Monday, September 1, 2008

Review of Literature on Countercyclical Fiscal Policy

There are a number of studies that have examined budgetary policies of the Government in the context of their responsiveness to cyclical fluctuations in the economy. Even though, as is widely believed, there is greater importance of such fiscal stance in developing countries, the stabilizing policies carried out by Western countries have also received considerable attention.

The present review of literature is essential in the context of the FRBM Act, which has been enacted not only by many of the states but also the Central Government of India. The issue of FRBM becomes vital since it is very much essential for the Government to fiscally intervene during the time of economic downturns, whereas the enactment of the Act itself binds the Government not to increase its expenditure in a productive manner during such times. There lies the contradiction, which leads one to go for a review of literature. Anybody who has studied Economics can always agree that there exists business cycle in a capitalist economy, and so there exist upturns and downturns. FRBM Act is always good when a capitalist economy is undergoing through rapid economic progress, so that productive Government expenditure do not crowd out private investment. However, some economists may claim that fiscal intervention may not be necessary during bad times because of the existence of “automatic stabilizers”. Hence, the enactment of FRBM Act is justified. But there is also the requirement for doing a study, which is empirical in nature so that one knows whether economic intervention by the Government is needed or not during the time of economic downturns (or recessions).

Auerbach (2002) finds that in the recent years, US discretionary fiscal policy appears to have become more active in response to both cyclical conditions and a simple measure of budget balance. Budgetary pressure may weaken the efficacy of expansionary fiscal policy, Auerbach (2002) argues. Fiscal policy, which is contractionary in nature, might have a positive impact on output. The paper by Auerbach (2002) says that automatic stabilizers embedded in the fiscal system have little net change since the 1960s and have contributed to cushioning cyclical fluctuations. The tax revenues itself is very much sensitive to the economic cycle. Auerbach (2002) finds that employment surplus has fallen in response to a rise in the Gross Domestic Product (GDP) gap, consistent with the use of discretionary countercyclical fiscal policy. Auerbach’s (2002) result suggests a recent increase in the responsiveness of discretionary spending to the budget surplus, with this relationship being statistically significant since 1993. Fiscal policy has been responsive both to cyclical factors and conditions of fiscal balance during recent decades. One method of measuring, according to Auerbach’s (2002), the strength of automatic stabilizers is related to the gap between the full-employment surplus, and the unadjusted surplus to the contemporaneous gap between GDP and full employment GDP. Auerbach’s (2002) paper show that discretionary fiscal policy’s overall impact was minimal compared to that of monetary policy. Automatic stabilizers are directly tied to output fluctuation. The role of current and tax provisions and expectations has been described by Auerbach (2002) using the standard Hall-Jorgenson user cost of capital, which provides a measure of the required gross, before-tax return to capital and hence a measure of the incentive to use capital in production. Auerbach (2002) has used the data from CBO forecast revisions, which are available since summer, 1984, as the pattern of semiannual forecast begins with the winter, 1984 Budget Outlook. For each observation, Auerbach (2002) measures the policy changes with respect to revenues, expenditures, or their difference—the surplus—as the discounted sum of policy changes adopted during the interval for the current and subsequent five fiscal years (relative to each year’s corresponding measure of potential GDP), with the six weights normalized to sum to 1. Auerbach (2002) has also done calculation on the basis of NBER TAXSIM model using a ‘tax calculator’ in order to estimate the impact on tax liability of changes in tax-return components of income and deductions.

Buti’s (2001) study find that it takes time, as well, to pass the fiscal measures through the national Parliaments and it takes time for the economy to respond. Hence, once decided, the fiscal policy measures can rarely be adjusted to the changing economic circumstances. Moreover, there are always political constraints: it tends to be much easier for governments to ease fiscal policy than to tighten and once the measure is taken it tends to become irreversible.

The study by Buti, Franco and Ongena (1997) where they have done historical analysis, without Stability Pact, shows that most EU members either carried out a fiscal retrenchment policy during the economic downturns or they were not able to smooth out the cycle through fiscal policies.

A study by Fatás and Mihov (2000), where they took the size of the government as a sample proxy for the automatic stabilizers, find that the size of governments is clearly inversely related to the volatility of GDP. Fatás and Mihov (2000) have pointed out that the size of government also reduces the volatility of the private GDP and the coefficient of correlation is equally high. Moreover, the reduction of volatility tends to be smaller when disposable income or consumption is used instead of GDP.

David and Christina Romer (1994), two post-Keynesians, who show that monetary policy alone is not sufficiently powerful and flexible tool to end recessions while, in contrast, discretionary fiscal policy does not appear to have had an important role in generating recoveries given that fiscal responses to economic downturns have, generally, not occurred until real activity was approximately at its trough. So, David and Romer (1994) feel that the best fiscal response to a strong slowdown in the economy is to let the automatic stabilizers play their role and avoid discretionary policy measures, which, because of constraints (that may be political in nature), tend to be irreversible, leading to ratcheting up public spending.

Dehesa’s (2001) review find that fiscal policy can be used as a stabilizing tool of economic activity either through the work of the built in ‘automatic stabilizers’, through discretionary tax or expenditure measures or through both. Dehesa (2001) finds that policy-makers in Europe committed mistake, during the course of most part of 2001, believing that the Euro-Area was not going to be much affected by the strong slowdown of the US economy.

Ilzetzki and Vegh (2008) have put together a database with quarterly, and not annual data. While annual data may be sufficient to explore the basic correlations and for some empirical approaches, they had seen that the identification assumptions underlying their VAR regressions are valid for quarterly, but not annual, data. To this effect they put together a database with quarterly data that encompasses 49 (27 developing and 22 industrial) countries, and which, depending on the country in question, goes as far back as 1960. They subject their data to a wide array of econometric tests aimed at disentangling causality. They resort to instrumental variables, GMM, simultaneous equations, and time series techniques (Granger causality and impulse responses). Their study shows that there exists procyclical fiscal policy in developing countries. Ilzetzki and Vegh (2008) show that procyclical fiscal policy amplifies the underlying business cycle. They inform that the two key fiscal policy instruments are government consumption (as opposed to government spending, which would include transfers and debt service) and tax rates (as opposed to tax revenues, which respond endogenously to the business cycle). While many studies in the literature look at the fiscal deficit, Ilzetzki and Vegh (2008) feel that this is not an appropriate measure of fiscal policy because of the cyclicality of tax revenues.

The paper by Michael D Bordo and Anna J Schwartz (2003) argues whether only money matters, disregarding interest rates and credit availability, and whether the Fed should have discretion or be bound by a rule. There is a need to look at how much budget cuts or tax changes contributed to stabilization, and whether there should be rigid rules or discretion to modify procedures for cutting or boosting taxes, Michael D Bordo and Anna J Schwartz (2003) add. While interpreting Friedman, Michael D Bordo and Anna J Schwartz (2003) say that with respect to fiscal policy, the state of the government budget matters for many things, but by itself it has no significant effect on the course of nominal income, on inflation or deflation, or on cyclical fluctuations. It is essential to separate the influence of fiscal policy from the monetary policy since changes in both occur at the same time. Michael D Bordo and Anna J Schwartz (2003) inform that Friedman regarded the US federal government budget as excessive. That is why he favoured expenditure decreases, rather than tax increase.

Charles Wyplosz (2005) thinks that research in the academia has exposed the limits of discretion following the discovery of the phenomenon of time inconsistency. Wyplosz (2005) mentions that there exist arguments against discretionary use of fiscal policy which is implemented too late and not as initially intended, that destabilizes the economy. Therefore, the solution lies in allowing the Government to make decisions without the approval of the Parliament. The author also informs that fiscal policy decision involves some income or wealth redistribution, either through tax-financed spending or through changes in tax collection. Monetary policy, however, is less redistributive in that sense. In the case of the US, there are flexibilities pertaining to the Budget Enforcement Act (BEA) in terms of the creative usage of ‘sunset clauses’. Sunset clauses stipulate that some fiscal decisions are temporary, which allows for temporary increases without violating the BEA. Fiscal policy must deliver long-term discipline, while allowing for flexibility in pursuing counter-cyclical policies in the short-run. Caps on the annual budgets are neither necessary not sufficient. Since annual budget is endogenous, hence it is beyond the control of the government. As a golden rule it is impossible to distinguish between public spending and public investment. Sometimes, public spending on education is likely to be more socially productive than the building of the roundabouts. Wyplosz (2005) stresses that the proper measure of fiscal discipline is the public debt (as a ratio to GDP), and not the annual deficit. Most importantly, a few years of debt decline are not enough to achieve sustainability, nor does a temporarily rising debt necessarily signal unsustainability. Time inconsistency implies combining short-run flexibility with long-run discipline. Rules that all but eliminate short-run flexibility can be very costly when they become binding, but this was seen as the price to pay for long-run discipline.

The paper by Farvaque, Huart and Vaneecloo (2003) evaluate the strength of automatic fiscal stabilisers in European countries by applying to EU countries the methodology proposed by John Taylor (2000), which relates the total budget balance to the output gap and the structural budget balance. In this paper, the authors have tried to find whether “Taylor's fiscal rule” could supplement or replace the Stability Pact as a guide for national fiscal policies under EMU. The authors inform that Taylor (2000) define a fiscal policy rule that relates the actual budget balance to the output gap and the structural budget balance as follows:

actual budget balance = f × (output gap) + structural budget balance

where f is a constant, the output gap is the deviation of real GDP from potential GDP as a percentage of potential GDP, and both the actual budget balance and the structural budget balance are measured as a share of GDP. According to this rule, actual budget balance (total budget) can be decomposed into a cyclical component, which is assumed to equal f × (output gap) and is said to reflect the size of automatic fiscal stabilisers, and a structural component (the standardized or cyclically-adjusted budget), which is taken as a measure of the stance of fiscal policy (the discretionary fiscal policy). Farvaque, Huart and Vaneecloo (2003) apply Taylor’s methodology to European countries in order to compare the degree of automatic fiscal stabilisation in the United States and in the European Union. They have utilized annual data from the European Commission (1995, 2002), for EU countries over the 1970-2001 period. There are four kinds of data: the net lending (+) or net borrowing (−) of general government in percentage of GDP (“total budget balance”), the cyclical component of net lending (+) or net borrowing (−) of general government in percentage of GDP (“cyclical budget balance”), the cyclically adjusted net lending (+) or net borrowing (−) of general government in percentage of GDP (“structural budget balance”), and the gap between actual real GDP and trend GDP in percentage of trend GDP (“output gap”).

By applying the fiscal rule proposed by Taylor (2000) to European countries, they have found several results. In the nineties, automatic fiscal stabilisers have been less stronger and discretionary fiscal policy has become more active and counter-cyclical in several countries. Due to this the influence of output fluctuations on the budget has increased over time. Although there exists large cross-country differences. The fiscal stance of discretionary fiscal policies has not been consistent with a total balanced budget in France, Germany, Greece, Italy and Portugal. On the contrary, in the last few years, six countries, namely: Denmark, Finland, Ireland, Luxembourg, Sweden and the United Kingdom, have succeeded in turning their structural deficit into a surplus, mainly because an increasing cyclical surplus (associated with strong automatic fiscal stabilisers and positive output gaps) has given them the opportunity to reduce the structural deficit.


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Bordo, Micheal D and Anna J Schwartz (2003): ‘IS-LM and Monetarism’, NBER Working Paper No. 9713, National Bureau of Economic Research

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