FP Flashcards
What is Fiscal Policy?
Fiscal policy refers to the government’s choice regarding the use of taxation and government spending to regulate the aggregate level of economic activity. The use of fiscal policy entails changes in the level or composition of government spending or taxation, and hence in the government’s financial position.
What are the key variables policy makers focus on regarding Fiscal Policy?
Key variables that policy makers focus on include government deficits and debt, as well as tax and expenditure levels.
These key variables are linked.
What is the economic function of government?
Microeconomic functions of a government: Provision of public goods and services. Income redistribution. Macroeconomic function: Consumption and tax smoothing Output and employment stabilization.
Key variables of fiscal policy
Total budget balances and primary budget balances.
Government debt and deficits.
Structural and cyclical budget balances.
Describe primary budget balance and total budget balance
Primary government budget deficits measures the difference between tax income and government expenditures (exlcuding debt service).
Total government budget deficits also take the debt service costs into account.
What must be done in order to have a balanced budget?
In order to have a balanced budget, the government has to make a primary surplus in order to pay the debt service costs.
The higher the debt level, the higher the surplus that is necessary to keep the nominal debt constant.
The higher the interest rate that a government has to pay on its debt, the higher the surplus that is necessary to keep the nominal debt constant.
What is the role of growth for the development of fiscal conditions?
When the real interest rate exceeds the growth rate, a government has to make primary surpluses to avoid a further increase in the debt level: The economy is on an explosive debt path.
When the growth rate of the economy exceeds the real interest rate (g>r), a government can even make a primary deficit, without that the debt level increases further.
This explains, why fast growing countries can have large debt levels without facing default. They grow out of debt over time.
What is the link between debt and deficit?
An increase in debt over time is equal to the accumulated past deficits.
On average this relationship should hold.
What are stock-flow adjustments?
Stock-flow adjustments can cause a wedge between the change in debt and the deficit in a specific year.
According to the EU Commission, stock-flow adjustments result primarily from financial operations e.g. debt issuance policy to manage public debt, privatization receipts, impact of exchange rates change on foreign dominated debt.
What is the difference between cyclical and structural deficits?
Cyclical deficit: Measures the portion of a country’s budget deficit that reflects the change in the economic cycle.
Structural deficit: Measures the deficit that will be posted, if the economy grows as its potential. It is the deficit level that occurs independent of the position of the business cycle. Structural issues can only be addressed by explicit and direct government policies.
Why is government debt so persistent?
“Human beings are myopic or short-sighted”.
Human beings care much more about present than about the future:
Politicians seek to get re-elected and therefore implement expansionary policies (assumes fiscal illusion); this holds especially in the run-up to elections (political business cycle) (empirical validity, however, mixed).
Welfare model: As societies are getting wealthier, needs change and become more sophisticated, while at the same time expectations on acquired rights grow.
The role of “common pool problem” and social inequality in the persistence of government debt
Human beings do not take into account the long-term/overall consequences/ costs:
Common pool problem: Politicians do not internalize fully the costs of spending decisions. Reason: Benefits of public spending are usually concentrated, whereas costs are spread across the whole tax-paying community.
The larger the social fragmentation and inequality in the society the less politician internalize the full costs: Government have incentive to insist on higher spending for their preferred sectors/constituencies.
Why has the speed of debt accumulation increased over time?
Potential explanations:
Demography: During the last decades, life expectancy has increased and birth rates have decreased Increasing welfare-related spending coupled with shrinking revenues lead to growing deficits.
Macroeconomic shifts: Most industrial countries have hit their technological frontier. Growth slowed down, productivity began to fall, inflation became more volatile and the structural unemployment increased.
Why do some countries perform better than other in terms of fiscal discipline?
Political and institutional characteristics affect the deficit bias:
Political parties differ in preferences.
Degree of regional decentralization matters: The less regional decentralization, the lower the deficit.
Degree of centralization in budgetary process matters: The higher centralization in decision-making process, the lower the deficit (no fight for resources).
Budgetary institutions matter: Deficits are lower in countries with fiscal rules, high degree of fiscal transparency, high institutional quality.
What is fiscal soundness?
Fiscal soundness is a prerequisite for price and macroeconomic stability and strengthen the condition for economic growth.
Fiscal soundness covers the health of public finances:
In the short-run - Fiscal stability: government‘s ability to service all upcoming obligations.
In the long-run - Fiscal sustainability: The present discounted value of the ratio of expected future primary surpluses to GDP is greater than, or equal, to the current level of public debt.
Long-term sustainability and short-term stability are linked: As long as investors are assured about the long-term sustainability of g‘ment finances, they are willing to provide short-term liquidity.
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How do we measure fiscal soundness in the long-run?
Required future surpluses have to be larger, when an economy is expected to grow slowly in future.
The assessment of fiscal sustainability is subject to considerable uncertainty. It requires the projection of fiscal policies (tax revenues, expenditure) and macroeconomic variables (economic growth, interest rates) into the infinite future. By nature, such projections carry large margins of error.
Debt sustainability assessment requires an assessment of the linkages between fiscal policies and macroeconomic developments and financial sector risks (e.g. with higher debt, the interest rate will rise and economic growth will decline).
For a sound analysis of fiscal sustainability, one should look on a broader set of fiscal indicators:
Gross vs. net government debt.
Contingent vs. non-contingent debt
Implicit vs. explicit debt.
Does the composition of sovereign debt influence the probability of fiscal crisis?
Short-term debt is more prone to currency crisis than long-term debt.
Reason: Higher vulnerability to “roll-over crises” and sudden changes in market sentiments as i.e. higher interest costs.
Foreign denominated debt is more prone to currency crises than debt issued in domestic currency.
Reason: Substantial currency depreciations can abruptly render a country insolvent.
Higher share of foreign investors is more crisis prone than higher share of domestic investors.
Reason: G’ments can simply tax domestically held debt. Moreover, default incentives are lower, when mostly domestic investors hold g’ment debt�.
Why some countries choose risky or “inefficient” debt structures?
Very often, the reason is that governments are forced so by markets: These debt structures are rationalized as necessary evils:
To reduce moral hazard on the part of policy makers.
To minimize debt dilution. Debt dilution describes the tendency of over-borrowing, because the borrower does not factor in the impact of a further increase in g’ment debt on outstanding debt. Indeed, it makes old more risky, and hence increases borrowing costs.
Thus, crisis-prone debt structures can (but must not) be a symptom rather than the root cause of countries’ inability to commit to good policies, which may in turn result from weak domestic institutions (Borenstein, 2005, p.5).
Sound macroeconomic policies and credibility are most important prerequisite for more desirable debt structures and therefore fiscal and financial stability.
Suggestions to promote safer debt structures
Explicit Seniority: Creditors that lend earlier have priority over those that lend later. This prevents creditors from consequences of future additional borrowing by the debtor country (debt dilution) and encourages borrowing.
Indexation of debt to real variables, such as exports or GDP: A proposed way to mitigate changes in debt sustainability that might result from real shocks. When e.g. GDP declines, value of government debt declines as well.
Two ways in which fiscal policy stabilizes the business cycle
Automatic stabilizers: They arise from parts of the fiscal system that naturally vary with changes in economic activity: e.g. output, tax revenues, unemployment benefits.
Discretionary fiscal policy: It involves active changes in policies that affect e.g. government expenditures, taxed and transfers.
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Describe automatic stabilizers
They arise from parts of the fiscal system that naturally vary with changes in economic activity. They adjust automatically in response to changes in aggregate variables.
Institutions that constitute automatic stabilizers: progressive income taxes, social insurance contributions, unemployment benefits, etc.
The size of automatic stabilizers depends on institutional rules, tax systems, the size of the government, political orientation.
However, they cannot be changed quickly in case of economic crises or unforeseen events.
Discretionary fiscal policy
Involves active changes in fiscal policies in response to economic events or changes in economic conditions that affect e.g. government expenditures, taxes and transfers.
In recessions, the government increases government spending to boost overall demand or decreases taxes to stimulate private consumption and investment.
What are the major concerns and obstacles in effectively using discretionary fiscal policy as a stabilizing tool?
Automatic stabilizers have several advantages in their implementation compared to discretionary fiscal policy measures:
They react promptly without an implementation lag.
Since they react automatically to economic conditions, policymakers have not to determine themselves, whether the economy is in a recession or not, which is very difficult to determine in real time.
Automatic stabilizers are indeed counter-cyclical and smooth the business cycle, while discretionary fiscal policy often turns out pro-cyclical.
They are budget neutral across a business cycle, while discretionary policy measures are not always neutralized and bear the risk to increase long-term debt.
What determines the size of a fiscal multiplier?
The size of the fiscal multiplier is obviously country-, time, and circumstance specific.
Some findings can be summarized:
Fiscal multipliers are higher in recessions than in periods, where the economy operates at full capacity.
Fiscal multipliers are higher, when Ricardian equivalence does not hold: people don’t expect that today’s increase in government spending leads to higher taxes tomorrow.
Fiscal multipliers are higher, when a large share of people lives according `hand-to-mouth´ principle: they spend additional money immediately and don’t save (either due to irrationality, or due to financial constraints).
Fiscal multipliers are higher in countries with fixed exchanges rates (thus also countries that join a monetary union).
Fiscal multipliers are higher, when monetary policy accommodates, thus, if monetary policy does not immediately raises interest rates, when inflation increases due to fiscal stimulus.
Fiscal multipliers are higher in closed economies (no leaking of fiscal stimuli to neighbouring countries).
Fiscal multipliers are higher in countries with sustainable fiscal policies and low debt levels. (They can be negative in high debt countries!).
Relation between fiscal multiplier and fiscal stimulus
The size of fiscal multipliers determines the effectiveness of fiscal stimulus in times of fiscal expansion, but also the extend, to which fiscal contraction compresses economic growth.
Why does high public debt pose a threat to price stability – A theoretical consideration? �
Inflation can be a “fiscal phenomenon”.
Fiscal policy is often subject to a time-inconsistency problem:
Policymakers are myopic: They are inclined to spend more than they can afford today and pass the burden of this spending on to future tax payers Deficit bias.
Fiscal policy is a powerful tool to influence public and private consumption and investment and therefore the whole economy.
Excessive government spending can results in inflationary pressures.
“Monetary dominance and Fiscal dominance”
Ideally, one wants to be in a situation of “monetary dominance”:
The central bank sets the price level according the definition of price stability and the government has to adopt government spending and revenues accordingly.
Inflationary problems arise, if one ends up in a situation of “fiscal dominance”:
The government determines the price level with its budget policy. Fiscal dominance is more likely the worse the budgetary situation of a country.
In case of “fiscal dominance” monetary policy might loose control over the price level and inflation rate. Excessive government spending can results in inflationary pressures.
“Unpleasant monetary arithmetic”
Coordination problem between fiscal and monetary authorities: Persistent fiscal imbalances can put pressure on the central bank to finance government budget deficits by printing money (seignorage) (Sargent and Wallace, 1981).
Inflation is within this argumentation still a ‘monetary phenomenon’, however, pressured by fiscal policy.
“Fiscal theory of the price level”
Inflation may occur even without monetary roots.
How the mechanism works:
Households notice that future surpluses are too low to offset gov’debt. They refuse to buy government bonds and prefer to invest in other assets or to consume prices rise.
Tax cuts or fiscal transfers to the private sector that are financed by fiscal deficits increase everyone‘s wealth and as a result aggregate demand inflation increases.
Note that prices increase, although the central bank is inactive!
A situation of fiscal dominance is more likely, when government debt is high and has hit the fiscal limit, when fiscal institutions are weak, or political factors prevent taxes from rising as needed to stabilize debt.
Fiscal discipline is necessary. Consensus, that national budgetary policies should support price stability oriented monetary policies.
Are fiscal deficits inflationary?
The link is non-linear and is influenced by other countries’ characteristics.
Studies results can be summarized:
Deficits are more inflationary in developing countries than in industrialized countries.
Fiscal deficit has a strong impact on inflation in high-inflation episodes, and has a weak impact in low inflation episodes
Effect is higher in periods of high debt.
Fiscal consolidation is more effective in stabilizing prices the higher the inflation rate and the level of government debt.
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Government debt and economic growth - effects
The results are broadly in line: The link between the two variables is non-linear:
Debt can have a stimulus effect on growth for low to medium debt levels (Keyensian effect).
For medium levels, the impact becomes insignificant.
For very high debt levels the relationship turns negative (non-Keyensian effect).
For developed countries the critical value lies around 85-95%, for developing countries this threshold is lower (35-60%).
Debt overhang periods
As sovereign governments service their debt by taxing firms and households, high levels of debt imply an increase in the private sector’s expected future tax burden.
Debt overhang characterizes a situation in which this future debt burden is perceived to be so high that it acts as a disincentive to current investment, as investors think that the proceeds of any new project will be taxed away to service the pre-existing debt.
Krugman’s (1988): A country suffers from debt overhang when the expected present value of future country transfers is less than the current face value of its debt.
Countries that suffer from debt overhang will have no net resource flows, since no new creditor will be willing to lend when a loss is certain.
Debt “Laffer curve”
The peak of the debt Laffer curve shows the point at which rising debt stocks begin acting as a tax on investment, policy reforms, or other activities that require up-front costs in exchange for future benefits, the peak may relate to the point at which debt begins to have a negative marginal impact on growth.
Countries have to assure to be on the good side of the Debt Laffer curve:
Fiscal consolidation that depresses the debt level below the critical threshold.
(Partial) debt relief that reduces the expected tax burden can make both lenders and borrowers better off by increasing investment and growth and thus tax revenues and the value of debt/expected debt repayment.
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Two options governments in “advanced countries” have to reduce public debt through fiscal consolidation
They can adjust fiscal policies by running sufficient primary budget surpluses to lower their debt.
They can create an environment conducive to growth through the implementation of sound macroeconomic and structural policies in order to „grow their way out“.
Successful fiscal consolidation
A successful consolidation refers usually to a more lasting as opposed to a merely short-lived correction of the budgetary position:
Nickel, Rother and Zimmermann (2010): Successful consolidation: Debt-to-GDP ratio declines by at least 10 percentage points in 5 consecutive years.
Larch and Turrini (2008): Consolidation is defined as an improvement of the CAPB of at least 1.5% of GDP which is either achieved (i) in one single year or (ii) over a period of three years. A consolidation is succesful, if in the three years after the end of the consolidation episode the CAPB does not deteriorate by more than 0.75% of GDP in cumulative terms compared to the level recorded in the last year of the consolidation period.
What determines the success of fiscal consolidation?
Decisive and lasting (rather than timid and short-lived) fiscal consolidation efforts.
Reduction of government expenditure, in particular, cuts in social benefits and public wages. Revenue-based consolidations do not seem to contribute to a major debt reduction.
Robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to “grow their way out” of indebtedness. Short-term fluctuations in the business cycle, however, do not seem to affect the success of a debt reduction favorable economic environment, international competitiveness, etc. more effective.
Likelihood of success increases if initial fiscal conditions are difficult.
Consolidation efforts accompanied by structural reforms.
Quality of fiscal governance turns out to be conducive to the success of fiscal consolidation: Effective budgetary procedures, fiscal rules.
The case for debt relief
If a country is far on the right side of the Laffer curve. In this case, debt relief may be necessary, to put the country back on track.
Debt forgiveness only works, if a country is on the wrong‘ side of the curve: A reduction in nominal claims outstanding will lead to an increase in the value of outstanding claims and will thus benefit creditors.
If the country is on the correct‘ side of the curve, debt forgiveness will not increase the market value of debt, and creditors will lose.
Effects of debt relief
The direct effect is that debt relief reduces a country‘s debt servicing obligations. The indirect effect is that debt relief cleans the books and paves the way for new creditors to lend (Summers, 2000).
However, even if an economy is on the `wrong‘ side of the Debt Laffer curve, empirical evidence shows that debt relief is not necessarily guaranteeing faster economic growth and economic recovery.
However, empirical evidence shows that debt relief is not guaranteeing faster economic growth and economic recovery per se, other factors seems to influence the success�.
What determines the success of debt relief programs?
Debt relief only helps, if the country shows some structural viability: A country attracts private investors, has sound political institutions, etc. - avoidance of adverse selection.
A debt relief agreement should go hand in hand with contractual agreements and conditionality, such as e.g. exclusion of possibility of further debt relief, structural reforms - avoidance of moral hazard.
Minimum requirements concerning institutional quality of debtor countries have to be fulfilled to assure effectiveness of debt relief.
Size of debt relief has to be large enough to put country back on track.
Commitment of majority of debt holders needs to be secured.
Market discipline hypothesis
Financial markets charge higher interest rates to borrowing countries whom they consider riskier.
Because of this default risk premium, governments debt service costs increase and governments have an disincentive to collect further debt.
Do financial markets enforce fiscal discipline on governments?�
Empirical evidence shows that financial markets indeed impose fiscal discipline on governments: Financial market values the default risk of high indebt countries in the way that the bond yield differential between two countries depends on the debt and deficit levels.
Impact of fiscal variables and the global risk factor on EMU yield differentials varies considerable over time:
Before the financial crisis, financial markets did not pay attention to government deficit ratios.
Financial markets monitored the debt to GDP ratio of the individual countries almost continuously.
Fiscal discipline imposed by financial markets has increased considerably since end of 2008.
Optimal design of fiscal policy rules
Another possibility to avoid excessive government spending and force governments to fiscal discipline is to introduce a fiscal policy rule.
Fiscal policy rules became extremely popular: While in 1990, only five countries had fiscal rules, by the end of March 2012, 76 countries had fiscal rules in place (Schaechter et al 2012).
Challenges for an optimal fiscal rule:
Long-run discipline.
Short-run flexibility
Enforceability.
Fiscal policy rule
A permanent constraint on fiscal policy through simple numerical limits on budgetary aggregates:
Permanent: Rule is for long-lasting time period and not only applicable for one year.
Numerical limits: Rule uses numerical value or value as a percentage of a certain indicator.
Simple: The rule can be readily operationalized, communicated to the public, and monitored.
Budgetary aggregates: The rule applies to a summary fiscal indicator (ie debt, budget balance, expenditure, or revenue).
To become effective, a fiscal policy rule also needs a clear institutional mechanism to map deviations from the numerical targets into incentives to take corrective action. For example, the rule could include a mechanism mandating the correction of deviations over a well-defined time frame (raising the cost of deviations), and an explicit enforcement procedure. (Kumar et al 2009).
