Property 101: The benefits of targeted fiscal intervention
Model simulations suggest that during private deleveraging, targeted fiscal interventions should be used to help unclog an economy’s credit system, as the cost of inaction is much higher including from a public debt sustainability perspective, according to IMF's latest report.
However, the optimal size of the intervention depends on the available fiscal space and the efficiency of intervention, under- scoring the importance of carefully designing these measures.
In the current global environment of low growth and private sector deleveraging—and with a strained financial system in some countries diminishing the effectiveness of monetary policy—there is a question of whether fiscal policy can play a role in facilitating the ongoing adjustment.
The dynamic general equilibrium model developed by Batini, Melina, and Villa (2016) is used in this box to assess the benefits of alternative fiscal policy measures.
The simulations assume that there is a shock in house prices similar in size to that observed in the United States during the global financial crisis, pushing the private sector into deleveraging. Three types of stimuli are considered: (1) a targeted intervention in the form of a subsidized government loan to the private sector when the credit channel is not working, (2) government consumption, and (3) public investment. Figure 1.4.1 shows the relative benefits of these measures compared to a no-policy-action scenario.
Overall, targeted fiscal intervention can alleviate the recessionary impact of private sector deleveraging, with the output gap up to 41⁄2 percentage points higher relative to no action (panel 1). By relaxing the private sector’s borrowing constraints, this type of measure allows households and firms to spend while deleveraging, supporting aggregate demand.
In addition, public debt is slightly lower than under no intervention, despite the up-front fiscal cost as a result of the boost to growth (panel 2). The benefits of intervention (in terms of minimizing output losses) for a given size of stimulus decrease with the inefficiency costs associated with poor targeting (red versus blue lines in panels 1 and 2).
The output benefits of targeted intervention are four times larger than those of more standard stimulus measures (panel 3). The main reason for this powerful result is that, by lending to credit-constrained house-holds and firms, the government can leverage a much larger amount of spending than through other policy stimuli of equal cost.
That is because the fiscal cost of targeted intervention is only a fraction of the total government loan.
The higher the initial public debt (a proxy of the available fiscal buffers), the lower the optimal level of intervention that minimizes output losses (panel 4). With higher public debt, the sovereign risk premium goes up, increasing the fiscal cost of intervention and thereby limiting the optimal amount of credit that the government can intermediate.
Still, intervening pays off as long as there are some buffers, suggesting that multipliers are very high.
