The right fiscal policy will ensure long term growth in Romania again

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.


19 thoughts on “The right fiscal policy will ensure long term growth in Romania again

  1. This what the IMF has been preaching since 2009 to the Romanian Gov. Unfortunately spending cuts have been performed in public sectors desperately needing more funding. There is still a lot of bad expenditure on goods at prices up to 20 times their market value and no present or future restrictions (no standardised costs).
    Lower taxes? Yes please, but be careful not to cut taxes in oligopolistic sectors.

    Lower Gov. expenditures? Yes please, but be careful what we cut. We may end up with bad education, bad health provisions or other services provided by the government (and no, as long as romanians are poor, private education or health are not a viable option).

    1. @ddr
      There is plenty to cut and it does not have to be overnight. The plan has to be credible and significant in the long run.
      I am not sure about “be careful not to cut taxes in oligopolistic sectors”. . Are you saying that in those sectors tax cuts will not be transferred to the rest of the economy?

      1. Yes, sectors with a low level of competition will not pass tax cuts to the rest of the economy.
        Why would they? Their clients are unlikely to go somewhere else since options are limited. Lower prices in Romania have only materialized when progress made goods and services cheaper. Not because of any tax cuts.
        Btw, what was the effect of the flat tax on inflation?
        I can’t remember anything in the NBR’s inflation reports stating lower taxes have helped reduce inflation.

      2. @ddr
        If you lower the flat rate from 16% to 0%, you will encourage investments in Romania. Less companies will move their activities offshore. It may lower prices but not necessarily.

        Business people are more likely to consolidate their finances and to expand their activities through investments because of higher profits instead of looking at the consumer and lower their prices.

        If the difference is used to pay back the debt then you will have more solvent companies. And also the banks will function better because of the additional cash that will be coming in.

        If the companies use the cash for investments, you will have more jobs for everyone or lower prices in the long term due to research or due to the new technologies that will be bought by the companies.

  2. Lowering taxes in this situation will increase disposable income, but hoseholds and firms will very likely start paying debt back or save a great portion of the gain(deleverage). This is what the keynesians say happens in a liquity trap. Government expenditure is then much more effective (in theory, because in this case I tend to think this will get to politicians’pockets).

    My opinion is that a restructuring of tax should be made, and the bureaucreacy for firms should be lowered. Property taxes should be increased, labor taxes decreased, and the reinvested profit should also have a lower tax. Also the fuel tax should be increased and the for the gain tax lowering should be given to population/firms. (it is known that the fuel companies move profit to mother countries).

    Nevertheless running bigger government deficits in such conditions create some risks of its own. (If some countries and big banks default on debts, the risk premium for emerging markets will likely go to the roof. This will make a combination of further enlargement of the goverment deficit, money printing, currency depreciation, recession.)

    1. @Andy
      Romania is far from a liquidity trap. You are right about household paying back debt but it should help the financial sector also releasing provision.

      Indeed the deficit issue is also key, that is why in the same time there is a need to cut expenditures (there are plenty of areas where this can be done).

      Regarding what Keynesians believe, you are right and Woodford has a nice paper showing this (if you believe that the economy follows that model).
      Romanian economy like most emerging markets will show that income from lower taxes will be used almost entirely for consumption.

      1. Thank you for the article.

        Regarding : “Romania is far from a liquidity trap. You are right about household paying back debt but it should help the financial sector also releasing provision.”

        In this case the financial sector will receive the provision, but very likely they will transfer it to the mother institutions. No new loans will be made (maybe only to the goverment, and this falls into fiscal policy) So this will not really stimulate the romanian economy in any way.
        Correct me if I am wrong. Is this not a situation where monetary policy does not work to stimulate the economy (and then a liquidity trap)? Or is is considered the liquidity trap is only around 0% central bank rates ?
        In my opinion hoarding of cash has begun after a long period of high inflation (and high expected inflation) so the long maturity interest rates go down much slower. Also the impredictibitaly of the fiscal policy slows it also (through the risk premium).The NBR could bring the nominal short rates in RON easily to near 0%, but it would not be credible anymore, and the banks would likely decrease the exposure on Romania (which is now also happening but at a slower rate).

      2. @Andy
        Indeed, the concept of liquidity trap conveys that monetary policy cannot push rates below zero and thus further relaxing the policy will not lead to any real effect in the economy, with or without price rigidities.
        If NBR will push the interest rate to zero I fear that the RON will depreciate and inflation will resurface via the exchange rate channel. Assuming that the central bank will intervene to contain this channel it will then have to sterilize all interventions to keep rates at zero. The end result will be losing reserves which is suicidal for a euroized economy.
        That is why I believe the fiscal channel works better. Yes I am biased towards lower taxes as I believe that in the long run is the more sensible path.

  3. Why do we need the fiscal policy to ensure long term growth? Why don’t we just let the private sector to do that (through new technologies, better productivity etc.)?

    1. @Sorin
      If you look at my proposal you see that I am for lower taxes and lower expenditures = smaller state. Lower taxes on capital should help business investment and entrepreneurship and finally productivity. It sells better if I give credit to the policy maker for the idea.

    2. Yes, I know you are pro-smaller state, but my feeling is that more and more economists are for a bigger state intervention in economy (why?!). If only these interventions would materialize themselves in some large projects that most of us would benefit and that are too costly for the private sector to accomplish them…

      1. @Sorin
        My hunch is that most economists who are favoring state interventions are looking to land a job with the state, i.e. Krugman or Summers.
        Banks favor interventions because it saves them and markets, i,e, traders, love interventions because short term all asset classes go up and they make the yearly budget.

        In the short term a big state helps the current generation and that is why everyone one seems to like it and support it. My fear is that they are myopic and current generation will soon have to pay for it. That is why it does not make sense from a rational agent point of view. Theoretically agents/people should have seen that current excess will have to be paid back via higher taxes in the future. However, there is no incentive for them to act this way.

  4. Here’s a simple way to plan a budget with no deficit, or at least with a small chance of having one.

    C2011 – 2011 state spending

    C2012 = 0.95 * C2011

    The politicians will ask themselves: How much money are we going to spend in 2012? Answer: 95% of what you spent in 2011 regardless of what happens during 2012.

    Politicians: What if we get more money and the economy is booming? Isn’t a waste to spend less money than you have?

    Answer: Don’t worry, we will spend the leftovers on our debt or on other things later. It’s better to be frugal right now and have no recession in the future. Then to get fat right now and die of hunger in 2 years time.

    They should consider the scenario of things getting worse. If they don’t get worse, they have a surplus. If they do get worse, they are prepared.

    This above method diminishes the risks associated with wishful thinking.

    1. @Adrian
      Yes this is a great rule which should in the long run lead expenditures asymptotically to zero. Very simple and transparent. I would be more aggressive in the first few years and then implement something like this. There is a problem if governments needs to respond to a negative shock. For example during recessions social transfers will increase this will create real problems for the functioning of the government. Thus I would add that you need to run surpluses during boom times to create a buffer for recessionary periods.

      1. @Florin
        I was thinking about applying this rule until the budget becomes small enough. 5% is not necessarily the magic number. It depends on the context of the situation.

        The idea is that you should plan for the worst and be prepared for it. I think that the 2012 numbers for the Romanian government were all up: more tax revenues, more European fund absorption, less black market etc. That’s what I call wishful thinking. You plan according to your wishes not according to reality. You should consider both the positive and negative possible outcomes.

        “For example during recessions social transfers will increase this will create real problems for the functioning of the government. ”
        I don’t buy it. When you have less resources, when you set limits for yourself, your mind becomes creative. And you can find better solutions that involve less money to the exact same problems.
        * politicians don’t have to go to parliament, they can vote online and read the laws online –> money saved to run the parliament and to pay for their trips
        * no more Helicopters and Mercedes for politicians –> money saved
        * plant plain old grass instead of roses in cities –>money saved
        * no more parties organized by local authorities like “The days of our greatest city” etc. –> money saved
        * the elderly shouldn’t be allowed to use for free the public transportation system –> resources saved
        * pensions – if the pensions are not enough to survive, the state could negociate and buy in bulk from supermarkets certain foods at a lower price. The supermarkets will afford to sell cheaply because of higher quantity, no need for marketing, no need for storage, quick cash flow .etc –>lives saved from the evil recession
        * equalize all the pensions to the same value, let’s say RON 772 as the average pension is right now. In this way, paper-moving-people will no longer have to calculate each pension separately. Plus, there will be no discrimination between who gets the bigger pension and the rest. No new laws will have to be issued to adjust them. And no tam-tam on television. –> money saved + more votes next time
        * no subsidies to politicians for fuel etc., reason? It’s recession brother! –> money saved, politicians made angry = good thing
        * the income tax should be 1 number, not 10 different smaller taxes like: social security paid by employee, social security paid by employer, pension, unemployment etc. –> paper–moving-people will be used for other things instead of computing numbers. Accountants will be less in demand too.

        The above are just a few examples on the top of my head. I looked at the Romanian budget for 2012 and it’s quite messy. To compile that thing it takes a month. Just by reading it, you can find a lot of things that aren’t needed in it.

        On the long term, efficiency leads to an increase for the real economy and to a destruction of the economic parasites.

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