Fiscal policy/Tutorials

Fiscal stability

Overview

The concept of fiscal sustainability is often used in discussing fiscal policy but it is absence is not directly observable. Fiscal instability, on the other hand, can be observed from the conduct of the CDS and bond markets. It is possible, moreover, that a fiscal stance which might otherwise be considered to be sustainable, may develop fiscal instability because of the development of debt intolerance toward the government in question that had arisen from herding behaviour in the bond market. Thus the avoidance of fiscal instability would appear to be the more pressing - and possibly more demanding - policy objective.

Sustainability and stability

Sustainability

It is a necessary condition for sustainability that budget deficits do not continue indefinitely, because that would lead eventually to the logically impossible outcome of an interest payment greater than the national income. The debt trap identity establishes that, for a government that has a budget deficit, the fiscal correction needed to avoid that outcome increases with the level of debt as a fraction of GDP at the time that the action is taken, and with the difference between the interest payable on the debt and the growth rate of GDP at the time (both of which are taken to remain constant). It is thus an entirely abstract requirement that depends upon unmeasurable factors and does not establish at what stage the corrective action must be taken. The further requirement that is necessary to determine the timing of the correction is a stipulation of the maximum feasible size of the correction (in terms of the changes in taxation or public expenditure that would be involved). Since that requirement cannot be objectively stipulated, sustainably is not an observable condition.

Fiscal instability

An increase in the risk premium that the bond market applies to a government's borrowing may increase the cost of its borrowing to an extent that increases the market's perception of its riskiness, as a result of which the bond market may apply a further increase in its risk premium. Repetition of that sequence could eventually force the government to default by placing the cost of a roll-over of maturing debt beyond its capacity to raise the necessary funds. The market's awareness of that possibilty may add to the destabilising effect of its actions. Unlike sustainability, fiscal instability is an observable phenomenon.

The fiscal dilemma

Fiscal policy necessarily poses a choice between the growth objective and the need to avoid fiscal instability. That choice arises, in particular, concerning the conduct of fiscal policy during a recession. The operation of automatic stabilisers during a recession necessarily increases a country's budget deficit - sometimes to the extent of raising fears of fiscal instability. The choice has to be made between increasing the deficit further in order to mitigate the severity of the recession, and reducing it in order to maintain investor confidence. That choice is complicated by the fact that, in the absence of effective action to counter the recession, its increasing severity might in any case raise the budget deficit to an extent that would cause a loss of confidence. The consensus policy choice before 2008 had been to refrain from fiscal expansion and to counter the recession solely by an expansionary monetary policy. But in face of the threat posed by the international crash of 2008, most of the G20 governments considered it necessary to use discretionary fiscal policy to augment the diminishing effects of monetary expansion. The recession came to to an end in 2009, but in view of the perceived fragility of the recovery, the dilemma remained: whether to implement immediate tax increases or public expenditure cuts, or to postpone such action pending signs of a sufficiently robust recovery.

Previous experience of that dilemma had been confined to the developing countries. Debt intolerance among investors and anticipations of default by speculators had been such a frequent cause of sovereign default among them that the International Monetary Fund had made its assistance conditional upon the avoidance of deficits, even during recessions).

The cyclical and structural components of public debt

The debt trap identity demonstrates that the fiscal surplus needed to restore sustainability increases with any increase in the opening level of debt or the interest rate on that debt, and with any decrease in the growth rate of GDP. Cyclical influences produce fluctuations in those factor that can sometimes lead to a precipitous loss of sustainability.

During periods of economic stability, and when liquidity is plentiful and domestic interest rates are low, investors tend to seek profit opportunities abroad, as a result of which debtor governments find it easy to borrow at modest rates of interest. However, an international economic downturn, or a credit crunch, or discount rate increase in their creditors' countries, can threaten the fiscal sustainability of debtor countries, even of those with relatively modest levels of national debt. The economic downturn may be transmitted to their economies and raise their budget deficits through the operation of their automatic stabilisers. A credit crunch or discount rate increase may make investors reluctant to roll-over their short-term debt, and the resulting fall in demand may raise the interest rate necessary for debtor governments to continue borrowing.

To avoid the complications of cyclical influences, the concept of a "structural deficit" is sometimes introduced to the consideration of sustainability. In fact that term can simply be defined as a deficit that is unsustainable. To avoid that circularity, however, an unsustainable deficit can more usefully be defined as that part of a cyclically-adjusted budget deficit that is not self-financing (by definition, a self-financing investment does not increase long-run public expenditure). In principal, however, the concept of self-financing publicly financed investment should extend, beyond investments that produce short-term accounting returns, to include those government-financed investments that yield increases in human capital or social capital that are self-financing in the longer term. Since there is always some uncertainty about the gains from such investments, the estimation of the size of the structural deficit (or surplus) involve the use of judgement.

The debt trap identity

According to the debt trap identity (proved in the appendix below), the increase, Δd, in national debt in any given year, as a percentage of GDP is given by:

Δd = f + d(r - g)

where d is the amount of the accumulated debt as a percentage of GDP at the beginning of the year,
and f is the primary budget balance for the year (shown with a negative negative sign if a surplus) as a percentage of GDP,
r is the interest rate payable on the debt,
and g is the then current GDP growth rate.

So that if Δd = 0

f = -d(r - g)

- which is to say that to avoid an increase in public debt in the course of any year, the budget balance during that year must not be greater than the opening level of debt multiplied by the difference between the interest rate on the debt and the GDP growth rate in that year (and that means a budget surplus if the interest rate is greater than the growth rate).

If, for example, r were 5% and g were 2% then a debt of 50% of gdp would require a surplus of 1.5% of GDP, a debt of 100% of GDP would require a surplus of 3% of gdp, and so forth.

(Proof:- Let D and Y be the levels of public debt and GDP at the beginning of a year; and,
let F be the primary, or discretionary budget deficit (the total deficit excluding interest payments) and,
let r be the annual rate of interest payable on the public debt;
and assume that  F, r, and g are all mutually independent.

- then the public debt at the end of the year is  D₁ = D + F +Dr; the GDP at the end of the year is   Y₁ = Y(1 + g);
and the ratio of public debt to GDP has risen from  D/Y to  (D + F + Dr)/{Y(1 + g);

- thus the increase in the ratio of public debt to GDP in the course of a year is:

Δ(D/Y) = (D + F + Dr)/{Y(1 + g)} - D/Y

Let 1/{Y(1;+ g)} = A  andso that AY = 1/(1 + g) ,and  1/AY = 1 + g  
- then:

Δ(D/Y) = A(D + F + Dr) - D/Y

=  A( D + F + Dr  - D/AY)

- and substituting 1 + g for 1/AY:

=  A( D + F + Dr - D - Dg)

substituting for A:

Δ(D/Y) = {F + D(r - g)}/{Y(1 + g)}

or, approximately:-

Δ(D/Y) = {F + D(r - g)}/Y

= F/Y + (r - g)D/Y

Let  f = F/Y ,and d = D/Y

- then                 Δd  =  f + d(r - g)

where f is the primary budget deficit as a percentage of GDP, and d is public debt as a percentage of GDP)