IDB: XLII Meeting of Network Central Bank and Finance Ministries, October 6/7, LAC Debt reduction: Fiscal Consolidation - and other options

Transcription

1 IDB: XLII Meeting of Network Central Bank and Finance Ministries, October 6/7, 2015 LAC Debt reduction: Fiscal Consolidation - and other options Marcus Miller University of Warwick

2 A tractable policy framework for Fiscal Consolidation, as in LAC Macro Report, IDB 2015 Start with a growing economy, with unsustainable fiscal position ( primary surplus is insufficient to service debt, already standing above a target level of, say, 40%) Add a simple Error Correction Mechanism to public expenditure to get debt to desired target. But how will the economy respond? Two possibilities: (i) expenditure cuts have no impact on output ; (ii) income is affected by Keynesian multiplier effects. 2

3 These represent two contrasting traditions of thought: of Dr Pangloss and of Mr Keynes El pensamiento utopica El realismo no magico All is for the best in the best of all possible worlds In the long run we are all dead.

4 Which is more relevant? Keynesian perspective warns of downside risk to output when Fiscal Consolidation is added to private sector deleveraging. (Note: EM private sector debt/equity ratio has doubled since 2008) Others argue that Fiscal Consolidation is essential to build resilience for the next credit crunch. OK, but what about the present? We ll look at both approaches, starting with the Panglossian assumption (that output is not affected by fiscal policy). 4

5 Two key relations: Domar equation and Fiscal Adjustment Idea is to look at the dynamics of debt and spending, with debt, b, plotted on vertical axis, and Government spending, g, on horizontal, both divided by capacity output. First comes the Domar equation that says debt grows if the primary surplus is less than the real interest rate minus the growth rate. Second is an Error Correction Mechanism for fiscal adjustment; cut g if structural deficit is above a fiscal target set to hit debt target. 5

6 The Domar equation at work: so b (debt relative to trend GDP) rises, falls; or stabilises (as on BB) b B Debt/GDP Tax take Cost of debt service bb = 0 A 0 A b 0 A 1 Arrows show how bond stock rises or falls, for given g Primary surplus B r-γ θ Primary deficit g Expenditure/ GDP 6

7 Next Fiscal Consolidation (FC), with spending adjusted to hit a target for structural deficit (as on FF schedule) b B F r Cut spending gg = 0 Tax take Arrows show how government spending is cut or increased to hit the deficit target, δ* E Increase spending θ δ* F θ' g 7

8 b B Putting both together gives convergence to target level of debt, b* F b* r bb = 0 A' E A Tax take Note the curvilinear approach towards equilibrium at E. B r-γ gg = 0 F g* θ δ* θ g 8

9 Can it really be that straightforward? So far it seems that getting debt down is fairly straightforward. But there are problems. First how long, O lord, will it take? Second, how painful will it be politically? Might there not be fiscal fatigue, where expenditure cuts meet political resistance. Third, and what if output is endogenous? 9

10 How long will it take? some historical perspective from UK Fiscal Consolidation was used to reduce UK public debt after the war against Napoleon. But it took 40 years to get the debt ratio from 160% to 90% of GDP, by running Primary Surpluses of 4 to 5% of GDP. 40 years later, by 1913, the debt ratio was down 25%. That s history: is it relevant today? 10

11 A current example? Jamaica Facing a, not dis-similar, debt/gdp ratio of about 140%, Jamaica is opting for Fiscal Consolidation - rather like Britain under Queen Victoria. Illustrative calculations suggest that it could take a bit under than 20 years to get the debt ratio down to 90% Looks better than Britain! But the planned primary surpluses are much higher, currently 7.5% of GDP. (Real interest rates are much higher than the 3 to 4% of 19 th century Britain.) There is a also danger of fiscal fatigue unless interest rates could be cut. 11

12 So what about some financial repression? After WWII UK debt was about twice GDP; but the strategy used for debt reduction was financial repression with real interest rates almost always below the growth rate. Debt management and controlling interest costs of the national debt were central tasks for the Bank of England throughout these decades( ). Interest rates were decoupled from those prevailing abroad. N Crafts(2015) Maybe Jamaica could do with some financial repression too? [Indeed, if banks are keeping rates high so they can collect seigniorage, this would be more like financial liberation!] 12

13 Fiscal Consolidation combined with cutting interest rates: avoiding fiscal fatigue in Jamaica Varying interest rates Reproduced from Malcolm (2013) x-axis=government spending as a % of G.D.P., y- axis=debt to G.D.P. ratio. Each line represents a different interest rate, coded by color. Red=0.17, Green=0.14, Blue=0.11, Pink =0.085, Black= In the graph, b*=0.60, bo=1.42, go=

14 Another option : debt forgiveness for Jamaica so as to avoid expenditure cuts ( including cuts to capital formation, health and education) Varying initial debt levels time (years) Reproduced from Malcolm (2013) y-axis=government spending as a % of G.D.P.. Each line represents value for initial debt coded by color. Red=0.80 Green=0.90, Blue=1, Pink =1.2, Black=1.42. In the graph, go= =

15 Turning now to Mr Keynes As the IMF has emphasized, there may be multiplier effects to be taken into account during Fiscal Consolidation, especially if private sector demand is weak. Keynesian multipliers likely to be much larger for an economy like Brazil, than for Jamaica. The income effects feed back onto debt dynamics by weakening the tax yield of deficit reduction. So fiscal consolidation, like blood letting, becomes a painful cure. 15

16 Time taken to reduce debt from 50% to 40% GDP rises from 10 to 14 years allowing for multiplier (IDB 2015) FIGURE 6.11 PATHS FOR FISCAL ADJUSTMENT 54 Adjustment with fiscal multiplier 52 starting point 50 % of GDP Primary 44 surplus Primary deficit 25.2 Adjustment with zero fiscal multiplier Green line is FF. Yellow line shows path with no multiplier. Blue is with low multiplier. Fiscal Expenditure (% of GDP) Source: IDB staff estimates based on Miller and Zhang (2013). 16

17 Actually, things can be a lot worse, as can be seen from the pessimistic scenario in the Table below (based on LAC Macroeconomic Report 2015 pp 48,9) Initial spending cut; years needed to reduce debt (from about 50% to 40%). Real interest less growth rate (percentage points) Optimistic scenario = 0.5 Pessimistic scenario = 2 No multiplier 1.7 cut / 10 years 2.4 cut /12 years Low multiplier (0.5) 1.9 cut / 14 years 2.6 cut/ 22 years 17

18 Finally, Evsey Domar and the power of positive thinking Imagine one starts with the pessimistic IDB scenario, growth of 2.5%, real rates of 4.5% Think of supply-friendly fiscal policies that raise growth to 3.0% Add some financial repression to cut real rates to 3.0%, so we re in the optimistic scenario. Now let the debt target be 50% rather than 40%, then a small fiscal adjustment (of just over 1% GDP) will stabilise debt on target immediately! 18

19 Evsey Domar in AER (1944) Now, some economic and political circles are burning with a desire to reduce the debt burden ( ). They should beware, however, lest the policies they advocate exert such a depressing effect on the national income as to result in an actually heavier debt burden. THE END 19