The Macroeconomics of Public Expenditures

1
The Macroeconomics of Public Expenditures

• Vandana Chandra, PRMEP
• PEAM Core Course
• January 12, 2004

2
Key Concepts

• Fiscal policy and growth the connections,
  complications and trade-offs
• Macroeconomic balances
• Debt sustainability

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Fiscal policy and growth

• Optimal fiscal policy is one that supports
  national objectives growth and poverty
  reduction efficiently in a sustainable manner
• Components of fiscal policy
• Revenues tax, fees, foreign transfers (and
  grants)
• Public expenditures (PE) recurrent (public
  consumption) and capital (public investment)
• Revenues public consumption public investment
• government budget deficit before grants
• Optimal level of fiscal components depend upon
  (1) country-specific circumstances (high or low
  income), (2) debt situation, (3)fiscal
  institutions, (4) governance, (5) capacity in
  government and private sector etc..

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Fiscal policy growth contd.2

• Links between fiscal adjustment and growth depend
  upon the type of economy
• Fiscal policy strengthens macroeconomic stability
  which enables investment and growth
• Fiscal incentives through taxes, subsidies and PE
  provide incentives for private sector growth
  especially through lower interest rates,
  provision of public goods, and service delivery
• Fiscal adjustment increases total factor
  productivity of labor and capital economy-wide
• In most developing countries, the level of PE are
  constrained by (a) available revenues (b)
  grants (c) level of fiscal deficit and its
  longer term sustainability. (b) is given and (a)
  is limited, especially if GNP growth is low.

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Fiscal policy growth contd.3

• Debt sustainability and size of total debt matter
  case by case basis
• If high and unsustainable debt, cannot use GBD to
  finance higher PE and growth without jeopardizing
  macro stability
• If low debt, can use higher PE, especially public
  investment provided concessional financing is
  available, to increase growth. Case by case
  approach is needed.
• Fiscal policy has to be tailored to country
  specific conditions to foster growth, I.e., a
  uniform approach to FP in which all countries are
  counseled to reduce their deficits under all
  circumstances is not appropriate. Baldacci,
  Clements and Gupta,Finance and Development,
  December 2003.

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Fiscal spending, trade-offs and growth

• The achievement of sustainable growth and poverty
  reduction is a complex process and determined by
  the pattern of growth desired and achieved
• Ceteris paribus, PE for sustainable growth
  presents various trade-offs
• Aggregate levels of public consumption and public
  investment
• Inter-sectoral public investment e.g.
  investment in human vs physical capital rural vs
  urban water vs roads
• Between categories of public consumption wages
  vs maintenance expenditures vs subsidies and
  transfers

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Macroeconomic effects of fiscal deficits -
based on Stanley Fischer and William Easterly,
1990
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Economics of the government budget constraint
(GBC)

• Fiscal policy in an open and globally integrated
  economy
• The national income identity effects of the
  fiscal deficit on domestic savings, investment,
  current account and growth
• Financing of the fiscal deficit and the
  implications for macro stability
• Debt dynamics issues of fiscal sustainability
  and solvency and long run constraints on fiscal
  policy

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Fiscal policy in an open economy

• GNP Y C I (T G) X M
• - I (Y C) ( M X) (T G )
• Private investment deficit (PID) Current
  Account deficit Government budget deficit (GBD)
• Keynesian idea to use fiscal spending to raise
  GNP during a recession counter-cyclical
• If perfect international capital mobility, then
  only tool is fiscal policy
• If imperfect, then both fiscal and monetary
  policy (limited) are available tools

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Government Budget Constraints

• Govt. budget deficit (GBD) (Private saving
  private investment) (Current account deficit)
• Link between GBD and CA deficit depends on
  monetary policy and X M elasticity.

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Financing of the fiscal deficit 4 ways

• Print money can be inflationary after a point.
  Seignorage1 2.5 of GNP (avg.)
• Foreign reserve use can lead to an exchange
  rate crisis
• Foreign borrowing - can lead to a debt crisis if
  resources are not used productively
• Domestic borrowing can lead to an increase in
  interest rates and dampen private investment
  also a domestic debt crisis
• All are interlinked and affect the macro
  environment.

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Debt dynamics for how long can a government run
deficits?

• ? debt /GNP (prim. deficit/GNP)
  seignorage/GNP real interest rate GNP growth
  ratedebt
• Sustainability as long as GNP growth gt real
  interest rate (I)
• If real interest rategtGNP growth, and the prim.
  deficit exceeds the amt. that can be financed by
  seignorage, debt/GNP will continue to rise until
  no one will finance the debt. Deficit will have
  to be cut.

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Is the deficit sustainable? Needs to be checked
through projections over time

• Sustainability depends on size and rate of
  economic growth. India, Pakistan, Malaysia ran
  high deficits in 1980-86 (now 11) with single
  digit inflation vs Argentina, Brazil same
  deficits, high inflation because of no growth.
• Are deficits from high public investment
  sustainable? No, because there is a danger that
  unproductive expenditures will be included.
• Tax and spending efficiency promotes higher
  deficits through higher growth.

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BUT sustainability is not equivalent to
optimality

• Large and continuing deficits crowd out private
  investment and growth
• Large and continuing deficits can become
  inflationary if the rate of seignorage is raised
  to finance them

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Debt dynamics.contd.

• Maximum non-inflationary seignorage possible?
  Usually 1 of GNP but in a rapidly growing and
  financially deep economy, may be 2.5 of GNP.
• What if real interest rate lt growth rate? Debt is
  eroded over time through growth, so primary
  deficits can be financed in excess of seignorage.
  A type of Ponzi scheme. East Asia.
• Real interest rates cannot remain below growth
  rates for long. Bond markets push up interest
  rates. Growth declines.
• What if govt. sets interest rate controls? Savers
  will take their savings out capital flight as
  in LAC.