Wednesday, October 5, 2011

Fiscal Stimulus Vs Fiscal Consolidation: Not Relevant For Malaysia

What’s going on in the US is dumb, what’s going on in Europe even dumber. In the presence of an outsize public debt, fiscal consolidation works – but only if you have economic growth. If you don’t, then cutting expenditure and raising taxes makes things worse, not better.

Greece and the other PIGS are in a bind primarily because of the straitjacket imposed by the necessity of keeping a nominal high exchange rate relative to what their economies need. The US is in a bind because signs of economic uncertainty boost the US dollar, which is the exact opposite of what should happen to a “normal” economy, as Ryan Avent points out (excerpt):

An exorbitant burden

...This is a manifestation of what Michael Pettis calls America's "exorbitant burden". Dollars are the world's primary reserve currency, and Treasuries are the world's preferred "risk-free" asset…When panic reigns, investors pour into dollars and dollar securities. In 2008, while financial collapse was gutting the American economy, the dollar soared in value. As panic subsided, the dollar resumed a slow slide, but with every new flare-up of the European crisis the greenback jumps in value.

…In recent weeks, European panic has led a number of financial institutions to pull money from emerging markets in Asia—risk-on financial bets—which has in turn led to swoons in the value of emerging-market currencies. This is just peachy so far as many emerging markets are concerned; at just the time that the world economy looks shaky, their export industries get a competitiveness boost. In America, by contrast, a shaky world economy leads to a rising dollar and a harder road for American exporters…

…This dynamic casts monetary easing in an interesting light, however. Sceptics of easy monetary policy often complain that easy money is designed to fuel consumption and put off adjustments: to give the American economy a temporary boost, delaying the inevitable reckoning. When we focus on the current-account picture, however, it's clear that monetary easing does just the opposite. When world markets are fearful and therefore rush for dollars, that impedes the adjustment in America's current-account deficit. When the Fed eases, it creates many more dollars, helping to meet the sudden excess demand for greenbacks and preventing a surge in the dollar's value. That, in turn, eases the pressure on American demand; it fends off the deflationary rise in the dollar while facilitating an internal rebalancing toward domestic demand.

But this interesting perspective on monetary policy aside, the evidence that fiscal consolidation works in boosting growth from a low base – that hoary old chestnut of “living within our means” – is decidedly shaky (excerpt):

De-Mythologizing Fiscal Consolidation

In Lost Decades, Jeffry Frieden and I argue that fiscal consolidation is a necessary prerequisite for long term recovery; however, fiscal consolidation too soon can derail the recovery, and plunge us further into debt. In contrast, some commentators have asserted that fiscal consolidation can be accomplished painlessly, or even with immediate benefits (e.g., JEC-Republicans, Rep. Paul Ryan/Heritage Foundation). Recent empirical work which carefully identifies the relevant episodes concludes that such instances of expansionary fiscal contraction are rare, and usually conducted near full employment. Ball, Leigh and Loungani review the effects of fiscal contraction in "Painful Medicine".

...fiscal consolidations typically have the short-run effect of reducing incomes and raising unemployment. A fiscal consolidation of 1 percent of GDP reduces inflation-adjusted incomes by about 0.6 percent and raises the unemployment rate by almost 0.5 percentage point (see Chart 2) within two years, with some recovery thereafter. Spending by households and firms also declines, with little evidence of a hand­over from public to private sector demand.

The September 2010 WEO cross-country analysis of fiscal contraction effects was discussed in this post (And the absence of expansionary fiscal contraction in the UK here).

Fiscal contractions raise both short-term and long-term unemployment, as shown in Chart 3, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting more than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.

So, in addition to contracting the economy, fiscal contractions exacerbate the already daunting challenges facing the long term unemployed (keeping in mind long term unemployment is not necessarily the same as structural unemployment). [1] [2]

What about how the burden of adjustment is allocated?

How does fiscal consolidation affect the distribution of income between wage-earners and others? The research shows the pain is not borne equally. Fiscal consolidation reduces the slice of the pie going to wage-earners. For every 1 percent of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by 0.9 percent, while inflation-adjusted profit and rents fall by only 0.3 percent. Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived (see Chart 4).

The foregoing suggests that the schedule of fiscal consolidation should be such that spending cuts and tax increases are implemented when the economy has recovered. The findings also imply that fiscal consolidation should be accompanied by measures to protect low wage earners and the long term unemployed.

In the Malaysian context of course, this debate is in a real grey area. Even if the fiscal deficit exceeds the government’s target of around 5% next year, our level of debt isn’t at critical levels. More to the point most of it is denominated in Ringgit, which provides a considerable cushion of safety.

To set against that, the fiscal multiplier for Malaysia is in theory and empirically close to zero – small open economy, with a floating exchange rate, and relatively independent central bank implies a zero multiplier for public sector consumption spending. Cutting government spending will ceteris paribus reduce imports, put downward pressure on the real exchange rate and reduce the real interest rate over the medium term, and not necessarily reduce growth very much if at all. The effects pretty much cancel out.

If fiscal policy therefore has no role in stabilising the growth path of the economy, then the concentration should be on boosting long term growth through investment and institutional reform. In other words, whether the government actually reaches its deficit targets is probably irrelevant – it’s what they spend it on that matters.

So looking ahead to this Friday’s presentation of the 2012 budget, don’t get side-tracked by the big numbers, or whether it’s a spend-spend populist election budget (which it most likely will be). What will matter more is the balance between investment and consumption, and replacing blanket subsidies with targeted transfers.

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