Volume 43, Number 168,
January-March 2012
Crisis and Economy Recovery: The Role of Fiscal Policy
Moritz Cruz and Javier Lapa
FINANCIAL OPENNESS, ECONOMIC POLICY RESTRICTIONS,
FISCAL POLICY AND ECONOMIC GROWTH: THEORETICAL CONSIDERATIONS

Argentina, Brazil, Korea, Mexico and Russia not only share the fact that they all experienced financial crises recently, but also the fact that prior to their respective crises, they implemented similar economic reforms. In effect, all three countries adopted neoliberal strategies (outlined in the so-called Washington Consensus) as a mechanism for economic growth, characterized among other features, by rapid, thorough trade and financial liberalization, prioritizing both domestic and external macroeconomic stability and an accelerated process of privatization. One of the main objectives of this strategy was to create an attractive, trustworthy environment that offered returns for foreign investors, and so attract large flows of capital. In other words the economic growth strategy adopted focused on gaining the confidence of investors (or the market) to guarantee strong, stable capital inflow. As a result economic recovery was essentially dependent on external capital inflow, particularly speculative capital.

Maintaining the stability of market confidence as a political objective meant, on the one hand, an increased cost in restricting ex ante the autonomy of economic policy, by focusing on macroeconomic stability and financial (and trade) openness. This restriction prevented alternative measures being adopted, among them growth policies led by aggregate demand, where the expansionist fiscal component is fundamental for promoting economic growth and development objectives. In addition, neoliberal openness also meant restricting economic policy ex post, given that during economic crisis governments are obliged to reinforce initial measures to regain the confidence of investors (Grabel, 1996).

The logic behind restricting economic policy ex ante and ex post as a result of a strategy of rapid financial openness is more explicitly as follows. The government of a country (especially a developing one) seeking to attract and maintain the flow of external investment (direct and portfolio) as a strategy to promote growth can be seriously restricted in terms of economic policy ex ante. Creating an adequate climate to attract capital implies adopting a series of policies aimed at gaining the trust of investors and offering rewards. This strategy, we maintain, involves restrictive monetary and fiscal policies, the priority evidently being healthy public finances, whether in terms of the budget balance or surplus, through cuts to public spending and/or via new consumption taxes. The aim is exclusively to stabilize prices, and maintain interest and exchange rates outside convenient levels that promote economic growth, for example a high interest rate and a continuously strengthening exchange rate.

On the other hand, in the case of capital outflow or financial crisis, the authorities may be obliged to adopt measures to regain the confidence of investors and so revert the outflow of capital and crisis. When the government does not wish to reintroduce capital controls and/or restrictions to currency convertibility or other measures regulating the inflow and/or outflow of external capital, these measures result in the initial policies adopted being intensified. On the other hand, political autonomy is restricted, ex post, a situation which can be aggravated when the country in crisis receives financial support from a multilateral institution or other governments. In general, this support comes with economic policy conditions attached.

Economic policy restrictions, including fiscal, have important repercussions for economic growth from a Keynesian viewpoint, that is from the perspective of growth models linked to demand. This is because from this viewpoint the main aspect of demand that stabilizes the economic cycle is public spending. This factor is exacerbated during periods of economic recession or crisis given that no other element of aggregate demand is capable of recovering in an autonomous way.5 Similarly, the role of public spending in economic growth is not only limited to regulating aggregate demand but also to having a positive impact on supply, by expanding national infrastructure, supporting development and research projects and improving the quality of human capital by offering health and education services. That is to say, public spending, according to Keynesian theory, has indisputably positive effects on economic growth, both short and long term. If for any reason government's capacity to make use of adequate fiscal policy is restricted (at its discretion, according to the economic cycle) economic growth will evidently be equally effected and with greater negative consequences, we maintain, if the economy is faced with crisis or recession.

It is precisely the Keynesian perspective (that assumes endogenous currency, the existence of unused productive capacities and determines production and employment rates in terms of effective demand) that maintains that the effects of public deficit on aggregate demand are diametrically different to those pinpointed by conventional theory (Wray, 2007).6

In effect, by increasing public spending, let us suppose via fiscal deficit, especially in the context of slow growth or economic crisis, employment and consumption immediately increase, breaking with negative expectations on the part of businesses as to whether to invest and/or maintain their productive capacity idle (breaking as a result the negative cumulative cycle of growth).7 More precisely, "Any increase in government expenditure on goods and services produced by the private sector, ceteris par ibus, will increase sales of industries, thereby encouraging entrepreneurs to increase employment especially in the industries from which the government directly purchase..." (Davidson 2007: 65). This ensures that expansive public spending promotes optimism in the "animal spirits" of entrepreneurs. Once the expectations of entrepreneurs are optimistic, they will make use of idle capacity, demanding a larger workforce, and eventually more investment and so expand their productive capacity. In short, this positive climate will increase effective demand and with it employment, consumption and revenue, initiating a cumulative, virtuous circle of growth.

5 The only exception may be to exports, but if there is significant growth in these during a crisis, this is down to a fortunate coincidence and can only be referred to as such.

6 From a Neoclassical perspective, i.e. from a conventional perspective, the impact of fiscal policy on economic growth is refuted. This theory is based on the assumption that Say's law is adhered to. This stipulates, among other outcomes, full compliance with production factors, maintaining that when expansive fiscal policy is implemented, the rate of activity in the economy is unaffected, at least in the long term. At best the expansive effect is reduced, short term and is temporary, because going back to the starting point would cause serious problems such as higher inflation and interest rates, and consequently increased debt for economic operators, including the government. The exchange rate would appreciate, and therefore the trade balance would deteriorate. In line with this theoretical framework, the solution to insufficient economic growth (and implicitly economic crisis) lies entirely in making the labor market more flexible, given that this is what determines the rate of economic activity. Increased economic growth (or an early return to the stability of employment) is thus ensured if the government implements measures focused on making the labor market more flexible, such as policy changes that relieve unemployment, and that improve minimum salaries and syndicate legislation etc. etc. (see Carlin and Soskice, 2006) i.e. measures that focus on improving the efficiency of supply in the economy.

7 In fact, regardless of which phase of the economic cycle the economy is in, the main objective of government spending is to keep the total expenditure rate for goods and services balanced, increasing it if private spending is less than the full employment rate and reducing it if aggregate demand exceeds the rate of full employment (Davidson, 2007: 66).

Published in Mexico, 2012-2017 © D.R. Universidad Nacional Autónoma de México (UNAM).
PROBLEMAS DEL DESARROLLO. REVISTA LATINOAMERICANA DE ECONOMÍA, Volume 49, Number 192, January-March is a quarterly publication by the Universidad Nacional Autónoma de México, Ciudad Universitaria, Coyoacán, CP 04510, México, D.F. by Instituto de Investigaciones Económicas, Circuito Mario de la Cueva, Ciudad Universitaria, Coyoacán,
CP 04510, México, D.F. Tel (52 55) 56 23 01 05 and (52 55) 56 24 23 39, fax (52 55) 56 23 00 97, www.probdes.iiec.unam.mx, revprode@unam.mx. Journal Editor: Alicia Girón González. Reservation of rights to exclusive use of the title: 04-2012-070613560300-203, ISSN: pending. Person responsible for the latest update of this issue: Minerva García, Circuito Maestro Mario de la Cueva s/n, Ciudad Universitaria, Coyoacán, CP 04510, México D.F., latest update: Feb 23th, 2018.
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