AN EMPIRICAL ESTIMATION OF THE OPTIMAL LEVEL OF FISCAL DEFICIT IN THE WEST AFRICAN MONETARY ZONE 1. Emmanuel Onwioduokit

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1 AN EMPIRICAL ESTIMATION OF THE OPTIMAL LEVEL OF FISCAL DEFICIT IN THE WEST AFRICAN MONETARY ZONE 1 Emmanuel Onwioduokit Abstract Preceding the actualization a monetary union, potential members are usually required to observe certain quantitative and qualitative criteria or benchmarks. These criteria are usually broadly classified into two: economic convergence criteria, and legal criteria. Specifically, the West African Monetary Zone (WAMZ), member countries among other criteria are required to fulfill fiscal target (fiscal deficit-gdp ratio of less than or equal to 4.0 per cent). The paper sought to ascertain the nature of relationship between fiscal deficits and economic growth, as well as to establish the fiscal deficit threshold that is consistent with economic growth in the West African Monetary Zone. Empirical evidence indicates a positive relationship with economic growth. Also the threshold level of deficit that is consistent with economic growth in the WAMZ was identified at 5.0 percent. The policy implications and recommendations based on the major findings of this paper is that fiscal deficit criterion in the WAMZ should be maintained at 4.0 per cent since this level falls within the acceptable range of optimal deficit identified in the study. JEL Classification: C2, E1, E2, O4, O5 Keywords: Fiscal Deficit, Economic Growth, Threshold, West African Monetary Zone INTRODUCTION Traditionally, the protocol governing the formation of an economic and monetary union requires member countries to adhere to prudent and consistent macroeconomic policies and structural reforms which should be sustained over time. Prior to actualizing a monetary union, potential members are usually required to observe certain quantitative and qualitative criteria or benchmarks. These criteria are usually broadly classified into two: economic convergence criteria, and legal criteria. The former is centred on three areas, namely monetary, fiscal and structural convergence, while the latter is concerned with the legal framework for monetary integration. In principle, these convergence criteria serve as a tool for providing information; an anchor for expectations and policies; and a mechanism for discipline. The criteria are expected to lend credibility to the monetary integration agenda. 1 Emmanuel Ating Onwioduokit is Deputy Director, West African Monetary Institute, Accra, Ghana. The views expressed in this paper are personal to the author and does not represent the official position of his employer.

2 Vol. 12, No.1 Journal of Monetary and Economic Integration Specifically, the West African Monetary Zone (WAMZ), member countries among other criteria are required to fulfill fiscal target (fiscal deficit-gdp ratio of less than or equal to 4.0 per cent). Among other reasons for setting a target on fiscal deficits, is the concern that excessive deficit financing would crowd out the private sector and net exports, and that, it would increase government debt to a level where inflationary financing, arrears and eventually default, would become a serious concern. At the practical level, there is the likelihood for potentially unsustainable fiscal deficit behaviour by governments if there are no explicit limits on the level of deficit financing. Furthermore, fiscal deficits limits are explicitly articulated within the context of a monetary union because; individual countries cannot finance their deficits through the issuing of new money. Countries do not hold any other major macroeconomic instrument than the fiscal policy. As a result, they may be tempted to exploit it in a nonsustainable manner, to promote short-run economic growth. If individual countries get to a situation where they can no longer finance the fiscal deficits, then they will have to be bailed-out or abandon the monetary union. In the first scenario, if any country is bailed-out by the central authority, a moral hazard problem emerges, as other countries will lack the incentives to keep their deficits under control. In the second case, if a country exits the monetary union, the common bond market is seriously affected. In this circumstance investors tend to run from public bonds, which lead to budgeting problems in the other countries. The commencement date for the launch of the common monetary union and the issuance of a single currency has been postponed three times (2003, 2005, 2009), with the expected date for the start of the union now fixed for January 1, The deferments of the commencement date of the Union have always been linked to non compliance of member countries with the stipulated convergence criteria especially the criteria on fiscal deficit-gdp ratio and inflation. A critical perusal of countries performance on the convergence scale over the period has shown that the fiscal deficits criterion has been the least fulfilled criterion by member countries (WAMI, 2009). Although the WAMZ convergence process largely mimics that of the European Monetary Union, there is very limited empirical evidence as to where the various bench marks for convergence criteria were derived. The general belief is that the WAMZ Authorities adapted the European Union convergence criteria and made some modifications to fit what was perceived as the peculiar conditions of the Zone (Nana, 2007). Consequently, the various WAMZ ratios and benchmarks have been in contention since the commencement of the process. (See WAMI, 2005). Although the importance of fiscal convergence, before and after the realization of the union is not in dispute, some critiques, including (Nana, 2007 and Balogun, 2007) have argued that the fiscal deficit/gdp ratio, excluding grants of 4.0 percent, the key fiscal convergence 2

3 Emmanuel Onwioduokit requirement for the WAMZ, is not optimal for growth without any further attempt to state empirically what the threshold should be. This paper seeks to empirically establish the optimal level of fiscal deficit that is consistent with growth in the zone. The remaining part of the paper is organized as follows: Part II contains a brief overview of the WAMZ economies including recent policy thrust. Part III dwells on theoretical and empirical issues. Part IV outlines the analytical framework and empirical methodology. The empirical findings are presented in Part V. Part VI contains summary and policy recommendations. OVERVIEW OF WAMZ ECONOMIES The WAMZ covers a total land area of 1.49 million sq kilometres. However, with the exception of Guinea, Liberia and Sierra Leone that have shared national borders, the other countries are not geographically contiguous. The Zone is heterogeneous in terms of GDP and population. Although, the economies are relatively open, the export sector is largely dominated by limited commodities. The Zone has a total combined population of about 200 million as at 2010, representing 67.8 percent and 20.2 percent of the population of ECOWAS and Africa, respectively. The Zone s economy, measured by its combined GDP, totalled $387,846 billion (PPP); 59.4 percent and 22.1 percent of ECOWAS and Sub-Saharan Africa, respectively. The Zone accounted for about 0.5 percent of world GDP in The average GDP per capita (PPP) was estimated at $1,513.4 in Nigeria is the dominant economy in the Zone, with about 77.1 percent of the population and 88.0 percent of the zone s GDP. The composition of the country s GDP in 2010 indicated: agriculture (33.4 percent), industry (34.1 percent) and services (32.5 percent). Nigeria s economy is oil-based, with the oil sector contributing about 28.0 percent of GDP, over 80 percent of total revenue, and over 90 percent of foreign exchange earnings. The second largest economy in the zone is Ghana, with 8.0 percent of the zone s GDP. Guinea and Sierra Leone accounted for 2.0 and 1.0 percent of the Zone GDP, respectively, while The Gambia accounted for 0.98 percent of the Zone s GDP. 3

4 Vol. 12, No.1 Journal of Monetary and Economic Integration Figure 1: WAMZ GDP by Country Contribution WAMZ GDP (US$) 1% 1% 2% 8% 88% The Gambia Ghana Guinea Nigeria Sierra Leone As indicated in figure 1, in 2010, Ghana s GDP was equivalent to 7.6 percent of Nigeria s GDP and four times that of Guinea. The Gambia had the lowest GDP (US$779 million). In terms of per capita income, Nigeria is number one in the zone ($2,274) followed by The Gambia ($1,911); Ghana ($1,558); Guinea ($1,042); and Sierra Leone ($782). Thus Nigeria s per capita GDP was about three times that of Sierra Leone in Recent Policy Thrust and Outcome The main objective of fiscal policy in the WAMZ member countries during the convergence period ( ) was the attainment of fiscal sustainability through broadening of the tax base to enhance tax administration and expenditure control. In The Gambia, the key objective of government was to improve fiscal management, accountability and the rate of budget execution to support macro economic growth. Ghana s general policy thrust was to correct the fiscal slippage and re-establish the role of fiscal policy in achieving accelerated growth with stability. In Guinea, the objective centered on rationalizing and prioritizing discretionary government expenditures in favour of essential public services while continuing to maintain good relationships with international creditors. Nigeria s key objective was to prop up macroeconomic stability with fastidious emphasize on provision of critical infrastructure and human capital development, implementing socio-economic reforms while consolidating democracy. Fiscal policy in Sierra Leone was directed at attaining and sustaining macroeconomic stability. In this direction, a battery of measures to improve tax administration and broaden the tax base was pursued. 4

5 Emmanuel Onwioduokit The overall fiscal deficit to GDP ratio (excluding grants) for the Zone moderated from 4.2 percent in 2001 to 1.3 percent in 2007, but deteriorated to 1.4, 3.8 and 6.2 percent in 2008, 2009 and 2010, respectively. All countries registered deficits, though at varying levels during the period. Tax mobilization efforts, represented by tax revenue/gdp ratio, declined from 14.6 percent in 2001 to 12.0 percent in The ratio improved steadily to 19.6 percent in 2005, and thereafter dropped to 11.2 percent in In 2008, 2009 and 2010, respective ratios of 17.0, 12.1 and 12.3 percent were recorded. Overall, the ratio for the Zone fluctuated between 10.7 percent (lowest) in 2002 and 19.6 percent (highest) in The observed development in the ratio reflected weak revenue performances in most of the member countries. With regards to total expenditure and net lending as a ratio of GDP, the zonal performance showed a mixed trend. From 34.1 percent in 2001, the ratio plummeted to 25.7 percent in the succeeding year and thereafter increased consistently, peaking at 42.6 percent in The ratio declined gradually to 25.3 percent in In 2008, 2009 and 2010, respective ratios of 31.8, 22.7 and 28.7 percent were recorded. Overall, the ratio ranged between 22.7 percent (2009) and 42.6 percent (2005). THEORETICAL AND EMPIRICAL REVIEW Government borrowing is an important part of fiscal policy and management of aggregate demand. When the government runs a fiscal deficit, it means that in a given year, total government expenditure exceeds total income. The government can borrow to cover the deficit through the issue of government debt such as Treasury Bills and long-term government bonds. The issue of debt involves selling debt in the bond and bill markets. Most of the government debt is bought by financial institutions and individuals. There is a near consensus that a persistently large fiscal deficit can turn out to be a major problem for the government and the economy. Fiscal deficits are generally expected to be growth-retarding, all things being equal. This can arise because total savings are reduced (if the private sector does not fully adjust its savings or government borrowing finances consumption goods provision), consequently reducing factor accumulation. On the other hand, if deficits are perceived as unsustainable, then changes in tax/expenditure policy and/or monetary policy will be anticipated. Either is likely to retard growth via effects on investment from increases in expected inflation or uncertainties associated with possible fiscal policy changes. Even if monetary policy is designed to counteract the inflationary effects of a budget deficit, growth is still likely to be retarded by the associated increases in interest rates (Tanzi and Zee, 1997). At the theoretical level, there are three schools of thought regarding the economic impacts of fiscal deficits: Neoclassical, Keynesian, and Ricardian. The Neoclassical paradigm anticipates perceptive individuals planning consumption over their own life 5

6 Vol. 12, No.1 Journal of Monetary and Economic Integration cycles. Fiscal deficits hoist total lifetime consumption by shifting taxes to succeeding generations. If economic resources are fully employed, increased consumption inevitably implies diminished saving. Interest rates must then increase to equilibrate the capital markets. Accordingly, fiscal deficits "crowd out" private capital accumulation. Within the Keynesian analysis, a considerable proportion of the population is thought of as either narrow-minded or liquidity constrained. The propensities to consume out of current disposable income of these individuals are assumed to be very high. A momentary tax cutback therefore has an instantaneous and quantitatively momentous impact on aggregate demand. If the economy's resources are at the outset underemployed, national income increases, in so doing generating second round effects and the renowned Keynesian multiplier. Given that deficits motivate both consumption and national income, saving and capital accumulation need not be negatively affected. Thus, aptly timed deficits have advantageous consequences on economic growth. In the Ricardian argument, succeeding generations are associated through intentional, selflessly goaded resource transfers. Within definite circumstances, this implies that consumption is determined as a function of dynastic resources, to be precise, the total resources of a taxpayer and all of his descendants. In view of the fact that deficits simply shift the payment of taxes to upcoming generations, the current discounted values of taxes and expenditures must equal, in so doing it leave dynastic resources unaltered. Thus, deficit policy is a matter of indifference. In the last decade, the issue of how best to design monetary unions has attracted huge academic concern. A fundamental question is whether restrictions in the member states fiscal policies should be obligated in a monetary union. The key debate regarding need for fiscal restraint in a monetary union centred around whether lack of fiscal discipline is an obstacle to achieving the objective of monetary union (in particular price stability). Also what form of fiscal constraints is appropriate for effective macroeconomic management, which will not interfere with the use of such policies for other legitimate purposes, including, cushioning the impact of shocks. Researchers, who have studied this area, hold remarkably different opinions regarding the influence of monetary union for fiscal discipline. Central to the discussion on the subject is the time inconsistency of optimal monetary and fiscal policy. Time consistency of optimal monetary and fiscal policy has been extensively discussed in the literature on the macroeconomics of public finance. For instance, the seminal work by Calvo (1978) pointed to the ex post incentives of a government to use a surprise inflation to reduce the real value of any outstanding fiat money, when other sources of finance distort economic activity. Lucas and Stokey (1983) extended Calvo s analysis by showing how similar timeconsistency problems arise in a real economy due to the government s ability to manipulate the market value of indexed debt. In addition, they showed that these problems can be avoided if every government undertakes a unique restructuring scheme 6

7 Emmanuel Onwioduokit of the maturity (and contingency) of the indexed debt left to its successor, under the assumption that outstanding government debt cannot be subjected to outright default. Lucas and Stokey (1983) also argued that the time-consistency problem is inevitable in a monetary economy, where governments constantly have an ex post incentive to reduce (increase) the real value of net nominal government liabilities (assets) by a surprise inflation, so as to lower distortionary taxes. Tabellini (1986), analyzed the coordination between a single monetary authority and several independent fiscal authorities in a game- type model, showed that policy coordination between the fiscal authorities and the common monetary authority increases the speed of convergence toward the common steady state as compared to the outcome of the non-cooperative game. However, Persson, Persson, and Svensson (1987) suggested that a unique restructuring of both nominal and indexed debt could resolve both types of time-consistency problems. More precisely, they suggested that the firstorder conditions for optimal fiscal and monetary policy in a sequence of discretionary equilibria could be made identical to the corresponding first order conditions for the Ramsey policy the optimal policy under commitment. One of their conditions for the nominal debt structure is that each government leaves its successor with a total value of nominal claims on the private sector equal to the money stock, such that net nominal liabilities are zero, which appeared to remove the incentive for surprise inflation. By applying an informal but innovative variation argument, however, Calvo and Obstfeld (1990) showed that the solution proposed by Persson, Persson, and Svensson (1987) is indeed not an optimum. Turnovsky, Basar and d Orey (1988), in a dynamic model, compared Nash, Stackelberg and Pareto solutions and found that the advantages from full-fledged cooperation are likely to be relevant. Sala-i-Martin and Sachs (1991) reported that full cooperation represented by fully centralized budget helps countries, which are hit by asymmetric shocks to attenuate the negative effect of the shock (decrease in output or increase in unemployment). The tool of full cooperation represented by centralized budget will soften the impact of the shock substantially from its original impact. The real impact of the asymmetric shock in a given country depends on two main factors: the size of the country and level of public debt. Nordhaus (1994) considered the strategic relationship between one fiscal and one monetary authority. When a Nash game is played (with the central bank), the lack of cooperation (among fiscal authorities) is responsible for an inefficient policy mix, resulting in an excessively restrictive monetary and an excessively expansionary fiscal policy. The solution of Stackelberg game (with the fiscal authority playing as leader, taking the central bank s monetary reaction into account) dominates the Nash outcome. This result is explained by the difference in the objectives of the two authorities. The fiscal authority tries to fight unemployment by means of an expansionary policy, but the 7

8 Vol. 12, No.1 Journal of Monetary and Economic Integration central bank reacts with a restrictive monetary policy to keep inflation under control. The outcome is a too expansionary fiscal policy in the Nash equilibrium and secondary effect is a crowding-out effect of private investments in favor of public expenditures. When the fiscal authority takes such behavior into account, and it plays the role of a Stackelberg leader, it will act in a less expansionary way, so as to allow the central bank to follow a less contractionary policy. Bayoumi et al. (1995) presented a further argument for effective fiscal discipline: using US and Canadian data on the borrowing costs of states and provinces concluded that in these currency unions, financial markets effectively price in differences in fiscal positions, providing proper incentives to take action before government debt becomes unsustainable. Masson (1996) supported the explicit inclusion of fiscal criterion on the ground that it would be especially difficult to rule out by statute, since there could be other plausible arguments for loosing monetary policy (or not tightening it in the face of inflationary pressures). Furthermore, he argued that a country in a monetary union with an overhang of debt would be vulnerable to adverse shocks, even if its fiscal deficits were currently under control. An unsustainable level of debt would raise the dilemma for the central bank of choosing between allowing a government to default and bailing it out. In addition, fiscal criteria signal the country s willingness to adhere to the constraints of monetary union. Inability to satisfy the criteria would indicate that the country was unlikely to maintain policies necessary to remain in the monetary union in the face of unfavourable shocks. Eichengreen and von Hagen, (1996) noted that in the case of a cooperative game only among the fiscal policies of the EMU member countries, in which the ECB stays outside, the fear of inflationary pressure due to an excessive expansionary fiscal policy will determine very small welfare gains. Their policy implication is straightforward: the SGP might have a very strong limiting impact on the efforts for a positive or active cooperation in EMU which would lead to more output and employment but will deal with interest rates and exchange rate disturbances, which can alter the equilibrium in investment and savings in EMU. In favour of fiscal restraints prior to the commencement of a monetary union, Woodford (1996) argued that, variations in the governments budget can be an important source of macroeconomic instability and that the instability is not eliminated when the central banker follows a monetary policy rule that is completely unresponsive to the size of public debt. If nominal rigidities are present, then this variation in governments budget and fluctuations in the level of aggregate demand resulting from fiscal shocks can cause variations in the level of real economic activity, real interest rates and rates of inflation, even though rational expectations are assumed. A Rational 8

9 Emmanuel Onwioduokit Expectations Equilibrium, not involving stable prices and output, may result when shocks that change the expected present value of current and future government budgets occur. This occurs as the fiscal policy regime is non-ricardian and therefore changes the households intertemporal budget constraints. In the context of a common monetary policy, this is important for member countries, since a path of unsustainable debt, followed by any government, will impose price level instability in the union overall, even if the other governments adhere to a sustainable debt path. The only way that other governments could ensure price level stability would be to vary their own budget surplus in the opposite way, so that the public debt of the monetary union remains on a steady path. Since this would amount to financing the fiscally irresponsible government s budget deficit, no government would want to extend such a favour. He concluded that a ceiling on debt would then ensure that the path of debt of all governments in the union is on a sustainable path. Following Woodford (1996), Buiter (1997) argued that achieving fiscal sustainability prior to joining a monetary union is highly desirable, perhaps even essential, from the perspective of the national interest of each candidate country. He contended, however, that it is not certain whether it is necessary to impose it externally as a pre-condition of membership, rather than allowing a country to join a monetary union even though its fiscal house is not in order, and letting that country live with the consequences of its fiscal non-sustainability. He further contends that fiscal sustainability is not synonymous with the achievement of the two Maastricht fiscal criteria, neither are they necessary nor sufficient for fiscal sustainability (or for macroeconomic stability) for the EU. Consequently, Buiter (1997) asserted that achieving durable fiscal sustainability is the only truly necessary financial-economic condition for joining a monetary union. It should also be a sufficient condition for membership. When a country joins a monetary union, a decision which should be irrevocable, it gives up its discretionary access to seigniorage and its ability to impose both the anticipated inflation tax and the unanticipated inflation tax. Such a reduction in the national crisis management arsenal should only be contemplated if there is confidence that politically mandated expenditure levels will be financeable with the available taxes and other regular sources of revenue, now and in the future. Beetsma and Bovenberg (1998) focused on the interaction between monetary-fiscal policies in a monetary union. They found that a monetary union with decentralized fiscal policies and centralized monetary policy produces an inflationary bias and excessive spending on public goods. The main policy-making suggestion deduced from their study is that fiscal coordination or fiscal centralization may discipline the macroeconomic policy in the EMU member countries. The practical response to these studies calling for tighter coordination between monetary and fiscal policies at the European level was the creation of the SGP (Stability and Growth Pact) that limited the maneuver area for fiscal 9

10 Vol. 12, No.1 Journal of Monetary and Economic Integration authorities in their expansionary fiscal policy driven by the government deficit. Consequently, the authors expressed concerns of moral hazard. They argued that in a monetary union, if a country running excessive fiscal deficits can be bailed out by the central bank, the costs are borne by other members of the union. This reduces the incentive that members have to be fiscally disciplined. In pursuance of the need for fiscal restraint in a monetary union, Eichengreen and Wyplosz (1998) contended that the main justification for explicit fiscal restraints is that prohibition against bailouts in some form is never iron clad especially for countries with weak monetary and fiscal institutions that also lack strong public support for low inflation. Consequently, formal rules are in danger of being set aside. Large fiscal deficits make it more likely that the point would be reached that the central bank, despite its formal statutes, might yield to pressures for bailout. This could come either in form of monetary financing, or through lowering interest rates, thus lowering government s interest cost and ultimately inflating away the real value of the debt. In support of the argument for fiscal restraint, Breuss and Weber (1999) demonstrated using a large-scale econometric model involving 10 EMU countries and the European Central Bank (ECB) confirmed that in the case of a full cooperation, where the 10 EMU countries simultaneously coordinate their fiscal policies with the monetary policy of the ECB, the welfare gains are very large for the whole EMU area. However the strong fiscal and monetary policy impulses would lead to a violation of the fiscal targets envisaged in the Stability and Growth Pact (SGP). They reported a trade-off between full cooperation and SGP, which limit the room for maneuver of fiscal policy for the EMU member states, also hinder the Pareto efficiency. Full-cooperation is the case of USA, where the evidence of higher fiscal deficits are obvious, but do not have negative impacts on the economic growth and macroeconomic stability. The studies compared European model of SGP and American model of full cooperation. Beetsma and Uhlig (1999) further argued that the main justification for fiscal restraints is that prohibition against bail-outs in some form is never ironclad, particularly in countries with weak monetary and fiscal institutions and lack of strong public support for low inflation. Large fiscal deficits make it more likely that the union central bank might yield to pressures for bail-out despite its formal statutes. Van Aarle, Engwerda and Plasmans (2001) applied a two-country model in a contest of existing monetary union with decentralized fiscal authorities and a centralized monetary authority. The cases they consider include: non-cooperation; full cooperation; coalition between the two fiscal authorities; coalition between one fiscal authority and the monetary authority. Their main finding is that cooperation is often efficient for the fiscal players. Although in many simulations full cooperation does not induce a Pareto 10

11 Emmanuel Onwioduokit improvement for the ECB, while the governments coalitions imply a considerable loss for the ECB compared to the non-cooperative and full cooperative cases. Lambertini and Rovelli (2002) claimed that with a common currency, the weaker EMU member states are exposed to greater competitive pressures, suffering higher levels of unemployment as a result of their lower productivity and competitiveness. Therefore, substantial transfer payments could be necessary. Alternatively, fiscal policy in each member countries can deviate from those in others and be used to counteract regional shocks. Thus, an active fiscal authority is necessary. What might be also necessary is an insurance mechanism against regional shocks. This may imply the need for a stronger political union too. Alvarez, Kehoe, and Neumeyer (2004) re-examined the time consistency of the optimal fiscal and monetary policy in a setting very similar to that of (Lucas and Stokey, 1983; Persson, Persson, and Svensson, 1987; and Calvo and Obstfeld, 1990), except that they assumed that private-sector preferences satisfy conditions that imply that the Friedman rule, a zero nominal interest rate, is optimal. Under the Friedman rule, Alvarez, Kehoe, and Neumeyer (2004) then demonstrated that the Ramsey policy can be made time consistent: this is achieved by the Lucas and Stokey (1983) conditions on the indexed debt structure plus the Persson, Persson, and Svensson (1987) condition of zero government net nominal liabilities. As Alvarez, Kehoe, and Neumeyer (2004) however noted, under the Friedman rule their monetary economy becomes isomorphic to a nonmonetary economy. The Alvarez, Kehoe, and Neumeyer (2004) results were essentially a restatement of the Lucas and Stokey (1983) result. Chari and Kehoe (2004) asserted that the desirability of fiscal constraints depends critically on whether the union s monetary authority can commit to its future policies. If the authority can commit, then fiscal constraints on member states will not increase welfare, but if it cannot commit, then such constraints will increase welfare. He asserts that a time inconsistency problem in monetary policy leads to a free-rider problem in fiscal policy. The authors illustrated in the simplest possible framework, a reduced-form two period benchmark model. In the first period of this model, fiscal authorities of states in a monetary union issue nominal debt to risk-neutral lenders who live outside the union; in the second period, the union s monetary authority decides the common inflation rate. They assume that second-period output is a decreasing function of the inflation rate, so that the monetary authority balances the benefits of devaluing nominal debt against the costs of reducing output. The larger the debt the monetary authority inherits, the higher it wants to set the inflation rate and, without some mechanism to prevent that, the higher it sets the inflation rate. Thus, without monetary policy commitment, when one of the fiscal authorities issues more debt, the others are made worse off. This free-rider problem implies that the level 11

12 Vol. 12, No.1 Journal of Monetary and Economic Integration of debt in a non cooperative equilibrium is different from that in a cooperative equilibrium. If the monetary authority instead commits to its policies, then the union has no free-rider problem. They sum up as follows: the desirability of debt constraints in a monetary union depends critically on whether the monetary authority can commit to its policies. If it can commit, then debt constraints are not desirable; they can only impose costs. But if the monetary authority cannot commit, then the time inconsistency problem in monetary policy produces a free-rider problem in fiscal policy, and debt constraints are desirable. De Bonis and Della Posta (2004) provided an analytical framework for the analysis of the monetary and fiscal interactions in an environment, which may represent the current European situation, characterized by a single monetary authority (ECB) and several fiscal authorities. Considering macroeconomic policy as implemented through two instruments, monetary and fiscal policy, and defined by two objectives, price and output stabilization, they justify the introduction of fiscal rule like those contained in the SGP. On the other hand, several arguments against fiscal constraint in a monetary union have been put forward by some other economists. Bovenberg et al., (1991) in their contribution underscored the danger that countries will be pushed into a region where fiscal policy becomes uncontrollable. Assuming that there is an upper limit to the debt ratio that investors are willing to finance, governments could be pushed close to this threshold as a result of the loss of seigniorage revenues occasioned by a move to monetary union. Given the impracticality of reducing the deficit to zero, governments would be vulnerable to adverse shocks that might lead inevitably to bail-out or default and the union central bank might be induced to provide the former. De Grauwe (1996) argued that the influence of any single government over the monetary authority is weakened, since it is but one of several governments in the monetary union. Similarly, Beetsma and Bovenberg (1998) posit that because of political myopia among other reasons, the fiscal authorities may attempt to force the central bank to moderate the effect of distortionary taxes by increasing inflation. Within a monetary union, their power to do so is diminished. However, if there is fiscal policy coordination by members in the monetary union, this may strengthen the hand of governments over the union central bank. Dornbusch (1997) opined that the inclusion of fiscal convergence criteria as preconditions for monetary union is unnecessary for two reasons. First, the provisions for the European Union for instance go all the way in assuring that the institution is independent, cannot solicit or accept guidance, and cannot finance governments. In addition, the provision of no bailouts of public debts eliminates an immediate spillover effect of poor public finance to the central bank or country s budgets. Thus, there is no 12

13 Emmanuel Onwioduokit basis for insistence on debt provisions; consequently the concern for fiscal probity is not justifiable by the need for sound monetary policy. Cooper and Kempf (2000) analyzed monetary and fiscal policy interactions in a twocountry model, with and without a monetary union, where the monetary and fiscal authorities agree on the macroeconomic goals. When the monetary authority has leadership, a monetary union is Pareto-efficient. However, if the fiscal authorities have leadership, a monetary union is Pareto-efficient only if the aggregate shocks are highly correlated. Tornell and Velasco (2000) opined that pegged exchange rates may provide a less visible discipline for policy makers than flexible exchange rates, contrary to conventional wisdom. Tornell and Velasco claimed that in situations where there is no fiscal discipline to begin with and authorities have no recourse to debt financing, fixed rates per se do not generate discipline; conversely, flexible rates may tilt the balance in favour of greater discipline because of the immediacy of punishment associated with imprudent fiscal policies. In a monetary union, with pooled foreign exchange reserves, the expanding country can avoid market discipline even longer. Overall, given the results in the literature, it would thus appear that the time-consistency problem of optimal policy is unavoidable in genuinely monetary economies where monetary instruments and nominal assets and liabilities play an essential role in shaping equilibrium allocations and raising some revenue for the government, in particular, in economies where the Friedman rule is not optimal. A plethora of studies have emerged in recent times regarding the impact of fiscal deficit on economic growth. As the debate on fiscal deficits and growth progressed, more elegant models and empirical strategies have been explored in the analysis of the subject. Prominent among these include, Christopher Adams and David Bevan (2002), Robert Korsu (2009) and Yaya Keho (2010). Their findings are divergent. However, the only study that sought to explicitly determine the optimal threshold of fiscal deficit that is consistent with growth is the work by Adams and Bevan (2002) that assessed the relation between fiscal deficits and growth in a panel of forty five (45) developing countries. An overlapping generation s model in the tradition of Diamond (1965) that incorporated high-powered money in addition to debt and taxes was specified. The estimation strategy involved a standard fixed effect panel data estimation and bi-variate linear regression of growth on the fiscal deficits using pooled data. An important contribution of the empirical analysis is the existence of a statistically significant non-linearity in the impact of budget deficit on growth. However, this nonlinearity the authors argued reflected the underlying composition of deficit financing. In effect, Adams and Bevan posited that for a given level of government spending, a shift from a balanced budget to a (small) deficit may temporarily reduce distortions especially 13

14 Vol. 12, No.1 Journal of Monetary and Economic Integration if the distortions impact growth rather than output. Based on a consistent treatment of the government budget, the authors found evidence of a threshold effect at a level of the deficit around 1.5 percent of GDP. While there appeared to be a growth payoff to reducing deficits to level, this effect disappeared or reversed itself for further fiscal contraction. The magnitude of this payoff, but not its general character, necessarily depended on how changes in the deficit were financed (through changes in borrowing or seigniorage) and on how the change in the deficit was accommodated elsewhere in the budget. The authors also found evidence of the interaction effects between deficits and debt stock, with high debt stocks exacerbating the adverse consequences of high deficits. Moreover, Gale and Orszag (2002) summarized the conclusions of almost 60 studies: of these fifty percent found a predominantly insignificant effect of fiscal deficits on interest rates and the other fifty percent a mixed or predominantly insignificant effects. They argued that even when interest rates do not increase as a result of fiscal expansion (e.g., because of foreign capital savings replacing domestic savings) economic performance may still be negatively affected by persistent imbalances as capital stock accumulation declines, either because of a fall in domestic or foreign net investment. The authors indicated that a projected rise in the fiscal deficits-gdp ratio of 1 percentage result in an increase in the long term interest rates by 0.4 to 0.6 percentage points. In the same manner, Dai and Singleton (2003) findings indicated that a 1 percentage point increase in the deficits increases 10 year (interest) rate by 41 basis points. Furthermore, Laubach (2003) reported that fiscal deficit has a significant effect on interest rate. A one percentage increase in the projected deficit-to-gdp ratio is estimated to raise long term interest rates by approximately 25 basis points. Similarly, interest rate rises by about 4 basis points in response to a percentage point in the projected debt-gdp ratio. At is clear from the literature is the opposition to convergence criteria is not so much based on the irrelevance of the criteria but the inability to ascertain the level that will be consistent with the various countries growth trajectory. ANALYTICAL AND FRAMEWORK AND EMPIRICAL METHODOLOGY The analytical framework adopted for this study follows essentially the Keynesian framework. Recalled that in a simple Keynesian framework, desired aggregate demand relationship is specified in the goods market as: Y C I G ( X M) (1) 14

15 Emmanuel Onwioduokit With the following behavioural equations: d C a by, b 0 d Y Y T I i, 0 G G X s e, 0 M m Y d, >0 Where Y is output; C, consumption; I, investment; G, government spending which is assumed to be exogenous; X, exports; M, imports; Y d, disposable income; T, tax revenue; i, interest rate; e, exchange rate. In equilibrium (after substituting behavioural equations into the desired aggregate demand equation (1)), output will be given by A 1 Y i e G ( b ) T (2) Where 1 b, A a s m From equation (2), increasing taxes will reduce output, while increasing government spending will increase output. But fiscal deficit (FD) is given by FD G T G ( b ) T (3) Fiscal deficit is the excess of government expenditure over its revenue. Assuming that the government derives its total revenue from tax sources (which is quite realistic), G-T gives the deficit position of the government. Since individuals do not spend all their income, the total revenue that could be generated from consumption expenditure is ( b ) T. Thus, subtracting this from government expenditure will give approximate position of the fiscal balance. Putting (3) into (2) gives A 1 Y i e FD (4) Given that the countries in the WAMZ are essentially small-open economies (without ability to influence international price developments) and for holistic treatment of the economy, the model is extended to incorporate the money sector as well as the external 15

16 Vol. 12, No.1 Journal of Monetary and Economic Integration sector. The money market in an open economy can be represented by the following equations: Money Demand Function: Money Supply Function: Equilibrium Condition: D M P S M P M D ky i, k 0, 0 B m1 m2i, m1, m2 0 P S M (7) where P is the general price level, B international reserves held by the central m bank and 1, m2 are coefficients. From the above money market model, the LM schedule 2 can be specified as B i Y, 0, 0 LM Schedule: P (8) Given the importance of the external sector in the countries of study, the influence of the sector is incorporated through the balance of payments schedule. The balance of payments schedule is given as B A Y e i,,, 0 BP Schedule: (5) (6) (9) A where 2 is the aggregate of exogenous components in the net export function and 0, 1, 2 are coefficients. Putting equation (8) into (3) gives B Y A1 1 2Y e FD P where 1 and 2 (10) 2 The LM curve is used to determined equilibrium in the money market. The L stands for liquidity and M for Money. 16

17 Emmanuel Onwioduokit Putting equation (9) into (10) produces 1 Y A1 A2 0Y 1e 2i 2Y e FD P (11) Isolating like terms and re-arranging equation (11) gives 1 Y C 1e 2i 3e 4FD P (12) where A1 1A , C, 1, 2, 3, 4 Recasting the second term on the right-hand side of equation (12) in logarithmic generic term gives Y C e i FD 2 4 where the rate of inflation and 1 3 In equation (12B), equilibrium output is positively related to fiscal deficit.. (12B) In a time series context, output is influenced by its own past level (output dynamics) which is consistent with accelerator principle. Equation (12B) can be restated as Y c Y i e FD t t 1 2 t t 4 t (13) Recasting (13) gives y c i e FD t 1 t 2 t 3 t 4 (14) y Y Y where t t t 1 which captures the change in GDP (growth rate of GDP) and, Equation (14) is essentially an output (GDP) growth model which gives the long-run relationship between output growth (change in output) and fiscal deficit. This relationship is positive; implying the widening of fiscal deficit will improve growth. However, some empirical studies document the negative relationship between growth and fiscal deficit, while some others establish a positive relationship as given by the simple Keynesian framework. This ambiguity of the relationship between growth and 17

18 Vol. 12, No.1 Journal of Monetary and Economic Integration fiscal deficit suggests a threshold effect of fiscal deficit on growth. This will inform the empirical modelling of growth-deficit relationship in this study. From the supply-side of the economy, output is a function of capital stock and labour. A simple Cob-Douglas production function generates a growth model of the form y ln K ln L Where K refers to capital stock, L refers to labour force growth, is a change notation,, are coefficients. and Specification of the Empirical Model In specifying the empirical model, the study relies on the above theoretical framework. From both the demand and supply sides of the economy, variables such as interest rate, exchange rate, inflation, fiscal deficit, investment (change in capital stock) and labour are identified as the key variables explaining growth. However, it is appropriate to include in the empirical model those reform variables that also influence economic growth. In the WAMZ countries, financial sector reforms have been undertaken, while trade liberalization policies have also been implemented. Hence, it is appropriate to include financial reforms variable and trade openness variable in the empirical model. The key variables in the empirical model are defined as follows: Dependent variable Y it = GDPG t = Growth rate of real GDP Independent variables = Gross fixed capital formation as a ratio of GDP as a proxy for growth in capital stock. Lab = Secondary school enrolment as a proxy for labour force. = FD/GDP = Fiscal Deficit/GDP, excluding grants = Inflation rate M 2GDP t = M 2/GDP ratio measuring financial depth = Exchange Rate expressed as a given amount of local currency per US dollar (Depreciation/ appreciation) = Degree of openness of the economy, measured as (15) Besides investment, labour force and fiscal deficit; other control variables included in the model are, namely, interest rate (, exchange rate depreciation/ appreciation (, inflation ( financial deepening M2/GDP and openness index (OPN). Interest rate 18

19 Emmanuel Onwioduokit has an important role in economic growth. Higher interest rates reduce the growth of consumer spending and economic growth. This is because more incentive to save in a bank rather than spend, more expensive to borrow, therefore less spending on credit and less investment; increase cost of mortgage repayments, therefore, reduce disposable income and therefore consumer spending. Consequently, an inverse relationship is expected between interest rate and economic growth. Exchange rate development impacts on the economic growth process. On balance we expect a positive relationship between depreciation and economic growth. Inflation is another significant variable influencing output growth rate. This variable is especially significant for in the WAMZ, where food price and other exogenous factors including high imports of food and intermediate products play very important role. In general, very high levels of inflation may undermine economic growth. However if the inflation rate is low, stable and sustainable, it may be interpreted as an indicator of macroeconomic stability that would enhance growth. And if the economy is at equilibrium higher inflation should impact adversely on growth. Hence, we expect to get inverse relationship with output growth. Financial deepening measured by the ratio of M 2 to GDP essentially seek to capture the role of the financial sector development in economic growth. The conventional theory predicts a positive correlation between the level of financial deepening and economic growth. In modern economic theory the role of the financial sector is seen to be catalytic to the growth of the economy. Also, the index of openness proxy by the ratio of the sum of imports plus export over GDP is expected to positively influence growth, all things being equal, the more open the economy the more access to foreign capital that is expected to increase investment and economic growth. Thus, the level of openness of the economy is expected to positively impact on economic growth. Budget deficit is another significant variable influencing output growth rate. This variable is especially significant for most developing countries including the WAMZ countries, where fiscal discipline plays very important role. In general very high levels of fiscal deficit may undermine economic growth. However if the budget deficit is low, stable and sustainable, it may be interpreted as an increased demand for goods and services. And if the economy is below its equilibrium on Keynesian cross, higher fiscal deficit, that is increased government expenditures, should stimulate growth. Consequently we expect to get positive relationship with output growth. Based on the general framework provided and the foregoing variables identified, the linear growth equation is explicitly specified as follows: The panel estimation model is specified as follows: 19

20 Vol. 12, No.1 Journal of Monetary and Economic Integration 16 Where i=1,2, 5 for countries. t = 1, 2, for time period. Specification of Threshold Autoregressive (TAR) Model The TAR model specifies that individual observations can fall into discrete classes based on the value of an observed threshold variable (Lee and Wong, 2005). Following the framework of Li (2005), we specify the threshold model for the WAMZ countries as follows: The panel estimation model is specified as follows: Where = Dummy variable with values 1 if > K * or 0 otherwise. K * = Annual fiscal deficit - GDP ratio. = The threshold level of fiscal deficit/gdp which is to be calculated. = The effect of fiscal deficit below the threshold level. = The effect of fiscal deficit above the threshold level. Other variables are as previously defined. Where i and t are as defined in equation (16). All the variables are as defined above. From the above equation, a priori expectations of a threshold effect of deficit on growth are that If threshold effect holds then the turning point can be calculated using the...17 relation 3 : Taking the antilog of this will give optimal level of fiscal deficit that will maximize real GDP growth. 3 ; 20