4  Fiscal stabilisation

4.1  Why is stabilisation policy important?

The purpose of a macroeconomic stabilisation policy is essentially to facilitate the adjustment of aggregate demand toward its equilibrium path when there are ‘shocks’ which cause a significant deviation. Aggregate supply, driven by demographic trends, labour and capital inputs, and technological progress, will at times evolve slower than aggregate demand. Aggregate demand, if forced away from the equilibrium level of aggregate supply, may experience large and prolonged deviations because of adjustment rigidities across the economy. Stabilisation policy is motivated by the argument that deviations of demand and output from equilibrium (which in principle would imply more volatile output growth) can have an adverse impact on long-term GDP. These adverse effects may arise from inflation, uncertainty, hysteresis effects, and costly sudden adjustments.

In New Zealand, as is common in most developed countries that are not part of a currency union, the primary responsibility for maintaining macroeconomic stability has been assigned to the central bank. Generally countries consider it appropriate to allow “automatic” fiscal stabilisers to operate to ameliorate the effects of demand or supply shocks. However, apart from this view, there is not a clear consensus amongst countries as to the appropriate role of fiscal policy in macroeconomic stabilisation.

4.2  Why do Central Banks have a primary role in macroeconomic stabilisation?

The “new consensus assignment” represents the view that active consideration of macroeconomic stability and particularly price stability should be solely the responsibility of the central bank, with the role of fiscal policy limited to the operation of automatic fiscal stabilisers. This view emerged after many countries experienced political business cycles which contributed to high inflation in the 1970s and 1980s. New Zealand was part of this experience. Wheeler (1991), for example, concluded that: “[E]xtensive use of fiscal policy in a demand management role did not produce sustainable growth and expansionary fiscal policy led to a rapid deterioration in the net debt position.”

International experience and emerging theoretical developments during the 1970s and 1980s spawned a reconsideration of the stabilisation role of fiscal policy. There were two main arguments against the active use of fiscal policy for macroeconomic stabilisation. One argument was based on the idea that fiscal policy could not affect aggregate demand owing to offsetting private sector behaviour. The other was based around the interaction of the incentives of politicians and expectations of private agents which lead to time-inconsistent discretionary fiscal and monetary policy. The second argument was particularly important in influencing thinking about the role and design of institutions and the idea that active or discretionary stabilisation policy needs to be undertaken by an entity independent of government.

4.2.1  Short-run impact of fiscal policy on demand

One reason why changes in fiscal policy may not impact on aggregate demand is that if private agents are forward-looking, their Ricardian behaviour will simply offset the impact of discretionary fiscal policy actions.[28] In response to an increase in government expenditures, households may increase saving in anticipation of the need to pay higher taxes in the future. Another reason why fiscal policy impulses may be impotent is that it may crowd out (or in) private sector activity via changes in interest rates and exchange rates.

Empirical and theoretical research tends to imply that fiscal policy does not fully crowd out private sector demand and can in fact impact on the business cycle. Solow (2005) and others argue that the weight of empirical evidence suggests that any Ricardian effects are well below the extent required for full crowding out of private demand. Theoretical models show that even with households displaying Ricardian features, the presence of labour market rigidities, in particular, can result in fiscal policy impacting on the business cycle (see Leith and Wren-Lewis, 2005).[29]

Recent vector autoregressive modelling also implies less than full crowding out. For example, Blanchard and Perotti (2002) and Perotti (2004) estimate the impact of government spending and net taxes for several developed economies.[30] A similar approach has been applied to the New Zealand data by Claus, Gill, Lee and McLellan (2006). They find that impulses to government spending and net taxation lead to short-run changes in domestic output, with government spending impulses having a larger impact than net taxation impulses. The expenditure and net taxation multipliers for New Zealand appear to be smaller than for the larger economies estimated by Blanchard and Perotti (2002) and Perotti (2004), suggesting more significant leakages or crowding out in a small open economy.[31] Thus, although fiscal policy actions may be offset to some degree, fiscal policy does impact on short-run demand. Furthermore, just as we found that the composition of fiscal policy matters for economic growth, the differences between the spending and net taxation multipliers revealed by these vector-autoregressive models illustrates the importance of taking into consideration changes in the composition of spending and taxation when assessing the impact of fiscal policy on the business cycle.[32]

4.2.2  Institutional issues

The second set of arguments about the effectiveness of fiscal policy stems from Kydland and Prescott (1977). They show that where a policy-maker’s objective is to maximise social welfare, they have an incentive ex-ante to prescribe a zero inflation policy (consistent with maintaining output at potential) but ex-post to generate surprise inflation and temporarily higher demand. As the policy-maker will not be able to commit credibly to the low inflation outcome ex-ante, agents expect the higher inflation outcome and hence this is what actually occurs. This results in an outcome inferior to one under zero inflation. The implication of this result is that while politicians care about social welfare, they will not have the right incentives to achieve sustained price stability.

These political economy ideas mean that politicians do not necessarily have the right incentives to effectively implement discretionary stabilisation policy, whether that is done by fiscal or monetary policy. One institutional-based solution to this problem is to make stabilisation policy, or price stability, the responsibility of an independent non-political entity and to ensure that contractually they are committed to that objective and that commitment is credible.

The choice has typically been to place responsibility for active consideration of macroeconomic stabilisation in the hands of an “independent” central bank through, for example, specification of an objective to maintain price stability whilst limiting the role of fiscal policy to the operation of the automatic fiscal stabilisers. In principle, this responsibility could have been assigned to an independent fiscal authority which, if provided with the scope to vary taxation, such as varying the rate of the Goods and Services Tax (GST), as proposed by Buiter (2006) for example, could have overcome the well known inside lags typically associated with fiscal decisions when those decisions are part of the legislative process. A number of other important considerations have influenced this choice of solution to the commitment problem including that fact that fiscal policy tends to have multiple objectives, tends to be subject to long decision and implementation (“inside”) lags, and that adjusting government spending and taxation rates may create uncertainty and may result in other government objectives not being fulfilled. This final concern in particular is one area in which the structural and stabilisation objectives of fiscal policy can potentially be in conflict.

The international experience with inflation targeting suggests that, in most circumstances, the combination of the central bank policy and automatic fiscal stabilisers will be capable of stabilising inflation (and hence output) in the face of exogenous shocks to the economy (Mishkin and Schmidt-Hebbel, 2001). However, as Allsopp and Vines (2005) state, that leaves the question of the role of fiscal policy within an inflation-targeting regime where the main macroeconomic concerns are assigned to monetary policy.