Ukraine’s fiscal plan: Hunger strike vs Change Diet

The recently released program of the Ukrainian government claims that the public spending should decrease by 10% of GDP over 2015-2016. Is this a good idea? To stimulate public discussion, VoxUkraine is starting a debate to present views for and against this proposal. The first post by Yuriy Gorodnichenko (University of California, Berkeley) argues “against” the proposal.

This program of fiscal austerity is comparable to what Greece implemented in 2009-2013. Greece had a large fiscal deficit in 2009 (about 12% of GDP) and it reduced it close to about 2% in 2013. But Greece received a huge aid package (110 billion euro loan in 2010 and 130 billion euros bailout in 2011) from the IMF, European Central Bank, and European Commission. This package is roughly equal to 100% of Greece’s pre-crisis GDP. For comparison, Ukraine’s aid from the IMF amounts to about 10% of GDP. In contrast to Ukraine, Greece did not have a war and disruptions in energy supplies. Yet, even in these relatively favorable conditions, the cumulative decline of output in Greece between 2007 and 2013 was 25%. The economic cost of austerity in Greece is simply tragic. This is as bad as the Great Depression was in the U.S.

How could one justify so much austerity for Greece? It was motivated by the belief that once government finances are in a better shape, the market confidence is going to be restored and the economy is going to resume growth via private consumption and investment. This belief proved to be utterly wrong. Instead, it became clear that fiscal consolidation in the midst of a major recession is particularly painful for the economy as fiscal multipliers are likely to be above one. In other words, a dollar reduction in government spending leads to a decrease in private consumption and/or investment so that aggregate output declines by more than a dollar. But if output falls, then government revenue falls which calls for a new round of government spending cuts. This vicious circle can go on and on. Even the IMF admits that it underestimated the extent to which budget cuts could exacerbate economic hardship for countries experiencing an economic downturn.

Now Ukraine plans to repeat what Greece did. Given how bad austerity played out in Greece, why would Ukraine want to do it? Proponents of fiscal austerity make several points.

1. Fiscal imbalances should be addressed to restore confidence. My discussion above suggests that it did not work for Greece (or any other country during the Great Recession) and one should not expect it to work in Ukraine.
2. Countries with a lower share of government spending in GDP grow faster. This relationship is in the data but it is a correlation. There is no causality here. Poland has a share of government spending in GDP that is comparable to what Ukraine has had in recent years. Yet, Poland grew as fast (if not faster) as other countries in the region.
3. The share of government spending in GDP is rising and this trend has to be stopped. A significant part of this rise is determined by the fact that Ukraine’s GDP (the denominator in this ratio) fell like a rock. The level of government spending in Ukraine was falling or flat. The policy should focus on stimulating GDP (improving the denominator) instead of reducing public spending (the numerator).
4. The debt to GDP ratio is rising to dangerous levels. A jump in the ratio is due to a large depreciation of hryvnia (over a half of public debt was in foreign currency and so the value of debt in terms of hryvnias rose), falling output (denominator of the ratio), and low tax revenue (mainly due to collapsing economy). The first factor may be interpreted as a one time event. The second factor is really a reason why the government should focus on stimulating output rather than shrinking it. The third factor has a similar implication plus calls for an optimization of public finances. Finally, Ukraine’s foreign public debt is about 35% of GDP which is far from lethal.
5. Now is the only time when the government and the public can make sacrifices. The record of the Ukrainian government on keeping promises is dismal. So there is an element of truth here. But the cost of being unable to commit to a course of actions in the future is extremely high: for every hryvnia cut in spending, output is going to fall by more than one hryvnia. And economic theory tells us that a unit of output is valued more in recessions than in expansions so the pain is further amplified. Does the government need to cut out its legs to prove that it’s not going to run away with the money it can obtain in the future to support public spending now?
6. The government does not have enough tax revenue and can’t borrow. It’s true that the tax revenue is low and the cost of borrowing in private markets is prohibitively high. But Ukraine received a significant loan from the IMF and more donor/public money can flow in if the government gets serious about reforms. For example, Ukraine could borrow one billion dollars cheaply with a guarantee by the U.S. government. The West signals that more support is conditional on reforms. Also the government can generate revenue from alternative sources (e.g., 3G auctions).
7. Government spending must be cut to get rid of waste. This argument effectively suggests that if a patient is obese because of a wrong diet, the solution to this patient’s problem is to stop eating. This argument is hard to swallow. A better solution is to improve the diet and exercise more. If there is waste in public spending, the government should reduce the waste, improve efficiency and hence stretch every buck of public spending as far as possible. For example, subsidies to Naftogaz should be eliminated as soon as possible.

The fiscal situation in Ukraine is difficult and this problem has to be addressed. However, the proposed solution to cut spending so drastically undermines all efforts to achieve macroeconomic stabilization. For example, does anyone believe that a further decline in output triggered by a massive fiscal downsizing is going to help stabilize inflation or the exchange rate in Ukraine? Stimulate investment? Improve allocation of resources in the economy? Raise confidence of consumers? Repair the banking system? In other words, is the benefit of the proposed austerity commensurate with the cost? I believe the answer to this question is “no”.

Fiscal problems have to be solved but it does not mean that it has to be done right now, when Ukraine’s economy is in a very bad shape. Cutting public spending and raising taxes (which includes closing loopholes in the tax law) will have to happen. However, given the current circumstances fiscal austerity treats symptoms rather than the disease. The consensus view, which is endorsed even by the IMF, is that fiscal and public debt problems should be addressed when economy is expanding, not collapsing. Fixing the government machine, reducing regulation, fighting corruption, implementing decentralization of economic decisions seem to be activities with higher returns for Ukraine’s development.

The bottom line is that the government should find a balance between improving fiscal stance and not destroying the economy in the short run. A reasonable solution could be to have a path of fiscal adjustment with fiscal consolidation back-loaded (that is, it should happen in a few years) rather than front-loaded (that is, it should happen immediately).