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The fewer the economic policy tools, the greater the need for unconventional fiscal policy
12-01-2012 16:39
Economic policy is often divided into fiscal policy, monetary policy and structural policy. Fiscal policy is primarily about reducing and increasing taxes and expenditure, while monetary policy in recent times has focused on using the key rate to meet more or less clear inflation targets.
Fiscal and monetary policy can both be used to stabilise the economic cycle, while structural policy is often aimed at improving the way different markets function to enable better long-term performance of the economy irrespective of the economic cycle. At the same time, it is primarily via fiscal polity that structural policy comes to life, e.g. incentives to work, start a new business, save and invest are changed by implementing tax reforms.
The global financial crisis and recession have given rise to new ways of thinking on fiscal and monetary policy. The first thing that happened was that the key rate was cut to almost zero. This was followed by major fiscal policy stimulus. Taxes were cut and expenditure increased over and above the automatic stabilisers, e.g. employment and consumption fell and unemployment benefit payments rose.
We have now reached the end of that road. The key rate cannot be less than zero, but market rates can still need to come down and the availability of credit could work better. Credit Easing (CE) was the first unconventional fiscal policy measure. Central banks, e.g. the US Federal Reserve, bought mortgage bonds to ease lending on the housing market. This measure expanded the central bank's balance sheet. The next unconventional monetary policy step was Quantitative Easing (QE) where the goal was more about forcing down interest rates, e.g. mortgage rates, by buying mortgage bonds. In a second phase of QE, the Federal Reserve mainly bought government bonds. This would decrease market rates, and at the same time ease the funding of government debt. The latter was not an explicit goal, but the printing of money probably still made life easier for the US Secretary of the Treasury. In the Euro zone, the EU Treaty does not allow the ECB to buy government bonds so this is done through commercial banks, either directly, or via loans where the funds are used by the banks to buy more government bonds.
Numerous research studies have looked at the effects of CE and QE. In the US, the initial phases were effective in that the market rates fell, but the results were not as uniformly positive in the second phase. The Japanese central bank can claim CE has been more successful than QE, i.e. the goal should largely be to ease the availability of credit in general. QE can be good for buying time, but unless other measures are implemented at the same time via structural policy, the effects are not so clearly positive in the longer term.
What then is the next step? When the rate is almost zero, there is a risk of falling into a liquidity trap (like Japan) where the real interest rate is negative: An extremely low nominal rate and deflation result in a negative real rate. In this situation, Keynesians argue that fiscal policy is more effective, and that the so called fiscal policy multipliers are stronger than normal. However, if there is no scope for fiscal policy (as government debt has risen unsustainably or if the finance market demands far too high a risk premium to fund the country's budget deficit) new ways of thinking must be found.
Emmanuel Farhi from Harvard University presented a paper “Unconventional Fiscal Policy at the Zero Bound” at the most recent annual meeting of the American Economic Association in Chicago. He proposed an unconventional fiscal policy. The thinking is to support economic growth while at the same time accepting the importance of attempting to increase inflation (such that real rates would then not be negative) without making government finances worse. This switch is done by increasing consumption taxes and cutting income taxes which can potentially deliver lower unemployment and the desired higher inflation.
This is just one example of current academic debate. Out in the “real” world, politicians are taking note. For instance, Nicolas Sarkozy is planning to increase VAT and reduce income taxes. Criticism has not been long coming. There is a risk that households become more cautious in their consumption, which puts at risk economic growth, enterprise and the opportunity to hire new employees despite the lower employment related taxes.
However, we will probably see more of this kind of thinking on how fiscal policy can be used despite the empty coffers. It is a case of both academic and practical economists needing to be as creative as possible to mitigate the crisis, as the answer to having fewer and fewer conventional tools and methods, is simply to become as unconventional as possible!
