Session 12.

Fiscal Policy

Government size

Budget balances

Fiscal Policy over the business cycle

Debt and sustainability

Macroeconomics in the Global Economy

 Fiscal Policy Framework

In the long run fiscal policy is decided by political goals (e.g. size of
government, who gets taxed)

In the short run fiscal policy is a stabilizing tool, the same way
monetary policy is. In recessions we expect spending to increase and
taxes to decrease – a larger budget deficit (or smaller surplus).

Governments can have imbalances (save or borrow) but they need to

ensure that fiscal plans are sustainable. Sustainability does not mean to
pay back the debt by a certain year. It means that the interest payments
are covered and that the debt path is not explosive.

Macroeconomics in the Global Economy

 Understanding Fiscal Policy:
Government size
Government size varies across countries. In general, advanced (richer) countries have
larger governments. Government size is also a function of whether key services
(education, healthcare) are provided by the government. Remember: government
spending = government consumption + government investment + transfers

Government Spending (% of GDP, 2022)

United States
Sweden
South Africa
Singapore
Nigeria
Mexico
Japan
Germany
France
China
Chile

0 10 20 30 40 50 60 70

Macroeconomics in the Global Economy

 Understanding Fiscal Policy:
Government size
From early 1970s until mid-1990s government size – measured as the ratio of
government spending to output was increasing steadily. Later, however, in many
countries there was reversal of this trend…until the 2008 crisis for some countries.

Government Spending (% of GDP)

80

60

40 SWEDEN
FRANCE
20 GERMANY
JAPAN
US
0
1978 1985 1994 2001 2020

Macroeconomics in the Global Economy

 Understanding Fiscal Policy:
Government Budget (the US, 2020)

“An insurance
company with
an army”.

Macroeconomics in the Global Economy

 Government (Im)Balance

Two definitions:

Overall (Financial) Balance

Taxes – Government Consumption – Transfers – Interest payments

Primary Balance
Taxes – Government Consumption – Transfers

Macroeconomics in the Global Economy

 Measuring the Budget Balance
Imbalances between expenditures and revenues appear as a deficit (or a
surplus) in Government budgets. The primary balance reflects the difference
between all expenditures and revenues without including interest payments on
the debt.
Government Balance as % of GDP (2022)
4

-1.8 -2.1 -1.7 -2.2

-4 -2.7
-3.4 -3.3
-4.4 -4.3 -4.0
-5.1 -5.4
-8
-7.9 -7.6

-12
France Germany Greece Italy Japan UK US

Financial balance Primary balance

Macroeconomics in the Global Economy
 Interest Payments and Government Debt
Interest payments are equal to the interest rate faced by governments times the
level of debt. If interest rates were the same for all governments, interest
payments would be just proportional the level of debt. Average Interest Rate
France 1.5%
Interest Payments and Debt (2022) Germany 0.8%
4 Greece 1.5%
Italy 2.3%
Interest Payments (% GDP)

Italy
3.5 Japan 0.1%
U.K. 3.0%
3 Greece
U.K. U.S. 1.5%
2.5
U.S.
2
1.5 France
1
Germany
0.5 Japan

0
0 20 40 60 80 100 120 140 160 180 200 220 240 260 280

Government Debt (% GDP)

Macroeconomics in the Global Economy
 Fiscal Policy over the Business Cycle
Budget balances move with the business cycle. Higher surplus or smaller
deficits when growth is high. Larger deficits when growth is low.

Euro USA
6 10

4
5

2
0
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
0
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
-5
-2

-10
-4

-6 -15

-8
-20
Government Balance GDP Growth
Government Balance GDP Growth

Macroeconomics in the Global Economy

 Fiscal Policy over the Business Cycle

China
South Africa
20
8
10
6
0
4 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
-10
2
-20
0
Government Balance GDP Growth
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
-2
Japan
-4
5
-6
0
-8 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
-5
-10
-10
-12
-15
Government Balance GDP Growth
Government Balance GDP Growth

Macroeconomics in the Global Economy

 Is Fiscal Policy Cyclical Enough?

The fact that budget balances change over the business cycle is partly the
result of automatic stabilizers:
• Taxes tend to go down
• Some spending categories tend to go up (e.g. Unemployment benefits)

To measure the actual discretionary policies implemented by governments

we measure the structural government balance. This is equal to the actual
balance excluding changes in taxes and spending that are automatic

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 Cyclical Enough?
What does fiscal policy look like if we remove the effect of automatic
stabilizers during the 2008-2014 Euro crisis? Austerity after 2010.

France Portugal
4 4

3
2
2

1 0

2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
0
-2
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
-1
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
-2
-4
-3

-4 -6

-5
-8
-6

-7
-10
GDP Growth Structural Balance GDP Growth Structural Balance

Macroeconomics in the Global Economy

 Cyclical Enough?
But what does fiscal policy look like if we remove the effect of automatic
stabilizers during the 2008-2014 Euro crisis? Austerity after 2010.

Greece Germany
10 6

5 4

2
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
0
-5

01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
-2
-10
-4

-15
-6

-20
-8
GDP Growth Structural Balance GDP Growth Structural Balance

Macroeconomics in the Global Economy

 How did we get austerity wrong?

Assuming governments are like individuals: if facing high debt the only
solution is to cut spending.

Assuming reducing governments will provide enough confidence so that

private spending (and GDP) will increase

Denying the fact that periods of low growth can be very costly. Effects on
GDP can be permanent.

We learned a lesson and the pendulum swung to the other side (US)

Macroeconomics in the Global Economy

 Cyclical Enough?

US Fiscal Policy was very aggressive during the COVID crisis.

Fiscal Policy (US)

22000

20000
Billions of US Dollars

18000

16000

14000

12000

10000
2004
2005
2005
2006
2007
2007
2008
2008
2009
2010
2010
2011
2011
2012
2012
2013
2014
2014
2015
2015
2016
2017
2017
2018
2018
2019
2019
2020
2021
2021
2022
Real Personal Disposable Income Real GDP

Macroeconomics in the Global Economy

 Debt in Advanced Countries: Sustainable?
The growth of government expenditures has not been matched by a parallel
increase in government revenues (taxes). As a result, many governments have
become heavily indebted in the last three decades.
Government Debt as % of GDP

264
238

155 147
122 133
120117
106 97 86 87
60 63 54 65 65 59 71 54 60 55 59 54
36 35 40
15 15 16

US JAPAN GERMANY KOREA ITALY UK

1981 1998 2003 2019 2022

Source: IMF fiscal Monitor, April 2021.

Macroeconomics in the Global Economy

 60
70
80
90
100
110
120
130
1998
1999
2000
2001
2002
2003
2004
2005
2006

Macroeconomics in the Global Economy

2007
2008
2009
2010
2011

Advanced
2012
Debt (% of GDP)

2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
0
1
2
3

0.5
1.5
2.5

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Government Debt: To Infinity and Beyond?

2009
2010
2011
2012
Advanced

2013
2014
2015
2016
Interest Payments (% of GDP)

2017
2018
2019
2020
2021
2022
 30
35
40
45
50
55
60
65
70
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

Macroeconomics in the Global Economy

2008
2009
2010
2011

Emerging
2012
2013
Debt (% of GDP)

2014
2015
2016
2017
2018
2019
2020
2021
2022
1
2
3

1.5
2.5
3.5

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Government Debt: To Infinity and Beyond?

2009
2010
2011
Emerging

2012
2013
2014
2015
2016
Interest Payments (% of GDP)

2017
2018
2019
2020
2021
2022
 Global Real Interest Rates (from session 2)
7

6
Annual Real Interest Rate (%)

-1
84

86

88

90

92

94

96

98

00

02

04

06

08

10

12

14

16

18
19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

20

20

20
Macroeconomics in the Global Economy Source: “Eight centuries of global real interest rates” Bank of England
 Annual Real Interest Rate (%)

-1
0
1
2
3
4
5
6
7
8

1984-01
1985-07
1987-01
1988-07

Macroeconomics in the Global Economy

1990-01
1991-07
1993-01
1994-07
1996-01
1997-07
1999-01
2000-07
2002-01
2003-07
2005-01
2006-07
2008-01
2009-07
2011-01
10-Year Real Interest Rates (US)

2012-07
2014-01
2015-07
2017-01
2018-07
2020-01
2021-07
2023-01
 Debt and Deficits: Are they sustainable?

The relevant question is how to ensure that debt is stable. Remember

that governments do not need to pay back debt. But they need to keep
it on a sustainable path.

The easiest way to assess sustainability is to ask the following

question: How large should the primary surplus be in order to
ensure that the Debt-to-GDP ratio stays constant? The answer can be
derived from the following relationship:
Required Primary-surplus-to-GDP ratio =
= (interest rate – growth of GDP)*Debt/GDP

Example: r = 4%, g = 2%, Debt/GDP = 120%.

Required primary surplus: 2.4%

Macroeconomics in the Global Economy

 The Dynamics of Debt and Deficits

Overall Primary Interest Interest Required

Balance Balance Debt Payments Rate Primary Balance
China -8.9 -7.9 77 1.0 1.3 -4.4
Japan -7.9 -7.6 264 0.3 0.1 -5.0
South Africa -4.9 -0.3 68 4.6 6.8 -0.2
United States -4.0 -2.2 122 1.8 1.5 -3.0
Euro area -3.8 -2.4 93 1.4 1.5 -1.4

All data from 2022 (% of GDP)

We need some assumptions about

Inflation Real Growth Nominal Growth real growth and inflation in the years
China 2 5 7 ahead to calculate the required
Japan 1 1 2 primary balance. We use inflation
targets and some growth projections
South Africa 5 2 7
from Sessions 3 and 4
United States 2 2 4
Euro area 1.5 1.5 3

Macroeconomics in the Global Economy

 The Dynamics of Debt and Deficits

Overall Primary Interest Interest Required

Balance Balance Debt Payments Rate Primary Balance
China -6.3 -5.5 57 0.8 1.4 -3.2
Japan -3.1 -2.4 235 0.7 0.3 -4.0
South Africa -4.8 -1.2 56 3.6 6.4 -0.3
United States -5.7 -3.5 108 2.2 2.0 -2.1
Euro area -0.6 0.8 83 1.4 1.7 -1.1

All data from 2019 (% of GDP)

We need some assumptions about

Inflation Real Growth Nominal Growth real growth and inflation in the years
China 2 5 7 ahead to calculate the required
Japan 1 1 2 primary balance. We use inflation
targets and some growth projections
South Africa 5 2 7
from Sessions 3 and 4
United States 2 2 4
Euro area 1.5 1.5 3

Macroeconomics in the Global Economy

 The Dynamics of Debt and Deficits

Real GDP Growth = 2.5%

Nominal GDP Growth = 5%

Interest Payments 2020 =

0.3-(-11.5) = 11.8%
Interest Rate = 11.8 / 162 = 7.3%

Required Primary Balance = (7.3%-5%) * 162 = 3.7%

Sustainable?????
Macroeconomics in the Global Economy
 Government Debt: Current and
Future Liabilities
If you want to assess sustainability you also need to look at future revenues and expenses as
well. A combination of demographic changes and increasing health care costs implies larger
future deficits and exploding debt levels for many advanced economies.
Projected increases in US government spending and revenues

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 Healthcare: One Country is Not Like the Others

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 The Failure of Politics to
Address Long-Term Sustainability

“President Clinton on Monday proposed paying off

the national debt by 2015 after issuing a new
budget outlook that adds $1 trillion more to the
overall budget surplus over the next 15 years.”
CNN, June 26, 1999.

Macroeconomics in the Global Economy

 Default: Government ≠ Business
When a company defaults we learn that their business model is not
viable. Our wealth and possibly future income will be lower. This is a
“real” shock.
When a government defaults, it simply decides to change who will pay
for the spending that it has already done. It is a redistribution of
resources. Resources are not destroyed (although the crisis that follows
can destroy some of them).

Macroeconomics in the Global Economy

 Paying for Government Debt
Default or Taxes?
Who held their Government Debt in 2011? (%)

Japan

Domestic
Foreign

Greece

0 20 40 60 80 100

Macroeconomics in the Global Economy

 Session 12. Summary

Government expenditures as a % of GDP are high and, in some cases,

increasing for advanced economies.

This has led to a problem of increasing debt and a question on the

sustainability of budgetary plans.

Sustainability depends on: the current level of debt, the interest rate faced by
governments and the future growth rate of GDP.

In the short-term government budgets are a stabilizing tool but sometimes

they are set by political agendas and not economic ones (Europe in 2010-14,
US 2021)

Macroeconomics in the Global Economy