The Budgetary Control and Fiscal Impact of Government Contingent Liabilities

Conventional fiscal accounting methodologies do not appropriately account for governments’ noncash policies, such as their contingent liabilities. When these liabilities are called, budget costs can be large, as evidenced by the U.S. savings and loan crisis. In general, deficit measures may underestimate the macroeconomic impact of government policies, promoting the substitution of noncash for cash expenditure and increasing future financing requirements. This paper describes extended deficit measures to address the problem, but notes their limited practical value. Nonetheless, some alternative methods of valuing contingent liabilities are proposed to gauge fiscal impact and facilitate budgetary control.


Conventional fiscal accounting methodologies do not appropriately account for governments’ noncash policies, such as their contingent liabilities. When these liabilities are called, budget costs can be large, as evidenced by the U.S. savings and loan crisis. In general, deficit measures may underestimate the macroeconomic impact of government policies, promoting the substitution of noncash for cash expenditure and increasing future financing requirements. This paper describes extended deficit measures to address the problem, but notes their limited practical value. Nonetheless, some alternative methods of valuing contingent liabilities are proposed to gauge fiscal impact and facilitate budgetary control.

Much of of the debate regarding the efficacy of conventional cash flow measures of the deficit as indicators of fiscal impact has ignored the fact that an increasingly significant instrument of government policy—the adoption of contingent liabilities such as deposit insurance, social security and health insurance, and loan guarantees—does not involve a current cash flow, but an obligation regarding possible future cash flows.1 Conventional budget methodologies account for contingent liabilities not when the obligation is incurred, but when the actual expenditure is made.2 However, insofar as contingent claims on the government are valued by the private sector in excess of any fees charged in exchange, they may affect economic behavior when issued in a fashion similar to a cash tax or subsidy. Therefore, the conventionally defined budget deficit, by accounting for contingencies only when a cash outlay is made, may misrepresent the government’s current fiscal impact and limit its analytic usefulness. Moreover, since the issuance of such contingencies may have severe future cash flow implications, by relying on conventional accounting methods, budgetary authorities may not be provided with the means to adequately monitor and control the government’s overall fiscal position.3

This paper reviews the types of contingent liabilities governments issue, and examines their accounting in conventional budget methodologies (in Sections IIII). The impact of government contingencies on private sector behavior is then discussed, and means by which measures of the fiscal deficit could be amended to account for contingencies are reviewed (in Sections IVVII). Although, in theory, deficit measures could be defined that would include the fiscal impact of governments’ issue of contingent claims, it is argued that they would be based on the choice of relatively extreme views regarding the macroeconomy. A simple alternative would be to require calculation of the change in the degree to which a contingency program is funded during each budgetary period. This would provide both an ancillary measure of the government’s impact on the economy and a device with which to gauge and enforce budget discipline.

I. Government Contingent Liabilities

The distinction between governments’ contingent and noncontingent liabilities (for example, interest-bearing debt) is that the nominal obligation and the settlement date of the latter are fixed at the date of issue, whereas with contingent liabilities, the contractual obligation of the government is dependent, in its timing and amount, on the occurrence of a particular event. A major proportion of governments’ contingent liability relates to social security programs—sometimes referred to as annuity programs—such as state pension schemes and medical insurance programs. These imply an obligation by the government to provide financial assistance to the private sector that is contingent on various criteria including need, disability, retirement, unemployment, or death.4

While it has been estimated that governments of 143 countries now provide some type of social security program, the scope and coverage of such programs differ widely.5 Coverage may be employment related, in which benefits are contingent on length of previous employment and earnings and benefits are usually partially funded through compulsory contributions either by employers or employees or both. Nonetheless, the central government usually contributes a major share of total revenue. Less prevalent are systems in which coverage is universal and benefits are untied to recipients’ employment history.

Governments provide a myriad of other, nonsocial security-related, programs that are primarily (but not exclusively) designed to stimulate particular economic activities by reducing risk, rather than to provide income support; these include loan guarantees, deposit insurance, mortgage guarantees, and trade and exchange rate guarantees. Unlike the annuity programs described above, which are usually based on a principal of universal coverage, loan guarantees and other similar insurance schemes are usually associated with the consumption of a particular service that is deemed worthy of subsidy (for example, deposit insurance and guarantees of student and housing loans).6

These programs encompass a broad range of characteristics.7 The guarantee may cover 100 percent of the credit arrangement, or up to some fraction or fixed amount. Most credit and deposit guarantee schemes require a fee or premium, which may be a one-time or annual payment and is usually based on a percentage of the amount guaranteed. Often these programs are “funded,” in the sense that some attempt is made to ensure the maintenance of a reserve that matches the expected liability, and in some cases the program’s liability is limited to the amount of the reserve. Guarantee or insurance schemes may be voluntary—for example, loan guarantee schemes—or mandatory, as in the case of deposit insurance.

In addition, a substantial share of governments’ contingent liabilities may be associated with the implicit guarantee of transactions of parastatal agencies or sectors of the economy. These implicit guarantees are distinct from those discussed above, in that no specified contractual basis exists defining the government’s liability. For example, government-sponsored enterprises (GSEs), although wholly privately owned, may be mandated to perform public policy.8 Because GSEs are constrained to fulfill public policy objectives and so may be prevented from profit maximizing, it has been suggested that governments face a “moral” (rather than a legal) obligation to guarantee their debt. Similarly, although a government may not be contractually bound to rescue industries or regions that suffer financial reverses, there may be a similar implicit obligation. Salient examples in the United States include the extension of substantial credit guarantees to Penn Central Railway (in 1970), Lockheed (in 1971), New York City (in 1975), and Chrysler Corporation (in 1979).9

II. Funding Contingent Liabilities

A firm’s contingent liabilities are considered funded if they are matched by a reserve or charge against profits equal to the actuarial value of the liability—that is, when the reserve equals the present discounted value of expected payouts. The relevance of this distinction, as often applied to pension and insurance funds, is whether or not the balance sheet is sufficiently strong to ensure that the liability can be repaid if the plan were terminated. Actuarial examination of a private sector pension plan, for example, will require estimation of benefits accrued to date—the actuarial liability—which represent the firm’s current obligation to current plan participants. The firm’s contingent liability is considered funded if this value is matched by reserve assets; the difference between the actuarial liability and any reserve assets that exist is termed the unfunded actuarial liability.

However, actuarial examination usually also requires the calculation of the expected present value of additional benefits expected to be accrued in the future. The sum of past and expected future accruals is termed the actuarial present value of future benefits. Firms are often legally required to erase the difference between this latter value and the value of reserve assets over a period of time through the adoption of a schedule of contributions that fund the benefits of the plan.10

It has been argued, however, that these actuarial concepts must be used with caution when applied to the government’s fiscal accounts. First, as the government’s power to levy taxes or create debt instruments to finance expenditure implies that it does not face the same solvency constraints as the private sector, actuarial techniques designed to measure solvency may be less relevant for an analysis of fiscal policy.11 Moreover, Selling and Stickney (1986) note that recent accounting standards set for the U.S. private sector require pension liability to be calculated on the basis of accumulated benefit and projected benefit obligations, neither of which include consideration of the impact of expected future service on benefit obligations.12 This similarly suggests that actuarial methodologies and standards, as applied to fiscal accounting, should be amended so as to place greater emphasis on expected future obligations, rather than on accrued obligations to date.

A frequently used criterion for measuring the degree to which a program is funded, especially in the case of social insurance programs, is that of “actuarial balance.” It differs from the previous definition, in that account is taken of the net expected benefits of expected future, as well as current, participants. A contingency program would be said to be actuarially balanced if the expected value of future payouts to all current and future participants equaled the expected present value of the inflows from all current and future participants, plus the value of any reserve fund. Since there is not necessarily a balance between current participants’ expected future contributions and benefits, even if a reserve fund did exist, it would not in general be equivalent to the program’s accrued liability.

Nonetheless, when a program is actuarially balanced, government tax revenue will not be required to meet its obligations. For example, a growing population or inflation could provide the resources to finance a social security system for which current participants’ expected benefits exceed expected contributions. Moreover, while an actuarially balanced program may suffer a temporary negative cash flow, in turn requiring financing from the government’s general revenues, actuarial balance implies that these negative cash flows will be transient and will be offset by future inflows, so that deficits may be offset by borrowing, with repayments fully covered by the fund’s own resources.

A stricter criterion for measuring the degree to which government programs are funded is actuarial fairness. In this case, a contingency program would be termed funded if the expected present value of future payouts to each of a program’s current participants equaled the expected present value of any current and future payments by current participants (for example, fees or contributions) to the program in addition to the value of any reserve assets. This calculation would also include consideration of benefits accrued in the future. If this criterion were met, and the revenues of the program are not added to the general revenues of the government, a fund would exist that matched the expected value of participants’ accrued benefits, and there should be no need for government tax revenue to be raised to meet the program’s expenditure.

Unfunded programs will not meet one or both the actuarial balance of actuarial fairness criteria, and expected receipts may fall short of expected payouts. The simplest example is that of pay-as-you-go (PAYG) schemes, in which contribution rates are adjusted periodically as necessary to meet cash outlays.

III. Contingent Liabilities in Conventional Deficit Measures

The treatment of contingencies in conventional fiscal accounting systems implicitly relies on a view that the macroeconomic impact of such programs occurs primarily at the future date when the contingent claim is realized and the cash flow is generated, rather than when the liability is issued. The implicit assumption is that consumers are myopic with regard to the future benefits that such schemes imply, or face liquidity constraints that inhibit the adjustment of current consumption to expected future benefits. In the latter case, an increase in expected future benefits, while increasing consumers’ net wealth, will not permit an increase in current consumption because capital market imperfections restrict consumers from borrowing against future income.13

The two most prevalent deficit measures—those prescribed by the United Nations in A System of National Accounts (SNA) or the International Monetary Fund in A Manual on Government Finance Statistics (GFS)—index the current period’s excess of governments’ expenditures over revenues on an accrual or cash basis, respectively. Both systems focus on current flows of goods and services rather than on current policy commitments that may imply future transfers between the public and private sector. GFS recommends the exclusion of imputed or accrued transactions in accounting for government activity (GFS, p. 2), in favor of an accounting method based solely on cash transactions. While conceding the importance of accrued assets and liabilities (for example, uncollected tax revenues), GFS excludes them, owing to the difficulty in accounting for them accurately and in a fashion consistent with other macroeconomic statistics (GFS, p. 108). Thus, with regard to loan guarantees, only payments in the event of default are included as an expenditure item. In particular, if these transactions give rise to a claim on the borrower, payment of principal and interest in the event of default is classified as net lending; receipts in repayment of defaulted amounts are included as repayment of a loan to the private sector (GFS, p. 105).14 Similarly, only the cash flows related to social security programs enter into the government’s accounts under the GFS system, and the accrued liability is ignored (GFS, p. 16).15

SNA’s budget methodology differs from that prescribed in GFS, with implications for the treatment of contingencies. In particular, government transactions are included in the fiscal accounts on the basis of changes in ownership of goods and services and accrued tax liabilities; sales of assets and net lending are treated as financing items. Therefore, the recommended treatment of social security flows “in the case of current transfers which represent obligations to, or commitments of, organs of general government is to record the transfer as of the date when they are due without penalty” (SNA, p. 128), rather than when the cash flow is generated. This results, however, in only a modest difference in timing compared with the methodology described in GFS. Similarly, SNA recommends accounting for payments upon default of government-guaranteed loans on an accruals basis—again when the liability is due with certainty. Since SNA focuses on changes in the government’s net indebtedness (rather than on the policy intent of its transactions), the settlement of such an obligation would be classified as a financing item.

IV. Contingencies and Alternate Budget Definitions

Conventional deficit measures are likely to be deficient indicators of fiscal impact except under extreme assumptions regarding private sector behavior—for example, myopia regarding the future implications of current government policy or liquidity constraints. However, if these assumptions are relaxed, and if contingency programs are not operated subject to the same incentives as the private sector, such programs may imply a net transfer to participants and may affect economic activity in advance of any cash outlay. For example, the announcement of expanded future social security benefits could increase current aggregate demand if some of the tax burden of the future benefits is expected to be borne by future generations. As households expect that their future benefits will exceed their future tax liability, their expected net wealth increases, thereby increasing their demand for current consumption.

Therefore, the macroeconomic impact of both social security and nonsocial security contingency programs is likely to be closely related to the degree to which programs are funded. For example, as mentioned above, if the contingency program operates as a forced savings vehicle, requiring contributions from participants that exactly match their expected payouts, the program will be fully funded, and it is unlikely that the program will have a macroeconomic impact. Similarly, a PAYG scheme, or one that is less than fully funded, may imply a net transfer from future generations to current consumers, and therefore induce an increase in aggregate demand.16 Two extended measures of the fiscal deficit are described below that address this possibility.

The Economic Deficit

As noted above, it is often argued that private sector behavior results from economic agents’ allocation of net wealth over their life cycle. In this context, it has been suggested that since social welfare programs offer a well-defined right to (possibly uncertain) benefits in the future, economic agents may view the payment of social security taxes as the purchase of an annuity or bond, rather than a compulsory tax, and may similarly view the payout as repayment of principal and interest (Kotlikoff (1984, 1986, and 1988); see also the discussion in Mackenzie (1989)).

In this circumstance, the prescription is to describe the government’s fiscal stance in terms of an “economic deficit,” in which social security tax receipts are reclassified as a financing item, while a portion of benefits are similarly included below the line as a loan repayment. Only the excess of benefits over payments to each individual is treated as an interest expenditure.17 Similarly, most expenditures associated with loan and other guarantees would remain above the line—reclassified as interest payments—while any premia or fees would be placed below the line and classified as financing items.18

Clearly, however, the extent to which social security, or any other contingency program, can be viewed as having the same fiscal impact as any other government financing instrument will depend on the degree to which the contingent claim represents a tax or a subsidy. For example, for social security payments to have an economic impact equivalent to the sale of other financing items, the rate of return on contributions would have to be the same as on other private sector savings instruments, adjusted for risk and other relevant factors. To the extent that the return is less (more) than on market instruments, households must be coerced into participation, and the program implies a tax (subsidy) in addition to a loan. A prescription, therefore, would be to include the (possibly noncash) transfer element of the contingency program in the fiscal accounts when the government issues the contingent claim; this measure would approximate an index of actuarial fairness described above (see also Section V).

Proponents of the economic deficit concept have argued that the government’s fiscal impact will also depend on the extent to which resources are transferred across generations. The impact of contingency programs would then depend on the degree to which current participants perceive that programs will be financed by future generations. Thus, calculation of the economic deficit would require detailed estimates of the intergenerational incidence of all fiscal activity, a task whose complexity limits its practical significance.

Government Net Worth

Alternatively, it has been argued that private sector macroeconomic behavior is best described in terms of a Ricardian consumer—an economic agent whose consumption and savings behavior is based on an extremely long-term assessment of household net wealth. In this case, a key variable that affects household net wealth, and therefore household behavior, is the government’s net wealth position—the expected present value of current and future tax revenue less its current net liability to the private sector. Government policies, such as a planned tax increase, that increase its net wealth permit greater government consumption of goods and services while constraining the private sector’s ability to finance its own expenditure. In its most general formulation, government net wealth will equal the expected present value of all taxes, including the seigniorage on its nominal debt, plus the net value of current assets, including natural resources and fixed capital, less the current value of current liabilities.19

The government’s provision of noncash contingency programs—such as social insurance and loan guarantees—also implies future subsidies or transfers to the private sector, and, unlike conventional deficit measures, affects the government’s net wealth and therefore the index of fiscal impact. The government’s issuance of loan guarantees will imply an expectation of a future cash payout (given a probability of default) and a reduction in the government’s net wealth (that is, the government will be unable to finance the same level of future consumption). Similarly, the expectation of a future transfer will increase household net wealth. The provision of social security-related insurance (or other such contingent payment systems) and the expectation of future transfers would also reduce the government’s net wealth. In either case, the increase in the government’s contingent liability will provide a stimulus to current private sector consumption.

However, underlying this concept is the view that the infinitely lived household is the relevant economic unit. If the economy is better described by heterogeneous (that is, by age and wealth) households with limited horizons, then changes in the government’s net wealth position may not be the most appropriate measure of fiscal impact.20 In addition, it has proven difficult to apply this concept; for example, valuation of such assets as natural resources, future seigniorage, and future tax revenue is extremely subjective.21 Further, it is likely that the private sector’s expectations regarding its future tax liability is not limited to existing tax regimes, but includes consideration of government reaction to future financing requirements.22

V. Measurement of Government Contingent Liabilities

The preceding discussion suggests that it may be impractical to abandon conventional deficit measures in favor of comprehensive indices of fiscal impact that encompass contingent liabilities. Nonetheless, indices of governments’ contingent liability are important. Since current contingent claims may imply future financing requirements, an index of the government’s net liability will allow for proper long-term fiscal budgeting. Similarly, since contingency programs may imply the use of scarce government resources, albeit at a future date, the appropriate design of public policy will depend on some measure of the tax and subsidy element embodied in such programs. Applications of these concepts are discussed below.

Actuarial Balance

This measure of a government’s net contingent liability is closely allied with the net wealth concept of the overall deficit described above. As mentioned above, it offers a useful gauge of the future tax liability or the required reduction in government consumption implied by a given program, information that is important both for budget management and for economic analysis of fiscal impact. To the extent that a program is unfunded from the perspective of its actuarial balance, the fiscal authorities are provided with an indicator of the inadequacy of contribution rates or benefits.

The actuarial balance can be calculated by comparing the net present value of a program’s assets to its liabilities:

autuarial balance =E[PV(inflows outflows operating expenses)]+ reserve,

where E[·] is the expectations operator; PV(·) is the present value operator; and inflows, outflows, expenses, and the reserve are defined in real terms. Since the underlying rationale for the above exercise is to examine the net worth of the program from the government’s perspective, it is usually assumed that the appropriate discount rate is the government’s opportunity cost—the real after-tax interest rate on government bonds.23

An advantage of using the actuarial balance as a measure of the government’s net liability is that, especially in the case of social security and annuity programs, there are well-established accounting and actuarial practices to facilitate the calculation, especially with regard to the appropriate expectations regarding, for example, mortality and fecundity.24 However, care must be taken with the application of these actuarial methodologies to the public sector accounts. For example, accounting practices for private sector pension are usually based on one of two alternate methodologies: the accumulated-benefit obligation; or the projected-benefit obligation. The former defines the pension obligation as based on the current salary and accumulated service to date of current plan participants, whereas the latter is based on expected future salaries and accumulated service to date (Selling and Stickney (1986)). Both are myopic with regard to the future service of current and prospective participants and exclude consideration of new entrants and their payment of premia or receipt of benefits. For the purpose of determining the net balance of government contingent liabilities, particularly public sector social security programs, a more economically relevant measure is appropriate. Since participation in such programs is mandatory, the potential future funding requirement of such programs should be defined with reference to the inflow and outgo associated not only with current but also prospective enrollees (for example, with appropriate assumptions regarding population and income growth).

However, for other, nonannuity, contingency programs, where participation is not universal or mandatory, long-term projections of participation would be difficult to incorporate in measures of actuarial balance. For example, the calculation of the balance for deposit insurance programs would require assumptions regarding the growth of deposits and new entrants, as well as an estimate of defaults. This difficulty is compounded for those programs in which participation by the private sector is optional (that is, loan guarantee and trade financing programs), where an assumption would be required regarding public sector participation and government policy toward their provision. In these instances, projections could be made based either on a shorter horizon, or simply with respect to current participants (see discussion below).

A final issue concerns cash flow deficits. A business strategy for private sector insurance companies may involve adjusting the level of reserves or premia, for example, to reduce the “probability of ruin” (that is, the probability that reserves will be more than depleted in any given period; see Buhlmann (1970)) to some minimum acceptable level. An actuarially balanced contingency program may face either the risk or the certainty of a negative cash flow in the near term, which would more than eliminate any reserve. At such a point, to maintain its commitments the program would require support from the general government budget. This could present significant difficulties, especially in the case of contingencies denominated in foreign currency, or for countries with limited access to domestic capital markets or limited tax bases. Thus, rather than targeting so that contingencies are actuarially balanced on an expected value basis, a concern for the risks associated with the program may dictate a more conservative strategy.

Market Value or Subsidy Measures

The actuarial balance of a program may be inadequate to gauge the subsidy or transfer to current participants of contingency programs, and thus of their short-run fiscal impact. Four theoretically equivalent indices that address this concern, and which correspond more closely to the paradigm underlying the concept of the economic deficit discussed in Section IV, are described below.

Actuarial Fairness

A simple alternative to the net worth or actuarial balance definition discussed above would be to calculate a program’s index of actuarial fairness. This would require the derivation of an index similar to that for a program’s actuarial balance, except that it would only include consideration of the net transfer to current participants—the expected present value of their current and future contributions less their current and future benefits, plus the current value of any reserve fund.

Since the index is intended to measure the change in current participants’ net wealth, rather than that of the government, the appropriate discount rate may differ from that used to calculate net wealth from the government’s perspective, owing to tax distortions, the existence of externalities (for example, the private sector may undervalue the impact of its investment on future generations), or risk. In principle, the appropriate discount rate would be the private sector’s opportunity cost of the cash flow associated with the contingency.25

The calculation of such an index would be relatively simple if procedures were already in place for calculation of the actuarial balance (for example, as is done for the U.S. social security system). However, if the actuarial exercise is not already routinely performed, the cost of developing the actuarial model—that is, the assumptions regarding the probabilities of default or illness, for example, as well as future economic scenarios—and of performing the calculations may be prohibitive.

“Market Value” Measures

An alternative approach is to use current market information to derive a market value of the contingency. For example, in the context of a loan guarantee, the market value of a program would simply be the difference between the rate that the borrower pays versus that rate paid in the absence of the guarantee.26 A nominal measure of the subsidy per period would be (ip – ig)L, where ip and ig are the annual rates of nominal interest on private sector unguaranteed and guaranteed loans, respectively, and L is the loan principal. The implicit subsidy, or the value of the guarantee (G), over the life of the loan (n), is simply the net present value of associated cash flows:


where the subsidy value would be reduced by the amount of initiation fees or other charges that the recipient is required to pay.27 The value of a government guarantee of an annuity contract, in which interest and principal are repaid by means of a fixed cash payment over the contract period, can be derived in a similar fashion. For example, suppose private sector credit is available such that a contract for an n-year loan of L dollars requires an annual payment of cp dollars. Given the effective interest rate of ip, the annual payment will satisfy


The analogous rate and debt-service payments (ig and cg, respectively) on a government guaranteed loan for the same initial amount L satisfy


The periodic subsidy to the holder of the guaranteed loan can be measured by the difference between the annual cash flows between the two loan contracts:




The full value of the guarantee is the present discounted value of the cash flow defined above, which in this case can be shown to equal


While the foregoing discussion has been in terms of loan guarantees, the same methodology could be applied to the full range of government contingent liabilities. For example, the subsidy associated with social security could be defined as the difference between the premia paid to the government program and the amount that the private sector would have charged for the same or similar insurance contract. The net present value of any subsidy could be calculated accordingly. Exchange rate guarantees would be similarly valued as the cost of purchasing a forward exchange contract with the same features as provided by the government.

In some cases, however, it may be difficult to determine the rate of interest that would have been paid in the absence of the guarantee. A representative sample of a guaranteed contract with similar risk characteristics may not be available, especially if the program in question has been initiated to resolve a market failure, or it has supplanted a private sector market. Moreover, even if a market rate is observable, it may understate the value of the guarantee, since the exit of the guaranteed borrowers may reduce the pressure on private sector rates. Finally, by guaranteeing private sector credit, the government also assigns many of the characteristics of government debt, both with regard to risk and transactions costs (since the guarantee may be associated with government management of the secondary market for the guaranteed debt). If the government is faced with anything but a perfectly elastic demand for its debt, the effect may be to increase its own cost of borrowing, in turn implying an additional indirect cost of the contingency program that would be difficult to quantify.

Option-Pricing Approach

An equivalent approach to measuring the subsidy associated with contingent claims is suggested by recent advances in option-pricing theory. In financial markets, a call (put) option is defined as the right to buy (sell) a prespecified quantity of a financial instrument (or commodity) at a prespecified price on or before a prespecified date.28 The purchaser of an option will exercise the right to purchase the underlying instrument if the market price exceeds the specified exercise price. Merton (1977) has observed that government provision of a loan guarantee or deposit insurance may also be viewed as the provision of an option. If the underlying value of the credit instrument falls below a given level, the borrower is in default and will exercise the option for the government guarantee. With modern option-pricing theory, an exact pricing formula (initially derived by Black and Scholes (1972)) for the implicit market value of such guarantees can be derived as a function of readily available market data.

For example, consider the government guarantee of a loan B. If, at the maturity date of the loan the value of the assets of borrower V on which the guarantee was issued exceeds B, then there is no default. However, if the value of the assets is less than the value of the loan, then the guarantee implies that the government must pay B – V; that is, the difference between the loan value and the surrender value of the assets. The implicit value of the guarantee at the maturity date of the loan (time T) is


Under the assumption of frictionless markets and that the return process to the underlying assets evolves according to a continuous stochastic process, Black and Scholes demonstrate the exact pricing formula for the option.29 For example, the value of the loan guarantee (at the initial date t) is



x1 [log(B/V)(r+σ2/2)(Tt)]/σ(Tt)x2x1 +σ(Tt),

and Φ is the cumulative normal density function, σ2 is the variance rate of the logarithmic changes in the value of V, and r is the “risk-free” rate of interest.

The formula above is not general; it must be amended according to the terms of the guarantee arrangement and the underlying assumptions regarding the market structure and the type of contingent claim.30 While this approach could be applied with some modification to the measurement of the value of social security programs, it is most relevant to financial market insurance programs. However, it is not clear that this measure would be any simpler to calculate than those described above. Moreover, the underlying assumption of the option-pricing model—that of frictionless markets in which asset prices, including those on options, adjust so as to eliminate the risk of the market portfolio—may invalidate its use in many cases, especially those in which markets are insufficiently deep to permit the creation of the perfect hedge assumed.

Welfare Measures

The above subsidy measures are explicitly based on the calculation of the financial worth of the contingency program. An alternative is to consider the welfare implications of the extension of a contingent claim to the private sector.31 This would involve an examination of the change to the consumer and producer surpluses, as defined by the areas under the private sector’s demand and supply curves for the “insurance” in question that resulted from the government’s intervention.32 However, this approach is poorly suited to a consideration of the second-round effects on the demand for and supply of credit of the government policy, which might result from substitutions from other markets or from the dynamic consequences of default on welfare.33 Moreover, although this type of approach may be useful for gauging the cost or benefit of specific government programs, it is less relevant for government budgeting. This is especially apparent given the obvious difficulties associated with measuring the parameters underlying the demand for and supply of credit, as well as the well-known methodological problems associated with measuring consumer surplus (see Auerbach (1985) for a discussion).

VI. Budgetary Controls

As noted above, conventional budget methodologies and deficit measures tend to ignore the future cash flow implications of government contingent liabilities. As a result, the cost of providing contingencies may be inadequately accounted for at the time of their provision. Moreover, the inadequacy of conventional budget methodologies may imply an incentive for the fiscal authorities to substitute away from cash to noncash activities as a means of circumventing constraints on the overall cash-based deficit or expenditure.34 While it may not be feasible to adopt the comprehensive deficit measures discussed in Section IV, a more piecemeal approach, incorporating the concepts described in the previous section, may provide the necessary budgetary control.

Ad Hoc Constraints

One approach is to place an ad hoc limit on the level of the government’s liability. For example, preparation of the government’s annual budget could include a forecast of the desired increase in total loans on which a government guarantee applies and the imposition of explicit constraints on agencies’ ability to exceed these limits during the year. This method may be useful in the case of programs where measurement of the subsidy component is difficult, or where technical expertise is unavailable. Thus, this approach is most often used with loan and other guarantee programs, rather than for social insurance programs where there exist relatively well-established actuarial methodologies. Moreover, such constraints ignore the value of contingencies and do not permit proper accounting of their cost or the implied subsidy; therefore, a comparison with other programs is impossible.35

Given that the fiscal authorities’ resources are limited, proper budgetary planning will require a measure of the subsidy transfer embodied in contingency programs. Three possibilities are discussed below.


A straightforward method of establishing the current cost from the provision of contingent liabilities is for the government to divest itself of the liability. This goal may be accomplished by purchasing offsetting insurance from the private sector, or by a voucher system in which borrowers are provided vouchers to purchase either explicit insurance or to provide lenders compensation for default risk.36 On the date the contingent claim is offered, a cash expenditure would therefore be required by the government representing the explicit subsidy or transfer. As a result, the future contingent cash obligation would be eliminated in favor of a current cash flow, which should approximate the actuarial fairness index described above.37

Although this proposal has been primarily associated with loan guarantees, it could be applied to social welfare and other government insurance programs. Its advantage is its transparency; the cost of the contingency program is made explicit at the point the contingent claim is issued. Moreover, by eliminating the ongoing administrative burden of such programs, a net savings to the budget may arise. Finally, the advantage of this approach is that the valuation of the contingent claim is provided by the market. However, as a result, it may only be relevant to those types of contingencies for which a private market would normally be viable. First, it would be difficult, for example, to apply a voucher system when the government’s intervention was originally intended to alleviate the market’s inability to provide the socially desirable level of insurance. This will be especially true in the case of social welfare systems. Second, it is possible that by pooling risks, the public sector would be the least-cost provider of insurance. By shifting the risk to the private sector, budgetary costs may be increased. Thus, while this approach has merit, it may be less useful in cases where the government’s original purpose in providing the contingency was to correct a perceived inadequacy of the private sector, on either economic efficiency or equity grounds.

Redefining the Deficit

A proposal closely allied with the concept of the economic deficit discussed above is to redefine government expenditure and revenue concepts to take explicit account of the subsidy component of contingency programs. Accordingly, the cash flows associated with the administration of contingency programs would be dichotomized; instead of including all cash receipts and disbursements as revenue and expenditure, respectively, only the net implicit subsidy resulting from the change in contingent liabilities outstanding would be included (as an expenditure). The difference between the calculated net subsidy and the program’s total net receipts would be reclassified as a financing item.38

Annual subsidy outlays would be calculated with reference to the market value of contingencies issued over a given period.39 At the beginning of a given budgetary period, agencies responsible for issuing contingencies would be assigned a constraint on their ability to issue additional contingencies, based on their subsidy value rather than the additional gross liability of the government. In this manner, the budget authorities would be provided with the appropriate trade-off between expenditure allocations, since the longer-run financing implications of contingencies would be accounted for. Moreover, as the budget deficit would be calculated on the basis of the subsidy component rather than the current cash flows associated with contingencies, it could more accurately represent the government’s fiscal impact on the macroeconomy.

Note that the subsidy under this scheme would be (broadly speaking) defined in terms of the expected net present value transferred to the current recipients of the newly issued contingent claim—that is, the amount that would render the contingency actuarially fair. Moreover, it would be implicitly assumed that the current fiscal impact of any current policy that implied a subsidy to future participants would be nil. Therefore, the resultant measure of the overall fiscal deficit would be implicitly similar to the economic deficit discussed above.

This approach would likely be most effective when applied to programs for which administering agencies have significant discretion regarding the amount and value of claims issued. In such cases, a constraint on the subsidy value of contingent claims issued during a given budgetary period may ensure that the issuing agency either restricts the issue of claims or adjusts the terms under which the claim is issued to reduce the subsidy component. However, the relevance of this method for imposing fiscal discipline in the case of contingency programs for which participation is mandatory and/or the terms of issuance are not under the administering agency’s control—for example, social insurance programs—is less clear.


An alternative approach is to require full funding of the subsidy component of contingencies—that is, agencies issuing contingent liabilities would be required to purchase assets equal to the value of the contingent liabilities issued in each budgetary period. Thus, instead of the somewhat artificial constraint that would be imposed under the scheme described above, issuing agencies would face a cash constraint. With this method, an actual cash expenditure is created that matches the change in the government’s liability, so that the overall deficit immediately includes the impact of contingencies.

However, in this case the type of asset used to match the government’s liability will be of concern. If the agency and its fund are consolidated with the government, and government instruments are the investment vehicles for the funding exercise, then the government’s overall deficit, and its net liability position, may continue to be understated.40 The funding requirement may provide the necessary institutional constraints to monitor and control the issue of contingencies appropriately, but the government’s future financing requirement will be unaffected, and the overall fiscal deficit will continue to account inadequately for the transfers associated with contingency programs.

The alternative (which has been proposed for the U.S. social security surplus) would be to make government debt instruments ineligible for funding of contingencies. Other things being equal, this will result in the government’s purchase of private sector debt or equity in an amount equal to the value of the contingencies issued each budgetary period. If and when contingent obligation became due, these assets would be sold to finance the required expenditure. Thus, under the GFS and similar systems, where such purchases are treated as an expenditure rather than financing, the government’s overall deficit would be increased at the date of issuance of any contingency, but would be unaffected when the contingency became due.

However, while constraining contingency programs in this fashion may be necessary where budgetary resolve and control are weak, it may be argued that the fiscal authorities’ ability to finance their other activities would be unnecessarily constrained. Just as it will be occasionally desirable to finance a government’s purchases of goods and services through domestic borrowing, it also may be desirable to issue contingent liabilities without cash expenditure until a future date. This will be especially relevant for countries whose capital markets are less well developed. In such cases, the government’s ability to finance the initial cash outlay may be limited. Moreover, it is possible that this activity could have undesirable macroeconomic consequences by altering significantly the private sector’s portfolio share of private and public debt instruments. Finally, requiring the purchase of nongovernment assets for investment of reserve funds would not by itself induce the desired budgetary discipline. It will be just as important to adopt measures that prevent excessive issuance of liabilities.

Thus, the issue of the composition of governments’ reserve or contingency funds seems to hinge more on budgetary control of both the issuance of contingent liabilities and other expenditure, rather than appropriate funding techniques. If budgetary control is weak, the additional resources made available from contingency programs may provide an incentive to expand expenditure in excess of prudent levels. However, if budgetary control is strong, and the fiscal authorities are provided with the appropriate measure of the noncash outlays implied by contingency programs, then the content of the reserve fund will be less relevant.

VII. Concluding Remarks

It is argued above that conventional budget methodologies ignore the issue of contingent liabilities, except when a cash flow is created. Thus, while conventional deficit measures will (subject to a number of caveats) accurately describe the change in the government’s nominal liabilities resulting from the need to finance cash expenditures, the change in its liability from noncash policies—that is, the extension of contingent claims—will generally be ignored. As a result, fiscal accounting systems will provide insufficient data for adequate budgetary control over such policies. Moreover, constraints on conventionally defined levels of expenditures and the deficit may have the unintended effect of creating the incentive to substitute noncash expenditure through the issue of loan guarantees or other means. As a result, conventional budget methodologies may lead to improper analysis of the trade-offs between current cash expenditure policies and the issuance of contingencies.

In addition, the design of macroeconomic policy will depend on an appropriate measure of the macroeconomic impact of the government’s fiscal activities. While there is substantial controversy regarding the impact of such contingency programs as social welfare, deposit insurance, and loan guarantees, it is likely to be significant. Thus, insofar as conventional measures of fiscal impact ignore these noncash fiscal activities, they may underrepresent the government’s effect on the macroeconomy.

Extended deficit measures can be defined to gauge the government’s fiscal impact. Deficits can be defined that measure the intergenerational transfers implied by contingency programs (and other government policies), or that sum government activity, including contingencies, over an infinite horizon. The choice will depend on the relevant planning horizon of the budget authority and the private sector. However, either alternative would likely be impractical given the data requirements, as well as requiring a choice between polar views regarding the determinants and the horizon relevant for private sector consumption and savings.

Nonetheless, the value of government contingencies should be measured, especially so that adequate budgetary controls may be applied. Two alternatives were proposed here that correspond closely to the underlying focus of the extended deficit measures: actuarial balance, which would represent the liability from the government’s (long-term) perspective; and actuarial fairness or a contingency’s subsidy value, which measures the transfer to current participants. In the latter case, a number of alternative measurement strategies can be defined, with the choice depending on the type of contingency in question and the data available. These measures can be used to form the basis of the appropriate budgetary control over the government’s provision of contingencies, as well as the analytic device for gauging their impact.


  • Atkinson, Anthony B., “Income Maintenance and Social Insurance,” in Handbook of Public Economics, ed. by Alan J. Auerbach and Martin Feldstein (New York: North-Holland, 1987).

    • Search Google Scholar
    • Export Citation
  • Auerbach, Alan J., “The Theory of Excess Burden and Optimal Taxation,” Chap. 2 in Handbook of Public Economics, ed. by Alan J. Auerbach and Martin Feldstein (Amsterdam: North-Holland, 1985).

    • Search Google Scholar
    • Export Citation
  • Auerbach, Alan J., and Laurence J. Kotlikoff, Dynamic Fiscal Policy (New York: Cambridge University Press, 1987).

  • Bernheim, B. Douglas, “A Neoclassical Perspective on Budget Deficits,” Journal of Economic Perspectives, Vol. 3 (Spring 1989), pp. 5572.

    • Search Google Scholar
    • Export Citation
  • Black, Fischer, and Myron Scholes, “The Valuation of Option Contracts and a Test of Market Efficiency,” Journal of Finance, Vol. 27 (May 1972).

    • Search Google Scholar
    • Export Citation
  • Boadway, Robin W., and David E. Wildasin, Public Sector Economics (Boston: Little, Brown, 1984).

  • Borensztein, Eduardo, and George Pennacchi, “Valuation of Interest Payment Guarantees on Developing Country Debt,” Staff Papers, International Monetary Fund, Vol. 37 (December 1990), pp. 80624.

    • Search Google Scholar
    • Export Citation
  • Boskin, Michael J., “Concepts and Measures of Federal Deficits and Debt and Their Impact on Economic Activity,” in The Economics of Public Debt, ed. by Kenneth J. Arrow and Michael J. Boskin (New York: St. Martin’s Press, 1988).

    • Search Google Scholar
    • Export Citation
  • Bosworth, Barry P., Andrew S. Carron, and Elisabeth H. Rhyne, The Economics of Federal Credit Programs (Washington: The Brookings Institution, 1987).

    • Search Google Scholar
    • Export Citation
  • Brau, Eduard H., and Chanpen Puckahtikom, Export Credit Cover Policies and Payments Difficulties, Occasional Paper 37 (Washington: International Monetary Fund, 1985).

    • Search Google Scholar
    • Export Citation
  • Buhlmann, Horst, Mathematical Methods in Risk Theory (Heidelberg: Springer-Verlag-Berlin, 1970).

  • Buiter, Willem H., “Measurement of the Public Sector Deficit and Its Implications for Policy Evaluation and Design,” Staff Papers, International Monetary Fund, Vol. 30 (June 1983), pp. 30649.

    • Search Google Scholar
    • Export Citation
  • Buiter, Willem H., “Measuring Aspects of Fiscal and Financial Policy,” NBER Working Paper 1332 (Cambridge, Massachusetts: National Bureau of Economic Research, 1984).

    • Search Google Scholar
    • Export Citation
  • Chaney, Paul K., and Anjan V. Thakor, “Incentive Effects of Benevolent Intervention: The Case of Government Loan Guarantees,” Journal of Public Economics, Vol. 26 (March 1985), pp. 16989.

    • Search Google Scholar
    • Export Citation
  • Diamond, Jack, and Christian Schiller, “Government Arrears in Fiscal Adjustment Programs,” in Measurement of Fiscal Impact: Methodological Issues, Occasional Paper 59 (Washington: International Monetary Fund, 1988).

    • Search Google Scholar
    • Export Citation
  • Ebrill, Liam P., “Social Security, Demographic Trends, and the Federal Budget,” IMF Working Paper 90/14 (Washington: International Monetary Fund, 1990).

    • Search Google Scholar
    • Export Citation
  • Eisner, Robert, “Which Budget Deficit? Some Issues of Measurement and Their Implications,” American Economic Review, Vol. 74 (May 1984), pp. 13843.

    • Search Google Scholar
    • Export Citation
  • Eisner, Robert, How Real is the Federal Deficit? (New York: The Free Press, 1986).

  • Eisner, Robert, and Paul J. Pieper, “A New View of the Federal Debt and Budget Deficits,” American Economic Review, Vol. 74 (March 1984), pp. 1122.

    • Search Google Scholar
    • Export Citation
  • Heller, Peter S., Richard D. Haas, and Ahsan S. Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper 44 (Washington: International Monetary Fund, 1986).

    • Search Google Scholar
    • Export Citation
  • Hills, John, “Public Assets and Liabilities and the Presentation of Budgetary Policy,” in Public Finance in Perspective, Report Series No. 8 (London: Institute for Fiscal Studies, 1984).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, A Manual on Government Finance Statistics (Washington: International Monetary Fund, 1986).

  • Ippolito, Dennis S., Hidden Spending: The Politics of Federal Credit Programs (Chapel Hill: University of North Carolina Press, 1984).

  • Jones, E.P., and S.P. Mason, “Valuation of Loan Guarantees,” in U.S. Congressional Budget Office, Conference on the Economics of Federal Credit Activity, Part II: Papers (Washington: Government Printing Office, September 1981).

    • Search Google Scholar
    • Export Citation
  • Kotlikoff, Laurence J., “Economic Impact of Deficit Financing,” Staff Papers, International Monetary Fund, Vol. 31 (September 1984), pp. 54982.

    • Search Google Scholar
    • Export Citation
  • Kotlikoff, Laurence J., “Deficit Delusion,” The Public Interest (Summer 1986), pp. 5365.

  • Kotlikoff, Laurence J., “The Deficit Is not a Well-Defined Measure of Fiscal Policy,” Science, Vol. 241 (August 1988), pp. 79195.

    • Search Google Scholar
    • Export Citation
  • Levitsky, Jacob, and Ranga N. Prasad, Credit Guarantee Schemes for Small and Medium Enterprises, World Bank Technical Paper 58 (Washington: The World Bank, 1985).

    • Search Google Scholar
    • Export Citation
  • Mackenzie, George A., “Are All Summary Indicators of the Stance of Fiscal Policy Misleading?” Staff Papers, International Monetary Fund, Vol. 36 (December 1989), pp. 74370.

    • Search Google Scholar
    • Export Citation
  • Mayshar, Joran, “Should Government Subsidize Risky Private Projects?” American Economic Review, Vol. 67 (March 1984), pp. 2028.

  • McGinn, Daniel F., Pension Funding: Actuarial Primer for Corporate Management (Chicago: Charles D. Spencer & Associates, 1980).

  • Merton, Robert C., “An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees,” Journal of Banking and Finance, Vol. 1 (June 1977), pp. 311.

    • Search Google Scholar
    • Export Citation
  • Pennacchi, George C., “A Reexamination of the Over- (or Under-) Pricing of Deposit Insurance,” Journal of Money, Credit, and Banking, Vol. 19 (August 1987), pp. 34060.

    • Search Google Scholar
    • Export Citation
  • Selling, Thomas I., and Clyde P. Stickney, “Pension Accounting and Future Cash Flows,” Journal of Accounting and Public Policy, Vol. 5 (Winter 1986), pp. 26785.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, Mario I. Blejer, and Mario O. Teijeiro, “The Effects of Inflation on the Measurement of Fiscal Deficits,” in Measurement of Fiscal Impact: Methodological Issues, Occasional Paper 59 (Washington: International Monetary Fund, 1988).

    • Search Google Scholar
    • Export Citation
  • Towe, Christopher M., “Optimal Fiscal Policy and Government Provision of Contingent Liabilities: The Example of Government Loan and Deposit Guarantees,” IMF Working Paper 89/84 (Washington: International Monetary Fund, 1989).

    • Search Google Scholar
    • Export Citation
  • United Nations, A System of National Accounts (New York: United Nations, 1968).

  • U.S. Congress, Congressional Budget Office, Credit Reform: Comparable Budget Costs for Cash and Credit (Washington: Government Printing Office, 1989).

    • Search Google Scholar
    • Export Citation
  • U.S. Department of Health and Human Services, “Social Security Programs Throughout the World—1987,” Research Report No. 61 (Washington: Government Printing Office, 1987).

    • Search Google Scholar
    • Export Citation
  • U.S. Office of Management and Budget, Special Analyses: Budget of the United States Government, Fiscal Year 1990 (Washington: Government Printing Office, 1989).

    • Search Google Scholar
    • Export Citation
  • U.S. Social Security Administration, “Short-Range Actuarial Projections of the Old-Age, Survivors, and Disability Insurance Program, 1988,” Actuarial Study No. 103 (Baltimore: Department of Health and Human Resources, 1989).

    • Search Google Scholar
    • Export Citation
  • von Furstenberg, George M., ed., Social Security versus Private Saving (Cambridge, Massachusetts: Ballinger, 1979).

  • Wattleworth, Michael, “Credit Subsidies in Budgetary Lending: Computation, Effects, and Fiscal Implications,” in Measurement of Fiscal Impact: Methodological Issues, Occasional Paper 59 (Washington: International Monetary Fund, 1988).

    • Search Google Scholar
    • Export Citation

For a useful summary of extended measures of the deficit, see Tanzi, Blejer, and Teijeiro (1988) and Mackenzie (1989).


Note that in accrual-based methodologies expenditure is included when the commitment is made with certainty. See, for example, Diamond and Schiller (1988, p. 40).


For example, in the United States deficit targets have been legislated that include the current, but “temporary,” surpluses of the Social Security Administration. For a description, see Ebrill (1990).


The rationale for such programs is most often normative—that provisions should be made to redistribute income to the needy or aged, or that households must be coerced into saving for old age. Alternatively, insurance market imperfections that restrict the development of private insurance markets, such as informational asymmetries between the insurer and the insured, are also viewed as an important reason for providing social security. See Atkinson (1987) for a description of social security programs and their economic implications.


For a complete cross-country description of the typical characteristics of social security programs, see U.S. Department of Health and Human Services (1987).


Nonetheless, these schemes may also be seen as a means of achieving welfare or redistributive goals. For example, increasing access to capital markets, which would have been denied owing to informational asymmetries, is argued to be a welfare-improving policy (see, for example, Mayshar (1984)). However, others have argued that such guarantees promote an inappropriate adoption of risky investments and are, therefore, inefficient (Chaney and Thakor (1985), Bosworth, Carron, and Rhyne (1987, p. 41), and Towe (1989)).


See Brau and Puckahtikom (1985) for a description and survey of exchange rate guarantee systems. For a useful survey of the characteristics of credit guarantee schemes in a number of industrial and developing countries, see Levitsky and Prasad (1985).


For a discussion of the special relationship that GSEs enjoy with the U.S. Government, see U.S. Office of Management and Budget (1989, p. F-24).


The budget implications of these “bailouts” are described in Ippolito (1984, Chap. 4).


For a further discussion, see McGinn (1980).


Nonetheless, while governments’ ability to issue nominal domestic currency debt is not limited, it has become apparent in recent years that governments can be insolvent, especially with regard to foreign currency or their “real” obligations. See von Furstenberg (1979, Chap. I) for a discussion of these issues.


The accumulated benefit is calculated on the basis of current salary and accumulated service to date; the projected benefit is calculated on the basis of expected future salaries but accumulated service to date.


See Bernheim (1989) for an interesting discussion and survey of the literature regarding the effect of liquidity constraints on the relationship between deficits and aggregate demand.


If no claim is created against the defaulter, the payment of the interest obligation is treated as an interest expenditure while repayment of principal is considered negative financing (GFS, p. 179).


The exceptions to consolidation include provident funds, government employee funds, and local and regional funds, which act more as savings instruments and more closely resemble their private sector analogues.


Note that GFS also seems to make this distinction in the case of social security funds, for which benefits are not directly related to contributions and which are assumed included as part of general government, whereas provident funds, which maintain the financial integrity of deposits, are excluded (GFS, p. 15).


As compared to the budget methodologies proposed by both GFS and SNA, for the purpose of defining a deficit, this system would place below the line all receipts and payments except those in excess of participants’ prior payments. Note that proponents of this system do not address the issue of decomposing benefit payments into “principal” and “interest.” Presumably, actuarial criteria could be applied.


Adjustment to the SNA system would be more dramatic since payments on default of guarantees are already treated as a financing item.


See Buiter (1983) for a comprehensive discussion of this formulation.


See Auerbach and Kotlikoff (1987) for an interesting discussion and application of these life-cycle concerns to the dynamics of fiscal policy. The empirical evidence regarding the economic impact of social security is ambiguous (see Atkinson (1987)), in some cases rejecting the pure Ricardian prediction that the private sector would react to the institution of a social welfare program by simply reducing savings, and in other cases, rejecting the alternate, life-cycle, hypothesis that savings would be only partially depressed, causing consumption to increase.


Examples of applications to specific countries include Boskin (1988) and Eisner and Pieper (1984) for the United States, and Hills (1984) for the United Kingdom. None of these studies was able to include consideration of expected revenues, seigniorage, and net investment, nor was the impact of government contingencies considered.


Eisner (1984, 1986) is considerably more sanguine regarding the impact of contingent government liabilities on private sector activity, arguing that if such unfunded obligations are expected to be met through increased taxes, the net impact on government net wealth will be zero.


See Buiter (1984, p. 32) for a discussion. In addition, although the formula above is defined in real terms, an alternate specification—using nominal magnitudes for cash flows and interest rates—could, and often is, defined to yield the appropriate nominal magnitude. The nominal formulation does not index the real balance of the program in question and may therefore be of limited usefulness as a measure of true opportunity cost.


For example, see U.S. Department of Health and Human Services (1989) and the discussion in Ebrill (1990).


The choice of the appropriate discount rate is discussed in the context of cost-benefit analysis by Boadway and Wildasin (1984).


For a brief description of the application to credit subsidies and guarantees, see Wattleworth (1988) and U.S. Congress (1989).


Note that it is assumed for the sake of simplicity that the appropriate discount rate, from the perspective of the recipient of the guarantee, is the yield in the private and unguaranteed loan market; that is, the rate that is the opportunity cost to the recipient.


A European put option may only be exercised at the expiration date; an American put option may be exercised at any time up to the expiration date.


The frictionless market assumption requires no transaction costs, continuous trading, unrestricted borrowing and lending at identical rates, and unrestricted short sales.


For example, Jones and Mason (1981) extend these results by examining a richer array of guarantee arrangements. By relaxing certain assumptions regarding the payment of interest, Merton (1977) derives a similar formula for the case of deposit insurance, which is extended by Pennacchi (1987). Borensztein and Pennacchi (1990) estimate the value of interest guarantees on developing country debt.


See Wattleworth (1988) for an application to explicit credit subsidies.


The area under the demand curve above the price paid is termed the consumer surplus; that is, the difference between what the consumer would have been able and willing to pay and the price paid. Under certain restrictions (see Auerbach (1985) for a discussion), this surplus can be thought of as the monetary equivalent of the consumers’ utility or welfare.


For an examination of these issues in the context of an overlapping generations growth model, see Towe (1989).


This point has been made in the context of the United States in U.S. Congress (1989).


These points are also made in U.S. Congress (1989).


These possibilities have both been suggested for the U.S. Congress (see U.S. Congress (1989) for a discussion).


Note that this type of scheme is substantially different from placing the cash flow associated with contingencies on an extrabudgetary basis. This latter approach, while avoiding funding of other expenditure from temporary cash surpluses from contingencies, does not address the issue of how future deficits are to be funded. Moreover, the liabilities of the extrabudgetary agency administering the contingency program will certainly be implicitly guaranteed by the central government. Finally, since such extrabudgetary agencies are performing governmental functions, GFS recommends consolidation with the government’s accounts.


This is essentially the recent proposal of the U.S. Congressional Budget Office to address the issue of credit reform (U.S. Congress (1989)).


See U.S. Congress (1989, p. 43) for an example of the derivation of this amount.


Similarly, GFS distinguishes between “funded government employee pension plans invested in the capital market or in loans and securities other than those of the employing government” (p. 16) and other funded plans.

Long-Run Money Demand in Large Industrial Countries: Volume 38 No. 1
Author: International Monetary Fund. Research Dept.