One of the primary goals of fiscal policy is to contribute to price stabilization in the context of a sustainable balance of payments.1 To attain this objective, public sector finances need to be equilibrated with the demand for investment and the supply of saving by the private sector and with available external financing flows. Indeed, fiscal policy plays a preeminent role in countries facing major macroeconomic difficulties, which are often associated with substantial disequilibrium in public finances. Under these circumstances, reducing this disequilibrium becomes a necessary condition for improving the macroeconomic situation.
Two key issues arise in defining the role of fiscal policy in adjustment programs. First, a “correct” measure of the fiscal position is needed to calculate the true extent to which the public sector is preempting resources. However, there is no single comprehensive and complete measure of the underlying fiscal position, but rather a series of alternative indicators, each with its advantages and disadvantages. Second, assuming that a reasonably dependable measure of the fiscal position is found, the size of the needed fiscal adjustment must be determined. More precisely, what proportion of the correctly measured fiscal deficit should be eliminated during the period covered by the program in order to attain its macroeconomic objectives?
This chapter will address both of these issues. It begins by discussing how the stance of fiscal policy can be defined and estimated; it then proceeds to review the use of various indicators and how they can jointly provide a sound basis for assessing the impact of fiscal policy on macroeconomic variables. Next, the problem of how government operations interact with other macroeconomic variables is considered within the framework of the intertemporal budget constraint of the public sector. In this context, the chapter discusses how specific indicators, mainly associated with the dynamics of the debt-to-GDP ratio, can be useful parameters for the targeting of a time path over which fiscal deficits will be reduced. Finally, the criteria for fiscal solvency and sustainability are incorporated into a discussion of the proper framework for determining the amount of fiscal adjustment consistent with sustainable domestic and external balances within the normal time frame of policymakers.
Measuring the Fiscal Disequilibrium
The correct measurement of the fiscal disequilibrium is fraught with difficulty. Indeed, a single summary indicator capable of unequivocally and clearly gauging the public sector’s net resource use—that is, the “true” fiscal balance—does not exist. There are instead a number of alternative measures, each of which provides useful insights on the stance of fiscal policy.
As can be seen from Figure 9.1, measurement of the fiscal balance raises three different types of issues: the basis of measurement, the definition of the public sector to be covered, and the relevant time horizon. Depending on which concepts are selected—for example, cash or accrual basis, the financial or the nonfinancial public sector, annual or intertemporal government balances—the quantitative measure of the fiscal balance changes accordingly.
When the fiscal balance is measured on a pure cash basis, only those government outlays for which cash has been actually disbursed, and only those cash receipts actually taken in, are included. By contrast, measuring the balance on an accrual basis captures the actual net resources being acquired and used by the government during the period chosen, whether or not the corresponding monetary transactions have taken place.
Regarding coverage, the recommended practice is to consolidate all transactions carried out by all entities performing nonfinancial government functions. Here “government function” means any activity to implement public policy through the provision of goods and services or the transfer of income, primarily supported by compulsory levies on other activities. This broad measure captures the overall impact of fiscal variables on macroeconomic performance. In many developing countries, however, even this measure is incomplete. Fully gauging the true fiscal position requires including any gains or losses of public financial institutions, such as the central bank and government-owned commercial banks. These institutions often undertake important quasi-fiscal operations, which are not funded through the government budget and therefore are not reflected in fiscal measures that cover only the budget.
Finally, although it is common practice to measure the fiscal balance as the net result of nonfinancial public sector operations during a 365-day period, it is also widely recognized that a fuller assessment of government behavior requires recasting the analysis from an annual to an intertemporal framework. Focusing only on annual developments of revenue and expenditure items implicitly assumes that a government’s consumption path is determined only by current income considerations. Clearly, to determine the sustainability of government consumption, one needs also to account for the permanent effects on the public sector’s net worth of factors not reflected in the conventional accounting of annual government operations. Here the main deficiencies stem from the omission of valuation adjustments in government assets and liabilities, and the handling of the financial implications of entitlement programs and government guarantees. Although these factors do not necessarily affect the budgetary position in the current year, they may have a profound impact on the government’s net worth and thus on the sustainability of public consumption. These issues are discussed in more detail in the section on government solvency and fiscal sustainability.
The most commonly used indicator to assess the stance of fiscal policy is the overall balance of the nonfinancial public sector, which measures the difference between revenue and grants, on the one hand, and expenditure and net lending, on the other, during a 365-day period. When data are available, this indicator should cover both the general government and all nonfinancial public enterprises, to arrive at an assessment of fiscal policy based on the most comprehensive definition of government possible. This provides a crucially important variable in the design of IMF-supported adjustment programs—namely, the public sector borrowing requirement. Recommended practice is to use a cash-based measure—which emphasizes the links with financial developments, particularly in the monetary accounts—except for interest payments, which are counted when they fall due, and tax revenues, which are counted at the time of collection.
When this overall balance is stated as a ratio to GDP, developments in the balance should provide an indication of the impact the budget is making over time on the economy. A growing deficit or a declining surplus suggests an expansionary fiscal stance. More precisely, the negative impact of taxes and other revenue on aggregate demand is increasingly being more than offset by the positive effects of government spending. Conversely, a declining deficit or a growing surplus indicates a contractionary fiscal stance, and the positive effects of government spending are being more than offset by the negative impact of revenue collection.
This overall balance, however, has some substantial shortcomings as a measure of the true impact of the fiscal position on aggregate demand. Three of the most important are differences in the impact on demand associated with different tax and expenditure categories, the endogeneity of the overall balance, and differences in the impact of different sources of financing.
Although all government transactions enter with the same weight in the calculation of the overall balance, some types of transactions have a different impact on aggregate demand than do others. Haavelmo’s (1954) balanced-budget theorem shows that a one-dollar change in taxes has different demand effects from a one-dollar change in government expenditure. It is also reasonable to assume that the impact of an additional dollar in government transfer payments differs from that of an additional dollar of expenditure on goods and services.
The problem is that it is difficult to agree on the weights to assign to these various budgetary items to fully reflect their different effects. The current balance and the domestic balance are two simple applications of this “weighted deficit” concept, which may complement the information provided by the overall balance. The current balance, which excludes capital spending from the calculation, is often used as a measure of government saving.2 The domestic balance is obtained by assigning nonzero weights only to those elements that directly affect the domestic economy, the rationale being that, in a small, open economy, the full impact of some government transactions may not be fully felt on domestic demand.3
The second limitation on use of the overall balance arises from the fact that this balance is an endogenous variable, reflecting not only the impact of fiscal policy on the economy but also, in turn, the impact of the economy on the government budget. For example, tax revenue tends to rise when economic activity expands and to fall when it contracts. In addition, some expenditures, such as unemployment compensation, are sensitive to the business cycle, rising during recessions and falling during expansions. Therefore, a large overall deficit is not always the result of expansionary policies; it may instead reflect the fact that the economy is in a downturn. Another important feedback from the economy to the budget is through rising inflation, which, other things being equal, typically increases the overall deficit as a percentage of GDP. High inflation reduces real revenue because of time lags in revenue collection (the so-called Tanzi effect) and through its effects on the real value of government assets and liabilities. Also, a rising inflation rate tends to push up nominal interest rates, which, in turn, result in higher interest payments on government debt and, consequently, in a larger overall deficit. This can happen even if the initial inflationary pressure was not caused by an expansionary fiscal policy stance.
The basic conceptual problem is how to separate the discretionary aspects of fiscal policy (changes in tax schedules and spending) from the automatic ones. One way is to calculate the cyclically adjusted balance, which involves an estimate of what revenue and expenditure would be if the economy were operating at its potential level of output.4 Although the cyclically adjusted balance may provide a useful indicator of the impact of discretionary government action, it still includes an important nondiscretionary variable—interest payments on public debt (and interest receipts on assets), which are predetermined by the size of past deficits. Thus, a further refinement is to remove net interest payments from the calculation. This yields the primary balance, a key concept in defining fiscal solvency and sustainability, which will be discussed in the next section. Finally, as mentioned earlier, whereas in periods of high inflation the overall deficit overstates the “true” deficit, the operational deficit, by excluding the inflationary component of interest payments from the calculation,5 provides a better gauge of the deficit that would prevail in a low-inflation environment.6
The third limitation of the overall deficit as a simple measure of the fiscal policy stance is that the macroeconomic impact of the budget depends largely on how the deficit is financed. For a given deficit, each of several different financing sources—the central bank, commercial banks, the nonbank private sector (through the issuance of bonds), domestic suppliers, and foreign financing—will affect aggregate demand differently:
Borrowing from the central bank (also referred to as monetization of the deficit) implies an increase in the monetary base, and thus in the money supply. It produces an expansion in domestic absorption, which, depending on the openness of the economy and the exchange rate regime, may lead to a loss of international reserves, higher inflation, or both.
Borrowing from the banking system does not lead directly to monetary expansion, unless the central bank decides to supply the banks with additional reserves. However, it tends unavoidably to crowd out private spending, mainly through interest rate increases that dampen private investment, and this effect contains the upward pressure on aggregate demand.
Borrowing from the nonbank private sector through the issuance of bonds enables governments to sustain their fiscal policy stance in the short run without causing inflationary pressures or running down international reserves. The increased supply of bonds raises interest rates, but the impact on aggregate demand might be more limited than in the case of commercial bank financing. The impact depends on the extent to which bond financing induces the private sector to save more in anticipation of future taxation to finance larger debt service obligations by the government.7
Although financing by the government’s suppliers may not show up in the recorded deficit, it may nevertheless affect aggregate demand. The impact depends on how those suppliers finance their cash flow shortfall. For instance, if they are forced to borrow from the banking system, the implications will be the same as those of government borrowing from the commercial banks. Recourse to this form of financing has the added disadvantage of jeopardizing future financing, government credibility, and the transparency of fiscal operations.
Foreign borrowing is the only way in which additional claims by the government on existing resources can be accommodated without any crowding out of the domestic private sector through the inflation tax (which is what happens when deficits are monetized) or through higher interest rates. However, except in the case of a developing country that can obtain foreign financing in highly concessional form, reliance on external borrowing will lead to an accumulation of external debt, which needs to be serviced and ultimately repaid. The decision on whether to resort to foreign borrowing to finance the deficit has to take this additional debt-service burden explicitly into account.
Arguably, the return to conditions of relatively greater price stability in the past 15 years has been made possible, especially in developing regions, by the implementation of effective fiscal adjustment programs. This trend toward lower inflation also occurred after a growing number of both industrial and developing countries passed laws prohibiting their central banks from financing budget deficits. This policy has no doubt been instrumental in significantly reducing the inflationary implications of fiscal deficits.
Continued concern about excess government spending is at present primarily associated with the need to limit the crowding out of private investment. In addition, an implication of the more limited access to bank financing observed in the past few years has been the rapid expansion of domestic nonbank debt. Here it is important to underscore that debt-to-GDP ratios in many countries have shown a rapidly increasing trend during the past two decades. Indeed, in the industrial countries as a group, despite stepped-up efforts at fiscal consolidation, net public indebtedness increased from 35 percent of GDP in 1990 to almost 50 percent in 1997.8 The growing stock of public debt means larger interest payments in the future, which will have to be accommodated through a proportionate reduction in primary (noninterest) expenditure, or a proportionate increase in revenue, to keep the deficit from rising. Otherwise, the accumulation of debt implied by the increase in the deficit will increase the debt burden, which can further expand future deficits and the debt. Therefore, the assessment of the fiscal balance has to be based not only on flow variables, such as the various definitions of the balance already discussed, but also on the outstanding stock of public debt and on its dynamics in order to avoid preempting future primary government spending.
Government Solvency and Fiscal Sustainability
The criteria discussed in the previous section can be of guidance in defining the current fiscal policy stance at any moment in time—that is, whether the budget is having an expansionary, contractionary, or neutral impact on the economy. However, as already mentioned, these flow measures provide little assistance if the question is how sustainable the current fiscal policy stance is. Fiscal sustainability “involves determining whether the government can continue to pursue indefinitely its set of budgetary policies” (Horne, 1991, p. 8). To answer this question, we need to look at the dynamic nature of the financing constraint that the public sector faces. We start with the following statement: a government may be able to maintain a fiscal imbalance by placing securities with domestic private and external creditors, but it cannot indefinitely accumulate domestic and foreign debt, because it is subject to an intertemporal budget constraint. Private consumption theories explain that consumers do not finance all of their spending out of current income. As economists have long recognized, this applies even more forcefully to the public sector, which is generally less liquidity-constrained than households or businesses. However, as the international debt crisis of the 1980s showed, even governments are constrained in their borrowing by the size of their permanent income. Indeed, private investors perceive that there are clear limits on the extent to which a government can “borrow” from future generations to finance its present consumption.
The Intertemporal Budget Constraint and Government Solvency
This section will first develop the algebraic formulation of the public sector’s intertemporal budget constraint. It will then discuss how this constraint can be used to highlight certain accounting-related aspects of fiscal solvency. Following Bean and Buiter (1987), fiscal solvency requires that the government’s spending program, its tax and transfers program, and its use of seigniorage be consistent with its initial outstanding financial and real assets and liabilities. In other words, the present value of its spending program must be equal to its comprehensive net worth (Bean and Buiter, 1987, page 27).
To develop a formal condition for fiscal solvency, one needs a definition of the public sector that covers all operations carried out by government-owned entities. This is a broader concept of the public sector than that discussed in the previous section, in that it includes the operations of central and local governments, public (financial and nonfinancial) enterprises, and the central bank. The consolidated public sector budget identity will then be
where PSBR is the public sector borrowing requirement of the financial and nonfinancial public sector, PDEF is the primary deficit, i and i* represent domestic and foreign interest rates, e is the exchange rate (defined as units of domestic currency per unit of foreign currency), and D and D* are the stocks of net public sector debt denominated in domestic currency and in foreign currency.
It is clear from examining the sources of financing of the public sector that the following also holds:9
and therefore,
where M is the monetary base and A is the difference between the proceeds from privatization and the recognition of contingent liabilities of the public sector. The left-hand side of equation (9.3) corresponds to stock adjustments—for example, an increase in domestic or external debt, monetary expansion, or net sales of public assets—needed to finance deficit-creating flow operations (shown on the right-hand side) carried out by government entities in the pursuit of fiscal policy objectives.10 Abstracting from seigniorage and from net privatization proceeds, it is then evident that the public sector can expand its net claims on domestic resources (that is, increase PSBR) only if creditors are willing to hold more public debt instruments (whether denominated in domestic or in foreign currency). Because such willingness decreases as the outstanding stock of debt increases, it can be shown that any indicator of fiscal sustainability has to demonstrate a converging time path of the debt-to-GDP ratio.
We define the following terms:
| Y | = | nominal GDP |
| y | = | real GDP |
| pdef | = | PDEF/Y, or the primary deficit divided by GDP |
| d | = | D/Y, the stock of domestic debt divided by GDP |
| d* | = | eD*/Y, the stock of public debt denominated in foreign currency divided by GDP |
| π | = | the domestic inflation rate |
| π* | = | the foreign inflation rate |
| r | = | (i – π), the real interest rate on domestic currency-denominated debt |
| r* | = | (i* – π*), the real interest rate on foreign currency-denominated debt |
| m | = | M/Y, the monetary base as a fraction of GDP |
| q | = | p*e/p, the real exchange rate |
| a | = | A/Y, the proceeds from privatization net of contingent liabilities, divided by GDP. |
| Y | = | nominal GDP |
| y | = | real GDP |
| pdef | = | PDEF/Y, or the primary deficit divided by GDP |
| d | = | D/Y, the stock of domestic debt divided by GDP |
| d* | = | eD*/Y, the stock of public debt denominated in foreign currency divided by GDP |
| π | = | the domestic inflation rate |
| π* | = | the foreign inflation rate |
| r | = | (i – π), the real interest rate on domestic currency-denominated debt |
| r* | = | (i* – π*), the real interest rate on foreign currency-denominated debt |
| m | = | M/Y, the monetary base as a fraction of GDP |
| q | = | p*e/p, the real exchange rate |
| a | = | A/Y, the proceeds from privatization net of contingent liabilities, divided by GDP. |
If we express the variables in equation (9.3) as fractions of GDP and take the time derivative of the ratios of domestic and external debt to GDP, then, collecting terms, the one-period public sector budget constraint becomes11
where λ is the growth rate of base money, which is assumed to expand at the same rate as nominal GDP; that is,
As reflected in the right-hand side of equation (9.4), the faster the ratio of public sector debt to GDP rises, the higher is the primary deficit (or the lower is the primary surplus), the lower is real GDP growth compared with real domestic and foreign interest rates, and the lower is seigniorage (which, in turn, depends on real GDP growth, the rate of inflation, and the ratio of base money to GDP). In addition, the faster this ratio increases, the lower are net privatization proceeds.12
Assuming for simplicity that net privatization proceeds are zero, the ratio of public debt to GDP will decline over time
If both purchasing power parity (PPP) and uncovered interest rate parity hold, then
However, the problem with expression (9.6) is twofold. First, the financial resources collected from seigniorage are usually limited. Second, if (ŷ – r) > 0, the government may continue to run a constant primary deficit and to service its debt forever by borrowing. Although a number of countries at different stages of economic development have satisfied this condition over prolonged periods, the standard situation in developing countries is the reverse.13
Expressions (9.4) through (9.6) are useful for analyzing the dynamics of the debt-to-GDP ratio. Solvency, however, has to be assessed in the context of the intertemporal budget constraint of the public sector.14 To arrive at a formal definition of solvency, let us rewrite the one-period budget constraint in equation (9.3), assuming that net privatization proceeds and revenue from seigniorage are zero. Also, to keep the algebra simple, we will not discriminate between domestic and external public debt.15 We obtain
It is convenient to write equation (9.7) in terms of the primary surplus PSt (defined as the negative of PDEFt):
Equation (9.7a) tells us that the end-of-period stock of debt increases at time t if the primary surplus is smaller than interest payments during the period. Dividing both sides of equation (9.7a) by Yt multiplying and dividing Dt–1 by Yt–1, and rearranging terms, we derive the following expression:
where pst is equal to PSt/Yt. Keeping in mind that the nominal interest rate is defined as the real interest rate times the inflation rate—that is, (1 + it) = (1 + rt) (1 + πt)—and that nominal GDP growth, Yt/Yt–1, can be defined as (1 + ŷt) (1 + πt), the law of motion for dt is the following:
where δ = (1 + r)/(l + ŷ). Solving equation (9.9) forward recursively for N years, we obtain
which provides the basis for a formal condition for solvency. The public sector is solvent when the present discounted value of future primary surpluses is at least equal to the value of its outstanding stock of debt. This implies that the last term of equation (9.10) must be nonpositive; that is, δ–Ndt+N ≤ 0. In other words, the public sector cannot be a net debtor in present-value terms. It has to satisfy its present-value budget constraint; it cannot resort to Ponzi games, paying forever the interest on the outstanding domestic and foreign debt simply by borrowing more. The above transversality condition, δ–Ndt+N ≤ 0, represents the strict condition for solvency, which requires that at some point in the future the primary balance will become positive.16 More pragmatically, a broader definition for solvency can be derived by imposing weaker conditions on equation (9.10). For example, it might be required that the debt-to-GDP ratio stabilize at some point in time: that is, that dt+N ≤ dt+N, where dt+N represents a finite upper bound consistent with the long-term policy objectives at time t + N.17
Fiscal Sustainability
The criteria for fiscal solvency set out in equations (9.7) through (9.10) will ensure that the intertemporal budget constraint is satisfied, thus meeting a necessary condition for fiscal sustainability. However, policy prescriptions cannot be derived unambiguously from these expressions.
The key difficulty is that all the relevant variables are endogenous, so that the feedback of fiscal measures on growth may in turn affect government revenue and expenditure, as well as interest rates, along with private saving and investment behavior. By contrast, solvency indicators assume that the projected paths of the primary balance, interest rates, and economic growth and inflation are independent. Thus, specific assumptions regarding the behavior of these variables are needed to determine whether the current fiscal policy stance is sufficiently conservative to ensure its sustainability. In carrying out this task, it must also be kept in mind that domestic or external shocks that affect income growth and interest rates may affect the ability or the willingness of the government to undertake fiscal consolidation in order to satisfy its intertemporal budget constraint.
Buiter (1985) has proposed a comprehensive summary measure of fiscal sustainability: the constant-net-worth deficit. Buiter defines the current level of government spending as sustainable if it keeps the government’s net worth constant on an ex ante basis. This net worth concept would have to include a comprehensive set of balance sheet items to capture the numerous ways in which a government can increase or reduce its net value.
Among the assets to be included are financial assets, real capital, and land and mineral assets; the present value of future taxes (including social security contributions); and the imputed present value of future seigniorage. Liabilities include government debt, the monetary base, and the present value of future expenditure on social security and other entitlement programs (including public guarantees). As might be expected, some major methodological and measurement problems limit the practical use of this indicator.
Blanchard (1990) has proposed the use of what he calls the primary gap indicator. This is defined simply as the level of primary surplus required to stabilize the debt-to-GDP ratio, given the projected paths of the primary balance, the real interest rate, and output growth. The gap is given by the difference between the present value of future primary deficits required to stabilize the debt-to-GDP ratio and the current balance. An alternative indicator also proposed by Blanchard—the tax gap—measures the required adjustment in the tax-to-GDP ratio needed to stabilize the ratio of outstanding debt to GDP. Here the gap is given by the difference between the present value of this calculated tax ratio and its current value. Applying these two indicators requires relatively little information—the initial debt-to-GDP ratio, real interest rates, the real growth rate, and, in the case of the tax gap measure, an assumption about the future noninterest expenditure path. Both, however, are very crude measures subject to the criticisms raised earlier in relation to the measure proposed by Buiter.
An approach recently proposed by Drudi and Prati (1999) to capture the endogenous link between fiscal consolidation and the credit rating component of interest rates may be helpful in gaining an insight into which fiscal variables signal debt sustainability. One result of their study is that credit ratings are positively related to a country’s primary balance and negatively related to its debt-to-GDP ratio. This explains why countries experiencing large primary deficits but low debt ratios enjoy high credit ratings, whereas countries with high debt ratios are required to run sizable primary surpluses to obtain similar ratings. This suggests that an “ideal” measure of fiscal sustainability should be based on some weighted average of these two variables.
When using the summary measures discussed in the previous section as a guide to the design of the policy package required for fiscal sustainability, any explicit (or implicit) assumptions regarding the feedback from nonfiscal macroeconomic variables should be carefully spelled out.
Although a given set of government policies might be regarded as sustainable because the economy is growing at a rate above the real interest rate, thus justifying a particular level of the primary deficit, the resulting increase in debt may eventually push up real interest rates and lead to an unsustainable increase in debt (see Masson, 1985).
Government solvency requires that the debt-to-GDP ratio be stabilized but does not set limits on its magnitude. However, a high ratio may affect the private sector’s perception of the government’s commitment or ability to meet its budget constraint consistently, and this may affect risk premiums and interest rates. The liquidity of the debt may also affect these variables: as its average maturity shortens, bondholders are likely to require higher real interest rates to roll over public debt.
Similarly, the pursuit (or postponement) of fiscal consolidation programs may influence interest rates and economic growth through, for example, interactions between public debt stocks and risk premiums, and through the impact of the composition of public expenditure and taxes on economic growth.
When public debt is held by nonresidents, a stable debt-to-GDP ratio may fail to signal the need to take fiscal policy action if external current account sustainability is being affected by external shocks—for example, a terms of trade deterioration, spillovers from regional currency fluctuations, or financial crisis.
The Appropriate Fiscal Policy Stance
Rules Versus Discretion
Determining what the fiscal position should be at a given time is a difficult task. It requires not only some measure of the fiscal disequilibrium, as already discussed, but, more important, a firm theoretical framework to support the proposed fiscal policy action. Although there is a consensus that persistently excessive deficits produce serious undesirable effects on the economy, it is less clear just what is “excessive.” Standard benchmarks for government behavior have been primarily based on Keynesian models of aggregate demand and on the neoclassical theory of fiscal policy (see Barro, 1979). The neoclassical theory stresses the importance of tax smoothing. Constant tax rates are regarded as more efficient and less costly to administer than variable rates; therefore, the public debt should fluctuate to finance budget deficits (surpluses) caused by temporary shocks, with tax rates kept constant to minimize distortions. The Keynesian approach, in contrast, emphasizes the role of fiscal policy as a stabilizer: net government expenditure should increase during recessions and contract during upswings to compensate for business cycle fluctuations.
If one combines the two paradigms, the general conclusion is that fiscal policy should be countercyclical, with expenditures increasing during recessions and falling in booms, but that tax bases should vary procyclically. Unfortunately, a large number of both industrial and developing countries have not always implemented this policy prescription symmetrically. Instead, they have often treated positive shocks as permanent and negative shocks as temporary. This tendency has imparted a bias toward deficits, which has resulted in a general deterioration in fiscal performance. After two decades this deterioration has only recently begun to be reversed. A growing political economy literature has offered several possible explanations for this tendency for countries to deviate from conservative fiscal policy. Some observers have posited a combination of “opportunistic” policymakers and naive voters, others have invoked distributional conflicts, and still others have pointed to the influence of geographically or ethnically dispersed interests (see Alesina and Perotti, 1995, and Milesi-Ferretti, 1996).
To correct for this bias toward budget deficits, many countries have resorted to fiscal rules as a permanent constraint on fiscal policy. These rules are typically expressed as a numerical ceiling or target for some summary indicator of overall fiscal performance, often defined as a ratio to GDP. Such rules have mainly consisted of various forms of balanced-budget rules, rules that impose limits or prohibitions on borrowing, and debt rules. Their rationale is to enhance policy credibility by designing fiscal policy guidelines to be implemented on a permanent basis and without discretion over a reasonably long period. Following such guidelines should tend to increase macroeconomic stability, enhance consistency with other policies, boost long-run policy sustainability, and minimize negative spillovers.
In principle, these policy objectives could also be achieved with discretionary fiscal measures. One might even argue that only the latter would allow policymakers to formulate the optimal policy strategy to attain the macroeconomic objective being targeted—certainly the case could be made that fiscal rules might impair the operation of the short-run stabilization and tax-smoothing roles of fiscal policy. On the other hand, the superiority of discretionary fiscal policy has not been frequently demonstrated in practice, especially in developing countries. In the final analysis, the strongest case for fiscal rules is related, as in the case of monetary rules, to political economy considerations. Indeed, as with monetary rules, a major advantage of rules-based fiscal policy over discretionary policy is, arguably, time consistency.18
The Amount of Fiscal Adjustment Required
Determining the amount of fiscal adjustment needed in the context of a stabilization program requires, in principle, the use of a full-fledged econometric model, and such models are not always readily available, especially for developing countries. Quantifying the appropriate fiscal position also requires, at a minimum, an informed judgment on the levels of certain key macroeconomic variables, such as the demand for money that is consistent with the inflation and output targets, expected private saving and investment behavior, and variables related to the external environment. Put more precisely, what proportion of the (correctly measured) fiscal deficit should be eliminated during the period covered by the program in order to achieve the program’s objectives?19
One simple prescription would be to eliminate the fiscal deficit completely and immediately. This amounts to implementing the most orthodox of fiscal rules: that the government should always keep the budget balanced. Under such a rule, when some factor—endogenous or exogenous, transitory or permanent—generates a deficit, policies ought to be quickly directed toward eliminating it. Some have argued, however, that it may not be necessary or even desirable to eliminate the fiscal deficit over the short run, not only because of the adverse effects that it would have on the level of economic activity, but especially because of potentially high efficiency costs. Too swift a fiscal action may require cutting much-needed public investment in infrastructure, cutting spending on crucially important social projects, or raising revenue quickly by imposing highly distortionary taxes.
An alternative, more flexible approach is to cut the deficit during the program period only to a level that can be financed without inflation. However, this rule may only succeed in eliminating the short-run problems generated by the fiscal imbalance. If the residual deficit that is not financed monetarily leads to higher public debt-to-GDP ratio, crowds out the private sector, or skews portfolio distributions in the financial sector, then the adjustment program will need to set limits on the total fiscal deficit, resulting in a stronger fiscal effort than might otherwise have been attempted (Tanzi, 1990, page 5).
The approach followed in IMF-supported programs is to limit the fiscal deficit to a level consistent with the setting of final objectives—in terms of inflation, growth, and the balance of payments—needed to achieve domestic and external sustainability in the medium term. In the context of the financial programming framework, which is the technique used to design IMF programs, an attempt is made to establish a close connection, through the overall expansion of liquidity and the demand for liquidity, among the financing requirements of the public sector, the private sector saving-investment balance, and the balance of payments outcome.
Once the level of the fiscal deficit has been derived and one can be confident that this level is consistent with inflation, growth, and balance of payments targets that are sustainable in the medium term, the central question becomes whether it is tax revenue that must be raised or public spending that must be cut. Alternatively, a combination of tax-raising and expenditure-reducing measures may be adopted. Although this question goes beyond the scope of this chapter, the attainment of the fiscal objectives bears heavily not only on the extent of revenue raising or expenditure cutting, but also on the nature and composition of these measures.20
Certain factors or circumstances may affect the amount of deficit reduction required (or the amount of surplus that must be generated) to help attain the program’s objectives. Some of these factors are discussed below.
The Business Cycle
As argued in the previous section, one of the roles of public finance is to help smooth aggregate demand over the business cycle. The application of countercyclical policies implies increasing fiscal deficits during a downturn and reducing them (or even running a surplus, or increasing the size of an existing surplus) during booms. Usually, automatic stabilizers—such as the fall in tax revenue and the increase in certain expenditures, such as unemployment compensation, during recessions, and vice versa during booms—allow the fiscal position to assume the recommended stance. However, if the elasticities of revenue and expenditure are small (or if the automatic stabilizers are not institutionalized), discretionary policies will be needed to avoid the emergence of an excessively procyclical fiscal posture.
For example, when an adverse and transitory shock occurs—such as a sudden fall in export prices or a sudden increase in import prices—a policy response is not necessarily required. In such a case, the shock can be accommodated by external borrowing or drawing down international reserves.21 By the same token, a positive and transitory external shock—such as a fall in import prices or an increase in export prices—would call for a symmetrical response: repaying external debt or accumulating reserves. However, if either type of shock is likely to persist for some time, a policy change is required to keep absorption within sustainable levels. When, for instance, the economy suffers a permanent negative external shock—say, a decline in prices for the country’s main export—a real depreciation of the currency is needed to help reduce the ensuing current account deficit. A tighter fiscal policy stance would then be needed to support such a depreciation. Depending on the initial fiscal position and on the country’s monetary situation, a fiscal surplus may even be in order.
Causes of the Macroeconomic Imbalance
If fiscal disequilibrium is at the root of the macroeconomic imbalance, the fiscal deficit needs to be reduced or eliminated. Excess net government spending, even when it does not create inflationary pressure, tends to have a negative impact on growth given its small (and, in some cases, negative) contribution to domestic saving. This is especially the case when excessive public consumption is unrelated to activities that build human capital or to the maintenance of infrastructure. Under these circumstances, resumption of growth requires the elimination of the deficit in order to free resources for more productive uses. Also, government dissaving, to the extent that the ensuing need to raise revenue is met through tax rate hikes, may have adverse supply-side effects. For example, excessive marginal income tax rates may reduce the incentives for saving and investment, and high payroll taxes may hinder employment creation.
As in the case of a permanent deterioration in the terms of trade, discussed above, when a sudden reversal of capital inflows causes the current account deficit of the balance of payments to become unsustainable, the public sector is usually called upon to contribute, along with the private sector, to reduce absorption to sustainable levels. Arguably, even if the public sector is running a fiscal surplus—for instance, even if the original surge in capital inflows was caused by excess private spending rather than by expansionary fiscal policy—there might be scope for some further fiscal adjustment. This is especially so if the required reversal is sizable and if the private sector debt is denominated mostly in foreign currency. Alternatively, adjustment would have to take place entirely through depreciation of the currency and increases in interest rates, with the private sector taking the full brunt of adjustment. In the case of IMF-supported programs in the recent Asian crisis, the original adjustment strategy included some fiscal retrenchment to offset the ensuing fiscal weakening and to support the required external adjustment without an excessive crowding out of the private sector. However, retrenchment was also needed to make room for the very high cost of restructuring a sizable number of troubled financial institutions.22
In addition to contributing directly to external adjustment through reduced domestic absorption, fiscal policy can reduce the amount of adjustment needed through its effect on confidence and thus on private capital flows. When fiscal action is expected to lead to stronger future current account positions, it may improve investors’ prospects of repayment, thus reducing the incentive for capital to exit.23
In general, if the government faces limits in its capacity to borrow abroad, it is important to build up its resilience to abrupt and discrete changes when the economy is hit by a negative shock. Under these circumstances, “to minimize risks, the fiscal position should provide a buffer to deal with unexpected shocks; the size of this buffer will be related to the probability and severity of potential shocks” (Bascand and Razin, 1997, page 59).
Debt Sustainability
For many countries, the growth of the debt ratio in the past few years has raised concerns about a debt trap, in which rising interest payments require rising tax ratios or symmetrical contractions in non-interest spending to stabilize the debt ratio. As discussed above, whatever the initial debt ratio, if the government is running a primary deficit, the debt ratio will increase unless the growth rate of the economy significantly exceeds the real interest rate. This means that, for the government to meet its intertemporal budget constraint, today’s primary deficit will need to be offset by future surpluses. The alternative would be to continue to borrow to repay the debt, which would force the debt ratio to rise without bound. Delaying fiscal adjustment, therefore, will require a stronger effort in the future (that is, fiscal surpluses will need to be larger), because at that time the debt ratio will be much higher.
Although sustainability indicators do not offer specific guidance about the appropriate level of the debt-to-GDP ratio (as opposed to its growth rate), a high ratio may affect the private sector’s expectations in important ways. Governments that commit themselves to generate primary surpluses in the future after allowing the debt to rise for a long period of time, as reflected in high debt-to-GDP ratios, are not perceived as credible. Even when the government’s commitment is taken at face value, the large debt may raise questions about the feasibility of the debt-reduction plan. In addition, a large debt not only complicates the management of monetary policy but also makes public finances extremely vulnerable to increases in international interest rates. For these reasons, a fiscal consolidation effort that is fully credible might reduce risk premiums and real interest rates sufficiently to limit (or even more than offset) the direct contractionary effects on the level of activity brought about by the reduction of net noninterest expenditure (Giavazzi and Pagano, 1990).24 At a minimum, a large primary surplus, by sending a strong signal about policy commitment, can enhance the chances of successful stabilization. The converse can also happen: if a government is already nearly insolvent, an expansionary fiscal policy stance—or even a package of measures perceived as inadequate—may lead to a collapse of confidence, with contractionary rather than expansionary effects on aggregate demand.
Transitory Receipts
A consensus seems to be emerging that transitory receipts—such as foreign grants, short-term capital flows, mineral resource revenue, or privatization receipts—need to be reflected in an increase in public saving.25 Specifically, if these receipts are in the form of foreign grants directed at financing productive investment, the optimal policy response is to expand government capital spending accordingly. To the extent that such spending implies an increase in imported capital goods, the external current account position will be unaffected.26 If, on the contrary, these grants cannot be used for productive purposes, they should be retained for future use, which implies that they should be fully saved by the government.
For countries experiencing large but short-term capital flows, the optimal policy response may include a fiscal component. Although these flows might be the result of improved confidence in the country’s prospects due to its successful stabilization and structural reform efforts, they might also be triggered by cyclical conditions in industrial countries. If the latter dominate, the resulting flows may be very volatile, and highly susceptible to sudden reversals when changes in expectations about the international situation occur. When these flows are sizable, they can lead to a deterioration in the external current account through a real appreciation of the currency. This can arise either from upward pressure on the nominal exchange rate or from higher inflation stemming from unsterilized flows. Successful policy responses have not relied on any single instrument, but monetary policy has often been more active during the early stages of the inflows, and a tightened fiscal policy, frequently involving a budget surplus, has been a key element.
In the case of countries that depend heavily on revenue from exhaustible resources, it has been argued that different generations should be treated identically from the point of view of economic welfare.27 Therefore, it may be appropriate to convert part of this revenue into productive assets that can be passed onto future generations. The policy most often referred to as optimal in this respect involves using the fiscal surpluses accruing from these activities for the accelerated repayment of public debt.
Although privatization, receipts are treated as revenue in the government accounts, obviously they cannot support a permanent increase in consumption. For analytical purposes, it is therefore better to treat them as a financing item, to be used to support activities intended to preserve the government’s net worth. If productive investment projects are not clearly identifiable, again the optimal solution might well be to repay debt.
Generational Accounting
Generational accounting is a term used to highlight the distributional implications of fiscal policies—that is, the intertemporal allocation of taxes and transfers—across generations. It is motivated by the concerns traditionally voiced about fiscal deficits: that they may unduly burden future generations and crowd out national saving.28
Advocates of generational accounting claim that in many countries the structure of tax and transfer spending policies is “present oriented,” providing substantial net gains to older citizens alive today while leaving their children and even citizens not yet born to bear the costs. This imbalance, which recorded budgets do not reveal, retards saving, investment, and economic growth, thus reducing the wealth of future generations.
The situation of the social security system in the United States illustrates these problems. Although the system today is running cash-flow surpluses, measured on an accrual basis these surpluses would turn into deficits. The large positive cash flow is being more than offset by growth in liabilities, reflecting the passage of the large baby-boom cohort through the system. The official accounting of the system fails to capture these liabilities.
The situation of the official pension system in many other countries parallels that in the United States. In all these cases the optimal response would be to levy higher contributions on current generations than are required to pay for today’s pensions, and to use the excess contributions to fund future pensions. Again, other things being equal, this implies running surpluses in the consolidated public sector accounts.
Budget estimates reflecting the concerns voiced by proponents of generational accounting would alert the public to the likely tilt of fiscal policies toward the present and away from the future. However, such accounting unavoidably rests on a number of specific views and assumptions regarding both private and government behavior, which will have a bearing on the estimates of net future taxes (taxes paid minus transfers received) paid by the various generations. This makes producing accurate estimates a very difficult task indeed.
Appendix 9.1: Derivation of Equation (9.4)
Dividing equation (9.3) by Y, one obtains
This allows straightforward derivation of equation (9.4). However, one must first simplify the terms
Taking the time derivative of (D/Y)—that is, the ratio of the stock of domestic debt to GDP—yields
Since
Defining
one obtains
Substituting equation (9.14) into equation (9.12) and rearranging terms yields
Taking now the time derivative of (eD*/Y)—that is, the ratio of the stock of external debt to GDP—one has
and, collecting terms, one obtains
Substituting now equations (9.15) and (9.17) into equation (9.11), using the definitions in the text and assuming that
Rearranging terms gives
Adding and subtracting π*d*, and collecting terms, one obtains
Now, using the definitions of real interest rates and the real exchange rate, one finally obtains
Equation (9.21) is identical to expression (9.4).
Bibliography
Alesina, Alberto, and Roberto Perotti, 1995, “The Political Economy of Budget Deficits,” Staff Papers, International Monetary Fund, Vol. 42 (March), pp. 1-31.
Auerbach, Alan J., Jagadeesh Gokhale, and Lawrence J. Kotlikoff, 1994, “Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy,” Journal of Economic Perspectives, Vol. 8 (Winter), pp. 73-94.
Barro, Robert J., 1974, “Are Government Bonds Suppliers Net Wealth?” Journal of Political Economy, Vol. 82 (November-December), pp. 1095-1117.
Barro, Robert J., 1979, “On the Determination of the Public Debt,” Journal of Political Economy, Vol. 87 (October), pp. 940–71.
Bascand, Geoffrey, and Assaf Razin, 1997, “Indonesia’s Fiscal Position: Sustainability Issues,” in Macroeconomic Issues Facing ASEAN Countries, ed. by John Hicklin, David Robinson, and Anoop Singh (Washington: International Monetary Fund).
Bean, Charles R., and Willem H. Buiter, 1987, The Plain Man’s Guide to Fiscal and Financial Policy (London: Employment Institute, October).
Blanchard, Olivier, 1990, “Suggestions for a New Set of Fiscal Indicators,” Economics Department Working Paper 79 (Paris: OECD).
Blejer, Mario, and Adrienne Cheasty, 1991, “Analytical and Methodological Issues in the Measurement of Fiscal Deficits,” journal of Economic Literature, Vol. 29 (December), pp. 1644-78.
Blejer, Mario, and Adrienne Cheasty, 1992, “How to Measure the Fiscal Deficit,” Finance & Development, Vol. 29 (September), pp. 40-42.
Buiter, Willem H., 1985, “A Guide to Public Sector Debt and Deficits,” Economic Policy, Vol. 1 (November), pp. 13–79.
Buiter, Willem H., 1997, “Aspects of Fiscal Performance in Some Transition Economies Under Fund-Supported Programs,” IMF Working Paper 97/31 (Washington: International Monetary Fund).
Chalk, Nigel, and Richard Hemming, 1998, “What Should Be Done with a Fiscal Surplus?” IMF Papers on Policy Analysis and Assessment 98/10 (Washington: International Monetary Fund).
Corsetti, Giancarlo, and Nouriel Roubini, 1991, “Fiscal Deficits, Public Debt, and Government Solvency: Evidence from OECD Countries,” Journal of the Japanese and International Economies, Vol. 5 (December), pp. 354-80.
Drudi, Francesco, and Alessandro Prati, 1999, “Signaling Fiscal Regime Sustainability,” IMF Working Paper 99/86 (Washington: International Monetary Fund).
Giavazzi, Francesco, and Marco Pagano, 1990, “Can Severe Fiscal Contractions Be Expansionary? Tales of two Small European Countries,” NBER Macroeconomics Annual (Cambridge, Massachusetts: National Bureau of Economic Research).
Hartwick, John, 1977, “Intergenerational Equity and the Investing of Rents from Exhaustible Resources,” American Economic Review, Vol. 67, No. 5, pp. 972-74.
Haavelmo, Trygve, 1954, A Study in the Theory of Economic Evolution (Amsterdam: North-Holland).
Heller, Peter S., Richard D. Haas, and Ahsan Mansur, 1986, A Review of the Fiscal Impulse Measure, IMF Occasional Paper 44 (Washington: International Monetary Fund).
Hemming, Richard, and James Daniel, 1995, “When Is a Fiscal Surplus Appropriate?” IMF Paper on Policy Analysis and Assessment 95/2 (Washington: International Monetary Fund).
Horne, Jocelyn, 1991, “Indicators of Fiscal Sustainability,” IMF Working Paper 91/5 (Washington: International Monetary Fund).
Hotelling, Harold, 1931, “The Economics of Exhaustible Resouces,” Journal of Political Economy, Vol. 39 (April), pp. 137-75.
International Monetary Fund, Fiscal Affairs Department, 1995, Guidelines for Fiscal Adjustment, IMF Pamphlet Series, No. 49 (Washington: International Monetary Fund).
Kopits, George, and Steven Symansky, 1998, Fiscal Policy Rules, IMF Occasional Paper 162 (Washington: International Monetary Fund).
Mackenzie, G.A., and Peter Stella, 1996, Quasi-Fiscal Operations of Public Financial Institutions, IMF Occasional Paper 142 (Washington: International Monetary Fund).
Masson, Paul R., 1985, “The Sustainability of Fiscal Deficit” (unpublished; Washington: International Monetary Fund).
Milesi-Ferretti, Gian Maria, 1996, “Fiscal Rules and the Budget Process,” IMF Working Paper 96/60 (Washington: International Monetary Fund).
Spaventa, Luigi, 1987, “The Growth of Public Debt: Sustainability, Fiscal Rules, and Monetary Rules” Staff Papers, International Monetary Fund, Vol. 34 (June), pp. 374-99.
Sturrock, John, 1995, Who Pays and When? An Assessment of Generational Accounting (Washington: Congressional Budget Office).
Tanzi, Vito, 1990, “Fiscal Issues in Adjustment Programs in Developing Countries,” Development Studies Working Paper 26 (Turin and Oxford: Centro Studi Luca d’Agliano and Queen Elizabeth House).
Of course, maintenance of a sound fiscal policy stance in the medium term, as will be discussed later, tends to be growth enhancing. In the short term, discretionary fiscal policy is a powerful tool to address temporary exogenous shocks, particularly in countries where scope for monetary policy is limited (for example, in countries belonging to a monetary union).
Not only can government saving contribute to keeping excess demand in check, it also can provide room for financing investment activity, thus contributing, other things being equal, to the country’s growth prospects. There are, however, limits to the use of the current account concept for analytical purposes: not only is the classification of current and capital outlays often arbitrary, but evidence from developing countries also shows that by no means is all government investment growth enhancing. By contrast, some current spending—for example, some expenditure on education and health—may bolster overall productivity in the medium term.
This concept has been usefully applied to gauge the fiscal stance of oil-exporting countries in which the petroleum industry is nationalized: the monetary impact of rising unsterilized oil receipts used to finance government spending is expansionary (and inflationary), although the overall balance fails to predict this expansion.
This approach, however, encounters difficulties in identifying reliable proxies for potential output and, consequently, in effectively discriminating between automatic and discretionary elements. Moreover, the appeal of these measures has recently waned, mainly because of the greater openness of many economies. As discussed below, when an economic slowdown reflects adverse external shocks, especially when these are perceived as permanent, there is little scope for accepting a larger fiscal deficit on the grounds that there is unemployment or idle capacity utilization. On the contrary, under these circumstances a more contractionary fiscal policy stance would be required to reduce absorption to sustainable levels. For a review of these indicators, see Heller, Haas, and Mansur (1986).
In effect, this component of interest, the so-called monetary correction, is treated as if it were the amortization paid creditors in order to maintain an unchanged real value of the debt. As such, it is a below-the-line item (that is, a financing item), which has to be excluded from the calculation of the deficit.
This indicator has been criticized for giving high-inflation countries yet another reason for postponing the required fiscal correction. The argument is the following: because nominal interest rates are likely not to adjust immediately to unexpected inflation, governments may have an incentive to pursue time-inconsistent policies by allowing actual spending to slip over budgeted levels, thus imparting an inflationary bias to fiscal policy. In addition, the operational deficit is based on the binding assumption that inflation does not affect the real demand for bonds—that is, that bondholders are willing to fully roll over the inflationary components of their nominal interest earnings. Despite these shortcomings, the operational deficit can usefully complement other indicators in high-inflation conditions.
This is the so-called Ricardian-equivalence hypothesis (Barro, 1974).
These figures are from the IMF’s World Economic Outlook database. What is worrisome about this steady rise in the public debt is that, unlike in previous historical episodes of sizable debt buildups, it is occurring in the absence of a major war or economic depression.
In the equations, a dot over a variable denotes its derivative with respect to time, and a caret over a variable represents its percentage change with respect to the previous period.
Including quasi-fiscal operations of the central bank. A review of the important implications of activities of this type goes beyond the scope of this chapter. These issues are thoroughly discussed by Mackenzie and Stella (1996).
The appendix to this chapter provides a formal demonstration of how equation (9.4) is derived from equation (9.3).
If the public debt is made up only of domestic debt, then equation (9.4) becomes the following simpler, more traditional expression:
It has also been argued that when output growth exceeds the real interest rate, the economy is “dynamically inefficient”; that is, the return to capital in each period is less than the amount of resources devoted to capital formation (see Buiter, 1997).
Standard references to the literature on solvency include Buiter (1985), Spaventa (1987), Blanchard (1990), and Corsetti and Roubini (1991).
In countries without capital controls, the distinction between domestic and foreign debt becomes blurred, since governments cannot control the purchase of government securities or the capital flows that occur in response to changes in domestic interest rates.
However, the higher the growth rate relative to the real interest rate, the lower the primary surpluses will have to be in order to repay the debt.
Under this condition, the intertemporal budget constraint is met, even in the presence of negative primary surpluses, provided that the debt grows at a rate lower than (r – ŷ).
For a review of the arguments for adopting fiscal rules and of country experiences with these rules see Kopits and Symansky (1998).
This section summarizes the discussion in Tanzi (1990), IMF (1995), Hemming and Daniel (1995), and Chalk and Hemming (1998).
General guidelines on the quality of fiscal adjustment can be summarized as follows: high-quality fiscal adjustment requires measures that in themselves are efficient, durable, and equitable. The measures must not be distortionary, must not self-destruct in the near term, and must not eliminate socioeconomically desirable expenditures. See Tanzi (1990), pp. 12–13.
Some countries have resorted to institutional arrangements to strengthen the working of automatic stabilizers in the case of external shocks. The stabilization funds for the price of coffee in Colombia and copper in Chile have operated with success for a number of years.
However, when the recession deepened in these countries in early 1998, the fiscal policy stance switched to provide increasing support to sagging domestic demand. Thus, programs were revised, first, to accommodate part of the larger fiscal deficits stemming from the effects of the automatic stabilizers and currency depreciation on the public finances and, then, to provide additional stimulus beyond the action of these automatic stabilizers, through some discretionary fiscal measures.
However, if fiscal contraction is carried too far, it can backfire through negative effects on economic activity that undermine investors’ confidence.
There could also be positive wealth effects resulting from the interest rate reductions and declines in the default premium on public debt. If government solvency is restored, the market value of wealth held by the private sector could increase, stimulating economic growth.
This holds true, strictly speaking, only if Ricardian equivalence does not prevail. Otherwise, private saving will always fully compensate for fiscal policy changes. The empirical evidence is, however, at best ambiguous, especially in the case of developing countries, on whether this theory has any practical relevance. (This section and the next are based on the discussion in Chalk and Hemming, 1998, p. 5.)
However, if the investment is perceived as profitable, the private sector might anticipate a higher future growth rate and match it with higher consumption, including consumption of tradables, thus increasing the current account deficit.
Classic references here are Hotelling (1931) and a later refinement by Hartwick (1977).
See Auerbach, Gokhale, and Kotlikoff (1994) and Sturrock (1995); the caveat expressed in an earlier footnote, about the potential for backfiring, applies also to this section.
