3 key questions for the future of macroeconomics

Following the Great Recession, public finance remains high on the global policy agenda. The expansionary monetary policy and quantitative easing of the major central banks, including the latecomer European Central Bank (ECB), have taken immediate collapse off the agenda and provided a lifeline to the world economy. Yet, without lowering debt and ensuring sustainable fiscal systems (including in a social sense) two risks emerge: either the system cracks, or at best, growth is too slow for structural changes required. And without reducing structural and long-term unemployment, the social consensus to address the fiscal problem cannot be created.

This is the politically charged context in which the World Economic Forum’s Global Agenda Council on Public Finance and Social Security is working in and is looking to find solutions. The council aims to provide answers on how to ensure sustainable public finances and adequate social security in a postrecession, low-growth economic environment that some regard, right or wrong, as the “new normal”.

This leads the work towards three critical questions focusing, respectively, on economic growth, public finance and social security. The starting point is that one cannot really discuss public finance without discussing growth – sustainable growth. By definition, economic activity measured in GDP is the denominator measuring the burden public expenditure and public debt create in an economy; thus, stronger and sustained GDP growth is essential for sustainable public finances and social security systems. These factors are intimately intertwined and affect each other, which is why they make up the key elements in the equation that defines economic and social success.

1. What kind of policy mix of monetary policy, fiscal policy and structural reforms can support stronger and more sustainable growth?

This is related to the recent debate on “secular stagnation”, where competing theories exist to explain the sclerotic performance of advanced economies. Many underline demand-side weaknesses and the constraints low inflation creates for monetary policy to keep activity close to the potential. Others refer to supply-side barriers, due to demographics and weakening impact of technological change on total factor productivity.

While Europe was the epicentre of the crises in 2010-2013 (and returned to the forefront in early 2015 with the victory of Syriza in Greece), it is important to take a global perspective. The emerging market economies, particularly China, India and Brazil, were able to grow throughout the financial crisis. However, recently China’s growth has slowed down, while Brazil and other emerging economies have been hit by declining raw material prices and exchange rate changes. And Russia’s economy is in a recession, partly due to the lower oil price and the country’s inability to modernize its economy, and partly due to the sanctions after it broke the rules of the European security order.

What can we learn from the policy choices of the emerging economies? What can we learn from the experience of the Asian financial crisis in the late 1990s, especially on how the majority of Asian countries put their fiscal houses in order and maintained solid growth rates during the recent crisis?

And what about the policy mix in the US and United Kingdom compared to the Eurozone? Did the US combination of the early financial repair and expansive monetary policy bring better results than the half-hearted monetary stimulus and delayed financial repair of the Eurozone? What lessons are there to be learned from comparing Europe and the United States in the current debate on sustainable growth?

Did the UK policy mix of expansive monetary policy and rigorous fiscal policy defy the critics and bring the economy back to growth better than they expected? A recent study of the IMF, relying on historical evidence from 91 adjustment cases in 1945-2012, concludes that “the size of fiscal adjustment is significantly associated with several important factors… fiscal adjustment tended to be larger when accompanied by an easing of monetary conditions”.

This issue may have played a key role in the story of European economic policy in the wake of the financial crisis. Would robust fiscal consolidation in the early years of the crisis, while necessary to restore confidence, have had much less negative impact on short-term growth in case the ECB had started its outright monetary transactions (OMT) and quantitative easing (QE) earlier than in the autumn of 2012?

The subsequent decisions of the ECB on OMT in AugustSeptember 2012 appear to be the turning point in the Eurozone crisis. While the years 2009-2012 were illustrated by stop-and-go policies due to the recurring threats to financial stability in many parts of the Eurozone, the recovery followed soon after the ECB’s decisive action.

But these elements were fundamentally intertwined. OMT promised monetary easing but required fiscal discipline. Moreover, if the ECB had not taken decisive action, Eurozone member states could not have slowed down the pace of fiscal consolidation, now focusing on the structural balance of public finances over the medium term, which has less negative impact on short-term growth.

Structural reforms in member states in product and labour markets have been equally important. Of course, the recovery in Europe is still relatively slow, although it has been recently strengthening despite external headwinds. Moreover, the Eurozone needs to pursue further reform of its governance and especially implement its recent reforms, such as the banking union.

2. What form should fiscal adjustment take?

The quality of fiscal adjustment has been a subject of long-standing academic and policy debate. For instance, during the Eurozone debt crisis the European Commission advocated, as a rule of thumb but based on empirical evidence of growth impact in the EU member states, to do two-thirds of fiscal consolidation by expenditure cuts and one-third by tax increases.

Meanwhile, the OECD [1] has suggested a method for choosing the instruments of consolidation so that they contribute to – or minimize trade-offs with – the goals of promoting near-term activity, long-term growth, income equality and global rebalancing. Simulations based on data from 31 countries point out that half of OECD countries can reduce excessive public debt mainly through moderate adjustments in instruments that have limited side-effects on growth, such as subsidies, pensions or property taxes. A smaller group of countries face more difficult choices and must do larger fiscal adjustment through expenditure cuts and tax increases while trying to minimize their negative side-effects. The OECD underlines the significance of structural reforms to counter and mitigate the negative effects on medium-term growth.

A recent study by Alesina et al [2] concludes that fiscal adjustments relying on expenditure cuts were much less costly in terms of output losses than those based on tax increases – “the difference between the two types of adjustment is very large”. The authors of the study also conclude that there is no sufficient evidence to claim that recent rounds of fiscal consolidation – when compared to those that took place before the crisis – would have been especially costly for the economy.

In reality, too often fiscal consolidation has been done only or largely through tax increases and cuts in capital expenditure, which tend to damage or even suffocate growth. Take France and Italy, which for many years suffered from the economically damaging combination of sluggish growth and high public debt. Instead of further tax increases, one should seek more growth-friendly ways of pursuing the necessary consolidation of public finances. This is what, for example, Ireland and Spain attempted by mostly relying on expenditure cuts; Ireland almost completely, and even Spain by two-thirds. Over the past years, while both countries have undergone a difficult adjustment and economic reforms, their exports are strong, economy is growing and employment is increasing. The Eurozone countries still in the need of economic reform, such as Finland, should do well to study the Irish and Spanish experiences very carefully.

3. How can the adequacy and sustainability of social protection systems be ensured while making them more supportive to growth?

There are several dimensions to this question. Virtually all countries face the challenge of how to design protections systems that maximize effectiveness given limited fiscal space. Another challenge, which applies particularly to advanced but increasingly also to developing countries, is adapting social protection to ageing societies. The objective of safeguarding social protection has important implications for the management of crises.

Designing effective protection systems is far from easy due to both technical and political economy reasons. In this regard, OECD and EU countries can learn from each other, but should also draw on the experiences of developing countries. Furthermore, in the pursuit of reform, countries should think outside the box. For instance, how can we better capitalize on information technology to enhance productivity, provide improved social and healthcare services and reduce the budgetary costs of their provision? Digital technology has revolutionized the service economy in the private sector, but the public sector is still clearly behind in using ICT and developing e-government and e-services. Cloud computing will only accelerate the trend. We need to be more innovative and also more effective in how we provide services.

With crisis-hit public finances and ageing populations, European societies in particular are currently facing a true stress test of their pension and social systems. In reaction, there is a wave of reforms going on: in 23 out of 28 EU member states, significant pension reforms have been decided in recent years. It may still not be enough, particularly in countries that have not yet linked the retirement age to life expectancy.

Finally, safeguarding social protection is also about avoiding deep and protracted spells of fiscal adjustment that cut into the bone of protection systems. This requires, first and foremost, responsible fiscal policies that build up buffers in normal times. But it also has to do with how crises are managed.

One implication is that cases of genuinely unsustainable debt problems have to be spotted and acted on earlier than is usually the case. This may call for better legal procedures to restructure sovereign debt, particularly in the Eurozone, where countries’ macroeconomic tools to deal with deep debt crises are more limited and the externalities of catastrophic debt crises may be larger than elsewhere.

Through the work of the Global Agenda Council on Public Finance and Social Security, we want to listen to fresh and innovative insights on these three intertwined sets of issues. We do not think there is a single policy prescription – a silver bullet – one can recommend to all countries around the globe. Our level of ambition is more modest but yet, perhaps paradoxically, more relevant: to provide analytically sound and politically realistic policy advice for reformers all over the world in order to underpin a sustained recovery, secure sound public finances and provide adequate social protection systems.

Read the report Global Fiscal Systems: From Crisis to Sustainability here.

References
1. OECD (2013), “How much scope for growth and equity-friendly fiscal con - solidation?, OECD Economics Department Policy Notes, No. 20 July 2013.
2. Alesina, Alberto, Omar Barbiero, Carlo Favero, Francesco Giavazzi and Matteo Paradisi, “Austerity in 2009-13”, Economic Policy, pp. 385-437, July 2015.