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Fiscal Policy, Budget Deficits and Government Debt
MSc EPS Session 5
Hilary term 2011
Professor Dermot McAleese
Aim of economic policy is to reduce volatility of market
economy
GDP
GDP with counter-cyclical policy
time
GDP withoutcounter-cyclical policy
Potential GDP
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” FT 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%
500550600650700750800850900950
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
GDP (1996 $)
.. and prices fall by 25%(Inflation US$1996=100)
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9
10
11
12
13
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
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“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)
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
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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
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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
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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 ..... 12
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 % GDPGrowing DEBT problems
• Private sector response to fiscal expansion becomes less positive
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RESULT
15
Fiscal policy still an important tool of policy,
but no longer as effective as it was in the past.
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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 paymentsPublic Sector Indebtedness (public debt adjusted
for pensions liabilities)Openness of the financial markets
fiscal conservatism … reinforced by ageing population
2000 2010 2030 2045Japan 46.6 55.3 71.7 91.0France 53.6 52.8 67.9 73.7Germany 46.0 49.4 69.9 83.6China 48.0 40.3 50.5 62.5
AGE DEPENDENCY RATE
Source: computed from WDI Indicators World Bank
Age dependency = (pop 0-14 + 65+)/ pop 15-65
Policy Options for Ageing
Remove incentives for early retirement
More reliance on privately funded pensions
Find appropriate balance between public and private provision of health services and long term care of the elderly
Efficiency and cost-benefit of healthcare – limiting level of treatment by expectation
of life
Japan’s government expenditure and revenues 1988-2008
25.0
27.0
29.0
31.0
33.0
35.0
37.0
39.0
41.0
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Expenditure Revenues
Source OECD
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
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• 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?
Fiscal policy essential when economy is in deep decline (2008-)
Government spending (% GDP)
Source: European Economy April 2010 (to be updated)
2006 2009 2010 2011
Euro Area 46.6 50.7 50.8 50.2
Japan 36.2 42.6 43.0 42.9
US 36.0 39.8 39.3 40
France 52.7 55.6 56.1 55.9
Germany 45.3 47.6 48.0 47.2
Netherlands 45.5 51.6 52.3 51.7
Sweden 54.0 56.3 55.9 54.8
Italy 48.8 51.9 51.3 50.5
UK 44 51.7 52.6 51.3
2009 2010 2011Euro Area 86.3 92.4 96.7Japan 192.9 199.2 204.6United States 83.0 89.6 94.8
Belgium 95.7 100.9Italy 128.8 132.0 134.7Germany 76.2 80.9 84.2France 86.3 93.8 99.3Spain 62.6 72.8 78.4UK 72.3 82.3 90.8Ireland 70.3 82.9 92.5New Zealand 28.4 32.8
Source: OECD June 2010
General gross government debt (% of GDP)
United States Budget Balance (% of GDP) 1988-2011
Source: OECD Economic Outlook Dec 2010
2008 2009 2010 2011-6.3 -11.3 -10.5 8.8
-3 -3 -3 -3
THE THREE T’s OF FISCAL POLICY
To be economically effective, fiscal policy must be:
Timely
Targeted
Temporary
Questions on Economist article, 1 Nov 2008
1. “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.
2. Explain the meaning of the term “money multiplier”? Why is it “collapsing”? What measures could be taken to raise its value?
3. What effect would a steep fall in property prices and in the stock market have on the level of investment?
4. What are automatic fiscal stabilisers? Why do they differ in magnitude between countries?
5. 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?
6. 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?
7. Why would a fiscal stimulus tend to be more effective in a large country (the US) than in a small open economy (Morocco)?
8. Under what circumstances is it justifiable for a government to plan for a budget deficit?
9. “Conventional monetary and fiscal policy may not prevent a prolonged deflationary slump.” What can be done if this happens?
10. What policy measures should Japan take to reduce its budget deficit?
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