Fiscal Stimulus and Consolidation during Financial Crises

Olivier Blanchard, chief economist at the International Monetary Fund (IMF), recently told the Council of Foreign Relations that he was surprised at the amount of debate surrounding the role of fiscal stimulus during economic downturns.  This comes after much criticism of the stimulus packages implemented across the world in early 2009, where the world economy was staring into the financial abyss.  There is this growing belief that fiscal stimulus does not work; that the macroeconomic theory behind government expenditure and the multiplier effect filling output gaps left by the private sector is flawed.

The political consequence of under-estimation

The evidence used by these ‘stimulus sceptics’ is the economic performance of the American economy since the implementation of the fiscal stimulus dubbed the ‘Recovery Plan’ in February 2009. The government predicted that, without the stimulus package, unemployment would peak at 9% – and that the US$800 billion fiscal stimulus would boost the American economy enough to maintain the rate below 8%. As we all know, the unemployment rate peaked at 10%, and has since been stagnant around 9-9.5% mark. The sceptics point to this as a failure of the stimulus plan.

At first look, this may seem very true. The problem with this simplistic argument is that we must assume that the government’s initial forecasts were correct – that the unemployment rate indeed would have peaked at 9% without the stimulus. However, if the administration had under-estimated the extent of the crisis, which is what the White House is now arguing, than that peak may  actually have been 12-13%. In this context, the stimulus package would be seen as a success, saving millions of American jobs.

The issue for the President is that arguing the counterfactual when unemployment remains at such elevated levels is proving impossible – the latest CBS News Poll shows that only 33% of Americans approve of his handling of the economy, whilst 60% disapprove. Similarly, just 35% approve his handling of job creation while 58% disapprove. And while 37 percent say the Obama administration’s policies prevented the country from going into a deeper recession, just under half – 49 percent – say those policies did not do that. While the economy remains the biggest political issue for voters going into next year’s presidential elections, President Obama can only hope that this anaemic recovery gains some momentum in the next 12 months.

Fiscal consolidation must be a medium term objective

Moving to the problems in Europe, Blanchard points to the over-importance placed on short-term fiscal consolidation at a time when most economists believe Europe is heading towards a mild recession. In my mind, the biggest problem is that rational economic policy is being hijacked by the interests of the schizophrenic irrationality of the markets. Under pressure from markets, governments are trying to satisfy them via faster fiscal consolidation through ‘tough’ austerity measures. This reactive policy approach may bring short-term gains across equity markets, but once the negative implications towards economic growth are realised months later, this has a substantively negative impact on markets. As Blanchard stresses, fiscal consolidation must occur over the medium to long-term, and governments trying to quicken a 10 year process into 1 or 2 years will damage their economies substantially.

This does not mean that fiscal consolidation is not an important goal for European economies – it must occur to regain their fiscal credibility with world investors. However, it must be a longer-term consideration, whilst the short-term must be focussed on reducing the fiscal drag created by the current recession.


For further analysis of the theory of macroeconomics in the aftermath of the crisis:


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