Debt, Deficit and Economic Performance

While the consequences of government deficits on the economy has been a continuing concern in the economic literature, the recent large increase in the US federal budget deficits has renewed interest in the topic. Most of the studies have concentrated on the same questions; one of them concerns the possible ways of financing the deficit. In general, a government deficit must be financed by selling bonds and printing money. The issue is: Can the monetary authority choose the trajectory of the money supply without considering the size of the deficit? The answer depends upon the feasibility of financing the deficit by selling bonds only. If this is possible, the money supply can be held constant in the presence of a government deficit and the monetary authorities do not need to accommodate fiscal deficits.

The first part of this paper presents a series of four charts that sumarize the fiscal experiences of eighteen OECD countries over the past twenty years. For each country the charts plot the net government debt, the overall budget balance, the level of government spending on goods and services, and the current account (all measured as a percent. of GDP). This section is primarly descriptive and is designed to provide background information.

In conventional macroeconomic analysis, government budget deficits raise perceived wealth and stimulate aggregate demand in part because households are modeled as having finite horizons. If households are instead modeled as having infinite horizons, budget deficits need not stimulate aggregate demand and hence need not affect output, employment, asset prices, and the price level. The reason is that households with infinite horizons do not view the government debt as net wealth and hence may regard budget deficits (i.e., deferred taxes) and current taxes as equivalent. Ricardian equivalence is said to hold if households behave in this fashion (1).

There has been much empirical macroeconomic research on the current account and fiscal linkages among the industrial countries (e.g. Bryant, Henderson et Al. [6]), but much less empirical analysis using multicountry general equilibrium models of the linkages between the industrial countries (the north) and the developing countries (the south) (1). In this paper, we make use of two recently developed global models, the IMF’s MULTIMOD (Masson, Symansky, et Al. [33]) and INTERMOD (Helliwell, Meredith, et Al. [23]), to spell out some of main channels (2). We shall assess the extent to which fiscal policies in the industrial countries during the first half of the 1980s contributed to the growth, debt, and debt-servicing experience of the developing countries. The fiscal policies of the major industrial countries have received much attention, but primarily as concerns their effects on industrial countries, e.g. on their current balances, exchange rates, and interest rates (Blanchard and Summers [2], Branson [4], Sachs [35], Masson and Knight [32], Helkie and Hooper [21]) (3). Here, the focus is on their impact on developing countries.

Just as the ultimate impact of changes in taxes with a macroeconomic impact, such as the corporate income tax, cannot be determined without considering the concomitant changes in fiscal and monetary policies that could be expected, so the impact of changes in national debt resulting from deficits cannot be determined withoret looking into the tax structure that is likely to be involved in ultimately paying off the debt. Indeed fairly drastic differences in the impact of government debt will result from what may appear to be minor changes in the tax structure.

The possibility to use fiscal policy tools to improve overall economic conditions has been a strong raising interest in the economic debate over the last decade. Traditionally, theoretical literature on taxation effects is more involved in equity than in efficiency and structural effects of different tax systems. Quantitative studies in this field have been mainly concerned with issues such as aggregate control of demand and supply, external unbalances and so on, while analyses using sectorial models of economy have been focused on short-term effects of fiscal policy on industrial cost-price system and competitiveness.

The international coordination of fiscal and monetary policy has recently been an important topic on the agenda of macroeconomic theorists and of policy makers. Initial theoretical work which relied on simple game-theoretic models suggested that large gains in welfare could be achieved from the explicit coordination of policy as opposed to devising optimal national stabilization policies while taking as given the actions of policy makers in other countries.

The Fisherian intertemporal utility maximization model has proved to be a rich source of hypotheses explaining consumption behavior. Both the Life Cycle Consumption Hypothesis (LCH) (Modigliani and Brumberg [20]; Modigliani et Al. [21]; Modigliani [19]) and the Permanent Income Hypothesis (PIH) (Friedman, [12]) share this heritage. The more recent rational expectations based Random Walk Hypothesis of consumption (RWHC) (Hall [13]) also comes out of this variant. However, there seems to be still another consumption hypothesis lurking in the Fisherian model. This emphasizes the role of uncertainty and makes a distinction between certain — or sure — income and uncertain income, and between certain — or sure — consumption needs and uncertain consumption needs. These distinctions lead to what might be dubbed as the Life Cycle Consumption-Uncertainty Hypothesis (LCC-UH).

This paper reviews and extends some recent work that I have done on the burden of government debt in an “almost small” open economy. An almost small open economy has unrestricted access to the international capital market at a given world real interest rate (plus perhaps an exogenous country risk premium) and faces given world prices for its imports, but it has market power in its export sector because its exports are perceived to be imperfect substitutes for the tradeables of other countries. The export industry is also assumed to be (approximately) perfectly competitive so whatever market power the country as a whole possesses will not be exercised by individual firms choosing the appropriate price markups; it will require some from of government intervention such as export taxes or quotas.

In recent decades, the Italian phenomenon has often come under close scrutiny as specialists of the field attempted to understand the workings of an economic systerm perceived as being somewhat strange; foreign commentators in particular incessantly wavered between forewarnings of inevitable crises and decline, and resounding praise of unexpected and surprising succes. However, harsh and one-sided value judgements must be avoided if the Italian system is to be truly understood. Instead of glancing briefly at the cover and table of contents, one must carefully scan each page of Italy’s complex, intricate and often contradictory development.

Over the last ten years the ratio of Greek public debt to GDP has increased by more than three times. At the end of 1989 it will be very close to unity, which is one of the highest in Europe and among the OECD countries. At the end of the 1970’s it was among the lowest in Europe, which implies a record rate of increase over the period in question. In addition, this ratio seems now to have been stabilized in most OECD countries while it keeps on rising rapidly in Greece.

The question of the current account deficit and the external debt has become the hottest issue in Australia since the «Bottom of the Harbor» scandal of 1982. The net external debt, currently calculated at a bit more than 30% of GDP (with interest payments at about 3% of GDP), is growing rapidly due to a current account deficit that, in the second half of 1989, was approximately 5% of GDP. The spirited and, at times, hysterical controversy over the debt and deficit issue has been lead by Professor John Pitchford, who supports (or at least gives comfort to) the Labor government’s policy of benign neglect of the deficit, arguing quite sensibly that foreign borrowing is not inherently bad in the absence of externalities that cause the private cost of external borrowing to fall short of the social cost (1). The financial press and, more recently, the business community, have strongly condemned the government’s attitude.