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2.3 From Fiscal Stimulus to Fiscal Contraction

In 2008-09 there was a global consensus on countercyclical fiscal policies, whereby countries coordinated policies to combat the negative social and economic impacts of the crisis. The IMF spelled out the need for global fiscal stimulus: ―In normal times, the Fund would indeed be recommending to many countries that they reduce t heir budget deficit and their public debt. But these are not normal times… if no fiscal stimulus is implemented, then demand may continue to fall… what is needed is… a commitment by governments that they will follow whatever policies it takes to avoid a repeat of a Great Depression scenario.‖ 3 During the first phase of the crisis 2008-09, 137 countries ramped up public expenditure, with the average annual expansion amounting to 3.3 per cent of GDP. At least 48 countries announced fiscal stimulus packages totaling US2.4 trillion, of which approximately a quarter was allocated to social protection measures Figure 4. Social protection played a key role in attenuating the immediate negative effects of the crisis on. One of the key lessons from these initial crisis responses is that social protection can function as an automatic stabilizer most effectively if the relevant schemes and programmes are implemented early ILO, 2014. In the absence of such social protection measures, the effect of the crisis on unemployment, households’ disposable income and poverty rates in 2009-10 would have been much worse ILO, 2011. Figure 4: Size of Social Protection Component of Stimulus Packages 2009 in per cent of total announced amount Sources: Authors’ calculations based on Zhang, Thelen and Rao 2010 and IMF country reports for Chile and Peru What prompted governments to abandon fiscal expansion in 2010 and embrace expenditure contraction? The conventional answer is to address debt and fiscal deficits. However this seemingly straightforward explanation deserves further exploration, especially given the fragile state of recovery in 2010 and the clear, negative impacts that fiscal retrenchment would have on economic activity. Early in 2010, IMF advice underwent a major change later supported by the OECD and ultimately also by the G20. Two IMF Board papers approved in February 2010 —―Exiting from crisis intervention policies ‖ and ―Strategies for fiscal consolidation in the post-crisis world‖—called for large-scale fiscal adjustment ―when the recovery is securely underway‖ and for structural reforms in public finance to be initiated immediately ―even in countries where the recovery is not yet securely underway‖ IMF, 2010a; 3 Olivier Blanchard, Economic Counselor and Director, IMF Research Department, IMF Survey Magazine, 29 December 2008. 0.0 10.0 20.0 30.0 40.0 50.0 60.0 T u rk e y Me xi co In d o n e si a Ba n g lad e sh Per u Phi li p p in e s V ie tn am Ch il e Ch in a T h ai lan d R u ss ia Mal ays ia H o n d u ras Ke n ya G e o rg ia S o u th A fri ca Is rae l Bel g iu m Ko re a S w itz e rl an d F ran ce A u str al ia Cz e ch R e p . G e rman y A u str ia Can ad a Po rt u g al Japan S lo ve n ia N e th e rl an d s N o rwa y Un ite d S tate s F in lan d T a iw an S in g ap o re High-income countries average: 27 Developing countries average: 24 9 IMF, 2010b. Reforms of pension and health entitlements were called for, accompanied by ―strengthened safety nets‖ for the poorest IMF, 2010a, pp. 15-32. On the composition of fiscal adjustment, it was advised that most of it could come from:  Unwinding the previously adopted fiscal stimulus packages;  Reforming pension and health entitlements to reduce the long-term financial obligations of the state by way of avoiding ―a rise in spending as a share of GDP‖ IMF, 2010a, p. 16;  Containing other spending, by means such as eliminating subsidies; and  Increasing tax revenues. All these suggested reforms became mainstream policy advice in a majority of countries around the world after 2010 and shaped the direction embraced by the economic adjustment programmes agreed with countries facing a sovereign debt crisis. Other international institutions also played a role. The Bank of International Settlements BIS —the bank for central bankers—joined the IMF in advocating front-loaded fiscal consolidation and structural reforms claiming that the limits to fiscal stimulus had been reached in a number of countries BIS 2010 and 2011. The OECD 2010 Economic Outlook OECD, 2010 also focused on the urgent need for fiscal consolidation and structural reforms in, for example, labour and product markets, pointing out that in both OECD and non-OECD countries the economic slack was disappearing and recovery taking hold rapidly. While these positions generally focused on higher-income countries, they also urged fiscal adjustment in developing countries, given that the risk of debt distress was increasing there too. However, as the global policy reversal was completed, it became apparent that recovery was not under way in the world’s largest economies. Instead a pattern of slow growth and persistent unemployment seemed to settle in, partly due to fiscal consolidation itself. Thus the second phase of the crisis, beginning in 2010, saw a total policy reversal, a 180-degree shift in governments’ public expenditure. The sovereign debt crisis in Europe turned public attention to government spending, as if it were the cause of the crisis. Rising debts and deficits at this point resulted from bank bailouts to rescue the financial sector from bankruptcy, stimulus packages and lower government revenues due to the slowdown in economic activity Figure 5. In other words, government debt and deficits were symptoms of the crisis, not its cause. Yet fiscal consolidation prescribed to cut back on public policies and downsize state budgets as the main ways to reduce deficits, calm the markets and revive the economy. Following this logic, the social welfare state was depicted as unaffordable and a burdensome impediment to competitiveness and output growth.