Friday, May 13, 2011

The role of fiscal policy

FISCAL policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy.

Coming out of Jamaica's recent budget presentations, and globally since the recession, some have asked the question, what is the role of fiscal policy? In fact, there has been a sharp division between those who support the Keynesian model and those who oppose it, particularly in the US, where the Republicans, Tea Party members in particular, have questioned Obama's use of fiscal spending in creating hundreds of jobs instead of allowing the free flow of the market.

The downside of fiscal spending is of course an increase in public debt, and the upside, it is argued, is the need to stabilise the economy, especially in a recession, to ensure that the decline is not so significant that it leads to poverty and possible social unrest. The results of this fiscal spending in the US have been (1) significant increases in the fiscal deficit and public debt; and (2) a reprieve for many households and a halt in the slide of the global economy.

Because history does not reveal its alternatives, one cannot with certainty argue what would happen if this fiscal spending did not take place. My own view is that the US economy would have declined further, like in the 1930s, thereby exacerbating the global crisis, and we would have seen much greater global suffering. In fact, we see what has happened in countries such as Greece, UK, and the Middle East, where the lack of fiscal spending has resulted in social unrest.

What is evident is that two similar forces cannot repel each other. So it is general consensus that in order to stop a recession then what is needed is an opposing force, such as private investments, job creation, or fiscal spending. In a declining economy, it seems logical to me that when private sector or consumer spending is in retreat, then one has to have fiscal spending in order to repel the force of recession. There is no doubt that economies cannot free-fall or rise forever, and will always adjust from strong growth or decline, as the survival instinct of people will always cause an adjustment. The challenge that governments face is how to smooth out these adjustments, so one does not have excessive overheating of an economy that causes inflation and rapid pull-back, or there is not prolonged decline.

This effort by governments is done through fiscal policy. It seems logical therefore that when an economy is growing fiscal policy should be mildly applied, and should be geared towards encouraging the continuation of an environment that prolongs the growth period and very importantly ensures that the wealth created is not concentrated in the hands of a few. This can be done through policies such as subsidised health and education, or tax incentives. When an economy is in growth mode the use of monetary policy is always more effective at smoothing out growth periods.

When an economy is in decline, however, monetary policy should take a back seat to fiscal policy. In other words, fiscal policy should be the counter-cyclical force to the recessionary environment. If this does not happen, then the economy will decline much further than if fiscal intervention is used to halt that decline, as business and consumer spending and investments will naturally be in retreat. This is because the natural behaviour of private individuals is to retreat when there is economic danger.

This has been the failing of the IMF programme and the previous budgets to this current one. This is also the reason why the economy went through 14 quarters of consecutive decline. The fact is that if an economy is in decline and all sectors retreat, including government (and government should be the savings account for the country), then obviously it will decline further unless some opposing force causes a sudden stop. In the Middle East, for example, that sudden stop was social unrest. In democracies like Jamaica, that sudden stop would have come after much prolonged suffering, when new injection comes in the form of aid, loans, or at a much slower pace, private investments and economic activity.

This is why the recent budget's direction, along with the PIOJ growth-inducement strategy, has been a significant positive change in the fortunes of the economy, as it shows that fiscal policy is now being used to create that enabling environment and inducement for economic growth. If this was done up to a year ago then we would have started to see growth already, as the global economic conditions had improved some time ago.

On the other hand, fiscal policy should not be used to facilitate welfare spending, which was the problem of the budget and economy prior to even the 2008 recession. This is why I have kept saying that Jamaica has always been a welfare state, and is the reason why the economy has struggled to grow. Our use of fiscal policy over the years has not allowed for the market to be efficient, and we have been no different from the archaic and inefficient economies created by the former socialist states.

It is for this reason that the recent budget presented by the government has been correctly welcomed by private sector groups, and understandably so. Government must now go further and eliminate all incentives and allow the entire private sector to play the game on a level playing field. If this is done then the more efficient companies will survive and the economy will grow. If we seek to protect inefficient companies then the economy will continue to experience stagnation or relatively slow growth.

Even while this change in the budget direction is welcome and necessary, including the upcoming tax measures, it is not sufficient. What will be needed is for a sustained move in this direction. We need to ensure that the government is held to account to continue moving fiscal policy in this direction, as it is the only way to get the market efficient and confident enough to maximise the value from private investments and spending, and ensure high levels of growth in the future.

What I am fearful of is that because of elections this trend might be reversed, just as we have in the past reversed positives in order to “run with it” for an election. If the government sticks to its commitment of preferring policies for economic growth over political expediency then we will get to the “promised land”. If, however, political expediency raises its ugly head again then we will be back on the track to nowhere.

It is therefore critical that when we are analysing the budget presentations, and policy proposals being put forward by the government, opposition, and other parties or independents going into election, we pay careful attention to the effect of the policy proposals and not be distracted by the hype and fever around election platform speeches. This is the role of those in civil society that have the capacity to understand the true effect of the policy proposals, and those persons should facilitate the education of the masses in this respect.

After the courtship leading up to the election, or even the wedding on election night, we have to live with the government for at least five years.


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