Fiscal Policy and the Business Cycle

1. Fiscal Policy and the Business Cycle • Changes in the AS/AD curves cause actualreal GNP to swing around natural real GNP. • That is, the business cycles tends to move from recession to boom and back again. • According to Keynesian theory, these booms/recessions can persist for long periods of time. • Keynesians advocate an active fiscal policy (changes in government expenditure and/or taxes) to try to stabilise the business cycle. • This keeps actual GNP close to natural GNP over time.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

2. Stabilisation policy % change Boom Inflation gap Actual growth rate 5 – 6% Growth rate of potential GDP Recession Unemployment gap Time  Leddin and Walsh Macroeconomy of the Eurozone, 2003

3. Assessing the Stance of Fiscal Policy • A recession automatically worsens the budget deficit. Tax revenues fall and social welfare spending rises. • Boom period, the deficit falls. • Define: Budget surplus = T – [G + SW] • Defining net taxes (NT) as: • NT = T – SW • NT is the proportion of government tax revenue and spending that varies with fluctuations in nominal GNP. • Positive relationship between NT and GNP. • Current spending (G) is assumed to be constant.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

4. Continued • Diagram shows how the budget balance varies as GNP changes. (Diagram 1) • Recession: Budget deficit. • Boom: Budget surplus. • Note distinction between automatic and discretionary changes in the budget balance. (Diagram 2) • Discretionary change occurs when the government deliberately changes G, T or SW. • The result is a balanced budget at different levels of GNP.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

5.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

6.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

7. Natural GNP Budget • At what level of GNP should the government attempt to balance the budget? • It is argued that the relevant budget balance is the natural GNP budget surplus. • That is, the government should choose a combination of taxes and expenditure that balances the budget if the economy were at natural real GNP. • This entails tolerating a deficit in times of recession and a surplus when the economy is over-heating. • The problem is that it is not easy to calculate the natural GNP budget.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

8. Problems Encountered in Stabilising the Business Cycle • The government is counter-acting shifts in either the AS or AD curves using only fiscal policy. • However, this is not an effective response to dealing with an adverse supply-side shock. • It solves the real GNP/unemployment problem but it makes inflation worse.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

9. Policy Lags • Recognition lag:a delay in realising the economy has gone into boom or recession. Data is out-of-date. • Decision lag: a delay in deciding how to spend, cut expenditure or change tax rates. • Implementation lag: for instance, tenders for projects delay expenditure. • Outside lags: the time policy takes to impact on the economy. • Government policy could be out-dated by the time it is implemented and could end up destabilising, rather than stabilising, the business cycle.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

10. How a stabilisation policy de-stabilises the business cycle % Economy hit by “shock” goes into recession change Boom Actual growth rate 5 – 6% Natural growth rate Expansionary fiscal policy implemented at this point Business cycle automatically rights itself Time  Leddin and Walsh Macroeconomy of the Eurozone, 2003

11. Continued • Changes in taxes can give unpredictable results.Refer to the Laffer curve. • Examine relationship between tax rate and tax revenue. • Optimal tax rate: T* • Below optimal: normal positive relationship. • Above optimal: an increase in tax rate may lead to a decrease in tax revenue. High taxes affect the “incentive to work” and drive industry into the black economy, as we saw in Ireland in the mid-1980’s.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

12. Laffer Curve Average tax rate 100% A T 1 Revenue maximizing Z * T tax rate T B 2 0 % R R 1 2 Tax revenue £m  Leddin and Walsh Macroeconomy of the Eurozone, 2003

13. Dynamically Unstable Debt • Problem with Fiscal policy in recession • Debt grows exponentially as economy declines and we borrow merely to pay interest on the stock of debt • Problem in 1980s • Could be problem again • Key variable is d=D/Y • Debt-GDP ratio • “debt burden”

14. d evolves according to the following equation • Where • r is the interest rate • g is the growth rate • p is the “primary balance”: G-T excl. interest • Difference equation with impulse and potentially explosive growth • Intuitive • Maths online

16. Fiscal rules Just as monetary policy has been taken over by independent central banks, out of the reach of politicians, should fiscal policy be removed from the political arena by subscribing to a fiscal rule?

17. Alternative fiscal rules • The EU Stability and Growth Pact • The Golden Rule • Stabilize the debt/GDP ratio • Sustainable investment rule

18. National fiscal policy and the Stability Pact The Stability and Growth Pact (SGP) was framed at the Dublin summit, December 1996, and ratified at the Amsterdam Summit, June 1997 Designed to prevent backsliding by countries that had met the Maastricht criteria

19. The SGP • Formalises the “Excessive Budget Deficits” procedure • Fiscal deficits should average at most 1% of GDP over the business cycle • Deficits in excess of 3% of GDP will attract penalties unless they were due to “exceptional” and/or “temporary” Could imply pro-cyclical transfers from countries to the centre. • Fiscal federalism in reverse

20. SGP • Countries have to prepare a Stability Programme when presenting their national budgets • This Programme contains projections of General Government Balance for four years showing that national fiscal policy respects the SGP

21. SGP: Rise, Fall and Rise Again • Ireland was reprimanded in 2001 because the Council felt that Budget 2001 was too expansionary • But the stagnation of the Eurozone economy during 2002 has lessened the appetite for enforcing the SGP • Portugal, Germany, Italy, and France at or above the 3% ceiling

22. The deadline for reaching a balanced budget postponed from 2004 to 2006 • Then France ignored SGP in formulating its 2003 Budget • Proposal to Scrap it • Prodi: “All rigid rules are stupid. The SGP is a rigid rule” • All changed now because of Greece and Ireland • Modify it: • “cyclically adjusted” budget balance, taking account of the automatic stabilisers

23. The Golden Rule • Alternative to SGP • Was followed by UK • Over the business cycle the government should borrow only to invest and not to fund current spending • No current deficits, but • Future generations should contribute to the costs of infrastructure from which they benefit • We adhered roughly to this rule in Ireland until the late 1970s • Is being suggested as part of new European rule

24. Problems with The Golden Rule • The threshold between current and capital spending is not hard-and-fast • Education? Health? Etc • Is government capital formation efficient? • Until the crisis government capital formation accounted for borrowing equal to about 4.5% of GDP • What happens if break it? Precedent of SGP

25. Sustainable Debt Rule • The debt/GDP ratio will be stabilized at a “prudent” level. • Maastricht criterion was 60% • UK Chancellor (Gordon Brown) defined it as 40% • There is no well-defined “optimal” level • And even if there were, it would change over time • See the maths of debt dynamics

26. Conclusion On Rules • Present Crisis: There is need for a rule • but a rigid one is undesirable • Probably unenforceable • Projections of GDP, tax revenue, and spending are uncertain • Rule should force the present generation to pay for the level of spending on (current) public services it desires