Jeffrey Frankel – Economy Watch

Fiscal Fallacies – How Developed Economies Got Stuck In A Policy Trap: Jeffrey Frankel

Jeffrey Frankel — Wed, 25 Jul 2012 08:39:22 +0000

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Over the years, politicians in advanced economies have tended to favour fiscal expansion during economic booms and austerity during recessions. But while a pro-cyclical policy is understandable from a political perspective, it also explains why these economies are rarely prepared for a crisis and why they eventually face so much difficulty recovering.

CAMBRIDGE – The world’s advanced economies remain divided over whether to strengthen budget balances in the short term or to use fiscal policy to promote recovery. Those worried about the short-run contractionary effects on the economy call the first option “austerity”; those concerned about long-term sustainability and moral hazard call it “discipline.”

Either way, the debate is akin to asking whether it is better for a driver to turn left or right; depending on where the car is, either choice might be appropriate. Likewise, when an economy is booming, the government should run a budget surplus; when it is in recession, the government should run a deficit.

To be sure, Keynesian macroeconomic policy lost its lustre mainly because politicians often failed to time countercyclical fiscal policy – “fine tuning” – properly. Sometimes fiscal stimulus would kick in after the recession was already over. But that is no reason to follow a destabilizing pro-cyclical fiscal policy, which piles spending increases and tax cuts on top of booms, and cuts spending and raises taxes in response to downturns.

[quote]Pro-cyclical fiscal policy worsens the dangers of overheating, inflation, and asset bubbles during booms, and exacerbates output and employment losses during recessions, thereby magnifying the swings of the business cycle. Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by it. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak.[/quote]

Consider the positions taken over the last three decades by some American politicians.

In his 1980 campaign and again in 1981, a period of recessions, President Ronald Reagan urged immediate action to reduce the national debt.

In 1988, however, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level that it had been under Reagan. “Read my lips: no new taxes,” Bush famously declared.

Predictably, Bush and the US Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment – in 1990, just as the US was entering a recession. Although the timing of the legislation was poor, the action was courageous: pay-as-you-go (PAYGO) budgeting rules and other reforms deflected government finances back onto a path that eliminated the budget deficit by the end of the decade.

But, three years later – at the start of the most robust recovery in American history – all Republican congressmen voted against President Bill Clinton’s 1993 legislation to maintain Bush’s spending caps, PAYGO, and tax increases. Even after seven years of strong growth, at the peak of the business cycle in 2000, with unemployment at record lows, George W. Bush based his 2000 campaign on a platform of large tax cuts.

After recovery from the 2001 recession had gotten underway, and the inherited budget surpluses had nonetheless turned to record deficits, the Bush administration pushed through a second round of tax cuts in 2003, and maintained a rate of spending growth that was triple the rate under Clinton. As Vice President Richard Cheney put it, “Reagan proved that deficits don’t matter.”

These policies were maintained for another five years, as another $4 trillion was added to the national debt. Predictably, when the worst recession since the Great Depression hit in 2007-2009, politicians were reluctant to launch an adequate fiscal response, owing to the huge deficits and debts that the government had already been running.

Republicans suddenly re-discovered the evil of budget deficits. They opposed Obama’s initial fiscal stimulus in February 2009, and succeeded in blocking further efforts when its effects petered out two years later. In my view, the government spending cutbacks of the last two years are the most important reason why the economic recovery that began in June 2009 subsequently stalled in 2011.

Here, then, are three generations of politicians who favoured fiscal expansion during booms (1982-1989, 1992-2000, 2002-2007) and austerity during recessions (1980, 1981, 1990, 2008-09). A similar unfortunate cycle – large fiscal deficits when the economy is already expanding, followed by fiscal contraction in response to a recession – has also been visible in the UK and the eurozone in recent years.

Turning left every time the road goes right, and vice versa, is worse than switching policies randomly.

[quote]But the pattern is understandable: when the economy is booming, there is no political support for painful spending cuts or tax increases. There is a hole in the roof, but the sun is shining. Then, when the thunderstorms roll in, sinners suddenly get religion and proclaim the necessity of reforming – just when it is most difficult to fix the problem.[/quote]

Historically, it used to be developing countries whose dysfunctional political systems produced pro-cyclical fiscal policies. Almost all of them showed a positive correlation between government spending and the business cycle from 1960 to 1999.

But things have changed. About a third of emerging-market countries’ governments – including authorities in China, Chile, Malaysia, South Korea, Botswana, and Indonesia – managed to reverse the historical correlation. They took advantage of the 2003-2007 boom to strengthen their budget positions, saving up for a rainy day. They were thus in a good position to use fiscal stimulus when the global recession hit them in 2008-2009.

In fact, a majority of the governments that have pursued countercyclical fiscal policies since 2000 are in emerging-market or developing countries. They figured out how to achieve countercyclical fiscal policy during precisely the decade when so many politicians in “advanced countries” forgot.

By Jeffrey Frankel

Copyright: Project-Syndicate, 2012

Jeffrey Frankel is the James W. Harpel Professor of Capital Formation and Growth at the John F. Kennedy School of Government in Harvard University. Frankel served under the Clinton Administration as a member of the Council of Economic Advisors and is currently the Director of Program in International Finance and Macroeconomics at the National Bureau of Economic Research.

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The Great Food Price Balancing Act

Jeffrey Frankel — Wed, 29 Jun 2011 07:19:28 +0000

Please note that we are not authorised to provide any investment advice. The content on this page is for information purposes only.

29 June 2011.

Rising food prices affect everybody, though obviously certain demographic groups – usually the poor – are affected more than the rest. As food prices continue to retain high levels of volatility, Jeffrey Frankel questions whether food prices can be stabilized and asserts that speculators could potentially act as “detectors of change” or as a “stabilizing force”.

29 June 2011.

CAMBRIDGE – Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. Small wonder: world food prices reached a record high earlier in the year, recalling a similar price spike in 2008.

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

[quote]Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.[/quote]

In theory, government stockpiles might be able to smooth price fluctuations. But this depends on how stockpiles are administered. The historical record is not encouraging.

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and is disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

In many developing countries, on the other hand, farmers lack political power.

African countries adopted commodity boards for coffee and cocoa. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price in the early decades of independence. As a result, production fell.

[quote]Politicians often seek to shield consumers through price controls on staple foods and energy. But artificially suppressing prices usually requires rationing to domestic households. (Shortages and long lines can fuel political rage just as surely as higher prices can.) Otherwise, the policy satisfies the excess demand via imports, and so raises the world price even more.[/quote]

If the country is a producer of the commodity in question, it may use export controls to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention – probably by working through the World Trade Organization – world price volatility might be lower.

[break]

Can Anything Be Done?

In the meantime, some obvious steps should be taken. For starters, bio-fuel subsidies should be abolished. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. (The US, it must be said, is the biggest obstacle here.)

[quote]It is probably best to accept that commodity prices will be volatile, and to create ways to limit the adverse economic effects – for example, financial instruments that allow hedging of the terms of trade.[/quote]

What the G-20 agriculture ministers have agreed is to forge a system to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

But the broader sort of policy that Sarkozy evidently has in mind is to confront speculators, who are perceived as destabilizing agricultural commodity markets. True, in recent years, commodities have become more like assets and less like goods. Prices are not determined solely by the flow of current supply and demand and their current economic fundamentals (such as disruptions from weather or politics). They are increasingly determined also by calculations regarding expected future fundamentals (such as economic growth in Asia) and alternative returns (such as interest rates) – in other words, by speculators.

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it, and that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals, or provide the signals that smooth transitory fluctuations. In other words, they often are a stabilizing force.

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

Can speculators really act as a “detector of change” or a “stabilizing force”? Or do they work only to serve their own self interest? Have your say below.

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