Transcript EPS Session5b 2011

Fiscal Policy, Budget Deficits
and Government Debt
MSc EPS Session 5
Hilary term 2011
Professor Dermot McAleese
Source and forecasts: Goodbodys Sept 2010
Yesterday
All my troubles seemed so far away
Now it looks as if they’re here to stay,
Oh! I believe in yesterday.
Suddenly I’m not half the man I used to be,
There’s a shadow hanging over me
Oh, yesterday came suddenly.
“Yesterday” The Beatles
The debt equation
(D/Y)t = (1 + (r - g)(D/Y)t-1 + d + b
• where D is debt, r is nominal interest rate, g is nominal
growth rate, d is primary deficit and b is bank
capitalisation costs
• The debt/GDP ratio this year is equal to the ratio last
year, plus the primary deficit, plus bank costs, plus
interest charged on last year’s debt less growth rate of
GDP
• Why the primary deficit? Because interest rates are not
something government can control
Aim of economic policy is to reduce
volatility of market economy
GDP without
counter-cyclical policy
GDP
GDP with counter-cyclical policy
Potential GDP
time
The bursting of bubbles causes credit contraction, the forced liquidation of
assets, deflation and wealth destruction that may reach catastrophic
proportions. In a deflationary environment, the weight of accumulated debt can
sink the banking system and push the economy into depression. That is what
needs to be prevented at all costs.
George Soros “The Game Changer” Financial Times 28 Jan 2009
FISCAL POLICY
 Counter-cyclical fiscal policy
 The limits of fiscal activism
 Fiscal policy 2008-10: averting a
world depression

Policy recommendations for 2011 and
beyond
US after the Great Crash 1929
…. Real GDP falls by 29%
950
900
850
800
750
700
650
600
550
500
29 9 30 9 31 9 32 9 33 9 34 9 35 9 36 9 37 9 38 9 39
9
1
1
1
1
1
1
1
1
1
1
1
GDP (1996 $)
.. and prices fall by 25%
(Inflation US$1996=100)
13
12
11
10
9
8
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
“I believe myself to be writing a book on
Economic Theory which will largely
revolutionise - not I suppose at once but in
the course of the next ten years - the way
the world thinks about our problems”
John Maynard Keynes - letter to George Bernard
Shaw in 1933. The book was:
The General Theory of Employment, Interest and Money (1936)
13
Chapter 1 The General Theory
I have called this book the General, Theory of Employment, Interest and
Money, placing the emphasis on the prefix general. The object of such a title
is to contrast the character of my arguments and conclusions with those of
the classical1 theory of the subject, upon which I was brought up and which
dominated the economic thought, both practical and theoretical, of the
governing and academic classes of this generation, as it has for a hundred
years past. I shall argue that the postulates of the classical theory are
applicable to a special case only and not to the general case, the situation
which it assumes being a limiting point of the possible positions of
equilibrium. Moreover, the characteristics of the special case assumed by the
classical theory happen not to be those of the economic society in which we
actually live, with the result that its teaching is misleading and disastrous if
we attempt to apply it to the facts of experience.
----------------------------------------------------------------------1.“The
Classical Economists” was a name given by Marx to cover Ricardo and James Mill and their predecessors, that is to say for the
founders of the theory which culminated in the Ricardian economics. I have become accustomed, perhaps perpetrating a solecism, to
include in "the classical school" the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian
economics, including (for example) J.S. Mill, Marshall, Edgeworth and Prof. Pigou
Key Elements in Keynesian Economics
Business expectations shattered by 1929 slump.
Lack of demand the problem , not lack of supply
Monetary policy by itself not sufficient to promote investment
Governments should:
•
SPEND IN A RECESSION, even though budget deficit is getting
larger (‘loan-financed public works’)
•
SAVE DURING THE BOOM, even though it has abundant tax
revenues
JM Keynes A General Theory of Employment Interest and Money 1936
15
Objections to Keynes’ theory
• “We cannot afford it”
•
Higher spending means more borrowing means higher interest
rates
•
More Goverment spending means higher future taxes
•
Better to cut wages and become more competitive
•
Trade unions too powerful
•
Recession/depression self-correcting in the long run
16
Achievements of Keynes
(see Chapter 15)
• A key factor in enabling world economy to
avoid repeat of Great Depression.
• Japan used Keynesian economics to avoid
economic disaster since early 1990s
• US used counter-cyclical policy aggressively
to offset effects of stock market collapse
2001-2
• And 2008-2010 also .....
17
Consensus turns Keynesian
(% of GDP)
IMF Oct 2009 ch 1
18
Limitations of fiscal policy
• Governments often got timing wrong – policies
turned out to be pro-cyclical
• Governments spent during the recession AND
during the boom:
Govt spending rises as % GDP
Growing DEBT problems
• Private sector response to fiscal expansion
becomes less positive
19
RESULT
Fiscal policy still an important tool of policy,
but no longer as effective as it was in the past.
20
PUBLIC DEBT
Public debt is sustainable when it remains
constant
proportion of GDP over time
Effect on financial markets’ expectations:
 inflation to erode real value of fixed-interest
debt
debt default, rescheduling or moratorium on
interest payments
Public Sector Indebtedness (public debt adjusted
for pensions liabilities)
Openness of the financial markets 
fiscal conservatism … reinforced by ageing
population
21
Note: ‘Underlying’ refers to potential GDP
OECD Dec 2010
OECD Econ Survey June 2010 p. 49
Japan’s public finances
Japan:
Source: Aherne et al (2002)
Japan’s government expenditure and revenues 1988-2008
41.0
39.0
37.0
35.0
33.0
31.0
29.0
27.0
Expenditure
Revenues
Source OECD
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
25.0
Japan's Deflation 1995-2009
2.0
1.0
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
0.0
-1.0
-2.0
Source: CPI data, taken from World Bank, OECD
27
Japan's government budget balance
4.0
2.0
-4.0
-6.0
-8.0
-10.0
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
-2.0
19
90
19
88
0.0
Japans Gross Government Debt as % GDP 1988-2007
200.0
180.0
160.0
140.0
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
120.0
100.0
80.0
60.0
40.0
Unemployment rates (% of labor force) for US, Euro area and Japan
OECD Dec 2010
JAPAN Real GDP growth 1961-2010 (% p.a.)
15
10
5
-5
End of Japanese boom
20
08
20
04
20
00
19
96
19
92
19
88
19
84
19
80
19
76
19
72
19
68
0
Fiscal policy – a Japanese view
•
Japan’s fiscal deficit is ‘a perfect example of a good
deficit’. Without the increase in spending that produced
such larger deficits, Japan would have experienced a
drop in GDP similar to that in the Depression era US
where GDP halved in just 4 years. (p. 259)
•
In a balance-sheet recession, the private sector
focuses on reducing debt not on maximising profits. To
increase government spending is the only effective
response.
Richard C Koo The Holy Grail of Macroeconomics; Lessons from Japan’s Great
Recession Wiley 2009
Fiscal policy: ECB pre-crisis
A discretionary fiscal policy attempting to fine tune the
economy can have stabilising effects, but the size of the
effect tends to vary depending on several factors and is
generally assessed to be small. What is not small,
however, is the risk associated with such activist fiscal
policies. Experience suggests that unless a discretionary
fiscal stimulus is timely, targeted and temporary, it
actually risks being harmful.
ECB Monthly Bulletin June 2008 p. 79
34
European Economic Advisory Group Brussels Feb 2010
Fiscal policy essential when economy is in
deep decline (2008-)
• Coarse tuning vs fine tuning
• Monetary policy expansion necessary but not
sufficient
• How do we know if fiscal stimulus has been a
success?
• Will experience follow that of Japan? If so, is
that necessarily undesirable?
• How will private sector react?
35
Government spending (% GDP)
2006
2009
2010
2011
Euro Area
46.6
50.7
50.8
50.2
Japan
US
36.2
36.0
42.6
39.8
43.0
39.3
42.9
40
France
52.7
55.6
56.1
55.9
Germany
Netherlands
Sweden
45.3
45.5
54.0
47.6
51.6
56.3
48.0
52.3
55.9
47.2
51.7
54.8
Italy
48.8
51.9
51.3
50.5
44
51.7
52.6
51.3
UK
Source: European Economy April 2010 (to be updated)
General gross government debt (% of GDP)
Euro Area
Japan
United States
2009
86.3
192.9
83.0
2010
92.4
199.2
89.6
2011
96.7
204.6
94.8
Belgium
Italy
Germany
France
Spain
UK
Ireland
New Zealand
95.7
128.8
76.2
86.3
62.6
72.3
70.3
28.4
100.9
132.0
80.9
93.8
72.8
82.3
82.9
32.8
134.7
84.2
99.3
78.4
90.8
92.5
Source: OECD June 2010
United States Budget Balance
(% of GDP) 1988-2011
2008
2009
2010
2011
-6.3
-11.3
-10.5
8.8
-3
-3
-3
-3
Source: OECD Economic Outlook Dec 2010
IMF WEO
Oct 2010
Questions on Economist article, 1 Nov 2008
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
“The standard response to a demand shock is to use monetary
policy.” a) What is a “demand shock” and what caused it in the
present context. b) Outline the major instruments of monetary
policy.
Explain the meaning of the term “money multiplier”? Why is it
“collapsing”? What measures could be taken to raise its value?
What effect would a steep fall in property prices and in the stock
market have on the level of investment?
What are automatic fiscal stabilisers? Why do they differ in
magnitude between countries?
What is meant by a “fiscal stimulus”? Does it matter if the stimulus
takes the form of an increase in spending or a fall in taxation?
Some argue that increased government spending will lead to an
expectation of increased taxes in future that will negate any effect
on aggregate demand in an economy. Do you agree?
Why would a fiscal stimulus tend to be more effective in a large
country (the US) than in a small open economy (Morocco)?
Under what circumstances is it justifiable for a government to plan
for a budget deficit?
“Conventional monetary and fiscal policy may not prevent a
prolonged deflationary slump.” What can be done if this happens?
43
What policy measures should Japan take to reduce its budget
deficit?
Exercise 4, p. 397