JDI Student Fellow Stephen Snudden offers his insights into the internationally coordinated effort to combat the Great Recession following the collapse of Lehman Brothers in 2008. At the time he was a Research Assistant at the Bank of Canada and has also served as a Project Officer for the International Monetary Fund.  He is currently a PhD Candidate and in the Department of Economics at Queen’s University. 

 

By Stephen Snudden, Queen’s University

A 2% fiscal stimuli to combat the Great Recession

It was October 7^th 2008. Lehman Brothers had just collapsed in mid-September and seemingly taken the global economy with it. Markets were in hysteria. We needed to figure out what to do quickly.

In Canada, Bank of Canada Governor Mark Carney’s actions played a key part in the global effort that followed. The night before the coordinated monetary action, he asked his staff: “How much global monetary and fiscal stimuli is needed to offset the recession?” At the end of the meetings the next day, seven Central Banks announced that they had coordinated 50-basis point policy rate cuts which were followed by a globally-coordinated 2% of GDP fiscal stimulus.

How was the 2% fiscal action chosen?

My colleagues and I at the Bank of Canada recommended 2% using, BoC-GEM[1], a dynamic (DSGE) model of the global economy.

BoC-GEM was the only global model available at the Bank of Canada that included both monetary and fiscal policy. Investment, preference and productivity shocks were simulated to replicate forecasted GDP, consumption and investment downturns that clearly predicted a severe recession.

Next, we generated monetary easing into the analysis, beyond that implied by a standard Taylor-type rule. Quickly realizing that all regions’ monetary policy quickly hit its limit, we added a combination of government consumption and labor tax rate fiscal stimuli. The objective was to see how much fiscal and monetary stimulus was needed to return GDP back to potential GDP.

Well after midnight, we armed Governor Carney with our short note[2] showing that all regions had room to ease by at least 50 basis points and that full easing along with 2 percent fiscal stimulus on average was needed to return GDP to potential in most regions.

The months to follow was a whirlwind for many economists, as academics and central bankers around the world updated their forecasts and conducted similar analyses.[3] For example, in November, the G-20 finance and central bank ministers were presented simulations by the staff of the International Monetary Fund (IMF) to show just how much worse the recession will be without sustained monetary and fiscal easing (Lee et al, 2009). At the G-20 meeting in March 2009, with monetary easing close to exhausted, the IMF formally recommended a globally coordinated 2 percent fiscal stimulus (Group of Twenty, 2009). Undoubtedly, the coordination and sharing of information were critical in the timely and informed responses implemented during the financial crisis.

With committed fiscal action being undertaken, the question quickly turned to accessing the size of fiscal multipliers. The multiplier was critical for the evolution of the forecasts and knowing if we were doing enough. DSGE modelers at central banks and international institutions convened in Washington in the middle of 2009 to compare and understand their multiplier estimates. This lead to a formal comparison of fiscal multipliers in canonical and policy DSGE models that lead the policy debates at their respective institutions (Coenen et al, 2008). The importance of the fiscal multiplier is evidenced by the revival of the literature on this topic around that time. Key features emerged from this research such as duration of the stimulus, lower bound on nominal policy rates, alternative fiscal instruments, long run fiscal adjustments, liquidity constraints, etc. No doubt, the size of the fiscal multiplier was just as important as the forecasts themselves for determining how much fiscal stimulus was needed.

Was it the right choice in hindsight?

Let us ask nearly ten years later: would we have followed the same method for determining the size of the fiscal stimulus? In particular, for the next recession, should we just be trying to return GDP back to baseline?

Let’s begin by reviewing some of the lessons learned about implementing fiscal stimulus. There was a delay in implementing government spending measures. This was particularly true for government investment. This contrasts sharply with labor tax and transfer stimulus measures, which were already partly implemented in the United States in the Economic Stimulus Act of 2008 by the time that Lehman collapsed. Subsequent work has highlighted the importance of the composition of the stimulus to stabilize GDP. Since government consumption had larger GDP multipliers compared to tax and transfer measures, the impact of stimulus on GDP was under-estimated at the beginning of the crisis due to these spending lags.

The recommended 2 percent of GDP fiscal stimulus on average was seen to be a minimum. Simulations suggested that the United States and emerging Asia needed more stimulus and had the fiscal space to do. The long run costs of the fiscal effort was a key concern. Both the rise in equilibrium real interest rates and the future consolidation to normalize debt levels had implication for the multipliers (Freedman et al, 2010; De Resende et al, 2010; Coenen et al, 2012).

However, none of the simulations included a response of sovereign risk premium to the rise in debt levels. Most countries at this time had ample fiscal space and even European countries with higher debt levels had seen a convergence of risk premium to historical lows. The proceeding rise in sovereign default risk was underappreciated and may have led to a lower recommended stimulus for some countries. That said, the stimulus measures were often not the largest contributors to debt and the sovereign risk crises would have likely still occurred given the collapse in revenues and the bailouts that contributed substantially to sovereign debt loads.

There was an underappreciation of the inherent pro-cyclicality of fiscal policy in recessions. Automatic stabilizers turned out to be dwarfed by other fiscal limits during severe contractions.[4] For example, a large part of the fiscal stimulus efforts in the United States were “transfers” from the federal government to the states. Many states were bound by fiscal rules that required them to maintain balanced budgets. As state and local tax revenues fell, so too did their spending. This can be evidenced by the negligible changes in overall government spending per capital over the crisis. Automatic stabilizers were present but the degree of inherent procyclicality of fiscal policy during recessions was generally under-appreciated in both forecasts and structural models.

Automatic stabilizers were known to be “smaller in emerging market G-20 countries, as well as in Australia, Canada, Japan, and the United States,” (pg. 27, Group of Twenty, 2009). This distinction is important going forward as fiscal multipliers are larger if unexpected. This raises an important concern if, in the next recession, people anticipate fiscal stimulus to be implemented and hence making it less effective. By contrast, automatic stabilizers, such as employment insurance and active labor market policies, ensure that the fiscal actions are timely and targeted to those with high marginal propensities to consume. If both automatic and “discretionary” policies will be expected going forward, let us make them timely and targeted.

This raises the most critical question: why was returning real GDP to baseline chosen as a target instead of other welfare criteria for accessing the size of fiscal stimulus?

Government spending or transfers that didn’t help the people hurt by the recession could raise GDP but are limited in their improvement in welfare. In contrast, transfers to constrained households are known to have larger fiscal multipliers and welfare implications. Arguably, GDP was chosen due to its importance as a signal for economic strength and confidence. Welfare criteria would suggest less overall fiscal stimulus and were busy trying to avoid a deflationary spiral into a depression. Clearly, the outcomes from the recession suggest that policy makers failed to return GDP to baseline, but also avoided a depression.

To conclude, as the crisis worsened, many countries implemented fiscal stimulus above and beyond 2 percent of GDP. Much emphasis on fiscal stimulus was to normalize real GDP and avoid a liquidity trap.

In retrospect, policy makers would have preferred to rely more on automatic countercyclical and targeted fiscal stabilization, especially if they were timely. Maybe more important to the GDP outcome is trying to get the most bang for our buck in economic welfare. What is clear is that such structural analysis and coordination helped inform leaders to make appropriate and timely actions.

References:

Coenen, G., C. de Resende, C. Erceg, C. Freedman, D. Furceri, J. in’t Veld, M. Kumhof, R. Lalonde, D. Laxton, J. Linde, A. Mourougane, D. Muir, S. Mursula, J. Roberts, W. Roeger, S. Snudden, and M. Trabant, 2012. “Effects of Fiscal Stimulus in Structural Models,” American Economic Journal: Macroeconomics, vol. 4(1): 22–68.

De Resende, C., R. Lalonde, and S. Snudden, 2010. “Power of many: Assessing the economic impact of the global fiscal stimulus,” Bank of Canada Discussion Paper, No. 2010-1. Bank of Canada.

Freedman, C., M. Kumhof, D. Laxton, D. Muir, and S. Mursula, 2010. “Global effects of fiscal stimulus during the crisis,” Journal of Monetary Economics, 57(5), 506-526.

Group of Twenty, Meeting of the Ministers and Central Bank Governors, 2009. “Global Economic Policies and Prospects” March 13–14, 2009. London, U.K. International Monetary Fund. http://www.imf.org/external/np/g20/pdf/031909a.pdf

Lalonde, R., and D. Muir, 2007. “The Bank of Canada’s Version of the Global Economy Model (BoC-GEM),” Technical Report No. 98. Bank of Canada.

Lee, J., D. Laxton, M. Kumhof, and C. Freedman , 2009. “The Case for Global Fiscal Stimulus”. Staff Position Note. No. 2009/03. International Monetary Fund.

[1] The model that was used is the Bank of Canada’s Global Economy Model, Muir and Lalonde (2008).

[2] The analysis of the global fiscal stimulus was published in De Resende et al (2010). The method to generate the needed stimulus required confidential forecasts, which is why the primary documents for this analysis and that at other central banks was not made public.

[3] For example, Freedman et al (2010), De Resende et al (2010) and other works surveyed in Coenen et al (2012).

[4] The use of fiscal rules for determining optimal fiscal policy and present in many structural models is likely to be misleading for these reasons. Fiscal constraints on spending levels during downturns, and political unwillingness to slow economies during expansions introduce important asymmetries in fiscal policy implementation.