Fiscal Policy and Sovereign Debt: Editors' Overview

• Author: Colin Mckenzie,Shujiro Urata,Kazumasa Iwata,Takatoshi Ito
• Published date: 01 December 2012
• DOI: http://doi.org/10.1111/j.1748-3131.2012.01244.x
• Date: 01 December 2012

Fiscal Policy and Sovereign Debt:

Editors’ Overview

Takatoshi ITO,1Kazumasa IWATA,2Colin MCKENZIE3† and Shujiro URATA4

1The University of Tokyo, 2Japan Center for Economic Research, 3Keio University and Sciences Po and 4Waseda

University

JEL codes: E62, E65, F36, H12, H20, H30, H61, H62, H63, H74

1. Fiscal Policy and Sovereign Debt

Over the past 50 years, perceptions of the effectiveness of fiscal policy as a tool of macro-

economic stabilization have gone through a rise and fall in both the academic literature

and the real world. During the golden age of Keynesianism in the 1960s and 1970s, dis-

cretionary fiscal policy was regarded as being as important as monetary policy in stabiliz-

ing fluctuations in aggregate demand. With deeper academic understanding of

stabilization policy and the fiscal multiplier, many governments attempted countercycli-

cal fiscal policy in the 1960s and 1970s. Symbolically, in 1971, President Nixon is

reported to have said,“[W]e are all Keynesians now.”

Fiscal deficits in the major western countries rose in the 1970s partly due to the col-

lapse of the Bretton Woodssystem and the two oil crises. The shift to a floating exchange

rate regime produced unexpected increases in exchange rate volatility. Countries that

experienced exchange rate appreciations suffered declines in exports. Sharp increases in

oil prices caused declines in aggregate output. Every democratically elected government

had an incentive to increase (discretionary) spending and to cut (discretionary) taxes

when there was a slight hint of a recession, especially in an election year. By the end of

the 1970s, inflation, which had origins in overly stimulatory fiscal and monetary policies,

became an important issue in major countries. Fiscal consolidation became necessary in

many countries, and as a stabilization tool, discretionary fiscal policy gave way to auto-

matic stabilizers in the 1980s and 1990s. An explicit or implicit monetary rule, which

later became crystallized into the Taylor rule, gained popularity among academics,

economists, and central bankers. Fighting inflation became a primary objective of central

banks in the 1980s.

Keynesian fiscal policy staged a dramatic comeback after the failure of Lehman

Brothers on September 15, 2008. As the global financial crisis (GFC) suddenly deepened,

a return of the Great Depression appeared probable. The central banks of the major

western countries quickly adopted a virtual zero interest rate policy and quantitative

easing. Governments also decided to stimulate their economies by increasing govern-

ment spending, introducing subsidies to eco-friendly industries, and cutting taxes.

†Correspondence: Colin McKenzie, Faculty of Economics, Keio University, 2-15-45 Mita, Tokyo

108-8345, Japan. Email: mckenzie@z8.keio.ac.jp

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doi: 10.1111/j.1748-3131.2012.01244.x Asian Economic Policy Review (2012) 7, 135–156

© 2012 The Authors

Asian Economic Policy Review © 2012 Japan Center for Economic Research 135

One of the reasons why fiscal policy received so much attention was because

monetary policy was believed to have lost most of its power after interest rates had

been lowered to virtually zero, and the impacts of quantitative easing have remained

controversial.

Fiscal policy became a major thrust of international cooperation to combat the GFC.

A coordinated fiscal stimulus was the centerpiece of G-20 leadership in The London

Summit of the G-20 in April 2009:

We are undertaking an unprecedented and concerted fiscal expansion, which will

save or create millions of jobs which would otherwise have been destroyed, and that

will, by the end of next year, amount to $5 trillion, raise output by 4 per cent, and

accelerate the transition to a green economy.We are committed to deliver the scale

of sustained fiscal effort necessary to restore growth.1

Major countries doubled and tripled their fiscal deficits in 2008–2009. Since there is a

leakage in the multiplier through imports, a concerted international action was consid-

ered to be most effective.

Many economies were affected by the GFC. Large declines in trade and output were

widespread among the major countries. However, thanks to the vigorous policy efforts, a

major collapse of the global economy comparable to the 1930s was avoided. Once the

acute crisis was largely over by late 2009, the large fiscal deficits, which prevented the col-

lapse of the economy, became a matter of concern. Among international leaders, the

interest in stimulus had already been lost and had been replaced by the promise of fiscal

consolidation in the future in the Toronto Summit of the G-20 in June 2010:

There is a risk that synchronized fiscal adjustment across several major economies

could adversely impact the recovery. There is also a risk that the failure to

implement consolidation where necessary would undermine confidence and

hamper growth. Reflecting this balance, advanced economies have committed to

fiscal plans that will at least halve deficits by 2013 and stabilize or reduce

government debt to GDP ratios by 2016.

Thus, we have seen the rise and fall of Keynesianism in decade-long waves between

the 1950s and the 1990s, and then the rise and fall of fiscal stimulus in a short wave in

2008–2009 (rise) and 2010–2011 (fall). How should we understand these popularity

cycles of discretionary fiscal policy?

The “rise”after the Lehman Brothers shock seems to be motivated by several factors.

Several reasons have implications for the specification of the policy effectiveness equa-

tion and the policy response function. First, when the interest rate is zeroor the economy

is in a liquidity trap, there is no reason to worry crowding out. The effectiveness of fiscal

policy is maximized. Second, the size of the shock of the GFC was considered to be so

large that any policy measures that could help to stimulate the economy were employed.

Maybe the fiscal policy response function should have a nonlinear term for the size of

Fiscal Policy and Sovereign Debt Takatoshi Ito et al.

© 2012 The Authors

Asian Economic Policy Review © 2012 Japan Center for Economic Research

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