Fiscal Policy, Budget Deficits and Government Debt

MSc EPS Session 5

Hilary term 2011

Professor Dermot McAleese

Aim of economic policy is to reduce volatility of market

economy

GDP

GDP with counter-cyclical policy

time

GDP withoutcounter-cyclical policy

Potential GDP

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

George Soros “The Game Changer” FT 28 Jan 2009

FISCAL POLICY

Counter-cyclical fiscal policy

The limits of fiscal activism

Fiscal policy 2008-10: averting a world depression

Policy recommendations for 2011 and beyond

US after the Great Crash 1929…. Real GDP falls by 29%

500550600650700750800850900950

1929

1930

1931

1932

1933

1934

1935

1936

1937

1938

1939

GDP (1996 $)

Private sector investment slumps .....

0

10

20

30

40

50

60

70

80

90

100

.. and prices fall by 25%(Inflation US$1996=100)

8

9

10

11

12

13

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

8

“I believe myself to be writing a book on Economic Theory which will largely revolutionise - not I suppose at once

but in the course of the next ten years - the way the world thinks about our

problems”

John Maynard Keynes - letter to George Bernard Shaw in 1933. The book was:

The General Theory of Employment, Interest and Money (1936)

Chapter 1 The General Theory

I have called this book the General, Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical1 theory of the subject, upon which I was brought up and which dominated the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

1.“The Classical Economists” was a name given by Marx to cover Ricardo and James Mill and their predecessors, that is to say for the

founders of the theory which culminated in the Ricardian economics. I have become accustomed, perhaps perpetrating a solecism, to

include in "the classical school" the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian

economics, including (for example) J.S. Mill, Marshall, Edgeworth and Prof. Pigou

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Key Elements in Keynesian Economics

Business expectations shattered by 1929 slump.

Lack of demand the problem , not lack of supply

Monetary policy by itself not sufficient to promote investment

Governments should:

• SPEND IN A RECESSION, even though budget deficit is getting larger (‘loan-financed public works’)

• SAVE DURING THE BOOM, even though it has abundant tax revenues

JM Keynes A General Theory of Employment Interest and Money 1936

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Objections to Keynes’ theory

• “We cannot afford it”

• Higher spending means more borrowing means higher interest rates

• More Goverment spending means higher future taxes

• Better to cut wages and become more competitive

• Trade unions too powerful

• Recession/depression self-correcting in the long run

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Achievements of Keynes (see Chapter 15)

• A key factor in enabling world economy to avoid repeat of Great Depression.

• Japan used Keynesian economics to avoid economic disaster since early 1990s

• US used counter-cyclical policy aggressively to offset effects of stock market collapse 2001-2

• And 2008-2010 also ..... 12

13IMF Oct 2009 ch 1

(% of GDP)

Consensus turns Keynesian

Limitations of fiscal policy

• Governments often got timing wrong – policies turned out to be pro-cyclical• Governments spent during the recession AND during the boom:

Govt spending rises as % GDPGrowing DEBT problems

• Private sector response to fiscal expansion becomes less positive

14

RESULT

15

Fiscal policy still an important tool of policy,

but no longer as effective as it was in the past.

16

PUBLIC DEBT

Public debt is sustainable when it remains constant proportion of GDP over time

Effect on financial markets’ expectations: inflation to erode real value of fixed-interest

debt debt default, rescheduling or moratorium on

interest paymentsPublic Sector Indebtedness (public debt adjusted

for pensions liabilities)Openness of the financial markets

fiscal conservatism … reinforced by ageing population

OECD Dec 2010

OECD Econ Survey June 2010 p. 49

2000 2010 2030 2045Japan 46.6 55.3 71.7 91.0France 53.6 52.8 67.9 73.7Germany 46.0 49.4 69.9 83.6China 48.0 40.3 50.5 62.5

AGE DEPENDENCY RATE

Source: computed from WDI Indicators World Bank

Age dependency = (pop 0-14 + 65+)/ pop 15-65

Policy Options for Ageing

Remove incentives for early retirement

More reliance on privately funded pensions

Find appropriate balance between public and private provision of health services and long term care of the elderly

Efficiency and cost-benefit of healthcare – limiting level of treatment by expectation

of life

Japan’s public finances

Japan:

Source: Aherne et al (2002)

Japan’s government expenditure and revenues 1988-2008

25.0

27.0

29.0

31.0

33.0

35.0

37.0

39.0

41.0

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Expenditure Revenues

Source OECD

Japan's Deflation 1995-2009

-2.0

-1.0

0.0

1.0

2.0

Source: CPI data, taken from World Bank, OECD24

Japan's government budget balance

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Japans Gross Government Debt as % GDP 1988-2007

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

Unemployment rates (% of labor force) for US, Euro area and Japan

OECD Dec 2010

JAPAN Real GDP growth 1961-2010 (% p.a.)

-5

0

5

10

15

End of Japanese boom

Fiscal policy – a Japanese view

• Japan’s fiscal deficit is ‘a perfect example of a good deficit’. Without the increase in spending that produced such larger deficits, Japan would have experienced a drop in GDP similar to that in the Depression era US where GDP halved in just 4 years. (p. 259)

• In a balance-sheet recession, the private sector focuses on reducing debt not on maximising profits. To increase government spending is the only effective response.

Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 2009

Fiscal policy: ECB pre-crisis

A discretionary fiscal policy attempting to fine tune the economy can have stabilising effects, but the size of the effect tends to vary depending on several factors and is generally assessed to be small. What is not small, however, is the risk associated with such activist fiscal policies. Experience suggests that unless a discretionary fiscal stimulus is timely, targeted and temporary, it actually risks being harmful.

ECB Monthly Bulletin June 2008 p. 79

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European Economic Advisory Group Brussels Feb 2010

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• Coarse tuning vs fine tuning• Monetary policy expansion necessary but not sufficient• How do we know if fiscal stimulus has been a success?• Will experience follow that of Japan? If so, is that necessarily undesirable? • How will private sector react?

Fiscal policy essential when economy is in deep decline (2008-)

Government spending (% GDP)

Source: European Economy April 2010 (to be updated)

2006 2009 2010 2011

Euro Area 46.6 50.7 50.8 50.2

Japan 36.2 42.6 43.0 42.9

US 36.0 39.8 39.3 40

France 52.7 55.6 56.1 55.9

Germany 45.3 47.6 48.0 47.2

Netherlands 45.5 51.6 52.3 51.7

Sweden 54.0 56.3 55.9 54.8

Italy 48.8 51.9 51.3 50.5

UK 44 51.7 52.6 51.3

2009 2010 2011Euro Area 86.3 92.4 96.7Japan 192.9 199.2 204.6United States 83.0 89.6 94.8

Belgium 95.7 100.9Italy 128.8 132.0 134.7Germany 76.2 80.9 84.2France 86.3 93.8 99.3Spain 62.6 72.8 78.4UK 72.3 82.3 90.8Ireland 70.3 82.9 92.5New Zealand 28.4 32.8

Source: OECD June 2010

General gross government debt (% of GDP)

United States Budget Balance (% of GDP) 1988-2011

Source: OECD Economic Outlook Dec 2010

2008 2009 2010 2011-6.3 -11.3 -10.5 8.8

-3 -3 -3 -3

THE THREE T’s OF FISCAL POLICY

To be economically effective, fiscal policy must be:

Timely

Targeted

Temporary

IMF WEOOct 2010

Questions on Economist article, 1 Nov 2008

1. “The standard response to a demand shock is to use monetary policy.” a) What is a “demand shock” and what caused it in the present context. b) Outline the major instruments of monetary policy.

2. Explain the meaning of the term “money multiplier”? Why is it “collapsing”? What measures could be taken to raise its value?

3. What effect would a steep fall in property prices and in the stock market have on the level of investment?

4. What are automatic fiscal stabilisers? Why do they differ in magnitude between countries?

5. What is meant by a “fiscal stimulus”? Does it matter if the stimulus takes the form of an increase in spending or a fall in taxation?

6. Some argue that increased government spending will lead to an expectation of increased taxes in future that will negate any effect on aggregate demand in an economy. Do you agree?

7. Why would a fiscal stimulus tend to be more effective in a large country (the US) than in a small open economy (Morocco)?

8. Under what circumstances is it justifiable for a government to plan for a budget deficit?

9. “Conventional monetary and fiscal policy may not prevent a prolonged deflationary slump.” What can be done if this happens?

10. What policy measures should Japan take to reduce its budget deficit? 

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