Economic Policy #03-04
Fiscal Policy


Fiscal Policy
•Concepts and measurements
•Theories: keynesian vs. neo-classical view
•Forms of fiscal policy: automatic stabilizers vs. discretion
•FP during crisis
•Public debt
–measurement
–debt and deficit dynamics
–how to reduce the debt burden
•Fiscal rules
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Concepts and measurements #1
•Fiscal policy (FP) contains decisions regarding taxes and public spending.
•
•The notion of FP usually refers to its stabilization function – changes in taxes and public
expenditures for purposes of dampening the fluctuations of the economic cycle – theoretically
inspired by J.M. Keynes.
•
•Toward the end of the 20th century theoretical and empirical doubts about the effectiveness of FP.
•
•Now in many countries the key point of FP is public debt sustainability.
•
•
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Concepts and measurements #2
•Public budget is a document that specifies the origin and volume of both income ("receipts") and
intended spending over a certain horizon (usually a year).
•
•Receipts: income from direct and indirect taxation, social contributions, income from public
assets or from provision of public services and, possibly, disposal of public assets.
•Spending: defense, police, justice, education, research, support to the economy, social policy,
health, foreign policy, development assistance, etc.
•Budgets for different levels of government, cities to central government.
•
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Various degrees of centralization
•Fig. Ratio of local to general government expenses and revenues
Source: Bénassy-Quéré (2012)
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Budget imbalance
•Budget balance = income – expenditures: surplus (+) or deficit (-)
•Financial (overall) balance (= net lending): including net interest payments
•Primary balance: excluding net interest payments
•‘Underlying’ primary balance: excluding net interest payments and one-off operations
•Cyclically-adjusted (structural) balance: excluding cyclical balance => FP stance
•
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Financial (overall) vs primary deficit
•Financial balance (net lending) = primary balance – net interest payments
•Fig. Financial and primary balance, Euro area and USA (% of GDP)
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Keynesian view
•Keynesian multiplier
•Limitations:
–slope of supply curve
–crowding-out (interest rate, exchange rate)
–Ricardian equivalence
•
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Neo-classical view
•complete crowding out or ricardian equivalence
•supply rigidity: price flexibility,  rational expectations
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Supply-side effects of FP
•Directs: positive for (most) tax cuts, negative for (some) spending cuts •Permanent spending cuts
also signal lower taxes in the future, thereby they have supply-side effects
•Composition of fiscal adjustments matters
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Threshold effects
•When the budgetary situation is perceived as unsustainable, further fiscal expansion makes fiscal
retrenchment more likely.
•Therefore fiscal expansion can provide a stimulus below a certain deficit/debt threshold, and be
contractionary above that threshold.
•Conversely, there is some evidence of expansionary or neutral fiscal contractions: Denmark
(1983‐86), Ireland (1987‐89), Finland (1992‐98) and Sweden (1993‐98) . But context of expansion
abroad, fall in interest rates, currency depreciation.
•
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Discretionary FP vs. automatic stabilizers
•Discretionary FP includes changes in government spending and taxation that need specific approval
(usually requires legislative action) => risk of time lags.
•
•Automatic stabilizers increase (decrease) budget deficits during times of recessions (booms)
without specific new legislation => no time lags: e.g. unemployment insurance program, progressive
income taxes.
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The end of discretionary fiscal stabilization?
Fig. Changes from 2008 to 2010 in actual and cyclically adjusted budget balances,
20 OECD countries (% of GDP)
Source: Burda&Wyplosz, 2013
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FP during the 2008-09 crisis
•Arguments in favor of 2009 stimulus:
–risk of depression
–ineffectiveness of monetary policy (transmission through financial system clogged, in addition to
zero bound)
•Exceptional effectiveness of fiscal policy because of:
–generalised excess supply
–excess savings and flight to safety resulting in ultra-low bond rates
–focus of agents on short-term horizon, credit constraints
–symmetric character of shocks, therefore gains from coordinated action
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FP after the crisis
•Fiscal space dramatically reduced in several Euro area countries because of concerns over:
–sustainability (Portugal, Greece)
–implicit liabilities (Ireland)
–transparency (Greece)
–macro conditions (Spain)
•Most countries moving towards budgetary consolidation in 2011
•Ideal policy combines improvement of intertemporal balance through reforms (e.g. pensions) and
limited fiscal contraction in the short term
•However many countries had no choice but to consolidate aggressively.
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Debt and foreign spreads
Fig. Long-term sovereign bond spread in Ireland, Portugal and Greece, 2010-11
Source: Blanchard et al. (2013)
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Public debt
•Public debt = the total of all bonds and other debt owed by a government. Usually cumulated
deficits.
•
•Debt-to-GDP ratio => ability to repay the debt. But the public debt needs not be repaid.
•
•Net public debt = gross public debt – value of public assets
•
•Problem of off-balance-sheet liabilities (ageing, too-big-to fail banks)
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Off-balance sheet liabilites
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Gross vs. net debt
Source: Bénassy-Quéré (2012)
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Debt and deficit dynamics
•Stock-flow equation: B = (1+i) B-1 + D where D is the primary deficit, B is the public debt and i
is the nominal interest rate.
•In percentage of nominal GDP:
•
•
•Denoting by n nominal GDP growth, g real GDP growth and r the real interest rate:
•
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Debt and deficit dynamics: implications
•
•Maastricht criteria: d + ib = 3% ; π + g = 5% ; b = 60%
•The debt ratio can remain constant despite permanent deficits (ex. b = 80%, g = 2%, π=2%,
d+ib=3.2%)
•If r > g, debt stabilization requires a primary surplus
•
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Net government indebtedness and primary budget balances, 2010 (% of GDP)
Net debt in 2010
Primary budget surplus in 2010
Required primary surplus
to stabilize the absolute debt stock
to stabilize the debt/GDP ratio
Belgium
80.8
-0.9
4.0
2.0
Germany
50.1
-1.3
2.5
1.3
Ireland
59.9
-30.0
3.0
1.5
Italy
99.1
-0.3
5.0
2.5
Netherlands
34.6
-4.1
1.7
0.9
Source: Burda&Wyplosz, 2013
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Lessons from history
•No economic limit to public debt (provided citizens are willing to pay for a high primary surplus)
•History does not provide a clear answer either. Debt ratios have reached 200% of GDP or more.
However defaults at lower debt levels were common before the 19th century and still occur in
developing and emerging countries.
•Reinhart, Rogoff and Savastano (2003) and Reinhart and Rogoff (2010) claim that ‘debt intolerance’
can set in at low debt-to-GDP ratios and that debt has negative consequences on growth already when
the debt ratio reaches 90% (60% in emerging economies).
•
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Large deficits are mostly the results of wars (e.g. USA)
Source: Bénassy-Quéré (2012)
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Advanced countries have been in deficit since 1970
•Fig. Public expenditure and receipts in OECD countries
Source: Bénassy-Quéré (2012)
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Public debt ratios have reached very high levels in the past
•Fig. Gross debt (as % of GDP)
Source: Bénassy-Quéré (2012)
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How to reduce the debt burden?
•#1. Fiscal adjustment: cut spending, raise taxes
–the most virtuous but also most difficult way
–
–
–
–
–
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•As difficult as it is, deficit reduction had been successfully implemented in many European
countries.
1981-85
1986-90
1991-95
1996-2000
2001-05
2006-10
Greece
0.2
1.3
1.3
3.5
4.0
0.8
Italy
1.7
3.1
1.3
1.9
0.9
-0.3
Portugal
1.5
6.2
1.9
4.2
0.8
0.5
Spain
1.3
4.7
1.7
4.1
3.3
0.9
Euro Area
n.a.
n.a.
1.4
2.7
1.5
0.8
EU
1.5
3.1
1.5
2.9
2.0
1.0
Source: Burda&Wyplosz (2013)
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How to reduce the debt burden?
•#2. Raising economic growth
–is possible in medium to long run
–factors determining the attainable rate of growth will be spelled out later (Growth policy)
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How to reduce the debt burden?
•#3 Monetization (inflation tax)
–reducing the value of the money base (the central bank’s liability) and of the public debt (the
Treasury’s liability) => tax on money and bondholders.
–inflation must rise unexpectedly and quickly enough
–temporary solution: lenders will demand higher interest rates and will be less willing to agree to
long-term loans
–risk of hyperinflation if the government will be forced to create more money to pay back maturing
debt
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How to reduce the debt burden?
•#4. Default
–not rare in Europe before 20th century
–restructuring: rescheduling, write-downs, haircuts, debt conversions (Brady plan, 1989), interest
reductions...
–voluntary/compulsory
–coordination: Paris club (public creditors); London club (private creditors); IMF, World Bank.
•
•
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Political theory of debt
•The choice of who should pay for the reduction of a high debt is a problem of redistribution.
•Suppose that society can be divided into three groups: rentiers, entrepreneurs and workers.
•Each of these interest groups will seek to avoid the burden of adjustment and shift onto someone
else.
–rentiers are opposed to default and inflation tax
–entrepreneurs are opposed to taxes on capital
–workers prefer taxes on wealth and capital and the repudation of debt
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Rules and principles
•Fiscal policy is traditionally discretionary
•However increasing reliance on rules to:
–improve predictability
–address political failures
–improve credibility
–enforce coordination
•European Stability and Growth Pact (1997)
•Current discussions in Europe:
–strengthening fiscal discipline
–national fiscal rules and institutions
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More and more rules
•Fig. Fiscal rules in EU member states, by sub-sector
Source: Bénassy-Quéré (2012)
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What is a good rule?
•The ‘good rule’ according to Kopits and Symansky (1998):
•clear definition,
•transparent public accounts,
•simplicity,
•flexibility – in particular regarding the capacity to react to exogenous shocks,
•policy relevance in view of the objectives pursued,
•capacity of implementation with possibility of sanctioning non-observance,
•consistency with the other objectives and rules of public policies,
•accompanied by other effective policies
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Many rules in practice
•Headline deficit rules (SGP)
•Structural deficit rules (Germany after reform
•Golden rule (Germany before reform, UK 1998)
•Debt rules (UK under Blair/Brown)
•Spending /receipts rules
•
•
•=> Enforcement is very uneven and difficult to check
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Example #1. The UK
• 1998-2008
•Golden rule (no borrowing for current spending)
•Sustainable investment rule (debt ratio 40% over the cycle)
•
•Two problems:
•Who determines what is the cycle?
•How to take contingent liabilities into account?
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Example #1. The UK (cont.)
•2010
•Fiscal mandate: structural deficit < 1 % of GDP over 5 years
•Office for budget responsibility: independent fiscal council in charge of forecasts and assessment
•
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Example #2. Germany
•Since late 1960s
•Golden rule of public finances ‘except macroeconomic disturbance’
•
•Two problems:
•extensive notion of ‘macroeconomic disturbance’
•no correction mechanism
•inconsistency with SGP (that does not distinguish between current and investment spending)
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Example #2. Germany (cont.)
•2009 -  (Debt brake)
•Fiscal rule: structural deficit < 0.35 % (Federal government) and < 0 % (länder)
•Control account: deficit < 1 % at any time.
•Exceptional circumstances
–natural disaster: more deficit allowed but amortization plan
•Progressive phase-in (2016)
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The Stability and Growth Pact #1
•Two planks
–Preventive arm
•Medium term objective (MTO)
•‘Stability’ (Eurozone) and ‘convergence’ (non-Eurozone) programs
–Dissuasive arm (‘Excessive Deficit Procedure’ – EDP) allows for:
•Advance warning
•Recommendation to correct excessive deficit within given timeframe
•Eventual sanctions
•
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The Stability and Growth Pact #2
•Recent reforms (six-pack, fiscal compact)
–Earlier sanctions
–Reverse-majority voting
–Debt rule
–Broadened surveillance (scoreboard)
–National rules
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What’s the rationale?
•Externalities
–Incentive to deficits in a fixed-exchange rate environment
–Financial cost of a debt default (banks, bail out)
–Economic cost of a debt default (pressure on the ECB to inflate away, risk of contagion and
disruption)
•Political economy
–External discipline as a substitute or complement to domestic discipline
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Box. Difficult implementation
French stability programmes: objectives and outturns
Source: Bénassy-Quéré (2012)
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