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In Times of Consecutive Crises, Is Fiscal Policy the Answer?

In recent weeks, fiscal policy – once the domain of policy wonks – has become part of dinner-table conversations. As Washington attempts to put its fiscal house in order, catchy metaphors from “fiscal cliff” to “fiscal calamity” to “austerity bomb” (and even “hostage crisis”) permeate the media.  Amidst the media spin and misnomers however, there lies a crucial debate. After all, fiscal policy, both through public spending and taxes, has a critical impact on long-run growth.

Common wisdom is straightforward. Investments in capital goods spur economic growth. Public infrastructure in sectors such as electric power and roads make private equipment, such as machinery and vehicles, more productive. A recent book. Is Fiscal Policy the Answer? A Developing Country Perspective (prepared by several PREM colleagues under the leadership of Blanca Moreno-Dodson), presents a comprehensive assessment of the trade-offs faced by policy makers (see video of the book launch discussion here), particularly as countries reacted to the 2008-2009 global crisis.

At its core, fiscal policy is a balancing act. Increases in public spending must be offset with increases in tax revenue, deficits or grants. These are not only politically difficult in most countries and circumstances, but can also act as a drag on the economy, particularly when certain levels of risk and distortions have been reached. Unsustainable public debt does endanger macroeconomic stability, and therefore undermines the credibility of the country, inhibiting private investment and growth. “The net effect of fiscal change on growth therefore depends on the way it is offset,” one of the chapters of the book notes. “The direct and indirect growth effects of the offsetting element may have similar or opposite impacts on the economy.”

Furthermore, when it comes to public spending, it is not the quantity but the quality that matters. As the book stresses, “it is not just accumulation of public capital. Rather, through affecting private productivity, certain types of public spending potentially raise the returns to investment, and thereby productivity of total (private and public) production factors.” Those “growth-enhancing” expenditures often lead to the creation of assets in education, health, transport and communication.

But public spending does not occur in a vacuum. Tweaking the levels or composition of public spending can be pointless if governance is poor. Translating the spending into public service delivery is when rubber hits the road. If teachers don’t perform their duties in school and students don’t learn, or roads are actually not constructed properly, fiscal policy will have little traction when it comes to growth and social welfare.  In fact, surveys that trace the flow of public resources suggest that low government accountability and public-spending leakages are the primary concern of policy makers.

In addition to diving into the institutional dimensions of fiscal policy making, the book takes the discussion on the impact of fiscal policy to another level. In their chapter, Eduardo Ley and Kirk Hamilton argue that in resource-rich settings, measuring growth rates alone could be deceiving if the wealth of the country (defined to include the depletion of natural resources and other assets) is deteriorating.  Therefore, policy makers must pay attention to such developments and use fiscal policy tools, mainly taxes and expenditures, to preserve and expand their wealth in the long run so that their populations can benefit from it.

Although this book focused entirely on developing countries – with a special chapter dedicated to Africa, where the diverse reactions to the latest global crisis offer numerous lessons – many of the book findings, I believe, can illustrate the current fiscal policy debates in the USA and Europe, as we are witnessing them these days.

Follow the latest from Otaviano Canuto at twitter.com/OCanuto and keep up with the World Bank’s efforts to help countries fight poverty and close gaps in income and opportunity at twitter.com/WBPoverty. For more Economic Premise notes, go to worldbank.org/economicpremise.

2 Responses to “In Times of Consecutive Crises, Is Fiscal Policy the Answer?”

Earl DougovitoDecember 22nd, 2012 at 4:24 am

‘Quality of investment, not quantity that counts’. Teachers must teach though without schoolchildren ready to learn ie properly nourished & disciplined, the nations classrooms become like poorly mixed road surface, forever in need of repair.
I would submit that the early investment may be the most vital to get right; that saturation levels exist so that public investment becomes more challenging over time and that all the cycle of life and death apply. All things must pass…the rise and FALL of the roman empire is as certain, over time, as sunrise and sunset.

benleetDecember 22nd, 2012 at 12:53 pm

The topic is very important. Recently I discovered that the combined wage income of the lowest-earning 40% of workers, all earning less than $20,000 during 2011 (61 million of 151 million workers who filed W-2 forms with the Social Security Administration in 2011) amounted to 1.7% of all personal income — 40% earn in wages less than 2% of all income. "Collectively the lower earning 40% of workers [all with incomes below $20,000 a year] earn $198 billion which is 3.2% of all U.S. wage income which is also only 1.7% of all U.S. personal income, about. (Total income figure, $11.468 trillion, comes from the Joint Committee on Taxation, page 28, linked to above)" That's how I stated it at my blog, http://benL8.blogspot.com in the most recent essay there — and I provide links to the SSA report and the Joint Committee on Taxation report. My point — Fiscal policy can amount to hiring workers to bury bottles filled with cash and hiring other workers to dig them up. It's simply a transfer of wealth, and the Earned Income Tax Credit costs the US federal government about $60 billion a year, and essentially it's a wage bonus to couples who are raising children, akin to burying cash in bottles. The in-kind transfers such as Medicaid and Food Stamps, and many other programs such as mandatory paid vacations that most countries have instituted. The capitalist economy has inherently a mechanism to drive down wages, therefore decreasing income of workers in competition for jobs. In the US, with a per capita GDP above $47,000, and a per worker GDP above $109,000, and with a SPM poverty measure of 16% or over 50 million, and a wealth distribution where half of the households own 1.1% of all wealth — it seems to me that its a step towards human civility that collective action would support the lowest paid workers and those unable to find work. And finding a balance that doesn't destroy the business motivation of those who find their success creating enterprises. On one hand I sound like a Commie, and on the other I sound like a Christian. Or both. But the world economy has come to a new appreciation of the inadequacy of markets and the profit motive alone for determining the allocation of resources.

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