THE core principles of good fiscal management of a country find a perfect metaphor in our daily lives: save now for a rainy day in the future. We are smart enough to realise there will be good and bad times, which leads us to save for crises like unemployment, bad health, natural disasters etc.
We also know from the work of macroeconomists that countries are prone to experiencing boom-and-bust cycles. The prescription to deal with the issue of macroeconomic fluctuation is to implement ‘countercyclical fiscal policy’. That might sound complicated, but the concept is simple: when the economy expands, do not spend all the extra money. Instead, use the extra money to save for a time when the economy is not doing well.
The Covid-19 crisis is a perfect example to illustrate the importance of countercyclical fiscal policy. Before the crisis, several countries were experiencing significant economic growth. The sudden onset of the pandemic depressed economic output across the world. In such circumstances, countries that had the fiscal prowess to be able to spend more during this time will be able to bounce back better.
A key question, of course, is how that extra spending is allocated, which to a large extent depends on the type of crisis at play. If the decrease in output is driven by citizens not having enough money to buy commodities (eg due to unemployment), then targeted transfer of money, expansion of unemployment benefits or public works programmes might be viable options. To tackle the Covid-19 crisis, the US sent its citizens stimulus checks in keeping with a similar thought process. The recent stimulus package in the US raised serious concerns of inflationary pressure in the economy, but that is a separate debate. The point here is that countercyclical fiscal policy can be an important tool for governments in times of crises.
When the economy expands, do not spend all the extra money.
A related question is whether in practice, countries across the world implement such fiscal policy. Most high-income countries do, but several low- and middle-income countries do the exact opposite: spend more in good times and have less in bad times, which amplifies the impact of economic crises. Ironically, it is these low- and middle-income countries that need countercyclical fiscal policy the most, and yet do not implement it. Pakistan in the past has also implemented pro-cyclical fiscal policy.
So why do these countries struggle to implement countercyclical fiscal policy?
Several complex factors can explain why such policy implementation is often difficult in practice. For instance, low-income countries often lack access to international credit markets at low interest rates which makes it hard to borrow in times of crises. Imagine two countries going through the same economic crisis. Country X has access to debt at low interest rates while Country Y does not. Both countries at the same time know that they can borrow and spend money today in order to cushion the impact of the temporary economic downturn right now to ensure a rebound. However, only Country X will find it easy to do so.
Political economy factors remain one of the most significant constraints to the implementation of countercyclical fiscal policy. A simple illustration can explain this: imagine that you have been elected prime minister of Country X for five years. At this point in time, you do not know whether you will get the next term in office. Right now, times are good, economic growth is solid, and tax revenues are increasing. Hence the government has growing resources to be able to spend on a variety of projects. At this juncture, it might be tempting to spend all the additional money on ambitious projects, especially due to the uncertainty of the next political cycle. Three years into your term, you have already spent all the additional money earned during the good times, and an economic crisis arrives. The country now lacks resources to cushion the impact of the crisis.
In these circumstances, how can countries address such political economy constraints?
The answer is to strengthen government institutions that are responsible for the implementation of fiscal policy. Such institutional strengthening requires political consensus and can come in the form of fiscal deficit rules, giving ministries of finance the power to deviate from the incentives of the political cycle etc. While it is important to note that getting such political consensus can often be hard, the implementation of countercyclical fiscal policy stands to benefit the country in a significant manner, as evidence in other countries shows.
However challenging such institutional strengthening may be, it is important to remember that it is only with good fiscal management that a country can develop further and prosper.
The writer has a doctorate from the University of Oxford and is graduate of the Harvard Kennedy School of Government.
Published in Dawn, April 23rd, 2021