Fiscal Policy and Sovereign Debt
Over the past 50 years, perceptions of the effectiveness of fiscal policy as a tool of macroeconomic stabilization have gone through a rise and fall in both the academic literature and the real world. During the golden age of Keynesianism in the 1960s and 1970s, discretionary fiscal policy was regarded as being as important as monetary policy in stabilizing fluctuations in aggregate demand. With deeper academic understanding of stabilization policy and the fiscal multiplier, many governments attempted countercyclical fiscal policy in the 1960s and 1970s. Symbolically, in 1971, President Nixon is reported to have said, “[W]e are all Keynesians now.”
Fiscal deficits in the major western countries rose in the 1970s partly due to the collapse of the Bretton Woods system and the two oil crises. The shift to a floating exchange rate regime produced unexpected increases in exchange rate volatility. Countries that experienced exchange rate appreciations suffered declines in exports. Sharp increases in oil prices caused declines in aggregate output. Every democratically elected government had an incentive to increase (discretionary) spending and to cut (discretionary) taxes when there was a slight hint of a recession, especially in an election year. By the end of the 1970s, inflation, which had origins in overly stimulatory fiscal and monetary policies, became an important issue in major countries. Fiscal consolidation became necessary in many countries, and as a stabilization tool, discretionary fiscal policy gave way to automatic stabilizers in the 1980s and 1990s. An explicit or implicit monetary rule, which later became crystallized into the Taylor rule, gained popularity among academics, economists, and central bankers. Fighting inflation became a primary objective of central banks in the 1980s.
Keynesian fiscal policy staged a dramatic comeback after the failure of Lehman Brothers on September 15, 2008. As the global financial crisis (GFC) suddenly deepened, a return of the Great Depression appeared probable. The central banks of the major western countries quickly adopted a virtual zero interest rate policy and quantitative easing. Governments also decided to stimulate their economies by increasing government spending, introducing subsidies to eco-friendly industries, and cutting taxes.
One of the reasons why fiscal policy received so much attention was because monetary policy was believed to have lost most of its power after interest rates had been lowered to virtually zero, and the impacts of quantitative easing have remained controversial.
Fiscal policy became a major thrust of international cooperation to combat the GFC. A coordinated fiscal stimulus was the centerpiece of G-20 leadership in The London Summit of the G-20 in April 2009:
We are undertaking an unprecedented and concerted fiscal expansion, which will save or create millions of jobs which would otherwise have been destroyed, and that will, by the end of next year, amount to $5 trillion, raise output by 4 per cent, and accelerate the transition to a green economy. We are committed to deliver the scale of sustained fiscal effort necessary to restore growth.1
Major countries doubled and tripled their fiscal deficits in 2008–2009. Since there is a leakage in the multiplier through imports, a concerted international action was considered to be most effective.
Many economies were affected by the GFC. Large declines in trade and output were widespread among the major countries. However, thanks to the vigorous policy efforts, a major collapse of the global economy comparable to the 1930s was avoided. Once the acute crisis was largely over by late 2009, the large fiscal deficits, which prevented the collapse of the economy, became a matter of concern. Among international leaders, the interest in stimulus had already been lost and had been replaced by the promise of fiscal consolidation in the future in the Toronto Summit of the G-20 in June 2010:
There is a risk that synchronized fiscal adjustment across several major economies could adversely impact the recovery. There is also a risk that the failure to implement consolidation where necessary would undermine confidence and hamper growth. Reflecting this balance, advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt to GDP ratios by 2016.
Thus, we have seen the rise and fall of Keynesianism in decade-long waves between the 1950s and the 1990s, and then the rise and fall of fiscal stimulus in a short wave in 2008–2009 (rise) and 2010–2011 (fall). How should we understand these popularity cycles of discretionary fiscal policy?
The “rise” after the Lehman Brothers shock seems to be motivated by several factors. Several reasons have implications for the specification of the policy effectiveness equation and the policy response function. First, when the interest rate is zero or the economy is in a liquidity trap, there is no reason to worry crowding out. The effectiveness of fiscal policy is maximized. Second, the size of the shock of the GFC was considered to be so large that any policy measures that could help to stimulate the economy were employed. Maybe the fiscal policy response function should have a nonlinear term for the size of the shock (say, the gross domestic product [GDP] gap). Third, the debt to GDP ratio has become substantially larger and now poses some concerns about sustainability, the effectiveness of fiscal policy is lessened, presumably making more people Ricardian, and policy becomes less sensitive to the GDP gap. Alan Auerbach's (2012) overview paper tackles this question with special emphasis on the USA.
Figure 1 shows the primary balances2 of the G-7 countries. From 2007 to 2009, all G-7 countries experienced sharp deteriorations in their fiscal situations. Japan, the UK, and the USA were the worst among the G-7 countries, recording primary deficits of 8–11% of GDP in 2009. The speed of fiscal consolidation in 2010 and 2011 has been slow in all countries.
Figure1.General government primary surplus (G-7).
Source: International Monetary Fund, World Economic Outlook Database, April 2012.
Just when the GFC that originated in the US subprime crisis was largely over, the European sovereign debt crisis started. In October 2009, the newly elected Greek government announced that the Greek deficit statistics had been misreported. The actual size of Greece's budget deficits were much larger than previously believed, and this scared the markets, and the interest rate on Greek bonds soared. This was the beginning of the protracted Euro zone sovereign debt crisis. The origin of the crisis was a straightforward fiscal crisis.
In order to gain time for fiscal consolidation, the Greek government asked the European Union (EU) and the International Monetary Fund (IMF) for financial assistance in May 2010, which would be known as the first rescue package. This was a very unusual IMF operation in that the assistance was extended to an advanced country.
Then, the European fiscal crisis spread from Greece to Ireland and Portugal in late 2010 and early 2011. Both Ireland and Portugal received financial assistance through packages provided by the IMF and EU. Greece, Ireland, and Portugal all had to adopt fiscal austerity plans, along with the IMF conditionality that came with IMF financial assistance. Ireland's fiscal situation became serious when the Irish government decided to rescue their failing banking system, so the origin of Irish crisis was different from that in Greece.
Greece received a second rescue package in May 2011, as the initial package of May 2010 turned out to be insufficient. One of the conditions for this second package was the arrangement of sovereign debt reduction. In May 2011, it was envisioned that the debt reduction would be achieved voluntarily, so that it would not become a credit event in the credit default swap (CDS) market. The debt reduction (haircut) was expected to be about 50% of the outstanding principal. However, as time progressed without a definite solution, the size of required debt reduction increased, and voluntary participation became doubted. When it was finally agreed to in October 2011, the size of the haircut increased and a small number of investors who had not agreed to the voluntary plan were forced to take the haircut. This triggered the CDS credit event. This became the first default case of an advanced country for a long time.
After the summer of 2011, the European fiscal crisis spread to Spain and Italy, with intermittent flare-ups in Greece. The market started to factor in the possibility of defaults of Spanish and Italian bonds and/or an eventual breakup of the euro. The viability of the currency, the euro, that is the centerpiece of the euro project, has been questioned.
In order to put the European situation in perspective, the European fiscal situation can be reviewed in terms of the gross government debt and primary balance. Figures 2 and 3 display the gross government debt to GDP ratios and the primary balance to GDP ratios, respectively, for the so-called southern European countries, and France, and Germany from 2000 to 2011.
Figure2.General government gross debt.
Source: International Monetary Fund, World Economic Outlook Database, April 2012.
Figure3.General government primary net surplus.
Source: International Monetary Fund, World Economic Outlook Database, April 2012.
There is no question that the Greek fiscal situation is very serious, and that just extending financial assistance will not resolve the situation. Italy and Spain are large countries, the third and fourth largest among 17 countries in the Euro zone. When yields on Italian and Spanish government bonds rose to 7%, this alarmed financial markets, and some started to mention the possible breakup of the Euro zone. However, from Figures 2 and 3, we can observe that the Italian primary balance is as good as the German balance, not to mention other southern European countries, and the Spanish debt to GDP ratio is smaller than that of France and Germany (see Figure 2). Of course, it is distinctively better than the other southern European countries. In fact, the Italian primary balance is better than that of the other G-7 countries (see Figure 1), not to mention the other southern European countries (see Figure 3). Why did contagion from Greece to Italy and Spain occur? Jose Manuel Campa's (2012) paper provides a view from Spain on this issue.
The global policy response to the GFC made it clear that the G-7 is no longer in the driver's seat of the global economy. When the advanced countries, represented by the G-7, experienced a financial crisis, they turned to the emerging market economies and invited them to become responsible partners. The G-20 Summit was created as a part of the global policy response.3 As the weight of emerging market economies in the global economy has increased, coordination of the emerging market economies has become indispensable. In terms of GDP, China has become the number two economy in the world, surpassing Japan in 2010. Concerted action on fiscal stimulus including China was essential for the G-7. This was achieved at the G-20 London Summit, quoted above.
What China did in stimulating the Chinese economy in 2008 and 2009 is difficult to assess, as the central government's fiscal stimulus – tax cut, subsidies, and infrastructure investment – was only a part of grand policy mix involving encouraging bank lending and creating and using local government investment “platforms.” Chinese local governments invested in the public–private investment arms, which borrowed from state banks and invested in infrastructure and real estate projects. This scheme was commonly viewed as a way to circumvent the prohibition on local governments issuing local bonds. Since there is little transparency associated with these investment platforms, it is difficult for outside observers to make an assessment of the associated fiscal stimulus, the risk of debt accumulation, and the risk of nonperforming assets. The paper by Gang Fan and Yan Lv (2012) examines the Chinese fiscal situation, including the relationship between the central and local governments, and the local governments' investment platforms.
When Greece required IMF/EU/European Central Bank (ECB) assistance, its debt to GDP ratio was around 120%. However, the Japanese debt to GDP ratio is much higher than that. In fact, in terms of the gross debt to GDP ratio, Japan is the worst country among the G-7 by far (see Figure 4). However, the Japanese government bond market did not experience any contagion from the European sovereign debt crisis. If anything, Japanese sovereign bond yields declined in the face of the European crisis as investors regarded Japan as a “safe haven.”
Figure4.General government gross debt (G-7).
Source: International Monetary Fund, World Economic Outlook Database, April 2012.
Although there is no sign of a fiscal crisis coming to Japan, many academics and market participants regard the Japanese fiscal situation, with a 200% debt to GDP ratio and an 8% deficit to GDP ratio, as being unsustainable. The Japanese Diet passed legislation to raise the value-added-tax (VAT) (called a consumption tax in Japan) rate in August 2012 as a first step toward fiscal consolidation. The legislation states that the VAT rate will increase from 5% to 8% in April 2014, and then to 10% in October 2015.
Those who opposed this increase in the consumption tax considered the tax increase may be ill-timed in that increases in VAT will decrease consumption and may derail the recovery from the GFC and the earthquake and tsunami disaster of March 11, 2011. Proponents think that the impact on the Japanese economy of the consumption tax hike will not be so bad, as people will spend more as the probability of a fiscal crisis will be reduced by the tax hike. A tax increase that results in stimulating demand is contrary to Keynesianism; thus, it is called a non-Keynesian effect. Some academic papers suggest that when the debt to GDP ratio is high, fiscal consolidation may act as a stimulus to consumption. Keigo Kameda's (2012) paper explores the possibility of a non-Keynesian effect in the current Japanese context.
So far, this introduction has examined the fiscal situations in European countries, the USA, Japan, and China. Developing countries, such as Latin American countries, often fall into a fiscal crisis as populist economic policies increase their fiscal deficits. However, the developing countries in Southeast Asia have been known for their fiscal conservatism, except for a brief increase in their government debt after the Asian currency crisis of 1997–1998. KanitSangsubhan and ChatibBasri's (2012) paper examines the impact of the GFC on developing countries, focusing on the ASEAN countries, in particular, Thailand and Indonesia. This paper confirms that even during and after the GFC, the ASEAN countries have their maintained prudent fiscal policy.