II. Public Expenditure, Stabilization, and Structural Adjustment

Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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What are the implications of public expenditure for inflation, the balance of payments, and growth in the short term and the long term?

How are the macroeconomic consequences of public expenditure influenced by the stance of fiscal and monetary policy?

How should a given level of expenditure be restructured to raise the sustainable growth rate?

The note on Public Expenditure and Sustainable Fiscal Policy emphasizes that the reconciliation of a particular level of public expenditure with broad macroeconomic goals depends upon revenue-raising possibilities and how any associated fiscal deficit is financed. This note focuses more directly on the link between the level and composition of public spending and stabilization and structural adjustment objectives.

Stabilization and Structural Adjustment Policies


The objective of stabilization policy is to avoid and if necessary correct domestic and external imbalances that threaten disruption to the economy in the short term. A high inflation rate and/or a large current account deficit, which are often associated with losses of foreign exchange reserves and capital flight, signal the need for policy responses to restore financial stability. Stabilization is pursued through a combination of corrective fiscal, monetary and exchange rate policies. These policies are interdependent. A tightening of monetary policy alone is potentially damaging to the private sector as either interest rates rise (often sharply in developing countries) or, with interest rate controls, credit is rationed. A depreciation of the nominal exchange rate will have only temporary consequences if domestic prices rise and so appreciate the real exchange rate. In both cases, a supporting fiscal contraction is needed, in the first case to reduce the public sector’s claim on available credit and prevent crowding out of the private sector, and in the second case to restrain aggregate demand. By the same token, fiscal policies alone are insufficient. A fiscal contraction will not result in lower inflation unless the money supply is constrained to a level consistent with the inflation target, and if wages and prices are relatively inflexible, a fiscal contraction will need to be accompanied by a nominal devaluation to achieve a real exchange rate depreciation.

Structural adjustment

Structural adjustment policies are directed toward the longer-term growth objective, by promoting efficient resource use. In one sense, the instruments of stabilization policy discussed above are also instruments of structural adjustment policy. Little progress is likely to be made on structural reform without the enabling environment provided by sound macroeconomic policies, while structural policies that are destabilizing cannot be sustained. But stabilization policies alone are not enough since of themselves fiscal retrenchment and monetary restraint can inhibit growth. However, these policies can be designed to fulfill their stabilization function while at the same time stimulating the supply side of the economy. In the case of fiscal policy, the focus shifts from the size of the fiscal deficit to the characteristics of the tax system and the composition of expenditure. In the case of monetary policy, the focus shifts from the rate of growth of money and credit to the process of interest rate determination and credit allocation. In other words, it is the structure of fiscal and monetary policies, rather than their stance, that has the more direct influence on growth, although the overall growth climate will be a reflection of both. Other policies will also be important. Liberalizing trade restrictions, industrial regulations, financial markets and price controls are central elements of most structural adjustment programs.

Public Expenditure, Inflation and the Balance of Payments

Public expenditure is a component of aggregate demand, affects private demand, and also influences aggregate supply. An increase in public spending will clearly change the composition of aggregate demand, but may not necessarily affect its level by the same amount. This depends upon the extent to which public spending crowds out private spending. Crowding out takes two forms. Direct crowding out arises when public spending displaces private spending which is a close substitute (e.g., education expenditure). It should be noted, however, that some types of public spending are complements to private spending (e.g., infrastructure investment). Generally, domestic spending will rise, but by less than public spending. Increased domestic spending will affect interest rates and the exchange rate, as a result of which there can also be financial crowding out of the private sector, and increased domestic spending will not translate fully into higher aggregate demand.

The extent of financial crowding out depends upon a number of factors: how the increase in public expenditure is financed; the stance of monetary policy and the interest elasticity of money demand; the mobility of international capital and the exchange rate regime; and supply responses. With an increase in expenditure paid for by higher taxes (i.e., no increase in the fiscal deficit), no change in the money stock, and interest inelastic money demand, interest rates will rise sharply, which—in tandem with higher taxes—will wipe out the initial impulse to aggregate demand. Relative prices will change, as interest-sensitive private expenditures are reduced, but the price level will not be affected. If money demand responds to interest rates, the increase in interest rates will be more modest—indeed, they may hardly change—and private spending will not adjust to fully offset higher public spending. There will be only partial crowding out. The impact on inflation will depend upon the extent to which the money supply is adjusted to contain further the rise in interest rates. In any event, relative prices will again adjust to reflect the changed composition of demand.

In an open economy, part of any additional domestic demand will be met through imports (i.e., the balanced budget multiplier will be less than unity) and the current account deficit will widen. The composition of imports will change to reflect that part of the additional expenditure which takes the form of government imports. Certain expenditures—defense, capital projects—are highly import intensive for most developing countries. This will influence the pattern of relative price changes associated with higher public expenditure. If the increase in public expenditure is accompanied by significantly higher interest rates, then with international capital mobility a flexible exchange rate will appreciate as additional capital inflows are attracted by the higher interest rates. The current account deficit will widen further, until eventually there is complete crowding out. But this can again be offset by monetary expansion to moderate the rise in interest rates, which will also determine the implications for inflation. With a fixed exchange rate, or if international capital is relatively immobile, there will be partial crowding out. Some of the net increase in demand will be met through higher domestic output, as long as there is some excess capacity in the economy. At full capacity, however, complete crowding out is unavoidable, at least in the short term.

Moving from taxation to deficit financing has similar crowding out implications, although the mechanism is more direct since the main forms of financing will be money creation, other private saving and foreign saving. In addition, accumulated debt will lead to additional pressure building up on interest rates and the possibility that future deficits may eventually have to be monetized (see the note on Public Expenditure and Sustainable Fiscal Policy for further discussion). In the longer term, the inflationary and balance of payments implications of a higher level of public expenditure depend significantly upon the extent to which this additional expenditure influences the underlying growth rate of the economy. The higher the growth rate, the lower the inflation rate associated with a given expansion of the money supply and the lower the burden of debt and debt service obligations associated with a given time path of current account deficits. The relationship between public expenditure and growth is a much discussed question.

Public Expenditure and Growth

It is a standard presumption that public expenditure supports the growth objective. Indeed, part of the economic rationale for intervention in terms of market failure and the resource allocation gains deriving from compensatory policies is predicated on this view. However, to the extent that the public sector engages in activities that can be more productively undertaken in the private sector, and given that the way in which expenditure is financed may have detrimental consequences, the link between aggregate public expenditure and growth is likely to be imprecise. Empirical evidence supports this: the data for a wide range of industrial and developing countries reveal no consistent correlation between aggregate public expenditure and growth.

It is more likely that growth is influenced by the composition of expenditure, since certain types of spending may have more of a growth orientation. Providing infrastructure to facilitate private investment, operations and maintenance to ensure that public infrastructure remains serviceable, education services to increase human capital, health services to increase labor productivity, and a general administrative and legal framework to support an increasingly complex economy should increase effective supplies of capital and labor, and thus promote growth. However, even apparently less productive expenditure—on defense, for example—may provide social and political stability that is necessary for growth, and reducing such spending could be counterproductive.

Empirical studies designed to resolve the expenditure and growth issue are mostly based upon the Denison growth accounting framework, according to which growth is explained in terms of changes in physical capital, human capital, technology, and efficiency in resource use. If public expenditure enhances any of these elements, a positive contribution to growth is expected. Studies to date provide some tentative support for a positive impact of capital expenditure on growth. Moreover, within capital expenditure it is education and other social sector spending that appears to have exerted the strongest influence. In addition, productive current expenditure—especially spending on social sectors and direct assistance to the private sector—also has a beneficial effect on growth. Overall, however, public spending is not among the most influential determinants of differences in growth rates either between countries or over time. External factors dominate most others, but much of the variation in growth rates remains unexplained. The main conclusions that can therefore be derived from these studies are that, to the modest extent public expenditure contributes to growth, it is indeed the composition rather than the level which is important and that, in the same context, the distinction between capital and current expenditure can be misleading; the focus should be on trying to distinguish productive from unproductive expenditure.

As indicated above, one possible explanation of the inconclusive empirical results is that while expenditure of itself may be growth promoting, the way the government chooses to pay for public expenditure has the opposite effect. This would occur when higher taxes constitute a disincentive to labor supply and savings while increased borrowing crowds out private investment. However, it has so far proved difficult to disentangle possibly stronger beneficial effects of public expenditure on growth from the offsetting influence of its financing.

Implications for Expenditure Policy

Adjustment programs typically call for policies directed toward both stabilization and structural adjustment objectives. The former comprises some combination of fiscal, monetary and exchange rate policies. In the fiscal area, an expenditure adjustment is often part of the policy package. However, as the preceding discussion illustrates, gauging the macroeconomic impact of an expenditure adjustment is complicated. Even in fairly simple models—of the type on which the macroeconomic framework underlying much of the Fund’s country analysis is based—yield only limited conclusions. An expenditure reduction is generally consistent with lowering inflation (assuming supporting monetary policy), and if it is consumption rather than investment spending that is cut, then higher domestic saving should lead to increased investment and higher growth. But depending upon the type of consumption spending that is affected, the response of the private sector, and the stance of other policies, output growth could fall, at least in the short term. The impact on the balance of payments is in turn a function of the price and output responses, and is in general indeterminate.

Moreover, other stabilization and structural adjustment policies influence the level and composition of expenditure. Thus, changes in interest rates affect domestic debt service, external debt service and import costs depend upon the exchange rate, indexed and quasi-indexed expenditures (pensions, wages, purchases of goods and services) are a function of the inflation rate, and the demand for certain programs (health, education) is related to income. At the same time, changes in interest rates and the exchange rate, inflation and income growth affect revenues. The net outcome of other macroeconomic variables on expenditure and the fiscal deficit is therefore ambiguous, and an ex ante expenditure cut could easily translate into higher ex post expenditure and a larger deficit. These feedback effects complicate policy analysis even further.

In the presence of such uncertainty, it is clearly important that expenditure reductions are borne by unproductive programs, and that there is a more general reallocation from unproductive to productive programs. While it may be difficult to maintain the growth momentum in the short term, the economy’s growth potential can then be more fully exploited over the longer term. Although there is widespread agreement as to the most obvious examples of unproductive expenditure—white elephants, overmanning, covering unlimited public enterprise losses—and productive expenditure—a high-quality public infrastructure investment program, supporting operations and maintenance funding, provision of education and health services—even in these apparently clear-cut cases the distinction between productive and unproductive spending is more elusive than it might at first appear. The note on Public Expenditure Productivity both discusses the principles that should be employed in making such a distinction, and provides some practical guidance as to how relatively unproductive expenditure can be identified.


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