Creating More Fiscal Space in Good Times

One of the lessons from recent crisis, according to the Fund;

A key lesson from the crisis is the desirability of fiscal space to run larger fiscal deficits when needed. There is an analogy here between the need for more fiscal space and the need for more nominal interest rate room, argued earlier. Had governments had more room to cut interest rates and to adopt a more expansionary fiscal stance, they would have been better able to fight the crisis. Going forward, the required degree of fiscal adjustment (after the recovery is securely under way) will be formidable, in light of the need to reduce debt against the background of aging-related challenges in pensions and health care. Still, the lesson from the crisis is clearly that target debt levels should be lower than those observed before the crisis. The policy implications for the next decade or two are that, when cyclical conditions permit, major fiscal adjustment is necessary and, should economic growth recover rapidly, it should be used to reduce debt-to-GDP ratios substantially, rather than to finance expenditure increases or tax cuts.

The recipe to create additional fiscal space in the years ahead and to ensure that economic booms translate into improved fiscal positions rather than procyclical fiscal stimulus is not new, but it acquires greater relevance as a result of the crisis. Medium-term fiscal frameworks, credible commitments to reducing debt-to-GDP ratios, and fiscal rules (with escape clauses for recessions) can all help in this regard. Similarly, expenditure frameworks based on long-term revenue assessments help limit spending increases during booms. And eliminating explicit revenue earmarking for prespecified budget purposes would avoid automatic expenditure cuts when revenues fall. A further challenge, as governments come under greater pressure to display improved deficit and debt data and are tempted to provide support to ailing sectors through guarantees or off-budget operations, is to ensure that all public sector operations are transparently reflected in fiscal data and that well-designed budget processes reduce policymakers’ incentives to postpone needed adjustment.

Related;
The Case For Higher Inflation

I would add, however, that there’s another case for a higher inflation rate — an argument made most forcefully by Akerlof, Dickens, and Perry (pdf). It goes like this: even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis.