Fiscal policy and financial crises--what are the actual effects of fiscal policy?

• Author: Midthjell, Nina Larsson

1. Introduction

   When the financial crisis reached its most critical stage after the collapse of Lehman Brothers in September 2008, the authorities in Norway and other countries faced a rare challenge. Money and capital markets seized up because banks were no longer willing to lend money to one another, and central banks worldwide had to make substantial interest rate cuts and provide almost unlimited liquidity to banks to keep them afloat. The collapse of financial markets had global macroeconomic consequences, in the form of rising unemployment and negative growth prospects. It became clear early on that monetary and liquidity policy instruments would be insufficient; there was also a need for fiscal policy measures. Fiscal stimulus packages were implemented in an effort to counteract the negative impact on economic activity. The stimulus packages were all designed following brief planning phases, involved huge sums and were primarily intended to take effect within two years.

   Despite the numerous studies on the effects of fiscal policy on the real economy, considerable uncertainty prevails. A good understanding of the effect of fiscal policy is important, both for private economic agents who make consumption and investment decisions and for the conduct of monetary policy. Accordingly, it is of interest to assess the effects of fiscal policy instruments--combined with monetary and liquidity policy instruments--as financial-crisis related measures.

   This article provides an overview of the different factors that contribute to uncertainty about the effects of fiscal policy, and analyses the available hypotheses and results in the light of the financial crisis. The rest of this article is organised as follows: Section 2 provides a short summary of the impact of the financial crisis on different countries and presents the fiscal stimulus packages of selected countries. Section 3 analyses the uncertainty relating to the scale of the effect of fiscal policy on the real economy, while Section 4 discusses whether the effect is influenced by the choice of fiscal policy instrument. Section 5 explores the importance of expectations and credible communication of future fiscal policy decisions. Section 6 analyses different situations that have a bearing on fiscal leeway. Section 7 provides conclusions.

2. Background

   The financial crisis brought with it negative economic growth, high unemployment and weak macroeconomic prospects. In addition, the many bank collapses during the financial crisis generated great uncertainty, and greatly reduced the willingness of banks in most countries to provide loans. The US and the UK were directly affected by the crisis at an early stage, owing to their banks' considerable exposure to home mortgage finance products and a sharp drop in house prices. With large-scale investment in the housing market and rapidly rising house prices ahead of the crisis, Ireland and Spain were also directly hit by the crisis when the housing bubble burst. Falling house prices and stricter credit standards led to a fall in private consumption and investment. Countries like Greece, Italy, Spain, Ireland and Portugal were affected by the crisis not least because they found it difficult, to varying degrees, to service high public debt, while their fiscal leeway was limited by large budget deficits. (2) Germany was hit hard, both directly through the banking sector--due to substantial exposure to home mortgage finance products, including through the partly state-owned Landesbanken banking group--and indirectly through falling exports due to lower global demand. As major producers of capital goods, Sweden and Finland were severely, albeit indirectly, affected through lower demand for exports.

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   Norway was less affected than other countries. Few Norwegians felt the crisis personally as unemployment showed only a small decline and economic growth slowed moderately. Norway managed to avoid serious problems in the banking sector and a marked fall in domestic demand primarily because Norwegian banks were not exposed to risky residential mortgage-backed securities (as in the case of US banks in particular), as well as a combination of low interest rates, a generous compensation scheme for laid-off workers in exposed sectors like the export and construction materials sectors, a high proportion of public-sector employees whose jobs were not at risk and a solid banking system.

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   Chart 1 provides a summary of growth in selected countries. In the US, the decline in economic growth was considerably smaller than in many other countries, probably because monetary and fiscal policy measures were implemented early on, thus curbing the fall in economic growth (see discussion below). The pronounced decline in growth in countries like Sweden, Finland and Germany indicate that lower export activity as a result of reduced global demand was of considerable importance. (3) The increase in global demand, particularly from Asia, has led to favourable growth prospects for export economies, particularly in 2010. In the US and the UK, positive economic growth is expected from 2010 onwards. In Norway, the slowdown in economic growth was considerably less pronounced than in most advanced countries, and growth is expected to show a steady increase ahead.

   Unemployment rose in most countries as a result of the crisis (see Chart 2). The sharp rise in Spain primarily reflects unemployment in the construction industry caused by the bursting of the housing bubble. In Germany, by contrast, unemployment did not increase as in other countries, but has been on the decline since June 2009. Spain and Germany thus show very different unemployment trends despite pursuing relatively similar labour market policies (see Darius et al. 2010). One reason for this may be that Spain was hit more directly by the crisis and suffered a permanent shock when the housing bubble burst. Germany was exposed to a temporary shock in the export sector. The fact that the German export sector is capital-intensive may also have dampened the rise in unemployment. Another factor may be that the German export sector expected a short-term slowdown in economic growth, and therefore considered the costs of dismissing experienced, skilful workers to exceed the costs of retaining them during the recession (referred to as labour hoarding).

   The rise in unemployment appears to be more persistent than the decline in economic growth. This is not necessarily unexpected. Reinhart and Rogoff (2009) argue that recessions following banking and financial crises can be expected to feature an increase in unemployment of up to 7 per cent, and that the increase will last for more than four years on average. At the same time, a fall of up to 9 per cent in GDP can be expected, although it will only last for two years on average. These figures are fairly consistent with the economic developments observed during the financial crisis (see Charts 1 and 2). Economic growth in the US, the UK and all of the euro area countries fell, on average, by 5.6 per cent from peak to trough, while unemployment rose by 5 per cent on average during the financial crisis. (4) Except in Greece, positive economic growth is expected in 2010, following one to two years of recession, while unemployment is expected to remain high.

   Uncertainty remains about how large a proportion of the positive growth prospects can be accounted for by the fiscal stimulus packages, but a highly expansionary monetary and fiscal policy has undoubtedly helped to make the macroeconomic picture more positive already this year. In autumn 2008, policy makers stated that they would do everything in their power to prevent the economy from collapsing. This may also have had a positive effect on the expectations of private economic agents, and helped to ensure that the decline in consumption and investment has been smaller than might otherwise have been the case (see, among others, Auerbach and Gale 2009).

   The fiscal stimulus packages were comprehensive and generous (see Table 1). The first US stimulus package, Economic Stimulus Act of2008, is said to have had a positive effect on consumption and investment during the first quarter of 2008, and helped to soften the downturn in economic growth in the US (see, among others, Sahm, Shapiro and Slemrod 2009). In contrast to Germany and the UK, therefore, the US introduced a fiscal stimulus package at an early point in time, which may have helped to ensure that the decline in growth was less steep in the US. However, the size of the stimulus package (USD 152 billion), added to the budget deficit that was already too large. Moreover, the effect of the stimulus package may have been brief. The effect of the next US stimulus package, American Recovery and Reinvestment Act (ARRA), is a matter of debate among economists (see box 2.1).

   Box 2.1 Disputed effect of the American Recovery and Reinvestment Act The US stimulus package in the American Recovery and Reinvestment Act (ARRA) originally amounted to USD 787 billion (see Table 1). The stimulus package comprises one-third tax cuts and two-thirds increased public expenditure. The effect of the crisis package on the real economy and whether it was appropriate to employ such a powerful economic stimulus as an instrument in addressing the financial crisis is a subject of debate among economists. The estimated effect of the package was presented in Bernstein and Romer (2009), on behalf of the authorities. ARRA was supposed to contribute to economic growth of 3.6 per cent in 2010, and to reducing unemployment by 2 per cent, from 10 to 8 per cent. A reduction of 2 per cent would imply a drop in the number of unemployed of 3.6 million. Before the package was implemented, the Congressional Budget Office (CBO) claimed that ARRA would stimulate the economy in the short term, but that the...