Monetary and fiscal policy, in response to natural disaster. Case of Albania 2019

The government should consider using methods devised by experts who have studied approaches to preventing and coping with the effects of natural disasters.

In a broader context, natural disaster risk assessments need to be integrated into the medium-term fiscal policy framework (including budgeting, public investment planning and debt management). Specifically, the government should regularly integrate potential estimates of the frequency and severity of natural disasters (floods, fires, etc.), analysis of potential fiscal costs and comprehensive financing strategies for post-disaster spending in their medium-term fiscal frameworks.

By creating adequate fiscal forecasts within the budget format, a risk-based approach to fiscal management can help determine the amount of self-insurance needed, as well as the number of resources to be allocated to prevent and mitigate natural disaster impacts. Thus, accurate estimates of potential fiscal costs are needed to facilitate appropriate responses to post-disaster situations and to enable better cost-benefit analysis of various risk mitigation and insurance programs. These estimates can be based on a country’s history of natural disasters.

The public investment strategy should strengthen the approach for infrastructure resilience to disaster risks and include regular contingent government obligations arising from natural disasters, which may include the costs of repairing local government infrastructure or state-owned enterprises.

The state budget for several years after a natural disaster, such as that of November 26^th, 2019, should have the flexibility to provide timely and effective response to the next disaster. In general, flexibility should include the ability to quickly reallocate spending across budget items, as well as streamline processes for preparing and ratifying revised budgets.

Contingency plans for disaster relief financing and post-disaster recovery should rely on a mix of potential disaster response plans, using borrowed resources or grants, as well as risk transfer using insurance, debt instruments, such as and other equity market options.

Depending on the extent of the consequences of a natural disaster, international experience suggests reserving up to 3 percent of costs in order to deal with the fiscal risks associated with natural disasters (Cebotari et al. 2009). Unused funds, within specified limits, may be transferred at the end of the budget year to another fiscal item, or carried over for the following year (e.g. to be used during a future disaster, or for other needs social emergency etc. of the government).

Monetary policy

The natural disaster can cause a conflict between two objectives that are subject to monitoring and regulation between the Government and the Bank of Albania.

On the one hand, the simultaneous rise in prices, i.e. inflation, and on the other hand the short-term tendencies for decreasing the upward trend of the economy.

It is up to the Bank of Albania and the Ministry of Finance, both of whom should be harmonized in policies and objectives to reassess the objectives and follow the best course of action. Because the initial influx of inflation following a disaster is temporary, localized and concentrated in specific sectors, monetary policy should affect keeping inflation low.

Even if the Bank of Albania wants to control inflation, it cannot do so without significantly raising interest rates as monetary policy targets the whole economy, which would put further pressure on an already slowing economy. Holding expansionary monetary policy in this context would provide additional liquidity for the financial system and maintain high confidence in the aftermath of the catastrophe.

However, both pre-disaster interest rate and inflation level may limit the use of monetary policy.

But in the meantime, the Bank of Albania may also could lower interest rates to stimulate interest-driven spending, such as capital investment and consumption of everyday goods and services.

Fiscal Politics

As monetary policy is developed under the discretion of the independent central bank, fiscal policy must balance public perception, political opposition, and public debt risk in setting a policy, both to finance a fiscal response and how the money will be distributed to the victims of the disaster.

Natural disasters affect both government spending and tax revenues with immediate and extended impact over the medium term.

However, the entire reconstruction process is expected to have an increase in tax revenue, as the economic impact recovery activity starting with the reconstruction process will have an impact on the revenue growth of the businesses participating in these projects, which will be financed by budget funds, but also by foreign funds, which are a capital inflow for direct investment into the economy.

On the expenditure side, the government has three options to finance a change in fiscal policy. It can reorient funds from planned projects and cut existing costs, borrow or raise taxes. For maximum effectiveness, the option chosen must be in accordance with prevailing economic conditions.

If fears of high inflation prevail and fears that the economy may be overheated by various restrictions and increased tax burdens, a temporary tax on citizens would be most effective as it reoriented funds to pressing areas while reducing demand. for additional funding from private businesses.

Meantime, when a natural disaster occurs, government finances are sensitive on two fronts. First, economic activity may initially shrink in the short term, reducing tax collection. But the impact of lowering revenues largely depends on the extent of economic diversification and the structure of tax revenues.

The effects vary depending on the economic sectors and sources of income (e.g. personal income tax (PIT), national taxes, VAT or customs duties, etc.). Second, post-disaster relief and reconstruction efforts can increase public spending and affect other priority spending, but also with potentially long-term effects on strengthening human capital and the rate of potential growth of an economic sector.

If the economy is considered to perform poorly (below its potential capacity), then borrowing is the most effective approach as it has the additional effect of increasing aggregate demand on reoriented resources. However, a government’s ability to borrow is limited by existing public debt, as additional debts can increase the risk premium and additional costs may outweigh the benefits.

The risk of over-indebtedness is particularly high when the low performance of tax collection is compounded by the negative effects of the additional costs dictated by the disaster.

That is why Japan, as the country with the highest debt burden in the group of industrialized countries, chose not to borrow after the earthquake emergency relief fund, despite a shrinking economy in those years.

By using the funds raised, the government in line with the Central Bank can compensate victims through additional cash payments, contribute to public infrastructure projects or subsidize affected industries by temporarily implementing direct money supply policy (Helicopter Money).