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 AD AD 2 E2E2 Output E1E1 E*E* AD 1 KAS Y*Y* Y2Y2

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

IS r Y LM IS’

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 often pro-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, 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)