The Fiscal Stimulus of 2009–2010: Trade Openness, Fiscal Space, and Exchange Rate Adjustment

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Previous articleNext article FreeThe Fiscal Stimulus of 2009–2010: Trade Openness, Fiscal Space, and Exchange Rate AdjustmentJoshua Aizenman and Yothin JinjarakJoshua AizenmanUCSC and NBER Search for more articles by this author and Yothin JinjarakSOAS, University of London Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThe global crisis of 2008–2009 focused attention on the role of fiscal policy at times of collapsing aggregate demand. Concerns about experiencing a reincarnation of the great depression induced the Organization for Economic Cooperation and Development (OECD) (high-income group) and emerging market countries to invoke extraordinary policies for extraordinary times. Countries adopted sizable fiscal stimuli, augmented by unprecedented monetary expansions supported by elastic swap lines between the Federal Reserve and the European Central Bank, and between the Fed and four emerging markets. The flight to quality and the shortage of dollar liquidity posed a special challenge for emerging markets, inducing them to supplement these policies with both large sales of foreign currencies at the height of the crisis and with sizable depreciations. Yet there has been a remarkable heterogeneity in the magnitudes of the fiscal stimuli, and of the exchange rate depreciation. The differential patterns of response are traced in Table 1, summarizing the fiscal stimulus/GDP and the depreciation rate in 32 countries, chosen by data availability. The first three columns overview the crisis related fiscal stimulus /GDP, 2009–2011, in OECD countries and emerging markets. The crisis led to a significant fiscal stimulus in the United States, Japan, and Germany, the magnitude of which increased from 2009 to 2010, reflecting various lags associated with fiscal policy. The fourth and the fifth columns report the massive “bailout” transfers to the banking system in the United States, Germany, and the United Kingdom that attempted to stabilize the financial panic. It is noteworthy that the size of the transfers to the financial system exceeded the direct fiscal stimuli in Germany and the United Kingdom. Similar trends, though in varying intensity, were observed in other OECD countries. Table 1 . Discretionary Fiscal Stimulus in 2009–2011 Crisis Fiscal Stimulus/GDP (%)Financial Sector Bailout (2009–2011, %GDP)Depreciation 2009–2010 (%)Country20092010(Expected) 2011PledgedNet CostCumulativeIndustrial countriesAustralia*2.71.71.3.0–.1–8.6 Canada*1.81.7.09.14.4–15.6 France*1.21.1.61.5.32.4 Germany*1.72.21.71.81.72.4 Japan*2.82.21.16.6.1–15.1 Norway1.2....7.1 Sweden1.4....9.4 Switzerland.6....–3.7 United Kingdom*1.6.0.011.96.119.0 United States*1.83.8.7.43.4–2.3Euro areaAustria1.5.3...2.4 Belgium1.0..4.34.12.4 Denmark1.93.1...1.3 Finland3.3....2.4 Greece*.–2.2.5.15.02.4 Ireland*.–3.5.3.028.72.4 Italy*.0.0.1.3.32.4 Netherlands1.4..14.46.02.4 Portugal*1.3–3.0...2.4 Spain*3.7..2.92.02.4Emerging marketsArgentina*4.71.4..0.23.9 Brazil*.7.6.0.8.–4.1 China*3.12.7..0.–2.6 Czech Republic1.6...0.11.9 India*.5.3.0.0.–5.6 Indonesia*1.4.0.2.0.–6.2 Mexico*1.51.0.0.0.13.5 Russia*4.55.34.77.7.22.2 Saudi Arabia*5.44.21.6.0.–2.3 South Africa*3.02.1.0.0.–11.4 South Korea*3.61.1.02.7.14.9Turkey*1.2.5.0.0.15.5Source. IMF Public Information Notice. *Fiscal Monitor (2010 November, 2011 January, April).Dots denote “Not applicable (no fiscal stimulus).”View Table Image: 1 | 2China, South Korea, and Russia provided front loaded fiscal stimulus at rates that were well above that observed in most OECD countries. Notable is the greater agility of the emerging markets’ response relative to that of the OECD countries, reflecting possibly faster policy response capacity of several emerging markets. The deeper safety net of the OECD (unemployment insurance, food stamps, social security, socialized medical care, etc.) provides automatic stabilizers that work to cushion the economy in addition to the crisis-related stimulus. Dolls, Fuest, and Peichl (2010) reported, We find that automatic stabilizers absorb 38 per cent of a proportional income shock in the EU, compared to 32 per cent in the U.S. In the case of an unemployment shock 47 percent of the shock are absorbed in the EU, compared to 34 per cent in the U.S. This cushioning of disposable income leads to a demand stabilization of up to 30 per cent in the EU and up to 20 per cent in the U.S. There is large heterogeneity within the EU. Automatic stabilizers in Eastern and Southern Europe are much lower than in Central and Northern European countries. (1) In contrast, emerging markets with a more limited safety net but with larger fiscal space tend to benefit by a more aggressive crisis-related fiscal stimulus, compensating partially for the absence of deeper social insurance.In this paper we study the response heterogeneity of countries during the crisis, indentifying the associations of economic structure (trade openness, fiscal capacity, etc.), the size of fiscal stimuli, and the exchange rate depreciations during the crisis. A useful theoretical anchor predicting such heterogeneity is the neo-Keynesian open economy, as predicted by the Meade’s (1951a, 1951b) framework. The textbook Meade model implies that at times of collapsing aggregate demand, economies that are more closed (or less open) should opt for a larger fiscal stimulus and should opt for larger fiscal stimuli, and should rely less on exchange rate depreciation (e.g., Blanchard 2008).1 Trade openness implies lower fiscal multipliers, as a share of the stimuli would “leak.” Trade openness may also increase the relative potency of exchange rate depreciation (relative to the fiscal stimulus) in mitigating the drop in demand for exportable goods, acting as a demand switching policy, whereby the improved competitiveness of a country increases the demand for net exports.2Fiscal policy is predicated on fiscal space and fiscal capacities. While the notion of fiscal space is fuzzy, it deals with the degree to which a country has the ability to fund a fiscal stimulus without a sizable increase in the real interest rate.3 The presumption is that public debt overhang (like higher public debt/GDP) reduces the ability to fund fiscal stimuli. Indeed, public debt/GDP has been frequently used by the literature and by policymakers as an important indicator for the soundness of policies, and as a measure of exposure to confidence crises. Reinhart and Rogoff (2010) warned that debt-to-GDP ratios over 90% are associated with lower growth.4 Similarly, the Maastricht criteria imposed thresholds of public debt/GDP below 60%, and fiscal deficit/GDP below 3% as criteria for joining the Euro. While these ratios are easy to track, we question the degree to which the normalization of public debt and fiscal deficit by the GDP is an efficient way of comparing and measuring fiscal capacities across countries and across time. A given ratio of the public debt/GDP, say 60%, is consistent with ample fiscal space in countries where the average tax collection is about or above 50% of the GDP, as is the case in France, Germany, and in most northern European countries. The same public debt ratio is associated with a limited fiscal space in countries where the average tax collection is about or below 25%, as has been the case in developing countries, emerging markets, and the South-Western Euro Area Peripheral (SWEAP) countries (Greece, Ireland, Italy, Portugal, and Spain). Instead of a normalization of public debt and fiscal deficit by the GDP, we contend that the tax revenue as a share of the GDP, averaged across the business cycle, provides a more efficient way of normalizing macro public finance data. Specifically, we point out that the tax collection/GDP, averaged to smooth for business cycle fluctuations, provides key information on the availability of the tax revenue to support fiscal policy. We define this ratio as the (de facto) tax base: short of a drastic change in tax rates and tax enforcement, the tax base provides a concise summary of the tax capability. The (de facto) tax base reflects both the ability and the willingness of a country to fund fiscal expenditure and transfers. Across countries, we find that the de facto tax base is more stable than public debt/GDP, and public debt/GDP normalized by the de facto tax base is more volatile than public debt/GDP (see the coefficient of variations reported at the bottom of Table 3). The public debt/GDP normalized by the de facto tax base is subject to greater cross country variation, and provides a more robust explanation for the scale of fiscal stimuli. Essentially, the public debt/GDP normalized by the de facto tax base measures the average tax years that it would take to “buy” the outstanding public debt, and provides a stock measure of public debt overhang. We view this measure as a more fundamental metric for fiscal space, as it links the public debt to the resources the public sector can mobilize without drastic change of the social contract. Consequently, we define the de facto fiscal space by the inverse of the average tax-years it would take to repay the public debt. It is noteworthy that if changing government expenditure and taxes are equally costly, our focus on de facto fiscal space would be questionable. For example, a high level of tax revenue could be interpreted as leaving little room to raise taxes, thus counting negatively toward fiscal space, unlike our interpretation. Our presumption is that the costs of changing the tax rates and their enforcement are high relative to the lower political costs of changing the public debt/GDP and the fiscal deficit/GDP. Thus, the tax base depends on structural factors that are harder to modify in the short run than adjusting government expenditure. This view is consistent with recent empirical literature finding that tax compliance and individuals’ willingness to pay taxes is affected by perceptions about the fairness of the tax structure. An individual taxpayer is influenced strongly by his perception of the behavior of other taxpayers (see Alm and Torgler 2006 and the references therein). If taxpayers perceive that their preferences are adequately represented and they are supplied with public goods, their identification with the state increases, and thus the willingness to pay taxes rises (Frey and Torgler 2007). In a follow-up work (Aizenman and Jinjarak 2011), we studied the relationship between the tax base and income inequality. We found that the Gini coefficient is negatively associated with the size of the tax base/GDP. This implies that changing taxes may be difficult in polarized countries. While all these factors are endogenous in the long run, they are mostly predetermined in the short run—the time that the policymaker determines in an unanticipated recession the implementation of fiscal stimuli. In a companion paper, we also study the usefulness of the de facto fiscal space measures by showing that they account better for sovereign spreads of countries than the more conventional public debt/GDP (Aizenman, Hutchison, and Jinjarak 2011).5We use the precrisis de facto fiscal space and structural controls to account for the patterns of fiscal stimuli and exchange rate adjustments during the crisis, validating the predictions of the Mundell-Fleming (MF) approach. We find that higher public debt/average tax base is associated with lower fiscal stimulus, and greater trade openness is robustly associated with a lower fiscal stimulus and a higher depreciation rate during the crisis. A one standard deviation increase of the public debt/average tax base lowers the size of the fiscal stimulus by about 2% of the GDP. A one standard deviation increase of trade openness increases the nominal depreciation during 2007–2009 by about 7 percentage points. Section II reviews the heterogeneity of the fiscal stimulus and of the exchange rate adjustment during the crisis window. We also investigate the patterns of de facto fiscal capacities in 123 countries, a sample chosen by data availability. Section III overviews selectively the literature on fiscal multipliers. Section IV applies the precrisis de facto fiscal space measures and other controls in a regression framework, accounting for the heterogeneity of the fiscal stimuli and of the exchange rate adjustments during the crisis. We also describe in this section the relevance of the de facto fiscal space in explaining sovereign spreads. Section V concludes. II. Assessment of the De Facto Fiscal Space Prior to the Crisis (2006)Insight regarding fiscal space is provided by tracing the precrisis 2006 public debt/GDP as a fraction of the precrisis average tax revenue/GDP during 2000–2005. To recall, the early 2000s were viewed as the continuation of the blissful “Great Moderation”—a period characterized by a drop in macroeconomic volatility and risk premium during the late 1990s and early 2000s.6 The precrisis average tax revenue/GDP measures the de facto tax capacity in years of relative tranquility. The top half of figure 1 reports the average tax-years needed to repay the public debt measure of 123 countries, subject to data availability in 2006. We obtain this measure by dividing the public debt/GDP in 2006 by the average tax revenue/GDP during 2000–2005. It shows the wide variation in the average tax-years needed to repay the public debt, from well below one year in Australia (indicating a high fiscal space), to about five years in Argentina, and above eight years in Bhutan (indicating a very low fiscal space). For most of the countries in our sample, the tax-years it would take to repay the public debt in 2006 were below five years. The bottom half of figure 1 reports another measure of fiscal tightness, focusing on flows instead of stocks (i.e., on fiscal deficits instead of public debt): the fiscal deficits/GDP in 2006 relative to the average tax revenue/GDP. Fig. 1. Fiscal space by country in 2006Notes: A, the fiscal space is calculated from public debt as of 2006 and 2000–2005 average tax/GDP; B, the fiscal space is calculated from fiscal balance as of 2006 and 2000–2005 average tax/GDP.View Large ImageDownload PowerPointFigure 1 is consistent with the notion that, even without increasing the tax base, a fair share of countries had significant fiscal space in 2006.7 The presumption is that a lower precrisis public debt/GDP relative to the precrisis tax base (i.e., higher de facto fiscal space) implies greater willingness to fund fiscal stimuli using the existing tax capacity. We apply these concepts in order to explain the cross-country variation in the fiscal stimulus during the aftermath of the global crisis.To track the adjustment of fiscal capacity across countries, the top half of figure 2 also reports our main fiscal space measure, the debt/GDP normalized by the average tax revenue/GDP, by country groups. Lower precrisis public debt/GDP, lower public debt/average tax base, and lower fiscal deficits relative to the average tax base imply greater fiscal capacity. The figure shows that fiscal space was weakest (highest levels of public debt/average tax base) in the low and middle-income countries. Although fiscal space measures are stronger in the SWEAP countries than in low- and middle-income countries, its debt/GDP ratio is higher. Generally, the SWEAP countries had more limited fiscal space during the tranquil period than other OECD countries—higher average public debt relative to the tax base, and a higher level of public debt to GDP. The lower panel of figure 2 provides similar measures of the fiscal deficit/GDP and fiscal deficit/tax base.Fig. 2. Average 2000–2006 fiscal space by regionNotes: A, the fiscal space is calculated from public debt as of 2006 and 2000–2005 average tax/GDP. SWEAP includes Greece, Ireland, Italy, Portugal, and Spain. B, the fiscal space is calculated from fiscal balance as of 2006 and 2000–2005 average tax/GDP.View Large ImageDownload PowerPointSome developments of the debt/tax base after 2006 are worth mentioning. High-income OECD and non-SWEAP Euro countries experienced an increase in the debt/tax base ratios of about 0.2 between 2006 and 2010. For SWEAP countries, the deterioration in fiscal circumstances was dramatic: the government debt of Ireland climbed from 25% of GDP in 2007 to 93% of GDP in 2010, while the government debt of Greece went from 95% to 130% of GDP. As a result, the public debt/average tax base ratio of Ireland jumped from 0.9 to 3.1, and that of Greece from 3.0 to 4.1, sharply diminishing their ability to conduct a discretionary fiscal policy. The large increase of the debt/tax base ratios in both countries captures a high degree of distress in their economic fundamentals, and the socialization of private banks’ liabilities in Ireland.Figure 3 provides the histograms of the average tax collection/GDP, public debt/GDP, public debt/GDP moralized by the average tax base, and the fiscal balance/average tax base of countries in the sample, based on public debt and the fiscal balance of 2006, and the average tax base of 2000–2005. The top left panel of the figure shows that the distribution of the tax base is tri-modal, approximately at 15, 25, and 35% of GDP. The top right panel suggests the average public debt of 50 to 60% of GDP. The bottom left panel shows that most of the public debt/average tax base observations are well below five, with the majority around two. The fiscal balance/average tax base in the bottom right panel indicates that this variable is approximately centered around zero.Fig. 3. Histograms of fiscal space 2006Note: The fiscal space is calculated from public debt and fiscal balance as of 2006 and 2000–2005 average tax/GDP.View Large ImageDownload PowerPointWe conduct first a descriptive analysis of the between-period stability for the key variables in Table 2. Specifically, we are interested in the relative stickiness of the average tax/GDP, public debt/GDP, and the public debt/average tax base between the 1993–1999 and the 2000–2006 periods, within each country in the sample. To have a representative comparison, we do this exercise for countries with at least three years of observations in both periods; this leaves us with 80 countries. We calculate the mean of these variables for each period, perform a t-test for each country, and report the significant (5%) results by country groups as well as the total. The total number of countries with a significant change of the average tax base/GDP over the decades is 66, slightly larger than the number of countries with a significant change of public debt/GDP, 58. A majority of countries sees a drop of average tax base/GDP (34 decline versus 29 increase), while the number of increases and decreases of the public debt/GDP are not as markedly different. In total, within country over the decade, the public debt/average tax base is more volatile than the public debt/GDP. Table 2 . Stability Test of Fiscal Space Lagged 5-yr Moving Avg. Tax/GDP (%)Public Debt/GDP (%)Public Debt/Tax (%)VariableChange: 1993–1999 vs. 2000–2006Change: 1993–1999 vs. 2000–2006Change: 1993–1999 vs. 2000–2006Country groupMean ChangeNo. of Countries t-testedNo. of Sig. IncreaseNo. of Sig. DecreaseMean ChangeNo. of Countries t-testedNo. of Sig. IncreaseNo. of Sig. DecreaseMean ChangeNo. of Countries t-testedNo. of Sig. IncreaseNo. of Sig. DecreaseA. Low income.1722–9.2712–62.7723B. Middle income.0361120–1.8361311–9.236189C. Other high income–.3704–1.1733–6.3732D. SWEAP.0541–1.3503–4.5505E. OECD–EURO.01696.1164101.01639F. EURO–SWEAP.1961–.2944–.9936All countries.1803234–.9802533–6.0802934Total no. of sig.665863Notes. The fiscal space is calculated from public debt as of 2006 and 2000–2005 average tax/GDP. The South-Western Euro Area Peripheral (SWEAP) includes Greece, Ireland, Italy, Portugal, and Spain.View Table ImageTable 3 . Mean and Dispersion of Fiscal Space Components Tax/GDP (%)PeriodCountriesMeanStandard DeviationMedian Coefficient of Variation1993–19998023.9811.1120.05.462000–20068023.9411.4821.37.481993–20068023.9611.2620.33.47 Public Debt/GDP (%)1993–19998060.7934.1955.38.562000–20068058.1832.8553.45.561993–20068059.4933.4555.16.56 Public Debt/Tax (%)1993–199980314.87234.05246.75.742000–200680302.76226.83233.37.751993–200680308.82229.83239.69.74Note. The fiscal space is calculated from public debt as of 2006 and 2000–2005 average tax/GDP.View Table ImageTable 3 provides the mean, standard deviation, median, and coefficient of variation for the same sample of 80 countries. The mean tax base is 24% of GDP, while the mean public debt is 60% of GDP. The mean public debt is 300% of the average tax base (3 tax years). The cross-country coefficient of variation confirms that the public debt/average tax base is subject to a sizably greater variation than the public debt/GDP (0.74 versus 0.56). III. Fiscal Multipliers in the Open Economy—Literature OverviewBefore turning to the regression analysis, we place the paper in the context of the evolving literature on fiscal policy at times of distress. Textbook analysis of fiscal stimulus in a closed economy suggests that an increase in government expenditure on goods and services in a closed economy would deliver a greater beneficial stimulus if It would not crowd out private sector activities. It would not increase interest rates, and would not raise concerns about the future fiscal and monetary stability of the country.It would target projects with high social marginal product, and would take place before the onset of the recovery, contributing thereby toward shortening the recession. Fiscal stimulus in an open economy involves further considerations, as the incipient appreciation under a flexible exchange rate with capital mobility may induce crowding out of export demand. Under a fixed exchange rate with capital mobility, fiscal policy tends to involve positive spillover effects, inducing higher demand for imports and incipient monetary expansion. These considerations imply that, at times of global recession, a properly coordinated fiscal expansion would mitigate most exchange rate appreciation concerns, inducing mutually reinforcing positive spillover effects that increase the ultimate stimulus. Similar considerations apply to a fiscal stimulus in the form of transfer income.Fiscal skeptics worry frequently about crowding out, and the growing costs of a prolonged fiscal stimulus. As there is no way to conduct controlled experiments regarding these key issues, views about the size of fiscal multipliers diverge. Conventional wisdom has been that developing countries have limited fiscal space—their limited tax capacity and possibly sizable debt overhang imply that a fiscal stimulus may backfire by increasing the interest rate and the risk premium facing the country, inducing down the road an Argentinean vintage 2000–2002 type funding crisis. The deeper taxation capacity of the OECD countries suggests wider fiscal space. However, the growing debt overhang associated with lucrative safety nets, unfunded liabilities, aging population, and demographic transitions may crowd out most of the fiscal space of OECD countries. These considerations suggest that, while a short-term fiscal stimulus following a deep crisis would be supported by most OECD countries, a prolonged fiscal stimulus would induce a vigorous debate that probably would constrain policymakers. These dynamics have been played out vividly in the years following the 2008–2009 global crisis.The literature pointed out the difficulty in calculating the net fiscal multipliers, as there is no simple way to control the “fiscal experiment.” The estimates of the fiscal multipliers vary, depending on the methodology, period, and controls applied (see Barro and Redlick 2009; Christiano, Eichenbaum, and Rebelo 2009). More recent work found that the size of the multiplier varies considerably over the business cycle: between 0 and 0.5 in expansions and between 1 and 1.5 in recessions (see Auerbach and Gorodnichenko 2010). Applying the history of the United States during World War II, Gordon and Kerrn (2010) inferred that when capacity constraints are absent across the economy, the fiscal multiplier is about 1.8, higher than most previous estimates. While useful, these studies focused mostly on the experience of the United States and the OECD countries. Ilzetzki, Mendoza,