The Macroeconomics of Public Expenditures Vandana Chandra, PRMEP PEAM Core Course January 12, 2004

Key Concepts Fiscal policy and growth – the connections, complications and trade-offs Macroeconomic balances Debt sustainability

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..

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.

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.

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

Macroeconomic effects of fiscal deficits - based on Stanley Fischer and William Easterly, 1990

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

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

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.

Financing of the fiscal deficit – 4 ways 1.Print money – can be inflationary after a point. Seignorage:1 – 2.5% of GNP (avg.) 2.Foreign reserve use – can lead to an exchange rate crisis 3.Foreign borrowing - can lead to a debt crisis if resources are not used productively 4.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.

Debt dynamics – for how long can a government run deficits? Δ debt /GNP = (prim. deficit/GNP) – seignorage/GNP + [real interest rate – GNP growth rate]*debt Sustainability – as long as GNP growth > real interest rate (I) If real interest rate>GNP 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.

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 (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.

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

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 < 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.