Session 11. Fiscal Policy Government size Budget balances Fiscal Policy over the business cycle Debt and sustainability
Understanding Fiscal Policy: Government size Government size varies across countries. In general, advanced (richer) countries have larger governments. Government size is also a function of whether key services (education, healthcare) are provided by the government. Remember: government spending = government consumption + transfers Government Spending (% of GDP, 216) Nigeria Singapore Mexico China Chile United States South Africa Japan Sweden Germany France 1 2 3 4 5 6
Understanding Fiscal Policy: Government size From early 197s until mid-199s government size measured as the ratio of government spending to output has been increasing steadily. In recent years, however, in many countries there was reversal of this trend until the current crisis. Government Spending (% of GDP) 8 6 4 2 1978 1985 1994 21 216 US SWEDEN FRANCE GERMANY JAPAN
Understanding Fiscal Policy: Government Budget (the US, 214) An insurance company with an army.
Government Balance Two definitions: Overall (Financial) Balance Taxes Government Consumption Transfers Interest payments Primary Balance Taxes Government Consumption Transfers
Measuring the Budget Balance Imbalances between expenditures and revenues appear as a deficit (or a surplus) in Government budgets. The primary balance reflects the difference between all expenditures and revenues without including interest payments on the debt. 4 Government Balance as % of GDP (216).1 1.2.1 1.3-4 -3.3-1.5-3.4-2.5-5.2-5.2-3.3-1.6-4.1-2.1-8 France Germany Greece Italy Japan United Kingdom Financial balance Primary balance United States
Interest Payments and Government Debt Interest Payments (% GDP) 4 2 Interest Payments and Debt (216) Italy Greece U.S. France U.K. Germany Japan 2 4 6 8 1 12 14 16 18 2 22 24 26 28 Government Debt (% GDP)
Debt in Advanced Countries The growth of government expenditures has not been matched by a parallel increase in government revenues (taxes). As a result, many governments have become heavily indebted in the last three decades. Government Debt as % of GDP 25 36 6 63 18 54 97 155 35 65 65 68 15 15 16 38 133 12117 6 55 59 54 89 US JAPAN GERMANY KOREA ITALY UK 1981 1998 23 216
Fiscal Policy over the Business Cycle Budget balances move with the business cycle. Higher surplus or smaller deficits when growth is high. Larger deficits when growth is low. Euro USA 4 6 4 2 2 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-2 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-2 -4-4 -6-8 -6-1 -12-8 -14 Government Balance GDP Growth Government Balance GDP Growth
Fiscal Policy over the Business Cycle Brazil China 1 2 5 15 1-5 -1 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216 5-15 -5 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216 Government Balance GDP Growth Government Balance GDP Growth 1 5 South Africa 1 5 Japan -5-1 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-5 -1-15 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216 Government Balance GDP Growth Government Balance GDP Growth
Cyclical Enough? The fact that budget balances change over the business cycle is partly the result of automatic stabilizers: Taxes tend to go down Some spending categories tend to go up (e.g. Unemployment benefits) To measure the actual discretionary policies implemented by governments we measure the structural government balance. This is equal to the actual balance excluding changes in taxes and spending that are automatic
Cyclical Enough? But what does fiscal policy look like if we remove the effect of automatic stabilizers during the recent Euro crisis? Austerity after 21. France Portugal 4 4 3 2 2 1 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-1 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-2 -2-3 -4-4 -6-5 -6-8 -7-1 GDP Growth Structural Balance GDP Growth Structural Balance
Cyclical Enough? Greece Germany 1 6 5 4 2-5 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216-2 -1-4 -15-6 -2-8 GDP Growth Structural Balance GDP Growth Structural Balance
Debt and Deficits: Are they sustainable? The relevant question is how to ensure that debt is stable. Remember that governments do not need to pay back debt. But they need to keep it on a sustainable path. The easiest way to assess sustainability is to ask the following question: How large should the primary surplus be in order to ensure that the Debt-to-GDP ratio stays constant? The answer can be derived from the following relationship: Required Primary-surplus-to-GDP ratio = = (interest rate growth of GDP)*Debt/GDP
The Dynamics of Debt and Deficits Required Primary surplus = (interest rate growth of GDP)*Debt/GDP Example: r = 4%, g = 2%, Debt/GDP = 12% Required primary surplus: 2.4% What if you deviate? Example: r = 4%, g = 2%, Debt/GDP = 12%, Primary surplus: % Debt/GDP in 1 years= 142%; in 2 years= 173% What if growth is faster? Example: r = 4%, g = 3%, Debt/GDP = 12%, Primary surplus:2.4% Debt/GDP in 1 years= 19%; in 2 years= 96% What if markets do not trust the government? Example: r = 6%, g = 2%, Debt/GDP = 12%, Primary surplus:2.4% Debt/GDP in 1 years= 144%; in 2 years= 184%
The Dynamics of Debt and Deficits Overall Primary Interest Interest Required Balance Balance Debt Payments Rate Primary Balance Brazil -1.4-2.8 78 7.6 9.7-1. China -3. -2.2 46.8 1.7-3. Japan -5.2-5.2 25.1. -1.9 South Africa -3.9 -.4 52 3.5 6.8 -.8 United States -4.1-2.1 18 1.9 1.8-1.5 Euro area -2. -.1 92 1.9 2.1.7 Inflation Real Growth Brazil 9 2 China 2.1 6 Japan -.2 1 South Africa 6.4 2 United States 1.2 2 Euro area -.2 1.5
Government debt: Current and Future Liabilities (US) If you want to be assess sustainability you need to look at future revenues and expenses as well. A combination of demographic changes and increasing health care costs implies large future deficits and exploding debt levels for many advanced economies.
2 15 1 5 What Is Really the Issue? Inability to prioritize on spending and/or raise the necessary taxes to finance those expenses (Below is an example of rebalancing for household budgets. Harder to achieve for governments) Components of Personal Consumption Expenditures, US, (% of total) 196 1963 1966 1969 1972 1975 1978 1981 1984 1987 199 1993 1996 1999 22 25 28 211 Food and beverages Health care
Healthcare: One Country is Not Like the Others
The Failure of Politics to Address Long-Term Sustainability President Clinton on Monday proposed paying off the national debt by 215 after issuing a new budget outlook that adds $1 trillion more to the overall budget surplus over the next 15 years. CNN, June 26, 1999. ----------- This is not at all the situation in our European economies. Our fundamentals are solid, we have a positive current account position, we have a level of savings in our economies that is the level required to finance our investments. We have a sound fiscal position. EU Economic and Monetary Affairs Commissioner Joaquin Almunia. January 22, 28.
Default: Government Business When a company defaults we learn that their business model is not viable. Our wealth and possibly future income will be lower. This is a real shock. When a government defaults, it simply decides to change who will pay for the spending that it has already done. It is a redistribution of resources. Resources are not destroyed (although the crisis that follows can destroy some of them).
Paying for Government Debt Default or Taxes? Who held their Government Debt in 211? (%) Japan Greece Domestic Foreign 2 4 6 8 1
Session 11. Summary Government expenditures as a % of GDP are high and in some cases increasing for advanced economies. This has led to a problem of increasing debt and a question on the sustainability of budgetary plans. Sustainability depends on: the current level of debt, the interest rate faced by governments and the future growth rate of GDP.