By Fredrik Andersson and Lars Jonung. Professors at Lund University.
"A number of economists are proposing a more expansionary fiscal
policy based on debt financing, most noteworthy Olivier Blanchard in his
presidential address at the ASSA meeting 2019 (Blanchard (2019). The
central argument is that the currently low yields on government bonds,
lower than economic growth, make it attractive to borrow and spend. It
is almost a free lunch. Growing inequality, wage stagnation, austerity
fatigue, and rising populism are other arguments for increased
government spending. Secular stagnation and a monetary policy that has
hit the zero lower bound serve as additional reasons for fiscal policy
assuming a greater role in stabilising the economy (e.g. Furman and
Summers 2019).
Expansionary fiscal policy relying on debt financing beyond the
traditional scope of business cycle stabilisation would be a radical
break from the present fiscal philosophy that emphasises fiscal
stability through deficit and debt rules, independent fiscal policy
councils, and other types of institutional restrictions on the
discretionary powers of governments.
Based on the Swedish experience, we propose an alternative
perspective on the present debate. For about a quarter of a century,
Sweden has followed strict fiscal rules, cut government debt almost in
half, relied on automatic stabilisers and monetary policy to stabilise
the economy over the business cycle, and used supply side reforms to
produce long-term economic growth. The outcome has been a relatively
solid growth performance and sustainable public finances. In fact, the
present public debate concerns how far debt consolidation should be
carried.
In our view, the present push for fiscal activism is short-sighted.1 It
has been tried before and failed. Discretionary fiscal policy has a
role to play in stabilising the economy but only during major economic
crises such as a deep financial crisis. Instead, governments should
stabilise the debt-ratio in normal times at a level that allows for
ample borrowing and spending if and only if the economy suffers from a
major crisis. Slow-growing economies should be subject to supply-side
reforms enhancing productivity. Sweden offers a clear example that this
is a way forward, counter to recent proposals of deficit financed fiscal
expansionism.
The Swedish case of restrictive fiscal policy
Fiscal policy in Sweden during the last half of a century can be
divided into two periods. The first period is marked by spending
policies inspired by the then prevailing Keynesian view aimed at
reviving a stagnating economy. Government debt increased sharply in the
1970s and 1980s. However, economic activity did not improve on average.
The second period starts with the deep financial crisis in the early
1990s with budget deficits in excess of 10% of GDP. The crisis
contributed to a complete re-thinking concerning economic policies. A
fiscal framework was established to reduce debt. Monetary policy was
given the prime role in stabilising the economy in the short run. A
number of supply-side measures were introduced to improve economic
growth.
The new policy approach was successful (Andersson and Jonung 2019).
As demonstrated by Figure 1, Swedish debt went from being one of the
highest in Europe to one of the lowest from 1998 to 2017. The debt ratio
was 40% in 2017. In the same period, in the euro area the debt ratio
increased to 87% and in France to almost 100%. In Germany the debt ratio
is 64%, almost back at the same level as in 1995. The debt ratio in the
US is presently close to 100% of GDP and on a rising trend.
Figure 1 The debt-to-GDP ratio for Sweden, the euro area, Germany, France, and the US, 1995-2017
Presently, the Swedish fiscal framework consists of five main
components: an expenditure ceiling, a surplus target for the entire
public sector, a fiscal policy council, a debt anchor, and a balanced
budget requirement for local governments. The surplus target is set at
one third of a percent of GDP over the business cycle for the general
government (central and local government, and the public pension
system). Debt is anchored at 35% of GDP +/- 5 percentage points.2
Has the Swedish fiscal consolidation hurt economic growth? Our answer
is no. Swedish growth performance has been similar or even better
compared to the US and Germany, as seen from Figure 2, which displays
the Swedish growth rate in relation to growth in the US and Germany.
Growth was lower in Sweden in the early 1990s during the Swedish
financial crisis of 1991-93. From 1995 to 1999 government spending was
cut drastically combined with increased taxation, bringing about a fall
in the debt ratio. Swedish growth was slightly below US growth during
this period but above German growth. From 1998 and onwards, Swedish
growth has been in line with US growth on average (0.3 percentage points
higher), and well above German growth on average (1 percentage point on
average) despite the surplus target and a falling government debt ratio
during this period. In terms of labour productivity (i.e. GDP per hour
worked), Swedish growth has been as high as US growth and half a
percentage point higher per year on average compared to Germany.
Long-run growth depends primarily on supply-side factors – not on
demand factors. It is true that the flexible exchange rate for the
Swedish currency introduced in 1992 has fostered the recovery from the
crisis of the early 1990s. However, Swedish growth has benefitted mostly
from supply-side reforms. Tax rates have been lowered, the labour
market partially de-regulated, the public sector has been made more
efficient by ending public monopolies and allowing private companies to
run public services. Here the Swedish example runs contrary to the
Japanese approach focused on deficit-spending and a rapidly increasing
debt ratio. Despite ballooning debt, Japanese growth has been modest
even when we take the declining population into account. Japanese labour
productivity growth since the late 1990s is well below growth in both
Sweden and the US.
Figure 2 Swedish GDP growth in relation to growth in the US and Germany, 1991-2017
Establishing a long-run fiscal target
The financial crisis of 2008/09 as well as all major crises in recent
decades demonstrate that stable public finances are necessary for a
proper fiscal response to the crisis-induced decline in economic
activity. Consequently, we suggest an insurance approach for the design
of the rules for public finances: fiscal policy should be framed today
so it can successfully deal with the worst-case scenario of a deep
financial crisis. As such, a crisis should be met with debt-financed
expansionary fiscal measures, fiscal space before the next deep
crisis should be sufficiently large to allow the government to respond
to a future crisis with aggressive fiscal measures without running into
restrictions of financing and sharply rising interest rates.
In other words, a low prudent level of national debt before
the next crisis gives rise to sufficient fiscal space. In addition, the
size of the fiscal multipliers is most likely larger when government
debt is lower and trust in the government’s ability to sustain the debt
is high. Government actions to limit the real economic effects of crises
thus become more effective and the output cost of crises is reduced.3
Entering a crisis with a low public debt is also important for
maintaining political stability. A low debt level before the crisis
reduces the likelihood that the government has to implement major
austerity measures during or immediately after a crisis with potentially
devastating political effects of the type seen from recent events in
Southern Europe.
We acknowledge that having too low a debt ratio can
potentially also be harmful. Sustaining large and consistent budget
surpluses risks ignoring vital public investments. High taxation in
relation to spending would drain resources from the private sector.
Intergenerational considerations imply that future generations should
pay for public investments made by present generations. Completely
eliminating government debt, and thus government bonds, would make it
more difficult for private sector investors to price and handle risk.
Eradicating all government bonds removes the infrastructure necessary
for issuing debt and servicing debt in case of a nation-wide emergency
such as a deep financial crisis. Consequently, there are several
benefits of having a public debt relative to no debt at all. The
challenge is to find the precautionary or prudent level of debt for the
long run – neither too low and nor too high.
For Sweden, based on the historical record, we find a long-run fiscal
target or debt anchor at a debt-to-GDP ratio of 25% of GDP to be
appropriate. We establish this level in two steps.4 First, we
estimate at which debt level the cost of servicing public debt begins
to rise sharply. The premium on Swedish bond yields compared to German
yields are closely related to the Swedish debt ratio. The premium is
close to zero for debt ratios of 40% and below. They increase linearly
thereafter. Sweden’s ability to service its debt becomes problematic
when the debt ratio hits 70%, according to the record from the mid-1980s
and onwards.
Second, starting from this level, we deduct the average fiscal cost
of financial crises since the 1980s as estimated by Laeven and Valencia
(2018). From these calculations, we conclude that Sweden should be able
to increase its debt ratio during a future major financial crisis by up
to 40 percentage points without facing rapidly increasing debt financing
costs.
From these calculations, we recommend a debt anchor of 25% +/- 5
percentage points for Sweden, thus lower than the present one set at 35%
+/- 5 percentage points.5 The appropriate debt level may be
different for other countries, although not radically different for
small open economies. Ideally, the actual debt ratio should be at the
lower end of the corridor during booms to allow debt to rise during
recessions, reflecting the workings of the automatic stabilizers and
limited discretionary short-run fiscal measures.
Our design of the fiscal policy rule based on a long-term debt target
resembles inflation targeting. Monetary policy is set to achieve the
numerical target over the medium to long run while allowing temporary
variations over the business cycle. The same approach should be used
when designing fiscal policy. For democratic reasons, fiscal policy
cannot be run by a fully independent body, similar to an independent
central bank as fiscal policy is inherently a very political issue – it
deals primarily with distributional issues. However, a fiscal framework
and an independent fiscal policy council would be a constructive way of
facilitating the workings of a democratic society, by fostering long-run
consideration in the fiscal policy process.
Conclusions
We derive three central lessons from the Swedish fiscal record.
First, a well-designed fiscal framework facilitates an orderly fiscal
consolidation over the long run. Second, fiscal consolidation as
reflected in a falling debt-to-GDP ratio does not arrest growth. Third,
fiscal consolidation should be halted at a proper or prudent long-run
level. Debt should not be too high, nor too low. In our view, the fiscal
target should be set such that it provides ample fiscal space to meet
the fiscal demands created by a future deep financial crisis. We
calculate this level for Sweden from data from recent financial crises.
In a similar way, long-run fiscal targets can be calculated for other
countries.
In our view, once country-specific fiscal targets have been
constructed with a tolerance band to account for fluctuations in debt
over the business cycle, a country with a debt-to-GDP ratio larger than
its debt anchor should set a surplus target over the business cycle to
reduce the debt level. In a similar way, a country with a smaller
debt-to-GDP than the debt anchor has fiscal space to increase its debt
until it reaches the fiscal target. The adoption of a debt anchor should
be combined with a fiscal framework, preferably monitored by an
independent fiscal policy council.
From the Swedish fiscal experience, we conclude that recent proposals
for debt-financed fiscal policy will not deliver a promising future.
Instead, the Swedish case from the last 25 years shows that stable
public finances combined with supply-side policies is the recipe for
economic stability and growth. Fiscal policy should follow strict rules
that prevent unsustainable deficit spending during normal times while
ensuring a sufficiently low public debt ratio and thus sufficient fiscal
space to meet a future economic crisis. Presently, neither the US, nor
Europe is stuck in a major economic crisis that warrants rising budget
deficits.
To sum up, we should not listen to the Sirens’ song of fiscal
activism. Interest rates will not remain low forever. Political populism
should not be met by fiscal populism. The role of the economics
profession is to bring out the connection between the short and the long
run, a connection that is easy to forget in times of populism, low
yields, and quick fixes."
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