Fiscal Policy, Budget Deficits and Government Debt

1. Fiscal Policy, Budget Deficits and Government Debt MSc EPS Session 5 Hilary term 2011 Professor Dermot McAleese

2. Aim of economic policy is to reduce volatility of market economy GDP without counter-cyclical policy GDP GDP with counter-cyclical policy Potential GDP time time

3. The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs. George Soros “The Game Changer” FT 28 Jan 2009

4. FISCAL POLICY Counter-cyclical fiscal policy  The limits of fiscal activism  Fiscal policy 2008-10: averting a world depression  Policy recommendations for 2011 and beyond

8. “I believe myself to be writing a book on Economic Theory which will largely revolutionise - not I suppose at once but in the course of the next ten years - the way the world thinks about our problems” John Maynard Keynes - letter to George Bernard Shaw in 1933. The book was: The General Theory of Employment, Interest and Money (1936) 8

9. Chapter 1 The General Theory I have called this book the General, Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical1 theory of the subject, upon which I was brought up and which dominated the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience. ----------------------------------------------------------------------- 1.“The Classical Economists” was a name given by Marx to cover Ricardo and James Mill and their predecessors, that is to say for the founders of the theory which culminated in the Ricardian economics. I have become accustomed, perhaps perpetrating a solecism, to include in "the classical school" the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian economics, including (for example) J.S. Mill, Marshall, Edgeworth and Prof. Pigou

10. Key Elements in Keynesian Economics Business expectations shattered by 1929 slump. Lack of demand the problem , not lack of supply Monetary policy by itself not sufficient to promote investment Governments should: SPEND IN A RECESSION, even though budget deficit is getting larger (‘loan-financed public works’) SAVE DURING THE BOOM, even though it has abundant tax revenues JM Keynes A General Theory of Employment Interest and Money 1936 10

11. Objections to Keynes’ theory “We cannot afford it” Higher spending means more borrowing means higher interest rates More Goverment spending means higher future taxes Better to cut wages and become more competitive Trade unions too powerful Recession/depression self-correcting in the long run 11

12. Achievements of Keynes(see Chapter 15) A key factor in enabling world economy to avoid repeat of Great Depression. Japan used Keynesian economics to avoid economic disaster since early 1990s US used counter-cyclical policy aggressively to offset effects of stock market collapse 2001-2 And 2008-2010 also ..... 12

13. Consensus turns Keynesian (% of GDP) 13 IMF Oct 2009 ch 1

14. Limitations of fiscal policy • Governments often got timing wrong – policies turned out to be pro-cyclical • Governments spent during the recession AND during the boom: • Govt spending rises as % GDP • Growing DEBT problems • Private sector response to fiscal expansion becomes less positive 14

15. RESULT Fiscal policy still an important tool of policy, but no longer as effective as it was in the past. 15

16. PUBLIC DEBT Public debt is sustainable when it remains constant proportion of GDP over time Effect on financial markets’ expectations:  inflation to erode real value of fixed-interest debt debt default, rescheduling or moratorium on interest payments Public SectorIndebtedness (public debt adjusted for pensions liabilities) Openness of the financial markets  fiscal conservatism … reinforced by ageing population 16

17. OECD Dec 2010

18. OECD Econ Survey June 2010 p. 49

19. Age dependency = (pop 0-14 + 65+)/ pop 15-65 Source: computed from WDI Indicators World Bank

20. Policy Options for Ageing Remove incentives for early retirement More reliance on privately funded pensions Find appropriate balance between public and private provision of health services and long term care of the elderly Efficiency and cost-benefit of healthcare – limiting level of treatment by expectation of life

21. Japan’s public finances

22. Japan: Source: Aherne et al (2002)

23. Japan’s government expenditure and revenues 1988-2008 Source OECD

24. Source: CPI data, taken from World Bank, OECD 24

27. Unemployment rates (% of labor force) for US, Euro area and Japan OECD Dec 2010

28. End of Japanese boom

29. Fiscal policy – a Japanese view • Japan’s fiscal deficit is ‘a perfect example of a good deficit’. Without the increase in spending that produced such larger deficits, Japan would have experienced a drop in GDP similar to that in the Depression era US where GDP halved in just 4 years. (p. 259) • In a balance-sheet recession, the private sector focuses on reducing debt not on maximising profits. To increase government spending is the only effective response. Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great Recession Wiley 2009

30. Fiscal policy: ECB pre-crisis A discretionary fiscal policy attempting to fine tune the economy can have stabilising effects, but the size of the effect tends to vary depending on several factors and is generally assessed to be small. What is not small, however, is the risk associated with such activist fiscal policies. Experience suggests that unless a discretionary fiscal stimulus is timely, targeted and temporary, it actually risks being harmful. ECB Monthly Bulletin June 2008 p. 79

31. 31 European Economic Advisory Group Brussels Feb 2010

32. Fiscal policy essential when economy is in deep decline (2008-) • Coarse tuning vs fine tuning • Monetary policy expansion necessary but not sufficient • How do we know if fiscal stimulus has been a success? • Will experience follow that of Japan? If so, is that necessarily undesirable? • How will private sector react? 32

33. Government spending (% GDP) Source: European Economy April 2010 (to be updated)

34. General gross government debt (% of GDP)

35. United States Budget Balance (% of GDP) 1988-2011 Source: OECD Economic Outlook Dec 2010

36. THE THREE T’s OF FISCAL POLICY To be economically effective, fiscal policy must be: Timely Targeted Temporary

40. IMF WEO Oct 2010

41. Questions on Economist article, 1 Nov 2008 “The standard response to a demand shock is to use monetary policy.” a) What is a “demand shock” and what caused it in the present context. b) Outline the major instruments of monetary policy. Explain the meaning of the term “money multiplier”? Why is it “collapsing”? What measures could be taken to raise its value? What effect would a steep fall in property prices and in the stock market have on the level of investment? What are automatic fiscal stabilisers? Why do they differ in magnitude between countries? What is meant by a “fiscal stimulus”? Does it matter if the stimulus takes the form of an increase in spending or a fall in taxation? Some argue that increased government spending will lead to an expectation of increased taxes in future that will negate any effect on aggregate demand in an economy. Do you agree? Why would a fiscal stimulus tend to be more effective in a large country (the US) than in a small open economy (Morocco)? Under what circumstances is it justifiable for a government to plan for a budget deficit? “Conventional monetary and fiscal policy may not prevent a prolonged deflationary slump.” What can be done if this happens? What policy measures should Japan take to reduce its budget deficit?  -------------------------------------------------------------- 41