When exactly did we forget about fiscal policy?
In his iconic 1948 book Economics, Paul A. Samuelson, one of the most respected and influential economists of the 20th century, wrote “…, it is absolutely certain that, just as no nation will sit idly by and let smallpox decimate the population, so too in every country fiscal policy always comes into play whenever depressions gain headway”.
At a time when austerity is the dogma of key European leaders and iron fiscal discipline perceived as the response to the escalating eurozone crisis, it is worth looking back at the basics of positive fiscal policy and how the prudent use of it can be the actual response to regaining growth, stability and confidence in the eurozone.
“Countercyclical compensatory” or “anticyclical” fiscal policy is a powerful tool in the hands of governments, used to dampen down the amplitude of the business cycle and, equally importantly, it involves a budget that is balanced over the business cycle.
Countercyclical Compensatory Policy
When private investment shoots up high, it is normal to expect the government to compensate by curtailing public expenditure and investment and increasing its tax collections. On the other hand, when private investment and consumption go into a slump, the government is then to compensate by stepping up its previously postponed expenditures and try reducing the tax collection.
According to the countercyclical view, the government budget need not be in balance in each and every year. On the contrary, during inflationary times, the budget should show a surplus of tax receipts over expenditures so the public debt can be reduced. But when the economy takes a downward turn, then the budget should show a deficit of revenues over expenditures, with the public debt returning to the previous levels. Only over the whole business cycle need the budget be balanced.
Public works, welfare transfers, automatic changes in tax receipts and tax rate changes are some of the main principles of countercyclical fiscal policy.
This principle of countercyclical finance was introduced by US Secretary of Commerce Herbert Hoover. Hoover argued that any spending in infrastructure or any other public investment should be planned so it does not coincide with periods that private investment is booming and manpower is scarce. Instead, it should be postponed until such time that the private sector releases materials and men.
The natural consequence will be stabilisation of the total business activity since the government will come up to fill in the trough of construction activity. Not only jobs will be created when are needed the most, but more than that the government will get the necessary public works at lower prices. To achieve that, Hoover passed through Congress a “permanent shelf of public work projects” with plans and blueprints always at hand, designed in such a way that would allow the anticyclical timing of public works.
During the period of the cycle the government’s activity is the exact opposite of the private sector’s so it can compensate for the effects of the cycle and the budget is not balanced in every year but only over the whole cycle.
At times when the private sector is reducing investment and production and, as a result, is cutting jobs, government expenditures on relief and unemployment play a key role in providing support to those in need and must automatically rise as people get thrown out of employment and again automatically fall as people return back to jobs.
Apart from the social aspect – that an organised society and welfare state must come to the support of those in need at times that is needed the most in order to maintain a respectable standard of living for its members – the welfare expenditures have a purely macroeconomic incentive. Considering that the level of unemployment benefits is such that covers at least the basic needs of an individual, this support is spent purely on consumption and with the known multiplier effect it contributes to purchasing power and employment.
Automatic changes in tax receipts and tax rates
The basic logic behind this principle is that the progressive elements of modern tax structures have a direct link between national income, the economy, and tax collections. Tax revenues should not be expected to remain constant throughout the cycle and this allows for tax receipts to rise when the economy is growing, leading to a budget surplus during boom periods, but at the same time fall sharply when the economy contracts.
This principle has a powerful effect stabilising the economy and moderating the business cycle provided that any attempt to keep tax revenues constant will further aggravate the effects of the economic slump.
Following from the automatic adjustment of tax revenues, depending on the business cycle, the time to reduce tax rates is at times of depression when overall purchasing power is low, allowing for more disposable income, and step up tax rates during boom times.
During depressions the government has at its disposal the powerful tool of fiscal policy that allows it to moderate the effects of the business cycle and by doing so, it creates the necessary conditions of quicker recovery and economic growth that will lead to higher revenues, budget surplus and reduction of the public debt.
All this makes perfect sense? Well, not for some if we consider the catastrophic policies that the troika of European Commission, ECB and the IMF imposed on Greece. The troika arrived in Athens towards the end of the sixth consecutive quarter of recession of the Greek economy with the mission to deal with a deficit problem that turned into a debt problem.
In cooperation with the Papandreou government they did everything that was within their control, instead of moderating the depression of the Greek economy, to accelerate it through a combination of cuts in public investment and EU co-financed public projects, reductions in wages, pensions and the overall purchasing power of the economy, increases in taxes through the reduction of tax-free levels, increases in indirect and consumption taxes and various “solidarity” and “emergency” tax measures included even in the electricity bills.
The results were indeed spectacular. After 18 months of this so-called “bail out” program the economy is expected to contract by 6% this year and a further 2.5% in 2012 by troika’s – repeatedly failing – projections, an estimated 10% contraction since they took charge of the country’s policies and finances. Unemployment stands at 18.4%, expected to close well above 20% by 2012 (25% of the Greek active population of 24-35 years old is unemployed, 43.5% of the 15-24 age group) and the nominal value of the 2011 deficit after two years of tax raids and “fiscal consolidation” will be in the region of EUR23bln or above 9% of GDP, having missed tax revenues and social constributions expenses targets purely as a result of the self-inflicted depression.
Einstein defined insanity as the condition of one doing the same thing over and over again expecting a different outcome, in the case of troika’s policies in Greece we have a textbook case.
Time to go back to the basics
This is not to say that Greece does not need reforms and long overdue structural and public sector changes in order to turn itself into a 21st century competitive economy.
However, this program did not fail because the closed professions of lorry and taxi drivers did not lose their “protected” status sooner. It failed because it was built on wrong macroeconomic foundations, or lack thereof, and is for the same reason that targets are missed in Portugal, new measures will be needed in 2012 in Ireland and will also fail in Italy.
Growth restoration is the response to this eurozone crisis that combined with the necessary reforms and EU framework adjustments will bring governments’ budgets back to healthy levels and will restore confidence in the servicing of the debt.
Fiscal discipline alone was tested and failed, who is going to tell the Germans…?