)Davide Furceri (OECD)Daniel Garrote (Banco de Espaa)Esther Gordo (Banco de Espaa)Hans Peter Grner (University of Mannheim andCentre for Economic Policy Research)Sanjeev Gupta (IMF)Britta Hamburg (Bundesbank)Tim Hampton (New Zealand Treasury)

David Heald (University of Aberdeen Business School)Richard Hemming (Duke University)Davide Iacovoni (Ministero dellEconomia e delle Finanze)Jan in t Veld (European Commission)Daisuke Ishikawa (Ministry of Finance, Japan)Roumeen Islam (World Bank)John Janssen (New Zealand Treasury)Thomasz Jdrzejowicz (Narodowy Bank Polski)Shane Johnson (Australian Treasury)Isabelle Justo (European Commission)Serguei Kaniovski (Austrian Institute of Economic Research, WIFO)

Radhicka Kapoor (London School of Economics)


10/790

Christian Kastrop (Ministry of Finance, Germany)

Walpurga Khler-Tglhofer (sterreichische Nationalbank)Christina Kolerus (University of Mannheim)Jana Kremer (Bundesbank)Ginette Lafit (National University of Crdoba, Argentina)Sven Langedijk (European Commission)Geert Langenus (National Bank of Belgium)Martin Larch (European Commission)Yngve Lindh (Ministry of Finance, Sweden)Ignacio Lozano (Banco de la Repblica de Colombia)Byron Lutz (Federal Reserve Board)Bernhard Manzke (Bundesbank)

Maria Rosaria Marino (Banca dItalia)Jason McDonald (Australian Treasury)Tracy Mears (New Zealand Treasury)ngel Melguizo (OECD)Sandro Momigliano (Banca dItalia)Daniela Monacelli (Banca dItalia)Carlos Mulas-Granados (Universidad Complutense de Madrid)Alejandro Neut (OECD)Joan Paredes (European Central Bank)Lucio Pench (European Commission)Javier J. Prez (Banco de Espaa)Juan Pradelli (The World Bank andUniversit degli Studi di Roma Tor Vergata)Lukas Reiss (sterreichische Nationalbank)Ernesto Rezk (National University of Crdoba, Argentina)Vanina Ricca (National University of Crdoba, Argentina)Pietro Rizza (Banca dItalia)Werner Rger (European Commission)Michio Saito (Ministry of Finance, Japan)Luis lvaro Sanchez (World Bank)Francesco Saraceno (OFCE/Sciences Po)Margit Schratzenstaller (Austrian Institute of Economic Research, WIFO)

Ludger Schuknecht (European Central Bank)Stefano Siviero (Banca dItalia)Teresa Ter-Minassian (formerly IMF)Pietro Tommasino (Banca dItalia)Tadashi Tsutsui (Ministry of Finance, Japan)Junji Ueda(University of Kyoto)Marcos Valli Jorge (Banco Central do Brasil)Patrick Van Brusselen (Federal Planning Bureau, Belgium)Joaquim Vieira Levy (formerly State of Rio de Janeiro)Mehmet Yrkolu (Central Bank of the Republic of Turkey)Aleksandra Zdzienicka (GATE-CNRS, University of Lyon)


11/790

FOREWORD

Daniele Franco*

This volume brings together the papers presented at the 12th

Banca dItalia Public Finance

Workshop, held in Perugia from 25 to 27 March 2010.

To counteract the 2008-09 recession, the most severe at global level since the Great

Depression, governments took unprecedented action. Discretionary measures were approved in

many countries to complement automatic stabilisers. International fiscal coordination was

enhanced. In some countries, rules and procedures were altered to create more room for budgetary

manoeuvre. Growing fiscal imbalances and rising debt levels gradually shifted the focus of debate

to the policies for regaining control of public finances. Structural reforms became more prominent

on the agenda in many countries in order to reinforce exit strategies.

The workshop focused on the implications of these developments for fiscal policy analysis.

The lessons to be learned concerning the role and size of automatic stabilisers, the need for

discretionary action and the timing and composition of fiscal policies were investigated. The

effectiveness of the fiscal packages was evaluated and the indications to be drawn concerning the

composition of discretionary measures were explored. The impact of the crisis on fiscal rules and

procedures was also examined together with the extent to which national rules and the revised

European Stability and Growth Pact coped with fiscal stress. Finally, the repercussions of the crisis

on fiscal sustainability and the need for structural reforms were assessed.

Banca dItalia is grateful to the institutions that contributed to the success of the initiative, to

the experts who provided research papers and to all who came to Perugia to take part in the

discussion.

This volume extends the analysis of fiscal policy issues carried out in the previous

workshops, which were devoted to Indicators of Structural Budget Balances (1998), Fiscal

Sustainability(2000),Fiscal Rules(2001), The Impact of Fiscal Policy(2002), Tax Policy(2003),

Public Debt (2004), Public Expenditure (2005), Fiscal Indicators (2006), Fiscal Policy: Current

Issues and Challenges (2007), Fiscal Sustainability: Analytical Developments and Emerging

Policy Issues(2008) andPension Reform, Fiscal Policy and Economic Performance(2009).

* Banca dItalia, Structural Economic Analysis Department.


12/790


13/790

INTRODUCTION

Marika Cioffi,*Daniele Franco*and Maria Rosaria Marino*

The economic downturn and its severe impact on public finances and long-term growth

prospects have rekindled the debate on the role, design and priorities of fiscal policy. The limited

effectiveness of monetary policy when interest rates are very low, together with the added

challenge of dysfunctional credit markets, gave rise to a renewed consensus on the

complementarity of monetary and fiscal policies. The role of fiscal policy in stabilising the

economy and providing stimulus for a prompt recovery was largely recognised.

As the consequences of the crisis became more and more dramatic, policymakers began

inquiring whether the role of fiscal policy for stabilisation purposes should differentiate between

ordinary and extraordinary times. In particular, the adequacy of automatic stabilisation underexceptional circumstances was questioned. In fact, while the timely and temporary free play of

the automatic stabilisers is commonly considered sufficient to ensure fiscal stabilisation during

ordinary times, their scope has been found to be too narrow when there is a severe recession.

Despite initial reluctance, the risk of economies being locked into a state of depression paved

the way in many countries for exceptional resort to discretionary fiscal stimuli. Crisis-related

discretionary stimulus measures in the G-20 countries averaged about 2 per cent of GDP in both

2009 and 2010. The design of stimulus packages varied significantly in size, depending on

macroeconomic conditions and priorities. While the United States swiftly approved massive

increases in government expenditure, European governments adopted comparatively prudent

measures, relying on the working of larger automatic stabilisers. The composition of stimulus

packages was also highly heterogeneous.The overall budget deficit of the advanced G-20 economies increased from about 1 per cent

of GDP in 2007 to 9 per cent in 2009. Structural budgetary positions, in some cases already

relatively weak on the eve of the crisis, grew substantially worse in many countries. This, and the

rapid build-up of public debt in many countries, constrained the further use of fiscal policy to

support the economy and made prompt fiscal consolidation a necessity.

The policy debate rapidly shifted to the timing, pace and procedure for withdrawing

extraordinary measures, seeking to balance concerns about fiscal sustainability and consolidation

with the need to avoid an overly rapid phase-out of fiscal support. In the aftermath of the crisis, it

became evident that the pace of financial consolidation and the optimal debt-reduction path are

highly dependent on government credibility: if markets are not completely confident in the

governments solvency, the high risk premia paid on public debt provide the rationale for aprogramme of rapid debt reduction, in contrast with the theoretical prescription of optimal tax

smoothing and debt stabilisation.

The reform of fiscal frameworks gained momentum. A strengthening of national fiscal

institutions, in the three dimensions of evaluation, planning and implementation, was recognised as

crucial to consolidation. The need for rules requiring budget surpluses during cyclical upturns and

the maintenance of prudent levels of public debt became even more evident. Medium-term

frameworks were deemed essential to ensure the sustainability of public finance. The debate

focused on expenditure rules and the role of independent fiscal councils. In the European

framework, a consensus emerged on strengthening the Stability and Growth Pact and introducing

additional provisions for addressing macroeconomic imbalances.

* Banca dItalia, Structural Economic Analysis Department.


14/790

14 Marika Cioffi, Daniele Franco and Maria Rosaria Marino

Fiscal developments during and after the crisis pose several challenges to fiscal policy

analysis. Were automatic stabilisers adequate? Which discretionary actions were more effective?

What is the additional evidence about the size of multipliers? Was international cooperation

adequate? Which fiscal frameworks proved more effective? How should fiscal priorities and tools

be modified to cope with the consequences of the crisis? In the euro area there is both a national

and a European dimension.

The papers presented at the workshop were organised in four sessions, mirrored by the

sections of this volume. Section 1 examines the lessons of the crisis for the role of automatic

stabilisers and discretionary fiscal policy. Section 2 investigates the effects of policy actions on the

economy. Section 3 considers the impact of the crisis on fiscal policy rules and procedures.

Section 4 deals with the legacy of the crisis and the policy actions required in the coming years.

1 Automatic stabilisers and discretionary fiscal policy

Session 1 contains papers dealing with the role of automatic stabilisers and discretionary

fiscal policies during the crisis. The first paper focuses on the discretionary measures introduced by

EU member states. The second examines the differences in the effectiveness of policy measures in

recessions as opposed to normal times. The third paper discusses fiscal policies before, during and

after the crisis. The last four papers present empirical exercises evaluating the effects of automatic

stabilisers and discretionary measures in different countries using different methodologies.

The paper by Fischer and Justo deals with the discretionary measures introduced by EU

member states in response to the crisis. It provides a broad overview of the types of crisis-related

measures taken and an estimate of their size. On the aggregate level, it appears that the

discretionary support was timely, temporary and targeted, and that the countries with limited fiscalroom did generally take a more restrictive stance than those with more room for manoeuvre. The

paper also looks at how discretionary measures complemented automatic stabilisers. Fischer and

Justo find that about half of the discretionary measures involved areas already covered by

automatic stabilisers, while the other half supported especially hard-hit industrial sectors and

population groups as well as public investment. The overall outcome suggests that it was helpful to

have ex ante principles for the provision of discretionary stimuli. The actual provision of

discretionary stimuli under such conditionalities reinforced the budgetary stabilisation capability in

a flexible way.

Bouthevillain and Dufrnot use a transition probability Markov switching model to argue

that the impact of changes in budgetary variables on real GDP, investment, consumption and

employment varies in sign and magnitude in times of crisis and non-crisis. The analysis shows that

fiscal variables have an asymmetric effect on these macroeconomic variables. These nonlinearities

are both frequent and significant. In particular, if one considers the GDP aggregate, public

expenditure has a stronger impact during crises and the expenditure multiplier is greater than the

tax multiplier. The consequence is that, during periods of crisis, an expenditure-oriented stimulus

plan can be more effective than a tax-based recovery plan. Tax-oriented measures are effective

only when private investment and employment are at stake. If households are sensitive to the

unemployment situation, tax cuts will not bring about an increase in consumption; larger transfers

would be much more effective.

Schuknecht discusses activist fiscal policies during good times, the crisis period and the

post-crisis period. First, during the boom, fiscal policies were overly imprudent, due in part to

real-time measurement problems. Then, during the bust, the analysis of the roots of the crisis

should have gone deeper, avoiding the excessive emphasis placed on the need for activist fiscaldemand support. Although the balance sheet nature of the crisis was largely unacknowledged,


15/790

Introduction 15

significant fiscal measures to support balance sheets were introduced. Scant attention was paid to

the fiscal consequences of facilitating the restructuring of economic sectors and the downward

adjustment of aggregate demand that had reached unsustainable dimensions during the boom. The

author recognises that fiscal exit strategies are being developed and implemented to correct

unsustainable fiscal balances. However, policymakers are taking too long to focus on the

underlying strategies, as in the case, Schuknecht argues, of expenditure reforms. The paper draws

three lessons for activist fiscal policies: i) apply prudent expenditure policies during the boom years

and improve the gauging of the fiscal stance; ii) target fiscal policies to the true causes of a crisis;

and iii) avoid delay in correcting fiscal imbalances and focus on remedying unsustainable

expenditure ratios.

Hamburg et al.examine public finance developments in Germany and Italy in 2009 and find

that the larger stimulus measures adopted in Germany were associated with a more favourable

underlying trend in the German budget balance. Overall, the cyclically-adjusted primary balances

deteriorated by a similar extent in the two countries. The automatic stabilisers are estimated to havehad an impact of a similar magnitude on the deficit in Germany and in Italy. Given the fiscal

conditions in 2008, it is not surprising that the size of the discretionary measures adopted by the

two countries were at the opposite extremes of the gamut of reactions of all European governments.

Hamburg et al. then assess the macroeconomic impact of discretionary measures and automatic

stabilisers on the basis of counterfactual simulations with the econometric models of the two

countries developed by Deutsche Bundesbank and Banca dItalia. Altogether, discretionary

measures and automatic stabilisers counteracted the fall in real GDP in 2009 by more than

2 percentage points in Germany and by 1 point in Italy. The difference reflects both the size of the

stimulus measures and the higher fiscal multipliers in Germany.

Follette and Lutz examine fiscal policy in the United States at both the federal and state and

local levels and look at the effects of automatic stabilisers and discretionary fiscal actions in threesteps. First, they provide the figures for the effects of the automatic stabilisers on budget outcomes

at the federal and then at state and local levels. For the federal government, the deficit increases by

about 0.35 per cent of GDP for each 1 percentage point deviation of actual GDP relative to

potential GDP. For state and local governments, the deficit increases by about 0.1 per cent of GDP.

The authors then examine the response of the economy to these automatic stabilisers by comparing

the reaction to aggregate demand shocks with and without them. Second, the paper discusses the

effects of discretionary fiscal policy actions at the federal and state and local levels. Federal policy

actions are found to be counter-cyclical: expenditures and tax actions are more stimulative after a

business cycle peak than before it. By contrast, state and local policy actions are pro-cyclical,

probably reflecting constitutional restrictions on general fund budget balances. Lastly, Follette and

Lutz evaluate the impact of the budget, through both automatic stabilisers and discretionary

measures, on economic activity over the past two years.

The paper by Daude et al. measures the cyclical component of fiscal balances using the

standardised OECD methodology. At the onset of the international financial crisis of 2008-09,

many indicators suggested that Latin American economies were facing it on relatively more solid

macroeconomic ground than in the past, both in monetary and fiscal terms. Inflation-targeting

regimes made monetary policy more credible; large budget surpluses and low debt-to-GDP levels

gave some countries unprecedented fiscal margins to pursue sustainable counter-cyclical fiscal

policies. The success of these counter-cyclical responses is still unclear, and will largely depend on

the size of the programmes and their actual impact. Besides, in the wake of the international

financial crisis, there was no consensus on whether the recent fiscal improvements were cyclical or

structural. The paper presents updated original estimates of cyclically-adjusted fiscal balances for

eight Latin American countries from the early 1990s to 2009, implementing the standardised


16/790


OECD methodology and regional-specific adjustments for the impact of commodity prices.

Standard debt sustainability exercises are also performed.

Rezk et al.argue that the impact of the world financial crisis on Latin America was buffered

by lower external private and public debt exposure and better macroeconomic fundamentals, which

reduced the negative effects of turbulences on financial systems. Nevertheless, negative effects

soon arose from the external sector. The paper stresses that the main causes of the recent weak

economic performance of Argentina lie in domestic economic policies. These policies sometimes

amplified the negative impact of the international crisis. Government revenues grew in relation to

GDP, though at a decreasing pace. The increase in primary expenditure in 2008 was not due to

measures aimed at counteracting the effects of the international financial crisis but rather to

decisions to maintain subsidies and freeze the tariffs of public services and utilities, and to

generalised increases in capital outlays. The low level that the primary surplus fell to in 2009

originated in expansionary fiscal policies decided in 2007. Although the sensitivity of tax revenue

to the economic cycle increased and stabilised at around 30 per cent in 2009, the automaticstabilisation proved insufficient and discretionary measures became necessary.

Brender disagrees with the main point of Bouthevillain and Dufrnots paper. He argues that

one should consider non-linearity in the effectiveness of various policies during recessions ( i.e.,

evaluating whether effectiveness changes when a recession has exceptional features) rather than

differences between the performance of policy measures during recessions compared with normal

times. Brender recommends extreme caution in moving from theoretical analysis to actual policy

prescriptions. He offers several suggestions to improve the specifications of the model so as to

avoid results that are driven mainly by the specific features of the model. Turning to the Fischer

and Justo paper, Brender recognises the usefulness of the dataset on the policy measures adopted

by EU members and agrees with the approach taken in the paper, but objects that the paper

provides too little analysis.

Langenus agrees with Schuknechts analysis but adds some points to the discussion. He

contends that as long as one accepts that the current assessment of the cyclical position depends on

projected future developments, estimates of structural balances will continue to present some

degree of uncertainty. In addition, it is necessary to bear in mind the unreliability of the

government accounts of certain countries, a situation that demands reforms both at the national and

the European level. Langenus also notes that the crisis provides an ideal opportunity to rethink the

design and implementation of the EU fiscal rules. The crisis showed that a much broader

assessment of fiscal risks is necessary: greater attention should be paid to public debt

developments, implicit liabilities and macroeconomic imbalances. Langenus finds the paper by

Hamburg et al. offers an excellent empirical assessment of the fiscal reaction to the crisis in

Germany and Italy. However, he argues that, by focusing on stimulus measures and automaticstabilisers, the authors neglected the differences in budgetary trends, even though they recognise

that these can be important and that the bottom-up measurement of fiscal stimulus may give a

misleading picture of the actual fiscal policy loosening. Langenus recommends further developing

the comparison of government actions in each country with a neutral benchmark. He also suggests

working on qualitative issues pertaining chiefly to the third T of the 3T principles, to assess how

appropriately targeted were the measures.

Larch observes that the papers by Follette and Lutz, Daude et al.and Rezk et al.illustrate the

persistent lack of clarity about just what automatic fiscal stabilisers are and how their effectiveness

should be assessed with respect to output smoothing. Follette and Lutz, as well as Rezk et al., take

the approach that automatic stabilisation results from changes in revenue and expenditure produced

by cyclical swings in economic activity. Alternatively, Daude et al.interpret automatic stabilisation

as resulting from the inertia of discretionary spending over the cycle, but with someinconsistencies. In particular, when discussing the concept of automatic stabilisation, they refer to


17/790

Introduction 17

cyclical swings of revenues, but in estimating the size of automatic stabilisers they follow an

approach developed by the OECD according to which the strength of stabilisation is largely

determined by the size of government. This issue becomes important for assessing the effects of

automatic stabilisation on output, because it affects the definition of the benchmark against which

those effects are to be gauged. When simulating the effect of automatic stabilisers on output,

Follette and Lutz and Rezk et al.define the neutral budget as one in which revenue and expenditure

are invariant with respect to output; Daude et al., by contrast, use a benchmark in which both

revenue and expenditure change in line with output. While equally arbitrary from an ex antepoint

of view, the two benchmarks have very different implications when it comes to assessing the extent

to which automatic stabilisers help mitigate output fluctuations.

2 Fiscal impulse

Session 2 examines the impact of policy actions on the economy. The first four papers look

at the links between fiscal policies and the macroeconomic situation and assess and measure the

effectiveness of fiscal policies in stabilizing the economy. The fifth paper provides an insight into

the spillover effects of the fiscal measures adopted by foreign countries on a small open economy.

The last three papers examine how fiscal policy may help lessen or, on the contrary, exacerbate

financial turmoil.

Debrun and Kapoor revisit the empirical link between fiscal policy and macroeconomic

volatility. Their analysis provides strong support to the view that fiscal stabilisation operates

mainly through automatic stabilisers. By contrast, fiscal policies systematically linked to cyclical

conditions do not appear to have a significant impact on output volatility, and changes in fiscal

variables not systematically related to the business cycle generally seem to increase output andconsumption volatility, possibly owing in part to conflicts with monetary authorities. Debrun and

Kapoor are aware that the last two results may suffer from a simultaneity bias because certain

sources of budgetary volatility are correlated with output volatility; and they observe that even if

financial development seems to exert a moderating influence on income and on consumption

growth, robustness tests indicate that it may proxy the role of other country-specific features not

included in the analysis. Concerning monetary policy, central bank independence is associated with

lower volatility, provided that the interaction between monetary and fiscal policies is taken into

account. In terms of policy implications, Debrun and Kapoor claim that fiscal policy is

unambiguously effective at stabilising the economy when it operates in the same way as automatic

stabilisers, and that governments could also contribute to macroeconomic stability by subjecting

the pursuit of other objectives, such as redistribution or efficiency, to a stability test.

Van Brusselen focuses on fiscal stabilisation providing an overview of the theory and

empirical evidence on the effects of fiscal policies implemented in the context of the recent global

recession and financial distress. Using the NIME model of the Federal Planning Bureau, he

calculates that in the first year of its implementation the European Commissions Recovery Plan

would raise the GDP of twelve euro area countries by 0.77 percentage points with respect to the

baseline. The initial effect would be to increase private sector output, creating about 200,000 jobs

in response to the rise in public consumption. The ensuing increase in household income would

raise private consumption expenditure. The second half of the stimulus package, to affect the

economy in 2010, would raise GDP by 0.62 percentage points. This lesser impact is related to

higher inflation and real imports and to a slight increase in nominal interest rates. Over the period

2011-15, the effects of the stimulus package on output would decline, with real GDP gradually

falling back toward its baseline level. Finally, Van Brusselen addresses the question of where theworld economy is headed, given the generally unsustainably high levels of public sector deficits


18/790


and debt and the possibility that the global financial crisis will have lasting adverse effects on

potential output levels.

In Rger and int Velds paper a multi-region DSGE model with collateral-constrained

households and residential investment is used to examine the effectiveness of fiscal policy stimulus

during a credit crisis. The paper explores alternative scenarios that differ according to the type of

budgetary measures, their duration, the degree of monetary accommodation and the level of

international coordination. An increase in households facing credit constraints, together with the

fact that the zero lower bound on nominal interest rates has become binding, increases the

effectiveness of temporary fiscal stimulus measures. In particular, the presence of

credit-constrained households raises the marginal propensity to consume out of current net income

and makes fiscal policy a more powerful tool for short-run stabilisation; credit-constrained

consumers react even more strongly to a fall in real interest rates, which can occur when monetary

policy can be accommodative towards the fiscal stimulus. While this suggests a larger role for

fiscal policy in the euro area, in many of the member states in central and eastern Europe interestrates were generally higher. As it is less likely that monetary policy in these countries can

accommodate the fiscal impulse, their fiscal policy turns out to be less effective than in countries

where nominal interest rates can be kept unchanged and real interest rates allowed to fall. However,

even when monetary policy cannot accommodate the fiscal impulse, well-designed fiscal stimulus

measures can still help to soften the impact of a crisis and mitigate its detrimental effects on

potential growth.

Valli Jorge and De Carvalho use an extension of the ECBs New Area-Wide Model

(NAWM) to model a fiscal policy that pursues primary balance targets in order to stabilise the

debt-to-GDP ratio in an open and heterogeneous economy where firms combine public and private

capital to produce their goods. The model has been extended by broadening the scope for fiscal

policy implementation and allowing for heterogeneity in labour skills; the domestic economy isassumed to follow a forward-looking Taylor-rule consistent with an inflation-targeting regime. The

model is then calibrated for Brazil to analyse some implications of monetary and fiscal policy

interaction and explore some of the implications of fiscal policy in this class of DSGE models.

Among other interesting results, Valli Jorge and De Carvalho find that an expansionary shock to

the primary surplus is not equivalent to a shock to government consumption, as the former impacts

both government consumption and investment to a different degree. Each of the fiscal shocks

(primary surplus, government investment and government transfers) has a distinct effect on the

model dynamics. The paper shows that under different specifications of monetary and fiscal policy

rules, fiscal shocks have important effects on the models dynamic responses and predicted

moments. Stronger commitment to stabilisation of the public debt strengthens the contractionary

impact of the monetary shock. Strongly (and negatively) correlated policy shocks also dampen the

contractionary consequences of the monetary policy shock.

Kaniovski and Schratzenstaller present a macroeconomic simulation of the short-term effects

of the fiscal stimulus measures adopted by Austria and by its most important trading partners to

cushion the economic downturn. The rationale of their simulation is to assess the effectiveness, in

terms of output and employment, of national stabilisation programmes and to evaluate the size of

cross-country spillover effects, expected to be quite large for a small, open economy like Austria.

Model simulation suggests that the fiscal packages may have dampened the downturn by a

cumulated 2.1 per cent of GDP in 2009 and 2010. Almost half of the fiscal impulse is generated by

national measures, while the incidence of the spillover, captured by the fiscal stimulus of partners,

accounts for one third of the overall estimated effect. In addition, the total impact on GDP secured

41,500 jobs and curbed the rise in the unemployment rate by 0.7 percentage points. The authors

conclude that, since some measures have a positive direct impact on employment that cannot be


19/790

Introduction 19

captured by this kind of model, the simulation results should be taken as the lower bound of the

overall employment effect generated by the fiscal stimulus programmes.

Baldacci et al.use an ordered logit model to assess the effects of fiscal stimulus packages

during episodes of systemic banking crisis in advanced and emerging market countries over the

period 1980-2008. Their results show that timely countercyclical fiscal measures can help shorten

crises by boosting aggregate demand and offsetting the collapse of private investments.

Nevertheless, these outcomes are weaker for countries with limited budgetary room and where

fiscal expansion is prevented by funding constraints or limited access to markets. The composition

of fiscal responses is important: fiscal expansions based on government consumption and income

tax cut are more effective in shortening the recession, while a larger share of public investment

yields the strongest impact on output growth. These findings suggest a potential trade off between

short-run aggregate demand support and medium-term productivity growth objectives. Two

stylised facts emerge: i) the fiscal measures enacted by G-20 countries may have curtailed the crisis

by up to one year and ii) they may have stimulated post-crisis growth by 1 per cent of GDPcompared with the counterfactual scenario of no fiscal stimulus. Results can be larger for emerging

market economies than for advanced countries, since the former devoted a greater share of the

stimulus to infrastructure, while the latter made greater resort to tax cuts and transfer increases.

Afonso et al. assess the extent to which government spending can mitigate economic

downturns in the short run and whether the impact on real GDP growth differs during financial

crises and ordinary times. In their panel analysis, conducted for a set of OECD and non-OECD

countries over the period 1981-2007, the authors also control for reverse causality, as current

economic growth may negatively affect government spending behaviour. Their results show that

the increase in real government spending has a positive and significant impact on real GDP growth.

The fiscal multipliers for the full sample of ordinary and crisis spending are estimated at 0.6-0.8.

However, although the impact of government spending is greater in times of distress, the Wald testsuggests that there is no statistically significant difference between spending in crisis and in

ordinary times. This significant result, indicating that government spending has essentially the

same impact on economic growth during ordinary times and during financial downturns, holds

throughout the sample, using a diversity of controls, sub-samples and specifications.

Focusing on Australia, McDonald and Johnson analyse how tax systems may have increased

economies vulnerability to financial shocks. In particular, tax systems have a bias towards

corporate debt financing over equity, thus contributing to excessive leverage; the tax preference for

housing may have prompted housing booms, although its contribution to financial instability is

unproven; in addition, concessional tax treatment of capital gains is likely to have distorted asset

allocation and to have encouraged investment in riskier assets. Some recent tax proposals, such as a

Tobin tax or other taxes and levies on the financial sector, could augment the vulnerability of thefinancial sector. As an alternative, the authors indentify a number of policy reforms aimed at

correcting tax-policy-induced risk misallocation rather than concentrating on financial sector taxes.

Among these, an allowance for corporate equity would reduce corporate debt biases, a flat tax rate

on capital income would diminish tax arbitrage across classes of assets, and improved loss offset

provisions would act as microeconomic stabilisers.

Lindh stresses that more caution than ever is required today in estimating automatic

stabilisers and fiscal multipliers. It is likely that the current deep crisis will change some economic

relationships even after new equilibrium paths have emerged. Referring to Debrun and Kapoors

paper, he suggests that it would be interesting to introduce some examples of fiscal activism not

related to the cycle. He argues that the finding that monetary policy frameworks are stabilising

depends in part on the data used and that the result could change if post-crisis data were included.

Lindh also stresses that, at least in normal times, it would be important for fiscal policy to pave theway for monetary policy by remaining prudent, and agrees with Debrun and Kapoor that the


20/790


practical way to ensure this is to subject the budget to quantitative objectives or binding constraints

defined in terms of structural balance or expenditure ceilings. Concerning the paper by Van

Brusselen, Lindh concentrates on the role that fiscal policies can play in stimulating demand during

deep crises. He observes that many stimulus packages include permanent measures and that it

would be interesting to assess whether such measures increase growth rates in the upturn after the

crisis. Lindh agrees with Van Brusselen that fiscal stimulus, to be effective, requires measures

tailored to individual countries and keyed to specific conditions such as the degree of openness of

the economy and the initial conditions of the government accounts. Nevertheless, Lindh stresses

that policy coordination among countries can also play an important role.

Before commenting on the papers by Kaniovski and Schratzenstaller, Valli Jorge and De

Carvalho, and Rger and int Veld, Monacelli depicts the current state of the debate on the

effectiveness of fiscal stimulus packages, on the size of fiscal multipliers and, more generally, on

the forecasting power of macroeconomic models and their reliability as potential policy guides.

More specifically, Monacelli describes Kaniovski and Schratzenstallers paper as a typical exampleof macro model simulation; she appreciates the wealth of details on the Austrian economy and the

analysis of spillover effects. She suggests providing a more detailed description of the functioning

of the macroeconometric model, the channels through which the spillover works and the impact of

the crisis on fiscal policy effectiveness.

Countryman comments on the papers by Baldacci et al., Afonso et al.and by MacDonald

and Johnson. He remarks that the three papers make valuable contributions to the debate on fiscal

policy: the first two papers focus on how fiscal policy can mitigate the effects of the economic

turmoil, while the third adopts a somewhat different perspective, examining how tax policies may

have made the recent financial crisis deeper and longer. Countryman suggests that an interesting

extension of the work by Baldacci et al. would be to evaluate the effects of fiscal measures on

long-term fiscal sustainability; in this context, time-limited spending could be more flexible thantax cuts, which tend to be more permanent. Concerning the findings of Afonso et al., he observes

that there is no evidence that fiscal policy is more effective during a financial crisis than in

ordinary times. He argues that this result may be biased because the authors do not control for the

monetary policy stance at the time of crisis. Finally, Countryman describes MacDonald and

Johnsons paper as a very good overview of how microeconomic policy instruments, such as taxes,

can have profound macroeconomic effects.

3 Fiscal policy and fiscal rules

The papers in Section 3 discuss the impact of the crisis on fiscal rules and procedures. The

first three papers examine fiscal policy developments and the debate on national fiscal frameworks,respectively, in the area of Eastern and Central Europe and Central Asia, in Colombia and in New

Zealand. The next two papers focus on the euro area. The last two papers are devoted respectively

to the issue of fiscal consolidation, with an emphasis on periods of financial crisis, and the impact

of the crisis on sub-national public finances.

Barbone et al.present an overview of the fiscal reforms enacted by the countries of Eastern

and Central Europe and Central Asia (ECA) during the last two decades, with a focus on Poland,

Russia and Turkey. In particular, most of the ECA countries adopted binding budgetary rules in

order to reduce institutional fragmentation, enhance transparency and promote fiscally responsible

behaviour. During the 1990s these countries were determined to accelerate the transition from the

central-planning system. In a favourable external environment, they strengthened their fiscal

institutions and improved their fiscal outcomes. This positive trend reversed when the globalfinancial crisis struck and some reforms proved too inflexible for a period of economic downturn.


21/790

Introduction 21

In the short term, the ECA countries reacted with measures to contain the deficit, boost aggregate

demand or protect certain segments of the population. Later, once the crisis revealed the risks that

volatile environments pose for long-term stability, the need for further institutional, social and

fiscal reforms became paramount.

The contribution of Lozano is twofold. First, he offers an empirical characterisation of the

fiscal policy in place in Colombia over the last decades. Estimating a standard fiscal reaction

function, the author provides evidence of the pro-cyclicality of Colombian discretionary fiscal

policy, its recently decreasing volatility and its long-term (weak) sustainability. This last result is

confirmed by a cointegration test between taxes and spending. Second, Lozano evaluates the fiscal

stance during the financial crisis of 2008. With little room to manoeuvre, Colombias fiscal

authorities adopted a rather neutral posture during the crisis, resulting in a deterioration of fiscal

indicators, with a drop in tax revenue and a rise in public debt and the budget deficit. Lozano

contends that the adoption of binding fiscal rules may strengthen policy credibility, thus hastening

economic recovery and ensuring fiscal discipline in the long term. To be effective, these rulesshould include more than just numerical targets for the coming years: they should guarantee a

decreasing trend for the debt-to-GDP ratio and allow for counter-cyclical fiscal policies in order to

smooth out the business cycle.

Mears et al. present an overview of the fiscal framework in place in New Zealand and

countrys economic performance during the last two decades. The present fiscal policy framework,

mainly designed by the Public Finance Act of 1989, is focused on maintaining prudent levels of

public debt (as a precautionary buffer) and on running fiscal surpluses on average over time, while

providing no specific indication for government spending. The existing fiscal institutions, along

with the economic expansion enjoyed by the country since the late 1990s, contributed to New

Zealands entering the financial crisis of 2008 with a low level of public debt, but with an

unprecedented level of government spending (as a per cent of GDP). In order to strengthen thegovernment fiscal strategy, the authors propose the introduction of a spending cap, designed as a

rolling three-year nominal target for operating expenses and excluding capital spending,

unemployment benefits (cyclical and part of automatic stabilisers) and interest payments (which are

beyond the governments control). This spending cap would narrow the scope for new

discretionary spending, while allowing a margin to accommodate unexpected changes in forecast

expenses. Nevertheless, the risks implied by the proposal, mainly in terms of reduced flexibility to

deal with shocks, motivated the government decision not to introduce a formal cap.

Burriel et al.evaluate the impact of fiscal policy shocks mainly on GDP and inflation in

the euro area. To this end, they implement a standard linear structural VAR model (as in Blanchard

and Perotti, 2002) using a newly-available quarterly dataset of fiscal variables over the period

1981-2007. They also compare their results with the findings of previous exercises conducted forthe United States. Government spending shocks are found to yield positive GDP responses during

the first five quarters in both the euro area and the USA; output multipliers are below one (thus

indicating sizeable crowding-out effects) and become insignificant after 3 years from the shock.

Symmetrically, net tax increases have a negative impact on output, inflation and long-term interest

rates. An interesting finding is that government spending multipliers increased in the sub-period

beginning in 2001, presumably owing to the global saving glut, which reduced the crowding-out

effects of fiscal policy on private investment. In line with the evidence of previous literature,

short-term tax multipliers are of a lower magnitude and less persistent (only three quarters

following the shock) than government spending ones. This is also consistent with the theoretical

prediction that a portion of the increase in disposable income deriving from tax cuts will be saved.

Creel and Saraceno join the debate on the effectiveness of the Stability and Growth Pact,

which mainly relies on automatic stabilisers as counter-cyclical instruments to ensure shockresilience and income stability. They marshal several arguments to show that the effectiveness of


22/790


automatic stabilisers has diminished enormously: the sensitivity of economic activity to cyclical

changes in government revenues and spending has waned; the responsiveness of unemployment

benefits to the unemployment rate has decreased, as has tax progressivity; similarly, the size of

government has been reduced almost everywhere in Europe. In addition, they employ a simple

micro-founded model to show that, in the current setting of strong liquidity constraints, the scope

for non-Keynesian effects of an expansionary fiscal policy is greatly reduced. Finally, they use the

arguments above and the findings of a recent strand of literature (starting with Blanchard and

Perotti, 2002) to challenge the current setting of the EMU institutional framework and to advocate

a reform of the Stability and Growth Pact in the direction of a greater use of discretionary fiscal

measures as valuable tools for stabilisation.

Barrios, Langedijk and Pench analyse past episodes of public debt expansion to provide

relevant policy indications, exploiting features in common with the recent global crisis. They use a

panel of OECD countries over the period 1970-2008 to investigate the determinants of successful

consolidation strategies (in terms of debt reduction). The main innovation of the paper is theassumption that the causes of fiscal consolidation are also likely to influence its success rate. Under

this assumption, the authors use a two-step Heckman probit estimator, which allows them to

control for sample selection bias, mainly in terms of starting debt level, which is likely to affect

both the decision to consolidate (a high-debt country is more likely to consolidate) and the success

of the consolidation. Their two-step strategy shows that the overall effect of the starting debt level

on the probability of successful consolidation is positive but lower compared with the ordinary

one-step results, suggesting that the estimate is upward biased when one does not control for the

correlation between the decision to consolidate and the likelihood of achieving a successful

consolidation. Another interesting finding is that consolidations undertaken during financial crises

and even in their aftermath are less likely to succeed, thus implying that restoring the financial

sector is a pre-condition for success. Ultimately, there is no evidence that a fiscal consolidation

would be facilitated by exchange rate manipulation to promote an export-led recovery.

Fedelino and Ter-Minassian assess the impact of the crisis on sub-national government

(SNG) finances. The crisis hit sub-national budgets both directly (e.g., via the decline in own

revenues and upward pressure on cyclically-sensitive spending programmes) and through the

involvement of SNGs in the implementation of the national fiscal stimulus packages. Against these

developments, central governments increased general-purpose and (prevalently) earmarked

transfers; their support also took the form of a temporary relaxation of fiscal rules and borrowing

constraints or a direct provision of loans. Thanks to the increased support and by using their own

available fiscal space, some SNGs could enact counter-cyclical responses. This proved

insufficient: most of them had to resort to pro-cyclical revenue increases or expenditure cuts. The

authors conclude by challenging the traditional view that excludes any role of SNGs in fiscal

stabilisation. Consistently with the ongoing decentralisation of spending, desirable arrangementsshould allow sub-national counter-cyclical policies, while laying down sub-national fiscal rules to

ensure the build-up of adequate reserves and reduce the risk of pro-cyclicality. Moreover, the

introduction of institutional mechanisms for coordination across government levels should

minimise adverse inter-jurisdictional spillover effects and improve the credibility of the overall

fiscal strategy.

Heald begins his discussion of the first three papers by posing some preliminary questions

about the role of fiscal policy and the most efficient way to manage abnormal events and large

public debt contingencies. He goes on to urge Barbone et al. to give clear answers to the three

research questions they pose and to carefully consider the potential gap between the formal design

of institutions and their actual performance. In reviewing Burriel et al., Heald acknowledges the

contribution of the paper, extremely clear and informative in the strand of the emerging literature.However, he suggests that the authors provide a sound justification for the comparability, in terms


23/790

Introduction 23

of fiscal policy impact, between the United States and the euro zone, given their entirely different

constitutional and fiscal framework. He also raises two data-related caveats. Finally, commenting

on Lozano, Heald recommends caution in calculating the output gap and advises the author to

complement the focus on fiscal rules with arguments for transparency of government measures.

Kastrop comments on the papers by Creel and Saraceno and by Barrios, Langedijk and

Pench. He challenges the empirical evidence, found in the first paper, that the effectiveness of

automatic stabilisers and of a rule-based fiscal policy is undermined when the conditions of the

Ricardian equivalence (such as the assumption of rational expectations) are not met. Kastrop agrees

with Barrios et al. that the success of a national fiscal consolidation depends on the contingent

economic conditions of each country (e.g., debt level and banking system), but he disputes the

evidence that an export-led growth strategy has no impact on consolidation and potential growth.

Kastrop advocates a reformed Stability and Growth Pact relying on a rule-based approach as an

instrument to promote fiscal consolidation in the short run and to boost growth in the long run. By

contrast, discretionary fiscal measures could turn out to be pro-cyclical if their timing is notappropriate. Finally, he calls for the introduction of a debt restructuring mechanism to tackle

sovereign solvency problems and to complement the Stability and Growth Pact in the EU

framework.

Kremer observes that the last two papers, by Mears et al. and by Fedelino and

Ter-Minassian, shed some light on the debate about the suitability of fiscal institutions to cope with

financial stability challenges with and without financial crises. Commenting on the first paper,

Kremer points out some general pitfalls of spending rules (e.g., unclear targets, increasing

expenditure ratio not reflecting a spending bias) and suggests two alternative definitions of the cap,

both taking these pitfalls into account. Her recommendation is to define the cap in terms of

cyclically-adjusted expenditure or, alternatively, to consider capping fiscal loosening after

unexpectedly favourable periods in terms of cyclically-adjusted tax revenues. Finally, Kremeragrees with Fedelino and Ter-Minassian on the necessity of a better alignment of fiscal rules across

different levels of government, but she asserts that fiscal stabilisation is less error-prone if

orchestrated at the national level. She also stresses the importance of the distinction between rules

for ordinary times and exemptions for extraordinary events (e.g., financial crises); in particular, she

calls for a more careful definition of the exemption clauses to prevent overly-broad exemptions

from undermining fiscal policy consistency in ordinary times.

4 The legacy of the crisis and the exit strategy

Session 4 examines the legacy of the crisis and the policy actions required in the coming

years. The first paper deals with the effects of the banking crises. The next two are country studieshighlighting the different impact of the crisis in developed countries and emerging market

economies. Two papers consider the case of Japan, where the current recession is exacerbated by

pre-existing problems. The last three papers examine, respectively, the theoretical case for debt

reduction after the crisis, the design of an optimal fiscal rule and the implications of the EU

medium-term targets.

Furceri and Zdzienicka assess the consequences of banking crises for public debt. They note

that direct bailout costs are only a part of the fiscal cost associated with banking crises. The fiscal

consequences also include the reduction in revenue due to output losses and the increase in

expenditure due to automatic stabilisers and discretionary policies. On the basis of a panel of 154

countries from 1980 to 2006, the authors show that banking crises are associated with significant

and long-lasting increases in debt-to-GDP ratios. Where there were severe output losses, bankingcrises were, on average, followed by a medium-term increase of about 37percentage points in the


24/790


gross debt-to-GDP ratio. The increase in debt ratios is greater in countries with relatively bad initial

fiscal positions and with a high share of foreign public debt. The authors conclude that, given the

severity of the current financial crisis and the associated fiscal policy response, countries should

take measures to avoid putting fiscal sustainability at risk.

Reiss and Khler-Tglhofer evaluate the implications of the economic crisis of 2008-09 for

fiscal policy in Austria. They show that the recession and the impending demographic changes

would cause the public finances to deteriorate significantly and permanently in the absence of

consolidation. The overall consolidation effort in the medium term would be close to 4 per cent of

GDP. The authors stress the need to: i) implement credible consolidation programmes in order to

secure public confidence in the sustainability of the public finances as soon as possible, ii) cope

with population ageing; and iii) build up margins for automatic stabilisers and discretionary

measures in view of possible future crises. They emphasise that consolidation should rely mostly

on spending cuts. In this regard, they point to the potential role of the medium-term expenditure

framework introduced by the 2007 Federal Budget Reform. These measures should be supportedby structural reforms to raise potential output. In particular, it would be important to raise

employment rates; neither higher temporary inflation nor personal income tax increases are a useful

option.

Vieira Levy examines the factors underlying the relatively brief and mild impact of the 2008

financial crisis on the Brazilian economy. He reviews the reforms undertaken since the mid-1990s

and the economic situation of Brazil before the crisis. In the late 1990s Brazil introduced a new

macroeconomic framework based on a flexible exchange rate, inflation targeting and fiscal

responsibility. The commitment to fiscal discipline was formalised in the Fiscal Responsibility Law

enacted in 2000. The law, applicable to all levels of government, sets constraints on the financing

of the public sector, including state-controlled financial institutions, and provides for budgetary

planning and disclosure rules. Fiscal targets were met every year up to 2009, with most of the fiscaladjustment falling on tax increases. The paper also examines the governments response to the

crisis, which involved protection of financial markets and support to credit, full operation of

automatic stabilisers and fiscal stimulus. Vieira Levy argues that Brazils success in withstanding

the crisis reflects the policies implemented since the mid-1990s. He also points to the risks ahead

and notes that priority should be given to fiscal responsibility. Medium-term fiscal spending

targets, together with further structural reforms, can reduce aggregate risks, bring down interest

rates and help the private sector to grow with less support from government.

Saito examines the budgetary problems of Japan and points to the persistent mismatch

between expenditure and revenue and to the difficulties in achieving consolidation targets. He notes

that the tax system has not produced sufficient revenues. This reflects repeated tax reductions

motivated by the need to stimulate the economy and to improve the competitiveness of Japanesecompanies. Saito argues that room for expenditure cuts seems rather limited while the relatively

low tax burden suggests there is significant scope to increase revenue. He notes that interest

expenditure is currently relatively small but could increase when economic growth and private

investment pick up.

Ueda, Ishikawa and Tsutsui point to the difficulty of assessing fiscal sustainability when

revenues fluctuate sharply and unexpectedly. They note that in recent years tax revenues in Japan

have been considerably unstable, so it is no longer appropriate to calculate the amount of structural

tax revenue using a standard elasticity. The paper examines the fluctuation of Japans corporate tax

revenue and its elasticity since 1980. In particular, it evaluates the role of structural and cyclical

changes in the distribution of value-added, the relationship between interest rates and return on

capital, asset price movements and return from foreign investment, the divergence of economic

fluctuations among sectors and the deductions of carried-over losses. Finally, the paper discussesappropriate methods for the estimation of structural corporate tax revenue.


25/790


26/790


country should make. He suggests that the authors take into account the work that has been done on

emerging markets with the specific objective of determining their specific debt tolerance.

Hemming welcomes the emphasis that Reiss and Khler-Tglhofer place on growth-oriented

adjustment and expenditure-based fiscal consolidation, regretting, however, the dearth of

information about the specific expenditure cuts they advocate. He also agrees with their tax policy

indications, but stresses that the reduction of marginal tax rates on labour should be given priority.

Jdrzejowicz comments on the papers by Caprioli, Rizza and Tommasino and by Yrkolu.

He notes that both address the issue of the optimal debt ratio using a theoretical model. He advises

Caprioli et al.to better model the possibility of default and to consider the level at which the ratio

should be reduced when agents fear a possible default. He also notes that stabilising debt ratios at

the post-crisis level, in the presence of full trust in government solvency, would lead to ever higher

debt ratios after each successive crisis or downturn. Jdrzejowicz then addresses the dual objective

of the rule proposed by Yrkolu. He remarks that maintaining a stable ratio of public expenditure

to nominal GDP would result in pro-cyclical policy. An alternative option would be to target astable ratio of spending to potential GDP, provided that the underlying fiscal position is sound.

Maintaining a stable debt ratio can be problematic since fluctuations of the ratio over the cycle are

the natural consequence of the operation of automatic stabilisers. If a government were to try to

minimise these fluctuations, this would again imply a pro-cyclical policy. He concludes that the

paper should take the cyclical impact of fiscal policy into account when discussing the design of an

optimal fiscal rule.


27/790

Session 1

AUTOMATIC STABILISERS AND DISCRETIONARY FISCAL POLICY


28/790


29/790

GOVERNMENT FISCAL AND REAL ECONOMY RESPONSES TO THE CRISES:

AUTOMATIC STABILISERS VERSUS AUTOMATIC STABILISATION

Jonas Fischer*and Isabelle Justo

*

This paper looks at the discretionary fiscal and real economy support measures introduced

by EMU Member States in response to the crises. The analyses build on a data base assembled by

the Commission on individual crises response measures with a view to survey the implementation

of the European Economic Recovery Programme (EERP). The paper first provides a broad

overview of the types of crises-related measures taken, including broad estimates of their

budgetary dimension. On this basis it appears that on an aggregate level, the discretionary support

has been in line with agreed principles of being timely, temporary and targeted. Member States

with restricted fiscal space has overall taken a more restrictive stance than those with more room

of manoeuvre. The paper then looks at how these discretionary measures complement the

automatic budget stabilisation. It appears that, in budgetary terms, about half of the

discretionary measures add to the areas already covered by automatic stabilisers while the other

half address other areas such as investments, industrial sectors and vulnerable groups particularly

hit by the crises. The overall experience may suggest that it has been helpful with agreed ex ante

principles for how discretionary stimuli should be provided and that the provision of discretionary

stimulus under such conditionality can work to strengthen the budgetary stabilisation capacity in a

flexible way.

1 Introduction

The economic crises have provoked substantive policy responses, in the EU and globally.

The role of discretionary fiscal stimulus as an ingredient in a successful policy response was

initially vividly debated and the stance among EU policy makers was arguably relatively cautious.

The cautiousness was rooted in a consensus, built-up over many years and backed up by historical

evidence,1 that discretionary fiscal stimulus suffers from problems related to the design,

implementation and reversibility of measures. Therefore, in normal circumstances the fiscal

stabilisation job should be restrained to the free play of the automatic stabilisers as they are

relatively well targeted and by nature also timely and temporary. Moreover, it has been argued that

in the EU/euro area the size of government is relatively large implying that also automatic

stabilisers are sufficiently large.2

Nevertheless, as the depth of the crises manifested itself with more strength, and as stimulus

through monetary policy appeared partially impaired, the worries of entering into an outright

depression led to a change of hearts. Despite quickly deteriorating fiscal positions, the concern

about using discretionary fiscal policy for stabilisation purposes were overridden by the greater

concern about economic developments and the risk of economies being locked into a state of

depression. Policy makers in the EU/euro area thus opened up to the idea that it would be

appropriate with additional fiscal stimuli given that this was not a normal downturn. Discretionary

fiscal stimulus was seen as an insurance policy, both from an economic perspective, to reduce the

risk of a depression, and possibly also from a political economy perspective to get acceptance from

* DG ECFIN at the European Commission.

The views expressed in the paper are those of the authors and do not necessarily represent those of the European Commission.

1 See, for example, the annual European Commission reportsPublic Finances in EMU.2 See, for example, Deroose, Larch and Schaechter (2008).


30/790

30 Jonas Fischer and Isabelle Justo

tax payers for the much larger public efforts to support the financial system. Against the

background of the simultaneous discussions at global level in the G20 context, in the EU, this

stimulus policy was manifested in the so-called European Economic Recovery Plan (EERP)

adopted by the European Council in December 2008 based on a Commission proposal.3In essence,

the EERP called for a coordinated EU crises response including a fiscal stimulus of overall at least

1.5 per cent of GDP over 2009-10 where measures should be timely, temporary and targeted. Out

of this Member States were asked to contribute with 1.2 per cent of GDP, where the size of national

contributions should take into account fiscal space, whereas the remaining 0.3 per cent of GDP

should come from EU level actions. Against this background the objective of this paper is to give

an overview of how the discretionary stimulus under the EERP has been distributed in euro area

Member States and how this support has complemented the stabilisation provided by the automatic

stabilisers.

The paper is organised as follows. On the basis of the Commission EERP data base,

Section 2 provides a broad overview of the crises response measures taken in euro area memberstates. This includes the division of measures across policy objectives as well as their budgetary

dimension including whether they are temporary or permanent. Section 3 then goes into more detail

examining the sub set of discretionary measures that could be seen to top-up the automatic

stabilisers. Section 4 follows with our concluding remarks.

2 Crises support measures in the euro area: an overview

The EERP called for a coordinated fiscal stimulus equivalent to 1.5 per cent of EU27 GDP

over 2009-10, whereof 1.2 per cent of GDP should come from Member States. The stimuli

measures should follow the TTT principles, that is, being timely, temporary and targeted, whilst

taking into account national starting points. In addition, priority should also be given to structuralreform measures as part of the Lisbon strategy for Growth and Jobs. There has been continuous

follow up exercises where the assessment of the Commission and the Council so far has been

positive in that broadly these ambitions have been met.4That is, the implementation of the EERP

has been showing good progress and been in line with the principles agreed in the EERP. The

objective here is not to confirm or question this assessment but merely to provide an overview of

the support measures to the real economy implemented by euro area Member States on the basis of

the measures included in the EERP data base5(see Box 1 for a description of the structure of the

data base).

2.1 The euro area budgetary dimension of EERP stimulus

Euro area budget positions have deteriorated sharply in connection with the crises.

According to the Commission Autumn Forecast (Table 2), on average, euro area deficits is

projected to widen by almost 5 per cent of GDP over 2009 and 2010 and the average deficit

position in the euro area to approach 7 per cent of GDP in 2010. Clearly the consolidation

requirements in the years to come will be challenging. A fair share of this deterioration can be

expected to be reversed in the recovery phase, in so far that it depends on the cycle. In the

3 COM (2008) 800 final, 26/11/2008, A European Economic Recovery Plan. Available at: http://ec.europa.eu/commission_barroso/

president/pdf/Comm_20081126.pdf4 Commission reports of the follow-up of the EERP have been presented in June 2009 and December 2009. SeeProgress Reporton

the implementation of the European Economic Recovery Plan of June 2009 and ditto, December 2009, available at

http://ec.europa.eu/financial-crisis/documentation/index_en.htm5 For a detailed overview of the measures in the data base in May 2009, see European Commission (2009).


31/790

Government Fiscal and Real Economy Responses to the Crises: Automatic Stabilisers Versus Automatic Stabilisation 31

Box 1

Structure of the EERP Data Base

The EERP data base refers to reforms and measures that can help with the recovery

process in the short-term, i.e.during 2009 and 2010, irrespective as to whether they were

devised specifically as a response to the crises. The data base include information on reforms

and measures that are relevant for (i) sustaining aggregate demand, (ii) sustaining

employment, (iii) addressing competitiveness problems and (iv) protecting incomes of

disadvantaged groups during that period. Financial market rescue packages are not included

in the data base. However, consolidation measures are included in the data base. In practice,

there is no clear separation between measures that are of a short term fiscal nature or a longer

term structural nature. Accordingly, some stimulus measures can be purely of a budgetary

and temporary nature or also be structural reforms with a budgetary impact. Measures havebeen classified according tofour broad typesof policy objectives with sub categories:

Measures and reforms aimed towards supporting industrial sectors, businesses and

companies, with sub-categories: (i) easing financing constraints for businesses/SMEs,

(ii) sector-specific demand support, (iii) non-financial measures supporting business (e.g.,

regulatory) and (iv) sector-specific direct subsidies.

Table 1

Overview of the Number of Measures in the EERP Data Base

BE 16 25 11 14 15

DE 23 12 13 16 2

IE 7 4 9 10 30

EL 13 13 7 12 18

ES 50 16 20 17 7

FR 23 15 12 18 1

IT 43 29 20 27 21

CY 12 16 9 11 0

LU 8 3 7 8 0

MT 13 5 17 11 13

NL 18 8 32 3 1

AT 28 15 16 16 0

PT 16 8 7 11 0

SI 11 7 12 2 2

SK 10 10 7 8 4

FI 4 14 6 7 5

TOTAL EA 16 295 200 205 191 119(percent of the total) 29 20 20 19 12

Policy Type

Member States

1

Supporting

Industrial

Sectors,

Businesses and

Companies

2

Supporting

a Good

Functioning

of Labour

Markets

3

Supporting

the

Investment

Activity

4

Supporting

the

Households

Purchasing

Power

5

Budgetary

Consolidation


32/790

32 Jonas Fischer and Isabelle Justo

Measures and reforms aimed at supporting a good functioning of labour markets,

including: (i) promoting wage moderation, (ii) temporary working-time reduction,(iii) reduction of tax on labour, (iv) unemployment benefit system and social assistance

and (v) easing labour market transitions (training, placement, other job-search help).

Measures and reforms aimed at supporting investment activity including: (i) physical

infrastructure, (ii) energy efficiency and (iii) R&D and innovation.

Measures and reforms that support household purchasing power, including: (i) income

support, general, (ii) income support, targeted and (iii) household subsidy for certain type

of goods/services.

Budgetary consolidation measures, including: (i) pure budgetary consolidation measure

and (ii) financing of recovery measure.

In some cases, a measure can relevantly contribute to multiple policy objectives. Forexample, some labour market measures involving tax reductions also contribute to

supporting household income. Also, tax reductions on the low paid can contribute both to

supporting transitions on the labour market and bolstering income of vulnerable households.

The resulting double counting implies that the 764 euro area measures are recorded 1010

times under different policy types. Measures have also been classified according to their

duration. Temporary measures have a budgetary effect only in 2009 and/or 2010. They

should be automatically reversed (e.g., measures with a limited budget envelope, a known

ending date, or one-off measures). In that respect, investment projects are considered as

temporary measures in the data base. Tax measures are considered as temporary only if the

end date of the tax measure is indicated in the decision. If the reversal/change of the measure

undertaken will require a new decision, it has been considered as permanent.

A detailed budgetary dimension (expenditures and revenues) of each measure for the

year 2009 and 2010 is recorded in the data base in millions of Euro, with an indication of the

Off-budgets or below the line amounts, essentially loan and guarantees, which

potentially could have structural and possibly budgetary effects in the medium term. Figures

are recorded as a change relative to the year 2008, also in 2010. In other words, if a measure

is permanent, the amount of the stimulus is reported both for 2009 and 2010, while one-off

measures appear only for the year when they occur. It should be noted that the information is

in gross terms both on the expenditure and revenue sides and refers to the general

government sector and state, regional, local and social security budgets.

Commission Autumn Forecast it is estimated that the cyclical budget component explains about

half of the deterioration in the euro area as a whole (column 3). Nevertheless, in this juncture the

estimates of the cyclical budget component are possibly more uncertain than ever, given the

difficulty in knowing what are really the representative output gap as well as budgetary sensitivity

to the cycle. Uncertainty is also increased by that some tax bases arguably have been structurally

reduced in connection with the crises and much of such revenue will therefore not return in a future

recovery.6

6 See European Commission, 2009 Aut

6 fiscal policy

Documents