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Economic Monthly Report

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What's to be done about the fiscal deficit?

Fri, Oct 23 2009, 10:41 GMT
by La Caixa Economic Research Dept.

La Caixa

Before the crisis there was a broad consensus that the utilization of discretional fiscal policies of a counter-cyclical nature was undesirable as they did not contribute to the stability of the economy and could even have adverse effects. It was better to allow the «automatic stabilizers» to operate. If economic activity was falling, the drop in tax collections and the increase in transfers to individuals (unemployment benefits) would automatically ease the decrease. On the other hand, if the economy heated up again, this mechanism acted in the other direction partly counteracting the cyclical movement. Furthemore, it was considered that monetary policy was indeed adequate to deal with episodes of recession or overheating.

This was followed in the early stages of the financial crisis that broke out in 2007. When the instruments of conventional monetary policy were used up (scarcely with any results), the central banks then applied measures of an exceptional nature in an attempt to expand liquidity by all possible means. Governments went on the alert in order to avoid a collapse of the financial system and to support those entities in difficulties. What was feared actually came to pass. The bankruptcy of Lehman Brothers on September 15, 2008 set off the alarms, turned the crisis into a global one and put many financial entities at grave risk.

With credit channels blocked, real economic activity suffered a sharp slowdown, all happening at the same time at the international level, that suddenly ended a long stage of prosperity, excesses and imbalances. In view of the severe and unexpected financial crisis, that inexorably was passed on to real economic activity, any initial hesitation to put extraordinary fiscal policies into practice was set aside. The automatic stabilizers were not working. Governments and international bodies called a clearing of the decks for action with fiscal measures. The disaster had to be faced, cost what it may.

And it has cost a lot. At this moment, the worst of the crisis seems to be behind us but this year many countries will reach government deficits at two digits of gross domestic product, something unheard of in times of peace. The mountain of government debt keeps on growing without stopping. Now the international bodies are hurrying to warn governments that they may not be able to manage the imbalance. What is to be done? We should distinguish between the four factors that put the deficits off the rails - the automatic stabilizers, financial system support, discretional fiscal stimulus and, in some cases, other nondiscretionary effects corresponding to extraordinary income arising from a real estate or financial boom that is not going to be repeated. In an optimum scenario in which the present incipient recovery is consolidated, the automatic stabilizers would stop generating deficits on their own, the reshaping of financial markets would minimize the losses arising from aids to entities and the fiscal stimulus packages would be retired as the economy recovered strength. The fourth factor in generating deficits would make it necessary to adjust government revenues and spending in those countries where these have developed. In any case, in this context, the balancing of government finances would be possible within a reasonable period of time.

The problem lies in whether we must wait for recovery to take place, if it is weaker than expected or should there be any repetition. In all these cases, we shall have to decide which is worse, whether we should let the deficit and the government debt keep growing (with increasingly dangerous deficits) or cut off the flow with the subsequent risk of jeopardizing recovery. This is a delicate dilemma the solution of which for the moment is floating in the air and for which there are no general recipes given that the situation is different in each country.

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Published on  Fri, Oct 23 2009, 10:41 GMT