Having discussed thc design of monetary policy in general, let us end this chaptcr hy looking at how the RBA actually carries out monetary policy in Australia.
The mandate of the RBA
Thc Reserve Bank Act of 1959 established the RBA, effectively giving it the central banking role that had been previously combined with commercial and savings bank (unctions at the government-owned Commonwealth Bank of Australia. The Act declares:
It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers ot thc Bank arc exercised in such a manner as, in thc opinion ot the Reserve Bank Board, will best contribute to:
• the stability of the currency of Australia,
• the maintenance of full employment in Australia, and
• the economic prosperity and welfare ol the people of Australia.
4 Note in Figure 25.2 that Australia has the seventh-highest index of central bank independence.
Recall (from Chapter 4) that we can think of the determination of the interest rate in three equivalent ways:
• The supply of central bank money must be equal to the demand for central bank money.
• The supply of reserves, equal to central bank money minus the currency held by people, must be equal to the
^ demand for reserves by banks.
• The supply of money (currency and demand deposits) must be equal to the demand for money.
There is one important point behind thc official language. Thc RBA has a mandate not only to achieve low inflation in the medium and long run but also to stabilise economic activity in the short run.
The organisation of the RBA
Policy decisions at the RBA are made by the Reserve Bank Board, which has nine members: the governor (who is the chairman), the deputy governor, the secretary to the Treasury, and six external members appointed by thc treasurer. The governor and deputy governor have seven-year renewable terms, and the external members have live-year terms. In recent years only one ol the external board members has been an academic economist—thc others have been prominent business people.
We discussed in Chapter 25 the importance of central bank independence. Thc RBA, in practice, is a relatively independent central bank. All management functions are in thc hands ol the governor, and thc main control lever available to the government ol the day is the appointment ol the governor every seven years. However, the government also has a voice and a vote at the board through thc secretary of the Treasury. In the event of an extreme disagreement of views, thc government does have the constitutional right to force a policy on thc RBA Board, but this right has never been exercised. F.ach year, thc RBA earns significant income in the form of interest and capital gains on its portlolio ot loreign and domestic bonds, and, alter paying its operating costs, distributes a dividend to thc government (which averages more than $2 billion). This means lhal the RBA doesn't have to secure a budget each year from the government, and so the government cannot put pressure on the RBA by threatening to cut its lunding. Thc governor of the RBA testifies twicc a year in front of a House of Representatives committee to explain the stance of monetary policy, and publishes a statement at the same time. Members of parliament often complain and grumble about the RBA's decisions, but there isn't much they can actually do about it. Demonstrating its independence in November 2007, in thc middle of a federal election campaign the RBA decided to raise the cash rate. As you would expect, this upset the incumbent parly.
4 The RBA's website (www.rba.gov.au) gives a lot of information about how the RBA is organised, and what it does.
The instruments of monetary policy
11 =
(26,2)
You saw in Chapter -1 that we can think of the interest rate as being determined hy the demand for and the supply of central bank money. Recall lhat the equilibrium condition (equation [4.11]) is given by
0(1 - c)\$YL(i)
On the left side is H. thc supply of central bank money—equivalently, the monetary base. On the right side is the demand for central bank money—thc sum of the demand for currency by people c$YL(i) and the demand for reserves by banks в I - c)$YL{i). A quick refresher:
• Start with $17.i i), thc overall demand lor money (currency and current account deposits. MI). This demand depends on income and the opportunity cost ol holding money—the interest rate on bonds.
See Chapter 4 for > • The parameter r is the proportion ol money people want to hold in the form ol currency. So. f$YL(l) a review. js the demand lor currency by people.
• What people dont hold in currency, they hold in the form of current account deposits. These deposits are therefore a fraction 1 г ol the overall demand lor money, so deposits are equal to
I c)$YL(i). The parameter и denotes the ratio of reserves held by banks to deposits. So the demand for reserves by banks is в 11 - i*i$Y/.1 /).
• Adding thc demand for currency, c$YL(i). and the demand for reserves by banks, 0 I - c)$YLi), gives the total demand lor central hank money the right side ol the equation.
An increase in в * increases the demand for reserves by banks, increasing the demand for central bank money.
Given an unchanged supply, the interest rate must increase.
The equilibrium interest rate is then the interest rate at which the supply and the demand lor central bank money are equal. The RBA has three instruments at its disposal to allect this interest rate. The lirst, reserve requirements, affects the demand lor reserves, and so allects the demand for central bank money. The other two lending to banks and open-market operations in government bonds, allect the supply ol central bank money.
Reserve requirements have been abandoned
The RBA can determine reserve requirements, thc minimum amount of reserves that banks must hold in proportion to current account deposits. Lven without such requirements, banks would want to hold some reserves to be able to satisfy their depositors' demand lor cash. Prior to the deregulation of the Australian linanciai system in the mid-1980s, the RBA did use ellective reserve requirements to control the banks (among other policies, such as controls on the interest rates they could pay and charge . However, since then, there have been no direct controls on the banks.
An increase in reserve requirements by the RBA could lorce banks to take drastic actions to increase their reserves, such as recalling some ol the loans they have made, for this reason, thc RBA decided to abandon reserve requirements as an instrument ol macroeconomic policy. Instead it relies on its second and third instruments, lending to the banks and open-market operations in bonds, to determine a preferred value ol the short-term interest rate, or the 'cash rate which is the market interest rate on interbank lunds. Let s see why it is able to exert influence on this interest rate using these instruments.
Lending to banks
1 he RBA can lend directly to banks i. an instrument we ignored in С .haptcr 4). I here are two aspects to
this:
• Thc lirst is the lending that thc central bank may undertake in extreme circumstances, when a hank is in crisis. This is sometimes called thc lender-of-last-resort lacility. This is a rarely used leature, and there arc no specific guidelines concerning it.
• The second form ot lending to banks is a highly active instrument, and the major method ol con¬ducting monetary policy in Australia. I bis lending involves open-market operations in repurchase agreements (or repos, lor short with the hanks.
From thc point ol view of the RBA, lending to banks with repos is very similar to buying govern¬ment bonds in an open-market operation. In both cases, the RBA creates money and so increases H. the monetary base. In lending to banks, the RBA receives in exchange a claim on the bank. In open- market operations, thc RBA acquires lor ownership a government bond, a claim on thc government.
What exactly are repos? They involve a holder (a bank' ol some securities such as bills issued by banks with an acceptable credit rating, or perhaps long-temi government bonds) selling them to the RBA lor money, with a commitment to reverse the transaction at some future date. Repos are therefore very flexible financial instalments which can be used to manage liquidity in the banking system. without the holders ol the securities giving up permanent ownership. This means that by selling a repo a bank can convert into money any securities that are acceptable to the RBA as collateral.
All linancial institutions lhat are supervised by the ollicial supervisory agency, thc Australian Prudential Regulation Authority APRA . may hold interest-earning accounts ai the Reserve Bank, known as exchange settlement accounts (ESAs). These arc the reserve deposits that appeared in equation i2(>.2i. Financial institutions have to hold (non-negative) ESA balances il they arc to conduct any linancial business with the government. Every morning thc RBA estimates the likely change in aggregate FSAs for the day, and then makes those transactions. At the end of thc day, il an institution is short o: ESA balances, il can borrow in a repo transaction from the RBA at 25 basis points above the cash rate. Any overnight balances earn the cash rate minus 25 basis points. Through these daily activities, the RBA plays a key role in settling the day-to-day transactions between banks, in what is known as the interbank market or cash market. Through these transactions thc ccntral bank varies П and because ol its ability to do so, it can choose to set a particular value ol the interest rate in the interbank market—the cash rate. Over the years the RBA has found open-market operations in rcpos to be the most convenient and flexible way of changing the supply ol central bank money and thus lor determining thc short-term cash interest rate.
The current and future expected values ot thc cash rate determine medium- and long-term interest rates, and so the RBA often signals its future intentions lor thc cash rate through speeches and media releases.
In addition, thc RBA does similar transactions to rcpos with foreign currency assets. These are known as foreign currency swaps. They operate in a similar way and are largely used to help manage liquidity in thc money markets, and to influence volatility in the foreign-exchange market.
Open-market operations in government bonds
The RBA's third tool is open-market operations in short-term government bonds (with less than one year to maturity). Thc RBA buys or sells these bonds outright that is, it takes immediate possession in exchange lor cash, or H. When the RBA buys bonds it pavs tor them by creating money, increasing H: when it sells bonds, it decreases II.
In contrast to what happens in the United States, where open-market operations in government bonds are the main instalment in Australia they are playing a decreasing role. More than 40 per cent ol open-market operations jse rcpos in Australia. One important reason is that the proceeds ol success¬ive liscal surpluses and privatisations in recent years have led to a dramatic reduction in outstanding government bonds. This is why the RBA has widened thc types ol securities it is prepared to accept as collateral in its rcpos transactions.
The practice of monetary policy
Most important monetary policy decisions are taken at the meetings ol the Reserve Bank Board, which take place on the lirst Tuesday ol every month except in January).
For these meetings, the RBA stall prepares forecasts and simulations of the effects ol dillerent monetary policies. The forecasts show what is likely to happen to thc economy under unchanged monetary policy and what the main sources of uncertainty appear to be. The simulations show the evolution of the economy under alternative assumptions about monetary policy.
Thc RBA Board then decides on the course of monetary policy. Decisions lo change the interest rate are publicised in thc media the next day al 9:3(1 am and the RBA's domestic markets department is instructed to conduct open-market operations to ensure thai the chosen interest rate is achieved in the overnight cash market. In that market, banks that have excess reserves (reserves in excess ol what they arc required ю hold1 lend overnight to banks that have insufficient reserves. The rate in that market is called thc cash rate.
From Chapter 15: Medium-cerm and long-term interest rates are weighted averages
i of expected short- term interest rates. A decrease in the cash rate, which leads participants in financial markets to expect lower short-term interest rates in the future, leads to a decline in medium- term and long-term interest rates.
4 For more on open- market operations, review Chapter 4.
As new information comes in, indicating, for example, that the economy is stronger or weaker than expected the RBA dealers must ensure that the cash rate remains unchanged. These dealers have to be involved more-or-lcss continuously in the interbank market to make sure thc cash rate remains closc to target. Why is this? Thc reason is that thc interbank is a market for settlements between financial
institutions, and new information and communications technology has meant that the processes now happen on-line and in real time—they are known as real-time gross settlement (RTGS) systems.
We have looked so far at the organisation and the instalments of the RBA. This doesn't tell us, however, what monetary policy the RBA actually follows. Does the RBA have an inflation target, and, if so, what is it? Does the RBA follow an interest rate rule, and, it so. what is the rule?
• The mandate of the Reserve Bank of Australia was clarified in 1496 when the Australian government and thc RBA lormalised the operational independence of the central bank with an explicit commitment by the RBA to keep 'underlying inflation' between 2 and 3 per cent on average, over the course ol the economic cycle. The term underlying inflation is a measure ol inllation that excludes volatile items, such as government charges and interest rate changes. In this Statement on the Conduct of Monetary Policy, it was acknowledged lhat the RBA should also take account of the implications ol monetary policy tor activity, and therefore employment in the short term'. In December 2007 the new Rudd government confirmed its support of the mandate by signing a Statement on the Conduct of Monetary Policy.
• The RBA doesn't say that it follows a rule But it does make it clear that it will use monetary policy tools to vary thc cash rate so that it can achieve its inllation target in the medium am or, in its words, 'over the course of the cycle >. Thc RBA is very clear about its inllation target, but rather nebulous about how and whether it will respond to movements in unemployment. Therefore, it is possible that the implicit RBA rule includes only an inflation target. However, as you saw in the discussion ot Taylors rule (equation [26.Ill, the evidence suggests that thc RBA behaved as if it was following a rule that includes targets for both inflation and unemployment.
Figure 26.2 shows the interest rate lhat the RBA uses as its monetary policy instrument, and the actual inflation rate. Ignoring the spike generated by the introduction of the new general sales tax, or C.ST, in 2000, thc two lines are surely correlated. Since 1993, the inflation rate has remained resolutely low, and, as you have seen in earlier chapters, output growth has been remarkably good in Australia. This successful inflation outcome must he credited to the good management ot monetary policy by thc RBA. We can also give it some credit lor the good output growth outcome. However, credit must also go to lhe successive governments since the 1980s that deregulated and reformed financial, goods and labour markets.
ВАС К TO POUCY chapter 26
Figure 26.2 The cash rate and the inflation rate
-I
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
in Australia, 1988-2008
Apart from the GST spike in 2000-01, the Interest rate set by the central bank appears to be linked to inflation.
In Figure 26.2, you can see the dramatic 1 per cent cut in lhe cash rate to 6 per ceni that occurred in October 2008, Inflation had been rising and was well above the RBA's inflation target range. Why did it cut thc interest rate so much and why was il expected lo cut the rale even lurther in lhe next few months? As you have read in many other chapters, it was because it leared thc risks to economic activity from the global financial crisis. Like most other central banks at thai time, it chose to provide a dramatic-
signal to financial markets. However, it is clear thai official interest rates everywhere arc getting closer to their zero limit, and so conventional monetary policy is becoming increasingly powerless. Central banks have had to consider developing unconventional ways ol doing monetary policy, such as dealing in longer term assets, as well as a wider variety of assets, including mortgage-backed securities. When you read this, you will have a good idea ol whether these actions worked or not.
SUMMARY
On the optimal rate of inflation
• Inflation is down to verv low levels in most OF.CD countries. One question lacing central banks is whether they should try to achieve price stability—that is, zero inflation.
• The main arguments lor zero inflation are:
1. Inllation together with an imperfectly indexed tax system, leads to tax distortions.
2. Because ol money illusion, inflation leads people and lirms to make incorrect decisions.
3. Higher inflation typically comes with higher inflation variability, creating more uncertainty and making it more difficult for people and lirms to make decisions.
I. As a target, price stability has a simplicity and a credibility that a positive inllation target doesn t have.
5. With imperfect indexation, inflation redistributes wealth from nominal creditors lo debtors.
• There are also arguments tor maintaining low but positive inflation.-
1. Positive revenues from nominal money growth—seignorage—allow for decreases in taxes else¬where in the budget. However, this argument is quantitatively unimportant when comparing inflation rates of 0 per cent versus, say, 10 per cent.
2. Positive actual inflation and expected inflation allow the central bank to achieve negative real interest rates, an option that can be useful when lighting a recession.
3. Positive inflation allows lirms to achieve real wage cuts when needed without requiring nominal wage cuts.
4. Further decreasing inflation from its current rate to zero would require an increase in unemploy¬ment for some time, and this transition cost might exceed whatever benefits come from zero inflation.
On the design of monetary policy
• Traditionally, the design of monetary policy was focused on nominal money growth. But because of the poor relation between inflation and nominal money growth this approach has been abandoned by most central banks.
• Central banks now typically locus on an inflation rate target rather than a nominal money growth rate target. And they think about monetary policy in terms ol determining the nominal interest rate rather than in terms of determining the rate of nominal money growth.
• The Taylor rule gives a useful way ol thinking about thc choice ot the nominal interest rate. The rule slates that the central bank should move its interest rate in response to two main factors: the deviation of thc inflation rate Irom the inflation target, and the deviation ol the unemployment rate Irom the natural rate of unemployment. A central bank that follows this rule will stabilise activity and achieve its target inllation rate in thc medium run.
On the RBA
• The Reserve Bank ol Australia is controlled by a board with nine members, including thc governor, who is the chairman.
• Open-market operations using repos are the main instrument ol monetary policy. Reserve require¬ments were abandoned in 1983, and open-market operations in government bonds are insignificant (largely due to the growing shortage ol government bonds).
• Decisions about the course of monetary policy are made on the first Tuesday of each month, except in January. The target cash rate must be achieved by the RBA money market dealers.
• The RBA has an explicit target lor inflation ol 2-3 per cent over the course ol the business cycle. Il doesn't have an explicit interest rate rule. But it seems to change thc nominal interest rate in a manner well described by a Taylor rule.
• Monetary policy has been very successful in the last ten years. Inllation has remained low. At the same time, the RBA has used monetary policy to help stabilise output.
KEY TERMS
• shoe-leather costs 592
• bracket creep, 592
• negative gearing, 593
• money illusion. 594
• liquid asset 599
• monetary aggregates. 599
• M3.MI 599
• broad money, 599
• inflation targeting 600
• Taylor's rule. 601
• Reserve Bank Act, 603
• Reserve Bank Board, 603
• reserve requirements, 604
• repurchase agreements, or rcpos, 604
• exchange settlement accounts ■ESAsi, 605
• real-time gross settlement RTC.S 606
QUESTIONS AND PROBLEMS
Quick check
1. Using the information in this chapter, label each of thc following statements 'trite', 'false' or 'uncertain'. Explain briefly/.
a. I he most important argument in lavour ol a positive rate ol inllation in OHCD countries is seignorage.
b. The RBA should target M3 growth because it moves quite closely with inllation.
c. Fighting inllation should be the RBA's only purpose.
d. Because most people have little trouble distinguishing between nominal and real values inflation docs not distort decision making.
e. The RBA uses reserve requirements as its primary instrument of monetary policy. I. Thc higher the inflation rate, the higher the effective tax rate on income.
2. Explain how each of the following would affect the demand for Ml, M3 and broad money:
a. Banks reduce penalties on early withdrawal Irom term deposits.
b. Thc government lorbids thc use ol EFTPOS and cheques Irom accounts at non-bank linancial institutions.
c. I he government legislates a tax on all ATM transactions.
d. The government dccidcs to impose a tax on all transactions involving government securities with maturities ol more than one year.
3. Taxes, inflation and home ownership
In this chapter we discussed the effect of inflation on the effective capital-gains lax rate on the sale of a home. In this question we explore the effect of inflation on introducing a new feature to the Australian tax code—the deductibility of mortgage interest.
Suppose you have a mortgage of $500,000, which is fully financing an investment property and which earns rent income of S20,000 per year. Expected inflation is and the nominal interest rale on your mortgage is i. Consider two eases.
(i) 77'' = 0 per cent; i = 4 per cent.
(ii) 77(' = 70 per cent; i = 74 per cent.
a. What is thc real interest rate you are paying on your mortgage in each case?
b. Suppose you can deduct these nominal mortgage interest payments net of rent from your normal income before paying income tax (as is the case in AustraliaAssume that your marginal tax rate- is 40 per cent. St), for each dollar you pay in mortgage interest you pay 40 cents less in taxes, in effect getting a subsidy from the government (or your mortgage costs. Calculate, in each case thc real interest rate you are paying 011 your mortgage, taking into account this subsidy. Are you better or worse oil when expected inllation is higher?
c. Considering only the possibility ol deductibility ol mortgage interest and not capital-gains taxation , would inllation be good lor home-owners in Australia?
Inflation targets
Many countries around lhe world have set explicit inflation targets for the central hank. Suppose that
MONL1ЛЙУ POLICY: л SUMMING UP chapter 26
the inflation target is тт1 and the Phillips curve looks like the one described in the chapter:
77.
/-1
- a(u, - it,,)
Il the central bank is able to keep the inllation rale equal to the target inflation rale every period,
does this imply that there will be dramatic fluctuations in unemployment?
Is the central bank likely to be able to hit its inllation target every period?
Suppose that the natural rate of unemployment, 11,.. changes frequently. How will these changes
allect the central bank's ability to hit its inflation target? Explain.
Dig deeper
5. Suppose that yon have been elected lo parliament. One day, one of your colleagues makes the following statement:
The RBA governor is the most powerful economic policy-maker in Australia. We should 1101 turn over the keys 10 the economy 10 someone who was not elected and therefore has no accountability. Parliament should impose an explicit Taylor rule on the RBA. Parliament should choose not only the target inflation mle but the relative weight 011 the inflation and unemployment targets Why should the preferences ol an individual substitute for the will ol the people as expressed through the democratic and legislative processes? Do you agree with your colleague? Discuss the advantages and disadvantages ot imposing an explicit Taylor rule on thc RBA.
Explore further
6. Go to the website of the Reserve Rank of Australia at
a. What has happened to the growth rate ol money since the last statement?
b. Does the RBA seem to be more worried about a slowdown in growth or an increase in inllation?
c. What is happening lo the benchmark cash rate?
d. Can you detect any signals about future monetary policy in the statement?
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
c.
for many World Wide Web exercises relating to issues similar to those in this chapter.
FURTHER READINGS
• 'Modern central banking written by Stanley Fischer for the 300th anniversary of the Bank ol England, published in Forrest Capie, Stanley Fischer, Charles Goodhart and Norbert Schnadi 1 cds), The Future of Central Banking (Cambridge, L1K: Cambridge University Press, 1095), provides a useful discussion of the current issues in central banking. Read also What central bankers could learn from academics—and vice versa', by Alan Blinder, Journal of Economic Perspectives. Spring 1997, pp. 3-19.
• On inflation targeting, read 'Inflation targeting: A new framework lor monetary policy? by Ben Bernankc and Frcdcric Mishkin journal of Economic Perspectives, Spring 1997. pp. 97-1 16. (This article was written before Ben Bernankc became chairman of the Fed. Frederic Mishkin was a member ol the Board of Governors ol the Federal Reserve until 2008. > Also read Inflation targeting: A decade ol Australian experience' bv Glenn Stevens, RBA April 2003.
• On the RBAs organisation and monetary policy design, download thc material in the education section Irom its website,
• To lind out more about how well a Taylor rule explains the RBAs recent behaviour, read 'Asymmetric monetary policy in Australia' by Shawn Leu and Icftrey Sheen. Economic Record, September 2006, Special issue, pp. 585-96.
• For more detail on how the Fed operates, read Glenn Hubbard, Money, the Financial System, and the Economy, 5th edn (Reading, MA: Addison-Wesley, 2004).
• For more on monetary policy under Alan Greenspan, read N. Gregory Mankiw, LIS monetary policy during thc 1990s' in American Economic Policy in the 1990s (Cambridge, MA: MIT Press, 2001).
• For a more relaxing read, see Bob Woodward. Maestro: Greenspan's Fed and the American Boom ( New York: Simon & Schuster, 2001).
Fiscal Policy: A Summing Up
I
n this chapter we do for fiscal policy what we did for monetary policy in Chapter 26—review what we have learned and tie up the remaining loose ends.
Let's first review what you have learned. (The focus box 'Fiscal policy: What you have learned and where' gives a more detailed summary.)
• In the short run. a oudget deficit (triggered, say. by a decrease in taxes) increases demand and output. What happens to investment spending is ambiguous.
• In the medium run, output returns to the natural level of output The interest rate and the composition of spending are different, however.The interest rate is higher, and investment spending is lower.
• In the long run, lower investment implies a lower capital stock, and therefore a lower level of output.
In deriving these conclusions, we didn't pay close attention to the government budget constraint—that is, to the relation between debt, deficits, government spending and taxes. Nevertheless, as our discussion of fiscal policy in Japan in Chapter 23 made clear, this relation is important. After a decade of large budget deficits, government debt in Japan has become very high, and this in turn very much restricts the scope for further use of fiscal policy. So. our main task in this chapter is to look at the government's budget constraint and its implications.
• Section 27.1 derives the government budget constraint, and examines its implications for the relation between budget deficits, the interest rate, the growth rate and government debt.
• Section 27.2 examines a number of fiscal policy issues where this constraint plays a central role, from the proposition that deficits don't really matter to the dangers of accumulating very high levels of public debt.
• Section 27.3 looks at the current Australian budget and the issues on the horizon, from the effects of increased defence expenditure to the implications of the ageing of Australia.
27.1 THE GOVERNMENT BUDGET CONSTRAINT
Suppose that, starting Iron a balanced budget, the government cuts taxes, creating a budget dcficit. What will happen to debt over time? Will the government need to increase taxes later? II so, by how much?
The arithmetic of deficits and debt
To answer these questions, wc must start with a definition ol the budget delicit. Wc can write the budget dcficit in year t as
deficit, = rS,_, + G, - T, (27.1)
FISCAL POLICY: WHAT YOU HAVE LEARNED AND WHERE
• In Chapter 3 we looked at the role of government spending and taxes in determining demand and output in the short run.
You saw how in the short run a fiscal expansion—that is, increases in government spending or decreases in taxes—increases output.
• In Chapter 5 we looked at the short-run effects of fiscal policy on output and on the interest rate.
You saw how a fiscal expansion leads to an increase in output, as well as an increase in the interest rate when the central bank keeps the money stock fixed. When it keeps the interest rate fixed, the fiscal expansion leads to a larger increase in output.You also saw how fiscal policy and monetary policy can be used to affect both the level and the composition of output.
• In Chapter 7 we looked at the effects of fiscal policy in the short run and in the medium run.
You saw that in the medium run (taking the capital stock as given) a fiscal expansion has no effect on output, but is reflected in a different composition of spending. The interest rate is higher, and investment spending is lower.
• In Chapter 11 we looked at how saving, and thus the budget deficit, affects the level of capital accumulation and the level of output in the long run.
You saw how once capital accumulation is taken into account, a larger budget deficit, and. by implication, a lower national saving rate, decreases capital accumulation, leading to a lower level of output in the long run.
• In Chapter 17 we returned to the short-run effects of fiscal policy, taking into account not only its direct effects through taxes and government spending but also its effects on expectations.
You saw how the effects of fiscal policy depend on expectations of future fiscal policy and future monetary policy. In particular, you saw how a deficit reduction may, in some circumstances, lead to an increase in output, even in the short run.
• In Chapter 19 we looked at the effects of fiscal policy when the economy is open in the goods market.
You saw how fiscal policy affects both output and the trade balance, and examined the relation between the budget deficit and the trade deficit.You saw how fiscal policy and exchange rate adjustments can be used to affect both the level of output and its composition.
• In Chapters 20 and 21 we looked at the role of fiscal policy in an economy open in both goods markets and financial markets.
You saw how in the presence of international capital mobility, the effects of fiscal policy depend on the exchange rate regime. Fiscal policy has a much stronger effect on output under fixed exchange rates than under flexible exchange rates.
• In Chapters 22 and 23 we saw how fiscal policy might be useful to moderate the possibly severe macro- economic effects of a financial crisis, which may end up in a recession or even a depression.
• In Chapter 24 we looked at the relation between fiscal policy, money growth and inflation.
You saw how budget deficits must be financed either by borrowing or by money creation. When money creation becomes the main source of finance, the result of large budget deficits is high money growth and high inflation.
• In Chapter 25 we looked at the problems facing fiscal policy-makers, from uncertainty about the effects of policy to issues of time consistency and credibility.
You saw the pros and cons of restraints on the conduct of fiscal policy, such as a constitutional amendment to balance the budget.
FOCUS
(box
V
• In this chapter we look further at the implications of the budget constraint facing the government and discuss current issues of fiscal policy in Australia.
All variables arc in real terms:
• is government debt at the end of year ( - 1, or equivalently, at the beginning of year f; r is the real interest rate, which wc will take to be constant here. Thus, rB, , equals the real interest payments on the government debt in year I.
• G, is government spending on goods and services during year f.
• T, is taxes minus transfers during year t.
In words: The budget deficit equals spending, including interest payments on the debt, minus taxes net of transfers.
Note two characteristics of equation (27.11:
• We measure interest payments as real interest payments—that is. thc product of thc real interest rate times existing debt—rather than as actual interest payments—that is the product of the nominal interest rate times existing debt. As we show in thc focus box Inllation accounting and the measurement ol deficits', this is the correct way of measuring interest payments. Ollicial measures of the deficit, however, include actual inominal' interest payments and are therefore incorrect. When inflation is high, official measures can be seriously misleading. I he correct measure ol the dcficit is sometimes called the inflation-adjusted deficit
• For consistency with our earlier definition ot G as spending on goods and services G doesn't include transfer payments. Translcrs are instead subtracted Irom T, so that / stands lor taxes minus transfers. In some countries (Australia, tor example official measures ol government spending add transfers to spending on goods and services, and deline revenues as taxes, not taxes net of translcrs. These arc only accounting conventions. Whether translcrs arc added lo spending or subtracted Irom
taxes makes a difference to thc measurement ol G and T but clearly doesn't alfcci G - T and thus doesn't aflcct the measure of the deficit.
The government budget constraint then simply states that thc change in government debt during year I is equal to the deficit during year t.
B, - B,_, = Deficit,
It the government runs a deficit, government debt increases. It the government runs a surplus, government debt decreases.
4 Don't confuse the words deficit and debt (Many journalists and politicians do.) Debt is a stock, what the government owes as a result of past deficits. The deficit is a flow, how much the government borrows during a given year.
4 Transfer payments are government transfers to individuals, such as unemployment benefits or the youth allowance.
Using the definition of the delicit (equation [27.1]), we can rewrite the government budget con¬straint as
(27.2)
B.
B,_, - rB,_, + G, - T,
The government budget constraint links the change in government debt to thc initial level of debt (which affects interest payments) and to currcnt government spending and taxes. Il is often convenient to decompose thc delicit into the sum ot two terms:
• Interest payments on the debt, rB,_,.
• Thc difference between spending and taxes, G, - T,. This term is callcd the primary deficit i equivalcntly. Г, - G, is called the primary surplus).
Using this decomposition, we can rewrite equation (27.2! as
Interest payments
Primary delicit
Change in the debt
>C. To
Or. moving B,_| to the right and reorganising
Debt at end ol .' I - r./i, , al end of i / - I I'rimarv deficit
rH,
(27.3)
B, = ; I + r li, ., + [С. T,)
Debt at the end ol year t. В., equals (I + r) times debt at the end ol year t - I B,_,, plus the primary delicit during year f, (G, -T,). This relation will prove very useful in what follows.
INFLATION ACCOUNTING AND THE MEASUREMENT OF
Official measures of the budget deficit are constructed as (dropping the time indexes, which aren't needed here) nominal interest payments. iB, plus spending on goods and services, G, minus taxes net of transfers, T:
Official measure of the deficit = iB + G - T
This is an accurate measure of the cash flow position of the government. If it is positive, the government is spending more than it receives and must therefore issue new debt. If it is negative, the government buys back previously issued debt.
But it isn't an accurate measure of the change in real debt—that is, the change in how much the government owes, expressed in terms of goods rather than dollars.
To see why, consider the following example. Suppose that the official measure of the deficit is equal to zero, so the government neither issues nor buys back debt. Suppose that inflation is positive and equal to 10 per cent. Then, at the end of the year, the real value of the debt has decreased by 10 per cent. If we define—as we should—the deficit as the change in the real value of government debt, the government has decreased its real debt by 10 per cent over the year. In other words, it has in fact run a budget surplus equal to 10 per cent times the initial level of debt.
More generally, if В is debt and тт is inflation, the official measure of the deficit overstates the correct measure by an amount equal to ~B. Put another way, the correct measure of the deficit is obtained by subtracting -B from the official measure:
Correct measure of the deficit = iB + G -T - ~B
= (i- тг) в + G-T = rB + G-T
where г = i - тг is the real interest rate. The correct measure of the deficit is then equal to real interest payments plus government spending minus taxes net of transfers—this is the measure we have used in the text. (Note that, here, r is equal to the nominal interest rate minus actual inflation. It would be more accurate to call it the 'realised real interest rate', to distinguish it from the real interest rate, which is equal to the nominal interest rate minus expected inflation.)
The difference between the official and the correct measures of the deficit equals тт В. So, the higher the rate of inflation, тт, or the higher the level of debt. B.the more inaccurate the official measure is. In countries in which both inflation and debt are high, the official measure may record a very large budget deficit, when in fact real government debt is actually decreasing. This is why you should always do the inflation adjustment before deriving conclusions about the position of fiscal policy.
Figure I plots the official measure and the inflation-adjusted measure of the fiscal balance of the federal government and state and local governments in Australia for fiscal years 1990 to 2007. (Recall that the fiscal year runs from July I of the preceding calendar year to June 30 of the current calendar year.) There has been little difference between the two measures in Australia since 1990 because both inflation and net government debt have been low. In the early 1990s after the recession of 1990-01, net government debt rose from 10 per cent to peak at 26 per cent of GDP in 1995-96, and inflation halved. After 1996, a series of fiscal surpluses reduced net debt, thus closing the (small) gap between the two series in Figure I. In 2008. with inflation running at about 3.5 per cent a year, and the ratio of net debt to GDP actually negative at about -7 per cent of GDP. the adjusted fiscal measure is less than the standard fiscal surplus.With the government a net financial creditor, inflation reduces the real value of its net asset position. The difference between the two fiscal
Figure I Official fiscal balance and inflation-adjusted fiscal balance for Australia, 1990-2008
The fiscal balance is the Australian general government underlying cash balance. Inflation is the annual rate of growth of the GDP deflator, and this is multiplied by net government debt to make the inflation adjustment. SOURCES: Final Budget Outcome 2007-08.
measures is roughly equal to (-7% x -4%) or -0.28 per cent of GDP. Put another way, an official budget surplus of 1.74 per cent of GDP corresponds to an inflation-adjusted budget surplus of about (1.74% - 0.28%) = 1.46% of GDP.
Current versus future taxes
Let's look at thc implications of a one-year decrease in taxes lor the path of debt and future taxes. Start from a situation where, until year I the government has balanced its budget, so that initial debt is equal to zero. During year I, the government decreases taxes by I (think Si billion, lor example) for one year. Thus, debt at the end of year 1, Я,, is equal to I. Thc question we take up: What happens thereafter?
Full repayment in year 2
Suppose that the government decides to fully repay thc debt during year 2. From equation (27.3), thc budget constraint lor year 2 is given by
B2 (I + r)B, + (G2 - T2)
If debt is lully repaid during year 2, then debt at the end of year 2 is equal to zero: B2 - 0. Replacing В i by I and B2 by 0 and transposing terms gives
T2 - G2 = (1 + r)l = (1 + r)
To repay thc debt fully during year 2, the government must run a primary surplus equal to (1 + r). Il can do this in one ol two ways: a decrease in spending or an increase in taxes. We will assume here and in what follows that ihe adjustment comes through taxes, so that thc path ol spending is unallected. It follows that the decrease in taxes by 1 during year I must be olfset by an increase in taxes by (I + r) during year 2.
The path ol taxes and debt corresponding to this case is given in Figure 27.1, panel (a). If debt is 4 Full repayment in year 2: fully repaid during year 2, the decrease in taxes ol I in year I requires an increase in taxes equal to T■ 1 by 1 T2 1 эу
-S
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
(I + r) in year 2. (1 + ')•
(a) Debt reimbursement in year 2
Year 0 12 3 4 5
Taxes 0 -1 (1+r) 0 0 0
End-of-year debt 0 + 1 4 0 0 + 0 Ф 0
(b) Debt reimbursement in year 5
Year 0 1 2 3 4 5
Taxes 0 -1 0 0 0 (1 + r)*
******
End-of-year debt 0 + 1 + (1+r) + 1 + r)2 +(1+r)3 + 0
(c) Debt stabilisation in year 2 Year 0 1 2 3 4 5
Taxes 0 -1
-l r r r r
******
0 +1*1+1+1 +1
End-of-year debt
Full repayment in year t
(a) If debt is fully repaid during year 2, the decrease in taxes of 7 in year 1 requires an increase in taxes equal to (1 + r) in year 2. (Ы If debt is fully repaid during year 5. the decrease in taxes of 7 in year 7 requires an increase in taxes equal to (1 + r)4 in year 5. (c) If debt is stabilised from year 2 on, then taxes must be permanently higher by r from year 2 on.
Full repayment in year t
Now suppose that the government decides to wail until year / to repay thc debt. So, Irom year 2 to year t- 1 the primary deficit is equal to zero—taxes are equal to spending, not including interest payments on the debt.
During year 2, thc primary delicit is zero. So, from equation 127.3.1, debt at the end of year 2 is
B2 - (1 + r)B, + 0 - (I + r)l - (I + r)
where the second equality uses the fact that B, = 1.
With the primary deficit still equal to zero during year 3 debt at thc end of year 3 is
В, = (I + r)B2 + 0 = (I + r)(l + r)l = (1 + r)1
Solving lor debt at the end of year 4 and so on. il is clear that, as long as the government keeps a primary deficit equal to zero, debt grows at a rate equal to the interest rate, and thus debt at the end ol year t - I is given by
8,., = (I + r)M (27.4)
Figure 27.1 Tax cuts, debt repayment and debt stabilisation
Despite the lact that taxes are cut only in year I, debt keeps increasing over time, at a rate equal to thc interest rate. The reason is simple-, while the primary deficit is equal to zero, debt is now positive, and so are interest payments on the debt. Facli year, the government must issue more debt to pay the interest on existing debt.
In year /. ihe year in which the government decides to repav the deht, thc budget constraint is
В, ш (I + r)B,_, + (G, - T,)
II debt is fully repaid during year I then B, (debt ai the end of year t) is zero. Replacing B, by zero, and H, | by its expression from equation (27.4), gives
0 = (I + r)(l + гУ'2 + (G, - Г,)
Reorganising and bringing G. - T, to thc left implies
T, - G, = (1 + r)' 1
To repay the debt, the government must run a primary surplus equal lo (1 • r*'"1 during year I. If ihe adjustment is done through taxes the initial decrease in taxes of I during year I leads to an increase in taxes of I + r : 1 during year I. Thc path of taxes and debt corresponding to ihe case where debt is repaid in year 5 is given in Figure 27.1, panel (b This example yields our lirsi set of conclusions:
• If government spending is unchanged a decrease in taxes must eventually he offset by an increase in laxes in the future.
• The longer the government waits to increase laxes or the higher the real interest rate, the higher the eventual increase in taxes.
Debt stabilisation in year t
We have assumed so far that the government lully repays the debt. Lei's now look at what happens to taxes if the government only stabilises thc debt. (Stabilising the debt means changing taxes or spending so that debt remains constant.1
Suppose lhat the government decides to stabilise thc debt from year 2 on. Stabilising thc debt from year 2 on means that ihe debt at the end ol year 2 and thereafter remains at the same level as ai the end of year I.
From equation (27.3), the budget constraint lor year 2 is
B2 - 1 I + r)B, + (Gj - T2)
Llnder our assumption that debt is stabilised in year 2, B2 = В, - I. Replacing in thc preceding equation:
1 = (1 . r) + (C2 - Tj)
Reorganising, and bringing (G2 - T2) to the left side:
T2 - G2 = (1 + r) - I = r
To avoid a further increase in debt during year 1. thc government must run a primary surplus equal to real interest payments on the existing debt. It must do so in following years as well. Each year, the primary surplus must be sufficient to cover interest payments, leaving the debt level unchanged. The path of laxes and debt is shown in Figure 27.1, panel (ch debt remains equal to 1 Irom year 1 on. Taxes are permanently higher from year I on by an amount equal to r. equivalently, from year I on. thc government runs a primary surplus equal to r.
The logic of this argument extends directly lo the case where the government waits until year f to stabilise. Whenever thc government stabilises, it must Irom then on run a primary surplus sufficient to pay interest on the debt.
This example yields our second set of conclusions:
4 Add exponents: (1 + r)(1 + ry 2 = (1 + г)"
See Appendix 2 at the end of this book.
4 Full repayment in year S:
Г, I by 1 = T5 T by (1 + r)\
4 Stabilising the debt from year 2 on:
r,iby1^Tj.T,...t byr.
• The legacy of past deficits is higher government debt.
• То stabilise the debt, the government must eliminate the deficit.
• To eliminate thc delicit, thc government must run a primary surplus equal to the interest payments on the existing debt.
The evolution of the debt-to-GDP ratio
We have focused so far on the evolution ol the level ol debt. But in an economy in which output grows over time, it makes more sense to focus instead on thc ratio of debt to output. To see how this change in focus modifies our conclusions, we need to go from equation (27.3) to an equation that gives the evolution of thc debt-to-GDP ratio—the debt ratio, lor short.
The arithmetic of the debt ratio
To derive the evolution of thc debt ratio takes a lew steps. Don't worry: the linal equation is easy to understand.
First divide both sides of equation '27.3 by real output, V,, to get
B, (1 + r)B,_, (G,-T,)
V,
Next rewrite B,_|/Y,r as (B(/Y,_,'II Y_,/Y,) (in other words, multiply the numerator and the denomi¬nator by Y,_ |):
(G, - T.)
v,., \B,_
B,
у, У,-
y,
To simplify this equation, assume that output growth is constant and denote the growth rate ol output by g, so V, ,/Y( can be written as 1/(1 + g). And use the approximation I ■ r)/( I ■ = I + r - g Using these two assumptions, rewrite the preceding equation as
(G, - Tt)
IIl
y,
JV Yt-
* £r-g)
(27.5)
y,
Finally, reorganise to get
;G, - T,I
У,
If wo variables (here debt and GDP) grow at rates r and g ^ respectively, then their ratio (here the ratio of debt to GDP) will grow at rate (r - g). See proposition 8 in Appendix 2 at the end of this book.
Y,
It look a few steps, but this final relation has a simple interpretation. The change in the debt ratio over time 1 thc left side of the equation) is equal to the sum of two terms:
• The first term is the difference between the real interest rate and the growth rate times the initial debt ratio.
• The second term is the ratio ol thc primary delicit to GDP.
Compare equation (27.5), which gives the evolution of the ratio of debt to GDP, with equation (27,2), which gives thc evolution of the level ol debt itself. The difference is the presence of r-g) in equation (27.5) compared with r in equation 27.2). The reason for the dillerence is simple. Suppose the primary deficit is zero. Debt will then increase at a rate equal to the real interest rate, r. But if GDP is growing as well, the ratio ot debt to GDP will grow more slowly,- it will grow at a rate equal to thc real interest rate minus the growth rate ol output, i r - g).
Thc evolution of the debt ratio in OECD countries
Equation '27.5 implies that the increase in the ratio of debt to CDP will be larger:
• the higher the real interest rate
Start from ►
Divide both sides by Г.; so. 1 = (1 + j>yH/V,. Reorganise to get:
Wr,= 1/(1+*)•
This approximation is derived as proposition 6 in Appendix 2 at the end of this book.
ML У,
ELL у,,
(i
-.4)
• the lower the growth rate ol output
• the higher the initial dcbl ratio
• the higher thc ratio ol thc primary dcficit to GDP.
This list provides a useful guide lo the evolution ol the debt-to-GDP ratio over the last lour decades in the OF.CI) countries.
• The I'161 Is was a decade of strong growth, so strong thai thc average growth rate exceeded the average real interest rate in most countries. As a result, > r- g) was negative, and most countries were able to decrease their debt ratios without having to run large primary surpluses.
• Thc 1970s was a period ol lower growth, but ol very low real interest rates. Nominal interest rates were high, but expected inflation was high as well T hus, (r-g) was again negative on average, and thc result was a further decrease in thc dcbl ratio in most OECD countries.
• The situation changed dramatically in the early 1980s. Real interest rates increased at the same time as growth rates decreased. To avoid an increase in their debt ratios, OECD countries would have had to run large primary surpluses. I hey didn't, and their debt ratios increased rapidly.
• In the 1990s real interest rates remained high and growth rates remained low. It became increasingly dear thai most countries had no alternative to stabilising their dcbl ratios other than to run larger primary surpluses. Most OEC.D countries have now done so. At the end of the 1990s, most countries were running a primary surplus sufficient to imply a steady decline in their debt ratios.
• In the first eight years of the twenty lirst century, real interest rates and growth rates were low. For ihe OECI) overall, thc primary fiscal position has turned into deficit—driven mainly by thc United States and Japan—as a response lo thc low growth rates. This means thai dcbl ratios have been increasing rising tor the whole OECD from 39 per cent in 2000 to 42 per cent by thc end ol 2008).
chapter 27
The OECD includes most of the rich countries in the world. (See Chapter I for a 4 description and a list of countries.)
4 1960s: high g. low r => BIY I.
4 1970s: lower g. very low
r => В/У i.
4 1980s: low g. high г =з в/У t.
4 1990s: low g. high r. primary surplus > 0 8/У ->.
4 2000s: low g. low r. primary surplus < 0 =»
В/У T.
For more on the reduction of deficits in Australia and the United States, see Chapter 25. For more on the evolution of deficits and debt in Europe since the early 1990s, see the focus box 'The Growth and Stability Pact h Europe: A short history' in Chapter 25. For more on the expanding fiscal deficit in Japan, see 4 Chapter 23.
Tabic 27.1 gives ihe evolution of net debt ratios lor Australia, thc United States, thc euro area. Japan and the whole OECD from 1990 to 2008. Thc lirst thing to note is lhal Australia's dcbl ratio has shrunk rapidly and was much lower than in the other countries in 2008. This suggests thai Australia is in a strong fiscal position, and there is no economic constraint inhibiting iis use of fiscal policy lor short- run stabilisation purposes. I lowever, later in the chaptcr wc will discuss why there needs lo be a long- run trend of an improving debt ratio. Note how high the debt ratio was in thc United States, thc euro area and particularly Japan ;n 2008. Japan saw its debt ratio lall dramatically between the 1980s and thc 1990s (even reaching 13 per cent in 1991 i. A long sequence ol primary surpluses (perhaps too long) preceded the deflation malaise thai eventually set in later in the 1990s. By 1994 the primary surpluses were reversed, but perhaps too late. The dcbl ratio climbed to 87 per cent in 2008, but Japan hadn't really shaken off its liquidity trap problem.
Table 27.1 Government debt and fiscal surplus for Australia, the United States, the euro area, Japan and the OECD, 1990-2008 (% of GDP)
Net debt/GDP Primary surplus/GDP
Country 1990 1995 2008 1990 1995 2008
Australia 10 26 -7 1.5 0.0 2.4
United States 45 54 48 -0.8 0.4 -3.3
Euro area 36 46.5 43 -0.1 -0.2 1.4
Japan 14 24 87 3.3 -3.8 -0.5
OECD 32 42.3 42 0.2 -0.6 -0.8
SOURCE OECD Economic Outlook. Tables 29.33.
27.2 FOUR ISSUES IN FISCAL POLICY
I laving looked at thc mechanics ol the government budget constraint, we can now take up tour issues in which this constraint plays a central role.
Ricardian equivalence
I low does taking into account the government budget constraint allect the way we should think of the effects of delicits on output?
One extreme view is that once thc government budget constraint is taken into account neither deficit nor debt has an effect on economic activity! This argument is known as the Ricardian equivalence proposition. David Ricardo, a nineteenth-century F.nglish economist was the lirst to articulate its logic His argument was lurther developed and given prominence in the 1970s by Robert Barro then at the University ol Chicago, now at I larvard Llniversity. For this reason, the argument is also known as the Ricardo-Barro proposition.
The best way to understand the logic ol the proposition is to use the example of tax changes from Scction 27. I:
• Suppose that the government decreases taxes by I iagain, think $1 billion) this year. And as it docs so, it announces that to repay the debt it will increase taxes by 11 + r) next year. What will be the effcct ol the initial tax cut on consumption?
• One answer is No effect at all . Why? Because consumers realise that the tax cut is not much ol a gill. Lower taxes this year are exactly offset, in present value, by higher taxes next year. Put another way, their human wealth—the present value ol after-tax labour incomc—is unaffected. Current taxes go down by I hut the present value of next year's taxes goes up hy (I + r)/( I + r) = I, and the net effcct of the two changes is exactly equal to zero.
• Another way ol coming to the same answer, this time looking at saving rather than consumption: To say that consumers don't change consumption in response to thc tax cut is the same as saying lhat private saving increases one-for-one with lhe deficit. So, the Ricardian equivalence proposition says that, if a government finances a given path ol spending through delicits. private saving will increase one-for-one with the decrease in public saving, leaving total saving unchanged. The lotal amount lelt lor investment won't be allcclcd. Over time, the mechanics of the government budget constraint imply that government debt will increase. But this increase won't come at thc expense of capital accumulation.
Llnder the Ricardian equivalence proposition, the long sequence ol delicits and the increase in government debt thai characterised the OFCD lor most ol lhe last twenty years are no cause for worry. As governments were dissaving, the argument goes, people were saving more in anticipation of the higher taxes lo come. The decrease in public saving was offset by an equal increase in private saving. Total saving was therefore unaffected, and so was investment. OFCD economies have the same capital stock today that they would have had il there had been no increase in debt. High debt is no cause for concern.
I low seriously should you take thc Ricardian equivalence proposition? Most economists would answer Seriously, hut not seriously enough to think that deficits and debt are irrelevant'. A major theme ol this book has been that expectations matter, that consumption decisions depend not only on current income but also on future income. II il were widely believed thai a tax cut this year is going lo he followed by an offsetting increase in taxes next year, the effect on consumption would probably be small. Many consumers would save most or all of thc tax cut in anticipation ol higher taxes next year. (Replace 'year' by month or week and the argument becomes even more convincing.)
While Ricardo stated the logic of the argument, he also * argued that there were many reasons why it wouldn't hold in practice. In contrast, Barro argues that the argument isn't only logically correct: it is a good description of reality.
Sec Chapter 16 for a ► definition of human wealth and a discussion of its role in consumption.
Of course, tax cuts rarely come with thc announcement of corresponding tax increases a year later. Consumers have to guess when and how taxes will eventually be increased. This lact docsn'i by itself invalidate the Ricardian equivalence argument. No matter when taxes will be increased the government budget constraint still implies that the present value of future tax increases must always be equal to the decrease in taxes today. Take ihe second example wc looked at in Section 27.1—drawn in Figure 27.1,
panel (b)—in which thc government waits I years to increase taxes, and so increases taxes by 1 I + r!' '. The present value in year 0 of ihis expected lax increase is (I + r)'_l/( I + r)' 1 - I—exactly equal to thc original lax cut. Thc change in human wealth Irom the tax cut is still zero.
But in so lar as future tax increases appear more distant and their timing more uncertain, consumers are in lact more likely to ignore them, Phis may be the case because they expect to die before taxes go up, or, more likely, because they just don't ihink thai lar into the Itiuirc. In either case, Ricardian equivalence is likely to fail.
4 Note the analogy with monetary policy: the fact that higher money growth leads in the long run to more inflation doesn't imply that higher money growth (or lower interest rates) should never be used for output stabilisation.
4 Ignore output growth in this section, and so ignore the distinction between stabilising the debt and stabilising the debt-to-GDP ratio. (Verify that the arguments here extend to the case where output is growing.)
So. it is sale to conclude thai budget deficits have an important ellect on activity, although perhaps a smaller effect than we thought before going through the Ricardian equivalence argument. In thc short ain, larger dclicits are likely to lead to higher demand and to higher output. In the long ain, higher government debt lowers capital accumulation and as a result lowers output.
Deficits, output stabilisation and the cyclically adjusted deficit
The fact that budget deficits have long-run adverse cffccts on capital accumulation and, in turn, on output doesn't imply that fiscal policy shouldn't be used to reduce output fluctuations. Rather, il implies that deficits during recessions should be offset by surpluses during booms, so as nol to lead to a steady increase in debt.
To help assess whether liscal policy is on track, economists have constructed delicit measures that tell them what the deficit would be, under existing tax and spending rules, il output were at the natural level ot output. Such measures come under many names, from lull-employment deficit to mid-cycle deficit, to standardised employment dcficit to structural dcficit the term used by the OECD). We will use cyclically adjusted dcficit the term we lintl the most intuitive.
Such a measure gives a simple benchmark by which to judge the direction of liscal policy. It thc actual delicit is large but ihe cyclically adjusted delicit is zero, then current fiscal policy is consistent with no systematic increase in debt over time. Debt will increase as long as output is below the natural level of output; but as output returns to its natural level the deficit will disappear and the debt will stabilise.
Il doesn't tollow that the goal of liscal policy should be to maintain a cyclically adjusted deticil equal lo zero ai all limes. In a recession, ihe government may want lo run a delicit large enough that even the cyclically adjusted deficit is positive. In thai case the lact lhat the cyclically adjusted deficit is positive- provides a useful warning: that the return of output to its natural level won't he enough lo stabilise thc debt. The government will have to lake specific measures, from tax increases to cuts in spending, lo decrease thc deficit at some point in ihe future.
Thc theory underlying the cyclically adjusted deficit is simple. The practice has proven iricky. To see why, we need to look at how measures ot the cyclically adjusted deficit are constructed. Construction requires two steps, l irsi establish how much lower thc dcficit would be il output were say. I per cent higher. Second assess how tar output is from its natural level.
• The first step is straightforward. A reliable ailc ot thumb in Australia is that a I per cent decrease in output leads automatically to an increase in the delicit ol 0.3 per cent of C.DP, This increase occurs because most taxes arc proportional to output, while most government spending doesn't depend on thc level of output, l hat means that a decrease in output, which leads to a decrease in revenues and not much change in spending, naturally leads to a larger dcficit.
If output is, say, 5 per cent below its natural level, the delicit as a ratio to GDP will therefore be about 1.5 per cent larger than it would be if output were at ihe natural level of output. This cflecl of activity on the delicit has been called an automatic stabiliser. A recession naturally generates a deficit, and therefore a fiscal expansion, which partly counteracts thc recession.)
4 The increase in taxes in t years is (1 + г)и. The discount factor for a dollar t years from now is 1/(1 + r)b1. So. the value of the increase in taxes t years from now as of today is (1 +г)'-'/(1 +r)M = 1.
• The second step is more dilficult. Recall from Chapter 6 that the natural level ot output is ihe output level lhat would be achieved il ihe economy were operating at the natural rate ol unemployment. Too low an estimate of thc natural rate ot unemployment will lead to too high an estimate of thc natural level ol output, therefore to too optimistic a measure ol the cyclically adjusted deficit.
This difficulty explains in part what happened in Europe in the 1980s. Based on the assumption of an unchanged natural unemployment rate, the cyclically adjusted deficits of thc 1980s didn t look that had. II European unemployment had returned to its level of the 1970s, the associated increase in output would have been sufficient to re-establish budget balance in most countries. But. il turned out, much ol the increase in unemployment reflected an increase in the natural unemployment rale, and unemploy¬ment remained very high during the 1980s. As a result, the decade was characterised hy high deficits and a large increase in debt-to-GDP ratios.
Wars and deficits
Wars typically bring about large budget delicits. As you saw in Chapter 25. the two largest increases in Australian government debt in the twentieth century were during the two world wars. We examine the case of the Llnited States in World War II in the locus box Deficits, consumption and investment in the United Slates during World War 1Г.
Is it right lor governments to rely so much on deficits to linance wars? After all, war economies are usually operating at low unemployment, so the output stabilisation reasons for running delicits examined earlier are irrelevant. The answer, nevertheless, is yes'. In fact, there are two good reasons to run delicits during wars:
• The lirst is distributional. Delicil finance is a way to pass some of the burden ol lhe war to those alive alter the war and it seems only fair tor future generations to share in the sacrifices the war requires.
Assume that the cconomy is closed, so that У = С + / + G. Suppose that G goes up and Y remains the same. Then. С + I must go down. If taxes aren't increased, most of the decrease comes from a decrease in I (through ► higher interest rates). If taxes are increased, most of the decrease comes from a decrease in C.
See the focus box 'German unification and the German monetary-fiscal tug of war' in Chapter 5. ►
• The second is more narrowly economic. Deficit spending helps to reduce lax distortions. Lets look at each reason in turn.
Passing on the burden of lhe war
Wars lead to large increases in government spending. Consider the implications ol financing this increased spending either through increased taxes or through debt. To distinguish this case Irom our earlier discussion ol output stabilisation, let s also assume that output is fixed at the natural level ol output.
• Suppose that the government relics on delicil linance. With government spending sharply up, there will be a very' large increase in thc demand tor goods. Given our assumption that output stays the same, thc interest rate will have to increase enough to maintain equilibrium. Investment, which depends on lhe interest rate, will decrease sharply.
• Suppose, instead, that the government finances the spending increase through an increase in taxes— sav ncome taxes. Consumption will decline sharply. Exactly how much depends on consumers' expectations. Thc longer they expect ihe war to last, the longer ihev will expect higher taxes to last, and the more ihev will decrease consumption. In any case the increase in government spending will be partly offset by a decrease in consumption. Interest rales will increase by less than they would have increased under delicit spending. Investment will decrease by less.
In short, lor a given output, the increase in government spending requires either a decrease in consumption or a decrease in investment. Whether the government relies on tax increases or deficits determines whether consumption or investment does more of the adjustment when government spending goes up.
I low does all this allcct who bears the burden ot the war? The more the government relies on deficits, the smaller the decrease in consumption during the war and the larger the decrease in investment. Lower investment means a lower capital slock alter the war, and so lower output alter the war. By reducing capital accumulation, deficits become a way ol passing some of the burden of the war on to future generations.
Reducing tax distortions
Look at our earlier ► discussion of the evolution of thc debt ratio in the OECD.
Return to the discussion ► of high European unemployment in Chapters 1.9 and 13.
Look at the two peaks ► associated with World War I and World War II in Figure 25.3.
There is another argument tor running deficits, not only during wars but, more generally in times when government spending is exceptionally high. Think, for example, ol reconstruction alter an earthquake or thc costs involved in the reunilication ol Germany in thc early 1990s.
DEFICITS, CONSUMPTION AND INVESTMENT IN THE UNITED STATES DURING WORLD WAR II
In 1939 the share of US government spending on goods and services in GDP was 15 per cent. By 1944 it was 45 per cent! The increase was due to increased spending on national defence, which went from I per cent of GDP in 1939 to 36 per cent in 1944.
Faced with such a massive increase in spending, the US government reacted with large tax increases. For the first time in US history, the individual income tax became a major source of revenues: individual income tax revenues, which were I per cent of GDP in 1939, increased to 8.5 per cent in 1944. But the tax increases were still far less than the increase in expenditures. The increase in federal revenues, from 7.2 per cent of GDP in 1939 to 22.7 per cent in 1944, was only a little more than half the increase in expenditures.
The result was a sequence of large budget deficits. By 1944 the federal deficit had reached 22 per cent of GDP.The ratio of debt to GDP, already high at 53 per cent in 1939 because of the deficits the government had run during the Great Depression, was 110 per cent!
Was the increase in government spending achieved at the expense of consumption or private investment? (As you saw in Chapter 18, it could in principle have come from higher imports and a current account deficit. But the United States had nobody to borrow from during the war. Rather, it was lending to some of its allies: transfers from the US government to foreign countries were 6 per cent of US GDP in 1944.)
The answer: The increase in government spending was achieved by a decrease in both consumption and private investment.The share of consumption in GDP decreased by 23 per cent, from 74 per cent to 51 per cent. Part of the decrease in consumption may have been due to anticipations of higher taxes after the war: part was also the result of the unavailability of many consumer durables; and patriotism probably also played a role in leading people to save more and buy the war bonds issued by the government to finance the war. But the increase in government purchases was also met by a 6 per cent decrease in the share of (private) investment in GDP—from 10 per cent to 4 per cent. Part of the burden of the war was therefore passed on in the form of lower capital accumulation to those living after the war.
The argument is as follows: II the government were to increase taxes to finance the increase in spending, lax rates would have to be very high. Very high tax rates can lead to very high economic distortions. Paced with very high income tax rates, people work less or engage in illegal, untaxed activities. Rather than moving thc tax rate up and down to maintain a balanced budget, it is better (Irom thc point ol view of reducing distortions) to maintain a relatively constant tax rate, to smooth laxes. Tax smoothing implies running large deficits when government spending is exceptionally high and small surpluses the rest of the time.
The dangers of very high debt
You have now seen two costs of high government debt—lower capital accumulation, and higher tax rates and higher distortions. The recent experience of several countries with high debt ratios points to yel another cost. High debt can lead to vicious cycles and make thc conduct of liscal policy extremely difficult.
To see why this is so, return to equation (27.5), which gave the evolution ol thc debt ratio:
B, B,_, . .B,., (G, - Г,)
Xt 'Ы «М '!
BOX
!
Гаке a country with a high debt ratio—say, 100 per ccnt. Suppose thc real interest rate is 3 per cent and the growth rate is 2 per ccnt. The first term on the right is (3% - 2%) x 100% = 1% ot GDP. Suppose, further, that thc government is running a primary surplus of I per cent, thus just enough to keep the debt ratio constant. (The entire right side of the equation equals 1% + (-1%) = 0%.)
Now suppose lhat financial investors start requiring a higher interest rate to hold government bonds. This higher interest rate may come from the lact that investors worry lhat thc government wont be able to keep the deficit under control, and so may not he able to repay the bonds in the future. The specific reason doesn't matter here. lor concretencss suppose that the domestic real interest rate increases from 3 per cent to, say. 12 per cent
Now assess thc fiscal situation: i r g) is now 12% 2% = 10%. With the increase in (r g) from I per cent to 10 per cent, the government must increase its primary surplus from I per cent lo Id per cent ol GDP just lo keep the debt-to-GDP ratio constant. I bis opens ihe scope lor potential vicious cycles.
Suppose thai the government lakes steps to avoid an increase in the debt ratio. The spending cuts or tax increases are likely to prove politically costlv. generating even more political uncertainty and the need lor an even higher interest rate. Also, the sharp fiscal contraction is likely to lead to a recession, decreasing the growth rate. Thc increase in the real interest rate and the decrease in growth further increase (r- g), making it even harder to stabilise thc debt ratio
Alternatively, suppose that thc government proves unable or unwilling to increase the primary budget surplus by 9 per cent ol GDP. Debt then starts increasing, leading linanciai markets to become even more worried and require an even higher interest rate. I he higher interest rate leads to even larger delicits, an even taster increase in the debt ratio, and so on. At some point the government has no other See the focus box on» option than lo delaull.
Argentina in Chapter 21. |n sh(m t|le |,^|1ег t|u. ralio ()f
If this reminds you of our discussion of exchange rate crises and the possibility of self-fulfilling crises, Exchange rate crises► you arc right. Very much the same mechanisms are at work. Expectations that a problem may arise lead were studied in to the emergence ot the problem validating initial expectations. Indeed in some crises both mechanisms Chapter 21. are at work. In the Brazilian crisis of 1998, tears of a devaluation of the real (the Brazilian currency) forced Brazil to increase interest rates to very high levels. These high interest rates led to much larger budget delicits, raising questions about whether the Brazilian government could repav its debt further increasing interest rates. Eventually, Brazil had no choice but to devalue. It did so in early 1999.
It a government decides that its debt ratio is too high, how and how last should it reduce il? Answer: Through many years, even many decades, ol surpluses. \ historical reference here is that of I ngland in the nineteenth century. By the end of its wars against Napoleon in the early 1800s, England had mn up a debt ratio in excess of 200 percent ol GDP. It spent most ol the nineteenth century reducing the ratio, so that by 1900 the ratio stood at only 30 per cent ot GDP.
The prospect ol many decades ol liscal austerity is unpleasant. Thus when debt ratios are very high, an alternative solution keeps coming up—debt repudiation. The argument is simple: Repudiating the debt—cancelling it in pari or in lull- is good for lhe economy. It allows tor a decrease in laxes and thus a decrease in distortions. It decreases the risk ot vicious cycles The problem with this argument is the problem ol lime inconsistency discussed in Chaptcr 25. II the government reneges on its promises to repay its debt, it may have great difficulty trying to borrow again lor a long time in lhe luture,- financial markets will remember what happened and be reluctant if) lend again. After the Russian Revolution in 1917, thc new Russian government repudiated the international debt thai the overthrown government had built up. Though this made it much easier for the new government to manage thc distressed economy, it took many decades belore lending resumed. What seems best today may be unappealing in thc long run. Debt repudiation is very much a last resort to be used when everything else has tailed.
27.3 THE AUSTRALIAN GOVERNMENT BUDGET
We conclude this chapter by looking at the Australian government budget. Table 27.2 gives the basic budget numbers tor fiscal year 2007-08.
Table 27.2 The consolidated Australian government budget, fiscal year 2007-08 (% of GDP)
REVENUES
Personal income tax 10.5
Medicare 0.7
Corporate taxes 5.7
Other taxes and revenues 5.2
GST 3.9
Other state/local revenues 9.4
TOTAL REVENUES (1) 35.5
EXPENDITURE
Social security and welfare 8.7
Health 3.9
Defence 1.6
Education 1.6
Other federal expenditure 4.2
Other state/local expenditures 12.9
TOTAL EXPENDITURES (2) 32.9
PRIMARY BALANCE = (1) - (2) = (3) 2.6
Net interest income (4) -0.5
OFFICIAL NET OPERATING BALANCE = (3) - (4) = (5) 2.1
Net investment expenditures (6)
FISCAL BALANCE = (5) - (6) = (7) 1.7
Inflation component of net debt (8) =02
INFLATION-ADJUSTED FISCAL BALANCE = (7) + (8) 1.5
Memo items
Net debt-to-GDP ratio Net worth-to-GDP ratio -6.8 71.5
Nominal GDP A$ billion 1129
SOURCES: Australian government budget 2007-08 and'Final budget outcome 2007 08' (www.budget.gov.au).
You may notice that some oi thc numbers aren't thc same as the numbers you have read in the press. The reason is that there are many different definitions of expenditures, revenues and dcficit.
Sometimes, numbers refer to the budget of the Commonwealth federal government only. Some¬times, numbers consolidate thc accounts ol the lederal government and state and local governments. State and local government budgets typically arc close to being in balance. In fiscal year 2007-08, thc combined liscal surplus of state and local governments was about 1.7 per ccnt ot GDI'. Revenues and expenditures were about 35 and 33 per cent of GDP respectively. In thc liscal accounts, there exist two sets of numbers:
• Cash flow measures. These capture all transactions when actual money payments are received or made, and thc underlying net cash balance is the difference. These measures provide important information tor the government in managing its own financial affairs, but they are of less interest to an economist. In 2007-08, the net cash balancc for thc Australian government was 1.3 per cent of GDP.
• An alternative—but not totally dilfcrent—set of numbers are based on accrual measures. These capture all transactions that have occurred during thc period—the liscal year, or perhaps a quarter—
regardless of whether cash payment has been received or made during the period. They would include, for example, taxes that arc due in a fiscal year but not yet paid at the end ol that year. The numbers in Table 27.2 are all accrual numbers. Thc difference between all accrual revenues and expenditures is the fiscal balance. In 2007-08 the liscal balance tor the Australian government was 1.7 per cent of CDP. This number includes net interest payments on government debt and net investment spending by thc government.
To an economist, the fiscal balance is more relevant than the cash balance because it measures the public sectors saving-investment balance. As you saw in equation (27.2). when the government runs a surplus in its liscal balance it reduces its net debt. When it runs a delicit, it increases its net debt.
Net government debt, or, equivalently, net debt held by the private sector, measures all types ol government bonds and loans less any linanciai assets. At the end of fiscal year 2007-08, net debt across the public sector as measured by thc ABS was -0.8 per cent ol CDP in Australia, while the value in 1994-95 was I 8 per cent. Why has net debt fallen so much in the last ten years? There are two reasons:
• The Australian government has run a series ol large fiscal surpluses.
• Many nationally owned assets have been privatised, yielding hinds that have been used in part to retire government debt I most notably the partial sale of Telstra in 1999-2000 for about $ 17 billion >. Thus, even though the net wealth position ol thc government is unchanged—thc reduction in government-owned assets is exactly equal to the reduction in government liabilities—the reduction in the net debt figure makes it appear that the government has been more frugal.
F.conomists are sometimes interested in changes in thc net worth—the economic measure of wealth—of the government, and then the liscal balance can be misleading, for two reasons:
• If the government has been selling public assets during thc period, the fiscal balance will overstate thc true frugality of the government because it includes these sale revenues. These asset sales bring in revenues now, but reduce revenues in the future (as the government no longer receives revenues for these assets . So, net worth shouldn t change.
• Also, the liscal balance counts all investment expenditures, including investment purchases (such as buildings, but not defence weapons such as aircralt carriers). However, lor understanding net worth, we should measure current expenditures rather than capital expenditures, and thus exclude new investment purchases but include depreciation on existing government-owned capital. New capital goods may have been funded, say, by issuing debt, and so net worth doesn't change from this capital accumulation.
A third balance avoids these two problems—the net operating balance. It excludes privatisation proceeds and only includes the current consumption (or depreciation) ol the government's fixed assets. If the net operating balance is in surplus, thc government's net worth increases as a result ol its current activities. It it is in delicit, net worth decreases. In 2007-08 in Australia, the net operating balance was 2.1 percent.
Net worth of the public sector takes into account all assets and liabilities, and is a better measure ol the government's contribution to the wealth of Australia. Net worth nets out the asset-liability ellects ol privatisations. It also includes major items such as the government's accrued superannuation liabilities to its employees, and its land assets. Thc Australian public sector (including the federal government and state and local governments) had a net worth in 2007-08 equal to about 71 per ccnt of GDP. Lip until 2004, the federal government had a negative net worth, while the state and local governments have- always had a positive net worth. Due to the build-up of the Future Fund the federal government now has positive net worth ol 71 per cent of GDP. Thc states have much higher net worth because the federal government provides significant funds to thc states for capital works (such as roads and utilities).
Now look at some of the detail in Table 27.2.
When presenting the budget for the year, a treasurer may focus the public's attention on у either the net cash balance or the fiscal balance, depending on which suits the government's political purpose.An economist is primarily interested in the fiscal balance.
You saw an example of ►
the relevance of this issue in the Chapter 5 focus box 'Deficit reduction: Good or bad for investment?'.
БАСК TO POLICY chaptcr 27
• In 2007 08, Australian consolidated government revenues excluding interest income were about 35 per cent of GDP. The lederal government's taxes on individuals yielded almost one-third of all revenue raised. The GST, introduced in 2000, now yields over 11 per cent ol all revenue, and all ol it is allocated by a (somewhat contentious) formula to the states. The states and local governments
themselves raise over one-quarter of all revenues themselves—for example through stamp duties, rates, land taxes and fines.
• Expenditures excluding interest payments were about 33 per cent of GDP. In the budget, transfers are included as expenditures, though ideally they should be subtracted Irom tax revenues. The social security budget is the biggest expenditure item (almost 9 per ccnt of GDP), followed by health
about 4 per cent), defence and education (each just under 2 per ccnt).
• The primary fiscal balance is thc difference between all revenues and expenditures excluding net interest payments. In 2007-08 it registered a surplus of 2.6 per ccnt of GDP.
• Adding net interest income to that gives a net operating balancc of 2.1 per cent of GDP. This surplus contributed to the public sector's net worth increasing over the year to 71.5 per cent of GDP.
• Subtracting net investment expenditures, which include the effects of asset sales and Future Fund injections, gives thc liscal balancc equal to 1.7 per cent of GDP. As you saw in the focus box Inflation accounting and the measurement ol deficits', we should adjust the fiscal balance tor thc clfects ol inllation on thc net consolidated dcbl ol Australian governments—with negative net debt (-6.8 per ccnt of GDP) , the adjusted fiscal balancc was 1.3 per cent.
Thc basic conclusion we can make about the current liscal state ol alfairs in Australia is that, by any measure, fiscal policy has been quite tight.
Will the Australian government continue to run these small surpluses in the luture? In late 2008 a number ol factors have led to a more pessimistic budget outlook:
• First, thc slowdown in commodity priccs will lead to a fall in corporate tax revenues Irom firms associated with commodity producers.
• Second, and more importantly, the global financial crisis in 2008 led to collapsing stock markets and a cessation of new bank lending. The Rudd government declared that thc past fiscal surpluses were appropriate lor building up the governments net worth in good times. Given thc serious threat to global and thus Australan economic activity as a result of the linancial crisis, the government has declared its intention to relax fiscal policy.
In its 2003-04 budget plans, the previous Australian government adopted a medium-term fiscal strategy to balancc the budget, on average, over thc course ol the business cycle. With this in mind, the government forecasted an unchanged small fiscal surplus beginning with 2005-06 lor the next ten years. Most economists would agree with thc Rudd government's decision to changc that plan in response to the 2008 crisis. But lhat should be a relatively short-term change (assuming that thc measures adopted globally work to fix thc crisis).
In the longer term, many economists believe that larger surpluses are desirable. Why is thai? Beyond 2015 thc fiscal balance will move into dclicit, getting worse and worse over the next twenty-five years. Economists who favour large surpluses rely on two separate arguments:
• Thc Australian saving rale is still very low and should be increased. This is showing up as large and growing current account deficits. One way to increase domestic saving is lo increase public saving— equivalently, run larger budget surpluses.
• Looking lar into the future, changcs in demographics imply large increases in spending in several government programs, increases that the government should start responding to now, by raising revenues and running budget surpluses.
Let us discuss thc two arguments in turn. Surpluses and the low Australian saving rate
Over the lasi twenty years, the average Australian national saving rale (20 per cent) has been iust below For the effects 0f tt,e the average ol OECD countries 12 I per ccnt I. Should Australia's saving rate be a matter of concern? We saving rate on output in discussed the issue in general in Chapter I 1. The saving rate does affect the level of capital and the level the long run. review of output in the long run. A higher saving rate would lead over time lo a higher standard ol living in 4 Chapter II. thc luture.
If we believe that Australia, as a nation, isn't saving enough for thc future, there is a strong argument lor taking measures to increase private saving or offsetting low private saving by higher public saving. This is thc lirst argument lor running large budget surpluses.
This advice raises an intriguing issue. Undercurrent projections (assuming that the expansionary fiscal response to the 2008 financial crisis is temporary), the ratio ol net government debt to GDI' will continue declining in thc next few years. When the government runs surpluses, eventually achieving a negative net linancial debt position, it could buy back all ot its debt and then only buy private bonds or stocks Or—and this would more likely be the case—it could leave some amount of government debt in the cconomy and use the surpluses to buy private bonds or equities. In any case, the government can easily extend its net creditor status. The vehicles that the Australian government uses tor this purpose are thc Future Fund (which was worth $64 billion or about 6 per ccnt ot GDP in June 2008i and the Higher Education Endowment Fund which had $6 billion in June 2008).
Surpluses and the ageing of Australia
About two-thirds of the Australian federal government spending is on entitlement programs. These are programs that require the payment of benefits to all who meet the eligibility requirements established by the law. The two largest programs are social security and welfare (which mainly provide pension and residential benclits to the aged, and support for disadvantaged families, people with disabilities and the unemployed) and the third is health (which mainly provides Medicare rebates, private health insurance rebates, hospital services and pharmaceutical benefits).
Table 27.3 shows actual spending on each of these three programs as a percentage ol GDP in 2006-07 and projected spending in 2011-12, 2026-27 and 2046-47. The projections arc from the second Intergenerational Report produced by the Treasury in 2007. They arc constntcted using economic forecasts and current mlcs (including future changes in rules it these changes have already been incorporated in thc law) tor each program.
Thc numbers are striking. Under existing rules, spending on the age pension is projected to increase from 2.5 per cent ot GDP in 2007 to 4.4 per ccnt in 2047. Residential aged care support will increase from 0.8 per cent to 1.5 per cent, and all health spending is projected to increase from 3.8 per ccnt to 7.3 per cent (with more than half of that increase from pharmaceutical spending!. If nothing is done, the ratio ol entitlement spending to GDP is projected lo increase by 6.6 per cent to 13.7 per cent of GDP over the next forty years.
There are nine OECD ► countries where the government is a net creditor: net debt to GDP in 2008 is 72 per cent in Finland. 40 per cent in Korea and -153 per cent in Norway, and small creditor positions in Australia, New Zealand. Denmark. Sweden. Luxembourg and the Czech Republic.
See the focus box The ► ageing population: Age pensions, superannuation and savings' in Chapter 11.
BACK го рои chapter 27
These projected increases have two sourccs: • The first and main one is the ageing ot Australia, the rapid increase in thc proportion ol people over sixty-live that will take placc as thc baby-boom generation begins reaching retirement age. trom year 2010 on. The old-age dependency ratio—the ratio ol ihe population sixty-five years or more to the population between twenty and sixty-four years—is projected to double Irom about 20 per cent :n 2007 lo above 40 per cent in 2042. This evolution explains the projected growth ol social security benefits and a good pari ol ihe increase in health benclits.
Table 27.3 Projected spending on all aged care and health in Australia, 2007-47 (% of GDP)
2006-07 2011-12 2026-27 2046-47
Age pension 2.5 2.8 3.5 4.4
Residential and community aged care 0.8 0.9 1.2 2.0
All health 3.8 4.0 5.3 7.3
Total 7.1 7.7 10.0 13.7
1
SOURCE: Australian government. Intergenerational Report 2007.
• Thc* second source which explains rhe rest of the growth of health expenditure is the steadily
increasing cost ol health care.
Can these increases in entitlement spending be offset by decreases in other government expenditures? The answer s 'No, not easily It is never easy to accommodate a 6.6 percentage point increase. In 2007-08, lotal government expenditure net of the aged and health care spending was equal to about 26 per cent ol CDP. It would be extremely difficult to cut this expenditure by one-quarter, to meet the projected increase in entitlement spending.
It is therefore clear that major changes in entitlement programs will have to be made. Social security benefits may have to be reduced relative to projections , and the provision ol medical care will have- to he limited (again relative to projections There is also little doubt that various taxes will have to be increased.
It is also clear that waiting to act until spending starts increasing would be waiting too long. The cut in benelits or the increase in tax rates needed to linance entitlement programs would be tot) large. Many believe that the government shouldn't wait but should start taking measures now.
What should these measures do? They have to combine tax increases and benefit reductions to increase surpluses now and accumulate more assets in the l uture fund in anticipation ol future spending. The government needs to continue building up net assets so that taxes don't have to be raised and government spending doesn't have to be reduced too much in the future. To put it another way. thc tax and spending paths over the next forty years should be kept relatively smooth.
How would this asset accumulation help in dealing with luture increases in spending? First, decumulation ol these assets later on can delay the date at which taxes have to be increased or benefits decreased. And il the accumulation in the Future Fund is large enough, the government could avoid the need for tax increases or benelit cuts altogether. An example will help here. Suppose that the real interest rate is 3 per cent. Then il the net assets in the future Fund were accumulated to an amount equal to 200 percent ol GDP, real interest payments from the fund would be equal to 3 percent of GDP, an amount sullicicnt to cover most ol the projected increase in age-related expenditures as a percentage of GDP from 2007 to 2048. Under current assumptions however, thc accumulation ol net assets won't come close to reaching such a level.
This section has concentrated on Australia. But similar problems—namely, the ageing of the population and the increase in medical costs—are affecting all OECD countries. Some of these countries are well advanced in their accumulation of net assets by the government to cover these future problems. For example. Norway's government already has accumulated 153 per cent of GDP. and Finland nearly 72 per cent The governments of the United States (-48 per cent), euro area (-43 per cent) and Japan (-87 per cent) are much further behind Australia.
In response to the global linanciai crisis ol 2008 and with monetary policy fast approaching its zero interest rate limit, the federal government wisely responded with a large expansion in liscal policy. The avoidance ol a recession was the key driver of the fiscal stance in 2008 and going into 2009. When this danger has eventually been resolved, the government will have lo return to its longer run agenda of building up net assets tor the future. Though there is a need lor the government to accumulate net assets over the longer run this does not imply that it should avoid productive investments in inlrestructure (like roads ;iorls, buildings and so on . There is nothing wrong with borrowing to finance productive infrastructure, il the net present value gains ol these projects exceed the cost ol borrowing.
Fiscal policy design is not easy. Policy-makers have to deal with the often conflicting tensions ol their short-run, medium-run and long-run objectives. Right now those tensions are acute. In 2008-09, governments are dealing with the short-run problems, but they will need lo return to their long-run objectives in the future When lo do this and how to do ii are likely to remain the main items on the budget agenda lor the foreseeable future
SUMMARY
Fhe government budget constraint gives the evolution ol government debt as a function ol spending and taxes. One way of expressing the constraint is that the change in net debt the deficit) is equal lo the primary delicil plus interest payments on the debt. The primary deficit is the difference between government spending on goods and services C. and taxes net ol transfers, T.
If government spending is unchanged, a decrease in taxes must eventually be offset by an increase in taxes in the luture. Thc longer thc government waits to increase taxes or the higher ihe real interest rate, thc higher the eventual increase in taxes.
Thc legacy of past deficits is higher debt. To stabilise the debt, the government must eliminate thc delicit. Го eliminate the deficit, it must am a primary surplus equal to the interest payments on the existing debt.
Under the Ricardian equivalence proposition, a larger deficit is offset by an equal increase in private saving. Deficits have no effect on demand and on output. The accumulation ot debt doesn't affect capital accumulation. In practice, Ricardian equivalence fails. Larger dclicits lead to higher demand and higher output in the short run. Thc accumulation of debt leads to lower capital accumu¬lation, and thus to lower output in thc long am.
To stabilise the economy, the government should atn deficits during recessions, and surpluses during booms. The cyclically adjusted deficit shows what the delicit would be, under existing tax and spending rules, if output were at its natural level.
Deficits are justified in times of high spending, such as during wars. Relative to an increase in taxes, deficits lead to higher consumption and lower investment during wars. They therefore shift some of the burden of the war Irom people living during thc war to those living after the war. Deficits also help to smooth taxes and reduce tax distortions.
Several European countries have very high debt-to-GDP ratios. In addition to reducing capital and requiring higher taxes, and thus creating tax distortions, high dcbl ratios increase thc risk of fiscal crises.
In 2008 thc Australian budget showed a surplus. How big deficits will be in the near future is unclear, given the use of expansionary liscal policy to counteract ihe effects of the global financial crisis of 2008 Several economists believe that large surpluses are very much needed in the longer ain. They rely on two arguments:
— Thc Australian currcni account is chronically in delicit. Larger public saving (larger surplusesl would increase national saving, decrease ihe currcnt account deficit, increase capital accumulation, and increase output in the long am.
- Australia is ageing. Thc proportion of retirees will increase steadily over thc next seventy years. This implies that spending on several entitlement programs will greatly increase in the future, and lhat we should prepare lor it by accumulating liscal surpluses in thc Future Fund. When the danger ol recession arising from the 2008 global financial crisis has been resolved, thc govern¬ment needs lo return to its long-am agenda of accumulating net assets.
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