Mr. Yehenew Endegnanew, Charles Amo-Yartey, and Ms. Therese Turner-Jones
This chapter examines the empirical link between fiscal policy and the current account focusing on microstates, defined as countries with a population of less than 2 million between 1970 and 2009. The extent to which fiscal adjustment can lead to predictable development in the current account remains controversial, with two competing views. The traditional view argues that changes in fiscal policy are associated with changes in the current account through a number of channels that are discussed in the literature review. The traditional view is challenged by the Ricardian equivalence principle, which states that an increase in budget deficit (through reduced taxes) will be offset by increases in private saving, insofar as the private sector fully discounts the future tax liabilities associated with financing the fiscal deficit, hence not affecting the current balance.
The Caribbean has a track record of high fiscal deficits, partly reflecting procyclical fiscal policies in good times. This has resulted in elevated levels of public-debt-to-GDP ratios since 1990. The predominant source of the budget imbalance is the central governments, even though public enterprises have also contributed significantly to the debt buildup. The debt accumulation stems from countercyclical fiscal policy in bad times and procyclical fiscal policy during periods of economic boom. The net result is that debt which has accumulated during periods of weak growth is not offset in good times, resulting in higher levels of debt in the medium term (Egert, 2011).
The global financial crisis has led to renewed interest in the issue of debt reduction for many governments. Low economic growth, low budgetary revenues, and stimulus spending to prop up economic activity have resulted in a sizable accumulation of debt, especially by the developed world. For instance, the ratio of general government debt to GDP increased from 50 percent in 2007 to 90 percent during the crisis in advanced economies. In the Caribbean, the ratio of public debt to GDP increased by about 15 percentage points between 2008 and 2010.