Some Lessons for Fiscal Policy from the Financial Crisis

In this new paper, I argue that the current crisis calls for a re-assessment of the optimal conduct of macroeconomic policies during non-crisis normal times. In particular, the risk and costs of crises can be mitigated by macroeconomic policies that lean against the wind in the face of cyclical, sectoral and external shocks. In this paper, I discuss the challenges involved in deploying fiscal policy in pursuit of a broad definition of macroeconomic stabilisation. The main policy conclusion is that pro-stabilisation fiscal policies are likely to be more effective if fiscal policy is determined under a formal fiscal framework that combines a set of fiscal rules and a substantive role for an independent fiscal policy council.  (Forthcoming in Nordic Economic Policy Review.)

9 replies on “Some Lessons for Fiscal Policy from the Financial Crisis”

@ Philip Lane,

Can I make one comment about policy. One of the surprising things I realised, when I began to think about the subject of ghost estates in Ireland, was that our design guidelines and building standards for development improved dramatically throughout the building boom period in Ireland in the 2000’s.

What I have realised now, to my own astonishment, is the negative effect that has on the cycle. In other words, it incentivises the creation of very large players in the supply chain for building stock delivery. I.e. Players who are big enough and capable of drowning the market with supply, as long as they can take advantage of the older design guidelines and building standards.

By that I mean, for instance, no. of apartment units per staircore decreased over the course of the building boom, which meant newer development was less profitable. Newer building regulations implied higher costs of construction as the building boom progressed. Therefore, it paid to over-produce units while the old rules were still in enforcement. That incentivised the creation of gigantic players in the industry, who could rush through big production output at a time.

I have realised to my own astonishment, that local authorities should be increasing the standards in design and construction right now in the recession period. That is very counter intuitive. What I argue should have, to employ counter-cyclical planning policy, is that standards should not be improved during a building boom. If anything, standards should be relaxed slightly – and that could be done, if one sets the standards high enough, during the trough of the construction cycle.

What I am saying is counter intuitive I know – but the introduction of higher standards during the boom felt really good – because it felt we were sticking it to the big players. But in reality, we were only encouraging the big players, to become even bigger – and thereby, greatly increase the chances of those big players collapsing and taking down the entire house of cards. BOH.

We will spend the entirety of the next upcycle adjusting our PSC to normality under the watchful gaze of the good Prof and his boy Elderidge.

Thats around €150-€200bn to be taken out by adjustment. I would not worry overly about public policy, based as it will be on the leavings from that table and the dictats of Brussels and Frankfurt.

We can come back to this paper in the middle of the next downcycle or in the middle of the downcycle after the downcycle after a possible double dip this year.

Your case appears rock-solid, but are you receiving any indication that the Powers That Be are taking a blind bit of notice? Unfortunately, it appears that it will be a long time time before any Irish government will have the luxury of contemplating a counter-cyclical fiscal stance. And the recent experience of the Office for Bugetary Responsibility in the UK offere a salutary warning.

I found your assertion that the deflationary impact of nominal wage reductions is self-correcting in a monetary union a bit puzzling (p15). I can see how lower nominal labour costs should reduce nominal costs in supply chains leading to lower final prices for goods and services which should boost demand, but, with any hint of money illusion, lower nominal wages might prevent this increased demand from emerging. Is there not a case for stripping out inefficiencies and rents in the state, semi-state and private sheltered sectors as well to boost the real buying power of the nominally reduced wages?

If one anayses our current economic situation through the lens of a self-serving bias one will end up with an apparently apppropriate solution – but this solution may be quite inappropriate. Some inconveniences are ignored.

Presumably the economic/financial model being analysed is our Permagrowth one – which is the real villian. Permagrowth requires increasing amounts of credit creation in order to keep ‘growing’. Therein lies the problem: debt. More growth more debt. More debt more growth. And on and on it goes – Ponzi to the inevitable collapse.

The present Tower of Ponzi has been propped up, but it will inevitably collapse – possibly in SloMo. What levels of surplus would be required to pay down the current (national, corporate and personal) debt levels (absent any further credit creation) – in say, 10 years? Would the absence of any further credit creation prevent the required growth?

We do need reform – both political and financial. But our current bunch of legislators will not lead the way. Political horizon is about 1 mm away. Economic-financial 7000 m! Relatively speaking!

Like the man said. ” We need a new model”.

B Peter

@ Brian Woods

The system is up and running and as with any Ponzi Scheme those at the top get rich and powerful, making it impossible to dismantle. That power being used in varying degrees to tip the rules in favour of those that are winning.

You’re bang on regarding the incompatiblity of the political and financial horizons, I’d imagine such a change would take something like a world war to be considered.

@ Philip Lane,

I happened to be looking at Constantin Gurdgiev’s blog entry this evening on the unemployment figures, and my eye wandered over to some of his featured visitor comments. One link to a Harvard Business School web page, revealed an interesting study done in the US. It is like, a lot to do with stimulus and pro-cyclical economic policy is counter intuitive. BOH.

Q: Perhaps the most intriguing finding, at least for me, was the degree and consistency to which federal spending at the state level seemed to be connected with a decrease in corporate spending and employment. Did you suspect this was the case when you started the study?

A: We began by examining how the average firm in a chairman’s state was impacted by his ascension. The idea was that this would provide a lower bound on the benefits from being politically connected. It was an enormous surprise, at least to us, to learn that the average firm in the chairman’s state did not benefit at all from the increase in spending. Indeed, the firms significantly cut physical and R&D spending, reduce employment, and experience lower sales.

The results show up throughout the past 40 years, in large and small states, in large and small firms, and are most pronounced in geographically concentrated firms and within the industries that are the target of the spending.

@Philip Lane
Well done for continuing to highlight the need for fiscal rules and an independent fiscal policy council. Hopefully there are far sighted politicians who realise that the recent catastrophic failure demands check and balances on government actions as much as it does on bankers’.

If we were to have rules then they’d probably boil down to “Neither a borrower nor a lender be – except maybe in moderation”, or “Save for a rainy day”.

Unfortunately when our starting point is huge borrowing, huge debt and huge unfunded pension liabilities the discussion may be somewhat artificial.

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