Fiscal policy and the economy – Introduction

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This series of articles will try to shed some light on one of the most important issues in economics: which are the effects on the economy of a relative increase or reduction in public expenditures?

Every country in the world is endowed with a public sector that, to a differing extent, has the mandate and the power to extract resources by imposing taxes and by issuing public debt, and then to use the proceeds for a variety of purposes. Among these are public investments in capital goods (roads, ports, highways and so on), employment of public workers in goods- and services-producing industries, and direct expenditures on goods and services. With the above in mind, the term fiscal policy can be defined as the set of decisions taken by the government regarding its revenues and spending.

Fiscal policy is of central importance in today’s Europe, as many countries are struggling to limit the damages brought about by the surge in government debt yields. This spike in interest rates is both hindering their economies and their financial systems, and forcing them to devote more and more funds to interest payments, which diverts them from more useful purposes.

It is evident to everybody that the crisis raging in the Eurozone is related to public debt and questionable fiscal policies at the national level, and to the lack of coordination in policy actions at the European one. Two opposite blocks of countries can generally be identified: the first one includes the northern states (Germany, Austria, Finland, the Netherlands, and France), while the second includes the so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain). The first group benefits from a situation of low yields, while skyrocketing yields and generally higher levels of debt and deficit affect the second.

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The ongoing debate about the possible solutions to the crisis is split between two major opposing views. The fiscal hawks, that see any intervention of the State aimed at supporting the economy as a damaging measure that would eventually erode confidence through higher debt and yields, and the Keynesians, that instead call for a large expansionary policy undertaken by a strengthened and coordinated European Union.

Acknowledging the importance of the subject, it will be useful to revise some basic concepts related to the economic effects of public expenditures. We will begin by discussing the arguments put forth by the two opposing sides and then we will review the evidence.

Michele Fornino

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