The IMF (International Monetary Fund) said in a paper published yesterday that
evidence on how advanced economies performed during and after the 2008–09 crisis
sheds new light on the fiscal risks these economies face and on the
effectiveness of using fiscal policy to stabilize the economy. The paper says
the Irish and Icelandic bank rescues raised public debt ratios over 40
This may be surprising news to some Irish people who believe Iceland got a free
lunch by being outside the euro.
paper [pdf] says that since 2008, macroeconomic and fiscal shocks have been
much larger than previously anticipated, which has caused debt-to-GDP ratios to
rise much faster than in prior downturns. On average, most of the surge in
debt-to-GDP ratios has been due to a shortfall in revenues as a byproduct of
sluggish growth in the aftermath of the financial crisis, rather than to direct
fiscal costs from bailing out banks.
However, in Ireland and Iceland, bank rescues drove an (unexpected) increase in
the debt ratio of 41 and 43 percentage points of GDP, respectively. These two
cases illustrate that even levels of debt well below what was considered prudent
before the crisis may not be “safe” in the face of large potential contingent
In the paper, staff looks at lessons from the recent crisis on the role of
fiscal policy in advanced economies. One of the key findings is that
countries should attempt to stabilise their public debt at lower levels than it
thought safe before the crisis.
The evidence shows that most advanced economies’ fiscal buffers were not big
enough to allow them to easily absorb the severe economic shocks they suffered,
with several countries experiencing sovereign debt crises as a result,” the
Our research has some interesting implications for policymakers, especially
on the use of fiscal policy as a tool to help stabilise the economy and on how
to deal with fiscal risks and high public debt,” said Bernardin Akitoby,
division chief in the IMF’s Fiscal Affairs Department. “For one, we see that
fiscal policy can have powerful short-run effects on the economy when economic
conditions resemble those that have prevailed in many advanced economies over
the last few years. We also see that advanced economies are exposed to
larger–than–expected shocks and need bigger fiscal buffers than we thought,”
said Akitoby, who led the team of economists from the Fiscal Affairs and
Fiscal policy to fight recessions
The paper reviews what economists have learned from the crisis about the
effectiveness of fiscal policy as a tool to stabilise the economy. Recent
evidence shows that some of the precrisis concerns about the effects of fiscal
policy and implementation issues related to discretionary fiscal stimulus were
The study finds that, under certain conditions, fiscal policy can have
powerful effects on the economy in the short run. Its effects are larger when
central banks are unable to reduce interest rates below zero, when the financial
sector is weak, or when the economy is producing at significantly below its
potential. New research has also raised doubts about the precrisis evidence that
fiscal contractions can have an expansionary effect on output.
The crisis also showed that economic stimulus measures need not take too long
to design and implement, as most advanced economies quickly enacted fiscal
stimulus efforts when the crisis erupted. Moreover, most temporary stimulus
measures were allowed to lapse or were rolled back after the initial phase of
the crisis had passed, countering the view that politicians are unwilling to
roll back stimulus measures once economies recover. Nevertheless, some of the
earlier concerns about whether discretionary stimulus measures will be timely
and reversible remain valid, especially during less severe recessions.
The findings also raise a critical question that has implications for the
Fund’s policy advice, according to Daniel Leigh, of the IMF’s Research
Department and co-author of the paper. “When we look at the use of fiscal
stimulus during the recent crisis and ask whether from now on governments should
use discretionary fiscal stimulus to fight recessions, the answer depends on
whether countries face circumstances in the future similar to those that led
governments to resort to discretionary tax cuts and spending increases—monetary
policy constrained by near-zero interest rates, for instance,” he said. “One
should not underestimate the likelihood of such conditions persisting or
Fiscal risks and debt sustainability
The paper also looks at the fiscal risks that advanced economies face and how
they can better prepare themselves to handle such risks in the future.
While a full-blown fiscal crisis in an advanced economy had generally been
considered a remote possibility before the crisis, events since 2008 have proven
otherwise. The evidence shows that most advanced economies’ fiscal buffers were
not big enough to allow them to easily absorb the severe economic shocks they
suffered, with several countries experiencing sovereign debt crises as a result.
One lesson the paper draws from these experiences is that governments should
take a “risk-based” approach to analyzing the sustainability of their public
debt—including risks from the financial sector and other fiscal vulnerabilities
specific to each country. In turn, the level of debt that might be considered
“safe” for each country will depend on the potential risks it faces. Generally
speaking, as they rebuild their buffers, prudent policymakers will want to aim
for a long-run debt level that is lower than what was considered reasonable
before the crisis.
Designing fiscal adjustments
Given the need to bring down public debt levels, the paper goes on to
examine the appropriate pace of fiscal tightening and what constitutes the best
revenue and expenditure mix for fiscal adjustment programs.
The IMF says economists are increasingly questioning the merits of always
doing the bulk of the fiscal adjustment upfront. Instead, how fast a country
should adjust depends on the state of the economy, the condition of public
finances, and the extent of financial market pressures.
The paper finds that most advanced economies today should adjust at a gradual
pace, within a credible medium-term plan, to limit the short-run impact of
fiscal tightening on growth. But excessively delaying the adjustment would be
unwise. The risk is that investors lose confidence in a government’s
willingness to put fiscal policy on a sound footing and begin to demand higher
interest rates, which, at high debt levels, can quickly lead to debt dynamics
that spiral out of control. Countries that are under pressure from financial
markets, or have lost market access, may have little choice but to “frontload”
their adjustments. Even for these countries though, there may be a “speed limit”
on the pace of adjustment, beyond which faster adjustment may be
While evidence on the best mix of adjustment measures is less clear cut, the
paper highlights the importance of taking into account equity considerations,
such as through better targeting of revenue and spending measures. The paper
also argues that raising taxes further when the tax burden is already high can
undermine a country’s potential growth, so countries with a relatively high tax
burden should focus on reducing spending. Countries with lower spending and
revenue levels would have more scope to boost revenues.
Fiscal institutions and transparency
The IMF says the crisis highlighted how important it is to have well
functioning fiscal institutions, including tools like medium-term budget
frameworks and fiscal rules, to ensure fiscal policy remains sustainable.
Medium-term budget frameworks and fiscal rules need to be credible, but the
IMF economists find that they also need to be sufficiently flexible to respond
to economic fluctuations. These tools can be designed to avoid overspending in
good economic times (by targeting the structural fiscal balance, for example),
and can also include “escape clauses” that allow countries more freedom to use
fiscal policy to support the economy when it is hit by large economic shocks.
Independent fiscal agencies can help to monitor adherence to the rules and make
sure greater flexibility is not abused.
Shortcomings in fiscal transparency have also been revealed by the crisis.
The paper concludes that further efforts are needed to improve the timeliness
and institutional coverage of fiscal reporting. Moreover, the paper says
countries should publish fiscal risk assessments to raise awareness about
potential sources of fiscal risks.