Fiscal Policy, Public Expenditure and Growth

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Fiscal Policy, Public Expenditure and Growth

• Anand Rajaram, PRMPS
• PFAM Course,
• PREM Learning Week
• April 23, 2007

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Motivation

• 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?

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Outline

• Views on Fiscal Policy
• Specifying the budget constraint
• Different measures of the deficit
• Macroeconomic implications of deficits and debt
• The governments 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 Public Finance work

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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

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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?

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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)

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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.

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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

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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

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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

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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.

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Then the lifetime budget constraint

• Can be used to derive a lifetime government
  budget constraint, expressed in terms of real
  values as
• bt-1 S (1r) (i1) (xti sti)
• Where b is the stock of real debt, x is the
  primary surplus, s 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 s), must be coordinated if inflation
  is to be contained.

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Fiscal policy and monetary policy need to be
coordinated

• bt-1 S (1r) (i1) (xti sti)
• 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.

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Debt dynamics with growth

• The budget constraint can be expanded to
  incorporate the effect of GDP growth
• bt-bt-1 it-xt-stptbt-11/(1pt)-gtbt-11/(1zt)
  
• This indicates that the change in the debt to GDP
  ratio b depends on interest payments i, primary
  surplus x, seignorage s , inflation p, and the
  nominal and real growth rates of GDP, z and g.
• For given i, x, s, and p, the higher is the real
  GDP growth rate g, the lower is the growth of
  debt to GDP

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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

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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, s p
• But do not have as firm a sense of how fiscal
  policy might affect growth
• x g

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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

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Recent history Fiscal policy has contributed to
price stability
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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?

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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

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Public capital formation has declined during the
period of fiscal adjustment
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Evidence of cuts in infrastructure investment
in LAC and SSA but also more broadly across lower
income groups
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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

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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
• ? a
• 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

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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

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Fiscal diamond a simple device to motivate a
broader framework for fiscal and public
expenditure policy
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Directions for potential policy focus recognizing
initial conditions
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Some thoughts on next steps

• Aggregate assessment of efficiency will have to
  draw on knowledge of public sector efficiency and
  effectiveness in major sectors
• Benchmarking relative to good performers can help
• But will require drilling down from spending to
  outputs in each sector

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Conclusions

• A solid understanding of the macroeconomics (and
  microeconomics) of the budget is essential for
  good public finance work
• A well developed view of constraints to growth
  and how fiscal policy and public spending might
  impact the growth - this requires deep sector and
  country knowledge
• Cross network approach will be critical a good
  country team can do better analysis with a longer
  term fiscal policy horizon necessary for
  development

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References

• Fisher and Easterly (1990), The Economics of the
  Government Budget Constraint WBRO.
• World Bank (2007), Fiscal Policy for Growth and
  Development Further Analysis and Lessons from
  Country Case Studies Background paper for
  Development Committee Spring 2007 Meetings.
• World Bank (2006), Fiscal Policy for Growth and
  Development An Interim Report Background paper
  for Development Committee Spring 2006 Meetings.
• IMF (2005), Public Investment and Fiscal Policy.