Wednesday, March 10, 2010

Fiscal Stimulus Exit Strategy

Now that monetary policy is on the way back to “normal”, whatever that is, it’s perhaps time to talk about fiscal consolidation; or to be more precise, whether it’s already begun.

I’ve outlined my suspicions in a previous post, but we won’t know for sure until the 4Q fiscal expenditure and revenue numbers are actually published. But from the trajectory of government spending and borrowing for the second half of 2009, consolidation has already begun.

That’s all to the good, because the flip side of Keynes’ prescription to spend during bad times, is to save during the good times. Something which all too many governments seem keen to forget, and something we have been guilty of in the past.

The facts as they are is that we are looking at a total fiscal deficit of  7.4% in 2009 and a projected 5.6% of GDP in 2010. Neither number is particularly controversial given the circumstances; but what is important now is less the spending that occurred during the recession (whether you believe it was effective or not), but rather how we now resolve the accumulated debt.

I’m not a balanced budget fundamentalist – to me the level of the budget surplus/deficit in any given year is far less important to fiscal stability and credibility than the ratio of debt to income (as measured by the ratio of debt to GDP). The former affects yields on short term government securities, but the latter affects interest rates over a longer horizon. And since corporate debt is benchmarked over MGS, that affects long term borrowing costs and thus private investment. There’s no evidence so far of any such crowding out of private investment – you don’t expect much during a downturn – but higher borrowing costs will be a factor going forward.

It’s interesting to note that bulk of MGS issuance over the past year has been in 3-5 year maturities, which is contrary to the government’s usual practice of issuing 5-10 year MGS maturities. It seems to me that right from the start, someone has been thinking of the possible repercussions down the road, and had the unwinding of the additional government debt already built-in. Either that or someone’s really dumb, because rolling over the short-term debt on maturity is going to cost the government plenty with interest rates projected to rise over the next couple of years. If the government was planning to keep the debt on the books, it would have been better to lock-in over a longer maturity the low yields of the past year.

Beyond these technical issues, there are two ways to reduce the debt/GDP ratio – either grow faster, which increase the denominator; or allow higher inflation which reduces the real burden of debt. The former effect is likely, as recovery is already beginning, but the impact will be slow. The latter is essentially an unwritten levy on investors and taxpayers, as debt is denominated in nominal historical terms, but the government revenue and interest payments are in current ringgit (you can read a historical perspective on the US here).

There’s a raging debate going on right now in the economics profession on whether a higher inflation rate might be desirable, not just for fiscal consolidation reasons, but also to increase the latitude of monetary policy in combating crises like the one just past (the IMF is floating the idea, but Paul Volcker among others is calling it nonsense).

But whichever way you look at it, having a clearly communicated, transparent and credible exit policy can have its benefits. This article on VoxEU makes the case that doing so actually increases the effectiveness of current fiscal stimulus (excerpts):

After the stimulus, the big retrenchment

“Demand for private consumption is always higher in the case of the spending reversal than in the pure tax-finance case. The stronger private consumption profile in turn raises aggregate (public plus private) demand for several quarters. Correspondingly, the equilibrium paths of inflation and the policy rate are also higher in the early periods.

The tax burden faced by consumers obviously differs in the two scenarios depicted in Figure 2. Taxes increase in the first scenario, but not in the second. Yet, this “wealth effect" is of little consequence for the dynamics of private consumption, as households’ permanent income falls very little in the case of temporary fiscal stimulus. Instead, the difference across the two scenarios is chiefly driven by the distinct behaviour of interest rates. Demand is higher with spending reversals because long-term real interest rates are lower, triggering strong intertemporal substitution effects.

The effectiveness of short-run fiscal stimulus depends not only on the specific fiscal measures taken today, but also the on medium-term fiscal outlook, notably the government’s expected strategy for fiscal consolidation.

We find that anticipated spending cuts generally enhance the expansionary effect of current fiscal stimulus. This result still holds when monetary policy is constrained by the zero lower bound on policy rates. In this situation, however, the spending reversal must not come too early on the recovery path, or at least must be suitably gradual.”

Note that they’re talking about expenditure cuts, not tax increases. On that basis, in my view the Malaysian government appears to be a little ahead of the curve. The problem is that the “stealth” approach being taken right now, if the results of the paper quoted are true, may actually be counterproductive. You won’t get the stronger consumption and investment effects down the road that can really bolster a recovery.

I think it’s time for the government to get out of the closet and start talking up consolidation rather talking about spending, political brownie points notwithstanding.


  1. The government cut the tax rate by 1%. Don't you think it's a good idea because this eventually will lead to a increase in domestic consumption. When the GST kick in somewhere in 2011, then the gov revenue will get on the track back. Just a thought.

  2. If you read through the article I linked, note that the authors explicitly segregated the effects of tax-funded consolidation and expenditure-cutback related consolidation.

    The higher growth trajectory only occurs with the latter i.e. a tax cut followed by an expected tax increase won't have the growth premium they calculated, which is what we will effectively get with the income tax cut and then implementation of GST. You'll still get some stimulus effect, but it would be higher if people knew the government would be cutting expenditure later.

    In any case, what appears to be happening now is that the government is actually cutting back on expenditure already. The problem is that this isn't being effectively communicated to the public and to investors, which means everyone is expecting an increase in taxes as the government's exit strategy to stimulus.

    This has the effect of setting expectations of higher interest rates down the road (MGS yields are already going up). And higher expected borrowing costs means less private consumption and investment right now.

    More generally, GST will effectively expand the tax base (the extra revenue is coming from somewhere), and is hence negative for output.