Fiscal Policy, Public Expenditure and Growth

1. Fiscal Policy, Public Expenditure and Growth Anand Rajaram, PRMPS PFAM Course, PREM Learning Week April 23, 2007

2. 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?

3. Outline • Views on 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 Public Finance work

4. 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

5. 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?

6. 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)

7. 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.

8. 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

9. 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

10. 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

11. 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.

12. Then the lifetime budget constraint • Can be used to derive a lifetime government budget constraint, expressed in terms of real values as: • 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.

13. Fiscal policy and monetary policy need to be coordinated • bt-1 = Σ (1+r) –(i+1) (xt+i + σt+i) • 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.

14. Debt dynamics with growth • The budget constraint can be expanded to incorporate the effect of GDP growth • 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

15. 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

16. 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, σπ • But do not have as firm a sense of how fiscal policy might affect growth • x g

17. 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

18. Recent history: Fiscal policy has contributed to price stability

19. 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?

20. 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

21. Public capital formation has declined during the period of fiscal adjustment

22. Evidence of cuts in infrastructure investment – in LAC and SSA but also more broadly across lower income groups

23. 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

24. 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 • ? α • 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

25. 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

26. Fiscal diamond – a simple device to motivate a broader framework for fiscal and public expenditure policy

27. Directions for potential policy focus recognizing initial conditions

28. 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

30. 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

31. 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”.