Return of Fiscal Activism

Japan’s fiscal stimulus, increasing of fiscal deficit targets in Eurozone economies, UK chancellor Hammond’s mulling reviewing his predecessor’s plan on budget, apparently indicate that fiscal activism is gaining currency in developed economies these days. The developed economies are mired with low or zero interest rates (negative interest rates in Japan) and monetary policy has reached its limit. These low interest rates had set up perfect ground for the fiscal policy to emerge as a powerful tool for these economies. In the liquidity trap scenario the fiscal multipliers are large and hence it is conducive to resort to fiscal activism (Strike when the iron is hot)

The genesis of fiscal activism can be traced back into Keynesian economics. The idea of welfare state was embraced during great depression of 1930s .

But Greece’s sorry tale of fiscal expansion following its adoption of the euro in 2001 is the epitome of fiscal activism gone wrong. The adverse consequences in fiscal activism have led to crises in Latin American countries, mainly in Venezuela.

A country’s fiscal space is judged not only by interest rates but also whether country’s public finances are on sustainable path . The basic equation of debt sustainability which includes factors such as country’s primary deficit , nominal GDP growth rate , nominal effective rate of interest and Debt/GDP ratio should be given prime importance. One of the criticisms against fiscal activism lies in  government’s inefficiency in understanding consumption patterns of the society. The ghost towns in China is a reminder of government’s failure to understand the demands of the people in the economy. Thus ill framed fiscal stimulus worsens the problem by increasing the number of non performing assets .

The fiscal activism should be used as a countercyclical policy i.e. an expansionary fiscal policy should be undertaken during economic slowdown and contractionary fiscal policy should be undertaken during boom. If the nature of polity acts as a straitjacket in resorting to contractionary fiscal policy then fiscal activism should be avoided because it will lead to huge fiscal deficits. The economic survey 2016-2017 highlights that the two episodes of Indian macroeconomic vulnerability in 1991 and 2013 were caused due to application of both procyclical and countercyclical policy. 

During 1980s the government increased fiscal deficits as a response to accelerating growth . The 1991 Balance of payment crisis again forced government to resort to expansionary fiscal policy. Similarly, during the 2000 growth boom government increased its spending program. But again in 2008, government had to increase its fiscal deficits due to Global Financial Crises. The combination of procyclical and countercyclical policy worsened the inflation in 2013.

The experiences of fiscal activism underscore that one-size fits all approach shouldn’t be followed. The authorities should take into account a plethora of factors and not just the interest rates while considering fiscal activism as a tool to solve economic problems.

- Tanushree Dutta