15. Fiscal Policy, Debt and Seigniorage Notes for instructors

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1 15. Fiscal Policy, Debt and Seigniorage Notes for instructors 15.1 Overview Governments spend and tax close to half of GDP in the EU with the larger share involving the redistribution of income among citizens. Government spending on goods and services is still on the order of a quarter of private consumption spending of households. Table 15.1 General government spending and finances EU USA Japan Total spending (% of GDP) Public consumption* as % of GDP as % of private consumption Budget surplus (% of GDP) Gross debt (% of GDP) *EU - 22 Source: OECD How we finance that spending, especially when tax revenues fall short of that spending boils down to borrowing, monetizing the deficit, or defaulting on the debt Fiscal policy and economic welfare First we discuss what is behind the trend of real government spending Provision of public goods and services From the point of view of macroeconomics it is less an issue where to draw the line between the private and public provision of goods, rather it is sufficient to determine that G> (and big enough to matter for macroeconomists to include it in their models) for reasons of positive externalities, increasing returns in production. Oxford University Press, 25. All rights reserved.

2 Redistributive goals: equity vs. efficiency Table documents both the significant scale and the variation across countries on the extent of redistribution. The idea of an equity-efficiency tradeoff boils down to a belief that Y if (gross) T. Government transfers Table 15.2 Transfers as % of Transfers as % of GDP government outlays Austria Belgium Denmark Finland France Germany Greece Ireland Italy Japan* Netherlands n.a Portugal Spain Sweden UK USA* Source: European Economy, *OECD Economic Outlook *Note: Accounting practices for transfers in the national accounts were changed in 1995 and may lead to a downward bias for the 196 figure. From the point of view of macroeconomic flows of income, taxes net of transfers is relevant, but from the point of view of the disincentive effects of increasing taxes or increasing means-tested transfers, the gross level of taxes and/or transfers is usually relevant Macroeconomic stabilization Now we return to the short-run, home of the cycle. Table 15.3 shows that budget imbalances are the rule rather than the exception. This needs to be explained. Chapter 15 2

3 Budget balances (% of GDP) Table 15.3 Average Austria Belgium Denmark Finland France Germany Greece Ireland n.a Italy Japan Netherlands Norway Spain Sweden UK USA Surplus (+) or deficit (-) Source : OECD Economic Outlook Deficit reduction has been the solution chosen for debt stabilization and achieved in several European countries. Countries with some of the most serious debt problems Belgium, Denmark, Ireland and Italy have turned their primary budgets around. The recent European consolidation can be attributed largely to preparations for monetary union Consumption and tax smoothing The following four time series plots show the rise and the decline of national debt/gdp for several countries. This is quite consistent with tax-smoothing, rather than allowing taxes for a concentrated burst of public spending for the war to rise sufficiently high to eliminate the wartime deficits. Same thing for the 197s post-oil-shock recession. % of GNP Historical evolution of public debt Fig USA % of GNP Germany Chapter 15 3

4 2 15 France % of GNP % of GNP UK Fiscal implications of German reunification (% of GDP) Table 15.4 Government expenditures Budget surplus Gross public debt Current account * Note: the jumps in gross public debt in 1993 and 1995 that seem to come out of the blue (no jump in government expenditures or budget surplus). These have to do with certain off-the-government-book debts becoming explicit. Chapter 15 4

5 Output and employment stabilization The issue here is macroeconomic laissez-faire in a sticky wage/price world vs. active demand stabilization policy. Fig Active fiscal policy aims to offset the exogenous negative shock to demand (stay at A) AS Inflation B C A AD AD Output gap ( Y-Y) Starting from long-run equilibrium at point A, the aggregate demand curve shifts from AD to AD. Under fixed exchange rates, the government can stop this process of spiralling demand decline. To keep the curve in its AD position and prevent the move from point A to point B, it either increases its own spending or provides tax relief. In effect, the government borrows on behalf of its credit-constrained citizens. Counter-cyclical fiscal policy may be a corrective device to keep unemployment at its equilibrium level, and output near its trend growth path. Sustaining aggregate demand with public spending when private demand weakens, or directly boosting private demand with tax relief, could eliminate business cycles altogether. Chapter 15 5

6 Automatic stabilizers Taxes less transfers from the government to the private sector, are strongly procyclical. Cyclical behaviour of net taxes in the UK 7 7 Fig Primary budget (% of GDP) Net taxes Capacity utilization Firms at full capacity, (%) annual average When incomes and spending rise, tax collection automatically rises, and conversely. Public transfers, on the other hand, and unemployment benefits in particular, rise during recessions and decline during booms. The automatic lowering of taxes in a recession amounts to an implicit fiscal expansion. Conversely, a better-than-expected economic performance reduces the budget deficit or increases the surplus because of enhanced tax income for the government, an automatic contractionary fiscal policy. Expected and realized budgets in 23 (% of GDP) Table 15.5 Forecast time December June December June December Actual France Germany Italy Netherlands Spain Source: OECD, Economic Outlook, and Eurostat Growth was worse than expected in 23 and the budget deficits were worse than expected for all countries except for Spain. Chapter 15 6

7 How to interpret budget figures The endogeneity of budgets means that it is not straightforward to determine the stance of fiscal policy is tight or easy from the change in the deficit alone. In order to separate out exogenous policy decisions from endogenous responses to cyclical fluctuations, we ask what would have happened to the budget balance if real GDP had been on its trend path. Fig Fig Expansionary fiscal policy lowers budget surplus for any given level of output (shift down) Budget surplus A A FP On trend this fiscal policy would generate an actual surplus (A). However, if the economy were in a deep recession, even this fiscal policy would generate a deficit (A ). Budget surplus A B FP FP B Note that the economic stimulus could increase output enough for the actual budget surplus to still remain positive (B ). Output gap ( Y-Y ) Output gap ( Y-Y) The given upward-sloping schedule FP (fiscal policy) represents a budget as approved by parliament. The positive slope of each schedule represents the automatic stabilizer: given tax and spending rules, an increase in the GDP improves the budget balance. The budget corresponding to schedule FP is tighter less expansionary than the budget represented by FP : for any given GDP level, the surplus is larger because of either less spending, or more taxes, or a combination of both. Chapter 15 7

8 The cyclically adjusted budget is the budget surplus or deficit that would occur if the economy were on its trend growth path, when the output gap is nil. Fig Changes in actual and cyclically adjusted budget balances (% of GDP) 3 Change in the structurally adjusted budget balance Belgium Austria Portugal Spain Australia Netherlands Norway Italy Denmark Japan Sweden Greece Germany France Canada Finland UK Ireland USA Change in the actual budget balance Countries where the cyclically adjusted budget has improved (above the horizontal axis) are countries where fiscal policy has been exogenously tightened up. The diagram makes clear that many countries have used the recent period of cyclical improvement in the budget as an opportunity to correct structural imbalances. Chapter 15 8

9 15.4 Deficit financing: public debt and seigniorage Gross public debt (% of GDP) Table Austria Belgium Denmark n.a Finland n.a France n.a Germany Greece Ireland n.a. n.a Italy Japan Netherlands Norway Spain n.a Sweden UK USA Source: OECD Economic Outlook In many industrialized countries public debts are very large. What is troublesome in the more recent period is that the largest European debts have grown in peacetime, mostly during the 197s. Considering a multiperiod government budget constraint to see how the debt process can become explosive. When there is no economic growth (i.e. Y is constant) we can focus entirely on the whether B = or not (see column g= in the table below). With economic growth, what is relevant is the relative size of the debt B/Y (see column g> in the table below). By explosive growth we mean B growing faster than Y so that B/Y continues to grow without bound. Assuming away default, the right hand side is the net bills we have to pay and the left hand side is that we either borrow or issue money to pay the net (of taxes) government bills. Divide through by nominal GDP=PY PB + M = P( G T) + ipb nominal change nominal new bonds in money nominal value of interest base gov't. deficit on debt Chapter 15 9

10 ( PB) M P ( G T ) PB + = + i PY PY PY PY We may not we may cancel P's. we may cancel P's cancel P's! ( PB) M ( G T ) e B + = + ( r + π ) PY PY Y Y We ll be replacing the expression in the box soon, using an approximation that some students will recognize as the quotient rule in differential calculus. = i change in the ratio of nominal debt to nominal GDP it was ok to cancel the P's within the parentheses ( PB) PB PB P Y Y P = PY PY PY PY ( ) PB B Y B P = + PY Y Y Y P ( PB) g B B = ( g π ) Y PY Y Combine the two equations with the boxed expression to eliminate the box: ( G T) B M e B B + = + ( r+ π ) ( g π) Y PY Y Y Y e For the case that inflation is perfectly anticipated π = π ( ) π B M G T B + = + ( r g) Y PY Y Y From this we consider the special cases of this section of the chapter: Chapter 15 1

11 π= π> debt accumulation debt accumulation g= g> B M G T ( ) B primary debt + = + r g budget service Y PY Y Y deficit change in seigniorage primary deficit B = G T + rb seigniorage total budget deficit B + M P = + G T + rb primary debt deficit service total budget deficit debt-gdp ratio limited to money required for growing economy at stable prices relative to GDP B M G T B ( r g) + = + Y PY Y Y change in debt-gdp ratio primary deficit relative to GDP There is one subtle point needed to understand this table: economic growth requires money supply growth to maintain price stability, i.e. inflation of zero. Thus, a growing economy provides seigniorage without inflationary cost. Table 15.7 shows that economic growth makes it easier to stabilize the B/Y ratio than to actually stabilize B. Table 15.7 Net debts and primary budget balances, 24 (% of GDP) Net debt Actual primary budget Required primary surplus: b in 24 surplus in 24...to stabilize absolute...to stabilize size of debt debt/gdp ratio Belgium Germany Ireland Italy Netherlands a These are forecasts produced in 23 by the OECD. b The required surplus assumes a 5% real interest rate and a 2.5% real GDP growth rate. Source: OECD, Economic Outlook The larger the debt is the larger is the surplus ultimately required to stabilize it. The third column gives the primary surplus needed to stabilize the debt level in 24. In some cases Germany and Italy doing so would have required a considerable tightening of public finances. Chapter 15 11

12 15.4 Three ways to stabilize the public debt Cutting the deficit Figure 5.9 Ireland Italy Primary budget surpluses % of GDP % of GDP U.K % of GDP % of GDP USA These countries show that deficit reduction is not hopelessly impossible Seigniorage and the inflation tax The important point here is that seigniorage is possible because the government can pay its bills by increasing the monetary base (essentially writing checks on itself to pay its bills) compared to the inflation tax which is possible when inflationary expectations are lower than actual inflation (i.e. some inflation is unanticipated). Since fooling people with higher inflation ratchets core inflation upward, a series of inflationary surprises only solves the immediate fiscal shortfall, leaving policymakers with the choice of increasing the surprises and triggering a hyperinflation or a combination of painful tax increases and spending cuts (which brings with it the immediate wrath of the citizenry) Default Table 15.8 Shows two reductions in Italian debt, first through spending cuts and tax increases and then through a bond conversion that amounted to a partial default of 2%. But the intertemporal implication of this solution to the debt problem is to make borrowing very expensive in the future as lenders will be sure to insure themselves against you defaulting again. Chapter 15 12

13 Table 15.8 Public finances in Italy, Tax revenues as % of public spending Debt-GNP (%) Source: Alesina (1988) Between 1923 and 1926, having eliminated all political opposition, Mussolini reestablished near budget balance and brought the debt GDP ratio down by reducing spending and raising taxes. The Italian government in November 1926 imposed a mandatory conversion of debt of less than seven-year maturity into fixed-rate (5%) longer-term bonds (i.e. a partial default of 2%). In 1934, these bonds were again forcibly converted into 25-year loans bearing a 3.5% interest (i.e. another partial default of 3%). The government found it very hard to undertake new borrowing after the last two moves. Where we are headed Next port of call is a critical look at real existing demand management. Macroeconomic policy makers have many reasons to be humble or at least cautious when trying to tame the business cycle. Links Trends in public sector debt in Germany since unification ecdb.pdf Tax policy and administration website of the World Bank Chapter 15 13