Fiscal Policy and the Credit Crunch: What Will Work?

As the real economy sinks quickly into a deep recession, governments are groping for measures to limit the downturn. And as interest rates are quickly bumping against the zero bound, an aggressive use of fiscal policy seems to be the only way to sustain demand.  Fiscal policy seems particularly appropriate since our macroeconomic models tell us that fiscal policy multipliers increase when more economic agents become liquidity constrained because they are then likely to spend any additional income they receive.

Unfortunately the discussions about the appropriate use of fiscal policy have degenerated into a shouting much with accusations of ‘crass Keynesianism’ and ‘stupid fiscal orthodoxy’. Instead of engaging in such polemics, one should look calmly at what fiscal policy can actually achieve under the present extraordinary circumstances. The key question: Can fiscal policy increase demand effectively? The most direct way for governments to increase demand is to buy goods and services from the market. However, most European governments spend very little this way. Public sector investment represents only 2–2.5% of GDP and is difficult to increase quickly since the large projects, which make up the bulk of the expenditure, take often a decade or more to realize. Even if governments were able to increase public investment by 20% in one year, this would result in a fiscal impulse of only less than 0.5% of GDP. Even in the US, this instrument will only have limited importance, as public infrastructure spending is projected to increase from around 2.6% (in 2007) to 3.6% of GDP (in 2009), thus constituting only a small fraction of the overall deficit, which is now projected to climb to around 8%–9% of GDP.

Any large-scale fiscal policy impulse must therefore, to be effective quickly, work through transfers to the private sector, either via lower taxes or via higher transfer to households. The key problem here is that under the present circumstances of extreme uncertainty households might just save any increase in their disposable income. How likely is this to happen?  A key factor will be the financial position of households themselves.

Households that depend on credit to finance their consumption will be most affected by the credit crunch and are thus most likely to react to a tax cut by maintaining their consumption. For this type of household, a tax cut (or an increase in expenditure) will be an effective tool to prevent an even sharper drop in consumption.

However, for households that do not depend on credit, the situation is quite different. Households that are saving anyway will probably at present just increase their savings in response to an increase in their disposable income that they know to be temporary.

This implies that the effectiveness of fiscal policy will vary greatly across the EU. Table 1 shows that households are on average net borrowers in only two of the larger member countries – Spain and the UK, unsurprisingly. In these two countries (with the largest housing bubbles) fiscal policy should thus be effective. However, in the three other large member countries, households are on average net savers. In these countries, and in particular in Germany where households are net lenders to the tune of about 10% of their disposable incomes, fiscal policy will not be effective – households can just increase their lending in response to a tax cut. The experiences of the US and Japan point in a similar direction. In Japan, the government has been running very large deficits for over a decade, but an increase in private savings has offset this, leaving domestic demand flat. Even in the US, where the private savings rate has been close to zero, households still chose to save more than half of the tax rebate decided earlier in 2008.


The fact that the marginal propensity to save is likely to be much higher in countries with solvent households (Germany and most of rest of continental Europe) also implies that the multiplier effect of spending on public infrastructure will also be lower than in the Anglo-Saxon countries where households are close to bankruptcy. This is another reason why the German government should be more hesitant than others to engage in a big fiscal stimulus.

A similar reasoning applies to the corporate sector – in a credit crunch investment will be strongly affected by the liquidity situation of enterprises. This implies that in countries where the corporate sector is a heavy borrower (Spain, France and Italy) it would be important to improve the liquidity situation of enterprises. One simple way to do this would be to allow all corporations to postpone payment of corporate income taxes for 1-2 years. This would not result in higher deficits as usually measured, but the cash deficit would increase as governments would effectively extend a credit to the corporate sector. Such a measure would thus be very different from a tax cut because it would not lead to larger debt levels and thus should not lead to sustainability problems later on. Postponing the payment of corporate income tax would of course help only enterprises that make a profit, but this should be considered an advantage because it would mitigate the impact of the credit crunch for sound enterprises, i.e. those that deserve to be saved. Companies that did not pay corporate income tax because they were not able to turn a profit even during the boom would not benefit, but they are also the most likely ones to be insolvent anyway.

One Response to "Fiscal Policy and the Credit Crunch: What Will Work?"

  1. GFDSG   April 1, 2009 at 10:29 pm