Macroeconomics of the Government Budget

1. Macroeconomics of the Government Budget Anand Rajaram, Lead Economist, PRMPS Public Finance Analysis and Management Core Course PREM Learning Week, May 1-5, 2006

2. Macroeconomics of the Government Budget(Things every PER team member should know…. but is afraid to ask) Anand Rajaram, Lead Economist, PRMPS Public Finance Analysis and Management Core Course PREM Learning Week, May 1-5, 2006

3. Motivation • PERs – constantly evolving in response to development agenda - from focus on investments, to budgets, to budget institutions, to service delivery • Agenda now – growth, poverty reduction, MDGs – focus on results, aid effectiveness • Expenditure - Outputs – Growth and Development • Current concern – does Fiscal Policy aid or constrain public expenditure and thus growth and development? • This session is about this question and how PERs can help improve the links to growth and development

4. Outline • How do PERs currently link to macro-fiscal policy? • Specifying the budget constraint • Different measures of the deficit • Macroeconomic implications of deficits and debt • The government’s lifetime budget constraint • What is missing in fiscal sustainability analysis? • Linking Public Finance to Policy Objectives • Fiscal policy and the “Fiscal Space” debate • Current thinking in the Bank • Implications for PER work

5. How do PERs link to fiscal policy? • Not very well • Typical PER - a brief discussion of overall macro (trends in growth, inflation, revenue and deficits) • Reference, perhaps, to an IMF-determined fiscal framework with medium term aggregate deficit, revenue and expenditure targets • PER may then turn to discussion of sector expenditures and/or budget formulation and execution, etc. • So, fiscal (deficit) policy is given by IMF program, composition of expenditure is seen as Bank area of responsibility, and PEM is an area of shared responsibility • Bank so far has not sought to engage on advising on composition for a number of reasons • But current debate calls this approach into question

6. Changing view of fiscal policy • Prior to the Great Depression (1929-33), idea of balanced budgets - government should offset deficits incurred during war with surpluses during peacetime • Keynes – activist fiscal (and monetary) policy should be used to manage aggregate demand and ensure full employment • Through 1980s, 1990s – fiscal policy driven by concerns over macroeconomic imbalances - inflation, BOP, deficits and debt

7. Growth of General Government

8. Macroeconomic stability • Fiscal policy emphasizes control over fiscal deficits because: • Larger deficits indicate expansionary impact of public sector on the economy which may create inflationary or BOP pressures • Deficits may contribute to increasing public debt, raising concerns re sustainability • Sustainability is really a concern that ignoring “budget constraint” can lead to bad outcomes – a fiscal/financial crisis and collapse of economic confidence • What is the budget constraint and how does that affect fiscal policy?

9. Specifying the budget constraint • Starting from the national income identity, the government budget deficit, (G-T) is equal to net private saving (S-I) plus current account deficit (IMP-EXP). • (G-T) = (S-I) + (IMP-EXP) • This suggests that an increased fiscal deficit will have to be balanced by increased net private saving (either by “crowding out” I, or by raising S, i.e. so called Ricardian equivalence) or by increasing the current account deficit (i.e. increasing reliance on foreign savings) • From the financing side: • (G -T) = foreign borrowing + domestic borrowing + printing money + depleting assets • (external grants may be counted “above the line” and would therefore be included in G-T)

10. Macroeconomic implications • Printing money is one way to finance a deficit. So long as the demand for base money is growing, as in a growing economy, governments can print money without raising inflation. If elasticity of money demand is unity, base money could be increased at the same rate as GDP growth. • Increasing base money at a higher rate can spur inflation. Inflation reduces the value of government debt and yields seignorage revenue - so provides an incentive for governments to expand money supply. Independent central banks intended to restrain this incentive of ministries of finance. • A second way is to run down foreign exchange reserves or other assets (privatization of public enterprise assets, or depletion of oil reserves, for example). Reducing reserves may cause the local currency to depreciate. • A third way is to borrow – domestically or externally.

11. Different measures of the annual deficit • Overall fiscal balance: G-T • on cash basis this is the Public Sector Borrowing requirement • Primary balance: G-T- interest expenditure • Measures the effect of current public demand on the economy, netting out effect of interest cost which reflects past policies • Current balance: (G-T) - net capital outlays (=pub. savings) • If the current balance is positive it suggests there is public savings which can be used for public investment • If the current balance is zero, it suggests that revenues cover only current expenditure and any capital outlays have to be deficit financed. This may be consistent with the “golden rule” which suggests that borrowing is justified if it is to finance capital expenditure. • If the current balance is negative, it suggests that the government is using deficit finance to cover current expenditure. • Structural or cyclically adjusted deficit: considers deficit relative to potential output, netting out the effect of automatic stabilizers • Operational deficit: is the overall balance (G-T) net of the inflationary premium paid to bond holders • Measures real fiscal disequilibrium more accurately by netting out effects of inflation on the deficit

12. The annual deficit is an incomplete measure • As a measure, it reflects aggregate demand pressure on goods and services and thus on inflation and BOP • It is thus useful to design fiscal policy to achieve macroeconomic stability • But as a fiscal rule, it is “myopic” and encourages “fiscal gimmickry” - running down assets, cutting productive expenditure, resorting to “off-budget” mechanisms, etc. • It may thus not reveal how well government is managing public finances • If the government were a company, we would want to monitor both the income statement and the balance sheet to assess if net worth is improving or declining • While a net worth assessment of government is difficult, it is still, in principle an important concept to keep in mind to offset the myopic bias of the deficit

13. Fiscal sustainability • Conventional assessments of fiscal sustainability project the implications of current fiscal/ monetary policies for deficits, real rates of interest and growth. • A set of policies would be fiscally unsustainable if it would result in the government being unable to pay its debts, i.e. if it resulted in insolvency • Fiscal sustainability analysis provides a judgment on whether a particular mix of fiscal/ monetary policies could be sustained

14. The inter-temporal budget constraint • Recognizing that governments can borrow, print money and tax, what is the real constraint on government spending? • We ignore asset depletion as a source of financing in the discussion below. Taxation is also inherently limited by the fact that you cannot tax more than 100% of income and wealth – and the economic effects are likely to be highly negative well below that confiscatory level) • Can a government keep borrowing indefinitely, like a Ponzi or pyramid scheme, using new borrowing to pay off interest on debts as they come due? • Or can a government keep printing money to meet its obligations indefinitely? • The solvency constraint (or the no-Ponzi rule) says that a government must ensure that it generates future primary surpluses and seignorage revenue whose present value would at least equal the face value of current debt – i.e. debt levels would not increase

15. First, consider a multi-period budget constraint • The budget constraint from the financing side: • Deficit financing = New borrowing + Base money printing • (Gt-Tt) = (Bt – Bt-1) + (Mt – Mt-1) Where B is stock of debt, M is stock of base money • Subtracting interest payments I from both sides: • (Gt-Tt) – It = (Bt – Bt-1) +(Mt – Mt-1) – It • Since (Gt-Tt) – It is the primary surplus: • Primary surplus Xt = (Bt – Bt-1) +(Mt – Mt-1) – It • i.e the primary surplus must equal new borrowing plus the amount earned from printing base money less the interest payments.

16. Then the lifetime budget constraint • Can be used to derive a lifetime government budget constraint, expressed in terms of real values as: • bt-1 = Σ (1+r) –(i+1) (xt+i + σt+i) • Where b is the stock of real debt, x is the primary surplus, σ is “seignorage”, the revenue from printing money, and r is the real interest rate • Fiscal sustainability requires that fiscal policy (which determines x, and monetary policy (which determines σ), must be coordinated if inflation is to be contained.

17. Fiscal policy and monetary policy need to be coordinated • bt-1 = Σ (1+r) –(i+1) (xt+i + σt+i) • Fiscal policy • Monetary policy • If the government is fiscally indisciplined the primary surplus x will be small or negative, requiring larger seignorage revenues and therefore the possibility of higher inflation • Even where a government chooses to borrow to finance its deficit and adopts a zero money printing rule, the constraint implies that future primary surpluses must be such that the constraint is observed.

18. Debt dynamics with growth • The budget constraint can be expanded to incorporate the effect of GDP growth • bt-bt-1 =it-xt-σt–πtbt-1{1/(1+πt)}-gtbt-1{1/(1+zt)} • This indicates that the change in the debt to GDP ratio b depends on interest payments i, primary surplus x, seignorage σ , inflation π, and the nominal and real growth rates of GDP, z and g. • For given i, x, σ, and π, the higher is the real GDP growth rate g, the lower is the growth of debt to GDP

19. Table. Main Factors Underlying Debt Reduction, 1990-2003 Based on Budina, Fiess and others (2004)

20. So what about fiscal policy and growth? • We now know something about how the government lifetime budget constraint reflects and shapes • Fiscal and monetary policies • How these can affect inflation • How debt dynamics depends on growth, inflation, seignorage, primary surpluses, etc. • But we have said little about how fiscal and monetary policy affect growth • Fiscal sustainability analysis either assumes growth or uses various growth scenarios to draw implications for debt and fiscal sustainability

21. Some knowns, some unknowns • So we can anticipate how growth might impact fiscal policy and debt sustainability • g x • We know that fiscal and monetary policies are key to controlling inflation • x, σπ • But do not have as firm a sense of how fiscal policy might affect growth • x g

22. The 1980s-90s: fiscal adjustment • So what was driving fiscal adjustment over the past two decades? • Concerns about inflation (median inflation in 1980s,90s, now) • Concerns about exchange rate and debt crises (mexico, turkey, brazil, argentina, russia) • IMF programs defined the scope of fiscal policy and emphasized macroeconomic stability • Price and exchange rate stability was seen as a prerequisite for growth • Governments were encouraged to cut fiscal deficits • Central Bank independence was encouraged as a way to limit monetary financing of deficits

23. Recent history: Fiscal policy has contributed to price stability

24. But the growth impact has been limited • Stability may have enhanced growth, but difficult to assess the counterfactual • Could fiscal policy have achieved stability with stronger growth?

25. Public expenditure as a key channel for fiscal impact on growth • Notice that much of the fiscal sustainability discussion focuses on the deficit or primary surplus and ignores the composition of expenditure • Even though there is concern for the long term budget constraint, it is confined to the way the deficit and its financing affect the economy • Would it matter for growth if for the same deficit, a government spent G on consumption or investment? It should, but most fiscal policy discussion ignores the key channel for fiscal policy to influence growth, i.e. the effect of the composition of expenditure (and taxation) • Not surprisingly, fiscal adjustment has often been achieved in ways that would have undermined long term growth

26. Public capital formation has declined during the period of fiscal adjustment

27. Evidence of cuts in infrastructure investment – in LAC and SSA but also more broadly across lower income groups

28. That brings us to the fiscal space debate • Number of reasons why fiscal-growth link has come into focus • IEO evaluation of IMF fiscal programs: • Programs characterized by “growth optimism” • No articulated link between fiscal stance and growth (recall x g link missing) • Growing dissatisfaction in countries with exclusive stabilization focus of fiscal policy, concern re fiscal rules, and lack of “fiscal space” for growth • PRSP, MDG agenda – identifying resource needs, “scaling up”, composition of expenditure, outcomes

29. Recent Policy papers: IMF papers and Bank DC paper • IMF papers on Public Investment and Fiscal Policy (2004,05) • largely retained status quo focus on stabilization; • seen by CODE as lacking a “development” perspective • Bank asked to provide its view on fiscal policy as an instrument for growth, taking account of differences in country conditions to make “pragmatic” suggestions • Interim report (Fiscal Policy for Growth and Development) provided to Development Committee for April 2006 meetings • Paper discussed at Bank Board meeting March 30th

30. Highlights of interim report to DC • Stabilization is necessary for growth but is not sufficient • Need for fiscal policy design to explicitly factor in both growth/solvency goal and macro-stability objective • Requires recognition that fiscal policy must consider both “macro-space” (when spending would not compromise macro- stability) as well as “fiscal space” (when spending would improve growth/solvency) • Fiscal policy over the past two decades has focused only on macro-space, ignoring scope for growth/solvency-enhancing choices • Report opens the door to consideration of how fiscal policy design might differ if we had more knowledge of the growth/solvency impact of public expenditure and taxation • ? α • x CE F g, MDG • Challenge is for Bank to expand its knowledge on how the composition and efficiency of public spending and taxation (and the institutions that influence them) affect growth and solvency

31. Highlights continued … • Paper proposes an approach to improving knowledge • Requires adoption of a broader public finance perspective that: • Considers inter-temporal budget constraint more explicitly • Reflects a comprehensive view of financing options available to countries (access to markets or aid) • Estimates the growth/solvency impact of the level, composition and efficiency of public expenditure and taxation • Takes account of institutional capabilities and political economy effects on composition and efficiency • Potentially impacts the scope and content of PER and growth work • Proposes pilot country studies to assess scope for pragmatically adopting such an approach

32. Fiscal diamond – a simple device to motivate a broader framework for fiscal and public expenditure policy

33. Directions for potential policy focus recognizing initial conditions

34. Board Reaction • Very positive response from EDs • Welcomed “balanced and prudent” approach that acknowledged the role of fiscal policy in supporting growth and the need for efficiency in expenditure • Supported the “fiscal diamond” approach to recognizing country specific initial fiscal conditions and identifying options for creating fiscal space • Encouraged consideration of institutional and political economy features • Suggested link to ongoing work on growth • Endorsed proposal to undertake country pilot studies • Asked that we ensure collaboration with IMF • (At the Board, the IMF indicated its agreement with this approach) • Requested a report on country studies for Spring 2007 meetings – and an interim seminar on progress in September 2006

35. Implications for PER work • Operationalize, as far as practical, the inter-temporal budget constraint – taking account of growth effects. • Broader public finance perspective that encompasses borrowing, revenue, grant aid and expenditure efficiency (also seignorage). • Particular emphasis on expenditure efficiency in sector work – will require that we try to connect • spending to outputs (efficiency and effectiveness) • and outputs to growth, equity and MDG objectives • Understanding of institutions will be key both links • Latter will require PER to link to growth analysis (constraints to growth)

36. Some thoughts on next steps • Aggregate assessment of efficiency will have to draw on knowledge of public sector efficiency in major sectors • Benchmarking relative to good performers can help • But will require drilling down from spending to outputs in each sector

37. Conclusions • A solid understanding of the macroeconomics (and microeconomics) of the budget is essential for good PER work • Must engage IMF and governments with a well developed view of how fiscal policy and public spending impact the growth and development process • This requires deep sector and country knowledge • Cross network approach will be critical – a good country team that has the right frame of reference can do better PER analysis with a longer term fiscal policy horizon necessary for development

38. References • Fisher and Easterly (1990), “The Economics of the Government Budget Constraint” WBRO. • Blejer and Cheasty (1992), How to Measure the Fiscal Deficit, F&D • Burnside (2005), “Fiscal Sustainability in Theory and Practice: A Handbook”. • Gill and Pinto (2006), “Public Debt in Developing Countries: has the Market Based Model Worked?”, World Bank seminar presentation.