Download Macroeconomics of the Government Budget

Macroeconomics of the Government
Budget
Anand Rajaram,
Lead Economist, PRMPS
Public Finance Analysis and Management
Core Course
PREM Learning Week, May 1-5, 2006
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
Motivation
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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
Outline
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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
How do PERs link to fiscal policy?
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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
Changing view of fiscal policy
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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
Growth of General Government
(In Percent of GDP)
70
Sw eden
60
France
50
Average
40
USA
30
20
10
0
about 1870
Late 19th
Century
1913
1920
1937
Pre World Post World Pre World
War I
War I
War II
1960
1970
1990
Post World War II
1996
Macroeconomic stability
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Fiscal policy emphasizes control over fiscal deficits
because:
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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?
Specifying the budget constraint
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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).
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(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
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(external grants may be counted “above the line” and would therefore be
included in G-T)
Macroeconomic implications
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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.
Different measures of the annual deficit
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Overall fiscal balance: G-T
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Primary balance: G-T- interest expenditure
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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)
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on cash basis this is the Public Sector Borrowing requirement
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
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Measures real fiscal disequilibrium more accurately by netting out effects of inflation on
the deficit
The annual deficit is an incomplete measure
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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
Fiscal sustainability
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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
The inter-temporal budget constraint
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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
First, consider a multi-period budget constraint
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The budget constraint from the financing side:
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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
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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.
Then the lifetime budget constraint
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Can be used to derive a lifetime government budget constraint,
expressed in terms of real values as:
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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.
Fiscal policy and monetary policy need to be coordinated
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bt-1 = Σ (1+r) –(i+1) (xt+i + σt+i)
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Fiscal policy
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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.
Debt dynamics with growth
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The budget constraint can be expanded to
incorporate the effect of GDP growth
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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
Table. Main Factors Underlying Debt Reduction, 1990-2003
Country, Time Period
Total
Change
(% of GDP)
Initial
Level
(% of GDP)
Main Contributing Factors (% of GDP)
Chile, 1991-1998
-30.2
42.7
–11.5
–15.6
Indonesia, 2001-2003
-22.3
90.3
-8.3
-9.5
Lebanon, 1991-1993
-48.5
98.4
15.8
-33.4
-45.5
18.6
Malaysia, 1991-1996
-41.4
91.4
-32.3
-37.3
16.5
17.8
Mexico, 1991-1993
-22.8
50.2
-12.9
-3.9
Pakistan, 2000-2003
-9.5
109.1
-11.1
-16.5
Philippines, 1994-1997
-25.3
93.5
-22.4
-15.1
-7.5
13.0
Poland, 1992-2000
-42.8
86.7
2.1
-25.5
-9.0
-9.5
Russia, 2000-2003
-55.2
88.7
-16.7
-15.4
-19.3
Turkey, 2002-2003
-24.9
91.0
-10.3
-11.3
-8.2
Primary
Balance
Based on Budina, Fiess and others (2004)
GDP
Growth
Real
Exchange
Rate
Real
Interest
Rate
Privatization
Other
Factors
-4.8
-5.9
14.8
8.2
-11.7
-6.5
8.9
10.8
So what about fiscal policy and growth?
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We now know something about how the government
lifetime budget constraint reflects and shapes
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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
Some knowns, some unknowns
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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, σ
π
But do not have as firm a sense of how fiscal
policy might affect growth
x
g
The 1980s-90s: fiscal adjustment
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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
Recent history: Fiscal policy has contributed to price
stability
Fiscal Deficit: Low Income
(incl. Grants)
Inflation (CPI): Low Income
30
8
25
% Change
6
5
4
3
2
20
15
10
5
1
Low income
Fiscal Deficit: Lower-Middle Income
(incl.Grants)
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1980
200 4
200 2
200 0
199 8
199 6
199 4
199 2
199 0
198 8
198 6
198 4
198 2
198 0
1984
0
0
1982
% of GDP
7
Low income excl. India
Inflation (CPI): Lower-Middle Income
30
8
25
% Change
6
5
4
3
15
10
Lower middle income
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
0
1
0
20
5
2
1980
% of GDP
7
Lower middle income, excl. China
But the growth impact has been limited
GDP Growth per Capita: Low Income
GDP Growth per Capita: Lower-Middle Income
Low income
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Low income excl. India
Lo we r m iddle inc o m e
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
-2
19
86
0
19
84
2
19
82
% Change
% Change
4
6
5
4
3
2
1
0
-1
-2
-3
19
80
6
Lo we r m iddle inc o m e , e xc l. C hina
Stability may have enhanced growth, but difficult to
assess the counterfactual
Could fiscal policy have achieved stability with
stronger growth?
Public expenditure as a key channel for fiscal impact on
growth
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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
Public capital formation has declined during the
period of fiscal adjustment
Public Capital Formation by Income Group
12
8
6
4
2
Low income
Lower-middle income
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
0
19
80
% of GDP
10
Upper-middle income
Evidence of cuts in infrastructure investment – in LAC and SSA
but also more broadly across lower income groups
Infrastructure Expenditure and Overall Deficit
(% of GDP, 11 countries, GFS data)
5
4
3
2
1
0
80-85
86-90
91-95
Infrastructure
Government Expenditures on Infrastructure,
Education & Health: Low Income
Deficit
Government Expenditures on Infrastructure,
Education & Health: Lower-Middle Income
6
6
5
5
4
% of GDP
% of GDP
96-01
3
2
4
3
2
1
1
0
1980
1985
1990
1995
2000
0
1980
Education
Health
Infrastructure
1985
Education
1990
Health
1995
2000
Infrastructure
That brings us to the fiscal space debate
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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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Recent Policy papers: IMF papers and Bank DC paper
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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
Highlights of interim report to DC
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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
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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
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x
?
CE
α
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
Highlights continued
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Paper proposes an approach to improving knowledge
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Requires adoption of a broader public finance perspective
that:
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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
Fiscal diamond – a simple device to motivate a broader
framework for fiscal and public expenditure policy
Figure 5: Fiscal Space
Increase of
Grant Aid in
% GDP
5
4
3
2
Improved
Expend.
Efficiency
in % GDP
1
0
New
Borrowing in
% GDP
Improved
Revenue
Effort in %
GDP
Directions for potential policy focus recognizing initial conditions
Fiscal Space: Chile
Fiscal S pace: Ethiopia
Increase of
Aid
Increase of
Aid
Revenue
Effort s
Expend.
Efficiency
Expend.
Efficiency
Increase of
Debt
Increase of
Debt
Fiscal Space: Brazil
Fiscal Space: India
Increase of
Aid
Increase of
Aid
Revenue
Effort s
Expend.
Efficiency
Increase of
Debt
Revenue
Effort s
Revenue
Effort s
Expend.
Efficiency
Increase of
Debt
Board Reaction
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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
Implications for PER work
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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
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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)
Some thoughts on next steps
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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
Fiscal Space: Brazil
Increase of
Aid
Revenue
Effort s
Expend.
Efficiency
Increase of
Debt
Improved
Expend.
Efficiency in
Education
Improved
Expend.
Efficiency in
Agriculture
Improved
Expend.
Efficiency in
Infrastructure
Improved
Expend.
Efficiency in
Health
Conclusions
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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
References
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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.