Pros and cons of various fiscal measures to stimulate the economy

Policy makers in the euro area and worldwide have intervened substantially to mitigate the economic and social disruptions of the present crisis and to stimulate recovery through various (conventional or unconventional) tools of monetary and fiscal policy. As regards fiscal policy, there is certainly a strong consensus that government rescue plans for the banking sector were needed to avoid a systemic crisis and restore confidence. A wealth of studies by the EC, IMF, OECD and also national bodies have supported this line of action, also in view of the experience of past banking crises , most notably in Japan, Korea and the Nordic countries. At the same time, fiscal measures to stimulate the economy in the short-run have been advocated by several voices within the economic profession, including international organizations and certain governments, and implemented in many countries of the euro area and worldwide. On this front, though, the whatever-it-takes approach that might be valid for financial rescue plans is usually not fully applicable for demand-oriented discretionary fiscal policy actions. First, the need for discretionary fiscal policy measures has to be assessed in conjunction with the counter-cyclical stimulus of fiscal policy built into tax and spending systems, i.e. automatic stabilization. Automatic stabilizers are those elements of fiscal policy that operate without any explicit government action, and thus are not affected by the implementation lags of discretionary policy. In this regard, a direct comparison of the “appropriate” discretionary stimulus in the EU and the US would be difficult, given the larger size of public sectors in the EU, with more progressive tax systems and more responsive social expenditure (in particular unemployment benefits). Second, the affordability of a fiscal stimulus plan depends primarily on an economy’s existing fiscal conditions or the degree of fiscal stress, either proxied by a high existing level of government debt, a rapid debt increase, or the extent of other long-term risks (such as aging costs). It is also likely to depend on the size of its external imbalances, particularly in the case of emerging economies. Hence, a country with a high level of foreign debt and/or confronting balance of payments problems is likely to have less room for fiscal expansion. Third, even in the event that indeed discretionary packages were to be implemented, some questions remain open to debate: How should they be designed to maximize the impact on the economy (fiscal multipliers)? How should measures be tailored, communicated and implemented in order to bolster consumers’ and firms’ confidence and help reduce aggregate uncertainty in the economy? In the event of the crisis lasting longer than envisaged, some additional questions could be posed: Would fi measures increase the probability of ending a recession in addition to mitigating the slump? Would they instead delay the recovery? This paper reviews the main pros and cons of discretionary fiscal packages trying to unveil what we can learn from the existing theoretical and empirical literature on the effects of discretionary fiscal policies, while at the same time drawing lessons for the actual packages recently put forward in some EU countries. The paper shows that it is extremely difficult to elaborate an unambiguous catalogue of measures defining an “optimal” fiscal package, though much attention has been paid in the policy debate to the requirement that measures taken should be “timely, targeted and temporary” (TTT). As regards the duration of measures, both temporary and more persistent measures may be defended depending on the proportion of liquidity-constrained agents in the economy, the reaction of long-term interest rates, and the expected duration of the adverse shocks hitting the economy. Targeting measures to some specific agents may be difficult in practice, given the uncertainty surrounding fiscal multipliers and the difficulties of designing well-targeted fiscal stimulus packages. Timeliness is the least controversial criterion in the current situation. Beyond the discussion on TTT, the literature suggests that the structure of a fiscal stimulus plan should take into account several factors, such as: (i) a proper balance between the expected short-term positive effects (mainly demand-side) with the costs that might be expected from the measures (mainly linked to the longer-term, and the supply side, but also to the shortterm via financial markets); (ii) the expected size of fiscal multipliers of various tools available; (iii) the degree of openness of the economy; (iv) the need to minimise distortions in market mechanisms and, in the case of EU countries, the compliance with single market rules.