Chapter 10. The Great Divergence of Policies
- Ayhan Kose, and Marco Terrones
- Published Date:
- December 2015
[F]ollowing fiscal rules blindly… is a recipe for disappointment and political conflict. Fiscal stabilization that supports growth is welcome. Premature fiscal stabilization that undermines it is yet another folly.
Martin Wolf (2010c)
The (Great) Depression teaches us that tax cuts and increases in government spending can help heal a depressed economy, but only if they are used on a sufficiently large scale. It shows that when interest rates are at zero, monetary policy can still be effective, but it will likely take a regime shift. Policy needs to be dramatic enough that it changes people’s expectations about future prices and output growth.
Christina Romer (2013)
The basic notion that what we need is more stimulus (uncertainty-creating activism) is badly misplaced. We are displacing a very large amount of private investment with the aggregate stimulus.
Alan Greenspan (2013)
We should be looking for a better balance between monetary and other growth-promoting policies, including fiscal policy.
Ben S. Bernanke (2015e)
The 2009 global recession and the ensuing recovery have opened a new chapter in the long debate on the role of economic policies in stabilizing macroeconomic fluctuations and promoting growth. This debate became more passionate after some advanced economies withdrew large fiscal stimulus programs they implemented early in the crisis. How have fiscal and monetary policies evolved during global recessions and recoveries? Is the latest episode different from the previous ones?
The Debate on Policies and Cycles
Do expansionary fiscal and monetary policies help a country recover from a recession? Or do these policies hamper growth while sowing the seeds of the next crisis? There has been a robust debate on these questions since the 2007–09 global financial crisis, especially in advanced economies.
The latest global recovery has followed an unusual path compared with the three previous global recoveries.
Some economists argue that macroeconomic policies implemented during 2008–09 were instrumental in preventing another Great Depression and that the recovery would have been even weaker if the large monetary and fiscal stimulus had not been in place. If anything, they claim that the fiscal stimulus in the United States during 2008–09 was insufficient given the depth of the recession, and that it was a major mistake to withdraw the stimulus before a durable pickup in the real economy. Some commentators also suggest that the Federal Reserve should have been much more aggressive. Specifically, they argue that the Federal Reserve should have attempted to create moderate inflation for a short period to help accelerate both the private sector deleveraging process and the healing of housing market problems.1
Others bring a totally different perspective: they claim that the weak recovery in advanced economies is a reflection of poorly designed macroeconomic policies. These policies led to rising public debt and increased uncertainty and expanded the boundaries of regulatory measures that weigh on growth.2 As a result, the investment climate has deteriorated, undercutting new projects and hampering employment growth. Some have also been very critical of expansionary monetary policies implemented by the Federal Reserve.3
Understanding the Great Divergence
The latest global recovery has followed an unusual path compared with the three previous global recoveries. Specifically, the recovery following the Great Recession exhibited two types of divergence. The first is the sharp divergence of activity between advanced and emerging market economies, as documented in Chapter 6. In emerging market economies, this recovery has been the strongest. However, there is no question that the Great Recession has been followed by a “Not So Great Recovery” in advanced economies. In fact, the latest recovery has been the weakest so far for them, as discussed in earlier chapters.
There has been a divergence of activity between advanced and emerging market economies and a divergence of policies among advanced economies.
The second specific feature is the great divergence of monetary and fiscal policies, which became increasingly more pronounced during 2011–13. In particular, while the directions of fiscal and monetary policies were aligned in previous episodes, during the current recovery, these policies have marched in opposite directions, mainly in advanced economies.4
We now trace the evolution of fiscal and monetary policies during global recessions and recoveries. Since we focus on the cyclical properties of these policies, we use measures that provide a good reading of the cyclical policy stance. For fiscal policy, we consider the evolution of real primary government expenditures. For monetary policy, we examine the evolution of nominal short-term interest rates and the size of central bank assets.5
Fiscal Policy: Stimulus First, but Then Austerity
In response to the large output and employment losses associated with the Great Recession, a number of advanced and emerging market economies employed wide-ranging expansionary fiscal policy measures during 2008–09.6 These coordinated measures were instrumental in supporting aggregate global demand during the height of the global financial crisis. In some advanced economies, especially the United States, the fiscal stimulus that was introduced at the outset of the financial crisis was far larger than in previous recessions, reflecting the severity of the episode (Figure 10.1). In 2009, fiscal deficits went up to 9 percent of GDP in the advanced economies and to 4.5 percent of GDP in the emerging market economies.
Figure 10.1Government Expenditures: Country Groups
Note: Indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line shows the purchasing-power-parity-weighted average of the countries in the respective group. Previous episodes refer to those prior to 2009. Line breaks for 2009 denote the IMF’s World Economic Outlook forecasts.
However, as public debt and financing requirements in some advanced economies rose significantly, market pressures and political constraints forced some of these economies to withdraw fiscal support in 2010.7 The change in policies led to an unprecedented outcome and set quite different paths for government expenditures in advanced economies than during past recoveries, when policy was decisively expansionary with increases in real primary government expenditures. Specifically, expenditures fell during the first two years of the latest global recovery and are projected to continue to decline modestly or to stabilize gradually. The pattern of contractionary fiscal policy also holds across the major advanced economies, with the euro area—particularly, the periphery economies that have experienced severe sovereign debt problems—and the United Kingdom showing sharp departures from the typical paths of government expenditures observed in the past episodes (Figure 10.2).8
Figure 10.2Government Expenditures: Countries and Regions
Note: Lines for the aggregates show the purchasing-power-parity-weighted average of the countries in the respective group. Euro area core includes France and Germany. Euro area periphery includes Greece, Ireland, Italy, Portugal, and Spain. Line breaks for 2009 denote the IMF’s World Economic Outlook forecasts. Indexed to 100 in the year before global recession. Zero is the time of the global recession year. Previous episodes refer to those prior to 2009.
In contrast, in emerging market economies, the ongoing recovery has been accompanied by a more expansionary fiscal policy stance than during past episodes (Figure 10.1). This was possible because these economies had stronger fiscal positions this time around than in the past.
Monetary Policy: On Steroids
Monetary policy has played a key role in restoring financial sector health and mitigating the adverse effects of the Great Recession on the real economy. During the early stages of the global financial crisis, central banks in the major advanced economies sharply reduced interest rates, expanded their liquidity facilities, and started purchasing longer-term assets. To the extent that these measures were effective in improving the health of the financial sector, central bank actions also supported economic activity. Policy rates were brought virtually to zero, and a variety of unconventional monetary policy measures were introduced, including quantitative easing and “twisting” operations. These policies increased the size and altered the composition of central bank balance sheets. The combination of zero interest rates and the record expansion of central bank balance sheets is unprecedented.
Monetary policies in advanced economies were exceptionally accommodative during the latest recovery compared with earlier episodes (Figure 10.3). In particular, policy rates remained at the zero lower bound, and central bank balance sheets in the major advanced economies continued to expand compared with earlier episodes (Figure 10.4). In addition, central banks began or intensified the use of forward guidance to provide information about the future direction of monetary policy to have a larger impact on expectations. Monetary policy in emerging market economies was also more supportive of economic activity than in the past, including through the non- or partially sterilized purchases of international reserves.
Figure 10.3Interest Rates
Note: Aggregates are market weighted by GDP in U.S. dollars; observations are excluded for countries experiencing inflation 50 percent greater than in the previous year. Interest rates refer to policy rates or three- or four-month Treasury bill rates. Zero is the time of the global recession year. Previous episodes refer to those prior to 2009.
Figure 10.4Central Bank Assets
Note: Euro area aggregate is market weighted by GDP in U.S. dollars. Zero denotes the year of the global recession. Previous episodes refer to those prior to 2009.
The Great Divergence in policy Effectiveness
Interestingly, the great divergence of fiscal and monetary policies appears to have coincided with a great divergence in policy effectiveness as well. The zero lower bound on interest rates and the extent of financial disruption during the crisis limited the impact of expansionary monetary policies in advanced economies. At the same time, the same zero lower bound and the extent of slack in these economies tended to amplify the impact of contractionary fiscal policies. The divergence of policies and their effectiveness is thus one likely factor contributing to the sluggish nature of the recovery in advanced economies. We briefly summarize the sizable literature analyzing the roles of fiscal and monetary policies in a FOCUS box at the end of this chapter.
Why Did Policies Diverge?
The stance of fiscal policy in the advanced economies during the latest global recession remains controversial. One view is that the fiscal stimulus at the onset of the recession was too small to engineer a robust recovery and that its subsequent withdrawal only made matters worse. Another view is that there are good reasons to employ contractionary fiscal policies. Specifically, caution about fiscal stimulus and the pace of consolidation in the latest recession and recovery are likely explained by high ratios of public debt to GDP and large deficits.
Advanced economies entered the Great Recession with much higher levels of debt than in the past (Figure 10.5). In fact, public debt in these economies reached record-high levels (Figure 10.6), with debt-to-GDP ratios larger than 100 percent in Japan, the United States, and many countries in Europe. The high debt levels reflect a combination of factors, including expansionary fiscal policies in the run-up to the recession, financial sector support measures, and substantial revenue losses resulting from the severity of the Great Recession. In a number of countries, large debt levels also coincided with significant deficits. The deficit levels in some advanced economies have been large in part because of the collapse in revenues. Moreover, sovereign debt crises in some euro area periphery economies and challenges associated with market access put pressure on these economies to accelerate their fiscal consolidation plans.
Figure 10.5Public Debt: Country Groups (percent of GDP of year before global recession)
Note: Aggregates are market weighted by GDP in U.S. dollars and refer to public-debt-to-GDP ratios. Line breaks for the 2009 episode denote the IMF’s World Economic Outlook forecasts. Zero is the time of the global recession year. Previous episodes refer to those prior to 2009.
Figure 10.6Debt, Deficit, and Inflation: The Big Picture
Note: Panel A plots the overall deficit and net debt of advanced economies in 2012. Panel B plots the gross domestic debt as a percentage of GDP in advanced economies. Panel C shows the debt-to-GDP ratios of selected advanced economies in 2012. Panel D shows the market-weighted inflation for advanced and emerging market economies (observations are excluded for countries experiencing inflation greater than 50 percent). AUS: Australia, AUT: Austria, BEL: Belgium, CAN: Canada, CHE: Switzerland, DEU: Germany, DNK: Denmark, EST: Estonia, ESP: Spain, FIN: Finland, FRA: France, GBR: Great Britain, ICE: Iceland, IRL: Ireland, ISR: Israel, ITA: Italy, JPN: Japan, KOR: Korea, NZL: New Zealand, PRT: Portugal, SWE: Sweden, USA: United States of America.
At the same time, the aggressive stance of monetary policy was relatively easy to defend given historically low levels of inflation in advanced economies (Figure 10.6). There was indeed more room for monetary policy maneuvering because inflation rates were much lower in both advanced and emerging market economies at the beginning of the recession than in the past, and a number of central banks had undertaken a wide range of measures to avoid deflation (Figure 10.7).
Figure 10.7Inflation: Country Groups
Note: Aggregates are market weighted by GDP in U.S. dollars. Observations are excluded for countries experiencing inflation 50 percent greater than in the previous year. Line breaks for the 2009 recession denote the IMF’s World Economic Outlook forecasts (2013). Zero is the time of the global recession year. Previous episodes refer to those prior to 2009.
What Is the Right Mix of Policies?
The evidence presented in this chapter does not in itself permit an assessment of whether the different policy mix pursued in the wake of the 2009 global recession was appropriate. The response may have been reasonable given the respective room available for fiscal and monetary policies in advanced economies. In particular, some advanced economies needed to improve their fiscal balances to reduce high levels of public debt to help reduce market pressures and mitigate the potential negative effects that high public debt can have on growth.9
However, there are also obvious concerns. Even though monetary policy has been effective, policymakers had to resort to unconventional measures. Even with these measures, the zero bound on interest rates and the extent of financial disruption during the crisis have reduced the traction of monetary policy. Together with the extent of slack in these economies, this may have amplified the impact of contractionary fiscal policies. Policymakers therefore may run the risk of overburdening monetary policy.
Winds of Change
Both monetary and fiscal policies underwent a transition in major advanced economies starting in late 2013. For example, the Federal Reserve took its first steps to normalize its monetary policy by gradually reducing its bond purchases as activity picked up and labor markets started to improve in the United States.10 Although the Federal Reserve stopped its quantitative easing policy in 2014, both the European Central Bank and the Bank of Japan continued their expansionary policies at the time of writing this book. In addition, there were also some slight changes on the fiscal policy front in many advanced economies.11 In late 2013, policymakers in the United States reached a two-year budget deal that reduced automatic spending cuts. Some advanced economies have recently slowed down fiscal consolidation plans.
Support from Global Growth: Next in Line
Each factor we studied in Part III played a unique role in shaping the dynamics of the 2009 global recession and subsequent recovery. We return to this issue in the last chapter to provide a synthesis of their roles. Before that, however, we turn in the next chapter to a brief analysis of the relationship between global and national cycles.
Impact of Policies on Activity
Economists have vigorously debated the effectiveness of fiscal and monetary policies in mitigating macroeconomic fluctuations. Much of this debate centers on the impact of active, or discretionary, policies rather than policies that automatically respond to the business cycle.12 This section briefly surveys the literature analyzing various aspects of these policies in the context of the 2009 global recession.
The debate over the role of fiscal policy has been particularly intense, and estimates of how output responds to discretionary changes in policy vary substantially depending on the methodology employed, the sample of countries, and the period under investigation. The growing consensus, however, is that discretionary fiscal policy does have a positive impact on economic activity, although the magnitude varies over the phases of the business cycle.13 The debt crisis in some advanced economies, especially in the euro area, brought to the fore questions about the optimal composition and speed of fiscal consolidation in a context of depressed economic activity (Blanchard and Leigh 2013a). Recent evidence suggests that public investment can have an important effect on output when the economy is operating below full employment and monetary policy is accommodative (Abiad, Furceri, and Topalova 2015).
There has also been a debate about the effectiveness of discretionary monetary policy in influencing economic activity. Some argue that, in a world with flexible prices and rational agents, monetary policy cannot systematically affect economic activity.14
Others, however, claim that in a world with sticky prices, monetary policy can have a short-term impact on economic activity. This view has been very influential and led to the design of monetary policy rules, such as the Taylor rule, aimed at stabilizing activity and inflation. One problem with the empirical literature examining the effectiveness of monetary policy has been the lack of good proxies for discretionary monetary policies. This issue was partly addressed recently, and there is evidence that contractionary monetary policy shocks have a negative impact on output and inflation (Romer and Romer 2004).
The effectiveness of monetary and fiscal policies has also been debated in the context of a zero lower bound in interest rates. The standard Keynesian models imply that monetary policy becomes ineffective if the economy is in a liquidity trap—a situation in which the monetary authority is unable to further reduce already low interest rates because agents hoard all available cash as they expect deflation. Some studies suggest, however, that monetary policy could be effective even when the economy hits the zero lower bound if the policy measures can influence the expected path of monetary policy (Eggertsson and Woodford 2003). Werning (2012) argues that in such a circumstance the optimal nominal interest rate should be kept at zero longer than warranted by the current inflation rate. This would promote inflation and stimulate future output after the economy recovers from the trap. And this, in turn, could lead to an increase in consumption, ameliorating the negative output gap.15
Effectiveness of Unconventional Policies
Central banks facing the zero lower bound have expanded and changed the composition of their balance sheets in recent years. In some cases, central banks, through their lending operations, became active financial intermediaries.16
How effective have unconventional monetary policies been in the advanced economies? There is evidence that these measures have helped reduce long-term interest rates.17 For example, D’Amico and others (2012) report that the large-scale asset purchases conducted in the United States were instrumental in reducing long-term rates.18 The reduction in long-term rates helped boost equity prices, shoring up the process of economic recovery (Kiley 2013). However, these findings should be interpreted with caution given the uncertainty associated with the effects and the fact that it is still too soon to reach definitive conclusions (IMF 2013c).
Some argue that there are major risks associated with the unprecedented policy measures adopted by the central banks. In particular, there are questions about the impact of forward guidance, the implications of a prolonged period of low interest rates, financial stability risks stemming from unconventional policies, the credibility of central banks, and the best strategies to exit from these policies.19