International Think-Tank on Innovation and Competition
We need a Supply-based Fiscal Policy to face the Crisis!
March 20, 2009
In the last decades U.S. fiscal policy has been often used in a countercyclical way, leading to surpluses during booms and deficits during recessionary phases. The most recent examples were the tax cut adopted by Bush at the beginning of 2008 and the recovery plan adopted by Obama at the beginning of 2009, the largest American fiscal stimulus package of all times.
At the beginning of 2008 the widespread dispersion of credit risk and the unclear effects of the subprime crisis on the financial institutions reduced the incentives to invest and to demand (and obtain) credit. Commercial papers for the finance of corporate business (mainly firms' working capital) collapsed, leading to negative implications for business and job creation. The risks of further impact on the real economy and the real estate downturn were primary determinants of the Economic Stimulus Act signed by the Bush Administration. This $152 billion package introduced tax rebates to low- and middle-income U.S. taxpayers and tax incentives to stimulate investment, and it relaxed prudential controls over government-sponsored mortgage lenders with the purpose of keeping real estate finance flowing. Unfortunately, the margins to stimulate aggregate demand were quite limited. Given the high current account deficit of the U.S. and the weak Dollar of the time, the only chance for such a fiscal package to stimulate the economy was by gradually restoring the incentives to create new business. This did not happen because, as we have seen, the financial crisis got worse in the second half of 2008.
In front of such a dramatic scenario, the new President Barack Obama has launched a massive Recovery Plan of $ 787 million spread over 2009 to 2013, including mainly new public spending in education, health care, energy and infrastructures, an expansion of unemployment benefits and other social welfare provisions, and a tax cut. The American Recovery and Reinvestment Act is clearly inspired by a Keynesian philosophy and aimed at raising aggregate domestic demand at the cost of increasing the public deficit (and adopting some protectionist measures, as "Buy American" policies).
The problem is that given the already high propensity to consume of the American citizens, an additional stimulus to private consumption may be partially ineffective (moreover, rather than spending, most Americans will simply repay their debts). It is true that a plan of additional public spending may increase aggregate demand, but on one side the associated additional burden of public debt may crowd out part of this increase, and on the other side the marginal return of additional public spending may be quite low in terms of business creation (relative to the return of private spending). Finally, it takes time before a fiscal stimulus exerts its impact on the economy, especially when largely based on long run public investments.
The IMF estimates that the size of the U.S. stimulus directly active in 2009 should be at least 2 % of GDP: together with the rescue packages financed by the government, this expansionary fiscal policy is expected to increase the U.S. public deficit beyond 13 % of GDP in 2009, and to substantially increase American public debt toward 100 % of GDP for the years to come. In spite of this impressive and unprecedented deficit spending policy, we doubt that this will be a key factor to trigger a quick recovery. Even if the financial crisis has not eroded the physical capital or affected productivity, we believe that an expansion of the aggregate demand alone is not going to bring production back to its full-employment level in a short time (contrary to what both the Keynesian approach and the neoclassical approach may suggest). The reason is that the structure of the aggregate supply changes during a recession: when net business creation falls, firms restrict production, market structures become more concentrated, and mark ups tend to increase, then the supply side is not going to satisfy anymore the same full-employment level of production as before. It takes time and further investments to recover the earlier supply levels, and a simple demand-based fiscal policy cannot succeed alone: there is the need for a supply-based fiscal policy.
Under the current conditions, we believe that it would have been better to focus more on private investment, in particular enhancing the incentives to create new business. The U.S. have been consuming more than they were producing for more than a decade thanks to substantial imports: this imbalance needs to be cured by increasing production and exports (and not by decreasing imports with passive protectionist measures). Fiscal incentives for new enterprises, lower sales taxes and corporate taxes, export subsidies and R&D subsidies would have a better chance to promote the recovery in this moment.
As well known, continental Europe is characterized by a larger role of the government compared to the U.S., a richer (but sometimes less efficient) welfare state, stronger automatic stabilizers and more rigid labor markets with stronger unions. For this and other reasons, including differences in the political systems, the role of discretionary fiscal policy for stabilization purposes has been sometimes more limited. Moreover, the creation of the E.U. has set additional limits to the discretionality of national governments in adopting countercyclical fiscal policies (even if their rigid implementation has been avoided in the last years). The same E.U. has a limited spending capability and a limited role in coordinating fiscal policies, a role that would have been precious during the current crisis, as many observers have noticed.
The reaction of European governments to the recession has been weaker than in the U.S., with small stimulus packages in France and Italy (respectively 0.7 % and 0.2 % of GDP) and larger ones in Spain (1.1 %), United Kingdom (1.4 %) and Germany (1.5 %), but this does not take into account the role of automatic stabilizers, that are stronger in Europe than in the U.S.: therefore also the European fiscal expansion has been in line with traditional Keynesian prescriptions of a substantial deficit spending. Overall, public finances are going to largely deteriorate in 2009 and 2010, with public deficits expected well beyond the Maastricht limit of 3 % of GDP (up to 11 % in U.K. and 7 % in Spain, whose debt levels are however low compared to the Maastricht limit of 60 % of GDP). Most packages are mainly focused on supporting aggregate demand through new investments in domestic public infrastructures and support to domestic firms in bad conditions. Also in this case, limited attention has been given to the support of business creation.
The IMF has calculated that more than a trillion Dollars will be concretely invested in stimulus packages worldwide during 2009. To have an idea of the size of this effort, notice that 2008 worldwide nominal GDP is estimated in $ 78 trillion, of which 18.9 produced in the European Union, 14.3 in the United States, 4.8 in Japan, 4.2 in China, 1.7 in Russia and Brasil, 1.6 in Canada, 1.2 in India, 1.1 in Mexico and one trillion Dollars in Australia. This means that from a global perspective we are in front of a stimulus package of more than 1 % of world GDP, a percentage that may increase in the next months, possibly through international fiscal coordination. However, we believe that the large size of this unprecedented global stimulus is not a sufficient condition to trigger the recovery. What matters is the way this money will be spent, whether to push aggregate demand and public investments only (as now seems to be the case), or also to boost aggregate supply, business creation and trade.
The Endogenous Market Structures approach suggests exactly the necessity of an intervention on the supply side rather than on the demand side during recessions. According to the conventional wisdom, when the market activity declines one can stimulate the aggregate demand by artificially augmenting private and public spending, so as to force firms to produce more. This is the typical recipe given by (Keynesian) economists, but there is an alternative way to look at the problem and find solutions. Loosely speaking, market demand increases not only when available income is higher, but also when prices are lower (relative to the wages), that is when the mark ups are lower. In a world of constant mark ups (as the neoclassical one with perfect competition or the New-Keynesian one with monopolistic firms) a mark up reduction can never occur, but in a world with endogenous mark ups and entry this can happen whenever policy stimulates business creation. Any policy aimed at promoting entry and innovation is going to strengthen competition, reduce the mark ups and increase the real wages. This increases the aggregate supply and attracts demand. In front of the limited success of policies aimed at supporting aggregate demand to promote the recovery, we may start thinking seriously about policies aimed at supporting aggregate supply.
Fiscal policy can promote business creation acting either on expected profitability or on the fixed costs of entry. On the first element, one can act on corporate taxes, capital income taxation and other taxes whose incidence is born by the production side, including production and labor taxation. In particular, a heavy but temporary reduction of the indirect taxation on sales and direct taxation on profits could generate substantial positive effects on consumption and profits, and therefore on entry and production, and could induce significant reductions of the mark ups. Moreover, the impact on the economy of these tax cuts could be quite rapid, as opposed to the slow impact of increases in public spending (especially for infrastructures) and of cuts on general income taxes. On the second element of the supply side, the fixed costs of business creation, one can act on subsidies for business creation, on temporary reductions of regulatory constraints to new business activities, especially in key sectors (as the construction sector), on temporary tax exemptions for new SMEs, on R&D subsidies aimed at promoting new and innovative products and on export subsidies aimed at extending business activities abroad.
The need for a supply-based fiscal policy is by no means new. However, it has been largely neglected in macroeconomic theory, which has been often biased toward a demand-based fiscal policy (in the Keynesian tradition) or toward a neutral tax smoothing policy (in the neoclassical tradition). In front of the inability, or at least the slowness, of repeated plans of fiscal stimulus based on support to the aggregate demand, it could be useful to point out the opportunity of a larger, and maybe complementary, support to the aggregate supply.
