Yesterday I presented a graph showing that now WB expects EU to be in recession in 2012. M y point was that Romania should take this information into account and act on it. And I left it like that. I would not have come back to it but one of my readers pointed out that it is easy to just point to a problem without offering a solution. This is true. It is easier to be a bystander pointing to a problem than offering the solution to the problem.
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I will in what follow put forward my view on the Romanian “situation”. To be clear, however, I do not have to do that. My “job” is to point to the problem but not to solve it. Even if I would want to I could not. But most importantly we have people paid to solve our problems. Furthermore, regular readers know that I have offered my view regarding fiscal and monetary policy in Romania.
The easiest advice based on yesterday’s information about EU growth is to adjust the budget for 2012 on a more realistic growth scenario. Of course governments do not have an incentive to do that as the cost of being wrong, i.e. end up with a higher deficit, will be borne by future generations and maybe have to be explained by other governments. No expectations that this will happen as it did not happen in 2009.
This is however just a short term solution. My estimates show that the annual potential GDP growth has moved from 6.6% to zero. Thus policies are needed to help Romania grow long term.
Governments have two major tools that can be used in deal with positive/negative surprises: monetary and fiscal policy. How do you choose which one to use? Do they lead to the same effect for the economy? Are there any risks?
Of course dealing with surprise shocks, especially negative one is not easy. But then nothing is, it just requires a pragmatic assessment of the situation. The first problem for policy makers is identifying the shock. Most of the time we see the effects, i.e. recession, but we do not know why we ended up there.
In the case of an emerging economy like Romania the main dilemma is if it should use primarily monetary or fiscal policy to push itself out of the recession – we already know how we got into recession. Also, how should those policies be used?
It depends on the respective fiscal or monetary multiplier. Does a looser monetary policy work faster to increase aggregate demand or is fiscal policy better suited for this? There is no right answer and it all depends on the structure of the economy.
Romanian economy has a history if high inflation. Even in 2011 average inflation was 5.8 although there are still prices controlled by the government, the currency did not depreciate and there was a massive positive shock from food prices due to a good agriculture year. In such an economy monetary policy needs to remain focused on inflation. Furthermore, data shows that the credit channel is destroyed. Relaxing monetary policy further would not help the economy grow via credit rather it would increase inflation expectation and create incentive for the government to over borrow due to lower cost of funding.
Then there is the fiscal policy. The government can decide to either increase spending or lower taxes. I favor the second but in a combination with lower government spending. Here is why. An increase in government spending will lead to expectations that taxes will have to be raised in the future to pay for those increases. As a result the increase in the government spending will be undermined by higher savings in the economy rendering the fiscal multiplier obsolete. Much like in the case of the monetary policy.
On the other hand lowering taxes – income, profit and social contributions – will increase disposable income, lower the price of capital and of labor. Such a policy will lead to increased consumption, investment and employment in the Romanian economy. But, of course there is a but, in order for this policy not to be perceived as temporary the Romanian government needs to cut expenditures and public debt in the same time. Otherwise it will lead to a higher budget deficit and in the end to a higher public debt. Without a credible plan to cut current expenditure and public debt the economy will expect once again higher taxes in the future.
In the end it comes down to what it works or the right tool for the job. Current structure of the Romanian economy shows that fiscal policy will be more suited for the job of pushing the economy out the muddle thorough period. Lowering taxes, while cutting expenditures and public debt, will have a bigger impact long term than pushing nominal interest rates to zero.