ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Fiscal Policy and Government Debts 1. More on Fiscal Policy: Automatic vs. Discretionary Fiscal Policy
Fiscal policy refers to the governments spending and taxing policies, or budget policy. It includes changes in: o Government spending o Net Taxes Budget Surplus/Deficit = T G o Budget surplus: T G > 0 o Budget deficit: T G < 0 In our last topic, we assume net taxes (T) to be autonomous, but net taxes usually vary directly with income (real GDP) in real world: o Taxes increases with income o Transfer payments decreases with income. When net taxes increases with income, the net taxes and budget surplus can be expressed as: Budget Surplus/Deficit = T G = tY G where t = T/Y is the average tax rate, we will assume it as a constant in our following analysis (i.e. proportional tax system1)

Government Spending (G), Taxes (T)

Budget Surplus

0
Budget Deficit

Y2

Y1

Y3

Income (Y)

In a progressive tax system, t increases with income. On the other hand, in a regressive tax system, t decreases with income.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Because net taxes go up or down in response to changes in the economy instead of the result of deliberate decisions by policy makers, economists occasionally use discretionary fiscal policy to refer to changes in taxes or spending that are the result of deliberate changes in government policy. The existence of income-dependent taxes makes it difficult to examine whether the actual discretionary fiscal policy is expansionary or contractionary. o To examine discretionary fiscal policy, economists use the concept of naturalemployment (or full-emmployment) budget or standardized budget. Instead of measure the actual government budget, it estimates the government budget when the economy is operating at its full-employment output level (i.e. potential GDP).

Government Spending (G), Taxes (T)

B1 B2

0
Cyclical Deficit Naturalemployment Budget Deficit (Expansionary) Y1 Yf Y2 Income (Y)

In the above diagram, at Yf, the budget deficit (G T) is zero. o The full-employment deficit is zero (Neutral fiscal policy) At Y1, there is a budget deficit. o The budget deficit is non-discretionary and is simply a result of lower income (recession). This kind of non-discretionary deficit is called the cyclical deficit. o What is the full-employment deficit? o The discretionary fiscal policy remains unchanged. What if the government increases its spending (G)? o It shifts the government budget line downward from B1 to B2. o At Y1, the budget deficit increases. o The full-employment deficit is positive. Expansionary fiscal policy

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

2. Automatic Stabilizers
Income-dependent net taxes is called built-in (or automatic) stabilizers: o During recession (Y decreases), budget deficit increases (expansionary) without discretionary action by government. o During expansion (Y increases), budget deficit decreases (contractionary) without discretionary action by government. To understand how the income-dependent net taxes automatically stabilize the short-run fluctuation in output, we incorporate it into our Keynesian model. In general, the net taxes can be rewritten as:
T Ta tY

where Ta is the autonomous part of the net taxes, and tY is the income-dependent part. Therefore, the aggregate expenditure function becomes:
AE C I p G NX

AE C a c(Y T ) I p G NX AE C a c[Y (Ta tY )] I p G NX AE C a cTa I p G NX (c ct)Y

AE A (c ct)Y

In equilibrium, Y AE :
Y C a cTa I p G NX a 1 c ct A s ct

o Note that the planned autonomous spending remains unchanged, but the multiplier decreases as: A Y s ct Y 1 k A s ct The multiplier becomes smaller because the effect of induced consumption is smaller. Initially, without income tax, when there is a $1 increase in income in each round, the increase in consumption (induced consumption) is c and as (s = 1 c) is saved. With income tax, when there is a $1 increase in income, the increase in consumption will be smaller each round because they have to pay more taxes. So, ( s ct ) will not be spent. In general, the multiplier becomes smaller because there are more leakages from the spending stream. A smaller multiplier implies the more stable economy. Are there any other factors that would affect the size of multiplier in real world?

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Other aggregate expenditure components that might be income dependent? Imports (leakage) Planned investment (injection) Other possible channels that an increase in current income might impact the multiplier: Higher current income may induce an increase in household wealth Higher current income may induce an increase in expected future income (forward looking behavior) How would these changes affect consumption and saving? How about multiplier?

3. Problems with Countercyclical Fiscal Policy Timing problems (time lags) o Inside lags: the time between a shock to the economy and the policy action responding to the shock in effect. Recognition lag: The time between the beginning of recession or inflation and the certain awareness that it is actually happening. Administrative lag: In a democratic government, changes in spending or taxes require long legislative process (the approvals of president and both houses of Congress in U.S.) o Outside (or Operational) Lag The time between a policy action and its influence on the economy (i.e. output, employment or the price level). Changing taxes usually have a shorter operational lag than changing government spending.

Political Considerations o political business cycle? o irreversibility Forward looking behavior o temporary tax cut vs. permanent tax cut? o Ricardian equivalence

4. The Long Run Consideration: Budget Deficits and Government Debts

When a government runs a budget deficit, it finances by borrowing from the private sector. The accumulation of past borrowing is the government debt. o It is usually measured as a percentage of GDP. Will the government remain solvent? o Refinancing o The only realistic concern should be the interest payment. The burden of interest costs could increase the government budget deficit and could cause the debt to GDP ratio to grow without limit.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The solvency condition: o Note that as long as the growth rate in debt to equal the growth rate in nominal GDP, the debt to GDP ratio remains constant. o In this case, the government can continue to pay interest on its rising debt without increasing tax rate. (Why?) o Suppose the nominal GDP is $1000 and the national debt is $500. Suppose the annual interest rate is 7%. To finance the interest payment of $35, what is the tax rate that the government needs to set? Suppose the nominal GDP and debt both doubled over time. The interest payment would also be doubled to $70. What is the tax rate that the government needs to set to cover the interest payment?

What are the real concerns? o Foreign-owned public debt o The potential increase in tax rate would dampen long-run economic growth. The debt problem can be very danger under the following cases: o A national debt growing too rapidly What would happen the growth rate of debt is faster than the growth in nominal GDP? A debt approaching national credit limit Countries borrow heavily abroad also must worry about foreigners perceptions of their economic policies and performance. Foreign investors who begin to lose their faith may become unwilling to lend, forcing the debtor to suffer through a sudden reduction in its ability to borrow. Higher risk also increases the cost of borrowing. Failing to account for future obligation.

Readings: Chapter 23 (p. 713 722) 24

China: Keynes v Hayek in China | The Economist

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China China spent 2011 worrying about others debt problems. In 2012 it will face one of its own
Nov 17th 2011 | HONG KONG | from The World In 2012 print edition

It took over 20 years for John Maynard Keyness General Theory to be translated into Chinese. That was still a bit too soon for some of its readers. Published in 1957, around the time of Mao Zedongs anti-rightist campaign, Keyness theory was denounced as anti-science and anti-people. He was accused of the unforgivable sin of seeking to defend capitalism. Over five decades later, things are different. The present leadership of the Chinese Communist Party, Hu Jintao and Wen Jiabao, have embraced Keynesian prescriptions with great determination. In response to the financial crisis of 2008 they approved an audacious stimulus package, unbalancing the governments books and spurring the countrys banks to lend. That helped defend their peculiar brand of capitalism from a crushing slowdown. Something similar may be required in 2012 if Americas stagnation and Europes debt crisis once again threaten the global economy. But the new leadership of Xi Jinping and Li Keqiang (expected to take over towards the end of the year) is unlikely to embrace Keynes as wholeheartedly as their predecessors. Indeed, they may find themselves slave to the scribblings of a different dead economist, Keyness intellectual foe, Friedrich Hayek. Whereas Keynes worried about inadequate investmenttoo little entrepreneurial spending to keep everyone gainfully employedHayek worried about bad investment. If credit were too easy, he argued, entrepreneurs would embark on overambitious projects that take too long to reach fruition and make insupportable claims on societys resources. It is not hard to find overambitious projects in China: think of the countrys ghost cities, such as Ordos in Inner Mongolia, which is being built by government fiat long before people are ready to live in it. But although China invests at a formidable pace, it also saves at a prodigious rate. In such a thrifty economy, interest rates should be low, credit should be readily available and investment should be high. Yet in 2009 and 2010 things went too far. Spurred on by the government, Chinas banks increased their lending by almost 9.6 trillion yuan ($1.5 trillion) in 2009. That is roughly twice the size of the Indian banking system, as Bank Credit Analyst, a research company, has pointed out. In other words, Chinas lenders added two Indias to their loanbooks in the space of a year. Much of this lending flowed to some 10,000 investment companies sponsored by local governments, which cannot borrow directly in their own name. These companies set about building roads, bridges, irrigation

The central government will

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works and some housing schemes of dubious merit. These loans added about 5 trillion yuan to the debt of local governments, which now amount to 10 trillion-14 trillion yuan or 25-36% of GDP (see chart).

step in

Chinas authorities now admit what was always obvious: many of these projects will fail to raise enough revenue to repay their creditors. Defaults have already surfaced in Yunnan province and elsewhere. Some of these projects will be abandoned halfway. They are what Hayek would call malinvestments, investments in capacity that no one is willing to pay for or wait for. Hayeks students dubbed their Austrian-born professor Mr Fluctooations because of his preoccupation with the ups and downs of the business cycle, which he described in heavily accented English. He believed that boom-time malinvestments were responsible for the subsequent bust, much as binge-drinking is responsible for the next mornings hangover. The road to nowhere? This sequence seems intuitive, but it is in fact something of a puzzle. In a caustic critique of the hangover theory of recessions, Paul Krugman, who won the Nobel prize for economics 34 years after Hayek, complained that nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. If an economy has squandered capital on misguided ventures, leaving its people worse off than they thought, why should so many of them stand idle? Surely people should work more, not less, in response to such bad news. Hayekians argue that after bad investments are exposed, it takes time for economies to reorganise themselves. Loan losses may undermine confidence in the banks that incur them, hampering their ability to finance fresh investments. And when workers are laid off, it may take a while for them to find new employers or acquire the skills that alternative jobs demand. Hayek believed that governments can do little to ease the pain of economic restructuring. Even if he is right, which is hotly disputed, politicians refuse to believe him. Chinas policymakers will prove no exception. The central government will step in, helping the banks and their borrowers to shoulder their debt burdens. How it intervenes is still an open question. It may use public revenues to complete some infrastructure projects, rather than allowing bridges to fall short of the opposite bank or roads to stop short of towns. It may force banks to write off other loans, recapitalising any lenders that cannot withstand the losses. These bail-outs may take place in the open, or they may happen behind closed doors, through regulatory indulgence and implicit subsidies. One Chinese scholar recently argued that Hayek was better known in China than in the West. But Chinas policymakers, just like their Western counterparts, will find Hayeks diagnosis of fluctooations more compelling than his prescription.

Simon Cox: Asia economics editor, The Economist

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Greece's sovereign-debt crunch: A very European crisis | The Economist

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Greece's sovereign-debt crunch

A very European crisis

The sorry state of Greeces public finances is a test not only for the countrys policymakers but also for Europes
Feb 4th 2010 | from the print edition

Illustration by Robert Venables

SOME would say that tragedy was inevitable from the moment, nine years ago last month, when Greece was admitted to the euro zone. Others would claim that woe was sure to befall such a disparate currency union sooner or later: if not Greece, then some other weak member of the club would have been the cause. Avoidable or not, trouble has arrived. At best, Greece has to undergo a dramatic budgetary tightening. Its fellow Europeans, or the IMF, may yet have to organise a humiliating bail-out. Some even talkprobably mistakenlyof the beginning of the end of the euro area. Last year Greeces budget deficit reached 12.7% of GDP. Worries over whether the Greeks would act to cut it have caused paroxysms in the bond markets: late last month the yield on ten-year Greek government bonds vaulted to 7.1%, the highest since the country joined the euro area and about four percentage points more than that on German bunds, the euro zones safest investment. The panic abated on February 3rd, when the European Commission endorsed the Greek governments plan to cut the deficit to 3% of GDP by 2012. The day before, Greeces prime minister, George Papandreou, had used a television address to announce higher taxes on fuel and an extension of a public-sector wage freeze to include low-paid civil servants. However, Greece and Europe are not out of trouble yet. The commission says it will watch Greece closely to ensure that it keeps its promises: it expects a report in mid-March on Greeces chances of hitting this years deficit target of 8.7% of GDP. Joaqun Almunia, the outgoing economics commissioner, said he hoped a positive assessment by the commission in mid-May would help restore confidence in Greece, which has one of the worlds largest debt burdens relative to its GDP (see chart 1). If the Greeks do not regain the markets confidence, they may fail to refinance the 20 billion ($28 billion) or so of debt that falls due in April and May. At that point the government would default or would have to be bailed out. And Greece is not the only country about which the bond markets are worried. On the same day as the commission approved the Greek plans, investors were selling Portuguese bonds. The spread of ten-year bonds against bunds widened by 0.16 percentage points, to 1.43 points. A marathon, not a sprint

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Greece has a long history of fiscal trouble. It has spent half of the past two centuries in default, note Carmen Reinhart and Kenneth Rogoff in This Time Is Different, a history of financial crises. When it became the 12th country to join the euro in 2001, its public debt was more than 100% of GDP. Many thought its chronic budgetary mismanagement might harm the currency. For Greece, membership was a boon. Bond markets no longer had to worry about high inflation or devaluation. Lower interest rates allowed the government to refinance debt on more favourable terms: the ratio of net interest costs to GDP fell by 6.5 percentage points in the decade after 1995. The underpricing of default risk during the credit boom gave Greece easy access to longer-term borrowing. Lower interest rates also spurred a spending splurge. The economy grew by an average of 4% a year until 2008.

But strong GDP growth masked the underlying weakness of the public finances. The public-debt ratio fell, but only because GDP in cash terms grew more quickly than debt. Large budget deficits continued. Once it was safely inside the euro, indeed, Greece relaxed its fiscal grip. The primary budget balance (ie, excluding interest payments) was in surplus in the run-up to membership but has been in deficit since 2003. That did little to cool the economy. Greeces inflation rate stayed above the euro-area average, hurting its competitiveness. The economy relied increasingly on foreign borrowing. The current-account deficit widened to 14.6% of GDP in 2008. If Greece had retained its own currency, trouble might have come sooner. But in the months after the collapse of Lehman Brothers, Greece was shielded by euro membership. It could still borrow easily, if not as cheaply, in bond markets even as investors aversion to risky assets peaked last March. The economy was on course for a shallow recession at worst. Greek banks were free of the toxic mortgage securities that felled others. Forecasts for the 2009 budget deficit, at 5% of GDP, seemed almost modest compared with the gaping shortfalls projected for other countries. Yet the reality was far worse, as became clear after Octobers election. The new government said the true deficit was likely to be 12.7% of GDP. Worse, the shortfall for 2008 was also revised up to include unpaid bills to medical suppliers. The mild downturn hurt tax revenues more than the previous administration had let on. The economy probably shrank by 1% last year, but consumer spending fell by more. Value-added taxes, a reliable source of revenue, were squeezed. Control of public spending had been relaxed in the run-up to the election, adding to the deficit. Investors trust in Greek statistics, never solid, was shattered. Two of the three main credit-rating agencies, Fitch and Standard & Poors (S&P), cut their rating on Greek bonds and gave warning that a further downgrade was likely. A debt standstill by Dubai World, a state-backed property venture in the Middle East, made bond investors more nervous about sovereign risk. Greek bond spreads started to widen again. In mid-December the government responded with a fresh plan to cut the deficit. Bond markets were unconvinced. So were the rating agencies: Fitch and S&P cut Greeces grade again, from A- to BBB+. On January 25th the Greek government enjoyed some brief reassurance, raising 8 billion in a sale of five-year bonds. The bank syndicate charged with placing the bonds said it had drummed up 25 billion-worth of orders in a matter of hours from investors attracted by an interest rate of 6.2%. Yet within a couple of days Greek bond yields were on the rise again. Stories that China had turned down an offer of Greek bondsdenied in both Athens and Beijingalso unsettled markets. Predictably, Mr Papandreou blames speculators for the flare-up in the markets. But he also concedes that his country has been left vulnerable by its own profligacy. If the government wants to restore the bond markets confidence, it will have to be bolder. The planned cuts to the public-sector wage bill look small when set against such a large budget deficit. They also look timid when compared with the much bolder action taken in Ireland, another cash-strapped euro member. In December the Irish government announced big reductions in civil servants pay, only months after it had introduced a pension levy that cut public-sector wages by 7%. Its courage has been rewarded with lower borrowing costs (see chart 2). Greeces finance minister, George Papaconstantinou, says the main problem in his countrys civil service is overmanning, not excessive pay: the right approach is to slow recruitment and allow

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the payroll to shrink as civil servants retire. Fine, but time is not on his side. To appease Greeces jittery creditors a policy with speedier and more visible results is needed. A big pay cut in the public sector would help. Private firms might then find it easier to follow suit, which would help Greece to regain its cost competitiveness. The government says it will present a plan for pension reform soon. Greece has one of the most generous, and therefore expensive, state pension systems among the 30 mostly rich OECD countries. Workers look forward to a pension of 96% of preretirement earnings. Greeks can no longer afford such a comfortable old age. In his television address Mr Papandreou hinted that a higher retirement age would be one plank of reform. A bolder package of budget cuts might secure bond-market finance at tolerable interest rates. The Greek government says it has to strike a balance between budget cuts and keeping its social partners happy. But if it is too kind to public-sector workers, pensioners and so forth, it will struggle to find buyers for its bonds. If the bond markets are closed to Greece, the country will face bail-out or default. Neither option is likely to contribute much to social peace. Which bucket to bail with? The thought that Greece might fail to carry out the necessary budget cuts has had officials scratching their heads about the form a bail-out might take. When yields soared in late January, nervous Eurocrats were briefing journalists that a rescue package for Greece was being considered. The treaty governing the European Union includes a no bail-out clause, forbidding countries from assuming the debts of others. That clause was inserted in 1991, at the insistence of Germany, at the EU summit in Maastricht, the Dutch town where many of the ground rules for the euro were set down. Other treaty clauses, however, may allow for aid to an EU state in trouble. One remedy would be for Greece to arrange a bridging loan from another euro-zone country in good credit, such as Germany. Such an arrangement may or may not be legal; it would certainly make for terrible politics. Voters in the donor country would be outraged if the rewards of their thrift were used to rescue the profligate. To ensure that good money was not thrown after bad, any loan would need to have conditions attached. That raises another problem. It is tricky for one country to tell another how to cut its budget. When Mexico was rescued in 1994, the Clinton administration at first wanted to manage the bail-out alone. It quickly realised that it would be better to have the IMF ask Mexico to sign up to conditions. For Mexico in the mid-1990s, read Greece today. If Germany steps in, there will be people on the Athens street who will say the Wehrmacht is back, an economist remarks.

Illustration by Robert Venables

European officials are privately horrified at the thought of calling in the IMF to bail Greece out. Pride is at stake. To turn to the fund for aid would be a humiliation for Europe, never mind the Greeks. The reputation of the euro is on the line and its members ought to be strong enough to fix problems within its borders. An IMF-led rescue would only underline the feebleness of the euro zones procedures to prevent fiscal laxity, even if few outside Brussels and Frankfurt ever set much store by them. European officials also seem reluctant to accept that the euro is not a shield against all crises. The EU has been content to work with the IMF in helping Hungary, Latvia and

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Romania, but these countries are not yet in the euro. The trouble is, the euro area has no mechanism to help a member that cannot fund itself in capital markets. So default is all too plausible. If Europe is too proud to call on the IMF, it will have to come up with its own fund as a backstop for Greece, and quickly.

A template for such a fund already exists. The EU has a loan facility to help members outside the euro with balance-of-payments problems. The funds ceiling was raised to 50 billion last spring, to cope with the potential need for emergency loans to Hungary and others. The facility is financed by EU-backed bonds, issued as the need arises. Loans for Greece could be raised in the same way, though it would mean that countries outside the euro, including Britain and Sweden, would be liable if they were not repaid. And the chances that Britain, determined to stay outside the single currency and short of money itself, would put itself on the hook for a bankrupt euro member seem slim even if British pension and insurance funds hold a good slice of Greek debt. In any case, a bail-out by Greeces partners is unlikely to be as effective in sorting out the countrys finances as an IMF programme. To assuage the lenders domestic voters, EU loans would have to be made at a punitive interest rate. The IMF, by contrast, would offer cheaper funds with stricter conditions. And it has the experienced staff the EU lacks to make sure a miscreant sticks to a plan to fix its finances. There is an alternative to a bail-out within Europe or by the IMF: default. Mr Almunia has insisted that this will not happen. In the euro areadefault does not exist, he declared (perhaps rashly) on Bloomberg television. Yet there is a view that default may be less bad than a bail-out, especially a botched one. Greeces financial woes are a problem for the country and its creditors to sort out. If Greece has to declare a debt standstill, say the hardliners, so be it. Financial aid would only discourage countries from mending their finances. Concerns that this would undermine the euros credibility may be misplaced. The countries that stand behind the rich worlds other main currencies (the dollar, the yen and the pound) have troubles of their own. Indeed, the euro is suffering from a surfeit of credibility since, on many gauges, it is overvalued against the dollar. Coming Acropolis What makes default unpalatable is the fear of contagionthat if Greece were allowed to go under, the cost of borrowing for other troubled euro members would shoot up. (Banks holding troubled countries bonds would also suffer.) Portugal, as the sell-off on February 3rd suggests, is next in line. Its public-debt ratio is 77% and rising. Its current-account deficit is almost as big as Greeces (see chart 3). Italy has public debt of a similar scale, relative to GDP, to Greeces; but its budget deficit is only half as big and its current-account deficit is relatively small. The Italian bond market is the worlds third-largest. Such a large and liquid market is less vulnerable to speculative attack than a small one, such as Greeces or Portugals. Ireland is small, too, but its government has shown itself willing to take unpopular decisions to right its public finances. The Irish economy is more flexible so its medium-term prospects seem brighter. The economy grew slightly in the third quarter of last year. There are even signs that tax revenues are recovering. The Greek crisis only confirms the folly of binding a group of disparate countries together in a currency zone with no mechanism, such as a central fiscal authority, to address its internal imbalances. The north-south divide in the euro area looks more marked than ever. The north, exemplified by Germany, relies on exports to power its growth, saves hard and runs trade surpluses. The southern economies, such as Greece, have leant too heavily on consumer spending, have weak public finances and rely on foreign capital to supplement their low savings. Do these disparities, and the trouble in Greece, threaten the break-up of the euro, as some believe? European officials retort that large imbalances are found in all large currency areas even the United States. Spains construction bust and rigid labour markets seem certain to condemn it to years of economic struggle and high unemployment, yet Michigan is scarcely in better shape. The states outlook is clouded by the long decline of Detroits motor industry.

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Greece is struggling to raise funds, but so is California, which accounts for a far bigger share of Americas output (one-eighth) than Greece does of the euro zones (a bit more than one-fortieth). An important difference in the case of the United States, however, is that the bulk of taxing and public spending is done by the federal government. As Marco Annunziata of UniCredit, an Italian bank, points out, Californias debt amounts to less than 1% of Americas GDP. Greek debt comes to 2% of the euro zones GDP. It is unlikely that Greece would be forced out of the euro, still less that it would choose to leave. Any hint of that would cause a bank run. A departing country may get a brief fillip from having a cheaper currency but it would still be left with expensive euro debt to service. Borrowing costs would shoot up to reflect higher currency and inflation risk. A more likely scenario than break-up is that the euro area finds ways around the absence of a central fiscal authority while stopping well short of a unified budget, for which there is scant political support.

A forthcoming paper from the Centre for European Policy Studies, a Brussels think-tank, sets out some ideas about how this could be done. The authors, Daniel Gros and Thomas Mayer, think the euro area should prepare for fiscal crises instead of trying only to prevent them. They propose an insurance system with premiums based on each countrys debt and budget deficit. The money raised would be used for loans to euro members shut out of bond markets. If a bailed-out country failed to comply with the conditions attached to loans and threatened default, the fund would stand ready to swap the countrys bad bonds, at a discount, for good bonds backed by euro-zone members, in order to limit the costs of contagion. Only if default is possible can market discipline be maintained, say the authors. Such a scheme would not obviate the need for deep reform in Greece. Successful companies complain that they are overtaxed to make up for evasion elsewhere. Small firms continue to operate below their efficient scale, because if they were bigger, they would attract the tax authorities. Greeces higher inflation is partly explained by a lack of competition in parts of the economy. As in Italy and Spain, wages are set centrally with too little regard for differences in productivity across industries and companies. If Greece is to get itself out of trouble, fixing the public finances is only the beginning.
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