to aecourage the exchange of ideas among Bank staff nd A othem inueesd ... Tohey should not be aunbiued to the World Hank. its Board of Dircto,. its ..... variables, we collected data on a large sample of countries, including OECD countries.
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Policy,Reesoh. andExlef Affairs
P
WORKING PAPERS Macrooonomlc Adjustmnt andGrowth Department CountryEconomics TheWorldBank October1991
The Macroeconomics of Public Sector Deficits
Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized
WPS 775
A Synthesis
WilliamEasterly and KlausSchmidt-Hebbel
Ten case studiessuggestthat two unorthodoxmethodsof deficit financing
-
inflation tax and financial repression
-
are both
ineffectivein raisingrevenueand disruptiveof macroeconomic stability. Fiscal stabilizationleads to both higher private consumptionand increasedinvestmentand to external adjustment - characterizedby a lower trade deficit and a depreciatedreal exchangerate. The Policy.Reaach, andEFema AffairsConplexdistnbutusPREWorkingPperstodissanrnatethe fudingsof wotkin progrs and to aecouragethe exchangeof ideasamongBankstaff nd A otheminueesd in developmentissoes.Thesepapen cany the nsmesof the authos. telect ony their views. and shouldbeused and cited accordingly.The findings.inrerpreaons. and conclusionsae the authre own.Tohey shouldnot beaunbiuedto theWorldHank.its Boardof Dircto,. its managanen. Ot any of its manber contries.
*
Policy,Research, andExtenalAffairs
Macroeconomic Adjustment andGrowth
i
WPS775
This paper -a productof the MacroeconomicAdjustmentandGrowth Division,CountryEconomicsDepartment -isa synthesisof a researchprojecton "The Macroeconomicsof PublicSectorDeficits"(RPO675-31). An earlier draft was presentedat the WorldBankConferenceon Macroeconomicsof PublicSectorDeficits,Washington,DC, June 1991.Copiesareavailablefreefromthe WorldBank, 1818HStreetNW,WashingtonDC20433. Pleasecontact Rebecca Martin,room Ni 1-053,extension39065 (91 pages). October 1991. Easterlyand Schmidt-Hebbelexaminethe macroeconomic consequencesof public deficits by summarizing the resultsof ten case studiesof developing countries- Argentina,Chile, Colombia,Cote d'lvoire, Ghana, Morocco,Mexico,Pakistan,Thailand,and Zimbabwe- as well as by examining broader evidence. Cross-sectioncorrelationsof fiscalbalanceswith macroeconomicvariablesare surprisinglystrong. Stable and low fiscal deficitsare associatedwith good growthperformance. Fiscal balancesare positively relatedto investmentand to currentaccount balances. Highfiscal deficits showan associationwith highly negativereal interest rates (financialrepression), moneycreation,and high black market exchangerate premia. The aggregateof the ten case studies shows an associationbetween fiscaladjustmentin the 1980s, improvementof the currenfaccount,and real depreciation of the exchangerate. The case studiesshow that both foreignand domesticmacroeconomicshocks playa secondary role in the cyclical variationand structuralchangesof nonfinancialpublic sectordeficits. Active fiscal policies,under the directcontrol of policymakers,are both the mainculpritof fiscalcrisesand an effective instrumentin bringingabout fiscaladjustment. Fiscal adjustmentis achievedby reducingoverblown governmentbureaucracies,cutting inefficient transfersand subsidies,reformingtax systemsto increasebroad-basedtaxation,and reformingor privatizingpublic enterprisesand comnmodity marketingboards. Inflationdoes not show any simplecorrelation with fiscaldeficits across countries. The crosssectionrelationshipbetween inflationand money creation shows a "Laffercurve" pattern,with maximum seigniorageat inflationbetween68 percentand 160 percent. In conu ist, the stud:es using individual
countries' time seriesdata findrevenue-maximizing inflationrates that seem to rise with actual average inflation- the "optimum"rate is estimatedto be only 4 percent in Thailand,but 966 percentin Argentina. The assumptionof a moneydemand with constantsemi-elasticityfor inflationoverestimatesthe "optimum"inflationrate in high-inflationcountries and underestimatesit in low-inflationcountries. Seigniorageis unimportantas a steady-statephenomenon, but it can be importantas a temporarysourceof revenuein timesof crisis. Even large surgesof moneycreationare not closely linked to accelerated inflation. Financialrepressionis a common resort for countriesin a fiscalcrisis. But the collapseof private credit, investment,and growth in those countrics followingepisodesof financialrepressionhardly makes it the recommendedway to deal with crises. Privateconsumptionand investmentare significantlyaffected by the public budgetstructure,the overall deficit,and its financing. Privateconsumption is reducedby incometaxes - with the size of the effect in betweenwhat the Keynesianand permanentincomehypotheseswouldpredict. Public saving(or the public surplus)tends to raise consumption somewhat- particularlyin countrieswhere the public sectorhas preferredaccess to resourcesof the financialsystem. Real interestand inflationrates and hence how the public deficit is financed- do not affectprivate consumptionin any systematicway. Responsesof private investmentto the public capital stock (or to public investment)range widely. And the fiscaldeficitexplains a great deal of variation in the trade deficitand the real exchangerate. The "fundamentals"approachto the real exchange rate is vindicated,whichshouldserve as an antidote to the notion that nominaldevaluationalonecan restorc macroeconomicbalances.
ThePREWorking PaperSeriesdisseminatesthc findingsof work underway in the Bank'sPolicy,Research.and Extemjl AffairsComplex.Anobjectiveoftheseriesisto get thesefndingsout quickly.evenif presentationsare lessthanfullypolished.
The findings,interpretations.and conclusionsin these papersdo not necessarilyrepresentofficialBank policy. Producedby the PREDisseminationCenter
TABLEOF CONTENTS 1
Introduction ................................................................
L Overview.............................................................. A. Correlationsof PublicSector Deficitswith Other EconomicVariables .... B. MacroeconomicTrendsin Case Study Countries ..........................
.....
2 2 5
H. PublicDeficits:Measurement,Causesand Remedies .......... .. ................ 13 A. PublicSector Deficits:AlternativeDefinitionsand PublicSector Coverage.... .. 13 B. Sensitivityof Deficitsto ForeignVariables .............................. 15 C. Sensitivityof Deficitsto DomesticMacroewonomic Variables ................ 19 26 D. FwscalPolicies.................................................... E. Quasi-FiscalDeficits............................................... 34 37 F. Sustainabilityof PublicSector Deficits ................................. IIL Deficits,Inflation,and Real Interest Rates ................................... A. Fiscaldeficitsand inflation:evidencefrom the case studies .................. B. Steady-stateseignorageversusone-shotseignorageepisodes ................. C. Interest rates, financialreprtssion, and fiscaldeficits:evidencefrom the case studies ......................................................
41 41 44
IV. PrivateSector Responseto PublicDeficits .............. .. ................... A. Private Consumptionand FiscalPolicies ................................ B. Private Investmentand FiscalPolicies..................................
56 56 60
V. Fscal Deficits,Trade Deficits,and Real ExchangeRates .........................
65
VI. PolicyConclusions........................................
68
Bibliography ..................................................
73
AppendixI Seignorage-Maximizing InflationRates and Mipecificationof MoneyDemand . . AppendixB Decompositionof Seignorage............ .......................... AppendixIm A Modelof PrivateInvestmentand GovernmentCapital .................. AppendixIV SustainableDeficits . ........................................... AppendixV AlternativeDefinitionsand Coverageof PublicDeficits .................
77 82 83 86 88
51
This paper is based on work done for the World Bank research project 675-31. We thank Mario Blejer, VittorioCorbo, StanleyFischer,Johannes Linn, CarlosRodriguez,Vito Tanzi,and participantsof the World Bank Conferenceon Macroeconomicsof PublicSector Deficits (Washington,D.C.,June 1991)for commentsto a previousdraft. We are also grateful for commentsand assistanceof Paolo Mauro, for research assistanceof Maria CristinaAlmero-Siochi and PiyabhaKongsamut,and for interactionwith the participantsin the research project. .
INTRODUCI1ON
Fiscaldeficitshave been at the forefront of macroeconomicadjustmentin the 1980s,both in developingand developedcountries. Fiscaldeficitswere blame,din good part for the assortmentof illsthat beset developingcountriesin the 1980s:over-indebtednessleadingto the debt crisisbeginningin 1982,high inflation,and poor investmentand growthperformance. This paper will examinethe evidencefor the macroeconomiceffectsof fiscaldeficits,usingthe results of a set of 10 case studies done for the World Bank researchproject,"The Macroeconomics of PublicSector Deficits."The ten cases were Argentina,Chile,Colombia,C6te d'Ivoire,Ghana, Morocco,Mexico,Pakistan,Thailandand Zimbabwe. The methodologyguidingthe case studiescan be summarizedbriefly.' The macroeconomiceffect of the fiscaldeficitdepends on how it is financed. To a first approximation,each major type of financingcorrespondsto a macroeconomicimbalance,if used excessively.Moneycreation to financethe deficitleads to inflation;domesticborrowingleadsto a credit squeeze and crowdingout of privateinvestmentand consun.ption;externalborrowing leadsto a current account deficitand real exchangerate appreciation. The effect of the deficitdepends also on the compositionof spending. Sometypes of publicconsumptionare complementsto privateconsumption,whileothers are substitutes. Deficitsmay directlylower privateconsumptionif consumersanticipate future taxesand save accordingly.Somepublic investmentsdisplaceprivateinvestment;others raise private profitability and thus investment. The effect of fiscalpolicyon the real exchangerate depends on the extent to whichpublic spendingis composedof nontradables. The organizationof the paper is as foliows:we first present a summaryof the stylized facts of fiscaladjustment,both within the 10 case studiesand in a broadersampleof countries. We then present the resultsof the decompositionof the deficit in the case studies,whichseeks to assessthe degree to whichdeficitswere driven by policyas opposed to externalor macroeconomic
Fuzter detail is avaiiablein the pfject's :mah prposaI Easterly,Rodriguez and Schmidt-Hebbel (1989).
2
shocls. The next three sectionsuse the resultsof the case studies to relate deficitsto macroeconomicimbalances:we first analyzethe relationshipbetween the domesticfinancingof deficits,inflation,and real interest rates; we then analyzethe relationshipof deficitsto private consumptionand investment;finallywe examinethe relationshipof deficitsto external imbalances.While macroeconomicimbalancesare clearlyinterrelated,we assumethe effectsof such interrelationshipare smaDland use a sequenceof partial equilibriumanalysesof each type of imbalance. We then close with some thoughtson policyimplicationsof the analysis.
L. OVERVIEW
A. Correlationsof PublicSector Deficitswith Other EconomicVariables To get an overviewof the relationshipbetween fiscaldeficitsand other economic variables,we collecteddata on a large sampleof countries,includingOECD countries. The statisticalappendixlists the data and sources for this sample. To get a feelingfor the usefulness of fiscaldeficitsas an indicatorfor overalleconomicperformance,we calculatedsimple correlationsbetween publicsector balances(as percent of GDP), and other major macroeconomic variables,shownin Table 1.1. There are good reasonsnot to expect verystrong correlations. Fiscaldeficitsare measureddifferentwaysacross countries,introducingsome measurementerror into the sample. In addition,the theoreticalrelationshipbetweendeficitsand other macroeconomicvariables depends cruciallyon the means of financingthem.2 Despite these caveats,we find a significant statisticalrelationshipbetween the deficit and many,though not all, macroeconomicperformance 3 There is variables. Per capita growthis significantlyand positivelyrelated to fiscalsurpluses.
2 3
ficl
M1 genally, simplecorelations may ail to be
dgnifat because of the ommion of oter variable
of Oiavazzian Papoo (1990)andBacbaNd (1990)that An Interaing short-runcounterpat to this result is the suggeuion awusty ca be inmknua,
3
Table 1.1 :Crssisecton Correlationsof Conlidated PublicSector Balance As Percent of GDP with Qther Variable
.. GDP growth
~~I -
Per capita GDP growth Per capita growthwith varianwof defic-ts
Real intraest rate Moneycreation (% of GDP) Inflation Investment(% of GDP) Total cosumption (% of GDP) .Prvat csumption (% of GDP) .'Ral excang tate v accout (% of GDP)
iBlck market premium
C-orreatg.
T-Statistic
016 037
3.02
.0.36
-2.88 *
0.31 -0.33 Q16 0.24 -0.48 -038 415
2.34 -2.40* -121 1.70 -3.97 -3.00* -1.10
054
4.76
-035
.2.65*'
1/
From DavidDoiar (1990)using PPP comparions from Summersand Heaton (1-968);apprecialtionis up.
-:N.-~
Public surplusis positive,deficitis neaiv OECIDcountries'publc balances are genra government. Samplesize vaes between50 and 59. Period of averagesiislongestperiod for whichda a a b &r each pairof
cot:cepts ec
out
Sourc
OECD EconomicOutlook;Wold Bank Data
* : **:
sigpficant at 5% level (one-iled): significant at-.% level (one-tailed)
also an interestingnegativeand significantcorrelationbetweenper capita growthand the variance of fiscalbalanes Low and stable fiscaldeficitsare associatedwith high growth. Fical balancesare positivelyrelated to real interest rates, contraryto the usual prediction that deficitslead to high interest rates and surplusesto low ones Since there are a large number of negativereal interest rates in the sample,this is likelyexplainedby an associationbetween financialrepressionand fiscaldefichs. Fiscalbalancesare negativelyrelated to moneycreation
4
(seignorage),whichconfirmsthat countriesthat run high deficitsdo so in part through greater 4 However,inflationrates show little correlationwith fiscalbalances, relianceon seignorage.
perhaps reflectingin part the non-linearrelationshipbetween moneycreation and inflationto be ,Iscussedin Section m. Fiscalbalancesare positively,though weakly,related to total grossdomesticinvestment, offeringat least superficialsupport to the notion that deficitscrowdout investment. The fiscal balance is negativelyrelated to both total and private consumption,whichis superficially consistentwith the notions that taxescrowdout privateconsumptionand that public and private notion that deficitslower consumptionare complements,and inconsistentwith the "RicardialIA consumption. These associationswillbe exploredin more detail using the case studyresults in Section IV. Fiscalbalancesare correlatedwith externalcurrent account balancesacrosscountries. This lends superficialsupport to the "fiscalapproachto the balanceof payments,"whichsaysthat fiscalimbalancesare the main source of externalimbalances.?The causationbehind the correlationcould go either waydependingon the type of financingconstraint-- countrieswith more accessto net externalfinancingmay run larger deficits,or those that run large deficitsmay require more externalfinancing. The estimatedrelationshipin the case studies (as discussedin SectionV of this paper) usuallyassumethe latter, and find strong time series correlationsas well. A suggestiveassociationis found betweenfiscalbalancesand black market premia,indicatingthat countrieswith high deficitsare more likelyto tightlycontrol the foreign exchangemarket and that deficitsdrive up the premiumcreated by such controls.' However,real exchangerates show little associationwith fiscaldeficits. This may reflect the extent to whichtrade interventiondiffers 4
de Ha awdZeihont(1990)findthatthecoreation hol onlyfor highinflationcountmim
SSWfor mple BaroH(1969),BAlM (1968),Sfth (1969)and Reisenand vanTrotsenburg(1988). However,note that the finkbrea down f the Rh:rdlanhypotb of offsetdngprivatesavinghold (Leiderman andBlejer(1988),Frenkdand Ruzin (19S7)). Ooe of the cm studia,Ghban,koked atthis relationshipin deail, and willbe discusedin sectionV.
5 across countries. SectionV willaddresssummarizethe time-seriesrelationshipsbetween fiscal balancesand the real exchangerate from the case studies,whichrelationshipstum out to be surprisinglystrong. There are two messagestr be.carried awayfrom this set of generallystrong but occasionallyweak set of associationsbetweenfiscalbalancesand macroeconomicperformance. One is that the fiscalbalanceis a usefulindicatorof macroeconomichealth despite problemsof comparabilityacrosscountries. The other is that we need to delvedeeper to trace the effect of variableslike inflation,privateinvestment,and real exchange deficitson specificmacroecononmic rates, as we willdo in the followingsections.
B. MacroeconomicTrends in Case StudyCountries Figure 1.1confirmsthat the dominantmacroeconomicpolicytrend of the 1980'swasfiscal adjustment. The case studycountriesregisteredsteadyfiscalimprovement,on average,from 1982 to 1988. Other developingcountriesshoweda less pronounceddeficit reduction;OECD countriescut their deficitsin half duringthe sameperiod. The .ounterpartto the fiscaladjustmentin developingcountrieswas a huge reductionin current account deficitsas shownin Figure 1.2. This again was more pronouncedin the case studycountriesthan in other LDCs. The simultaneousdeclineof fiscaland extemal deficitsis another bit of evidenceon the close associationbetweenthe two. The counterpart to the decline in externaldeficitsin the projectcase studies is a major depreciationof the real exchangerate as shownin figure 13. This is an interestingcontrast to the remainderof LDCs,whichif anythingshow moderate real appreciation. Whilethe real exchangerate, fiscaland externaldeficitsseem to movetogether in the project case studies, this is not the case with inflationand real interest rates. Figure 1.4 shows inflationto be a noisy,trendlessseries in both the project cases and in other developing
6
Figure 1.1
PUBLIC SECTORBALANCES Percent of GDP
OECD AND DEVELOPING COUNTRIES
-3-4 -5
-7 -8 t
/
-10 1981
1982 -
1983
OECD
-
1984
1985
1986
10 Project Cases
1987
1988
23 Other LDCs
Figure 1.2
CURRENTACCOUNTBALANCES Percent of GDP -0.01
PERCENT OF GDP
-0.02 -0.03 -0.04
F
-0.056 -0.06 -0.07 -0.08 -
-0.1
1980
1981 -
1982
1983
10 Case Studies
1984
1986
1986
25 Other LDCs
1987
1988
7 7 This is in contrast to the steadydisinflationin the OECD countries. Similarly,real countries.
interest rates show no trend to speak of in the 10 projectcases and in other LDCs,whilereal interest rates rose steadilyin OECD countries(figure 1.5). The volatityof the LDC real interest rates and the large negativenumbersfor averagereal interest rates makesclear that financial repressionwas alive and well in the 1980s. We next examinethe individualmacroeconomicevolutionof the case study countriesin the 1980s. Figure 1.6showsthe evolutionof consolidatednonfinancialpublicdeficitsin the 1980s.' We see strong fiscaladjustmentin Chile, Ghana, Mexico,and Thailand. Fiscal adjustmentis absent or reversedin Argentina,Cote d'Ivoire,and Pakistan. Colombia,Morocco, and Zimbabweare in between. The compositionof the financingof the deficitin the case studycountriesis shownin figure 1.7. Argentina,Ghana, Mexico,and Zimbabweincreasedtheir relianceon domestic financingin the early 1980sat about the same time the debt crisisbegan (late 1982),the consequenceof whichwas a decline of externalfinancingof fiscaldeficits.' We willsee later how this led to implicittaxesthrough financialrepressionin these 4 countries. Morocco(not shownin the graph for lack of data) also turned increasinglyto domesticfinancein the aftermathof the cutoffof externallending. Chile experienceda milderversionof the turn from externalto domesticfinancingof the deficit, until the deficitwas turned into a surplus in 1987-88. Colombiawas able to smooth the reductionin extemal financingand saw only a gradual rise in domesticpublicborrowing. Thailandmaintainedsteady flowsof domesticfinancinguntil deficitswere cut sharplyafter'1986. Pakistanalso slowlyincreasedits relianceon domestic
7
Couutdts that acperienced inflation above 1000 percent are ecluded becausethy hae a disproponionate effecton the aveage. Thus,Argentina u ccludedfromthe projectsertes,and Bolina, Braziland Peru from "othec" developingcountries The xciduded obsevtiom also do not sba a ckar trend. #AppendixV describesdeficit definitions. 9
Ghaa subsequently benefitted fromlae reformprogram
inflowsof foreignfinancing (muchof it highlyconcessionary)a it bepn a major
8
REALEXCHANGE RATEINDEX AVERAGES
A0totiatizO * 120._
ro6
-
id0 ....
960
~ ~1088 ~ 1968~ 1964t1t
att1981
t6
P,oZctCae
-tO
196
1@ 96? 196
1960
'-* 2t Otiw LOC
INFLATIONRATES(CPI) AVERAGES BY COUNTRYGROUP
40F
-L-
1900 1961 1902 *.n
O0CC -9 M@Iwii
1963 1944
1966
PROJECC OSCSA
19n6 -'
196r
19U
1989
28 OTHERLOCO*
U nUU. 61481. 4.4 PA
REALINTERESTRATES P,erent AVERAGES, DIFFERENTCOUNTRYGROUPS
.§9co no6o ttW
-IOPROJECTCAS. 1962 1986 1964
1966
19U6
196?
1966 A.
9
STRONGFISCAL ADJUSTMENT Conmel.PubUlo Surplus. 1076-6
(% GOP)
6X
-160_
76
79
61
so
62
64
03
so
a0
o7
64
Years *
CHILE
-
GHANA
@
Fgw.
MEXICO
**
THAILAND
lOb
MODER .d"E FISCAL ADJUSTMENT Consol. Pubilo Surplus. 197£-OS(% GOP) 4
2~~~~~~~~~~~~~~
76
79
80
82
61
83
64
a8
61
87
68
Years COLOMBIA
-
MOROCCO
G ZIMBABWE
REVERSEDOR ABSENT FISCAL ADJUSTMENT Coasol. PubiUc Surplus. 1907-OS C%fGOP)
2A
-12
.- 4 -16 76
79
60
t1
62
63
64
of
s0
r
Years -
ARGENTINA
-
COtE O1VOIRE
PAKISTAN P.
as
Fioure 1.7a
Flur* W1i
DOMESTICFINANCINGOF FISCALDEFICITS a
eroentof GDP
DOMESTICFINANCINGOF FISCALDEFICITS percent of GDP 12 11
14 13 -10
-1~~~~~~~~~~~~~~~~~~~~~~~ 12
4~~~~~~~~~~~~~~~~~~-
4
o ~ ~ ~ ~ ~ ~ ~~~
~ ~ ~ ~~~
~~~ 0~~~~~~~~~~~
124 11
3~~~~~~~~~~~~~~~~~~-
10
-2
-13-24-
1980 1980
1981 1981
1982 1982
1983 1983
1984 1984
1986 19816 1988 1986
ARGEN71NA ARIGENTINA- ME MEXICO XICO - {>GHANA 'GHANA
1987 19817 1988 1988
u- ZIMBABWE UZIMBABWE
1980 1980
1981 1981
- "*PAKISTAN ss-PAKISTAN
1982 1983 11982 1983 - -THAILAND THAILAND
1964 1984
1986 119816 1986 1986 COLOMBIA
-~COLOMBI1A -
1967 1987 -""CHILE *-CHILE
19688 1988
11 financingas its publicexternalbor,Rowiggraduallydiminished.These three countriesavoided the sharp macroeconomiccrisesthat affectedthe others, in part because they had greater access 0 to foreign financing,reflectinggood fiscalbehavrior.'
'Four of the countriesthat were identifiedas makingsharp shiftsfrom extemal to intemal financing-- Argentina,Mexico,Ghana, Chile -- also had severe episodesof negativegrowthin the early 1980s. Ghana's and Chile's growthsubsequentlyrecoveredstronglyin the wake of fiscal adjustment,other reforms,and improvedaccessto foreignfinancing. C6te d'Ivoireexperienceda severe declinein externalborrowingand also had negativegrowth. Other countriesthat relied increasinglyon domesticfinancingof deficitswithouta sharp financingcrisis-- Morocco, Zimbabwe,and Colombia-- have had erratic growthperformance,but not as poor as the previous ones. lle star performersare Thailandand Pakistan,countriesthat had continuingaccessto external financingand eschewedfinancialrepressionas a meansof financing." Figure 1.8 showsthe inflationrates of the case studycountriesduringthe 1980s. There were accelerationsof inflationin Argentina,Ghana, and Mexicoat about the time of the shift from external to domesticfinancingof fiscaldeficits,and a mildertemporaryaccelerasionin Zimbabwe. However,other countriesthat relied increasinglyon domesticfinancingshow no evidenceof higher inflation,as inflationwas stable in Zimbabwe(after 1983),Morocco,Chile, Pakistan,and Colombia. We concludefrom this section that strong fiscaland externaladjustmentwas typicalof both the 10 case studies reviewedhere and LDCsin general. The case studiesare less typicalin the strong real depreciationthey achieved. Inflationand real interest rates do not show clear
Pakaln's deficit was hight but we will see laterhow the deficit was consistent with stable debt ratio and low infation untl later in the 1980L 10
Ilhe high grwth in Pakistanenabled the countryto sustain a higher deficit, as will be discsed in section 11,but the sourca of the gowth are not fullydear.
12
INFLATION RATES,1978-88 (D"o. to 0O.. CPILos chang*) 2
0.1
~~~~
*
0 78
79
61
s0
82
03
64
~I.A....... as
O6
67
as
07
60
Years -
ARGENTINA
GHANA
MEXICO
4
INFLATIONRATES,1978-88 (DMc. to Dec. CPI Log change)
0.36
0.3
0.1
0.2
76
70
80
-- MoRoCco
82
63
64
68
6a
Y,ears AISTAN
-
flgr
0.1
'. ''ITNLANO
-
ZISADWE
tao
INFLATIONRATES,1978-88 (De. to Doc CP Log change
0.215 0.05
78
61
79
so
SI
62
83
84
86
86
67
Years +
CHILE
- PAKISTA
COTE O1VOIRE
86
13 trends in response to fiscaladjustment. The countriesforced to make an abrupt shift from external to domesticfinancingof the deficitfared poorlyin termsof growth,and some of them show an accelerationof inflation. In the remainderof the paper, we will examinesome of the problemsposed by the macroeconomicstylizedfacts presented here. Were deficitsconsciouspolicychoicesor did they passivelyrespond to externaland domesticmacroeconomicvariables? How tight is the link between deficits,seignorageand inflation? How muchdid countriesresort to financialrepression to financethe deficit? What were the consequencesof deficitsfor interest rates with and without financialrepression? How did the deficitand its compositionaffect private consumption(and thus saving), privateinvestment,and thus growthprospects? How importantare deficitsin explainingreal exchangerate movements?
H. PUBLICDEFICITS:MEASUREMENT, CAUSESAND REMEDIES TIis sectionfocuseson alternativepublicdeficitconcepts,deficitdeterminants,and componentsof successfulfiscalstabilizationprograms,derivedfrom the project's 10-country sample.
A. Public Sector Deficits:AlternativeDefinitionsand Public Sector Coverage Alternativedeficitmeasuresdiffer by how they are defined and whichpublicsub-sectors they encompass. AppendixV' reviewsthe main deficitcategories. Figure 2.1 illustrates differentabove-the-linedeficit categoriesfor the cases of Morocco(1983-88)and Argentina (19"80). The significantfiscaladjustmentachievedby Moroccois underestimatedby the decline of its cash basis deficit,becausethe countrywas able to reduce its accrualsbasisdeficitat an even
2
For dtaild diauion andauuuanmof aditerutvedefiat meaur see Blejerand Chu (1968),Tanzi,Bleje,and Tapjeuo (196), Bu_e (1967),Coauional BudgetOffice(1990),Einer(1986),Koikoff (1988),FscberandEast" (1990),Makenzie (1969),Tanzi(1965),Tajdem(1969),Towe(1991),andWorldBank(1988).
14 Figure
2.1
PUBLIC SECTOR DEFICITS: ALTERNATIVE MEASURES AND SECTOR COVERAGE A. Morocco 1983-88 Fiscal Adiustment: Alternative Measures of Central Government Deficits (% of (lP)
14% -__ 12% -
-+-
+t
12%
\
^sv
X
Primary Dot ~~~~Accruals ,ug Arroars
Q
8%f
~~~~~~~Cash Basis Deficlt ,,Accruals OPwratio6al iDo
o
1%-
Accruals Basis Dof
4%2%
.E~~~~~~~.E
'''''"--
O%
0%
1983
1984
1985
1986
1987
1988
B. Argentina 1980-85 Fiscal Destabilization: CNFPSand Quasc-FiscalDeficits I* of GOP)
1980
1981
Total PSDefiit *O- CNF Primary PS Deficit -Cone
1983
1982 I~
z
1984
CNFPSIDeficit Ouaei-FiscalDeficit
1985
15 more stringent pace by reducingaccumulationof arrears and starting to repay them in 1986. However, the operational deficit -- economicallymore meaningful than the nominal deficit -- did
not fall as fast as the latter, due to the declineof the inflationcomponentof domesticinterest paymentsresultingfrom lower inflation. The Argentineexperienceof seriousfiscaldeteriorationillustrateshow misleadinga partial measureof the deficit is when the central bank pursuesquasi-fiscalprogramsleadingto significantlosses. Between 1980and 1983the nominalconsolidatednon-financialpublicsector (CNFPS)deficitdoubled,but a significantshare of this increasewas due to higher nominal interest paymentsfrom an explodinginflation. Anyway,either measureof the CNFPSdeficit-nominalor operational-- seriouslyunderestimatesthe deterioratingtotal fiscalstance in 1982 (and afterwards),when the Central Bank'squasi-fiscaldeficitincreasedby an unprecedented25 percentagepoints (pp.) of GDP! The next subsectionsfocusmostlyon nominalabove-the-lineCNFPSdeficits,to be followedby a last subsectionon quasi-fiscaland total publicdeficitsfor the relevantcountrycases.
B. Sensitivityof Deficitsto Foreign Variables Foreignshocks are a source of fiscalinstabilityin developingcountries. Commodity exporters and highlyindebtedcountriesface an inherent instabilityfrom fluctuatingexport prices and foreign interest rates which hinder significantlyfiscaladjustmentefforts. In the followingwe will test the sensitivityof public deficitsto foreignshocksin a sub-sampleof 6 of the case studies."
SIubnod teas, countres ace fourtype of foreignshock: changeio pncesad intemt oonditions of theirfofeigntradeand aedit fows ad uchae in quantiyconstints affecting foreigntradeandcedit flo. Whilequmatityconstraintse rather unnmmonin foren trade(abscting fro countnesaffectedby globalembarg or traderestrictions affectingcerain items). mmasieces in borowingcorstraints rea stylizedfat Increit markets Th aftermathof the 1982debtcrisi pliedin facta maivere hnge in the formof fop rewource constrintsfacedsuddenlyby mt developilndebtoreconomie Whilethe Iattercostute a strongforip shockaffectingbelow-the-line fionacingweures w focusin the folowingonlYon chnges in forign term of trde and intest rateswhichaffect above-the-Une defcits
16 Changesin export prices affect the publicsector directly(via profitsof the exportingstateownedcompanyor marketingboard) or indirectly(throughtaxeson profitsor on exports). The quantitativeimpactof the export price shock on governmentaccountsdepends on the tax and propertystructure, the amountexported,and the magnitudeof the price shocl. Countries facing high export price volatility,and where a largeshare of exportsis through a SOE (such as Chile and Mexico)or a marketingboard (Cote d'Ivoire, Ghana), have fiscalaccountssensitiveto terms of trade shocks. Publicsector accountsin countrieswith a diversifiedforeigntrade structure where the private sector is the main exporter and export taxesare low or absent,such as Pakistan or Zimbabwe,do not suffer significantlyfrom export price volatility. Import prices affect public expenditurein some countries. In Morocco,for instance,the decline in importedfood priceswas the main cause of the substantialdecline in subsidiesto the privatesector in the mid-1980s. Changesin foreign interest rates affect highly-indebtedcountrieswith a high share of variableinterest debt, such as Argentinaand Colombia. In additionto measuringthe impactof foreignshockson public accounts,it is illuminating to assesstheir contributionto overallpublicsector deficits. Both dimensionsare presented for 6 countriesin table 2.1. Column 1 determinesthe averageabsolutechange in publicdeficitsdue to different foreignshocksover the relevantsampleperiods. For instance,foreignshocks have contributedon averageto a 2.3% of GDP variationof the public sector deficit in Chile and to a 0.3% of GDP variationin Zimbabwe. Countrieshighlysensitiveto terms of trade changesare Chile (copper), Mexico(oil) and Thailand,while in Colombia(coffee and oil) and Morocco (phosphates)the averagecontributionof terms of trade shocksto deficitsis only around 1% of GDP. In Zimbabwethe influenceof terms of trade shocks on governmentrevenue is negligible. By contrast to terms of trade shocks,interest rate fluctuationshave muchlower effects on public deficits- they contribute at most 0.4% of GDP to the variationof publicsector deficitsin our sample.
17 TABLE 2.1 CONTRIBUTION OF FOREIGN SHOCKS TO PUBLIC DEFICITS (1) Average Absolute Variation of Public Deficits Due to Forpig Shocks (% of GDP)
(2) Average Relative Contribution of Fore40 Shocks to Variation of Public Defidct (% of variation of deficits)
1. Chile. 1973-1988 Foreign Shocks Copper Price Changes Foreig Interest Rate Changes
2.3 2.7 0.4
12 iS -3
2. Colombia, 1984-1989 Foreirn Shocks CoffeeFund Changes Oil Co. Surplus Changes
1.0 1.2 0.9
50 59 -9
3. Gha. 197731988 Foreig lnteret Rate Changes
0.1
0
4. MoNaro. 1971-1988 PhosphateCo. Contributions
0.8
.17
2.2
41
0.3
.3
S. Thiland. 1970-198P
Termsof TradeChanges 6. Zimbabwe, 1980/81-198,89 Foreip Interest Rate Changes
Note. The first column computes the annual average absolute variation of the deficit caused by the corresponding changesin forign variabls (Ihe aception is Chile, which prsents period averages fot 1973-75, 1975-81,1981-86,and 1986-88). If more than one foreign variable is considered, the sum of the average absolute variations for the individualvariables differs from the average absolute variation of the combined shocks,due to opposite signs of individualvariations Tne second column reflects the average relative 'OR
contribution of forign shocks to the variation of public defidts, defined as:
t+4
dvsig
d,) | Id,|
where d i the
change in the defidt in period i, dv1 is the change in the deficit caused by variable v, t is the initial period, and n+I is the total number of periods
18 The average relativecontributionof foreign shocksin column2 measuresthe degreeoof correlationbetween foreign-shockinduceddeficitsand the overallpublicdeficit. In Chile, Colombia,and Thailand,adverseforeignshocksincreasedeficits,with shares varyingbetween 12%and 50%of the total fluctuationof deficits. In Ghana, the tiny foreign interest shocksare uncorrelatedwith deficits. However,in Zimbabweand Moroccoforeignshocks have the opposite signof the changesof overalideficits,indicatingthat domesticmacroeconomicshocksand fiscal policychangesmore than compensatefor the influenceof adverseforeignshocks. Even moderateshocks couldexplaina lot of deficitvariation. In Colombia,for example, shocks of moderate magnitudehave a huge influence(50%) on the variabilityof deficits. Colombiadid not requiresuch substantialfiscaladjustmentduring the relevantsampleperiod (1984-89),so that foreign shockshad a more significantrole in its deficitevolution. However,in Chile,which showsthe highest magnitudeof foreignshocks,their relativecontributionto deficit variabilityhas been low (12%). Chile embarkedduring 1973-88on massivefscal adjustment programswhichovershadowedthe influenceof foreignshocks. Optimalresponses to shocksdepend on their transitory/permanentnature: purely transitoryshocksshould be (dis) saved and hence reflected by public deficits,whilepermanent shocksshouldinducecorrespondingchangesin expenditureor revenuewithout affectingdeficits. In the case of public sectorswhichown large commodity-exporting companies(Morocco,Chile, Mexico)or collectlarge revenues from privateexporters (Ghana, Cote d'Ivoire),price or revenue-stabilizationfunds (such as those implementedin Chile and Venezuela)or hedging through risk-sharingcontracts are efficientmechanismsfor isolatingthe budget from transitory export price shocksL
19
C. Sensitivityof Deficitsto DomesticMacroeconomicVariables A secondgroup of variablesaffectingdeficits-- still outside the direct controlof fiscal policymakers-- are domesticmacroeconomicvariables. In the following,we concentrateon those variableswhichhave the strongesteffectson publicbudgets: inflation,the real interest rate, the real exchangerate, and growth.
Inflation 4 Anticipatedinflation Inflationaffectsthe budget deficitsthroughvariouschannels."
affectsnominalinterest paymentsto domesticdebt holders. Inflationalsoaffectsthe primary 5 Tax collectionlagsin non-fullyindexedtax systems effect)." deficit(the Keynes-Olivera-Tanzi
(for example,nominallyfixedexcisetaxes) lead to decliningreal revenuewhen inflationincreases. Inflationalso tends to lead to publicdemoralizationand hence lower tax compliance. However,if incomebrackets are non-indexed,higherinflationleadsto bracket creep and hence higherdirect taxation. Real publiccurrent expendituredeclineswith inflationwhen publicwagesor transfers are not indexed. While in manycountriesthe net effect of inflationis to increase primary deficits,the budget structure couldconceivablyreverse this effect. Table 2.2 summarizesthe effectsof inflationon publicdeficitsin the samplecountries, identifyingthe channelsthrough whichthey operate.' Results from estimatedtax
14The channes mentionedbelow add bracket creepand transfereffects to the fivc-itemlist of Dombusch, Sturzenegger. and Wolf (1990).
Is See Oliv (1967), and Tanzi (1977, 1978). Sometimesthe Keynes-OlhverTanzieffect is used more resuictivelyfor the tax erosioneffect mentined below MmTbe effec of ination on deficits via nominal interest payments on the debt is ecxcudedftrm table 2.3.1 as a separatechannelof
20
TABLE22 INFLATION AND PUBLIC DEFICITS 1. Effects of Inflation on Tax Revenue: 1.1 Negative
1.2 Zero
1.3 Positive. Due to NonIndexation of Income Brackets
Colombia: T (1972-1987)
Chile: DT, IT (1973-1989)
Zimbabwe: DT (1970171-1988/89)
Ghana: DT, IT (1970171-1988)
Morocco: T
Pakistan: DT, TT, IT (1972173-1987/88) Zimbabwe: IT, TT (1970/71-1988/89
2. Effects of Inflation on Public Expenditure: 2.1 Negative
2.2 Zero
Chile: Transfers (1973-1989)
Morocco: Public Expenditure
3. Effects of Inflation on Public Deficit: Positive Effect of Inflation on CNFPS Deficit Thailand (1971-88)
Note: DT is direct tax revenue, IT is indirect tax revenue, TT is trade tax revenue, and T is total tax revenue.
21
revenue functionsallowus to classifycountriesaccordingto the net influenceof inflationon tax revenue. Inflationlowerstaxesin Colombia(for aggregatetax revenue) and in Ghana (for both direct and indirecttaxes). The only positiveeffect of inflationon taxes is found for direct tax revenue in Zimbabwe,where non-indexationof incomebracketsleads to bracket creep.
Short
collectionlags,indexationof trx revenue and/or indexationof incomebracketscould be behind the non-significanteffectsof inflationon tax revenue in the other 4 cases:Chile (direct and indirecttaxes),Morocco(total taxes),Pakistan(direct, indirect,and trade taxes),and Zimbabwe (indirectand direct taxes). Somepartial evidenceon the effectsof inflationon expenditurecategoriesfollowsin Table 2.2. Transfersto the privatesector in Chile declinewith inflation,presumablydue to incompleteindexation,while no evidenceof a significanteffect of inflationon aggregatepublic expenditurecould be found in Morocco. In most countries,the net influenceof inflationis to raise nominalpublicsector deficits, due to the dominanceof the interest paymentand tax reductioneffectsof risingprices. An exampleis Thailand:accordingto econometricresalts a 10 pp. increase in inflationraises the 7 CNFPSdeficitby 0.9 pp. of GDP."
Real Interest Rate Real interest payments(and hence both the nominaland the operationaldeficit) obviously increaseone-to-onewith the real interest rate. Inflationshockswhichare unexpected(or, even if expected,are not reflectedby higher nominalinterest rates due to interest controls),reduce ex-
t7
Cakulationbasedon a reduced-form equationestimated for the CNFPSdeficitin radiand and on 1988deficit,inflaim and
GDP leveL
22 post real interest rates and hence the operationaldeficit. For instance,in Ghana the one-period inflationrise from 30% in 1982to 115%in 1983increasedthe nominalCNFPSdeficit only slightlybut reducedthe operationaldeficitsignificantlydue to the drop in ex-postreal interest rates to negativelevels. Financialliberalizationsince the mid-1970s,with partialor completederegulationof interest rates, has increasedthe sensitivityof deficitsto interest rate. After early and radical financialliberalizationsin Chile (1974-75)and Argentina(1977),the 1980ssaw partial or completeliberalizationsin Mexico,Morocco,and Zimbabwe. Whilethe massiverise in real interest rates during the 1970sin Chiledid not impingeon the deficitdue to the virtualabsence of domesticinterest-bearingdebt, the increasingdomesticdebt stocksof the 1980s,in conjunction with moderatelyhigh interest rates, added to the burden of the central bank, whichholdsmost of the public sector domesticdebt. In Morocco,partial liberalizationof interest rates since 1984has increasedsignificantlythe cost of domesticdebt to the Treasury. It is estimatedthat a future increaseof rates on governmentdebt to competitivemarket levelscould add 2 pp. of GDP to the deficit. Less accessto foreign financingafter 1982caused manycountriesto combinedeficit reductionwith increaseddomesticfinancing. A case in point is Pakistan. After 1981/82its governmentdecided to raise its domesticnon-bankborrowing,whichcontributed 1.5 pp. of the increase in the nominaldeficit,from 4.8%of GDP in 1980/81to 7.4% in 1987/88,through higher domesticinterest payments.
23
Real ExchangeRate A real depreciationraises publicexpenditure(measuredin local currencyunits)by increasingforeign interest paymentsand the cost of traded-goodscapital and intermediategcods acquiredby the publicsector. Publicsector revenue is boostedby a real depreciationfrom higher surplusesof traded-goodsproducingfirms and from direct and indirecttaxationon productionor sales of traded goods. The net effect of the real exchangerate (RER) on the deficit(in real terms or as a share of GDP) hence depends on the relativeweightsof traded and ncn-traded items in publicexpenditureand revenue. Table 2.3 summarizesthe effectsof the RER on tax revenue,SOE profits,transfersand 6 In Colombia,total tax revenuewas reduced by real devaluation-consolidateddeficits.'
presumablybecause of the negativecorrelationbetween the RER and quantitativeimport restrictionsor because of a highly elastic importdemand. The opposite is true for Ghana and Zimbabwe,wherevariousrevenue categories(direct and indirecttaxes in Ghana, direct and trade taxes in Zimbabwe)are increasedby devaluation-- presumablybecausetraded-goodsactivities (sales and production)are taxed more heavilythan non-tradedactivities. Becausethe remaining tax categoriesare shownto be insensitiveto the RER, aggregatetax revenue rises with a higher RER in the latter two countries. Positiveeffectsfrom real devaluationson publicbudgets are reaped in countrieswhere a significantshare of SOEs is comprisedby tradable-goodsproducingcompanies- typicallythe case where the big commodityexportersare publicenterprises- Chile,Colombia,Mexico,and
18 be rel exchange rateis definedhere consistentwiththe relatie pnce of tradedto non-tradedgoods - a realdeprecaiuo means a higherRER.
24 Morocco. Devaluationsalso boost net revenuesfrom profitsof agriculturalmarketingboardsthis is clearlythe case in Cote d'Ivoire. A computationof the net effect of the RER on the CNFPSdeficitcombinesthe above mentionedeffectson publicrevenue with the large and positiveeffect of the RER on foreign interest paymentsand with any effectson publicexpenditure. In manyof our samplecountries, the interest effect dominateswhateverpositiveeffect the RER has on the primarydeficit. Tbe exceptionsare Colombia,where the RER effect is zero, and Mexico,where the share of oilrelated federal revenuein GDP (7.9% in 1989)is more than twiceas large as interest payments on dollar-denominateddebt (3.4% in 1989).
Outout Transitoryoutput shocksaffect non-financialpublicdeficitsbecause of changingtax bases and transferpaymentsto the private sector. This anticyclicalbehaviorof public deficitsmotivated traditionalKeynesianprescriptionsof usingthe budget as an automaticstabilizerto counteract "autonomous"demandshocks. In countrieswith non-independentcentral banks or under extreme financialcrises,the anti-cyclicalbehaviorof the non-financialdeficit is reinforcedby anticycical quasi-fiscaloperationsof the financialpublicsector, as we discussbelow. Trend growthis sometimesseen as a cure to public deficits- if growthis high enough, it is argued,tax bases expand and hence countriescan growout of deficits. This view is flaweddue to two reasons. Fust, it neglectsthe fact that not only tax bases but also successfulpressuresfor higherpublic expenditurerise with output levels. Second,growthwill not materializeif public deficitsare high, inflationand real interest rates are high, and hence private investmentis depressed.
25 Table 2.3 Real Exchange Rate and Public Deficits
1. Effects of a RER Devalu:tion on Tax Revenue:
1.1 Negative
1.2 Positive
Colombia: T (1972-1987)
Ghana: DT, TT (1970/71-1988) Zimbabwe: DT, IT (1970/71-1988/89)
2. Positive Effects of a RER Devaluation on Profits or Transfers from SOEs: Chile: Surplus of SOEs and Copper Taxes Colombia: Surplus of Coffee Fund and State Oil Company Cote D'Ivoire: Revenue from Cocoa/Coffee Marketing Board Mexico: Surplus of SOE Morocco: Contributions of State Phosphate Company 3. Net Effect of the RER Devaluation on the CNFPS Deficit: 3.1 Increases Deficit
3.2 Close to Zero
3.3 Lowers Deficit
Chile Ghana
Colombia Thailand (sns) Zimbabwe (nns)
Mexico
Note: T is total tax revenue, DT is direct tax revenue, IT is indirect tax revenue, and TT is trade tax revenue; sns is statistically not significant and nns is numerically not significant.
26 An Iglustration
How sensitiveare deficitsto domesticvariables? Table 2.4 presents the case of Zimbabwe,showingby howmuch the CNFPSdeficitis affectedby normalizedchangesin macroeconomicdeterminants. The domesticreal interest rate has a significanteffect on the deficit,resultingfrom the high levelof publicdebt: a 1 pp. increasein the rate raises the deficit by 0.4 pp. of GDP, reflectingthe 0.40domesticdebt/GDP ratio. Interestingly,inflationhas a lower positivee'ffebton the deficitthan the real interest rate; the reason being that the 0.40 effect on the deficitvia higher nominalinterest paymentsof a 1 pp. rise in inflationis neutralized in part by the positivebracket-creepeffect on incometaxation. A devaluationcontributesto a slightlylower deficitin Zimbabwe;the higher foreign interest paymentsare more than compensatrd by increasedtax collection. Finally,growthseems to have a strong effect on deficits; however,its magnitudeis overestimatedbecause it considersor
the influenceof GDP on tax
revenue, not on public.expenditure.
D. FiscalPolicies In this subsection,we comparethe role of fiscalpolicyvariablesto the influenceof foreign and domesticmacro variablesin the evolutionof publicdeficits. Basedon time-seriesresultsfor the decompositionof public sector deficitsaccordingto the three groupsof deficit determinants,' we compute the contributionof each of these groups to changesin public deficits. Figure 2.2 presents the averagerelativecontnbutionof the three groupsof variablesto
I%ed
on the defict dempoition
methodolog by Mansail and Schmidt-Hebbel(1989).
27
Table 2.4 SENSITIVITY OF NON-FINANCIAL PUBLIC SECTOR DEFICITS TO CHANGES IN MACROECONOMIC DETERMINANTS: ZIMBABWE 1988
Changes in Macro Determinants
Changes in NFPS Deficits (Percent. Points of GDP)
1 pp. Increase of Domestic Inflation
0.31
1 pp. Increase of Domestic Real Interest Rate
0.40
1 % Devaluation of Real Exchange Rate
-0.06i
1 % Growth of Real GDP
-0.37
1 pp. Increase of Foreign Interest Rate
0.25
Note: based on 1987/88 and 1988/89 CNFPS budgets.
changes in CNFPS deficits' and the evolution of deficits over time in Chile, Ghana and Zimbabwe. This evolution reflects the influence of both transitory (or cyclical) shocks and,
201heaveage relative contribution of each groupof deficit deteminants is calculatedbasd on the equation presented in the note to table 21; bence the equationis now used separately for aternal, domestic wacwcoomic and fiscal policyvariable. However, in order to prent the reative contribution of each group of variables,d is defined herea the eaplained changein the deficit, not the actual changeasin table 2.1. Hence the averagerelative contribution of estemalvariables to actual defcits in column 2, table 2.1, absolute deviationt diffea from the average relative contributionof external variables to cxplained dficits in figure22. The average deficit changesin pp. of GDP are 0.9 for Chile (197448), 2.0 for Ghana (197V3M1988),and 1.4 for betwee actual and explained Zimbabwe (1981182-198M89).
Figure 2.2 Nominal Consolidated Non-Financial Public Sector Deficits and Deficit Decomposition According to Main Determinants in Three Countries: 1971-1989 (Central GovernmentDeficits for Ghana) Deficit (% ot GDP)
25% -
-
-
20%
__
_
EV
15% X
\
/
_
ZIMBABWE
9 g2%
GHANA 10%
_
I
iV
El
~~1 t
DV
FPV
,.IV
7. Morocco.
(
(0)
0.882 3. Pksslauaka(0) 1963-87
9. Thailand,
0.25" (0)
1.35S
0 -0.23"
( -0.561
(
()
1971-87
0.794
10. Zimbabwe, 196558
(t) 0 63
0.10"
0.10
O)() 0.33
(0)
-0.23% (0)
59
Table 4.1 (Cont'd) Notes: (i)
Symbols(+), (-) and (0) denote signs of the coefficientsof private consumptiondeterminants from the correponding econometric estimation. The positive and negative signs correspond to statisticallysignificant coefficients,(0) denotes a coeMcient not significantlydifferent from zero, and a blank space denotes the ecxdusionof the corresponding variable from the country study.
(ii)
EHITR denotes public expenditure on privatelyappropriated services (education and health) and/or transfers to the private sector.
(ili)
Specificationsand estimation techniques vary by countries. The dependent variable (private consumption) enters in leves for Argentina, Ghana, and Pakistan, log levelsfor Morocco and Thailand, both levelsand log levels for Coiombia,ratio to national income for Cote d'lvoire, and ratio to private disposable income for Chile, Mexico,and Zimbabwe.
(iv)
The numerical coefficientswithout a note are partial derivativesof private consumption rates (to either private diposable or national income) with respect to the rate of the correponding variable (to either private disposable or national Income), unles noted otherwise. When noted othetwise, coeffidents are 1) marginalpropensities; ) elasticities; 3) semi-elasticitieL
(v)
The specificatio for Morocco, Colombia,and Pakistan (the two latter based on error-correction models) allowto distinguish between short and long-runcoeffidents; the latter are presented for Morocco and Pakistan in the table.
4 liberalizedits domestic result firomdirect-crowdingout due to financialrepression? Argentina
financialmarketsin 1977(late in the relevantsampleperiod),whileMoroccoand Zimbabwehad non-liberalizedfinancialmarketswith institutionalarrangementsallowingthe publicsector preferentialaccessto resourcesof the domesticfinancialsystem. Hence we concludetentatively 4' that DCH dominatesREH in those cases.
The real interest rate is not a significantconsumptiondeterminantin 5 of the 8 countrieswhichincludedit as a right-handvariable. Three countriesshow significanteffectsof the real interest rate: in Mexicoit depressesprivateconsumption(whichsignalsthe dominanceof
4§In the cae of Argentina,public xpenditureand revenue, not the defict, were entered spartely asconsumptiondeterminants, kves, that the public deflit is a However,their coefficientswere so similarin manitude - with opposite sigs - and sgniSicance valid summayvariable for them. Hover, the relevant income variable was caoen to be GNP, not private dispoble income net of tae Hence the introduction of the deficit (or of revenue and xpenditure septely) does not cancel tame induded in disposable income, and therefore this specification is not directly consistent with the REH. 4 The rewlts for Cile, Zimbabwe,Ghana, and Morcoo are consistent with those of a recent 13-developingcountuy study (which includes them with eception of Morocco), whichestimates the following anges for the coefficients of current income,estimated permanent income, and estimated permanent public saving,respectively 0.494079,0.20-28, and0.42-0.56(Corbo and SchmidtHebbeL 1991, table 3.1).
60
the substitutioneffect)while in two countries(Colombiaand Thailand)a higher real interest rate raises consumption,i.e., reducesprivatesaving. The non-significantresultssuggestthat either the liquidity,income,and wealtheffects tend to cancel each other and/or borrowingconstraints precludeconsumersfrom respondingto interest rate swingsby shiftingconsumptionacross time accordingto their preferences. Inflationhas an unexpectedeffect in our sample. Whileinflationhas no discernible influenceon privateconsumptionin three countries,it has a significantlynegativeeffect in three other countries(Morocco,Pakistan,and Thailand),whichare amongthe low-inflationcountries of our sample. Seigniorage(and hence inflationtax) and inflationare correlatedin two of these three low-inflationcountries,' and hence higherinflationcausesa drop in real incomenot reflectedin conventionaldisposableincome. Alternatively,higher inflationis correlatedwith greater macroeconomicinstability,inducinghigher precautionarysaving.
B. Private Investmentand FiscalPolicies Fiscalpoliciesaffect private investmentthrough variouschannels: 1.
PublicCapital:in AppendixIII we present a model in whichthe relationshipbetween
private investmentand publiccapital is theoreticallyambiguous. Public capitalcould be a nearperfect substitutefor privatecapital and drive downthe private rate of return. Publiccapital investedin steel plants is an obviousexample. However,governmentsalso investin activities where the private sector would not invest,like infrastructure,for whichit is difficultto charge user fees. The net effect on private investmentwillbe stronger the lower the substitutabilityof private capitalfor publicinfrastructure. 2.
Public Deficit:as in the case of consumption,domesticfinancialrepressionwith
preferentialaccessof the publicsector to domesticresourcesin order to finance its deficit implies
to Morocw and Thailand,the inflation rate is poitive and signiricantat a 10% lvel in an equation rorseignloage. In Pakistan it i not anifintly diffaent frm zeo
61 that the latter could crowdout directlyprivateinvestment. If this is in particularthe case of public sector investmentprojects,it leadsto the direct crowdingout of private investmentby public investmentflows. 3.
Corporate Taxesand InvestmentIncentives:the profit tax and investmentincentive
structure affectsafter-taxprofitsand the user cost of capitaL In the countrystudies,corporate tax revenue is entered either as a separate investmentdeterminantor as a tax rate affectingthe user cost of capital. Other tax incentivesto investmentalso modifythe user cost of capital. 4.
Real Interest Rite: withoutfinancialrepression,domesticdeficitfinancingtends to
raise the real interest rate and hence lower investmentprofitability. Table 4.2 summarizesthe effectsof the above mentionedfiscalpolicy-related variableslleavingthe discussionof the role of non policy-relatedvariablesto the originalcase studies. Consistentwith the theoreticalambiguityof the relationshipbetween publiccapitaland private investment,the case studies found sharplydifferentresults. The Pakistanstudy found that the ratio of private capitalstock to output risesby 2.1 pp with a 1 pp increase in the public capitalstock/outputratio. In Zimbabwe,a higher publiccapitalstock raises private investment flows;however,the effect is smallerthan in Pakistan. The Chile and Colombiastudiesfound the oppositein some regressions,indicatingsubstitutionbetween publicand private capitalin production. Somestudiesused public investmentrather than the publiccapitalstock as a determinantof private investment-- again the results showoppositesignsin differentcountries. The Ghana and Mexicostudiesfound a negativeeffect of public on privateinvestment(although the Mexicoeffect was onlyweaklysignificant),whilethe Thailandstudy found a positiveeffect of publicon private investment. For Argentina,no significanteffect was found. Finallv.the
TABLE 4.2 SENSITIVITY OF PRIVATE INVESTMENTTO FISCAI. POLICIES
Coefficients) Rcsponse (Qualitalive andQuantilative Cimiurv
PtlPublic Capital Flow
StoCk
2. Chile,
Dlficjj
Consumptim (-)
(0)
1. Argentina, 1915-U4
CoIgrale Tax
P-iblic Revenm
Reveal
Costof Capital UserCot
RealIna.Rate
(0)
()I(-)
(0)(°)
1961-1988 3. Colombia, 1925-88
(O)(-)
(-)
(-) -0.10
4. Coled'lvoire, 1972-87
.
5. Ghana, 1967-88
( -1.10
3.97
6. Mexico, 1970-89
(0)I(-) 0-0.12
(O) -0.401-0.86
8. Pakistan, 1972/73-1981/88
(O) 2.09"'
9. Thailand,
1971-87 10. Zimbabwe, 1965-88
(t)
0.20
(O) -0.05
(-)
(t)
7. Morocco.
(0)
(
-1.26w (M)
(O)
0.57"
-1.15" (-) -0.45
63
Table 4.2 (Cont'd) Nots: (i)
Symbols(+) (-) and (0) denote signs of the coefficientsof private consumption determinants from the conrspondingeconometric estimations. The positive and neptive signs oorrespond to statisticallysignificant coefficients,(0) denotes a coefficientnot significantlydiffrent from zero, and a blank space denotes the exclusionof the corresponding varable from the country study.
(U)
Specificationsand eatimation techniques vary by countries.Tbe dependent variable is private investment for all countries (leu Cote d'lvoire and Pakistan); it enters in levels for Argentina, log levels for Thailand,ratio to GDP for Chile, Ghana, Madco and Zimbabwe, log ratio to GDP for Morocco,and either level,log level or ratio to GDP for Colombia. In the case of Pakistan, the dependent variable is the private capital stock to GDP ratio. Due to data limitations,the dependent variable is the domestic investmentto national income ratio in the case of Cote d'lvoire.
(Ili)
The numerical coefficientswithout a note are partial derivativesof private investment rates (to GDP) with respect to the rate of the correponding variable unless noted otherwse. When noted btherwise.coefficientsare: 1) elasticities. In the aesof Pakistan, the coefients are: 2) partial derivativesof the private capitalstock/output ratio with respect to the private capitalstockloutput ratio and the user cost of capital,respectively.
(iv)
The specifications for Morocco,Colombia,and Pakistan (the two latter based on error-correction models) allow to distinguishbetween short and long-runcoefficients; the latter are presented for Morocco and Pakistan in the table.
(v)
Ihe specifiation for Morocco indudes an output and a private investmentequation, the latter depending on output growth. Output was found to be positively(margiially significant)affected by public investment. Hence we infer that reduced-form private invetment depends positivelyon public investment,as shown in the table.
Moroccostudy found that public investmentcontributesto growth,and becausethe latter raises private investment,we mayinfer that publicinvestmentincreasesprivatecapitalformation." If these resultsare taken literally,we find direct evidencefor the beneficialeffect of public sector capitalon private investmentonly in three of the studies,whichis surprisingin view of the widespreadassumptionthat public investmentraises the privaterate of return to capital and thus private investment. A plausibleexplanationin those countriesthat find a negative (Chile,Colombia,Ghana, and Mexico)or zero (Argentina)relationshipis that public investment is concentratedin activitiesthat substitutedirectlyfor privateinitiativeand/or that financingof public investmenttakes directlyresourceswhichwouldhave been availablefor private investment. Only a few studies entered publicdeficits(or their main components)as separate privateinvestmentdeterminants. In the two cases wheredeficitsare entered directly,they play a
51
8y wayof compariso Aschauer(1989) finds public capital to poitivety influenceprivate investment in the U.S., and Bartoli (1969) find a simiar rolt for a smple of Latin Americancountries.
64
I
negativerole, whichis weak in Cote d'Ivoire and strong in Thailand. In the Argentinastudy,the three maincomponentsof deficitsinsteadof the deficit per se are entered. As already mentioned,public investmentdid not affect private capitalformationin Argentina;however, publicconsumptionand public revenue play significantroles, wi.h signsconsistentwith the crowding-outhypothesis. From our partial evidencewe mayconcludethat deficitstend to crowd out private investment,particularlywhen the publicsector has no easy accessto foreignfinancing, but has preferentialaccessto domesticresourcesthrough represseddomesticfinancialmarkets. Corporate taxeshave a strong negativeeffect on private investmentin Mexico (wherethey enter separately)and in Morocco(where the corporate tax rate is part of the user cost of capital). In Moroccoinvestmentincentivesalso play a strong positiverole, as reflected by 52 In Ghana, however,corporate taxesplay an unexpectedsignificant the user cost of capital.
and positiverole in privateinvestment-- presumablydue to the exclusionof corporate profitsas a result of data unavailability. Fmally,the real interest rate enters privateinvestmentequationsin seven case studies. The results,as comparedto other studieswhichshow frequentlythat private investment is interest-insensitive,are surprisinglystrong: the effect of the cost of capital is significantand negativein S cases.5' The correspondingcoefficientsrange from low (Chile and Mexico)to moderate (Zimbabwe)and to high (Moroccoand Pakistan). Only two cases (Colombiaand Ghana) found private investmenttc be interest-insensitive,and in the former an interest effect was found in some regressions.
2Ihe Morcco study istheonlyonewbicb iders the corporatetaxrate andinvtment incentives,differentiatedbv reions of the usercostof capitalsl md capitalcategoda, in the calulation -"See R
(1990) and Sene and Solmano (1991).
65
V. FISCALDEFICFrS,TRADEDEFICITS,ANDREALEXCHANGERATES The project case studies foundsurprisinglyrobust relationshipsbetween the fiscal deficit,the trade deficit,and the real exchangerate, of the type proposedby Rodriguez(1989). He suggesteda two-steprelationshipbetweenthe fscal deficitand the real exchangerate: the fiscaldeficit and other determinantsof investmentand savingbehaviordeterminethe external deficit,whichthen determinesthe real exchangerate consistentwith clearingof the domestic goods market. Figure 5.1 presents the evolutionof real exchangerates in the 10 projectcountriesin the 1980s. Real exchangerates are ciosely,correlatedwith the behaviorof fiscaldeficitsin many episodes. The major fiscaladjustmentin dote d'lvoire in 1982-85was accompaniedby real depreciation;subsequentfiscalbackslidingin 1985-88occurredtogether with real appreciation. The large fiscaldeficitreductionin Colombiaover 1983-88was accompaniedby real depreciation. Similarly,Chile's real depreciationof 1984-88wascontemporaneouswith a fall in the deficit. Ghana's reform programafter 1982includedboth a deficitreductionand a real depreciationof the officialexchangerate (as well as a depreciationof the real black market exchangerate). Moroccoexperiencedboth a deficit reductionand a real depreciationover 1982-85;Thailandhad both occurringtogether over 1985-88. These episodesdemonstratethat fiscaladjustmentand real depreciationare closelyassociated,becausereal exchangerates reflect fundamentalssuch as excessdemand arisingfrom deficits,and in some of these cases becausenominaldevaluationsand fiscaladjustmentoccurred together in adjustmentpackages.' Six of the case studiestested directlythe relationshipbetween fscal and external deficits(the others used comprehensivemacroeconomicframeworksthat related the variables indirectly). All of the six found evidencethat fiscaldeficitswere associatedwith external deficits,
Schngeate signifiantly in the first year,and that the rea 5%dwurd (1969) fnd that nominal dealuationaffected the rea meange rate adjued lowly to its equilibriumvalue, altbough nomia dealuation was neutral in the long run (p. 141). Howese,
if accompaiedby fil nona devluations gtas realdevaluations
adjusnt.
66
REAL EXCHANGERATEINDEX AOpetatbtIon up LOG DEVIATIONFROM 1980 0. 0.1
._
-
.
02 -0.3 -0.4 1060
1062
1061
-- ltMOtOCCO
066
106$ 1904 -60AKIaTAN
166
10947 1966
THAILAND -
4-
1960
ZIU116WU
Figurs G.S
REAL EXCHANGERATEINDEX AOteciaton in up LCA DEVIATIONFROM 1960 ..
0.2
1960
t191 *-
1062
CHILE
106
1964
COrE OiVOINS
Plei
lose tees -4
fear -
COLOMBIA
saas waoe 61141co
6."6
REAL EXCHANGERATEINDEX Ap#eation , up LOG DEVIATIONFROM 1980 1
0 -0.2 -0.4
-. 6A
1960
10116
6$11064 -ARGENTINA
wall
1666 G-ANA
1967
1666
10966
67 althoughin two of the cases the evidencewasqualified.55These samesix studiesfound that the trade surplus was a significantdeterminantof the real exchangerate, with the expectedsign that higher surpluseslead to greater real depreciation. Thus, in the completesystem,a lowerfiscal deficitleads to real depreciation. The other four case studiesalso found evidencethat the fiscaldeficitsignificantly affectsthe real exchangerate.'6 In Thailandand Morocco,the estimatedmodelequations indicatean appreciationof the real exchangerate when fiscaldeficitsincrease. In Ghana, a modifiedapproachto take into account a black marketin foreignexchangefound that higher fiscaldeficitsboth appreciatethe officialexchangerate and raise the black market premium. The onlycortrary result was in the Pakistanstudy,wherea deficitreductiondue to a cut in public investmentwould appreciatethe real exchangerate in generalequilibriumbecauseof the negative supplyeffect of reducingpublic investment. The studiesalso examinedthe Rodriguez(1989)hypothesisthat increasesin public spending,for a givendeficit,would affect the real exchangerate becauseof differencesbetween the publicand private sector propensityto spend on nontradablesvis-a-vistradables. The results from the six case studies that tested this directlyare split. In C6te d'Ivoire,Argentina,and Zimbabwe,higher governmentspendingleads to real appreciation,indicatingthe governmentis more prone to consumenontradablesthan the privatesector. In Colombia,Chile, and Mexico,it is the reverse,suggestingthat those governmentsconsumetradablesmore heavilythan the private sector.
The studies also generailyfound that terms of trade improvementslead to real appreciationof the currency. Sixof the seven studiesthat tested this relationshipfound this effect to be significant,althoughthe seventhstudy,Thailand,found the counter-intuitiveresult "EnChie, onlythe umple omreation wa signiricant; thesipificancedisappearedwhenother determinantsof the trade defiit wereadded In C&ted'vmire,the relationship ws significantonlyin the 1979489periodn Un generaL canity maynotbe unidirectioaal:Section11of this paperand Fieo and Reieo (1990)showhowthe resa change rate mayaffectus reenue
68
that terms-of-tradeimprovementsdepreciatethe real exchangerate. The Ghana studyfound that terms of trade improvementstend to lower the black market premium. Thus, all of the studiesgivesupport to the notion that the real exchangerate is sensitiveto both policyand externalvariables,with the fiscaldeficitprominentamong them. This contrastswith the result mentionedearlier that there is little cross-sectionassociationbetween deficitsand real overvaluation.A plausibleexplanationis that differencesin trade intervention are largelyresponsiblefor cross-nationaldifferencesin overvaluation,while in any givencountry macro policiessuch as fiscaldeficitsexplainreal exchangerate movementsover time. For example,the Colombiastudy found that most of the real depreciationassociatedwith the adjustmentprogramof 1985-89was due to the reductionof the deficit.
VI. POLICYCONCLUSIONS To conclude,we summarizethe main policyimplicationsof the 10 case studiesand the analysisof this paper. FiscalAdjustment. Three case studiesof the project (Chile,Mexico,Thailand)show strong and fast fiscaladjustment,four followa,more gradualistapproachto rscal stabilization (Colombia,Ghana, Morocco,Zimbabwe),and three correspondto moderate (Pakistan)or massive(Argentina,Cote d'Ivoire) fiscaldeterioration. The first two groups encompasscountries whichhave achievedin the late 1980ssustainabledeficit levels,defined as those compatiblewith stable publicdebt to income ratios. By contrast,the latter three countrieshave raised their deficitslevelsincreasinglybeyondsustainablelevelsduring the 1980s. Both foreign and domestic macroeconomicshocksplay a minorrole in the cyclicalvariationand structuralchangesof nonfinancialpublicsector deficits. Activefiscalpolicies,under the direct controlof policymakers,are both the main culprit of fiscalcrises and an effectiveinstrumientin bringingabout fiscal stabilizationand adjustment.
69 The experiencesshow that successfulnon-financialpublicsector adjustmentrequires actingon four fronts: reducingan overblowngovernmentbureaucracy,cuttingtransfersand subsidies(other than efficientsocialprograms),adoptingtax systemsconduciveto broadly-based direct and indirecttaxation,and reformingor privatizingpublic enterprisesand commodity marketingboards. Efficientpublic investment,particularlyin socialor physicalinfrastructure, shouldnot onlybe exemptedfromfiscalcuts but possiblyexpandedto encourageeconomic growth. Quasi-fiscallosses-- the deficitsof the publicfinancialsector, particularlythe central bank -- are a result of emergencyloans to the financialsystemor exchangerate subsidies,granted in periods of financialdistressand externalcrisesand in countrieswhere the central bank is subordinatedto the ministryof finance. A sound regulatoryframeworkfor the commercial bankingsector and a more independentcentral bank are necessaryfeatures -- althoughno guarantees- for preventingrecurrent quasi-fiscaldeficits. Fiscaldeficitsand inflation. A conventionalinflationtax "Laffetcurve"is well supported by cross-sectionalempiricalevidence. Conventionaltime-seriesestimatesof revenuemaximizinginflationrates appear to be biased (upwardin high inflationcountries,downwardin of moneydemandas being of constant semi-elasticitywith low inflationones) by misspecification respect to inflation,when in fact the semi-elasticityfalls as inflationrises. Thus, to the extent that deficitsare financedby moneycreation,the relationship between fiscaldeficitsand inflationis indisputable. HIwever, the "fiscalapproachto inflation' exaggeratesthe link Seignorageis so trivialas a source of fiscalrevenue, and the tradeoffs between additionalinflationand amountsof fiscalfinancingso unfavorable,that it is hard to believe that revenue motivationsalone explaincases of chronic high inflationlike Argentina."
57SiUr ccmdua
eAMhKd in Tbewor of upel
and
Utan
(1989).
70
Seignorageis more important as a sourceof temporarysurges in revenue, but even there the link to inflationis weakL Fiscaldeficitsand financialrepression. There is an associationbetween financial repressionand fiscalcrises -- high fiscaldeficitsare correlatedwith highlynegativereal interest rates, and the disappearanceof external financingof fiscaldeficitsseems to lead to high taxes on financialintermediation. But the poor performanceof countries-- in termsof depressed private credit, investment,and growth-- that engage in strong financialrepressionhardlyrecommends this solutionto fiscalcrises. It is true that financialliberalizationwillworsen the publicdebt burden. However,adjustmentof conventionaltaxes to lower deficitswould be far preferableto implicittaxeson financialassets - since both are taxes,there is no reason to expectconventional fiscaladjustmentto be any more contractionarythan adjustmentthrough financialrepression." Budget Structure.Deficits.and PrivateConsumption.Taxes have an unambiguously negativeeffect on private consumptionthrough disposableincome. While a temporarytax hike does not have the massiveeffect predictedby the simpleKeynesianhypothesis,nor does it have the minimalsize attributedto it by the permanent-incomehypothesis." If the tax increase is maintainedover time, the response of consumptionwillgrowstronger. Accordingto the Ricardianequivalencehypothesis,higher (permanent)publicsavingshould lead to an offsetting reduction in privatesaving. Alternatively,if domesticfinancialmarketsare controlledand if the public sector has preferentialaccessto their resources,a higher (current) deficit willdirectly crowdout private expenditurein general and consumptionin particular. However,most studies showedthat publicsaving(or publicdeficits)had no significanteffects on private consumption. The policy implication is that increasing public saving - reducing public deficits -- is the most
"Dombuschet aL(1990) makea similararpmentwithrapectto inflationtam. 5
"A similar ondetiuoL reachedfor the U.S.by Potefba(1968).
71
effective contribution fiscal policy can make to raise national saving.' The way the deficit is financed -- and hence the changes in domestic real interest and inflation rates -- can have some effect on private consumption. While the role of real interest rates is either ambiguous or negligible, inflation tends to reduce consumption in low-inflationcountries. Budget Structure. Deficits. and Private Investment. A wide range of responses of private investment to the public capital stock (or to public investment) is observed in developing countries. A negative influence of public capital on private investment is frequently present in countries with a large public enterprise sector which competes with private firms and where the public sector has preferential access to domestic financial resources. Aggregate public deficits -not only public investment -- tend to crowd out private investment (and consumption) in the latter countries. The implication is that privatization or reform of public firms and marketing boards, a concentration of public investment on public and social infrastructure, and deregulation of domestic financial markets (encompassing the elimination of credit ceilings, compulsory credit allocation, preferential access of the government to credit, and interest coitrols) are the three elements which would reenforce private/public sector complementarity and hence increase the prospects for higher private investment and growth. Fiscal deficits. trade deficits, and real exchange rates. A simple model relating real exchange rates to trade deficits to fiscal deficits explains a great deal of real exchange rate variation. Real exchange rates really do seem to be driven by "fundamentals",which should serve as an antidote to the mistaken notion of many policymakersthat nominal devaluation by itself can restore macroeconomic balance although it is useful in combination with fiscal adjustment.' Real exchange rates also seem to be affected considerably by whether government spending is oriented more towards tradables or nontradables -- our studies show no strong presumption either lhis condusion is shared by recentcro-country saving studies for developingcountrie Corbo and Schmidt-Hebbel (1991) and Schdidt-Hebbel, Webb, and Conetti (1991).
6-
6%dwards(1969) concludes that real echange rates can reach their fundamentale-determined level mormquickly by combining adjustment with nomunaldvluation.
72 way.' This suggeststhat policymakerspay attention to the compositionof governmentspending when decidingon an accommodatingexchangerate policy. Fiscaldeficitsand growth. This research project did not directlyaddressthe effect of fscal deficitson growth. But there are some suggestivefindingspointingtoward further research. Low per capita growthis associatedwith both a high level and a high varianceof the riscal deficit." The conventionalnotion that publicinvestmentis good for private investmentand growthreceiveslittle support in the econometricworkfor the case studies, so there is little basis on whichto justifyhigh deficits"becausethey are due to investment".Countriesthat were forced to shift from external to intemal financingof deficits- often becauseof debt crises inducedbv previousfiscalmismanagement-- had particularlypoor growthperformancein the 80's. Lowand stable fiscaldeficitsseem to be a good idea for the long-runprospectsof a countryas well as for the shor-run imbalancesreflected in inflation,interest rates, and real exchangerates. And growthitselfmakes deficitsless harmful:countrieslike Pakistanand Thailandcould sustainlarger deficitsbecauseof high growth,whileeconomiccollapseworsenedthe macro effectsof deficitsin Argentina,Cote d'Ivoire, and Mexico.
62Seethe modd of Khanand Lizondo(1967) for a similartheoretical rsult. .
OW"hile this audyjumtboked at aimpleilludtive corrlations Fscher (1991) found an effect of the level of the deficit on Vrbh in cm-4ction multhte r _egioaL
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75 K4uel, M. (1989). "BudgetDeficits,Stabiity, andthe Monetary L)ynamicsof Hyperinftation,"Journal of Money.Credit and Bankinc 21, No. 2, May, pp. 148-157. Kiguel, M. and Livitan, N. (1988). "InflationaryRigiditiesand Orthodox Stabilization Policies Lesons from Latin America,"World Bank Economic Review2, no. 3, September, pp. 273-98. Kotlkoff, L (1968). "The deficit is not a well defined measure of fiscal policy,"Scence August, 241, pp. 791-79S. IArranga, 0. and Eyzagmrm,N. (1990). "Macroeconomiade las Operciones Cuasi-Fales en Chile,"mimeo, ECLAC, Chile. Leiderman, L and Blejer, M. (1988). "Modellingand Testing Ricardian Equivalence:A Survey,"IMF Staff Pamen 35, no. 1, March, pp. 1-3S. Luca, R. and Stokey,N. (1987). "Moneyand Interest in a Cash-in-AdvanceEconomy,"Econometrica 5S, No. 3, May, pp. 491-S13. Marsall, J. andSchmidt-Hebbel,K. (1989). "Economicand Polcy Determinants of Public Sector Deficits,"World Bank WPS 321, December. Macenzie, 0. (1969). 'Are All Summary Indicatorsof the Stance of Fscal PolicyMisleading?" Staff Papers 36, pp. 743-70, December. Mankiw,N.G. (1987). "The Optimal Collection of Seigniorage:Theory and Evidence,"Journal of Monetary Economics 20, September, pp. 327-341. Menron R. C. (1977). "An Analytic Derivation of the Cost of Loan Insurance and Government Guarantees," Journalof Banking and Finance1 (June), pp. 3-11. Nicoletti, G. (1988). "A Cros-Country Analysis of Private Consumption,Inflation and the 'Debt-NeutralityHypothesis',"OECD. Ollvera, J. (1967). "Money,Prices and Inflation Lags: a Note on the Dynamics of Inflation,"Banca Nazionale del Lavoro Quarterly Review 20, pp. 258-67. Polak,J. (1989). "Ftnancial Policies and Development,"OECD Development Centre Study, Paris. Poterba,J. (1988). "Are Consumers Forward-Looking? Evidence from Fwsal Experiments,"American Economic Review 48, no. 2, May, pp. 413-481. Reisn, H. and van Trotsenburg, A. (1988). 'Devebping Country Debt: the Budgetary and Transfer Problem," OECD Development CentreStudy, Paris. Rama, M. (1990). "EmpiricalInvestment Equations in DevelopingCountries,"World Bank WPS 563, December. Robinson,D. and Stella, P. (1988). "AmalgamatingCentral Bankand Fisca Deficits," in M. Blejer and KI Chu, eds., Measurement of Fiscal Impact: Methodoloeical Issues IMF Occasional Paper 59, Washington,IMF. Rodriguez,C. (1989). She External Effects of Public Sector Deficits,"PRE WPS 299,World Bank,November. Sachs, J. ad. (1989). DevelovinaCountry Debt and the World Economv. Chicago, Universityof Chicago Press. Sargent,T. and Wallace, N. (1981). "SomeUnpleasant Monetarist Arithmetic,"Federal Reserve Bank of Minneapolis Quarterly Review S, pp. 1-17. Schmidt-Hebbel K., Webb, S. and Corsetti, G. (1991). 'Household Saving in Deveoping Countries Fit Cross-Country Evidence." WocddBank WPS 575 (forthcoming in World Bank Economic Review). Sere, Sumw,
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77 APPENDIX 1: SEIGNORAGE-MAXMIZING INFLATION RATES AND MISSPECIFICATION OF MONEY DEMAND
An empiricalregularitynoted in the text is that the estimatedseignorage-maximizing inflationrate riseswith Lheinflationrate that is actuallyobserved. In high inflationcountries,the seignoragemaximizingrate is high, whileit is low in low inflationcountries. For example,the estimatedseignoragemaximizingrate in Thailandis only4% per annum,whilein Argentinait is 21.8%per month, This suggestsa systematicmisspecification of moneydemand. In a constantsemielasticitymoneydemand functiona la Cagan(1956),the seignorage-maximizing rate isjust the reciprocalof the semi-elasticityof moneydemandwith respect to inflation. Thus, it appearsthat high inflationcountriessystematicallyhave lowersemi-elasticities, whichcontradictsthe assumptionof constancyof this parameter. This is intuitivelyplausible-- as inflationgets high, householdssubstituteinto other assets that play some of the roles of money. At very high rates of inflation,all the good substitutesfor money have alreadybeen found. Further increasesin inflationwouldnot have mucheffect,since moneydemandis alreadyat rock bottom. This intuition is confirmedby a simplemodel of moneydemand,inflationand seignorage. A model of seignorage.moneydemand,and growth function:
(1)
It is assumedthat infinitelyliveddynastiesmaximizea standardintertemporalutility
fe'dt 0
wherep is the discountrate, c is consumption,and 1/ais the intertemporalelasticityof substitution.
Production(y) in the one-goodeconomyis assumedto depend only on a broad concept of capital(k), as in Rebelo (1991)and Barro (1990). Populationis assumedfLxedand normalizedat one, so all variablescan be interpretedin per capita terms. (2)
y - A k
There are three assets availableto the consumer-- capitalk, nonindexedmoney (real value m), and indexedmoney(real value b, referred to as "bonds*for short). Bonds pay no interest but are fullyindexedto the price level. This type of asset is observedin manyLatin Americancountriesthat have highlyliquiddepositsindexedby consumerprices (for example,the UPAC depositsin the Cajasde Ahorro y Viviendain Colombia). Sincecapitalhas real return A and there is no uncertainty,capital alwaysdominatesbonds, and capitaldominatesmoneyat expected inflationrates above -A. However,there is assumedto be a cash-in-advanceconstraint, .L
78 whichis that some combinationof moneyand bondsmust be held in order to purchase consumptiongoods: (3)
f(m,b) - c k O
Here f is linearlyhomogeneousin m and b, and satisfiesf,>O, fb > 0, f= 0 (but c 1, asrequired)then the absoiutevalueof uanieetelty nay a initially asinflauonrise butwill ventuallyfall - ination goesto infinity.A sufficentcodition for the absolute valueof the emlelatidly to faUmonotonically is n < 12 (eldaity of substitutionle than 2).
80
this substitutionproceeds,the marginalvalue of bonds in transactionsfalls so that the responseto further changesin inflationis low when inflationis alreadyhigh. It is of interest to see how this affectsthe calculationof the seignoragemaximizing rate. Seignoragewillbe givenby moneygrowth,whichis equal in steadystate to the inflation rate plus the growthrate, timesexistingholdingso' noney(definedas a ratio to consumption): (1J)
S = (X +g) rm/c
The governmentis assumedto determinemoneygrowthexogenouslyand to waste the proceeds s (or equivalentlytransfer them back to consumersin lumpsum form). An interior maximumfor seignoragewillexist if moneydemand falls off more quickly than inflationrises at some level of inflation. It can be shownthis requiresthat the elasticityof substitutionbetweenbonds and moneybe greater than one in absolutevalue. If this elasticityis less than or equal to one, then seignoragewill alwaysincreasewith inflationuntil consumptionis driven to zero. Intuitively,money is essentialto transactionsif the elasticityis less than one, so seignoragebehavesas it would in the cash-in-advancemodelwith only money. The seignoragemaximizingrate does not have a closedform solution. However,the modelcan be simulatedwith notionalparametersto see how the optimalinflationrate responds to the substitutabilityof money. Table 1 showsthe simulatedvaluesof optimalinflationfor variouselasticities. The optimalinflationrate becomesastronomicalas the elasticityapproaches unity,whileit is modestwhen substitutabilityis high. Simulationof modelwith differentelasticities c
.2 .225 .25 .275 .3 .35 .4 .5
1
Jr max
-1.25 -1.29 -1.33 -1.38 -1.43 -1.54 -1.67 -2.0
12,600% 5,200% 1,750% 760% 400% 160% 80% 40%
n-i
The cross-sectionresults presentedin Section2 of the text suggestan inflationmaximizingrate between 68 and 160%acrosscountries,consistentwith moderatelyhigh substitutabilitybetween bonds and money. This would suggestthat th_ optimal inflationrate was overestimatedin the high inflationcountries(e.g. Argentina)and underestimatedin the low inflationcountries(e.g. lthailand).
81
of moneydemand If the true moneydemandfunctionis such that the semi-elasticity will lead one to function semi-elasticity constant fallswith inflation,then the use of a Cagan overestimateoptimalinflationin high inflationcountries,and underestimateit in low-inflation countries. To see this, considera genericmoneydemandfunction: (16)
Im m = g(:) whereg1cO and g"'>O
The only restrictionson moneydemandare that it is a negativefunctionof inflationand that the of moneydemandwith respect to inflationfallswith inflation, absolutevalue of the semi-elasticity as impliedby the model. "optimal"inflationrate will be givenby the solutionto The seignorage-maximizing the implicitfunctiongivr.- by the first order condition: (17)
, = -1/g-(n,x
x
However,suppose that the moneydemandfunctionis erroneouslysupposedto be of constant semi-elasticityand a log-linearCaganfunctionis estimated. We can think of this as an estimation of the linear approximationof (16) in the neighborhoodof the historicalaverageinflationNH: (18)
In m = g(7c1 ) + g(oil)
* (7x)
The estimated"optimal'inflation3r.. willthen be givenby: (19)
,,
= -11g(o)
The assumptionthat g">O (the absolutevalue of the semi-elasticityfallswith inflation)ensures
that the estimatedoptimalinflationNx,, will rise with historicalaverageinflationx,H. Since( 17) is not affectedby the historicalaverageinflation,this means that the estimatedoptimalinflationwill be greater than the true optimalinflationin countrieswhere historicalinflationis higherthan the true optimum,and lower in countrieswhere historicalinflationis below the true optimum. Fiom (17) and (19), we can see that the erroneouscalculationof optimalinflationis due to failure to take into account the variationin the semi-elasticityas inflationvaries.
82 APPENDIXI DECOMPOSMONOF SEIGNORAGE
The decompositionis based on the followingequationfor seignorageT:
(1)
T =
MP*I - Pr tl P,, U,
=
nt
M +M M
where P, is the price level at time t, K is the real money supplyat time t, and x, is the inflation -rateat time t. The steady-statevalue of seignorageis givenby the following: (2)
IC M + 1+4 1+
1+8
where a bar denote an averagelevel of a variable,and we assumethat real moneygrows proportionallyto output, with output growthgivenas g and the trend value of real moneyas M. The fist term gives the inflationtax componentof seignorage,while the second givesthe seignoragethat accruesfrom an increasein real moneybalances. The deviationof seigorage from the averagecan then be givenas follows:
(3) 3)~T,-T
. j;
+ (M.- M.t
ij i1
&M
The first term here is the above-averageseignoragedue to the inflationtax rate being above average. The second term givesthe above-averagerevenue due to the real money base being above average. The third term gives the real change in the money base minusthe amount that would take place as moneygrowswith output. The last term is the covarianceof inflationand money.
83 APPENDIX III A MODEL OF PRiVATEINVESTMENTAND GOVERNMENTCAPITAL
In the stylc of the newgrowthliterature," we assumethat there are constant returns to scalein all typesof capital,where capitalis broadlydefinedto includeboth physical and humancapitaL However,we aggregatephysicaland human capitaland distinguishonly between public and private capital. Publiccapitalincludesonlygoodsthat will not be producedin the absenceof governmentintervention,such as infrastructure. Privatecapitalconsistsof investmentswhere the returns are not appropriableby other agents. The governmentcan invest in either type of capital,whereasthe privatesector willinvestonly in privatecapital. We assume that governmentinvestmentsin privatecapitalare a perfect substitutefor those made by the privatesector. This impliesa productionfunctionlike the following: I
(1)
Y = A (y(K,+G,)q +(l-y)G)-
where Kpis private-ownedprivatecapital,Gpis government-ownedprivatecapital,and G. is governmentinfrastructurecapital. Infrastructurecapitaland privatecapitalare imperfect substitutes,with elasticityof substitutionl/(1-1). We need to specifya policyrule wherebygovernmentcapitalis determined. To be consistentwith a steadystate solution,the policyru!e needs to have governmentcapitalgrowwith the overall growthof the economy. One analyticallytractablepolicyrule is that the government investsso as to maintaina desired ratio of infrastructureto privatecapital,and governmentownedprivate capitalto private-ownedprivatecapital:
(2)
Gp = eOKp
(3)
Go =e Kp
Growth in this economywillbe givenby the usual Euler conditionthat consumption growthrespondsto the marginalproductof privatecapitalas follows:
(4)
8
c=
e
c
a
wherep is the rate of time preference,6 is the rate of depreciation,and o is the inverseof the intertemporalelasticityof substitution.
"For a urvr we Eas*,
qJng Rebeloand Levine (1991)
84 Takingthe £le,wativeof (1) with respect to K,, and substitutingin from (2) and (3), the marginalproductof private capitalwillbe givenby:
(5)
a8y = Ay (y + (l-y) e
(10+e1y) j
From (5), it can be shownthat an increase in infrastructurecapital unambiguously raises the marginalproductof privatecapital (and thus growth),whilean increasein govemmentownedprivate capitallowersthe rate of return to privatecapitaland growth. Thus, whether publiccapital lowersor raises the rate of return to privatecapitaldepends on whether public investmentis in infrastructureor in capitalgoodsthat are substitutesfor capitalin whichthe privatesector wants to invest. However,while the rate of return is straightforwardlyrelated to the comnositionof publicinvestment,the responseof privateinvestmentis more complicated.In steady state, the ratio of private investmentto GDP wilibe givenby:
(6)
K K Y
Y
The effect of publiccapitalon privateinvestmentdepends not only on how public capitalaffects the rate of return, but also on how it affectsthd steadystate ratio of privatecapital to output. From (1)-(3),this ratio willbe givenby:
(7)
vp
=
A-l (y(a+0)r +( -Y)e)) ~~~~~~~~~~~~~~~~~I' Y
The ratio of private capitalto output goes downif either type of governmentcapitalincreases, which ;s simplydefinitionalsincegovernmentcapital is defined as a ratio to private capital. From (6), we see that privateinvestmentis unambiguouslynegativelyrelated to governmentinvestmentin privatecapital. This investmentlowersboth the rate of return to privatecapital and the ratio of private capitalto output.' lhe relationshipbetweenprivate investmentand governmentinfrastructurecapitalis ambiguous. Using (4), we can rewrite (6) as follows: BY
(8)
1P =
_K '
I
Y
Y
Y
6 7te apum that ometypeof gpwement capital is a perfect ubstitute forprivatecapitalis aon3 than required 'Me highly,but notperfectly, subtitu'able for privatecapitaL prae rateof mutewill*ill fasl withpubiciveatmets that ame
85 he firnt term in (8) gives the share of private capital in total production. A sufficient condition for infrastructure capital to increase private investment is that the share of private capital increase with an increase in infrastructure capitaL which will occur if the marginal product of private capital rises proportionately more than the ratio of private capital to output falls. Not surprisingly,whether this share rises or falls depends on the elasticity of substitution between infrastructure and private capitaL An elasticity less than one (17
