Fiscal Stimulus

Fiscal Policy in Practice

Fiscal stimulus are policy measures undertaken by a government to counter the effect of its financial crisis by reducing taxes or regulations and increasing public spending in order to lift the economy.

There is no fiscal policy to speak of in the absence of a significant budget Opens in new window. But the opposite is not true: a country can record a high government budget and refrain from fiscal activism.

Fiscal stabilization policy is a creation of the second half of the twentieth century.

It was made official policy under US president John Kennedy in the early 1960s, and its influence gradually extended to Europe (though Germany only briefly endorsed it around 1970).

By the late 1970s, it was already subject to controversies:
  • it shared the discredit of policy activism that resulted from inflation and the failure to revive high growth after the oil shocks;
  • it was accused of focusing too much on the demand side, whereas economic difficulties mainly arose from the supply side;
  • its effectiveness was questioned because budgetary decisions must go through a lengthy parliamentary process;
  • it was criticized for being much less nimble than monetary policy, which only requires a decision by the central bank to change the interest rate;
  • and, from a political economy standpoint, it was accused of providing an easy excuse to governments that are politically unable to balance their budget.

Writing at the turn of the century, Stanford professor (and former economic advisor to President George W. Bush) John Taylor (2000) Opens in new window assessed that “empirical evidence suggests that monetary policy has become more responsive to the real economy, suggesting that fiscal policy could afford to become less responsive” (p. 35) and that it seems “best to let fiscal policy have its main countercyclical impact through the automatic stabilizers” (p. 34).

Despite these criticisms, though, US presidents never relinquished fiscal policy entirely. It was mainly the political deadlock with Congress over federal spending and federal taxes that made fiscal policy increasingly difficult to rely on.

The fate of fiscal policy should have been more favorable in Europe because, under a fixed exchange rate (until 1998) and monetary union (from 1999 onward), monetary policy was not available at a national level as a stabilization instrument.

This should have led governments to rely more on fiscal policy. But failed fiscal reflation attempts after the oil shocks, high levels of public debt and an adverse doctrinal climate made them increasingly cautious.

When the monetary union was negotiated in the late 1980s, the focus of Germany was on preventing excessive deficits and a potential monetization of excessive public debts Opens in new window rather than on ensuring that there would be sufficient scope for fiscal stabilization.

Its views prevailed, and significant constraints to fiscal activism were introduced in the EU treaty.

Most small-country governments had little appetite for it at any rate because, in small open economies, the cost of a stimulus is borne by national taxpayers in the form of higher public debt, whereas a large part of the benefits of higher demand accrue to the country’s neighbors. In the end, Europe has remained more reluctant to embrace fiscal activism than the United States.

The one country where fiscal stimulus was lastingly endorsed has been Japan.

In the 1990s, the Japanese government launched a series of stimulus packages to counter the effect of its financial crisis and lift off the economy.

Partly because the private economy had been severely affected by the crisis and bank restructuring and recapitalization was a condition for the economy to gain momentum, and partly because action lacked decisiveness, the results were disappointing (see below).

However, fiscal policy Opens in new window was never removed from the policy toolkit. When the global crisis Opens in new window hit in 2008, the Group of Twenty was quick to endorse IMF proposals for a coordinated stimulus.

In London in April 2009, the leaders of the G20 committed to “deliver the scale of sustained fiscal effort necessary to restore growth.” Data indicate that they actually did deliver. In 2009, the breadth of the concerted stimulus was unprecedented: both emerging and advanced countries participated.

Already in 2011, however, their stances started to diverge: fiscal policy remained supportive in the United States and China, whereas Europe embarked on an early retrenchment.

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Fiscal Policy in Japan in the 1990s

During the 1990s, the Japanese government repeatedly tried to raise the level of GDP growth and inflation through two significant fiscal stimulus programs: one from August 1992 to September 1995, and one from April 1998 to October 2000.

In the first round, the fiscal impulse (measured as the change in the cyclically adjusted budget balance) averaged 1.5% of GDP per year, while the second impulse was smaller in magnitude and duration.

Both phases of fiscal expansion focused on public investment, mainly infrastructure projects, while most of the remainder was allocated toward purchases of land and to financial and housing loans.

The government included a large tax reduction in the first stimulus, with the expectation of compensating the reduction in income taxes with a later rise of value-added tax (VAT) rates. Over the 1990s, government debt doubled as a share of GDP, and the cyclically adjusted budget balance declined from 2% to –6% of potential GDP.

Although it had some positive short-term macroeconomic effects, the fiscal stimulus policy of the 1990s failed to bring back previous growth rates of the Japanese economy (Bayoumi, 2001).

Part of the failure can be attributed to factors beyond the immediate control of the authorities (the Asian financial crisis and population aging). But the “lost decade” was also related to the failure of the government to swiftly clean up the banking sector. The resulting “zombie banks” failed to provide credit to stimulate private investment.