Fiscal policy responses to crises the social impacts

Counting the social impact

Lost in a lot of the discussion on fiscal-policy procyclicality has been the social impact of contractionary fiscal policy during recessions – things such as for example:

  • the poverty rate,
  • income inequality,
  • the unemployment rate, and
  • domestic conflict.

In a recently available research paper we look at the way the fiscal-policy responses to GDP crises have affected social indicators such as for example those in the above list (Vegh and Vuletin 2014). We find that contractionary fiscal policy during crises has tended to worsen social indicators both in Latin America and, recently, in the Eurozone, which calls into question recent claims on ‘expansionary fiscal austerity.’

Crises and fiscal-policy responses in Latin America

Because of this study, our sample of Latin American countries is comprised what’s commonly known as LAC-7 (Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela) and Uruguay. The combined GDP of the eight economies take into account a lot more than 90% of the region’s GDP. Due primarily to our dependence on quarterly data, the sample period for every country differs but, apart from Venezuela, all samples begin in 1980 or earlier.
Analyzing policy responses to ‘crises’ naturally requires defining a ‘crisis.’ For simplicity, we focus exclusively on the behavior of real GDP and define an emergency as from the quarter where real GDP falls below the preceding four-quarter moving average and ending in the quarter where real GDP reaches the pre-crisis level.

Using this definition we identify 34 crises inside our eight Latin American countries (see Table 1).

Table 1 . GDP crises: Basic stylised facts

  • Argentina spends the most amount of time in crisis (number of quarters in crisis over final number of quarters) and Colombia minimal.
  • The common duration of crises is 11 quarters and the common intensity of crises (measured as the fall in the amount of GDP right away of the crisis to the trough) is 8.6%.

If we break our sample in to the periods before and after 1998, how have the frequency, duration, and intensity of crises in Latin America changed? 1

Figure 1, Panel A demonstrates normally, GDP crises have grown to be less frequent in the post-1998 period and even less so in the newest period within the global financial crisis. The common duration and intensity of crises in Latin American in addition has fallen in the post-1998 period (Figure 1, Panel B).

Figure 1 . Latin America: Average frequency, duration, and intensity of GDP crises

We argue that the low frequency of crises could be simply because of ‘luck;’ Latin American crises are mainly explained by external factors (commodity prices, global liquidity, etc.). The decrease in the severe nature and duration of crises, we argue, is explained by a shift, typically, from procyclical to countercyclical policy choices. 2 Basically, we find significant statistical evidence showing that more countercyclical fiscal/monetary policy leads to shorter and less severe GDP crises.

Behavior of social indicators

Figure 2 talks about the behavior of four social indicators (poverty rate, ratio of richest 10% to poorest 10%, unemployment rate, and domestic conflict) through the GDP crises episodes identified in Table 1.

Figure 2 . Latin America: Changes in social indicators during GDP crises

  • Panel A implies that, typically, the poverty rate has increased significantly less during GDP crises in the post-1998 period than before.

Actually, it barely changed through the global financial meltdown. The same is actually true of the ratio of the richest 10% to the poorest 10% (with the ratio actually falling through the global financial meltdown).

  • Panel B shows an identical story for the unemployment rate and domestic conflict.

In the post-1998 period, the unemployment rate has truly gone up by two percentage points, in comparison to 3.6 percentage points before 1998. Because the global financial meltdown, it has increased by even less. Domestic conflict in addition has risen by less in the post-1998 period and has actually fallen because the global financial meltdown.

In a nutshell, social indicators during crises in Latin America look better after 1998. The question then becomes whether we are able to relate this improved behavior in social indicators during crises to a change in the fiscal-policy response to crises.

The role of fiscal policy

We capture the cyclical stance of fiscal policy by looking at the correlation between your cyclical the different parts of GDP and government spending. A positive (negative) correlation indicates procyclical (countercyclical) fiscal policy. Figure 3 shows scatter plots of the cyclicality of fiscal policy against each one of the four social indicators. In each case, we visit a positive and statistically significant relationship, which we interpret as saying that the more procyclical is fiscal policy, the worse may be the performance in the corresponding indicator.

Figure 3 . Latin America: Cyclicality of fiscal policy and changes in social indicators during GDP crises

Correlation and causality

Correlations usually do not imply causation. The business enterprise cycle itself, for example, may lead to both better social indicators and more government spending. To consider this, we construct a ‘fiscal readiness index’ which is actually an index of initial conditions that captures the ‘fiscal space’ that countries may have before an emergency to conduct countercyclical fiscal policy through the crisis. We then utilize this index to instrument for fiscal policy. With this, we find that causality runs from countercyclical fiscal policy to smaller deterioration in social indicators.

Eurozone: The old Latin America?

Do our findings for Latin America have relevance to the Eurozone Crisis? By the last quarter of 2013, the GDP crisis is ongoing for six of the tencountries inside our sample, with Ireland and Italy showing the longest crises. 3 The common intensity of the existing Eurozone crises is 8.3%, which roughly coincides with the common intensity of crises in Latin America (8.6% from Table 1). The GDP crisis has been the most intense in Greece (with a fall in GDP of 24% from peak to trough) and Ireland (with 10%).

How did fiscal policy respond to the crisis? Figure 4 shows our way of measuring fiscal-policy cyclicality (i.e., the correlation between your cyclical the different parts of government spending and real GDP during crises) for every of the ten countries. 4

Figure 4 . Eurozone: Country cyclicality of fiscal policy during last GDP crisis

Note : Domestic conflict can be an index that comprises variables such as for example assassinations, strikes, guerrilla warfare, government crises, purges, riots, revolutions, and anti-government demonstrations.

  • Four EZ countries inside our sample had procyclical responses: Greece, Ireland, Italy, and Portugal.
  • The other six countries pursued countercyclical fiscal policy, with Germany at the forefront.

With regard to social indicators, Figure 5, Panel A, shows the changes in the unemployment rate inside our ten Eurozone countries. Needlessly to say, the biggest changes occurred in Greece, Ireland, Italy, Portugal, and Spain. That is largely in keeping with Panel B, which plots the changes in domestic conflict, with Greece and Spain clearly standing out.

Figure 5 . Eurozone: Changes in social indicators during last GDP crisis

Note : Vertical axis may be the correlation between your cyclical the different parts of government spending and GDP (during last GDP crisis).

The question now arises: Has procyclical fiscal policy resulted in a far more pronounced deterioration in social indicators through the crises? Figure 6 has an response to this question by plotting the index of fiscal cyclicality against the change in unemployment (Panel A) and the change in domestic conflict (Panel B). The partnership is positive and statistically significant. That is consistent with the theory a procyclical fiscal response in the Eurozone has resulted in a far more pronounced deterioration in social indicators. 5

Figure 6 . Eurozone: Cyclicality of fiscal policy and changes in social indicators during last GDP crisis

Policy conclusions

Even though many Latin American countries have ‘graduated’ from procyclical to countercyclical fiscal responses to GDP crises, many industrial economies (like Greece, Ireland, Italy, and Portugal) followed contractionary fiscal policies in the aftermath of the Global Crisis. Our work finds that countercyclical fiscal policies have a tendency to soften the undesirable ramifications of GDP crises on social indicators such as for example poverty, income inequality, unemployment, and domestic conflict. Alternatively, austerity policies have a tendency to worsen most of these social indicators.

This evidence supports the desirability of pursuing expansionary fiscal policies in times of distress – which might mean postponing for quite a while needed structural fiscal adjustment – instead of getting into fiscal austerity amid a recession.

References

Blanchard, Olivier and Daniel Leigh (2013), “Growth forecast errors and fiscal multipliers”, IMF Working Paper No. 13/1.

Calderón, César and Klaus Schmidt-Hebbel (2008), "Business cycles and fiscal policies: The role of institutions and financial markets", Central Bank of Chile Working Paper No. 481.

Frankel, Jeffrey (2012), “Chile’s countercyclical triumph”, Foreign Policy.

Frankel, Jeffrey, Carlos A Vegh and Guillermo Vuletin (2013), "On graduation from fiscal procyclicality”, Journal of Development Economics, Vol. 100, pp. 32-47.

Vegh, Carlos A and Guillermo Vuletin (2013a), “Tax-policy procyclicality”, VoxEU.org, 1 October.

Vegh, Carlos A and Guillermo Vuletin (2013b), “The street to redemption: Policy response to crises in Latin America”, paper presented at the IMF’s conference honoring Stanley Fischer (November).

Vegh, Carlos A and Guillermo Vuletin (2014), “Social implications of fiscal policy responses to crises”, NBER Working Paper No. 19828. [A shorter version entitled “Fiscal policy responses during crises in Latin America and Europe: Implications for the G-20” is forthcoming in Kemal Derviş and Peter Drysdale (eds.), The G-20 at Five (Brookings Institution Press, 2014).]

1 While admittedly arbitrary, the decision of 1998 seems an all natural one because (i) through formal regressions we are able to detect a shift in fiscal policy in the late 1990s; (ii) 1998 is a year without the crises and thus offers a clean break; and (iii) we had a need to have a reasonably long window for the ‘after’ period.

2 We have to remember that this average behavior masks a substantial amount of heterogeneity across countries, with Chile, Brazil, Colombia, Mexico, and Peru showing countercyclical fiscal and/or monetary policy responses to crises in the post-1998 period. Not coincidentally, they are countries that tend to be hailed in the financial press for having considerably improved their macroeconomic management through the years, with Chile being clearly the star of the ‘graduation’ movement (see Frankel 2012). At the other side of the spectrum, countries like Argentina, Venezuela, and, more surprisingly, Uruguay continue being procyclical in the post-1998 period.

3 The sample comprises Austria, Belgium, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, and Spain.

4 To ensure we’ve the same sample period for our different indicators, the sample because of this plot and the ones that follow ends with the first quarter of 2013.

5 For Latin America, we constructed a fiscal readiness index and verified that the causality runs from fiscal policy to the social indicators.

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