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Fiscal policy universalism, small country hawks, and a shrinking world

David Skilling
8 March 2013

This is the latest edition of a series containing reflections on recent global economic and political developments and debates from a small country perspective. This week, a few observations on the global fiscal policy debate motivated by recent events in the US, Italy, and the UK. Is there a distinctive small country perspective on fiscal policy?

The limits of fiscal policy universalism
The global fiscal policy debate continues, with high-profile arguments to loosen fiscal policy made by commentators such as Martin Wolf and Paul Krugman. This argument has been strengthened by sluggish growth in the UK and elsewhere in Europe, emerging political and social stress in southern European countries, and recent IMF research on fiscal multipliers. But this policy narrative, which is often developed in reference to the large economies, does not map directly onto small advanced economies. Fiscal stimulus is likely to be less effective in small economies, because of the larger size of the globally exposed sector. And small economies have less scope to accumulate public debt because financial markets tend to sanction loose fiscal policy in small countries more than in larger countries. As the crisis experience demonstrated, fiscal positions in small countries can unwind very quickly after an external shock and so a higher level of prudence is appropriate. Small countries are not just scaled down versions of larger countries; different policy approaches are sometimes needed. Although tight fiscal policy in small countries can lead to slower growth and higher unemployment, advice that small country governments should stimulate growth through loose fiscal policy should be treated cautiously. It may possibly be useful to talk about austerity v growth in the US, but this is often a misleading framing to use in small countries where small economies have much more limited freedom of manoeuvre. Small country governments should remember the importance of the small country context when large country voices speak, and look for policy guidance from their small country peers.

Small country hawks
An examination of fiscal policy across the advanced economies over the past several years shows a more conservative approach in small countries. For one thing, small countries had lower levels of net public debt going into the crisis in 2008 (an average of about 30% v 60% of GDP), even though small country public expenditure tended to be higher. And small countries have shown a marked tendency towards fiscal discipline, running tighter cyclically adjusted fiscal positions than larger economies. And those small countries that experienced fiscal difficulties, such as Ireland and Latvia, are pursuing aggressive fiscal consolidation policies. More generally, small countries are more likely to have announced short-term targets to get out of deficit. It is difficult to find a small advanced economy that is not engaging in tight fiscal policy, whereas the record across the larger economies is much more variable. Interestingly, this small country fiscal discipline is supported by a high degree of social consensus and political support (relative to larger countries like Spain, Italy and France). There seems to be a general understanding that fiscal discipline is appropriate in a volatile global economy. A key part of resilience in small economies is a solid fiscal position, so that the government can better manage through the shocks that small economies are exposed to. Indeed, it may be that the North v South divide on fiscal policy in Europe should be better seen as a difference in perspective between large and small economies.

Large becoming small
There is ongoing debate about the tight fiscal policy in the UK, as the government tries to halt the growth of its public debt. Critics argue that this approach is self-defeating, leading to slower growth (and downgrades), while George Osborne argues that it is a critical part of restructuring the economy. One way of interpreting this debate is in terms of whether the UK is a large or a small economy. Much of the criticism implicitly assumes that the UK has the fiscal space of a large country like the US, whereas the government’s approach suggests that it sees the UK as a smaller economy (and that it had few alternatives before market sentiment turned). Whether the UK has got this assessment right is a matter for judgement, but my sense is that increasingly other medium-sized countries will have to grapple with similar fiscal policy challenges. The intense process of globalisation, and the increasing exposure of all economies to international forces, reduces the effective size of larger countries. Although differences clearly remain with small economies, increasingly medium-sized economies will have to adopt an approach to fiscal policy that is closer to that adopted by many small countries – that is, more fiscally conservative. Similarly, part of the European fiscal policy debate depends on whether we should assess the tightness of EU fiscal policy in the context of a large regional economy or as a collection of individual countries (many of which are small). Thinking through the implications of economic scale will be increasingly important in designing and assessing fiscal policy.