Fiscal P olicy

1. Fiscal Policy An Analytical Framework With Application

2. Outline • Deficits: Definitions and explanations • Fiscal sustainability. What do you want to call fiscal balance? • How should fiscal policy look like in theory? • How does it look in practice?

3. Deficits: Definitions • Different concepts of Deficit • Full-employment (structural) deficit • Note that the deficit varies with the business cycle • Revenues are greater in expansions • Expenditures are greater in recessions • What would the deficit be if we leave aside these cyclical fluctuations? • In a recession, structural deficit is lower than overall deficit • Primary deficit • Net of interest payments: • Some of the current deficit is simply interest on previously accumulated debt • Credit card again: regardless of what you do this month, you still have to pay interest on your balances

5. Why Run a Deficit? • Stabilization • Fiscal Policy as a tool to manage AD in the short run • Example: Tax cut • But recall our discussion on the multiplier: What if people look ahead and see that the extra deficit will have to be paid for at some point (with interest!)? • This is often called the “Ricardian” view • “Tax Smoothing” • Even if deficits have no impact on AD, it may still be the case that you want to run them • Taxes have a distortive impact on incentives (i.e. they can affect AS)  The distortion is greater at higher rates • If you have temporary need for high spending, you want to borrow instead of raising taxes

6. US Federal Budget (% GDP) Source: Economic Report of the President

7. Country averages, 1999-2007 (2008 where available)

8. Deficits : Thinking about The Future Burden

9. Financing a Deficit • Borrowing • If the government needs to incur some expenditure beyond current revenues, it can issue a bond and sell it to the private sector • In other words, it borrows money from the private sector, and pays interest on it • Ex: In the US, government can issue Treasury bill (to be paid back in one year or less), T-note (two to ten years), T-bond (twenty to thirty years) • T-note and T-bond pay interest (“coupon”) every six months; T-bill pays no explicit interest, but is sold at a discount • These bonds are also traded in secondary markets (that’s where the Fed conducts open market operations)

10. Financing a Deficit • Monetizing • In principle, the government can also sell these new bonds to the Central Bank • To buy them, the CB “prints money” • This form of raising revenue for the government is called “seignorage” • This is a way in which FP can influence MP • Independence of the Central Bank is meant to prevent this type of process

11. Current Challenges • Current Outlook • Right now, most developed countries are running very high budget deficits • To a large extent, this is a product of the recessions • However, there are structural issues that, if unaddressed, may lead to structurally high deficits, and consequently to increasing (possibly unsustainably so?) debt levels • Demographic issues • Aging  Pensions / Health expenditures • Fewer workers to tax to pay for that • Less private savings (older people save less) • A lot of these are off-budget items

12. Current Challenges • What Is “Unsustainable”? • Ultimately, it’s about the country’s perceived ability to repay • If investors think they won’t be repaid, they won’t buy bonds • Look at Greece right now • If debt relative to GDP is too high (and rising), the ability to repay may be a concern • But how high is “too high”? • That depends a lot on the situation of each country!

13. Fiscal sustainability • Debt is accumulated in order to fund a fiscal deficit • The fiscal deficit can be decomposed into three components • Deficit = G – T + i D • Primary spending • Current revenues • Interest on the debt • We do not consider debt issuance or privatization as revenue or debt amortizations as spending • We call T – G the primary surplus, S • Deficit = i D - S • The deficit is just equal to the increase in net debt

14. Fiscal sustainability • An unsustainable position is one where the debt rises faster than the capacity to pay for it • For debt to be sustainable in the long run, some ratios have to be stable • Debt to GDP • Debt to tax revenue • What needs to be the fiscal balance for this to occur?

15. Constant debt ratio Consider the following law of motion Where b is the debt to gdp ratio, r is the nominal (real) interest rate, g is the nominal (real) rate of gdp growth and s is the primary surplus. Then b(t) = b(t-1) if:

16. Numerical examples • A typical tax revenue ratio for an LDC is 15-20 percent • A typical real growth rate is 3-4 percent • A typical debt ratio is 40% of GDP • A typical real interest rate is 5% • The equation implies that the primary surplus needs to be • s=(.05-.03).4=0.8% • So if T/Y = 15%, then G/Y =14.2%

17. Some fiscal numbers

18. What happens if the debt is denominated in dollars? Consider the debt ratio Where B* is debt in dollars (tradables) and Y* , Y is tradable and non-tradable output

19. What happens if there is a real depreciation? The elasticity of b relative to e is given by:

20. Who is most mismatched?Some numbers

21. How should fiscal policy look like?

22. Fiscal policy: Keynesian • Fiscal policy as business-cycle management • Spend in bad times, save in booms • Use fiscal policy when monetary policy is ineffective • Liquidity trap • Japan • Problem: suffers from long and variable lags, but also slow to decide and difficult to change • The problem with the shower temperature

23. The New Classical critique • People have expectations about the future • The do not see debt as net wealth, since it will be serviced with their own taxes • Ricardian equivalence: an increase in public spending is an increase in future taxes, leading the private sector to spend less in the present • Useless from the point of view of demand management

24. Ricardian Equivalence • Two periods, no discount rate, r=0 • i=0, rate of discount = 0 • Government consumes always the same amount but taxes only in period 2 • G1=G2=G • Private income is given, Y1, Y2 • 2G= t * Y2 • Y1+(1-t)Y2=C1+C2 • U=u(C1)+u(C2) • C1= C2= [Y1+(1-t)Y2]/2 = [Y1+Y2]/2-G • dC1/dG = -1

25. A rationale for tax smoothing • Distortionary taxes Y=Y(t), Y’<0, Y’’<0 • E.g. Y1 = Y – at2 • Budget constraint of govt • G1+G2=t1*Y1 + t2 * Y2 • (1-t1)Y1+(1-t2)Y2=C1+C2 • U=u(C1)+u(C2) • C1= C2= [(1-t1)Y1+(1-t2)Y2]/2 • At the optimum t1 = t2

26. Critique of Ricardian equivalence • Imperfect capital markets in dev. countries • Off-set coefficient: how much does private saving increase when public saving declines? • Standard estimates at 0.5 (Edwards 1996) • But only because of crisis times (Gavin 1997) • In normal times offset is very high • It is very low in bad times • Overlapping generations • I get the money, my children pay the taxes • Exploiting non-equivalence is a weak basis for policy • Tell it to the Republicans

27. The world is volatile • Y may be volatile because of supply and demand shocks • G may be volatile because programs may have uncertain costs • T depends on Y • G may also depend on Y, ideally with a negative correlation • Unemployment compensation • Automatic stabilizers can do the trick

28. Optimal policy • Optimal policy: stabilize tax rates in an inter-temporal program that is solvent • How does it look like? • Run deficits in periods of low income • Run surpluses in periods of high income • Make sure that debt ratios remain stationary • Looks keynesian. What is the difference?

29. Implementing in practice • The OECD calculates the full-employment deficit • They calculate what would have been the deficit if the economy was at the equilibrium Y • Is this appropriate for developing countries?

30. What would you want to control for in a developing country? • The terms of trade may be at non-equilibrium levels • The current account may be at non-equilibrium levels • Since there is taxation on spending and imports, this may generate a difference of income vis a vis equilibrium • The real exchange rate has important fiscal implications • Calculate FD at equilibrium RER • Are interest rates at equilibrium levels? • Domestic rates and the “peso problem” • Foreign rates are volatile • Old debt may be at different rates than current rates • “Structural fiscal deficit” is where the FD&BB curve cross the NN curve

31. Fiscal behavior in practice

32. Do countries behave a la Barro? Fiscal balance during recessions 20% América Latina OCDE 10% 0% -10% -20% -30% 1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 recessions Cummulative GDP fall (%) Change in fiscal surplus (% del PIB)

33. Fiscal policy has been pro-cyclical Correlation coefficient with GDP; 1970-95 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 Fiscal Balance Public Consumption Inflation tax América Latina OCDE

34. Fiscal accounts are much more volatile in developing countries Volatility of fiscal variables; 1970-94 (Standard deviations of the rates of growth) 35% 30% 25% 20% 15% 10% 5% 0% Fiscal shock Revenues Current spending Capital expenditures OCDE América Latina

35. The cost of borrowing is volatile (LEI, Spread over US Treasuries) 1200 Current level 1000 Pre-Argentine Crisis 800 Pre-Russian Crisis 600 Pre-Asian Crisis 400 776 pb 200 May-97 May-98 May-99 May-00 May-01 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01

36. Volatility and pro-cyclicality are linked Volatility of GDP growth and Pro-cyclicality of government consumption 1970-95 1.0 VEN PER CRI MEX 0.8 PRY PAN SLV CHL TTO 0.6 BRA GTM URY JAM DEU HND 0.4 Pro-cyclicality of government consumption COL ARG BOL BRB ITA ECU JAP 0.2 DOM CAN 0.0 USA GBR -0.2 FRA -0.4 1% 2% 3% 4% 5% 6% 7% Volatility of GDP growth

37. There is a strong electoral budget cycle Fiscal Policy and Elections Latin America, 1980-96 1.5 1 0.5 Percent of GDP 0 -0.5 -1 -1.5 Fiscal Outcome Pre-election Election year Post-election

38. Questions • Why do developing countries face precarious access to borrowing? • Do they borrow too much? • Do they tax too little? • Why do they exhibit pro-cyclical instead of anti-cyclical fiscal policy? • Why is there an electoral budget cycle?

39. Why is fiscal policy messy? • Coordination problems • The common pool problem • Delayed stabilization • Aggregation problems • Arrow’s impossibility theorem • Electoral rules • Agency problems • Credibility/time-inconsistency problems

40. The commons problem • Chicken and lobster • While their benefits tend to be concentrated, they tend to be financed from a common pool of resources • (Weingast, Shepsle and Johnsen 1981) • The budget is the result of a collective decision-making process, involving a variety of agents: • Legislators • Spending ministers • The finance minister • Generates a tendency to overspend and to overborrow

41. Common pool problems • Dynamic version • Tendency towards pro-cyclical spending

42. Agency problems • Delegated choice, incompatible objectives and asymmetric information • Governments may want to spend more money than the public, because they can appropriate part of it • Lack of confidence • Incentives to lie about real situation • Incentives to distort reality through policy • E.g. The electoral budget cycle (Nordhaus 1975, Tufte 1978, Rogoff 1990)

43. Credibility, time inconsistency • What is optimal today is not optimal tomorrow • Let bygones be bygones • Promise to repay in good times is not credible • Imperfect credibility leads to undereborrowing in bad times • Signalling (Saint Paul)

44. Aggregation and electoral rules • Whose choice is it? • Down to West Palm Beach • Proportional representation vs. first past the post • District magnitude • Margaret Thatcher’s landslide? • What are the costs and benefits • Better representation vs. more difficult aggregation • Effective number of parties • One or two chambers?

45. Proportional representation or first-past-the-post systems Representatives per electoral district Lower chamber Brazil Mexico Bolivia Argentina Venezuela El Salvador Costa Rica Nicaragua Honduras Guatemala Uruguay Suriname Colombia Peru Paraguay Dom Rep Ecuador Chile Panama Belize Jamaica Barbados Haiti Trinidad Bahamas 0 4 8 12 16 20 Guyana ha sido excluída del gráfico por razones de presentación. Su número de representantes es 43.4.

46. More proportional representation,more parties Instituciones Electorales y Resultados Políticos 10 BRA ECU FIN CHL DNK VEN BEL NED PAN SLV BOL ITA FRA SWE URY Número de Partidos Efectivos POR DEU PER ARG IRE NIC SPA GTM DOM AUT PRY CRI MEX COL TTO GUY GBR GRE HND BLZ BRB HTI BHS JAM 1 1 10 100 1000 Representatives per district (log scale) El número de representantes por distritos en los sistemas bicamerales es el máximo entre las dos cámaras

47. …and less support for the government in congress Fragmentation and minority governments Lower chamber 0.9 JAM BHS HTI 0.8 0.7 BRB Representation of the executive’s party in congress MEX 0.6 CHL COL PER HND BLZ GUY GTM TTO ARG PRY CRI 0.5 DOM SUR PAN NIC BOL 0.4 BRA SLV URY 0.3 VEN ECU 0.2 1 10 Effective number of parties

48. More proportional representation, larger deficits Superávit Fiscal (% del PIB) 0.04 JAM PRY 0.02 BRB CHL TTO BRA MEX 0.00 COL PAN GTM CRI DOM ECU URY SLV BHS -0.02 IRE PER DNK ARG DEU NED FIN AUT FRA BOL -0.04 GBR HND HTI POR SPA NIC BLZ SWE BEL VEN -0.06 -0.08 ITA -0.10 -0.12 1 10 100 1000 Representatives per district (log scale)

49. …and more debt Public debt Percentage of revenues) 1.40 BEL 1.20 ITA HND 1.00 PAN IRE JAM ECU BOL GRE NED PER 0.80 DNK CRI POR SWE AUT SPA ARG 0.60 VEN DOM DEU GBR FRA BRA FIN TTO 0.40 URY BLZ SLV MEX COL CHL PRY GTM 0.20 BHS 0.00 1 10 100 1000 Representatives per district (log scale)

50. …and more pro-cyclicality Pro-cyclicality of government consumption vs. district magnitude 0.80 0.60 MEX 0.40 CRI VEN 0.20 BRA COL PRY GTM PER JAM PAN 0.00 HND URY SLV DOM TTO BOL CHL ECU ARG -0.20 FRA -0.40 GBR BRB -0.60 1 10 100 Representatives per district (log scale)