Crisis Offers Preliminary Lessons on Fiscal Policy

Crisis shows fiscal policy to be essential macroeconomic tool

Credibility, not just speed, is what matters for adjustment

Crisis shows “safe” debt levels much lower than earlier thought

A new paper by IMF staff looks at lessons from the recent crisis on the role of fiscal policy in advanced economies.

“Our research has some interesting implications for policymakers, especially on the use of fiscal policy as a tool to help stabilize the economy and on how to deal with fiscal risks and high public debt,” said Bernardin Akitoby, division chief in the IMF’s Fiscal Affairs Department. “For one, we see that fiscal policy can have powerful short-run effects on the economy when economic conditions resemble those that have prevailed in many advanced economies over the last few years. We also see that advanced economies are exposed to larger–than–expected shocks and need bigger fiscal buffers than we thought,” said Akitoby, who led the team of economists from the Fiscal Affairs and Research Departments.

Fiscal policy to fight recessions

The paper reviews what economists have learned from the crisis about the effectiveness of fiscal policy as a tool to stabilize the economy. Recent evidence shows that some of the precrisis concerns about the effects of fiscal policy and implementation issues related to discretionary fiscal stimulus were overblown.

The study finds that, under certain conditions, fiscal policy can have powerful effects on the economy in the short run. Its effects are larger when central banks are unable to reduce interest rates below zero, when the financial sector is weak, or when the economy is producing at significantly below its potential. New research has also raised doubts about the precrisis evidence that fiscal contractions can have an expansionary effect on output.

The crisis also showed that economic stimulus measures need not take too long to design and implement, as most advanced economies quickly enacted fiscal stimulus efforts when the crisis erupted. Moreover, most temporary stimulus measures were allowed to lapse or were rolled back after the initial phase of the crisis had passed, countering the view that politicians are unwilling to roll back stimulus measures once economies recover. Nevertheless, some of the earlier concerns about whether discretionary stimulus measures will be timely and reversible remain valid, especially during less severe recessions.

The findings also raise a critical question that has...