G20 Could Shed More Light, Less Heat

Authors: Uri Dadush, Vera Eidelman, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace

The G20 was right to concentrate on short-term macroeconomic policy during its meeting in Toronto last week, but the leaders should have acknowledged the similarities in their counter-cyclical policies, rather than painting a world sharply divided between Keynesians clamoring for continued stimulus and anti-Keynesians favoring austerity. Almost all member countries have enacted policy to stimulate their economies through 2010 and measures across the G20 will become only gradually more restrictive thereafter. At the same time, leaders should recognize that different circumstances among nations, such as those of the weaker and stronger Euro area members, require different approaches. In addition, the G20’s attention should now turn toward policies that promote long-term growth and assure budget balance in the long run.

 The over-hyped debate over stimulus policies

While much of the debate has centered around stimulus versus austerity, the increase in deficits during the crisis was largely the result of recession-induced, automatic declines in tax revenues and increases in expenditures—not changes in discretionary stimulus spending. Fiscal balances in the G20 countries deteriorated from -0.9 percent of GDP in 2007 to -7.5 percent in 2009, but crisis-related discretionary spending accounted for only 2 percent of GDP in 2009 on average, according to the IMF. In other words, 2009 discretionary spending was responsible for less than 1/4 of the deterioration from 2007 to 2009¹.

Similarly, successful enactment of the big deficit reductions promised at the Toronto summit will depend much more on the continuation of recovery than on discretionary fiscal policy. The proposed budgets of the United States and the UK exemplify this point. While the UK has announced heavier cuts in spending, the U.S. deficit is projected to decline more rapidly based on faster projected growth.

As is often the case, however, the effects of government action are being exaggerated to score political points: opponents of stimulus imply that the increase in deficits was solely the result of stimulus while incumbents are preparing to take credit for the deficit reduction that will occur automatically if recovery is sustained.

Similarities in short-term macroeconomic policy

The posturing was clear at the G20 summit in Toronto, where several countries, including Germany, the UK, China, and Canada, supported more aggressive budget consolidation, while others, primarily the United States, argued that those countries that can afford it—including the United States—should delay austerity until the global recovery strengthens. Yet, for a start, stimulus spending was never as high as claimed. Though the G20 pledged a fiscal expansion of $5 trillion—8.6 percent of 2009 global GDP—in 2009 and 2010, the IMF estimates that crisis-related discretionary spending will reach “only” $2 trillion by the end of 2010.

Furthermore, the budget proposals going forward are also not as different, nor are the deficit reductions as draconian, as the rhetoric suggested. Basing their plans on the assumption that the moderate-speed recovery will continue, the advanced G20 countries aim to rein in deficits at a similar pace. The UK, Germany, Italy, and France had all embraced halving deficits by 2013 prior to the Toronto meeting—but so had the United States, the most ardent proponent of delaying fiscal consolidation².

Japan claimed that its chronically slow growth makes the G20 target nearly impossible, and was exempted from it. Yet the new prime minister, Naoto Kan, has declared debt reduction a top priority and announced a goal of budget surplus by 2020.

Greece, Ireland, Portugal, and Spain (none of which are G20 members), on the other hand, are caught in the crosshairs of financial markets and have no choice but to pursue larger deficit cuts. They plan to reduce their budget shortfalls by approximately $82 billion—or 4.5 percent of their combined GDP—through 2011. In comparison, Italy, the UK, and France are targeting a reduction of $75 billion—or 1.1 percent of their GDP—over the same period.

Monetary policy also remains similar across the advanced countries, with nuances  reflecting mainly institutional differences. The central banks in the United States, Europe, England, and Japan have maintained their commitment to low interest rates amid persistent low inflation, high unemployment, and large excess capacity. Their approach to quantitative easing, however, has been more differentiated. While Japan has expanded its bond purchasing program and the ECB continues to offer shorter-term loans to banks, the United States and the UK have put their programs on hold. Monetary tightening has been most aggressive in China, where credit has expanded most, growth has been most rapid, and the threat of overheating is now significant.

Need to focus on long-term growth

In a recent note, the IMF’s Olivier Blanchard and Carlo Cottarelli estimate that a one percentage point increase in potential growth lowers a country’s debt-to-GDP ratio by 30 percentage points in ten years, assuming the resulting revenues are saved. Higher potential growth decreases the ratio directly by raising the denominator and indirectly by boosting tax revenues³.

Structural reforms that can help catalyze long-term growth are badly needed across the advanced G20 countries, and the need is even greater in slow-growing Japan and the uncompetitive countries in the European periphery. The OECD’s annual list of necessary structural reforms provides a starting point:

Of the G20 nations, only Spain has announced a program of significant structural reform this year. It focuses on improving the labor market⁴ and increasing efficiency in the cajassector⁵.  Italy is making some progress as well, cracking down on pension fraud. However, none of these moves is sufficient to tackle the serious growth challenges that confront these two countries.

Rather than continue the high-profile and unproductive stimulus-versus-austerity debate G20 leaders should acknowledge the similarities across their fiscal and monetary policy strategies and explicitly recognize the need for different approaches in countries dealing with different situations. They should increasingly focus on structural reforms that address long-term growth and budget weaknesses.

¹ In the United States, for example, tax receipts fell by 3.7 percent of GDP and expenditures rose by 5.1 percent from 2007 to 2009, while the federal stimulus amounted to less than 2 percent of GDP in 2009. Even 2 percent of GDP is an overestimate, however, as more than one third of estimated stimulus outlays went towards stabilizing or relieving states’ fiscal funds.

² Prior to the G20 summit, Italy announced plans to cut its 2009 deficit of 5.3 percent of GDP in half by 2012, while France is making efforts to lower its deficit from 7.5 percent to below 3 percent in 2013. Germany, a leader of the austerity movement and a country which clearly could do more to stimulate domestic demand, anticipates an increase in its deficit in 2010, followed by small (0.5 percent of GDP) cuts to the structural deficit each year through 2013. The U.S. deficit is also expected to rise from 9.9 percent of GDP in 2009 to 10.6 percent in 2010 before getting cut to 4.2 percent in 2013.

³ Blanchard and Cottarelli assume a tax ratio of 40 percent.

⁴ Severance payments per year worked have been cut from 45 days to 33 and policy to discourage temporary hiring has been enacted.

⁵ Cajas are Spanish savings institutions that are required to operate “in the public interest.” Their performance during the crisis was particularly poor. Spain has merged 29 of the 45 savings institutions.