WITH A PERMANENTLY PRO-CYCLICAL FISCAL POLICY, WE COULD LOSE DEMOCRACY AND MONETARY POLICY.

• Author: Croitoru, Lucian

1. Introduction

   Over the past two decades, Romania's fiscal policy has been mostly pro-cyclical, i.e. its fiscal impulse and output deviation from potential have been concomitantly either positive or negative. Pro-cyclical fiscal policies increase growth rates in the business cycle upswings and lower them even more to very negative levels in recessions. Politicians in Romania have not learned this lesson yet. In 2017, despite a GDP growth rate of about seven percent and an excess demand of about 2.9 percent of potential GDP, the government decided to administer the economy a positive fiscal impulse of about 1.4 percentage points.

   In this article I will focus on two issues. First, I will come up with two possible explanations for promoting a pro-cyclical fiscal policy in Romania during periods of swift economic growth, at rates above potential, partially fueled by the fiscal policy itself. The need for such explanations arises because, unlike the monetary policy, which is partly insulated from political interference, the fiscal policy is formulated in an intricate political process. Neglecting this process may lead either to misunderstanding or underestimating long-term trends which, as I will show, erode democracy or to unrealistic conclusions about how to preserve a correct fiscal policy stance at all times.

   Then I will analyze the consequences of the expansionary fiscal policy separately for the 'normal' phases of the business cycle, when monetary policy rates are significantly positive, and for the 'abnormal' phases, when policy rates are virtually equal to zero. Experience so far has shown that, during normal business cycle phases, if the short-term Phillips curve (the link between inflation and excess demand) is not flattened (i.e. excess demand generates relatively high levels of inflation), a pro-cyclical fiscal policy during the expansion entails a massive rise in inflationary pressures, which calls for higher interest rates. Then, when the economy inevitably enters the contraction phase, fiscal policy remains pro-cyclical, this time unintentionally, deepening recession and unemployment. In other words, the pro-cyclical fiscal policy in the expansionary phase of the normal cycle leads to the loss of fiscal policy during the recession and the exit from recession.

   I will show, however, that if the short-term Phillips curve is flattened (excess demand generates relatively low levels of inflation), then it is likely for inflationary pressures that lead to higher interest rates during the normal phase not to emerge anymore. In an environment of relatively low inflation and interest rates, along with a pro-cyclical fiscal policy, it is highly likely that the entry into recession triggers an abnormal phase of the business cycle, when monetary policy rates hit the zero mark without the economy returning to potential, which would entail the loss not only of the fiscal policy, but of the conventional monetary policy as well.

2. A cognitive explanation of pro-cyclical policies in democracies with weak institutions

   Most economists and analysts have explained the pro-cyclical fiscal policy in Romania during expansionary phases of the economy through populism and lack of knowledge of the implications of a pro-cyclical fiscal policy. In other words, according to these authors' explanation, the promoters of such a policy believe they are right in their actions, without realizing that they might add problems to inflation management in the expansionary phase of the business cycle or that they definitely contribute to higher unemployment thereafter. This explanation is similar to that suggested by Rogoff and Reinhart (2008) through the phrase 'this time is different', which also implies the lack of knowledge, not necessarily of the negative effects, but of the unavoidability of a crisis.

   However, part of this explanation--namely that regarding the obliviousness of the harmful effects or inevitability of a crisis--might not be correct. Economists have repeatedly explained that, in an economy such as Romania, a pro-cyclical fiscal policy in the expansionary phase is almost doomed to remain pro-cyclical during the downturn as well, deepening unemployment. Figure 1 depicts the pro-cyclicality of the fiscal policies in Romania through positive (negative) fiscal impulses and positive (negative) output gaps simultaneously at work. It can be seen that pro-cyclical fiscal policies in expansionary phases have remained pro-cyclical during downturns and for quite a while afterwards as well. This brings up the question of why a government would want to implement pro-cyclical fiscal policies if it can anticipate their detrimental effects on voters. In extremis, in a cognitive approach, like the one proposed herein, there can only be two answers: governments either use those detrimental effects as a means to a political end or believe they can dodge such effects. I will explore the two possibilities one by one.

   2.1. The 'fiscal cynicism' assumption

   Capitalizing on the harmful effects can be an end only in a democracy with weak institutions. My explanation, which I call the 'fiscal cynicism' explanation, is that--in such a democracy--there may emerge a logic of alternance in power whereby the costs of a pro-cyclical fiscal policy will be borne by the current opposition (future ruling party), which will weaken and reduce it in favor of the current ruling party (future opposition). By virtue of this logic, any party coming to power during the upswing of the business cycle would promote pro-cyclical fiscal policies.

   This explanation assumes there are political parties or coalitions that embark on a path of maximizing their political market share over the long term, and decide to govern, if they can, in all periods of economic expansion, which they amplify via pro-cyclical policies in order to weaken their political foes, and not to govern in any recessions. As I will show at the end of this section, in Romania we can identify a party that has so far governed almost exclusively during upturns of the business cycle and promoted pro-cyclical fiscal policies each time. However, we have no grounds to claim that governing solely during upswings was or was not part of a strategy pursued by the said party or that it was guided or not by cynical or benevolent intentions. It is not the aim of this article to determine what intentions or strategies have guided or are guiding the pro-cyclical fiscal policies of political parties. The aim of the article is to identify the possible explanations for these pro-cyclical fiscal policies, and to infer the implications that arise if, for whatever reason, one and the same party governs during all business cycle upturns and promotes pro-cyclical fiscal policies.

   The objective of governing solely during periods of expansion (not at all in recessions) is rational from the perspective of a cognitive bias of the public: the significance in terms of advantages and disadvantages that an unanticipated gain has compared with an unanticipated loss of equal magnitude is stronger in case of the loss. As I have shown in another article (Croitoru, 2017), the first economist to write about this cognitive bias was Knut Wicksell (1898, p. 3). In virtue of this cognitive bias, losses emerging in recession are perceived more strongly in absolute value than gains during upswings. Thus, if a party that governs in the expansionary phase of the business cycle and promotes pro-cyclical fiscal policies were to govern during the ensuing contractionary phase as well, its image would be seriously dented. By contrast, governing exclusively during periods of upturn, there is increased likelihood for the respective party to be associated by the public with the idea of success and welfare.

   In the theory of fiscal cynicism there are no guarantees about how long an expansion can last. Expansions can be very brief. For instance, in the US, the shortest upturn after World War I lasted 12 months. In theory, as time goes by, the economy nears a potential recession which can set in anytime. Hence, for parties maximizing their market share by governing only in virtually all times of economic expansion, in the logic of fiscal cynicism there arises, on one hand, the need for fiscal policy to be pro-cyclical from the beginning and, on the other hand, the urge to step down from power immediately after the possible entry into recession. Moreover, it is sensible that the pro-cyclicality of fiscal policy should heighten towards the end of the governing period, which coincides in time with the approaching of parliamentary elections. Heightened pro-cyclicality may ensure the success in the forthcoming elections of the party that governs solely in the expansionary phases, without any political damage in the future. If, after winning the elections, the economy is hit by recession, the logic of fiscal cynicism dictates that the respective party steps down, so as not to pay the cost of the expansionary fiscal policy it promoted.

   The explanation I have put forward triggers immediately two questions: why the ruling parties that promote fiscal cynicism are not penalized by voters? And why the other parties do not adopt strategies to prevent the governing of one and the same party only in the expansionary phases of the business cycle?

   The answer to the first question is that the lack of sanctions from voters owes to the influence of three factors. One such factor is none other but the aforementioned cognitive bias of the public at large, to whom the significance of losses is greater when compared to that of gains of equal magnitude. Another factor is that, while almost...