September 2013
IMF Policy Paper
IMF POLICY PAPER
REASSESSING THE ROLE AND MODALITIES OF FISCAL
POLICY IN ADVANCED ECONOMIES
IMF staff regularly produces papers proposing new IMF policies, exploring options for reform, or
reviewing existing IMF policies and operations. The following documents have been released and
are included in this package:
The Policy Paper on Reassessing the Role and Modalities of Fiscal Policy in Advanced
Economies prepared by IMF staff and completed on June 21, 2013 to brief the Executive
Board on July 24, 2013.
The Executive Board met in an informal session, and no decisions were taken at this meeting.
The publication policy for staff reports and other documents allows for the deletion of market-
sensitive information.
Copies of this report are available to the public from
International Monetary Fund Publication Services
P.O. Box 92780 Washington, D.C. 20090
Telephone: (202) 623-7430 Fax: (202) 623-7201
E-mail: [email protected] Internet: http://www.imf.org
International Monetary Fund
Washington, D.C.
September 17, 2013
REASSESSING THE ROLE AND MODALITIES OF FISCAL
POLICY IN ADVANCED ECONOMIES
EXECUTIVE SUMMARY
This paper investigates how developments during and after the 2008–09 crisis have
changed economists’ and policymakers’ views on: (i) fiscal risks and fiscal sustainability;
(ii) the effectiveness of fiscal policy as a countercyclical tool; (iii) the appropriate design
of fiscal adjustment programs; and (iv) the role of fiscal institutions.
Advanced economies have experienced much larger shocks than was previously
thought possible and sovereign-bank feedback loops have amplified sovereign debt
crises. This has led to reassessing what constitutes “safe” sovereign debt levels for
advanced economies and has prompted a more risk-based approach to analyzing debt
sustainability. Precrisis views about the interaction between monetary and fiscal policy
have also been challenged by the surge in central bank purchases of government debt.
This has helped restore financial market functioning, but, to minimize the risk of fiscal
dominance, it is critical that central bank support is a complement to, not a substitute
for, fiscal adjustment.
The crisis has provided evidence that fiscal policy is an appropriate countercyclical
policy tool when monetary policy is constrained by the zero lower bound, the financial
sector is weak, or the output gap is particularly large. Nevertheless, a number of
reservations regarding the use of discretionary fiscal policy tools remain valid,
particularly when facing “normal” cyclical fluctuations.
The design of fiscal adjustment programs, and particularly the merit of frontloading, has
returned to the forefront of the policy debate. Given the nonlinear costs of excessive
frontloading or delay, countries that are not under market pressure can proceed with
fiscal adjustment at a moderate pace and within a medium-term adjustment plan to
enhance credibility. Frontloading is more justifiable in countries under market pressure,
though even these countries face “speed limits” that govern the desirable pace of
adjustment. The proper mix of expenditure and revenue measures is likely to vary,
depending on the initial ratio of government spending to GDP, and must take into
account equity considerations.
The crisis has revealed the challenges involved in establishing credible medium-term
budget frameworks and fiscal rules to underpin fiscal policy that are also sufficiently
flexible to respond to cyclical fluctuations. Moreover, shortcomings in fiscal reporting
point to the need to reassess the adequacy of fiscal transparency institutions.
June 21, 2013
REASSESSING FISCAL POLICY
2 INTERNATIONAL MONETARY FUND
Approved By
Olivier Blanchard and
Carlo Cottarelli
Prepared by a staff team led by Bernardin Akitoby and comprising
Nathaniel Arnold, Mark De Broeck, Geremia Palomba, Jaejoon Woo,
Luc Eyraud, Andrea Schaechter, Anke Weber, Jason Harris, Richard
Hughes, Johann Seiwald, Sami Ylaoutinen, Asad Zaman (all FAD);
Daniel Leigh, Suman Basu (RES); Manal Fouad (ICD); S. Ali Abbas (EUR);
and Emine Hanedar (Dutch Ministry of Finance). External comments
were provided by Roberto Perotti. General guidance was provided by
Philip Gerson (FAD) and Jonathan Ostry (RES). Production assistance
was provided by Patricia Quiros, Juliana Peña, and Ted Twinting (FAD).
CONTENTS
INTRODUCTION AND MOTIVATION ____________________________________________________________ 4
FISCAL RISKS, SOLVENCY, AND SUSTAINABILITY ______________________________________________ 4
A. Fiscal Risks, Fiscal Solvency, and “Safe” Levels of Debt __________________________________________ 5
B. Financial Market Discipline of Sovereigns and Multiple Equilibria _____________________________ 11
C. Central Bank Financing and Fiscal Dominance ________________________________________________ 13
D. Sovereign-Bank Links and Risks from Private Sector Balance Sheets _________________________ 13
FISCAL POLICY AS A COUNTERCYCLICAL TOOL ______________________________________________ 16
A. Fiscal Policy Effects ____________________________________________________________________________ 17
B. Fiscal Policy Implementation __________________________________________________________________ 21
THE DESIGN OF FISCAL ADJUSTMENT ________________________________________________________ 28
A. The Pace of Fiscal Adjustment _________________________________________________________________ 29
B. The Composition of Fiscal Adjustment ________________________________________________________ 33
BUDGETARY INSTITUTIONS, FISCAL TRANSPARENCY, AND FISCAL RULES ________________ 37
A. The Design of Medium-Term Budget Frameworks ____________________________________________ 37
B. The Transparency of Fiscal Accounts __________________________________________________________ 39
C. The Effectiveness and Design of Fiscal Rules __________________________________________________ 41
CONCLUSIONS AND IMPLICATIONS FOR FISCAL POLICY ____________________________________ 46
ISSUES FOR DISCUSSION _______________________________________________________________________ 49
References _______________________________________________________________________________________ 50
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 3
BOXES
1. Fiscal Space and Prudent Debt Levels: Issues to Consider _______________________________________ 9
2. Equity Considerations for Program Design in the Crisis _______________________________________ 36
FIGURES
1. Commercial Bank Assets for Selected Countries Before the Crisis _______________________________ 6
2. Average Structural Balance and Public Debt Ratios for Advanced Economies
and the Euro Area _______________________________________________________________________________ 6
3. Cumulative Change in Gross Debt to GDP Since the Start of Recessions ________________________ 7
4. G-20 Advanced Economies: Increase in General Government Debt, 2008–15 ___________________ 8
5. Advanced Economies: Fiscal Stimulus and Precrisis Net Debt Levels __________________________ 10
6. Sovereign Bond Yields for Select EMU Countries, 1992–2012 _________________________________ 12
7. Sovereign-Financial Linkages __________________________________________________________________ 14
8. Sovereign Bond Yields, Net Foreign Assets, and the Change in Non-financial
Private Sector Indebtedness from 2001–10 ___________________________________________________ 16
9. United States: Historical Multiplier for Total Government Spending __________________________ 20
10. Advanced Economies: Time Lag Between Lehman Failure and
Fiscal Stimulus Packages _____________________________________________________________________ 22
11. G-20 Advanced Economies: Contributions of Discretionary Stimulus and
Automatic Stabilizers to the Primary Deficit, 2009-10 ________________________________________ 26
12. Timeline of U.S. Fiscal Packages and Federal Funds Rate, 2008–18 __________________________ 27
13. Government Expenditures During Global Recessions and Recoveries ________________________ 28
14. Advanced Economies: Fiscal Adjustment and Market Conditions ____________________________ 32
15. Advanced Economies: Phasing of Fiscal Adjustment _________________________________________ 32
16. OECD Countries: Average Composition of Fiscal Adjustment, 1978-2008 ____________________ 34
17. Average Three-Year Ahead Forecast Error, 1998–2007 _______________________________________ 38
18. Sources of Unanticipated Increases in Public Debt Between 2007 and 2010 _________________ 39
19. EU Countries: Precrisis Fiscal Performance and National Fiscal Rules ________________________ 43
20. Number of Countries with Budget Balance Rules Accounting for the Cycle __________________ 44
21. National Fiscal Rules Index ___________________________________________________________________ 44
TABLE
1. Selected Fiscal Stimulus Measures Used by Advanced Economies ____________________________ 25
REASSESSING FISCAL POLICY
4 INTERNATIONAL MONETARY FUND
INTRODUCTION AND MOTIVATION
1. Before the 2008–09 crisis, the consensus view was that fiscal policy should play a
limited role as a stabilization tool.
1
Monetary policy was seen as a sufficient tool for short-term
macroeconomic stabilization. Numerous studies questioned the effectiveness of fiscal policy for
stabilization purposes, partly based on Ricardian considerations, and instead emphasized the long-
term goals of fiscal policy, including the provision of public goods and services, and long-term fiscal
sustainability. In addition, sovereign debt crises were seen primarily as a phenomenon of emerging
market and low-income countries, of limited practical relevance for advanced economies.
2
Before
the crisis, it was also believed that when risk premia and sovereign borrowing costs were high, “non-
Keynesian” confidence effects or supply-side improvements, such as lower labor costs, could offset
much of the negative direct effects of fiscal adjustment on economic activity.
2. Despite this precrisis consensus, almost all advanced economies deployed fiscal
stimulus at the start of the crisis. This renewed reliance on fiscal policy may have been driven in
part by the depth of the downturn, interest rates at the zero lower bound (ZLB) for some advanced
economies that limited the scope for traditional monetary policy, and a moribund credit channel.
New research points to large fiscal multipliers when economic conditions resemble those prevailing
in advanced economies in the post-crisis period. Against this background, debate continues on the
merits of frontloaded versus gradual (but steady) fiscal adjustment when financing permits. In
addition, the scale of the current fiscal problem has revived the debate on the importance of
institutions that underpin fiscal adjustment.
3. This paper provides an organizing framework to draw preliminary fiscal policy lessons
from the crisis. It addresses four main areas: (i) fiscal risks and fiscal and debt sustainability; (ii) the
effectiveness of fiscal policy as a countercyclical tool; (iii) the design of fiscal adjustment; and
(iv) fiscal transparency, fiscal rules, and budgetary institutions. The analysis will focus on advanced
economies, the country group most directly affected by the crisis.
FISCAL RISKS, SOLVENCY, AND SUSTAINABILITY
4. The crisis has exposed macro-fiscal vulnerabilities in advanced economies (AEs) that
were not fully recognized beforehand. It has revealed that fiscal risks and the buffers required to
protect against them are much larger than previously thought. For example, headline fiscal surpluses
can mask large structural deficits during asset price booms and contingent liabilities stemming from
large internationally-connected domestic banks can dwarf reported public debts. Thus, assessments
of fiscal sustainability—traditionally rooted in headline fiscal balances and debt ratios—are now
1
When the paper uses terms such as “we,” “our views”, or “the consensus view,” it is referring to common or
widespread views of economists and policymakers.
2
While some analysts did point to concerns about long-run sustainability in advanced economies, these were based
on the long-term demographic pressures, not doubts about short-term solvency.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 5
being reconsidered to take better account of the underlying (structural) fiscal position, the likelihood
of events that could threaten fiscal sustainability, and the speed with which markets’ perceptions of
sovereign risk can change.
5. The sovereign debt crisis in the euro area has shown that the precrisis belief that AEs
were not at risk of a fiscal crisis was misplaced. Among other things, the crisis exposed
shortcomings in the euro area institutional architecture, including those that prevented the provision
of timely and sufficient support to banks and sovereigns under duress (Ghosh, Ostry, and Qureshi,
2013). In light of central banks’ recent role in eliminating risks of bad equilibria, economists have
also questioned the precrisis consensus on avoiding central bank financing of the government. This
section will lay out the precrisis views on each of these topics and assess how the crisis and its
aftermath have caused our thinking to evolve.
A. Fiscal Risks, Fiscal Solvency, and “Safe” Levels of Debt
6. Before the crisis, we thought AEs were less exposed to fiscal risks. During the two
decades preceding the crisis—a period referred to as “The Great Moderation”—AEs exhibited much
less volatility in macroeconomic variables than did emerging markets (EMs) and low-income
countries. Also, systemic financial crises in AEs were thought to be relatively rare and the related
contingent liabilities, if they were to materialize, were thought to pose a limited risk to these
countries (Laeven and Valencia, 2012). Moreover, little attention was paid to possible adverse
feedback loops between bank risk and sovereign risk, despite the presence of large financial sectors
in many AEs (Figure 1).
7. The probability of a full-blown fiscal crisis in AEs was generally considered remote,
despite the looming fiscal impact of aging-related spending. Before 2007 there appeared to be
little concern about the short-run fiscal solvency of most AEs, in spite of nontrivial fiscal deficits,
particularly in the euro area, and relatively high debt-to-GDP ratios (Figure 2).
3
This reflected a
number of factors. First, the view prevailed that when financial markets are sufficiently developed
and deep, they can easily absorb temporary surges in public debt. Second, advanced economies
were perceived as having fiscal institutions that would ensure that debt surges would lead to later
fiscal corrections. Third, in the euro area, membership in the area was seen as sufficient to avoid a
surge in interest rates since government bonds issued by different countries could be regarded as
(nearly) perfect substitutes. However, there was significant concern about the impact of population
aging on fiscal solvency in many AEs over the long run (Heller and Hauner, 2005; Hauner, Leigh, and
Skaarup, 2007).
3
The structural deficits depicted in Figure 2 are current estimates. As noted, before the crisis structural deficits
appeared to be smaller.
REASSESSING FISCAL POLICY
6 INTERNATIONAL MONETARY FUND
Figure 1. Commercial Bank Assets for Selected Countries Before the Crisis
(Percent of GDP)
Sources: IMF Global Financial Stability Report, various issues.
Figure 2. Average Structural Balance and Public Debt Ratios for Advanced Economies and the
Euro Area
(Percent of GDP)
Sources: IMF World Economic Outlook (WEO), Fiscal Monitor, and Historical Public Debt Database.
8. The precrisis build up of fiscal and macro-financial imbalances in AEs posed much
larger risks than previously thought. Partly owing to the difficultly of diagnosing asset bubbles
until they have burst, such bubbles emerged undetected. In some countries, such as Ireland and
Spain, headline fiscal surpluses generated by housing and credit booms masked unsustainable
0
100
200
300
400
500
600
700
0
100
200
300
400
500
600
700
DEU GBR ESP IRL GRC IT
A
FRA USA
2003 2007
0
20
40
60
80
100
0
20
40
60
80
100
All AEs
Euro Area
Gross Public Debt Ratio
-6
-5
-4
-3
-2
-1
0
-6
-5
-4
-3
-2
-1
0
All AEs
Euro Area
Structural Fiscal Balance
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 7
structural fiscal positions that were revealed when the crisis struck.
4
The fiscal risks created by large
(relative to GDP), growing, and interconnected financial sectors were also underappreciated, partly
because of confidence in financial markets’ capacity to self-regulate (Greenspan, 2010) and the
opacity of cross-border exposures.
5
9. During the crisis, debt increased much more than was thought possible, raising doubts
about what level of debt could be regarded as “safe.” Since 2008, macroeconomic and fiscal
shocks have been much larger than previously anticipated, which has caused debt-to-GDP ratios to
rise much faster than in prior downturns (Figure 3). On average, most of the surge in debt-to-GDP
ratios has been due to a shortfall in revenues as a byproduct of sluggish growth in the aftermath of
the financial crisis, rather than to direct fiscal costs from bailing out banks (Figure 4).
6
However, in
Ireland and Iceland, bank rescues drove an (unexpected) increase in the debt ratio of 41 and 43
percentage points of GDP, respectively. These two cases illustrate that even levels of debt well below
what was considered prudent before the crisis may not be “safe” in the face of large potential
contingent liabilities.
Figure 3. Cumulative Change in Gross Debt to GDP Since the Start of Recessions
(Percent of GDP)
Sources: Kinda, Poplawski-Ribeiro, and Woo (2013), and IMF staff estimates and projections.
Notes: Solid line corresponds to 2008—12, and dashed line to 2013—17.
4
The structural balance is generally defined as cyclically adjusted balance corrected for “one-off” items. Newer
measures of the structural balance also make adjustments for factors beyond the business cycle, such as asset prices
cycles (e.g., housing, stock markets). The cyclically adjusted balance is the difference between the overall balance and
the automatic response of fiscal variables to changes in output (i.e. automatic stabilizers).
5
A prime example of cross-border exposures is the exposure of German banks, especially the publicly-owned
Landesbanken, to complex asset-backed securities (e.g., backed by sub-prime mortgages) from the United States.
6
Note, however, that part of the revenue loss is not regarded as cyclical, not only because revenues were inflated by
asset price bubbles but also because part of the output loss during the crisis is regarded as permanent.
-15
-5
5
15
25
35
t+1
t+3
t+5
t+7
t+9
Past recessions, 25th
–
75th percentiles
Past recessions, median
Current crisis
0
5
10
15
20
25
30
35
t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9
Years
Advanced
Economies
REASSESSING FISCAL POLICY
8 INTERNATIONAL MONETARY FUND
Figure 4. G-20 Advanced Economies: Increase in General Government Debt, 2008–15
(Percentage points of GDP)
(April 2013 projected total increase: 37.1 percentage points of GDP)
Sources: IMF staff estimates and projections based on the Fiscal Monitor (see IMF, 2011a).
Note: Weighted average based on 2009 purchasing power parity-GDP.
10. As a result, there is a need for a more holistic approach to measuring public debt and
determining “safe’’ levels of debt. The official debt ratio fails to reflect contingent liabilities, which
are often underestimated until they materialize (Irwin, 2012). This argues for a much lower “safe”
debt level than was thought necessary before the crisis (Ostry and others, 2010; Blanchard, Mauro,
and Dell’Ariccia, 2013). On the other hand, the crisis has also shown that for some AEs considered
safe havens (Japan and the United States, for example), markets can tolerate much higher debt
ratios than previously thought, at least for a time. Since sentiment can shift quickly, a cautious
government may rationally err on the side of having a low debt ratio in order to avoid the risk of
punishment by the market (Mendoza and Ostry, 2008; Ostry and others, 2010). These issues have
prompted new research on assessing fiscal space in AEs (Box 1).
Revenue loss
21.7
Fiscal stimulus
6.4
Financial
sector support
1.9
Net lending
and other
stock-flow
adjustments
2.8
Interest rate-
growth
dynamics
4.4
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 9
Box 1. Fiscal Space and Prudent Debt Levels: Issues to Consider
The literature has recently proposed various definitions of fiscal space. Aizenman and Jinjarik
(2010) use the debt-to-revenue ratio as a simple measure of fiscal space (with a lower ratio meaning
more space). Bi and Leeper (2012) propose the notion of country-specific fiscal limits, defined as “the
point at which for economic or political reasons taxes and spending can no longer adjust to stabilize
debt,” at which point, fiscal space runs out (see also Bi, 2012). Focusing on the debt level, recent IMF
research has developed a new and more precise definition of fiscal space, defining it as the distance
between the current (or projected) debt ratio and the debt limit, the point above which the sovereign
loses market access (Ostry and others, 2010; Ghosh and others, 2013). The debt limit is determined by
the maximum primary balance (PB) that can be sustained both economically and politically (i.e. the
fiscal limit) and the interest rate-growth differential (r-g), which is the difference between the real
interest rate on public debt and the real GDP growth rate (IMF, 2011b). While the assessment of r-g is
essentially forward looking, a country’s historical experience can be informative. Comparator countries’
experiences could also be used, where appropriate.
There are several approaches to gauging the level of the maximum sustainable primary balance.
One may look at a country’s history, institutions (and how they might change), at periods of
extraordinary fiscal effort, or regional peers (Abiad and Ostry, 2005). Using a country’s best historical
fiscal performance as a proxy for future fiscal performance helps inform the assessment of what
constitutes the maximum fiscal effort. As Rogoff, Reinhart, and Savastano (2003) argue: “history
matters: a country’s record at meeting its debt obligations and managing its macroeconomy in the past
is relevant to forecasting its ability to sustain moderate to high levels of indebtedness for many years
into the future.” However, this does not take into account that relatively low primary surpluses in the
past may simply reflect a period in which there was not an urgent need for fiscal adjustment. Thus,
historical experience does not necessarily imply that a country cannot achieve higher surpluses when it
has a high (or unsustainable) debt level and wants to put the debt ratio firmly on a downward
trajectory.
A country’s desired degree of fiscal space should account for fiscal risks. Assessments of country-
specific fiscal risks can help inform the decision on how much fiscal space to maintain. For example,
stochastic projection methods that model correlated shocks, such as the “fan chart” approach
developed by Celasun, Debrun, and Ostry (2007), can help estimate the size of the risks posed by
macroeconomic shocks. Such assessments should also take into account the country’s policy flexibility
(e.g., monetary sovereignty), long-term fiscal pressures (e.g., aging-related spending), risk management
(e.g., fiscal institutions that conduct regular risk assessments) and mitigation measures (e.g., higher
capital requirements for banks if the banking sector is large relative to the economy), as well as the
degree of cross-country risk sharing available to offset different shocks (e.g., a banking union in the
euro area). In sum, this means there is not a one-size-fits-all “safe” level of debt.
11. Countries may also want to maintain lower debt levels to create fiscal space for
countercyclical fiscal policy. Christiansen and Perez Ruiz (2013) find that over the past four
decades, discretionary countercyclical fiscal responses have been provided mainly by governments
REASSESSING FISCAL POLICY
10 INTERNATIONAL MONETARY FUND
with lower debt levels. Consistent with this finding, in the recent crisis the discretionary
countercyclical fiscal policy response of AEs appears to be negatively associated with their initial
debt levels (Figure 5).
Figure 5. Advanced Economies: Fiscal Stimulus and Precrisis Net Debt Levels
(Percent of 2008 GDP and percent of 2007 GDP, respectively)
Sources: IMF staff estimates based on WEO and Fiscal Monitor data (IMF, 2010a).
Notes: Sample includes Australia, Canada, Denmark, France, Germany, Israel, Italy, Japan, Korea, the Netherlands, New Zealand,
Portugal, Spain, the United Kingdom, and the United States. The fiscal stimulus measure is from the Fiscal Monitor database. Several
countries for which data are available that have a net debt ratio less than -10 percent of GDP (Norway, Finland, and Sweden) are
excluded for presentational purposes. Including these outliers would strengthen the relation between the size of stimulus measures
and initial net debt levels.
12. In light of the above lessons, debt sustainability analysis should take a more risk-based
approach than in the past.
7
Most importantly, sensitivity analyses need to capture country-specific
fiscal risks and vulnerabilities, especially risks from the financial sector.
8
The macro-fiscal shock
scenarios should also reflect interactions among key variables, and capture the impact of correlated
shocks (for instance through a fan chart). To help prevent contingent liabilities from public
enterprises and other state-related entities from catching policymakers off-guard, analyses should
be conducted using the broadest possible definition of the public sector. For example, in the United
States, potential contingent liabilities stemming from the debt of government-related enterprises is
estimated to exceed 50 percent of GDP (IMF, 2013a).
7
For further details see IMF Policy Papers “Modernizing the Framework for Fiscal Policy and Debt Sustainability
Analysis for Market-Access Countries” (IMF, 2011b) and “Staff Guidance Note for Public Debt Sustainability Analysis
for Market-Access Countries” (IMF, 2013b).
8
This includes vulnerabilities stemming from not having monetary sovereignty, as in a currency union.
AUS
CAN
DNK
FRA
DEU
ISR
ITA
JPN
KOR
NLD
NZL
PRT
ESP
GBR
USA
0
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3
4
5
6
0
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2
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5
6
-20 0 20 40 60 80 100
2009–10 Discretionary Stimulus
(in percent of 2008 GDP)
Net Debt in 2007 (percent of GDP)
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 11
B. Financial Market Discipline of Sovereigns and Multiple Equilibria
13. The ability of financial markets to “discipline” profligate governments was a subject of
active debate before the crisis.
9
Financial markets discipline government finances primarily
through the response of the sovereign debt risk premium to higher fiscal deficits and public debt
levels, with markets demanding higher interest rates to compensate for a perceived rise in default
risk and, in extremis, by denying access to financing altogether (Akitoby, 2006; Akitoby and
Stratmann, 2008). In the euro area, some thought that the Maastricht Treaty’s “no bailout” clause
would reinforce financial market discipline. However, skepticism about the effectiveness of the
market discipline mechanism was also present in the early stages of the European Monetary Union
(EMU), and was indeed the main rationale for the introduction of fiscal rules in the area. The 1989
Delors Report noted that “[t]he constraints imposed by market forces might either be too slow and
weak or too sudden and disruptive.”
14. It is still an open question as to why market discipline may have been ineffective in the
euro area.
10
The focus on headline fiscal positions, temporarily inflated in some countries by asset
prices and credit booms, distracted attention from the widening of underlying fiscal deficits and the
buildup of private sector imbalances (e.g., in Ireland and Spain). Investors may also have rationally
believed that the “no bailout” clause lacked credibility. This could reflect the presumption that, for
either political or economic reasons, an EMU member facing sovereign debt distress would be
supported by other member states or the ECB, which treated all members’ public debt as risk free
(Jahjah, 2001; Buiter and Siebert, 2006; Gros, 2013).
11
While this belief was partly confirmed by the
euro area’s response to the crisis, the expected bailouts did not materialize smoothly. This may have
caused markets to revise their assumption that the “no bailout clause” lacked credibility. In fact,
spreads for the crisis-hit countries widened to levels that greatly exceeded what deteriorating
fundamentals alone could explain (Poghasyan, 2012; IMF, 2012a; De Grauwe and Ji, 2013), as market
attention focused on the difficulties of adjustment inherent in currency union membership (Ghosh,
Ostry, and Qureshi, 2013) and concerns about currency convertibility risk re-emerged (i.e. that a
country would exit the euro area).
12
15. The sovereign debt crisis in Europe has brought to light the risk of multiple equilibria.
Multiple equilibria risks can emerge if investors become concerned about the possibility of
9
See, for instance, Alesina and others (1992) for some earlier evidence supporting the market discipline hypothesis.
10
Although part of the precrisis convergence to very low interest rate spreads among member states reflected the
convergence of their inflation rates and removal of currency devaluation risk with the adoption of the euro, the wide
variance in the underlying fiscal positions of the member states may have justified wider spreads. For instance, in
2005, interest rate differentials on government bonds were only about 30 basis points, with budget balances ranging
from a 2 percent of GDP surplus to a 5 percent deficit and debt ratios between 7 percent and 108 percent of GDP.
11
Despite how it was presented, the “no bailout clause” did not technically prevent some sort of assistance to
distressed members, which may also account for some of the skepticism.
12
See the July 26
th
, 2012, speech by Mario Draghi, the President of the ECB at the Global Investment Conference in
London. Available online at: http://www.ecb.int/press/key/date/2012/html/sp120726.en.html.
REASSESSING FISCAL POLICY
12 INTERNATIONAL MONETARY FUND
sovereign default and begin to demand higher interest rates. This makes it more costly for a
sovereign to service its debt, thereby increasing the risk of default and potentially making investor
concerns self fulfilling. Multiple equilibria can emerge even at low levels of debt, but are more likely
at high debt levels, since a smaller move in interest rates can shift the sovereign from solvency to
insolvency (Blanchard, Mauro, and Dell’Ariccia, 2013).
Figure 6. Sovereign Bond Yields for Select EMU Countries, 1992–2012
(Percent; monthly data)
Sources: National Data, Bloomberg, and European Central Bank.
16. In principle, a central bank can prevent a bad equilibrium by committing to provide
liquidity to the sovereign bond market to facilitate its monetary policy objectives. Events
during the crisis suggest that currency union members, in particular, are prone to multiple equilibria
risks. The market’s differentiated treatment of the United Kingdom and Spain—two countries with
similar fiscal and debt dynamics—seems to suggest that the Bank of England was able to prevent
the risk of a liquidity crisis in the UK sovereign debt market (De Grauwe, 2011), although the long
average maturity of UK sovereign debt also reduced rollover risks. The commitment of the ECB to
intervene, if necessary and conditional upon fiscal adjustment, appears to have reduced the risk of
“bad equilibria” in the euro area (Abbas and others, 2013). However, in practice intervention could
require large purchases and there are likely to be limits on how much a central bank can do. It can
be difficult to distinguish between illiquidity and insolvency situations, so the central bank may
worry it is taking too much credit risk (Blanchard, Mauro, and Dell’Ariccia, 2013).
0
2
4
6
8
10
12
14
16
0
2
4
6
8
10
12
14
16
France Germany
Italy Spain
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 13
C. Central Bank Financing and Fiscal Dominance
17. Central bank financing of the budget could undermine its independence and its
control of inflation.
A key lesson from the “unpleasant monetarist arithmetic” of Sargent and
Wallace (1981) is that lax fiscal policy can put pressure on the monetary authorities to monetize
public debt. If fiscal imbalances are sufficiently large over a long period, it creates a risk that
monetary policy could eventually become subservient to fiscal considerations (so-called “fiscal
dominance”) and the central bank’s inflation objective would be seriously compromised. To avoid
this state of affairs, prior to the crisis monetary policies in AEs were typically focused on price
stability as their main objective and central banks were given operational independence, including
prohibitions on directly funding government deficits (Mishkin, 2000).
18. Central banks’ actions since 2008 have challenged our precrisis views about fiscal and
monetary interactions. The surge in central bank purchases of government debt has been
spectacular in some countries. For instance, the U.S. Federal Reserve has purchased large quantities
of U.S. government debt as part of its unconventional monetary policy (UMP) measures, more than
doubling its holdings between 2007 and 2011. Similarly, by the end of 2012, the Bank of England
increased its holdings of U.K. government debt from almost nothing to more than a quarter of the
outstanding stock.
13
So far, the massive expansion of some central banks’ balance sheets—aimed at
repairing the broken monetary policy transmission mechanism—has not undermined the credibility
of fiat money, as inflation expectations remain well anchored in the context of a liquidity trap.
14
19. Central bank purchases of government debt have turned out to be useful to allow for
a more gradual fiscal adjustment. Accommodative monetary policy can support fiscal adjustment
in that it reduces the cyclical impact of fiscal adjustment and the risk that fiscal tightening is
counterproductive (leading potentially to a rise in interest rates; Cottarelli and Jaramillo, 2012).
However, given high debt levels in most AEs, fiscal adjustment is necessary to avoid the risk of fiscal
dominance down the road. The risk of governments pressuring central banks to help limit borrowing
costs may arise if public debt levels remain high when it is time to normalize monetary policy
(Blanchard, Mauro, and Dell’Ariccia, 2013).
D. Sovereign-Bank Links and Risks from Private Sector Balance Sheets
20. Domestic bank holdings of public debt were not thought to pose a risk to the financial
system in AEs. If anything, holding sizable amounts of safe and liquid assets, like government debt,
13
Prohibitions on “monetary financing” of the government did not include the purchases of government bonds from
secondary markets, since these are often used to conduct open market operations in some countries. Thus, the
increase in purchases of government bonds by central banks has not violated existing legislation.
14
See IMF (2013d) for further discussion of UMP measures. Also, forthcoming work by IMF staff will examine fiscal
and monetary policy interactions, the quasi-fiscal aspects of UMP, and implications for Fund policy advice on central
bank purchases of government debt, as well as broader issues related to policy coordination between central banks
and governments, including in the case of a deep crisis.
REASSESSING FISCAL POLICY
14 INTERNATIONAL MONETARY FUND
was thought to make banks less risky. This view was reflected in the regulatory capital rules that
allowed banks to assign a zero-risk weighting to holdings of their own government’s debt.
21. We have seen that a sovereign-bank feedback loop can emerge and amplify a
sovereign debt crisis. A sovereign-bank feedback loop can initially stem from either a rise in
sovereign yields diminishing the value of public debt held by domestic banks, raising concerns
about banks’ solvency when they hold large quantities of public debt, or from systemic banking
sector problems, with the potential fiscal costs raising concerns about fiscal solvency (Adler, 2012).
In such situations, a feedback loop emerges that is often fueled by increasing uncertainty regarding
the solvency of both the government and the banks, leading investors to demand higher default risk
premia and creating self-fulfilling crisis dynamics, as seen in the euro area crisis countries (Figure 7).
Figure 7. Sovereign-Financial Linkages
Sources: Bloomberg L.P.; Dealogic; national authorities; Arslanalp and Tsuda (2012); and IMF staff estimates.
1
Outstanding guaranteed bonds corresponding to bonds issued by private and public banks and financial institutions and carrying
state guarantees. Short-term debt is not included.
22. Decisive actions to reduce uncertainty and the risk of multiple equilibria are critical to
severing the sovereign-bank feedback. Severing sovereign bank links in the short run requires
short circuiting the emergence of self-fulfilling crisis dynamics. This calls for: (i) central bank
provision of sufficient liquidity to the financial sector and the sovereign bond market to ensure a
liquidity problem does not become a solvency problem; (ii) transparent and credible stress tests and,
if needed, plans to recapitalize or restructure weak banks at minimal fiscal cost; and (iii) formulating
and announcing a credible medium-term fiscal adjustment plan to reassure investors concerned
about fiscal solvency. As in the case of monetary financing of the deficit, the provision of large
AUS
AUT
BEL
DNK
FRA
DEU
IRL
ITA
NLD
NZL
PRT
KOR
ESP
SWE
GBR
USA
-4
-2
0
2
4
6
8
-4-202468
Change in 10-year sovereign bond
yields, 2008–12 (percent)
Change in government guarantees,
1
2008–12
(percent of GDP)
AUS
AUT
BEL
DNK
FRA
DEU
IRL
ITA
NLD
NZL
PRT
KOR
ESP
SWE
GBR
USA
-4
-2
0
2
4
6
8
0 10203040
Change in 10-year sovereign bond
yields, 2008–12 (percent)
Public debt held by domestic banks, 2011
(percent of GDP)
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 15
(potentially unlimited) amounts of liquidity to banks cannot be a substitute for addressing the
underlying problems.
15
23. For the euro area, a cross-country risk-sharing mechanism is needed to help break
national sovereign-financial linkages.
16
Given the size of national banking systems, banking sector
problems can easily overwhelm the fiscal capacity of a single member state. To prevent this, a
common backstop for dealing with distressed banks is needed. Recent policy announcements —
including the ECB’s Outright Monetary Transactions (OMT) and the political agreement to allow
bank capitalization directly through the European Stability Mechanism (ESM)—have provided some
financial respite. However, so far, other efforts to develop more robust risk-sharing mechanisms
have faced significant political economy hurdles. For example, proposals for “Eurobonds,” for which
EMU members would share joint liability, have not gained traction.
24. Macro-financial imbalances stemming from private non-financial sector balance sheets
can also pose risks to the sovereign. During the European sovereign debt crisis, a striking
correlation has emerged between the rise in private sector indebtedness (indicated by the area of
the bubble), the external liabilities of a country (as measured by the net foreign assets (NFA)
positions) and sovereign yields (Figure 8). This may be indicative that markets see a large increase in
private sector leverage as a risk factor for the sovereign, whether indirectly through lower growth if
deleveraging is drawn out or directly if the government is pressured to help bailout important firms
or industries. Such private sector indebtedness can also create additional indirect pressures on the
sovereign through the financial sector, as loan defaults rise. If the increase in private sector
indebtedness is externally financed, this may also compound a country’s vulnerability to a “sudden
stop” of capital flows because foreign creditors are more sensitive to changes in perceived risks
(IMF, 2012b). In sum, private sector balance sheets should not be ignored when assessing fiscal risks
and sustainability.
15
Although beyond the scope of this paper, the first response to large bank systems requires more fundamental
financial sector and regulatory reforms (IMF, 2013c; Global Financial Stability Report, various issues).
16
See IMF (2012c) for a further discussion of issues related to creating an EMU banking union.
REASSESSING FISCAL POLICY
16 INTERNATIONAL MONETARY FUND
Figure 8. Sovereign Bond Yields, Net Foreign Assets, and the Change in Non-financial Private
Sector Indebtedness from 2001–10
(In percent and percent of 2010 GDP, respectively)
Sources: IMF International Financial Statistics, OECD.
Notes: The area of the bubbles represent the change in the non-financial private sector debt-to-GDP ratio between 2001 and 2010.
The color of the bubble indicates whether the change is positive or negative, with blue indicating an increase and white indicating a
decrease
FISCAL POLICY AS A COUNTERCYCLICAL TOOL
25. The prevailing consensus before the crisis was that discretionary fiscal policy had a
limited role to play in fighting recessions. The focus of fiscal policy in advanced economies was
often on the achievement of medium- to long-run goals such as raising national saving, external
rebalancing, and maintaining long-run fiscal and debt sustainability given looming demographic
spending pressures. For the management of business cycle fluctuations, monetary policy was seen
as the central macroeconomic policy tool. Fiscal contraction was sometimes recommended during
periods of economic overheating as a means of supporting monetary policy, for example to take
pressure off the exchange rate in the face of persistent capital inflows. However, during downturns,
it was deemed that there was little reason to use another instrument beyond monetary policy.
FRA
DEU
GRC
IRL
ITA
JPN
NLD
PRT
ESP
GBR
USA
0
2
4
6
8
10
12
14
16
18
0
2
4
6
8
10
12
14
16
18
-150 -100 -50 0 50 100
10-year Sovereign Bond Yields, 2011
(percent)
Net Foreign Assets, 2010
(percent of GDP)
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 17
Automatic stabilizers could be left to operate in economies that did not face financing constraints,
but there was little call for a more activist approach to fiscal policy.
17
26. There were many reasons for this consensus. First, there was widespread skepticism about
whether discretionary fiscal policy would have any meaningful impact on economic activity, while it
was generally accepted that monetary policy would do so. Second, lags in the design and the
implementation of fiscal policy, together with the short length of recessions, implied that even if
fiscal measures did affect output, their impact would likely come too late to be of much help. By
contrast, monetary policy could react more nimbly to economic developments, particularly when
conducted by a central bank with operational independence. Third, due to political constraints, fiscal
expansions in particular were seen as being easier to initiate during economic downturns than to
reverse during economic expansions, implying a ratcheting up of government spending and debt
over time.
A. Fiscal Policy Effects
27. For much of the two decades preceding the crisis, there was skepticism, both in
academia and among policymakers, regarding the macroeconomic effects of fiscal policy. The
skepticism, though not universal, reflected the possibility of a private sector offset to fiscal stimulus
and a lack of consensus in the empirical literature regarding the sign, let alone the magnitude, of
fiscal multipliers––the change in output resulting from a discretionary change in a government
spending or taxes.
18
Part of the literature even found evidence of negative multipliers. For example,
in seminal contributions, Giavazzi and Pagano (1990, 1996) showed that a number of fiscal
adjustments were correlated with expansions in private demand in the short term, providing
evidence of “expansionary fiscal contractions.”
28. The resurgence of countercyclical fiscal policy at the start of the crisis coincided with
new research on its macroeconomic effects. Some of this research, typically based on data
covering the precrisis period, concludes that fiscal multipliers have been low in advanced
economies, around 0.5 or less (Alesina and Ardagna, 2010; IMF, 2010b; Barro and Redlick, 2011, for
example). Other studies, also based on data covering normal times, find evidence of larger
multipliers, well above 1 (Romer and Romer, 2010, for example). However, in view of their reliance
on data covering the precrisis period, these studies are unlikely to fully reflect the peculiarities of the
current economic environment.
17
It is worth acknowledging that the rejection of discretionary fiscal policy as a countercyclical tool was not universal,
and was perhaps stronger in academia than among policymakers. Discretionary fiscal stimulus measures were
sometimes deployed in the face of severe shocks––for example, during the Japanese crisis of the early 1990s.
18
This uncertainty reflected various factors, including the difficulties involved in identifying the causal effects of fiscal
policy on economic activity due to two-way causality; different types of taxes and government spending; the
temporary or permanent nature of the measures; the initial state of the fiscal accounts; and different responses of
monetary policy.
REASSESSING FISCAL POLICY
18 INTERNATIONAL MONETARY FUND
29. While debate continues, the evidence seems stronger than before the crisis that fiscal
policy can, under today’s special circumstances, have powerful effects on the economy in the
short run. In particular, there is even stronger evidence than before that fiscal multipliers are larger
when monetary policy is constrained by the zero lower bound (ZLB) on nominal interest rates, the
financial sector is weak, or the economy is in a slump. A number of studies have also questioned the
earlier evidence of negative fiscal multipliers associated with expansionary fiscal contractions.
Beyond this general conclusion, however, many open questions remain—in particular, on the
differential effects, if any, of changes in government spending and taxes, or the dependence of the
multiplier on the initial state of the fiscal accounts.
Fiscal multipliers: at the zero lower bound
30. During the crisis, central banks in most advanced economies quickly cut their policy
rates to close to zero. By most estimates, central banks would if possible have decreased policy
rates well below zero in the absence of the zero nominal interest floor constraint. For example,
Rudebusch (2009) estimates that, in the United States, based on the typical response of the Federal
Reserve to economic conditions before 2008, the federal funds rate would have declined to -5
percent in 2009. After economies hit the ZLB, central banks moved to using various unconventional
monetary policies. IMF (2013d) concludes that, while these policies generally reduced tail risks,
evidence regarding the policies’ macroeconomic effects is less clear cut. Similarly, Chung and others
(2012) conclude that “the Federal Reserve’s asset purchases, while materially improving
macroeconomic conditions, did not prevent the ZLB constraint from having first-order adverse
effects on real activity and inflation.”
31. A number of studies suggest that the ZLB constraint increases the size of fiscal
multipliers. Coenen and others (2012) quantify the effect of the ZLB on fiscal multipliers based on
seven macroeconomic models developed at six policy institutions.
19
In all seven models, fiscal
multipliers associated with various fiscal instruments rise substantially at the ZLB.
20
Based on data for
27 economies during the 1930s—a period during which interest rates were at or near the ZLB—
Almunia and others (2010) conclude that fiscal multipliers were about 1.6. For the current crisis,
Blanchard and Leigh (2013) argue that fiscal multipliers have been above 1 in economies at the ZLB,
at least in the early years of the crisis, based on the relation they find between growth forecast
errors and fiscal consolidation forecasts for these economies. Additional evidence that fiscal
19
The seven models employed by the study are the Bank of Canada Global Economy Model (BoC-GEM), the FRB-US
and SIGMA models of the Board of Governors of the Federal Reserve System, the New Area-Wide Mode (NAWM) of
the European Central Bank, the QUEST model of the European Commission, the Global Integrated Monetary and
Fiscal Model (GIMF) of the IMF, and the OECD Fiscal Model.
20
See also, Christiano, Eichenbaum, and Rebelo (2011). In these studies, the ZLB amplifies the effects of fiscal policy
because policy interest rates do not respond to changes in fiscal policy in an offsetting manner. For example, at the
ZLB, central banks cannot cut policy interest rates to offset the negative short-term effects of a fiscal consolidation
on economic activity. By the same token, as long as the unconstrained policy rate is negative, the policy interest rate
does not rise during a fiscal expansion, and monetary policy thus accommodates the expansionary effects of fiscal
stimulus.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 19
multipliers can be large in settings where monetary policy is constrained come from studies based
on regional data from a particular country.
21
32. A related implication of the ZLB constraint on monetary policy is that fiscal policy
changes abroad are likely to have larger effects on the domestic economy. This is relevant for
settings where fiscal stimulus or consolidation occurs simultaneously in many economies (also see
the next section on the design of fiscal adjustment). Fiscal consolidation abroad reduces domestic
growth by reducing export demand. When the ZLB constrains the ability of the domestic central
bank to cut interest rates in an offsetting manner, the negative effect on the domestic economy is
likely to be larger (see IMF, 2010b, for an example). It is worth clarifying that the effect of fiscal
consolidation abroad comes in addition to the effect of any domestic fiscal consolidation. Since the
multiplier is larger at the ZLB—for any exogenous shock to aggregate demand—the final
contraction in output in response to the combined shock is likely to be larger when monetary policy
is constrained.
Fiscal multipliers: when the financial sector is weak
33. A key feature of the crisis has been the reduced availability of credit to households
and firms. Numerous advanced economies have experienced a systemic banking crisis (Laeven and
Valencia, 2012), with an associated reduction in the supply of loanable funds. More limited access to
credit implies that consumption and investment depend more strongly on current than on future
income. Therefore, fiscal policy changes, by affecting current income, have larger multipliers in
economies characterized by tighter credit constraints. To the extent that households and firms
become more credit constrained during financial crises, model simulations predict that fiscal
multipliers are likely to be larger during such episodes.
22
In line with this logic, Corsetti, Meier, and
Müller (2012) find that during actual historical episodes of financial crises, the responses of output
and consumption to public spending are substantially higher than during normal times, and are
consistent with fiscal multipliers as large as 2.
21
See, for example, Chodorow-Reich and others (2011) and Nakamura and Steinsson (2011) based on U.S. regional
data, and Acconcia, Corsetti, and Simonelli (2013) based on regional data from Italy. An important caveat applies to
studies that estimate fiscal multipliers based on subnational data. Taxpayers outside the region receiving central-
government funds may anticipate higher taxes in the future and reduce their spending accordingly through a
negative wealth effect. Since this negative wealth effect is limited at the regional level, the multiplier estimated at the
regional level would overstate the overall (national) output effect. At the same time, spending in one region could
increase demand in other regions, and such positive spillovers could imply that multipliers estimated at the regional
level would understate the overall output effect.
22
See Perotti (1999) and Fernandez-Villaverde (2010), for example. In related work, Eggertsson and Krugman (2012)
highlight the role of a private debt overhang in amplifying fiscal multipliers based on a New Keynesian theoretical
model. In their model, the debt limit of “impatient” households (who borrow from “patient” households) is suddenly
reduced. This makes these households’ spending more dependent on current income and, as a result, fiscal
multipliers rise well above 1.
REASSESSING FISCAL POLICY
20 INTERNATIONAL MONETARY FUND
Fiscal multipliers: in slumps
34. Earlier research often assumed that the impact of fiscal policy was similar across
different states of the economy, but a number of recent empirical studies suggest that fiscal
multipliers may be larger during periods of slack. Importantly, since these studies’ results are
based on precrisis data, their findings of larger multipliers in slumps reflect mechanisms distinct
from the ZLB and financial sector weaknesses discussed above. Instead, the authors of these studies
appeal to the early Keynesian notion that, when the economy has slack, fiscal expansions are less
likely to crowd out private spending. Using U.S. data, Auerbach and Gorodnichenko (2012) find that
fiscal multipliers associated with government spending fluctuate widely across the business cycle:
from 0–0.5 during expansions to 1–1.5 during recessions (Figure 9).
23
However, in this literature, the
definition of fiscal shocks and the measure of slack are important. Owyang, Ramey, and Zubairy
(2013), using a narrative approach to derive a different measure of government spending shocks,
find no evidence of higher multipliers during high-unemployment periods from U.S. data going back
to 1890, although they do find such a result for Canada.
23
Other studies, including Auerbach and Gorodnichenko (2013), Baum, Poplawski-Ribeiro, and Weber (2012), Batini,
Callegari, and Melina (2012), and IMF (2012d), find some supporting evidence for other OECD economies. It is worth
noting that, according to these studies, multipliers sometimes vary substantially across countries and across different
fiscal instruments.
Figure 9. United States: Historical Multiplier for Total Government Spending
Source: Auerbach and Gorodnichenko (2012).
Note: Shaded regions are recessions defined by the NBER. The solid black line is the cumulative multiplier, which indicates effect
on GDP of a 1 percent of GDP increase in government spending. Dashed lines indicate the 90 percent confidence interval.
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
50 55 60 65 70 75 80 85 90 95 00 05
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 21
35. A separate, but related, issue is that fiscal policy may have more persistent effects
during periods of economic slack. While this is still the subject of some debate, DeLong and
Summers (2012) argue that, during the recent long-lasting slump, a process of “hysteresis” links the
short-term cycle to the long-term trend, so that a temporary change in unemployment has a
tendency to become permanent. According to this view, in a depressed economy, low rates of
investment imply a deterioration of physical capital, human capital declines as workers without
employment lose their skills, and the long-term unemployed face a declining likelihood of being
rehired. All of these factors influence potential output. Thus, if hysteresis effects are stronger during
slumps, then fiscal policy is likely to have more persistent effects on economic activity.
Expansionary contractions and confidence effects
36. Before and early on in the crisis, a number of researchers and policymakers argued
that positive confidence effects could dominate the adverse mechanical effects of cuts in
spending or increases in revenues, and lead to “expansionary fiscal consolidations.” However,
recent research suggests that previous findings of expansionary effects are sensitive to how fiscal
consolidation is defined (IMF, 2010b; Guajardo, Leigh, and Pescatori, 2011), and that the most
famous episodes of expansionary contractions observed in Europe in the 1980s and 1990s were
typically driven by external demand more than by a surge in internal private demand on the back of
confidence effects (Perotti, 2011). While more evidence needs to be gathered, it does not appear
that confidence effects have played a major role in this crisis. In particular, a key channel through
which expansionary effects could occur––namely by decreasing risk premia on sovereign bonds and,
thereby, on domestic lending rates––has not been at work, since risk premia were already quite low
in most advanced economies when consolidation took place, although they were elevated in several
peripheral euro area countries.
37. The scope for confidence effects to offset the direct Keynesian effects of fiscal policy
could also be hampered by the reaction of spreads to economic activity. There is some
evidence that sovereign spreads appear to react strongly to output growth as well as to changes in
the fiscal accounts (Cottarelli and Jaramillo, 2012; Romer, 2012). These results––suggestive as they
are––imply that a fall in fiscal deficits associated with fiscal consolidation could, perversely, trigger a
rise in sovereign borrowing costs if the impact of lower growth dominates, thus contributing to a
further fall in output. In this case, confidence effects would reinforce rather than offset the direct
effects of fiscal policy (see also the next section on the design of fiscal adjustment plans).
B. Fiscal Policy Implementation
38. For fiscal policy to be truly effective as a countercyclical tool, a number of additional
conditions, beyond positive fiscal multipliers, need to be satisfied. First, fiscal authorities should
have room to maneuver so that the increase in debt associated with a fiscal expansion does not
trigger a sovereign debt crisis. As the previous section argued, the crisis has shown that this is a
concern for a number of AEs. Second, fiscal authorities should have the ability to respond to
economic developments in a timely and temporary manner. Prior to the crisis, a widely-held view
was that fiscal policymakers, unlike monetary policymakers, would respond too slowly to be able to
REASSESSING FISCAL POLICY
22 INTERNATIONAL MONETARY FUND
deliver fiscal stimulus during a recession.
24
In addition, there was suspicion that stimulus introduced
during downturns would not be subsequently fully withdrawn, leading to overheating (Taylor, 2000)
and a ratcheting up of government debt over time. This subsection assesses what lessons have
emerged from the crisis about these important real-world issues. Given the recent (and, in some
economies, ongoing) nature of the crisis, any lessons are necessarily tentative.
Fiscal response lags: this time was different
39. The experience with discretionary fiscal policy since the crisis demonstrates that
policymakers can rapidly deploy substantial fiscal stimulus. After the failure of Lehman Brothers
in September 2008, it became clear that the global financial sector was suffering a shock of a
magnitude unprecedented in the postwar period. Fiscal policymakers in most advanced economies
passed fiscal stimulus packages by the end of 2008—a relatively fast pace for discretionary fiscal
policy, albeit slower than that of monetary policy (Figure 10).
24
Fiscal policy lags would arise because of delays both in assessing the need for stimulus after the onset of a
downturn, and in legislating and implementing countercyclical legislation.
Relatedly, Romer and Romer (1994)
concluded that U.S. discretionary fiscal policy played a minor role in ending recessions from 1950 to the early 1990s,
while monetary policy played a substantial role. Auerbach (2009) and Auerbach and Gale (2009) find that U.S.
discretionary fiscal activism increased during the 2000s.
Figure 10. Advanced Economies: Time Lag Between Lehman Failure and
Fiscal Stimulus Packages
(In Months)
Sources: International Institute for Labor Studies (2011), IMF (2010a), and IMF staff estimates.
Notes: Figure indicates time in months until first fiscal stimulus package announced after September 15, 2008. Stimulus measures
announced prior to that date, are not included in the chart.
0123456
United States
Finland
Singapore
Norway
Canada
Sweden
Portugal
Israel
United Kingdom
Spain
New Zealand
Netherlands
Korea
Italy
HongKong
German
y
Denmark
Japan
France
Australia
Response time in months (after Sept. 15, 2008)
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 23
40. In the United States, the country at the center of the global financial crisis,
discretionary fiscal policy had already started in February 2008. The Economic Stimulus Act
provided around US$150 billion in stimulus to the economy in the same year, primarily through
refundable tax rebates targeted to low- and middle-income households, who started receiving the
payments in May 2008. This occurred even before there was an accepted consensus that a recession
had begun or would materialize (Auerbach, Gale, and Harris, 2009).
25
In July 2008, a new tax credit
for first-time homebuyers was also passed to target weakness in the real estate sector.
41. There was heterogeneity across countries in the size and time profile of stimulus
measures. Of the advanced economies in the Group of Twenty (G-20), Australia, Canada, Germany,
Japan, Korea, and the United States launched fiscal stimulus packages following the Lehman episode
that exceeded 3 percent of 2008 GDP in discretionary stimulus over 2009 and 2010 (IMF, 2010a). The
combined U.S. fiscal stimulus from all measures, including the American Recovery and
Reconstruction Act (ARRA) passed in February 2009, amounted to 4.6 percent of 2008 GDP over
2009–10. The United Kingdom deployed nearly all its stimulus through temporary tax cuts in 2009.
Australia also deployed significantly more fiscal stimulus policy in 2009 than in 2010. Canada,
France, and Japan delivered stimulus fairly evenly over the two years, while Germany and the United
States delivered more fiscal stimulus in 2010 than in 2009.
Fiscal response lags: why was this time different?
42. A number of factors explain the relatively rapid fiscal response during the crisis. The
size of the shock to the world economy was, arguably, the primary factor. Another plausible
explanation for the increased reliance on discretionary fiscal policy stimulus during the crisis was the
ZLB constraint on monetary policy. Fiscal authorities especially stepped up their activism in the final
months of 2008, around the time that nominal policy interest rates were coming close to the ZLB.
Moreover, the shift toward discretionary fiscal stimulus in many economies coincided with a
multilateral drive for global fiscal stimulus. On November 15, 2008, a G-20 communiqué urged a
coordinated policy response to the crisis, including “fiscal measures to stimulate domestic demand
to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal
sustainability” (G-20, 2008). This was followed by a range of fiscal policy proposals from the IMF
(Spilimbergo and others, 2008). Global coordination arguably helped policymakers recognize the
positive spillover effects of expansionary fiscal policy.
25
The Business Cycle Dating Committee at the National Bureau of Economic Research announced in December 2008
that the U.S. had entered recession in December of the previous year, when payroll employment started declining
according to the Bureau of Labor Statistics large survey of employers. The first quarterly decrease in real GDP
occurred in the third quarter of 2008. As late as March 2008, the Congressional Budget Office (2008) forecast growth
rates of GDP of 1.9 and 2.3 percent for 2008 and 2009, respectively.
REASSESSING FISCAL POLICY
24 INTERNATIONAL MONETARY FUND
Fiscal response lags: which measures were implemented fastest?
43. Discretionary fiscal packages contained several types of stimulus measures, with some
policies being implemented faster than others. As Table 1 reports, the policies with the fastest
implementation times were tax relief measures, such as targeted tax rebates in the United States,
value-added tax (VAT) cuts in the United Kingdom, and car scrappage schemes, such as those
implemented in France, Germany, the United Kingdom, and the United States. Transfers programs,
such as extensions and expansions of unemployment benefits and other social benefits had short to
moderate lags. Finally, public infrastructure investments were implemented with longer lags arising
from project evaluation and procurement procedures. Bringing forward pre-planned capital
expenditures also mitigated this problem, as in the case of stimulus programs implemented in
Belgium, France and the United Kingdom. Also, as the slump persisted for longer than expected,
protracted outlays, such as those related to infrastructure projects, would have been timely and at
the same time supportive of future growth. Assessing the specific impacts of these varied fiscal
measures on economic activity is the subject of ongoing research.
26
26
Feldstein (2009) and Shapiro and Slemrod (2009) calculate modest effects on aggregate U.S. consumption from
the rebates of February 2008, which could reflect the fact that the payments reached a wide range of households, not
all of whom were tightly credit constrained. Mian and Sufi (2012) find that the U.S. car scrappage program led to an
increase in car sales, although over a short horizon, as purchases were brought forward. Chodorow-Reich and others
(2011) show strong (regional) effects from U.S. federal aid to the states.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 25
Table 1. Selected Fiscal Stimulus Measures Used by Advanced Economies
Sources: Budget documents, and Saha and von Weizsäcker (2009).
44. Finally, it is worth recognizing the sizeable role that automatic fiscal stabilizers, the
size of which varied across countries, played during the crisis. Figure 11 reports a breakdown of
the overall fiscal expansion across discretionary measures and automatic stabilizers for G-20
advanced economies. For this sample, it appears that countries with smaller automatic stabilizers
provided larger discretionary stimulus.
27
27
Relatedly, Auerbach (2009) argues that for the United States fiscal experimentation during the crisis was aided by
the increasing fiscal activism of the preceding decade, in turn partly motivated by a decline in automatic stabilizers.
Aizenman and Pasricha (2011) suggest another possible reason for the large discretionary fiscal impulse of the U.S.
government is that it helped offset a strong contraction in fiscal expenditures at the state and local level.
Type of measure Selected country examples Full impact Target Duration
France2009:€1000ormore,dependingonnewcar
Germany2009:€2500incentive
UK2009:£2000incentive
USA2009:$3500or$4500,dependingonnewcar
UK2008:TemporarycutstobasictaxrateandVATrate
USA2008:One‐timerefundabletaxrebates.2009:Two‐year
refundablerebatesforlowincomehouseholds;one‐yeartaxcutfor
medium‐incomehouseholds.2010:Payrolltaxcut
Austria2009:Pre‐plannedtaxreformbroughtforwardbyoneyear,
incometaxcutsformediumtohighincomeindividuals
Germany2009:Riseintax‐freeallowanceandcutinbasicrate
Sweden2009:Cutsincorporatetax,socialsecuritycontributions
andpersonalincometax
Belgium2009:Higherunemploymentandothersocialbenefits
USA2009:Extensionofunemploymentbenefits,fundingfor
medicalcareandnutritionsupportforlowincomehouseholds
Netherlands2009:Energyefficiencyandgreengrowthmeasures
Sweden2009:School,vocationalandresearchfunding
USA2009:Renewableenergy,transferstostatesforeducation
Australia2009:Schoolbuildingprogram
Belgium2009:Newandacceleratedpublicinvestments
France2009:Centralandlocalgovernmentinvestmentsbrought
forwardfrom2010to2009
Germany2009:Accelerationoftransportationandother
infrastructurespending
Spain2009:Publicinvestmentinmunicipalworks
USA2009:Newtransportationandotherinfrastructurespending
Carscrappageschemes
(replacingoldcarswith
fuel‐efficientvehicles)
1‐3months
Fromafewmonths
touptotwoyears
(oftenextended)
Automobile
industry
Lowandmedium
income
households;
consumption
Some
immediate,
somephasedin
overtime
Various
Envisionedtobe
permanent;Austria
raisedupper
incometaxratein
2013
Permanenttaxcuts
Temporarytaxcutsand
transfers
Immediate 1‐2years
Infrastructure
investment
2009for
accelerated
investments,
2010‐2011for
newprojects
Educationand
transportation
infrastructure
1‐2yearsfor
accelerated
investments,3‐6
yearsfornew
investments
2009‐2010
Expansionoftargeted
transferprograms
Liquidity‐
constrained
households
Mostofspending
within3‐5years
Governmentpurchases
ofgoodsandservices
Mostly2009
and2010,upto
2012forUSA
Educationand
greenenergy
1‐3yearsfor
education,1‐8years
forR&D
REASSESSING FISCAL POLICY
26 INTERNATIONAL MONETARY FUND
Figure 11. G-20 Advanced Economies: Contributions of Discretionary Stimulus and Automatic
Stabilizers to the Primary Fiscal Deficit, 2009–10
(Percent of 2008 GDP)
Sources: IMF staff calculations based on WEO and Fiscal Monitor (IMF, 2010a) data.
Notes: Sample comprises advanced countries in the G-20. Contribution of automatic stabilizers is calculated as the residual change
in the primary deficit after accounting for the discretionary stimulus. Staff calculations indicate that Korea’s automatic stabilizers
damped the change in the primary deficit over 2009–10, consistent with strong nominal GDP growth.
Reversibility of stimulus
45. The crisis also provided numerous examples of policymakers undertaking
discretionary fiscal stimulus measures that, according to the evidence available thus far, were
largely temporary. Temporary tax cuts and transfers were planned to be the largest single
component of stimulus programs for the United Kingdom, the Netherlands and Belgium. The United
Kingdom ended the temporary VAT tax cut at the end of 2009, and actually raised the VAT rate in
2010 above its precrisis level as part of its fiscal consolidation program.
28
Car scrappage schemes,
used in several countries, were often extended, but eventually ended. Similarly, in the United States,
as Figure 12 reports, fiscal stimulus took the form of a series of temporary fiscal packages. One-time
tax rebates provided to low- and medium-income households in early 2008, and the rebates and
transfers to these households and to social security recipients as part of the ARRA, were withdrawn
as scheduled. Some temporary measures were extended in a limited fashion when economic activity
remained sluggish: owing to persistently high unemployment, the payroll tax cuts implemented in
2010 were extended twice, before being terminated at the end of 2012.
29
28
By contrast, permanent tax cuts and transfers accounted for a larger share of the fiscal stimulus packages in
Germany, Austria and Sweden (Saha and von Weizsäcker 2009).
29
At the same time, the precrisis tax cuts passed under the Bush administration, primarily for reasons other than
countercycical concerns (Romer and Romer, 2009), were largely made permanent.
-5
0
5
10
15
-5
0
5
10
15
AUS
CAN
FRA
DEU
ITA
JPN
KOR
GRB
USA
Automatic Discretionary
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 27
Figure 12. Timeline of U.S. Fiscal Packages and Federal Funds Rate, 2008–18
(In billions of U.S. dollars and percent, respectively; annual data)
Source: IMF staff calculations based on CBO and OMB data.
46. Moving from individual measures to the aggregate fiscal stance, many countries
began reversing stimulus measures as early as 2010. This marked the start of multi-year
consolidation plans in many AEs. While the fiscal adjustment in some AEs was induced by market
pressure, the overall pattern of fiscal consolidation following fiscal stimulus in 2009 is striking. As
Kose, Loungani, and Terrones (2013) point out, in AEs, the recovery from the global financial crisis
has featured a more pronounced reduction in government spending than observed following
previous recessions (Figure 13).
Jan-08
May-
…
Sep-08
Jan-09
Ma
y
-
…
Se
p
-09
Jan-10
May-
…
Sep-10
Jan-11
May-
…
Sep-11
Jan-12
May-
…
Sep-12
Jan-13
May-
…
Sep-13
Jan-14
Ma
y
-
…
Sep-14
Jan-15
May-
…
Sep-15
Jan-16
May-
…
Sep-16
Jan-17
May-
…
Sep-17
Jan-18
May-
…
Sep-18
-1
0
1
2
3
4
5
-100
0
100
200
300
400
500
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
US $ bn
Economic Stimulus Act of 2008 ARRA February 2009
November 2009 package Jobs bill March 2010
Extensions of unemployment benefits (2010) Summer 2010 measures
President's December 2010 package December 2011 package
February 2012 package ATRA 2012 (Fiscal cliff deal)
Fed Funds Rates (right-axis)
REASSESSING FISCAL POLICY
28 INTERNATIONAL MONETARY FUND
Figure 13. Government Expenditures During Global Recessions and Recoveries
(Years from global recession on x-axis; indexes = 100 in the year before the global recession)
Sources: IMF Public Finances in Modern History database (Mauro and others, 2013); World Bank World Development Indicators
database; and IMF staff estimates.
Notes: Expenditure series is real primary expenditures. Aggregates are purchasing-power-parity weighted. Dotted lines denote WEO
forecasts.
THE DESIGN OF FISCAL ADJUSTMENT
47. The fundamental challenge facing policymakers today is to reduce deficits and debt
levels in a way that ensures stability but is sufficiently supportive of short-term economic
growth, employment, and equity. As many AEs grapple with high public debt and unsustainable
fiscal deficits, the design of fiscal adjustment—in terms of both speed and content—has returned to
the forefront of the policy debate. Recent international experience has stimulated an active debate
regarding the optimal pace of fiscal consolidation and how that pace depends on the state of the
economy, the conditions of public finances, and the extent of market pressures.
60
70
80
90
100
110
120
130
140
150
-4 -3 -2 -1 0 1 2 3 4
Advanced Economies
60
70
80
90
100
110
120
130
140
150
-4 -3 -2 -1 0 1 2 3 4
United States
60
70
80
90
100
110
120
130
140
150
-4-3-2-101234
Euro Area
60
70
80
90
100
110
120
130
140
150
-4 -3 -2 -1 0 1 2 3 4
Japan
Recovery from the Great Recession
Average of previous recessions (1975, 1982, 1991)
Global recession year
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 29
A. The Pace of Fiscal Adjustment
48. The choice of the appropriate speed of adjustment has to weigh the costs (i.e. adverse
short-run effects on growth) against the benefits (i.e. reduction in sovereign risk) of a faster
adjustment. Countries that have lost access to financial markets often have little choice but to
frontload fiscal consolidation. For economies with access to markets, however, a number of country-
specific factors are likely to shape the choice of the speed of adjustment.
49. Frontloaded fiscal consolidation was often thought to be the most effective approach
to restoring the health of public finances. Based on a cross-country panel analysis, Alesina and
Ardagna (1998) argues that frontloaded fiscal adjustment: (i) maximizes debt reduction, since the
earlier a country achieves a high primary surplus, the higher would be the cumulative primary
surpluses and therefore the more debt reduction over any given horizon; (ii) minimizes corporate
and household uncertainties about (future) fiscal consolidation needs, which would otherwise weigh
on private demand; (iii) boosts market confidence (especially in countries experiencing sovereign
stress) and lowers government yields, with knock-on benefits for both fiscal indicators and private
investment; and (iv) is associated with higher long-term growth and more durable debt reduction.
50. However, the desirability of frontloaded fiscal consolidations was less established in
policy circles. Some IMF studies of large fiscal adjustments (Horton and others, 2006, for example)
found that both frontloaded and phased consolidations could be durable. Moreover, for a sample of
emerging economies, Baldacci and others (2006) found that “large and back-loaded fiscal
adjustments have the highest likelihood of success.” A more recent study of 66 fiscal consolidation
plans in the EU over 1991–2007 by Abbas and others (2011) also suggests that policymakers were
not convinced about the benefits of frontloading consolidation, since less than one-fourth of the
plans studied envisaged frontloaded consolidation.
51. The crisis has reignited the debate on the merits of frontloaded fiscal adjustment. As
discussed above, there are reasons to believe that fiscal multipliers are higher during crises than in
normal times, and that hysteresis effects could be more pronounced in deep recessions.
30
As a
result, a view has emerged that excessive frontloading can hurt growth to the point that it
undermines social and political cohesion, and weakens rather than strengthens market confidence
(Cottarelli and Jaramillo, 2012). In such an environment, frontloaded efforts may even be “self-
defeating,” and fail to achieve the consolidation targets in the short run due to negative growth and
negative confidence effects. For this to happen, the initial level of the debt-to-GDP ratio must
already be high and the negative growth impact on the denominator of the debt-to-GDP ratio must
be large enough to increase the debt ratio in the short run (Eyraud and Weber, 2013). IMF (2012e)
analyzes the case of the UK to show that the combination of multipliers that are asymmetrically
30
Hysteresis is expected to be more pronounced during deep recessions: the unemployment rate, the duration of
unemployment spells (which increases non-linearly with the unemployment rate), and the probability of dropping
out of the labor market are all higher.
REASSESSING FISCAL POLICY
30 INTERNATIONAL MONETARY FUND
large in recessions and substantial hysteresis effects can render frontloaded consolidations welfare-
reducing.
52. While too much frontloading may be “self-defeating,” excessive delay may also be
very costly. In particular, if markets lose confidence in the government’s willingness eventually to
put fiscal policy on a sustainable footing and start to demand higher interest rates, then debt
dynamics can quickly become unsustainable. Given the uncertainty about the point at which a
country will lose market access, and the possibility of multiple equilibria, judgments about whether
consolidation programs are excessively frontloaded will be uncertain in practice: country authorities
will never be in a position to know for sure whether a slightly more gradual adjustment path than
that opted for would have been accepted by markets or would have led to a collapse of confidence.
On the other hand, Blanchard, Mauro, and Dell’Ariccia (2013) have argued that given the limited
empirical evidence in support of confidence effects, frontloading as a means to increase confidence
does not seem desirable, except for countries facing market pressures.
53. The cost of excessive frontloading or excessive postponement can be particularly
large, even nonlinear, during deep recessions.
31
As discussed above, fiscal multipliers are
especially large when monetary policy is constrained by the ZLB and credit is tight; and the cost of
an output loss is larger and hysteresis effects are more pronounced than usual when the economy is
in a slump. But the costs of indefinite postponement of needed adjustment are also particularly
large during deep recessions because the risk of a confidence crisis and associated output losses
may increase non-linearly with the size of fiscal imbalances. Even if a crisis can be avoided, a modest
increase in interest rates can still have severe effects when government debt is high. The risk of a
confidence crisis or higher interest rates may be high enough that there is social and political
consensus to move ahead with fiscal adjustment.
54. As mere promises to undertake fiscal adjustment later may not be persuasive, gradual
consolidation needs to be anchored in a credible medium-term plan. In countries with some
fiscal space in the short run, policymakers concerned about the growth impact of fiscal adjustment
could approve deficit reduction measures now, but phase in the actual spending cuts and tax
increases. For example, reforms to public pension plans can be legislated now, but with much of the
savings only starting to accumulate starting several years out, as seen with the reforms to Social
Security in the United States in the 1980s (Romer, 2012). However, in the absence of a “perfect
commitment technology” that can ensure that fiscal adjustment promised for later will be
implemented, a gradual fiscal adjustment should, in general, involve a “modicum” of fiscal
adjustment at an early stage and be anchored in a credible medium-term plan (Blanchard and
Cottarelli, 2010; Cottarelli and Viñals, 2009; Abbas and others, 2010; IMF Fiscal Monitor, various
issues). To reduce the risk of a negative market reaction, medium-term adjustment plans should be
supported by reforms to strengthen fiscal institutions, as discussed below, and broader structural
31
For a more in-depth discussion of possible nonlinearities arising from following “extreme” approaches, see
Cottarelli (2013).
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 31
reforms to boost growth (Everaert and Allard, 2010; IMF, 2012a).
32
Given a credible plan supported
by strong fiscal institutions, if growth does underperform (relative to expectations), the government
should allow automatic stabilizers to operate. This means letting headline balances deteriorate, as
long as the structural fiscal adjustment plan is on track and the market does not react badly (IMF,
2012d).
33
55. Countries under market pressures, however, may still have little choice but to
frontload adjustment. They will face higher interest rates, which will translate into a higher debt
service and crowd out socially beneficial spending (Debrun and Kinda, 2013). Moreover, these
countries risk losing market access if adjustment efforts are not viewed as credible or sufficient
(e.g., to stabilize the debt ratio and put it on a declining path over time). As we have seen for some
euro area members, countries in a weak fiscal position that are facing market pressure or have lost
market access have undertaken large and frontloaded adjustments (Figures 14 and 15; see also the
IMF Fiscal Monitor, various issues). In many countries, fiscal imbalances are of such magnitude that
addressing them in the near term would require adjustment on a scale that would dramatically
impact economic activity and would have devastating consequences for the provision of
government services. Depending on the elasticity of the response of output to deficit reduction, and
of interest rates to growth, it is conceivable that a very large adjustment could lead—at least in the
short run—to an increase, rather than a decline, in debt ratios and borrowing costs. Accordingly,
even for countries under market pressure there are “speed limits” that govern the desirable pace of
adjustment (Cottarelli, 2013).
56. The crisis has reaffirmed the precrisis views on cross-country fiscal policy coordination
and fiscal spillovers. In the early phase of the crisis, a fairly broad consensus emerged that the
unprecedented shocks hitting AEs required international coordination of fiscal stimulus measures.
34
As the conventional view predicts, and the previous section illustrates, the channels along which
fiscal spillovers operate can work during consolidations too, with effects of consolidation amplified
when synchronized across countries, especially when monetary policy accommodation is
constrained by the ZLB. This would argue in favor of coordinating policies across AEs to reduce the
synchronization of fiscal adjustment efforts, but since 2010, this has not been achieved.
32
In this context, consideration could be given to making a more gradual adjustment contingent on a commitment
to specific growth-enhancing structural reforms.
33
Consistent with this, the IMF and some euro area member states have successfully argued for a relaxation of
headline fiscal deficit targets, even in crisis countries such as Ireland and Spain, as long as progress is being made on
structural fiscal adjustment plans. The Fund has also advised countries with relatively more fiscal space and the
confidence of markets (e.g., Germany, the Netherlands, the United Kingdom, and the United States) to slow the pace
of consolidation if growth slows down (IMF, 2012d).
34
See the section on fiscal policy as a countercyclical tool and references therein.
REASSESSING FISCAL POLICY
32 INTERNATIONAL MONETARY FUND
Figure 14. Advanced Economies: Fiscal Adjustment and Market Conditions
Sources: Bloomberg L.P., and IMF staff estimates and projections.
Notes: The relationship between the change in the cyclically adjusted primary balance (CAPB) and 10-year sovereign bond yield is
statistically significant at the 95 percent confidence level.
Figure 15. Advanced Economies: Phasing of Fiscal Adjustment
Sources: IMF staff estimates and projections.
Notes: Fiscal adjustment in 2010–11 refers to the change in the cyclically adjusted primary balance (CAPB) in 2011 compared to
2009; 2012–13 refers to the change in the CAPB in 2013 compared to 2011; and 2014–15 refers to the change in the CAPB in 2015
compared to 2013.
AUT
BEL
CYP
FIN
FRA
IRL
ITA
LUX
MLT
NLD
PRT
SVK
SVN
ESP
DEU
GBR
JPN
USA
AUS
CAN
CZE
DNK
ISL
ISR
KOR
NZL
SWE
CHE
-4
-2
0
2
4
6
8
10
12
-4
-2
0
2
4
6
8
10
12
024681012
Change in the cyclically adjusted
primary balance, 2009–13 (percent of
potential GDP)
10-year sovereign bond yield, end-2010
(percent)
-5 0 5 10 15 20
Greece
Iceland
Ireland
Portugal
United Kingdom
Spain
United States
Slovak Republic
Slovenia
France
Italy
Belgium
Netherlands
Austria
Sweden
Germany
Finland
Change in the cyclically adjusted primary balance
(percent of potential GDP)
2010–11
2012
–
13
2014–15
Advanced
Economies
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 33
57. The lack of broad support for coordinating adjustment efforts illustrates the
challenges of policy coordination when national interests do not coincide. One argument for
more gradual or back-loaded adjustment in countries with fiscal space is that, by reducing spillovers,
it allows for slower (less frontloaded) adjustment in countries without fiscal space. However,
countries may be reluctant to smooth frontloaded adjustments for the purpose of reducing negative
spillovers if this puts market confidence at risk and reduces their own fiscal space. Although a
coordinated adjustment could ultimately benefit all countries, a cooperative agreement may be hard
to reach and, because countries have no ex-post incentive to comply, even harder to sustain (IMF,
2007a).
B. The Composition of Fiscal Adjustment
58. Before the crisis, expenditure-based consolidations were seen as generally more
durable than revenue-based ones. A number of studies of fiscal adjustment in advanced
economies before the crisis highlighted the long-term growth benefits and durable debt reduction
from expenditure-based consolidation (see, for example, Alesina and others, 2002; Horton and
others, 2006). The theory was that the distortionary impact of taxes (especially income taxes) would
weigh on potential growth by reducing labor supply, investment and firm profitability. The marginal
distortionary cost of higher taxation was considered to be non-linear, suggesting little or no room
for tax increases in countries with already high revenue-to-GDP ratios. Moreover, an increase in
indirect taxation could have inflationary effects, possibly triggering a monetary tightening.
35
On the
other hand, expenditure cuts (especially to wages and welfare) lowered labor costs, and were thus
associated with higher investment, net exports and growth (Alesina and Perotti, 1995, 1997; Alesina
and Ardagna, 1998, 2010; and Alesina, Perotti, Tavares, 1998). Studies of the financial market
response to consolidations suggest that sharper cuts to primary spending, transfers and the wage
bill, in particular, are associated with lower interest rates and higher equity prices (Ardagna, 2009).
59. Most policymakers also supported expenditure-based consolidation. Four-fifths of the
large fiscal consolidation plans designed in Europe over 1991–2008 were expenditure-based, and
often provided for some tax cuts (Abbas and others, 2011). An analysis of discretionary changes in
taxes and government spending incorporated in multi-year consolidation plans in 17 OECD
countries confirms that almost two-thirds of the consolidation plans were expenditure-based
(Devries and others, 2011), reflecting that many of the countries already had relatively high spending
and revenue levels. In fact, some countries introduced consolidation packages that relied almost
entirely on expenditure measures. Figure 16 illustrates the predominance of expenditure-based
adjustments during 1978–2008.
35
Effects on (short- and long-term) growth of revenue-based consolidations could be different, depending on the
type of tax. The impact of an income tax increase on long-term growth via its distortionary effects on saving and
investment is well established (Acosta-Ormaechea and Yoo, 2012). While consumption taxes are less damaging for
long-run growth, hikes could dampen short-term growth if the inflationary consequences lead to monetary
tightening in response or by directly reducing consumers’ purchasing power when demand is already deficient. How
important these various effects are empirically remains an open question.
REASSESSING FISCAL POLICY
34 INTERNATIONAL MONETARY FUND
Figure 16. OECD Countries: Average Composition of Fiscal Adjustment, 1978–2008
(share of total in percent)
Source: IMF staff calculations based on data from Devries and others (2011).
Notes: The data from Devries and others (2011) is based on 173 fiscal policy adjustments in 17 OECD countries, including: Australia,
Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, Sweden, the
United Kingdom, and the United States. The cumulative impact of adjustment measures (in percent of GDP) over 1978–2008 was
calculated for each country. The cross-country average (mean) was then taken for each measure and then the share of the average
total of adjustment efforts over 1978–2008 was calculated.
60. However, revenue-based consolidations, while not the norm, were not uncommon. For
instance, in the aftermath of the oil shocks in the early 1980s, countries such as the United States,
Japan, Germany, and Canada relied relatively more on tax increases. Horton and others (2006)
argues that revenue-based consolidations could be durable, especially when initial revenue-to-GDP
ratios are relatively low. Abbas and others (2011) make a similar argument for actual consolidations
in the EU since 1990. Mauro and Villafuerte (2013) also show that the ex post composition of
adjustment often turned out to be different than planned, with expenditure cuts falling short of
target and revenue over-performing (see also, Mauro (ed.), 2011).
61. The crisis has not offered conclusive lessons regarding the relative size of revenue and
government spending multipliers. Some recent studies suggest that spending multipliers are
larger than revenue multipliers (Baum, Poplawski-Ribeiro, and Weber, 2012; Erceg and Linde, 2013),
while others reach the opposite conclusion (Alesina, Favero, and Giavazzi, 2013).
36
Blanchard and
Leigh (2013) find little evidence of a difference between multipliers for spending cuts and tax
increases. Although the relative impact of spending and revenue measures is still subject to much
36
Differences in the definition of government spending may help explain part of this difference in results. Baum,
Poplawski-Ribeiro, and Weber (2012) define spending as direct purchases of goods and services by the government,
while Alesina, Favero, and Giavazzi (2013) adopt a more comprehensive measure that includes government transfers.
Expenditure
Measures
63.1
Revenue
Measures
36.9
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 35
debate, the size of short-term multipliers is only one of the many factors that need to be considered
in determining the appropriate composition of fiscal consolidation for any single economy. Long-
term effects on potential output are also important, and the already-high tax pressure in some
countries (particularly in Europe) point to the need for expenditure-focused adjustment (IMF, 2012c).
62. A renewed emphasis on equity strengthens the case for better targeting of both
spending and revenue measures. New research suggests that large expenditure-based
consolidations tend to increase inequality (Woo and others, 2013; Ball and others, 2013), and that
higher inequality can undermine growth (Berg and Ostry, 2011; Woo, 2011). Equity considerations
suggest that a larger share of the adjustment burden could be borne by the rich, which could be
achieved through revenue measures targeted at the higher income segments of the population (see
Box 2). Revenue increases can therefore be an important component of consolidation packages,
even in countries where the adjustment should focus on the expenditure side, as in a number of
European countries. However, better targeted spending can also help achieve equity objectives,
though there may be a trade-off between growth and equity concerns when choosing consolidation
measures (see also IMF, 2011a, and IMF, 2012d).
63. In addition, political economy arguments related to the crisis have supported higher
taxation of financial activities. Insofar as the need for fiscal consolidation is perceived to be due in
part to the economic consequences of excessive risk taking in the financial sector, political economy
arguments would point to taxes that internalize externalities associated with risky financial activities
(e.g., a tax on banks’ non-core liabilities).
37
In fact, a range of European countries (Austria, Germany,
France, Hungary, Portugal, the United Kingdom, Sweden, and the Netherlands) have introduced
some form of financial transaction tax or financial/banking sector levy.
64. Taking into account these new views, the composition of adjustment should continue
to be calibrated with a view to minimizing the short- and long-term costs. In designing the
composition of fiscal adjustment, the pre-adjustment levels of revenue and spending, the differential
growth effects of various measures across time horizons, and the durability of the selected measures
need to be considered. In a number of European countries, precrisis levels of spending and taxation
were very high, pointing to the need for expenditure-focused adjustment. In addition to the
aggregate expenditure-revenue mix, the efficiency, growth, and equity implications of individual
measures should be considered. For instance, protecting the most progressive social benefits and
better targeting of social welfare spending can help ensure that the burden of adjustment is
distributed in an equitable manner.
37
For a more general discussion of financial sector taxation in the context of the crisis, see IMF (2010c).
REASSESSING FISCAL POLICY
36 INTERNATIONAL MONETARY FUND
Box 2. Equity Considerations for Program Design in the Crisis
A large and protracted fiscal consolidation is likely to exacerbate income inequality. Studies show
that income inequality tends to rise during periods of fiscal adjustment, especially when it is based on a
retrenchment in spending (see Woo and others, 2013; Ball and others, 2013).
1
Besides the direct impact
of consolidation on different income groups, via particular tax or spending measures, unemployment
appears to be an important channel through which fiscal tightening affects inequality.
2
Inequality has
tended to rise most in countries with the sharpest increases in unemployment (Ireland, Lithuania,
Spain) and to a lesser extent in ones that provided less discretionary fiscal support during the crisis (see
Box Figure).
Adjustment packages should be carefully designed to limit their negative social effects and
improve their sustainability. Fiscal adjustments that are seen as unfair are unlikely to be politically
sustainable. As is generally true, but especially important in the current circumstances, better-designed
tax measures and the more efficient allocation of spending, such as through better targeting social
benefits, can help offset some of the adverse distributional effects of consolidation. For example,
discretionary spending cuts could be combined with an enhancement of social safety nets, supported
by means-testing. Alternatively, revenues raised through more regressive types of taxes can be used to
finance expenditures that are more progressive, resulting in a net positive impact on low-income
households. Finally, equity can also be improved by combating tax evasion, since, relative to low wage
earners, large firms and wealthy individuals often have more of their income in forms that are easier to
shield from scrutiny by tax authorities, stronger incentives to avoid taxes, and the means to do so. As
the recent IMF Policy Paper on fiscal policy and employment noted, employment and earnings growth
that benefits low-income groups, in particular, should be facilitated and encouraged (IMF, 2012f).
Box Figure. Selected European Countries: Change in Unemployment, Cyclically Adjusted Balance,
and the Gini Coefficient, 2007–10
Sources: Woo and others (2013); EU Statistics on Income and Living Conditions (EU-SILC).
1
See Bastagli, Coady, and Gupta (2012) and Woo and others (2013) for discussions on the various channels through which
income distribution has been affected by fiscal consolidation.
2
In most countries, other cyclical and structural factors besides fiscal adjustment also contribute to increases in unemployment.
BEL
BGR
CZE
DNK
DEU
IRL
GRC
ESP
FRA
ITA
CYP
LTU
LUX
HUN
MLT
NLD
AUT
POL
PRT
SVN
SVK
FIN
SWE
GBR
NOR
-4
-3
-2
-1
0
1
2
3
4
-5 0 5 10 15
Ab so lute change in G ini co efficient
Change in unemployment
(percentage points)
BEL
BGR
CZE
DNK
DEU
IRL
GRC
ESP
FRA
ITA
CYP
LTU
LUX
HUN
MLT
NLD
AUT
POL
PRT
SVN
SVK
FIN
SWE
GBR
ISL
NOR
-4
-3
-2
-1
0
1
2
3
4
-10 -5 0 5
Ab so lute cha nge in G ini co efficient
Change in cyclically adjusted balance
(percent of potential GDP)
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 37
BUDGETARY INSTITUTIONS, FISCAL TRANSPARENCY,
AND FISCAL RULES
65. Although fiscal institutions are no substitute for political will, they have gained
prominence as tools to underpin effective fiscal policy.
38
Already prior to the crisis, fiscal
institutions were seen as an important device for sound public financial management (Akitoby and
Stratmann, 2010). The crisis has highlighted further their crucial role in achieving the desired fiscal
outcomes and, in particular, successful consolidations. However, the crisis has also shown that it is
not easy to design effective institutions. For example, in the context of acute economic uncertainty,
the crisis has revealed the challenges involved in establishing a credible medium-term budget
framework (MTBF) that balances medium-term certainty against flexibility with regard to changing
economic circumstances. It has exposed shortcomings in fiscal transparency standards and fiscal
accounts in advanced economies, which resulted in large unreported deficits and debt. Finally,
simple fiscal rules that relied on nominal variables were often procyclical and lacked the flexibility to
accommodate major shocks, which made it more difficult to enforce the rules.
A. The Design of Medium-Term Budget Frameworks
66. Even before the crisis, multi-year budgeting was advocated as good practice. Multi-
year budgeting provides insight into the implications of current policy decisions and future
programs, and how these fit within sustainable medium-term budget envelopes.
39
It also helps to
reduce fiscal risks due to inadequate planning. For instance, the absence of a binding/credible MTBF
is associated, on average, with a much higher forecasting error than that of countries with a binding
MTBF like Sweden or the UK (Figure 17).
40
67. The crisis has further illustrated the contribution of effective MTBFs to fiscal policy
credibility. In most instances, MTBFs helped governments respond to the crisis by providing a well-
established platform to plan, explain, and deliver both fiscal stimulus packages and subsequent
fiscal adjustment programs, thereby improving the credibility of fiscal policy.
41
As Harris and others
(2013) argue, regardless of their debt levels in 2011, governments with binding MTBFs were better
able to convince the markets that they would deliver on their medium-term fiscal adjustment plans
in the wake of the crisis.
38
As with all institutions though, the effectiveness of mechanisms like MTBFs, fiscal rules, and fiscal councils can
depend on a range of factors, including cultural and political willingness to adhere by the restrictions such
mechanisms place on policymakers and government officials.
39
See, for example, Potter and Diamond (1999) and IMF (2007b).
40
A binding MTBF holds the government accountable for multi-year expenditure parameters (e.g., ceilings), meaning
that some corrective action is required if there is evidence that a previously set parameter will be exceeded (see
Harris and others, 2013, p. 145).
41
While it is difficult to establish causality between the two, individual country cases may provide some insights (see
Harris and others, 2013).
REASSESSING FISCAL POLICY
38 INTERNATIONAL MONETARY FUND
Figure 17. Average Three-Year Ahead Forecast Error, 1998–2007
(Percentage points of GDP)
Sources: EU Countries: Stability and Convergence Programs. All other countries: year-end budget reconciliation documents.
68. At the same time, MTBFs need to be sufficiently flexible to respond to adverse
economic shocks. Successful MTBFs have combined multi-year discipline with responsiveness to
shocks. This has been achieved in a number of ways, including:
Excluding cyclically sensitive expenditures like interest expenses and unemployment benefits
from multi-year spending ceilings (e.g., Finland, France, the Netherlands, the United Kingdom);
Setting targets in real or volume terms so the expenditure limits are automatically adjusted to
reflects changes in the price level (e.g., the Netherlands) or number of beneficiaries
(e.g., Finland);
Building some unallocated spending into the overall expenditure limits that can be used to meet
unanticipated spending needs (e.g., Sweden);
Allowing spending to be reprofiled within multi-year limits, to bring some infrastructure
spending forward during a downturn for instance (e.g., the United Kingdom);
Designing escape clauses to deal with unforeseen and severe shocks. This will leave open the
option to revise the entire MTBF, if the severity of the shock requires a fundamental change in
fiscal policy. In this case, to safeguard the credibility of the overall framework, the government
should provide a transparent account of the revisions to MTBF that clearly separates the impact
of economic shock from other factors, including policy changes, as done in Sweden and
Australia. Who decides when the escape clause is to be activated is also important. In this
regard, fiscal councils can play a crucial role, including reviewing the MTBF revisions.
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Expenditure Revenue Balance
Percentage Points of GDP
Binding Indicative Neither
Cautious
Optimistic
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 39
B. The Transparency of Fiscal Accounts
42
69. The decade before the crisis saw a concerted effort to develop a set of internationally
accepted standards for fiscal transparency. There was also a steady improvement in the
comprehensiveness, quality, and timeliness of public financial reporting in countries across the
income scale.
70. Despite precrisis advances, shortcomings in fiscal disclosure resulted in an inadequate
understanding of underlying fiscal positions and fiscal risks. Several countries have experienced
large unexpected increases in deficits and debt as a result. For example, between 2007 and 2010, the
average unanticipated increase in the general government debt ratio was about 26 percent of GDP
for the ten countries with the largest unexpected debt increases (Figure 18). Roughly a quarter of
the increase was due to failures in retrospective fiscal reporting and more than a third was due to
underestimated fiscal risks from macroeconomic shocks and contingent liabilities. Less than one-
fifth was attributable to discretionary fiscal measures (the balance is unexplained). As Ostry and
others (2010) point out, a large fiscal revision can cause a bigger shift in market sentiment than the
size of the revision alone would suggest.
Figure 18. Sources of Unanticipated Increases in Public Debt Between 2007 and 2010
(Percent of 2010 GDP)
Source: IMF staff estimates using WEO data.
Notes: The “unanticipated” increase in debt is measured as the difference between the actual 2010 general government gross debt-
to-GDP ratio and the October 2007 WEO forecast of the 2010 debt ratio. The chart shows the GDP PPP weighted average across 10
countries: France, Germany, Greece, Iceland, Ireland, the Netherlands, Portugal, Spain, the United Kingdom, and the United States.
42
This section draws on the IMF Policy Paper “Fiscal Transparency, Accountability, and Risk” (IMF, 2012g).
1.3
4.7
3.8
6.0
4.7
5.9
0
5
10
15
20
25
30
0
5
10
15
20
25
30
Deficit revisions
Expanded Gen. Govt.
Defn.& Cash-to-Accrual
Macroeconomic
shocks
Financial sector
support
Stimulus
(or consolidation)
Other factors
Total unanticipated increase in debt = 26.4% of GDP
Fiscal Reporting
(23% of total)
Underestimated
Fiscal Risks
(37%of total)
Discretionary
(18% of total)
Unexplained
(22% of total)
REASSESSING FISCAL POLICY
40 INTERNATIONAL MONETARY FUND
71. The shortcomings in fiscal disclosure were mainly due to a narrow scope of fiscal
reporting or weak compliance with fiscal transparency standards. In particular, the
shortcomings related to:
Narrow scope of fiscal reporting: Most countries report fiscal variables for the general
government. However, this excludes a range of entities outside of the general government
perimeter whose activities can have fiscal implications. For example, in Portugal about one third
of the increase in the general government debt between 2007 and 2011 resulted from
reclassifications of entities that were previously outside of the general government perimeter,
notably, state owned enterprises (SOEs) and public-private partnerships (PPPs). These
obligations dealt a blow to the government’s finances when they were reclassified under the
European fiscal reporting rules after the crisis struck.
Lack of timely information about the current fiscal position: A number of countries did not fully
report in-year fiscal developments. For example, in Greece, a lack of timely and accurate in-year
fiscal data contributed to substantial revisions to initial estimates of the general government
debt and deficit. These large ex post revisions rendered the fiscal adjustment plan out of date
shortly after approval.
Shortcomings in fiscal forecasting: There are no internationally accepted standards for the
content and presentation of the budget and related documents. As a result, the production and
presentation of fiscal forecasts and budgets varies greatly across countries and often with
significant shortcomings.
43
72. Looking ahead, fiscal reporting should be enhanced to address the gaps in fiscal
transparency standards and practices revealed by the crisis. While improving fiscal reporting
cannot eliminate fiscal risks, it can help policymakers to identify, understand and respond to risks.
44
Some steps, discussed in the section on fiscal risks, include expanding the institutional coverage of
fiscal reporting to capture risks from SOEs or PPPs, preparing and publishing broad fiscal risk
assessments to determine the likely sources and sizes of contingent liabilities, and conducting stress
testing of fiscal policy and debt sustainability under alternative macro-fiscal scenarios (as in the
DSA).
45
Additional steps to address weaknesses in fiscal transparency practices include: (i) improving
43
According to the OECD’s 2007–08 Survey of Budget Practices and Procedures in 97 countries, the shortcomings
relate to methodology (only one-third systematically distinguish the fiscal impact of current and new policies),
construction and presentation (less than half prepare disaggregated multi-year budget estimates), and time horizon
(less than one-quarter routinely produce long-term fiscal projections).
44
Arbatli and Escolano (2012) have shown that increased fiscal transparency can also improve credit ratings and
lower sovereign bond yields.
45
It should be noted that assessing contingent liabilities is difficult in practice. Explicit contingent liabilities, such as
government guarantees to SOEs or potential costs due to PPPs, are easier to estimate than implicit contingent
liabilities, such as those generated by the financial sector during a crisis. Implicit contingent liabilities are difficult to
estimate in part because the sources of such liabilities may not be recognized, but also because their ultimate cost is
typically a function of policy choices. See Cebotari (2008) for more details.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 41
the timeliness of reporting to ensure fiscal forecasts are based on an up-to-date understanding of
the fiscal position, and (ii) adopting accrual-based reporting alongside cash-based reporting to help
identify hidden liabilities (such as expenditure arrears) consistent with the Government Finance
Statistics Manual (GFSM) 2001 standards.
73. The IMF’s Fiscal Transparency Code, Manual, and Assessment have been updated to
reflect the lessons from the crisis.
46
The update involved: (i) broadening the institutional coverage
of fiscal reports; (ii) providing balance sheet information; (iii) increasing the frequency of fiscal
reporting; (iv) requiring greater disclosure and management of contingent liabilities; and
(v) increasing the consistency between forecast, in-year, and year-end fiscal data. These revisions
reinforce the focus on the quality of fiscal reports, rather than the adequacy of reporting procedures.
By incorporating a set of qualitative fiscal transparency indicators that illustrate the materiality of
any gaps in country’s reporting practices, the new assessment provides an answer to the question of
whether available fiscal information provides an adequate description of the state of public finances.
Finally, rather than providing a one size fits all approach, the new code and assessment are based on
a graduated set of basic, good, and advanced practices that provide a guide for fiscal reporting at
different capacity levels.
47
C. The Effectiveness and Design of Fiscal Rules
74. Before the crisis it was widely believed that keeping rules simple and transparent
would help enforcement via market discipline and public pressure. Fiscal rules that impose
long-lasting constraints through numerical limits on budgetary aggregates have traditionally been
advocated by the Fund as a tool for disciplining fiscal policy and ensuring debt sustainability
(e.g., Kopits and Symansky, 1998).
Fiscal rules need to be better enforced while allowing more flexibility to deal with shocks
75. One lesson from the crisis is that fiscal rules should be made more binding in good
economic times, while allowing room to maneuver when the economy is weak. Precrisis budget
balance rules, typically defined in headline terms, allowed for fiscal expansion during the boom
(e.g., Spain) and called for procyclical and politically difficult tightening when the economy
weakened. Moreover, with a few exceptions (e.g., Brazil, Switzerland), most precrisis fiscal rules did
not explicitly foresee how to deal with exceptional economic circumstances. Consequently, during
the crisis, many rules were put into abeyance to avoid required fiscal tightening and without a
clearly defined path back. In this respect, national rules that provided some flexibility, either by
accounting for the cycle (e.g., Australia, Switzerland) or by including explicit escape clauses
(e.g., Brazil), generally fared better. This leads to three conclusions:
46
For further information about the IMF’s work in the area of fiscal transparency see www.imf.org/fiscaltransparency.
47
Further, the Special Data Dissemination Standard Plus (SDDS Plus) has been created as a third tier of the Fund’s
data standards initiatives to help address data gaps revealed during the global financial crisis. SDDS Plus prescribes
quarterly dissemination of general government operations and general government gross debt data.
REASSESSING FISCAL POLICY
42 INTERNATIONAL MONETARY FUND
Structural budget balance rules can better handle the trade-off between the objectives of counter
cyclicality and sustainability than headline rules. Using structural budget balances helps
policymakers take a more medium-term perspective rather than attempting to fine-tune fiscal
policy. Setting the limit in structural budget terms also allows excluding one-off effects, such as
banking sector recapitalization measures. However, large “one-off items” can still have important
implications for sustainability.
Computing structural budget balances is not straightforward, and results are difficult to
communicate, thus calling for greater involvement of independent agencies. As the crisis has
revealed, focusing only on the output gap may not be sufficient since cyclical revenue can be
associated with absorption or credit booms, as well as changes in the composition of GDP that
would need to be corrected for. Moreover, the post-crisis uncertainty about the impact on
potential GDP makes the structural budget balance prone to backward revisions, thus potentially
changing the assessment of the fiscal stance. Though not a panacea, independent fiscal
institutions can play an important role in avoiding having the costs of greater complexity and
less transparency of structural budget balance rules outweigh their added flexibility. In
particular, with the right expertise, independent fiscal institutions can estimate structural budget
balances or assess those of the government, monitor their development, and explain changes
and potential deviations from the rule to the public (further details below).
Well-defined escape clauses add welcome flexibility to fiscal rules. They should clearly define
under what circumstances and by whom the clauses can be triggered, as well as the timeframe
for returning to the numerical limits.
76. Enforcement mechanisms and other arrangements supporting the implementation of
fiscal rules should be strengthened. In particular, attention has been focused on the role of
corrective mechanisms for deviations, fiscal councils, and medium-term supporting frameworks.
Specifically, automatic mechanisms that correct for past deviations from fiscal rule targets have
emerged as a tool to strengthen enforcement since they require “undoing” past fiscal excesses and
determine the path back to the fiscal rule. Independent fiscal councils are now increasingly viewed
as natural complements to fiscal rules because they raise the reputational costs for deviating,
including in the use of “escape clauses,” and help provide greater public scrutiny, particularly in
cases where rules are more complex and less transparent (IMF, 2013e). Moreover, better supporting
arrangements, such as medium-term forecasting, planning and reporting (see above) help support
better monitoring and implementation of fiscal rules, thereby ensuring compliance.
77. Finally, supranational rules should be complemented with national fiscal rules. In the
EU, supranational budgetary limits were not sufficient to ensure fiscal discipline at the national level.
Precrisis structural deficits remained high in many EU countries,
48
though this was not as much the
48
For most countries, this was already apparent from the estimates at the time, though the extent of the imbalances
were larger in hindsight. Notable exceptions are Spain and Ireland, for which the revenues from their construction
booms were not flagged as transitory in the standard structural balance measures, but only in augmented indicators
(Martinez-Mongay, 2007, and Kanda, 2010, respectively).
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 43
case in EU countries with strong national rules in place (Debrun and Schaechter, 2013). For example,
before the crisis the Netherlands and the Nordic countries, with their traditions of rules-based
medium-term fiscal policy making, had small structural deficits or surpluses on average and were
among the few to meet their medium-term budgetary objectives (Figure 19). Of course,
supranational and national rules should be consistent with each other to avoid conflicting goals.
Figure 19. EU Countries: Precrisis Fiscal Performance and National Fiscal Rules
(Average over 2002–07; in percent of potential GDP)
Sources: IMF WEO data and IMF staff assessment.
78. A number of countries have already taken steps to reflect these lessons by adopting
“next generation” fiscal rules. Such rules tend to explicitly combine the sustainability objective
with more flexibility to accommodate economic shocks (Schaechter and others, 2012). Following the
earlier examples of Chile, Germany, and Switzerland, many of the newly adopted rules set budget
targets in structural terms (e.g., Austria, Colombia, France, Germany, Italy, Portugal, Spain,
Switzerland), cyclically adjusted terms (e.g., the United Kingdom), or account for the cycle in other
ways (e.g., Panama, Serbia) (Figure 20). In the EU, the so-called “Fiscal Compact” goes in the same
direction. It requires that national legislation adopt a structural budget balance rule combined with
legally enshrined automatic mechanisms for correcting deviations from the rule. In addition, the
recent “Two Pack” reform calls for the creation of independent national bodies to assess compliance
with the rule in EMU member states. Overall, the design features of fiscal rules have become more
encompassing, as seen in the fiscal rules index in Figure 21.
-8
-6
-4
-2
0
2
4
6
HUN
GRC
PRT
ITA
MLT
CYP
ROU
CZE
IRL
SVK
LVA
BEL
GBR
POL
FRA
DEU
LTU
AUT
SVN
ESP
NLD
SWE
LUX
DNK
BGR
EST
FIN
Average structural balance, 2002-07 (percent of potential GDP)
Medium-term budgetary objective (structural balance)
= National fiscal rule in place
REASSESSING FISCAL POLICY
44 INTERNATIONAL MONETARY FUND
Figure 20. Number of Countries with Budget
Balance Rules Accounting for the Cycle
(Number of countries)
Figure 21. National Fiscal Rules Index
(Index ranging from zero to five)
Source: IMF (2012a).
1/ Includes those with a clearly specified transition path.
2/ Includes those EU member states that have signed the Fiscal
Compact but have not yet adopted a rule that accounts for the
cycle.
Source: Schaechter and others (2012).
Notes: The index is calculated by accounting for a number of
characteristics, such as the legal basis, coverage, enforcement,
and supporting procedures and institutions. The index has been
standardized and ranges from 0 to 5.
Fiscal councils are important tools to enforce fiscal rules
79. Fiscal councils have been increasingly recognized as useful facilitators to maintain
sound public finances.
49
Fiscal councils are publicly funded independent bodies with a mandate
from elected officials to provide non-partisan oversight, analysis and/or advice on fiscal policy and
performance (OECD, 2012). Based on experiences prior to and during the crisis, recent analysis has
identified two main channels through which councils exert a positive effect on public finances. They:
(i) influence the public debate, mainly through communications and formal appearances before
parliamentary committees (Debrun, Gérard, and Harris, 2011), and (ii) provide or publicly assess
macroeconomic and budgetary forecasts to be used for budget preparation (Frankel and Schreger,
2012).
80. In particular, fiscal councils can enhance the enforcement of fiscal rules (IMF, 2013e).
Fiscal councils can help monitor fiscal rules as mandated, for example, by recent EU legislation.
50
With more countries formulating fiscal rules in structural terms, fiscal councils could also monitor
the technically complex adjustment calculations for the cycle, watch over the appropriate use of
escape clauses, and the implementation of adjustment paths. In many countries, the newly
49
See the forthcoming IMF Policy Paper on fiscal councils (IMF, 2013e) for further discussion.
50
They could be particularly useful in times of strong economic growth, when uncertainties about the permanence of
revenue gains may feed complacency and hamper a sufficient build up of fiscal buffers.
0 5 10 15
Rule committed to but
not yet adopted
Rule adopted but not
yet operational
Operational rule in place
Advanced economies Emerging markets
1
2
1
1.5
2
2.5
3
1990 1993 1996 1999 2002 2005 2008 2011
Advanced economies
Emerging economies
Low-income economies
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 45
established fiscal councils do have the mandate to monitor compliance with fiscal rules and targets
(e.g., Ireland, Italy, Romania, Serbia, Sweden, the United Kingdom), as well as to assess or prepare
macro-fiscal forecasts. However, in only a few cases are the fiscal council’s views binding for the
government (e.g., Slovenia, the United Kingdom), a practice which is more common across older
fiscal council legislation (e.g., Belgium, Korea, the Netherlands).
81. Recent studies have attempted to identify good practices on fiscal council design
(OECD, 2012). Three features seem to emerge. First, fiscal councils must have a mandate aimed at
addressing the origin of the fiscal policy bias (e.g., the regional common pool problem in Belgium,
and the optimistic forecasting bias in the United Kingdom). Second, they must be functionally
independent. This implies not only guarantees against political interference but also resources
commensurate with their tasks to safeguard against the political temptation to limit the fiscal
council’s activities (as illustrated by the fate of Hungary’s council in 2010-11). Third, fiscal councils
must be mindful of the political landscape and legal traditions.
Fiscal decentralization creates new challenges for the relations between the fiscal rules of
central and subnational governments
82. The crisis has reaffirmed that subnational finances are often more difficult to control
than central governments’ finances. In particular, two classic drawbacks of fiscal decentralization
have come to the fore during the crisis: deficit bias and coordination failures (see, for example,
Eyraud and Moreno Badia, 2013):
Deficit bias. A failure by lower level governments to fully internalize the costs of public spending
tends to create overspending or undertaxation, resulting in a deficit bias (for example,
overspending by regions in Spain resulted in larger than expected deficits, particularly in 2011).
Coordination failure. In a decentralized system, subnational and central governments’ policies
may not be consistent and pull the fiscal stance in opposite directions. For example, countries
with strictly enforced subnational nominal budget balance rules, such as the United States,
experienced notable procyclical tightening by state and local governments during the crisis,
while the central government was targeting a countercyclical stimulus (Aizenman and Pasricha,
2011; Jonas, 2012).
83. The crisis has also revealed that subnational governments had accumulated significant
fiscal risks over the years. This was the case in countries both without and, to a lesser extent, with
subnational fiscal rules (see, for example, Escolano and others, 2012). For example in Iceland, where
in precrisis years there were no formal constraints on local government finances, local government
debt surged to 37 percent of GDP at end-2009 and debt-to-revenue ratios exceeded 150 percent in
two-fifths of municipalities owing to a lack of proper oversight.
84. In response to these experiences, institutional reforms are now focusing on making
subnational constraints more binding. A number of countries without subnational constraints are
in the process of putting them in place, and have typically opted for fiscal rules (e.g., Iceland). In
REASSESSING FISCAL POLICY
46 INTERNATIONAL MONETARY FUND
some countries with an earlier focus on cooperative arrangements between central and subnational
governments (e.g., internal stability pacts), more emphasis is now placed on numerical rules (e.g.,
Austria, Germany). Finally, many countries with rules are strengthening them. For example, more
countries are now imposing limits on the budget balance rather than, or in addition to, capping debt
stocks. At the same time, enforcement is being strengthened, including through more/stricter
options for remedial actions (e.g., intense central monitoring, fiscal adjustment plans, hiring or salary
freezes, reductions of central transfers, suspension of fiscal powers).
51
CONCLUSIONS AND IMPLICATIONS FOR FISCAL
POLICY
85. The crisis has spurred a fundamental reappraisal of macroeconomic policy. Fiscal policy
is at the center of that reassessment. From the lessons highlighted above, we can draw a number of
implications for fiscal policy design and implementation, though for some issues conclusions are
tentative and some open questions remain.
Fiscal risks, and fiscal and debt sustainability
86. The weaknesses of conventional fiscal indicators suggest that new measures of the
structural fiscal position and fiscal risks are needed. Notably, both headline balances and
precrisis estimates of structural balances that did not account for asset price cycles obscured the
underlying structural weaknesses of fiscal positions in a number of AEs. The fiscal risks associated
with financial sector balance sheets (sovereign-bank feedback loops) were underestimated and the
transitory nature of revenue associated with real estate and financial market booms was not
accounted for.
87. AEs can experience economic and financial shocks that are larger than what was
thought possible, which calls for a reassessment of long-term “safe” public debt levels. The
emerging post-crisis consensus suggests lower values for what constitutes “safe’’ debt to GDP ratios,
to account for much-larger-than-imagined macroeconomic shocks and contingent liabilities.
However, it is still an open question as to why and for how long the markets will tolerate very high
debt ratios in some AEs (e.g., Japan, the United States).
88. AEs are not immune to sudden changes in market sentiment of the sort that have
provoked past crises in emerging markets. The risk of multiple equilibria associated with high
levels of public debt, especially for members of a currency union, has raised the stakes of
maintaining a heavy debt burden and made it imperative to stabilize and reduce public debt ratios
over the medium term.
51
Examples include Romania, where local governments can only commit to new spending after they have cleared
their arrears, and Spain, where failure to meet fiscal targets requires presenting a correction plan and spending cuts
are automatically triggered in the event of non-compliance with the plan.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 47
89. Central banks can mitigate the risk of a bad equilibrium by committing to provide
liquidity to the sovereign bond market to facilitate its monetary policy objectives. Large
central bank purchases of sovereign debt do appear to have helped restore financial market
functioning and intermediation. When output gaps are sizable and financial conditions severely
distressed, coordination of fiscal and monetary policies becomes a requirement to facilitate the
recovery. However, even if central bank purchases of government debt in pursuit of monetary policy
goals can also support fiscal adjustment, they are not a substitute for it. Fiscal adjustment is
essential to lower the risk of future political pressure on central banks.
Countercyclical fiscal policy
90. It remains an open question whether the conditions that warranted a greater use of
discretionary countercyclical fiscal stimulus at the start of the crisis will recur in the future.
Greater reliance on fiscal policy reflected constraints on conventional monetary policy (including
those arising from the zero lower bound and a weak financial sector) and insufficient support
provided by existing automatic stabilizers. One should not underestimate the possibility that such
conditions could persist or recur in the future, especially if automatic stabilizers continue to provide
insufficient support to the economy in severe recessions. Indeed, Japan‘s policy interest rates have
been near zero since the mid-1990s, as have those of most other advanced economies since 2008,
and there is wider recognition of the risk of banking crises in AEs. In addition, discretionary
countercyclical fiscal policy may remain an essential tool as long as automatic stabilizers have not
been made more effective in countering severe recessions. Of course, in deploying countercyclical
fiscal policy, the authorities should ensure that they have sufficient fiscal room to maneuver so that
the increase in debt associated with a fiscal expansion, on top of any realization of contingent
liabilities, does not trigger a sovereign debt crisis. This may be a particularly relevant concern in
economies that experienced a trend increase in the government debt-to-GDP ratio since the 1970s.
91. Countercyclical fiscal policies (either automatic or discretionary) could be made more
effective. Automatic stabilizers are not typically designed to deliver the optimal fiscal policy
response, since they reflect many societal choices—for example, regarding the size of government—
that are unrelated to cyclical considerations. The effect of conventional automatic stabilizers on debt
is also only self-correcting if output fluctuations are temporary, which may not be the case. There is
therefore a case for improving them, for instance, by increasing the role of temporary and targeted
fiscal measures contingent on the state of the economic cycle, rather than simply on the level of
output. On discretionary fiscal policy, while the evidence in the last few years is more positive, a
number of precrisis political-economy concerns regarding the timeliness and temporariness of
discretionary fiscal measures may remain valid, particularly when facing “normal” cyclical
fluctuations. Going forward, the emerging literature on the effectiveness of various fiscal measures
can provide some guidance on the sets of discretionary policies that are most appropriate for
different kinds of recessions.
REASSESSING FISCAL POLICY
48 INTERNATIONAL MONETARY FUND
Design of fiscal adjustment
92. The optimal pace of adjustment depends on the state of the economy, the condition
of public finances and the extent of market pressures. The merit of universal frontloading has
been questioned by developments in the last few years. Given the nonlinearities associated with
excessive austerity or profligacy, the case for proceeding with fiscal adjustment at a moderate pace
within a medium-term adjustment plan to enhance credibility has been strengthened for countries
that are not under market pressure. Frontloading is more justifiable in countries under market
pressure, though even for these countries there is a “speed limit” beyond which consolidation efforts
can be self-defeating.
93. Regarding the composition of the adjustment, some degree of pragmatism is needed.
The importance of taking equity considerations into account—certainly not a new paradigm—has
been confirmed by the need for policymakers to reverse measures that were not perceived as fair.
As to the proper balance between revenue increases and spending cuts, it is still too soon to draw
conclusions from recent developments. It continues to stand to reason that countries with a
relatively high revenue-to-GDP ratio would have to adjust primarily on the spending side, even if the
short term multiplier of spending cuts may be higher, because of medium-term growth
considerations. Countries where spending and revenue ratios are lower have space to act more on
the revenue side. In any case, at least in the current circumstances, it is unlikely that fiscal
adjustment would not involve some short term output loss, regardless of the composition of the
adjustment.
Budgetary institutions, fiscal transparency, and fiscal rules
94. More attention is needed on how to reconcile MTBFs and fiscal rules with the need for
flexibility to respond to cyclical fluctuations. Both can be formulated in structurally adjusted
terms, which can help avoid fiscal pro-cyclicality. It is more difficult to accommodate discretionary
actions within MTBFs, as the purpose of the latter is indeed to give some certainty to future fiscal
policy actions. Yet, defining the conditions under which MTBF could be revised (e.g., large deviations
of output from initial projections), could help, particularly if combined with institutional
arrangements to ensure that this increased flexibility is not abused (e.g., fiscal councils).
95. Improving fiscal transparency will contribute to a better understanding of underlying
fiscal positions and related risks. Further efforts are needed to improve the timeliness and
institutional coverage of fiscal reporting and adopt accrual-based reporting (in addition to cash-
based reporting); prepare alternative macro-fiscal scenarios to ensure that fiscal policy settings are
robust to macroeconomic shocks; and publish fiscal risk statements to raise awareness of contingent
liabilities.
96. Both the enforcement fiscal rules and coordination of policy across levels of
government need to be improved. Institutional reforms are focusing on making subnational
budget constraints more binding through tighter fiscal rules and stricter enforcement. While this is
appropriate, it is also critical that these constraints are well designed to reduce procyclicality.
REASSESSING FISCAL POLICY
INTERNATIONAL MONETARY FUND 49
ISSUES FOR DISCUSSION
Do Directors agree that the crisis has revealed a need to reconsider what constitutes “safe”
sovereign debt levels?
Do Directors share the view that conventional concerns about large central bank purchases of
government debt are less compelling when negative sovereign-bank feedback loops emerge
and bad equilibrium outcomes can materialize in sovereign bond markets, as long as central
bank intervention is a complement not a substitute for fiscal adjustment?
Do Directors agree that while fiscal policy played an important role for short-term stabilization
during the crisis, there are areas for improvement in the structure of automatic stabilizers and
the implementation of discretionary fiscal policy measures?
Do Directors agree that there is stronger evidence than before the crisis that fiscal policy can
have important short-term effects on economic activity, in settings where monetary policy is
constrained by the zero lower bound, the financial sector is weak, and the economy is in a
slump?
Do Directors agree that monetary policy, rather than discretionary fiscal measures, remains the
most appropriate tool for macroeconomic management in normal circumstances?
Do Directors agree that a pragmatic, country-specific approach is needed in designing fiscal
adjustment packages and that, depending on the initial level of revenue and spending, the
composition of the adjustment could rely more or less on spending cuts? Do Directors agree
that greater importance needs to be given to equity considerations in designing adjustment
packages?
Do Directors agree that the effectiveness of fiscal policy as a countercyclical tool and the success
of fiscal consolidation efforts critically depend on the quality of fiscal institutions and fiscal
reporting? Do Directors support the measures proposed by staff to enhance budgetary
institutions, fiscal transparency and fiscal rules?
REASSESSING FISCAL POLICY
50 INTERNATIONAL MONETARY FUND
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