Fiscal Policy, Budget Deficits and Government Debt

Fiscal Policy, Budget Deficits and Government Debt Week 9 SF Intermediate Economics Professor Dermot McAleese

OUTLINE  Counter-cyclical fiscal policy  “Crowding-out”  The limits of fiscal activism  Public debt + “ageing” of population

COUNTER-CYCLICAL FISCAL POLICY The Keynesian aggregate supply curve and fiscal policy Price level KAS E1 AD1 E2 E* AD AD2 Y2 Y* Output

CROWDING OUT Crowding out refers to the various ways by which changes in public spending impact negatively on private sector spending. (+)G (+) Budget Deficit  borrowing  (+) r (-) I, (-) C BD matched by (+) LM offsets crowding out effect

r LM IS’ IS Y

RICARDIAN EQUIVALENCE (-) T today(+) Budget Deficit today (+) Govt borrowing  (+) T tomorrow  (-) C today The stimulus to AD by budget deficit will be offset by a rise in private sector saving  Financing by borrowing = increase in taxation  Rational expectations

FISCAL ACTIVISM: THE LIMITS Knowledge gaps and time lags  Political interference  Inefficiencies of the public sector  Deterrent effects of public debt overhang  Private sector response  Empirical experience

The Debt Penalty - Limits to Public Borrowing Public debt is sustainable when it remains constant proportion of GDP over time (see formula in Appendix) Effect on financial markets’ expectations:  inflation to erode real value of fixed interest debt debt default, rescheduling or moratorium on interest payments New measures of indebtedness(public debt adjusted for net pensions liabilities) Openness of the financial markets  fiscal conservatism Further reinforced by ageing

EMPIRICAL EXPERIENCE  Fiscal policy oftenpro-cyclical instead of counter-cyclical Private sector response not always positive • Extreme Cases expansionary fiscal contraction (Ireland?) extreme incipient indebtedness (Japan) surplus for an ageing population (Norway)

CONCLUSION Coarse-tuning instead of fine-tuning Effectiveness of fiscal policy depends on: initial position (public debt, size of public sector) political institutions (credibility)

Table. 1 Industrial countries: fiscal balances (% GDP) Source: IMF, World Economic Outlook (May 1996 and May 2000)

Table. 1a Industrial countries: fiscal balances (% GDP) Source: IMF, World Economic Outlook (May 1996 and May 2000)

Table. 2 Fiscal policy stance, 1999-2000 Source: IMF, World Economic Outlook (May 1996 and May 2000)

Table. 3 Government spending (%GDP) Source: European Economy, Annual Report No 59, 1995; European Economy, special Supplement, Spring 1995; OECD; pre-Second World War figures taken from Vito Tanzi and Ludger Schuknecht, ‘The Growth of Government and the Reform of the State in Industrial Countries’, IMF Working Paper, December 1995; European Economy No. 68, 1999.

Table. 4 General government net debt (%GDP) Source: European Monetary Institute, First Annual Report, April 1995; OECD Economic Outlook,, various issues.

Table. 5 Elderly dependency ratios Source: Eurostat

Table. 6 Public sector debt and net public pensions liabilities, 1990 (%GDP) Source: Van Noord and Herd (1994)

Fiscal Policy, Budget Deficits and Government Debt