Autocorrecting a Recession
Updated: Jul 1, 2020
BA (H) Economics, Hansraj College
Economic fluctuations are inevitable, governments can use fiscal and monetary policy as a
countercyclical policy measure but fluctuations cannot be outright forestalled. As they say, “You cannot turn the tide but you can sure rock the boat.” Particularly now when the pandemic has pushed the global economy into recession, fiscal measures totalling to $10 trillion have been announced and central banks have injected liquidity to the tune of $6 trillion, the world over. However, there are certain features of the fiscal policy that are not discretionary or to put it in other words, these do not require explicit government intervention. These are what we call ‘automatic stabilisers’ and they essentially work to mitigate the irregular changes in output level due to economic shocks, such as the one we are currently experiencing.
The value of fiscal policy multiplier for a closed economy is given as –
where c denotes marginal propensity to consume and t denotes the marginal tax rate.
Now consider the case of a country with a progressive tax system - one where people are taxed based on income levels. That way, an individual falling in a higher income bracket will be subject to a higher tax rate and likewise. This country will, by nature, witness a decline in the marginal tax rate as incomes decline. That being the case, the value of multiplier increases. So previously, if a discretionary fiscal policy, such as increasing government expenditure by $1 could potentially increase output by $1.5, with the decline in the marginal tax rate, it would raise the output by $2. For an open economy, there is a minor change to the value of multiplier –
where m denotes the marginal propensity to import. In an economy grappling with a recession, marginal propensity to import declines thus raising the value of the multiplier. Hence, the domestic income increases by a greater magnitude than it previously could. Intuitively, it’s because since people aren’t buying foreign goods anymore, domestic spending increases. Without any policy intervention, this stimulates domestic demand, thereby dampening recessionary pressures.
So far, the discussion has been centred primarily around taxes. But another set of important
automatic stabilizers is transfer payments and welfare schemes that are already in place to buttress the economically disadvantaged. As incomes start to decline, more people become eligible for food stamps, unemployment allowances or other forms of government aid. During a recession, the government transfers would increase as more people apply for government aid, implying that government spending increases during the slump without policymakers actively deciding to make that happen. But there’s a caveat here - for automatic stabilizers to work, it must be the case that tax cuts translate into an increase in aggregate demand. Or that transfer benefits translate into an increase in consumption expenditure. More often than not, that is the case, especially in a liquidity starved economy, unless there is a contagion in the financial system and people tend to save up the tax savings or transfers instead of spending it on consumption. A better argument would be that with lower incomes, the marginal propensity to consume (MPC) increases and saving avenues are not appealing due to low-interest rates in the economy.
Some would be tempted to argue that while this looks good on paper, it is quite an
oversimplification of how things pan out in the real economy. But most economists share a common consensus on the effectiveness of automatic stabilisers and their ability to pull the economy out of a recession.
A Historical Perspective
A decade ago, when the United States was embattled with the Great Recession, the Obama
administration proactively used fiscal policy to combat the crisis. Over five years between 2008 to 2012, discretionary fiscal policy measures averaged at 2% of GDP, attaining a peak of 2.7% in the year 2010. In conjunction with that, automatic stabilisers scaled up the size of fiscal policy measures to 3.4% of the GDP over the five years. This was on account of increased expenditure on unemployment benefits, reduced taxes and augmented social security allowances. Unemployment Insurance (UI) emerged as the most robust automatic stabilizer, with UI recipients skyrocketing to 7 million by 2010. Studies prove that tax-induced consumption increase can offset as much as 8% of the GDP shock.
In the contemporary economic downturn exacerbated by the spread of coronavirus, unemployment claims in the US are peaking. Merely over the last week, 6 million unemployment claims were filed. By the end of May, the total number of beneficiaries of government aid stood at 29 million, although a large part of these workers is seasonally unemployed. However, it would be wrong to term all fluctuations in unemployment allowances as ‘automatic’, because, during times of higher unemployment, governments also amend the rules regarding the maximum weeks of coverage. Thus, there is a ‘discretionary’ element to it. But the vitality of unemployment claims and the reduction in taxes as a feature of the countercyclical fiscal policy certainly makes a case for the use of automatic stabilizers as a cushion against income shocks. Economies need to prime their fundamental fiscal structure to be crisis-ready, if not crisis-proof.