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Date: 16 October 2014 Speaker: Dr. Carlo Cottarelli, Italian Commissioner for Public Spending Reform; Former Director, Fiscal Affairs Department, International Monetary Fund, , Italy Discussant: Fillipo Taddei, Assistant Professor of Economics, Johns Hopkins University SAIS Europe, Bologna, Italy Chair: Michael G. Plummer, Director and Professor of International Economics, Johns Hopkins University SAIS Europe, Bologna, Italy

“Spending Review, Fiscal Policy and Growth” Part of the Financial Crisis and Growth Series

Dr. Carlo Cottarelli outlines the relationship between fiscal policy and growth in advanced economies against the backdrop of the recent findings of the Italian spending review and budget. He analyzes the debate regarding the role of public spending in generating growth and reducing unemployment. Further, he offers objective analysis of the conservative, liberal, and hybrid approaches to fiscal strategy and investigates the underlying methodologies used to evaluate the impact of fiscal policy on projected growth and GDP. Ultimately, Cottarelli maintains that changing the way spending reviews are executed is a necessary step for appropriate fiscal policy evaluation.

Cottarelli begins his analysis by reviewing the effects of the 2008 financial crisis on European economies and their fiscal stances. In general, and particularly in the periphery, fiscal policies have shifted from expansionary to contractionary starting in 2010, as governments attempt to improve imbalances. Cottarelli notes the significance of fiscal policy among Eurozone countries, since they have relinquished many traditional mechanisms for combatting country-specific economic malaise, including independent monetary policy and exchange rate influence. Thus, in an environment where interest rates are essentially zero, unemployment is high, and growth is low, Eurozone countries must be particularly deliberate in their fiscal strategies.

Cottarelli subsequently examines the overriding austerity debate from various perspectives. The conservative view holds that expansionary fiscal policy is not stimulative, and governments should focus on shoring up their deficit positions as a means for generating growth. On the other extreme are the more classic Keynesian advocates, who believe fiscal multipliers are large, and spending cuts would have a strong negative impact on economic growth. The Keynesian view has gained renewed legitimacy in the wake of the crisis, as most economists acknowledge at least the short-term negative economic impact of spending cuts, although the degree of that impact is heavily debated. A middle ground perspective suggests that fiscal policy impact depends on a country’s level of debt and the type of spending being undertaken. In general, Cottarelli maintains that we should design fiscal policy taking into account the short-term effects of spending cuts on growth, but we should not lose sight of the need to foster sustainable long-term patterns of spending.

Cottarelli next examines more technical aspects of fiscal policy evaluation. He extensively reviews the trend toward focusing on cyclically adjusted budget balances as opposed to headline government spending figures. Importantly, he notes that two of the three major rules under the EU Stability and Growth Pact are currently based on cyclically adjusted budget balances. As Cottarelli explains, cyclically adjusted budget balances aim at better identifying fiscal trends by correcting for the impact of economic activity of fiscal balances. They are thus designed to avoid pro-cyclical fiscal policies, namely the need to tighten fiscal policy in an economic downturn just because of the revenue loss related to the downturn itself.

The trouble with the trend toward cyclically adjusted budget balances, in Cottarelli’s view, is that this metric requires good estimates of potential growth, and those estimations are often remarkably misguided. Thus, while Cottarelli maintains that simply relying on nominal spending metrics can be misleading, we should also be cautious about relying too heavily on cyclically adjusted budget balances as our primary benchmark.

While acknowledging challenges in fiscal policy evaluation, Cottarelli offers specific prescriptions for improving the spending review process. Above all, he advocates taking a holistic approach to evaluating government spending programs. Often, countries focus exclusively on revising past spending programs, without thoroughly scrutinizing new spending programs. Spending review processes should validate the quality of all spending items, not simply past items. He also points out the significance of increased efficiency in spending, which can lead to notable savings. With respect to the Italian spending review process, he believes Italy has made good progress but several structural issues remain to be tackled, for example the presence of the central government at the local level, or the reform of the five police forces into a more cohesive unit.

Overall, Cottarelli is positive about the increased recognition that public spending policies play a key role in impacting the cyclical and structural aspects of economic growth, and he supports the many necessary measures that have already been undertaken to improve the process of spending reviews. However, more needs to be done at the technical level to improve the spending review process, and all countries should continue to reevaluate their methods for analyzing fiscal policy.

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