Thorvaldur GylfasonInternational Monetary Fund/Asian Development

Bank Course on Financial Programming and Policies

Seoul, Korea, 17-28 May 2010

1. Objectives of fiscal policy Stabilization, allocation, distribution

2. Global financial crisis and fiscal policy response

Benefits associated with fiscal policy

3. Risks associated with fiscal policy

Public debt dynamics Sustainability of public debt Safeguarding fiscal sustainability

1. The term fiscal policy fiscal policy refers to the use of public finance instruments to influence the working of the economic system to maximize economic welfare

2.2. Effects of fiscal policy Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing

3. Assessing the stance of fiscal policy stance of fiscal policy requires taking account of the activities of allall levels of government

Vito Tanzi

1. StabilizationFiscal policy influences aggregate demandaggregate demand

Directly because Y = C + I + G + X – Z Indirectly because C depends on income after taxafter tax

Through demand, fiscal policy affects output, employment, inflation, balance of payments

2. AllocationFiscal policy also influences aggregate supplyaggregate supply

Public infrastructure, education, health care

3. DistributionThrough taxes, transfers, and expenditures Progressive, neutral, regressive

Fiscal policy can be used to several ends To achieve internal balanceinternal balance

By adjusting aggregate demand to available supply By achieving low inflation, potential output

To promote external balanceexternal balance By ensuring sustainable current account balance By reducing risk of external crisis

To promote economic growtheconomic growth E.g., through more and better education and health care

Fiscal policy needs to be coordinated with monetary, exchange rate, and structural – i.e., supply-side – policies

Demand managementE.g., lower income

taxes Aggregate supplyin short run

Aggregate demand

Pri

ce level

Output

A

B

Demand managementE.g., lower income

taxes

Supply managementE.g., lower import tariffs

Aggregate supplyin short run Aggregate supply

in short run

Aggregate demand

Aggregate demand

Pri

ce level

Pri

ce level

Output Output

A

B

B

A

National income accounts Y = C + I + G + X – ZY = C + I + G + X – Z S = Y – T – C = I + G – T + X – Z, soS = Y – T – C = I + G – T + X – Z, so G – T = S – I + Z – X G – T = S – I + Z – X

Government budget deficit must be financed either by (a) having private saving in excess of private investment or (b) by accumulating foreign debt through a deficit in the current account of the balance of payments, or both

Alternative formulation G – T = G – T = B + B + DDGG + + DDFF

Government budget deficit must be financed by borrowing either at home or abroad, i.e., from (a) the public, (b) the banking system, or (c) foreigners

Y = GDPC = ConsumptionI = InvestmentG = Government expenditure (plus lending minus repayments)T = Taxes (plus grants)X = ExportsZ = ImportsB = Government bonds outstandingDG = Credit from banking systemDF = Credit from foreigners

Inflationary vs.

noninflationary

finance

Central bank financing involves money money creationcreation Inflation taxInflation tax: Most inflationary form of financing

Bond finance is less inflationary Removes financial resources from circulation Increases real interest rates Crowds out private investment

External financing can be inflationary Especially if it leads to currency depreciation

Evidence from cross-country data Strong links between budget deficits and inflation

in developing countries, but not in industrial countries

Bond finance is the rule in industrial countries … … and money finance is the exception

Conventional budget surplus T – GT – G

Large in upswings when tax base (YY) is strong Small in downswings when tax base is weak

Full-employment surplus TTFEFE – G – G

Use tax revenue as it would beat full employment

Independent of business cycles A budget in deficit could be in

surplus with full employment Deficit can be consistent with

a tight fiscal stance fiscal stance (see chart)

T, G

YYFEY < YFE

T

G

Problem here is not

that deficit is too

large but that income

is too lowEconomic expansion

would automatically

turn deficit into

surplus

Public sector borrowing requirementBroad measure of public sector deficit,

including central, state, and local government Primary budget balance

Leaves out interest payments Conventional deficit = G – T = GN + GI – T = GN + iDG

- T Primary deficit = GN – T = G – T – iDG

GN = Noninterest expenditureGI = Interest expenditurei = Nominal interest rateDG = Government debt outstanding

Operational deficitLeaves out inflation component of interest

payments Operational deficit = conventional deficit minus

inflation componentinflation component of interest payments = primary deficit plus real component real component of interest payments

Conventional deficit: G – T = GN + iDG – T = GN + (r + )DG – T

Operational deficit: G – T - DG = GN – T + rDG

Hence, operational deficit includes only real real part part of interest payments, leaves out the inflation partinflation part

GN = Noninterest expenditureGI = Interest expenditurer = Real interest rateDG = Government debt = Inflation rate

r ≈ i -

Before Great Depression 1929-39, many thought that governments needed to balance their budgets from year to year

Even so, US had built is railways through borrowing, for example

Keynes revolted (General Theory 1936) If private sector failed to consume and invest,

government could fill the gap Y = C + I + G + X – ZY = C + I + G + X – Z CC and II and GG appear side by side Guns or butter? Makes no difference Also, could reduce taxes to encourage CC and II

Multiplier analysis It could be shown that, with unemployed

resources, an increase in G would raise Y by an amount greater than the original increase in G

Active fiscal policy was used consciously in Sweden even before Keynes …

… and adopted in US and elsewhere after 1960 (Kennedy-Johnson administration) Coincided with buildup of US as a welfare state

with greater emphasis on public services and social security, like in Europe

Active fiscal policy came naturally to Europe

Fiscal policy can affectAggregate demand, output, and price level

Cut taxes: Consumption, output, and prices riseRate of monetary expansion and inflation

Increase spending financed by credit expansion: Money expands (M = D + RM = D + R), so inflation goes up

Aggregate supply and economic growth Boost education and health care: Efficiency and

long-run growth go upCurrent account of balance of payments

Raise taxes: Disposable income and imports fall, so current account improves unless currency appreciates

Fiscal multipliers are positive, but small Impact of fiscal policy actions depends on

Whether economy is open or closed (import leakage) Exchange rate regime (fixed or floating) Type of budget financing (money creation or debt) Degree of confidence in economic policy

Level of government debt Financing constraints Risk premia on debt

Whether fiscal changes are considered temporarytemporary or permanentpermanent

How close the economy is to full employment

Expenditure Income Interest Rate(+) (+)

Consumption

Investment

Tax revenue

(+)

(-)

(-)Gov’t BudgetBalance

(+) (-)

RE(+)

(+)

Capital

Labor

(+)(+)

Fiscal Policy

(+)

(-)

(-)

Monetary policy has been used heavily

Its further impact may be limitedIn many countries, policy interest rates

already approach zeroMonetary policy may have limited effect

during “balance sheet recessions,” when many firms are technically bankrupt, will use increased earnings to restore capital, and may not respond to lower interest rates Koo (2009), Holy Grail of Macroeconomics: Lessons from

Japan’s Great Recession

Mixed evidence on efficacy of fiscal policy in developing countries

While automatic stabilizing impulses are weak and make the case for discretion, there is also the widely noted occurrence of pro-cyclicality

The focus of stimulus packages differ between advanced and developing countries

Infrastructure spending 46% of fiscal stimulus in developing economies, but 15% in advanced economies

Tax cuts over 34% of fiscal stimulus in advanced economies, only 3% in developing economies Khatiwada, S. (2009), “Stimulus Packages to

Counter Global Economic Crisis; A Review,” International Institute for Labour Studies Discussion Paper 196.

No clear consensus among economists about the size of fiscal multipliers (response of real GDP to tax cuts or higher spending)

Recent IMF Staff Position Note reports: A rule of thumb is a multiplier (using the definition ΔY/ΔG and

assuming a constant interest rate) of 1.5 to 1 for spending multipliers in large countries, 1 to 0.5 for medium sized countries, and 0.5 or less for small open countries.

Smaller multipliers (about half of the above values) are likely for revenue and transfers while slightly larger multipliers might be expected from investment spending.

Negative multipliers are possible, especially if the fiscal stimulus weakens (or is perceived to weaken) fiscal sustainability.

Source: Spilimbergo, Symansky, and Schindler (2009), “Fiscal Multipliers,” IMF Staff Position Note spn/09/11.

Countries Countries Amount in Amount in

US$ (billion) US$ (billion)

As a % GDP As a % GDP Fiscal balance 2009 Fiscal balance 2009 (% of GDP, est.)(% of GDP, est.)

Japan 774 16.4 -6.8 China 586 14 -3.1 S. Korea 86 12.8 -2.1 Singapore 13.8 10.7 -3.5 Malaysia 18.1 10 -7.4 Thailand* 3.3 1.2 -4.0 Indonesia 6.1 1.2 -2.6 Philippines 6.5 4.6 -3.2 Vietnam* 17.6 22 -7.0 Cambodia 0 0 -3.2

*Financing of Vietnam and Thailand’s second stimulus packages have been excluded as financing is yet to be finalized.

23

CountriesCountries Debt (% of GDP)Debt (% of GDP) China 16 Hong Kong 14 Indonesia 30 Japan 170 Korea 33 Malaysia 43 Philippines 56 Singapore 114 Thailand 42 Vietnam 39

Source: ADB.

SolvencySolvency Satisfying solvency condition

LiquidityLiquidity Ability to meet maturing obligations

SustainabilitySustainability Solvency + liquidity + no expectation of unrealistically large adjustment

VulnerabilityVulnerability Risk of insolvency or illiquidity

Monetary surveyM = R + DD = DG + DP

Fiscal policy determines government’s demand for bank financing (DDGG), which, in turn, affects total domestic credit (DD), i.e., net domestic assets (ignoring other items net), and money (MM)

Increased budget financing requires greater monetary expansion unless credit to private sector (DDPP) is cut or foreign reserves (RR) go down, reflecting weaker balance of payments position

M = Money supplyR = Reserves (NFA)D = Domestic credit (NDA)DG = Domestic credit to governmentDP = Domestic credit to private sector

In times of financial and economic crisis, fiscal policy plays key role in government’s response

Fiscal policy played a role during Great Depression, even if theory behind it was poorly understood, or even disputed

Fiscal policy plays key role in current crisis Monetary policy is ineffective if real interest

rates cannot be reduced without igniting inflation

Fiscal policy is more effectiveMassive fiscal stimulus in US, Europe, and Asia: it

works!Fiscal stimulus is assisted by automatic stabilizers

Fiscal stimulus packages need to include an exit strategy exit strategy to ensure that solvency is not at risk, and should

Not have permanent effects on budget deficitsProvide a commitment to fiscal correction,

once economic conditions improve Include structural reforms to enhance growthShould firmly commit to clear strategies for

health care and pension reforms in countries facing demographic pressures

Need for financing tends to lift interest rates, so capital flows in and currency tends to appreciate

Central Bank must offset incipient appreciation by expanding money supply, thereby reinforcing initial fiscal stimulus

Otherwise, exchange rate could not remain fixed Fiscal stimulus works

under fixed exchange

rates

Need for financing tends to lift interest rates, so capital flows in and currency appreciates

Appreciation reduces net exports, aggregate demand, and interest rates

Process continues until interest rates fall to their initial level

So, fiscal stimulus is ineffective with perfect capital mobility

But concertedconcerted

fiscal stimulus can

work even

under floating

exchange

rates

In times of large deficits and growing large deficits and growing public debtpublic debt, public spending can have weak or even negative effectsBy creating expectations of a fiscal fiscal

crisiscrisis, and hence of higher future taxesIncreased saving may lead to a sharp fall

in consumptionHence, fiscal stimulus can fail, and may

even prove counterproductiveConversely, fiscal contraction may prove

expansionaryRicardian equivalence

Fiscal policy is frequently key to addressing balance of payments problems

Simple mechanismM = R + D M = R + D means R = R = M – M – D = D = M – M – DDGG – – DDPP

Hence, given MM and DDPP, key to raising RR is reducing DDGG

IMF: It’s Mostly Fiscal!

Or look at it this way:Y = C + I + G + X – Z Y = C + I + G + X – Z means

X – Z = Y – C X – Z = Y – C – T– T – I – G – I – G + T+ T = S – I + T - G = S – I + T - GHence, current account balance (X – ZX – Z)

equals sum of private sector surplus of saving over investment (S – IS – I) and government surplus of taxes over public expenditure (T – GT – G)

Equivalently, Z – X = I – S + G – T Z – X = I – S + G – T means that external deficit equals sum of private sector deficit and government budget deficit

Unsustainable fiscal policy can trigger a crisis if public loses confidence in government’s macroeconomic policy

Sudden capital outflow can result, weakening balance of payments and leading to a sharp devaluation

Financing the budget externally builds up external debt, increasing risk of crisis

Fiscal sustainability thus matters not only for debt, but also for balance of payments

Fiscal contraction (spending cuts, tax increases) can slow down inflation, reduce current account deficit

Fiscal expansion (tax cuts, spending increases) can shrink unemployment, increase aggregate demand and help restore output to full capacity, i.e., bring actual GDP up to potential GDP, especially if monetary policy is impotent

Automatic, or built-in, stabilizers are revenue or expenditure provisions that have counter-cyclical impact withoutwithout need for policy intervention

Protect against shocks Dampen business cycles

ExamplesProgressive taxes on income, profits Price stabilization fundsUnemployment insurance

Canada had no major bank

failures during Great

Depression, and did not

establish its Deposit

Insurance Corporation until

1967

How about the U.S. next

door?

Change in Canada’s per capita GDP from year to year 1871-2003 (%)

Change in US per capita GDP from year to year 1871-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Change in UK per capita GDP from year to year 1871-2003 (%)

Not quite as clear, but standard deviation of per

capita growth fell from 3.1% 1831-1945 to 1.8%

1947-2003

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Change in French per capita GDP from year to year 1821-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Change in German per capita GDP from year to year 1851-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Source: Maddison (2003).

Change in Swedish per capita GDP from year to year 1821-2003 (%)

Objections to fiscal activismBorrowing to finance increased government

expenditures raises interest rates, thereby crowding out crowding out investment and reducing multiplier

At full employment, increased public spending, however financed, leads to inflationinflation without stimulating output except temporarily

Increasing spending or cutting taxes to combat unemployment may impart inflation bias inflation bias to economic system Rules vs. discretion Long lags, including approval and implementation

Fiscal activism may tend to expand public public sectorsector

Government has vital role to play in modern mixedmixed economies (allocation role)

EducationHealth care, cf. current debate in United States Infrastructure (roads, bridges, etc.)

Some would also stress government’s distribution role …

… claiming that the government should try to secure reasonable equality equality in the distribution of income and wealth, including poverty poverty alleviationalleviation

Normative or positive economics? Partly positive: Equality is good for growth

Two views Inequality Inequality

sharpens sharpens incentives incentives and thus helps growth

Inequality Inequality endangers social endangers social cohesion cohesion and hurts growth

117 countries,1960-2000

-8

-6

-4

-2

0

2

4

6

10 20 30 40 50 60 70

Gini index of inequality

Pe

r ca

pita

gro

wth

ad

just

ed

for

intia

l in

com

e (

%)

r = -0.27

Equality is good Equality is good for growth for growth

No visible sign here that equality stands in the way of economic growth

An increase in Gini Gini indexindex by 16 points goes along with a decrease in per capita growth by one percentage point per year

-8

-6

-4

-2

0

2

4

6

10 20 30 40 50 60 70

Gini index of inequality

Pe

r ca

pita

gro

wth

ad

just

ed

for

intia

l in

com

e (

%)

r = -0.27

Why not raise government expenditure on public services or whatever and reduce taxes? – to buy votes

Supposing all objections could be swept asideBecause this would create a deficitdeficit and

deficits can lead to inflationinflation, and inflation is undesirable for many reasons – it reduces efficiency and growth, for one thing

Even so, a modest deficit can be sustained in a growing economy

So how modest is modest?

Debt accumulation is, by its nature, a dynamicdynamic phenomenon A large stock of debt involves high

interest payments which, in turn, add to the deficit, which calls for further borrowing, and so on o Debt accumulation can develop into a

vicious circlevicious circle How do we know whether a given

debt strategy will spin out of control or not?o To answer this, we need a little

arithmetic

Revenues Expenditures

Budget Deficit

Financing

Increase in debt

Higher interest payments

Recall operational budget deficit:G – T = G – T = B + B + DDGG + + DDF F = = D D = G= GNN + +

rD - T rD - T where DD is total government credit

outstanding Further, assume for simplicity

T = GT = GNN

Then, we haveD D = rD= rD

This gives

rD

ΔD

So, now we have:

Now subtract growth rate of output from both sides:

g-rY

ΔY

D

ΔD

Y

Yg

rD

ΔD

But what is

This is proportional change in debt ratio:

Y

ΔY

D

ΔD ??

YDYD

Δ

Y

ΔY

D

ΔD

This is an application of a simple rule of arithmetic:

%%(x/y) = (x/y) = %%x - x - %%yy

z = x/ylog(z) = log(x) – log(y)

log(z) = log(z) = log(x) - log(x) - log(y)log(y) But what is log(z) log(z) ?

So, we obtain

z

Δz

z

1

dt

dz

dt

dlog(z)Δlog(z)

y

Δy

x

Δx

z

Δz

Q.E.D.

We have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Deficits can be Deficits can be

sustained as long as sustained as long as

debt ratio does not spin debt ratio does not spin

out of control – i.e., at out of control – i.e., at

least as long as g least as long as g >> r r

Y

Dd

We have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Need economic Need economic

growth to keep growth to keep

debt ratio under debt ratio under

controlcontrol

Y

Dd

We have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Higher interest Higher interest

rates can turn a rates can turn a

sustainable debt sustainable debt

position into an position into an

unsustainable oneunsustainable one

Y

Dd

Take another look Intertemporal budget constraint:

Dividing by nominal GDP (= PY), we get

1

1

1 1

1

1 1t tt

tt t t

t t t t t t t t

d pbd

iD D PB

PY g P Y PY

tt-t PBDiD 1t 1

Primary deficit = GN – T = G – T – iDG

Primary balance: PB = T – G + iDG

tt-t

tt pbd

g

rd

11

1 If r > g, d rises over time

If r = g, d remains unchanged

If r < g, d declines

t

tt

ir

1

11

We have seen that

To find where debt ratio is headed, i.e., the long-run equilibrium value of d, we set dt = dt-1; this gives

tt-t

tt pbd

g

rd

11

1

tt

ttt rg

pbgd

)1(

> 0 if pb < 0 and g > r

pb < 0 means that

primary budget balance

is in deficit

Reducing primary deficit is

key to reducing

debt ratio

Sound fiscal policy is critical for good macroeconomic management, and can help manage capital flows

Fiscal stimulus is usually expansionary, but not invariably

Fiscal policy crucially affects BOP, and interacts with monetary policy

Fiscal policy, as before, is crucial to responding to financial crisesEspecially when monetary policy lands in

liquidity trap and loses traction Fiscal policy can help foster rapid growth