Achieving the Best Fiscal Outcome: What Does the Government Need to Know?

This paper examines the operation of fiscal policy under incomplete information when the central bank sets the stance of monetary policy so as to achieve a zero inflation target. The fiscal authority is assumed to aim to achieve a target level for output and a zero level of public debt. The best fiscal policy setting arises under full information and is one where output attains its full employment level and public debt is driven to zero. Deviations from full information can lead to a considerable divergence from the best fiscal setting involving substantial levels of public sector indebtedness. The results suggest that a government should invest available resources determining what outcomes are achievable and what outcomes are not. Then it should focus all its energies on trying to deliver achievable outcomes. The benefits from such a strategy can be substantial.     

Public investment,the rate of return,and optimal fiscal policy in a stochastically growing economy

This study examines the optimal fiscal policy in a stochastic endogenous growth model with private and public capital. The government is willing to actualize a socially optimal equilibrium using a lump-sum tax and government debt linked to public investments, subject to the budget constraint under the golden rule of public finance. A socially optimal fiscal policy states that a deterministic rate of return on government bonds sets the marginal product of public capital. Moreover, public investments optimally adjust the ratio of private capital to public capital to equate the rates of return on such capital. The presence of stochastic disturbances results in a disparity between the optimal marginal products of the two types of capital, as reported in previous empirical studies. This disparity significantly affects the socially optimal growth rate in response to investment risk.     

Debt,inflation and central bank independence

Increasing the independence of a central bank from political influence, although ex-ante socially beneficial and initially successful in reducing inflation, would ultimately fail to lower inflation permanently. The smaller anticipated policy distortions implemented by a more independent central bank would induce the fiscal authority to decrease current distortions by increasing the deficit. Over time, inflation would increase to accommodate a higher public debt. By contrast, imposing a strict inflation target would lower inflation permanently and insulate the primary deficit from political distortions.     

Public capital in the 21st century: as productive as ever?

The global financial crisis and the euro area sovereign debt crisis that followed induced a rapid deterioration in the fiscal positions of countries across the globe. In the ensuing fiscal adjustment process, public investments were severely reduced in many countries. How harmful is this for growth perspectives? Our main objective is to find out whether the importance of public capital for long run output growth has changed in recent years. To this end, we expand time series on public capital stocks for 20 OECD countries and estimate country-specific recursive vector autoregressive (VAR) models. Results show that the effect of public capital shocks on economic growth has not increased in general, although results differ widely between countries. This suggests that the current level of public investments generally does not pose an immediate threat to potential output. Of course, this could change if low investment levels are sustained for a long time.     

Corruption and public debt: a cross-country analysis

Using data from a large panel of countries over the period 1995–2015, this article empirically investigates the effect of corruption on public debt. Overall, the estimates reveal that corruption increases public debt. The effect, however, appears to be heterogeneous across income-related sample splits: it is stronger for advanced economies, but weaker and less statistically robust for less-developed countries, where external factors such as foreign aid may also affect public debt. The analysis suggests the inadequacy of conventional wisdom assuming that more detrimental fiscal effects of corruption arise in low-income countries.     

Government debt and optimal monetary and fiscal policy

How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first-order approximations to optimal policies, but is shown to be quantitatively significant in a second-order approximation, especially when technology movements are largely unpredictable in nature.     

Fiscal Prudence and Growth Sustainability: An Analysis of China's Public Debts

This paper analyses and assesses China's current fiscal system, including its basic institutional arrangements, the relationship between central and local governments, and the fiscal balance and public debt. This paper pays special attention to the local government borrowings that have increased dramatically in recent years, and tries to measure the “overall public debt risk” by including all kinds of eligible debts. This paper finds that although the large expansion of local government debt during the fiscal stimulation response to the global financial crisis was devastating, the all‐inclusive total public debt to gross domestic product ratio remains under 50%, and as long as the local debt stops growing, the risk is quite manageable. This paper also points out that more attention should be paid to improving and reforming the Chinese fiscal system, particularly the reform of the fiscal relationship between central and local governments, and the legal framework for local government debt management.     

Growth Effects of Fiscal Policy and Debt Sustainability in the EU

In this paper we study the relationship of fiscal policy and economicperformance of some core countries in the EU. Our aim is to find outwhether public deficit and public debt have consequences for real variables in the economies we consider. The background of our empirical study is a growth model that provides us with some predictions on the relationship between fiscal policy and economic growth. In a first step we then use Granger causality tests to analyze empirically whether some of the implications of our model arecompatible with the data. In a second step, we investigate whether the fiscalpolicies of the member states have been sustainable. Given this information,we then pursue the question of whether differences in the fiscal positions ofcountries have consequences as concerns the outcome of our empirical testsof step one. Finally, we study whether the impact of the public deficit ratiodepends on the magnitude of the debt ratio.     

The trade-off between public debt reduction and automatic stabilisation

This paper addresses the basic tradeoff between the stabilisation properties of budgets and the sustainability of long run fiscal positions. The modeling framework consists of a simple non-monetary endowment economy with overlapping generations, extended to account for stochastic endowments and borrowing constrained households. A benign government chooses the optimal degree of responsiveness of net taxes to individual incomes and an optimal measure of long-run public debt in order to smooth households' consumption across states of nature. In the presence of a deficit constraint for the government, the results point to the desire for lower debt levels than those currently prevailing in European Union countries in order to enable a more effective hedging of personal income uncertainty by means of more active automatic fiscal stabilisers. The optimal degree of automatic stabilisation and debt reduction is conditional on the characteristics of economic cycles.     

Inflation and the fiscal limit

We use a rational expectations framework to assess the implications of rising debt in an environment with a “fiscal limit”. The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.     

CENTRAL BANK INDEPENDENCE AND THE MONETARY INSTRUMENT PROBLEM

We study the monetary instrument problem in a dynamic noncooperative game between separate, discretionary, fiscal and monetary policy makers. We show that monetary instruments are equivalent only if the policy makers' objectives are perfectly aligned; otherwise an instrument problem exists. When the central bank is benevolent while the fiscal authority is short‐sighted relative to the private sector, excessive public spending and debt emerge under a money growth policy but not under an interest rate policy. Despite this property, the interest rate is not necessarily the optimal instrument.     

The debt brake of the German states: a faulty design?

The debt brake for German states, which demands that they are forbidden from taking up new net debt from 2020 onwards, has two major shortcomings. First, states do not have tax autonomy. In fiscal crises, they can only make adjustments to expenditure but not on the revenue side. Given the fact that most expenditure is—at least in the short term—predetermined by law, in such a crisis a balanced budget without new debt is hardly feasible. Second, the measure does not take into account that large investments, in particular in small regional units, can scarcely be financed by current expenditure. Thus, there is a high probability that at least some states will take up new net debt even after 2020 and, therefore, violate the rules of the debt brake.     

Central bank independence,fiscal deficits and currency union: Lessons from Africa

Can central bank independence (CBI) help to reduce fiscal balances? In this paper, we answer this question using novel measures of CBI based on the turnover rate of central bank governors (TOR) and the Garriga measure of legal independence for 30 African countries for the period 1990–2017. Our novel measures of CBI capture the degree of alliance between the fiscal authority and the monetary authority which can potentially lead to debt monetization and higher fiscal balances. Thus, we classify central bank governor changes into ally changes or non-ally changes; in addition to that, we decompose our full sample into CFA zone countries and non-CFA zone countries to capture the effect of currency union membership. Our results show that for CFA zone countries, central bank autonomy, when proxied by the turnover rate of central bank governors, is associated with a decrease in fiscal balances and replacing a central banker with a non-ally, is negatively and significantly associated with fiscal balances.     

DO BALANCED‐BUDGET RULES INCREASE GROWTH?

This study tests the hypothesis that balanced‐budget rules (BBRs) that restrict public borrowing to investments in public infrastructure increase growth by increasing the productivity of debt, either because investments in public infrastructure are more productive than other uses for which states borrow funds or because BBRs lower borrowing costs. Results are based on data at 5‐year intervals for 49 US states over the period 1957–2007. The tests strongly support the hypothesis that BBRs increase growth by increasing the productivity of debt and withstand a variety of robustness checks, including alternative lags, exogeneity tests, GMM estimation, a placebo test, and the influence of outliers.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

INTERACTION BETWEEN MONETARY AND FISCAL AUTHORITIES UNDER INCOMPLETE INFORMATION

This paper analyzes the interaction between monetary and fiscal authorities under incomplete information. The inflation goal of the central bank is assumed to be unknown to the fiscal authority and the public. The central bank signals the goal by choosing the first‐period monetary policy before the fiscal authority joins the policy‐making game. If the central bank would like the fiscal authority and the public to believe that it is wet (dry), the central bank would distort the money supply upward (downward) in order to reveal its actual type.     

Central governance or subsidiarity: A property-rights approach to federalism

We consider a model where one region in a federation can realize a public project after undertaking value-increasing investments. While negotiations on the federal level ensure that an efficient project size is implemented in equilibrium, non-contractibility of investments causes the overall outcome to differ across regimes. If the region bears the entire implementation costs of its policies, underinvestment prevails and subsidiarity (centralized governance) is superior when spillovers are weak (strong). Conversely, if linear cost sharing arrangements are feasible, decentralized authority often admits a socially optimal outcome while centralized authority (with majority or unanimity rule) does not.     

Thoughts on a Fiscal Union in EMU

Using an estimated large‐scale New Keynesian model, we assess the consequences of introducing a fiscal union within EMU. We differentiate between three different scenarios: public revenue equalisation, tax harmonisation and a centralised fiscal authority. Our results indicate that no country would significantly benefit from introducing any form of fiscal union. Comparing long‐term, that is, steady state, effects we have winners and losers depending on the scenario. Differences in terms of business cycle statistics as well as in terms of risk sharing of asymmetric shocks are minor. This also explains why welfare differences are small across the fiscal union scenarios. A counterfactual exercise indicates that with a fiscal union regime already installed at the start of EMU, key macroeconomic variables would have reacted very similarly while debt dynamics would have changed notably.     

The determinants of vulnerability to currency crises: country-specific factors versus regional factors

We investigate the determinants of exchange market pressures (EMP) for some new EU member states at both the national and regional levels, where macroeconomic and financial variables are considered as potential sources. The regional common factors are extracted from these variables by using dynamic factor analysis. The linear empirical analysis, in general, highlights the importance of country-specific factors to defend themselves against vulnerability in their external sectors. Yet, given a significant impact of the common component in credit on EMP, a contagion effect is apparent through the conduit of credit market integration across these countries under investigation.     

Variation in the fiscal multiplier with the method of financing: evidence across industrial countries

Government spending has often varied with the business cycle to stimulate the economy and to revive economic conditions. However, the state of public finances has often necessitated higher borrowing to finance widening fiscal deficits. Indeed, recent austerity packages around the globe have crystalized the importance of fiscal consolidation against the backdrop of rising public debt. To shed light on recent debates regarding fiscal multipliers, the article estimates variation in these multipliers with the method of financing, using annual data for a sample of industrial countries. There is a large variation in the effects of expansionary and contractinary government spending shocks on economic variables within and across countries. The significant effects of negative government spending shocks (fiscal contraction) appear more prevalent than those of expansionary shocks on real output growth, price inflation and nominal wage inflation. Consistent with theory’s predictions, the fiscal multiplier is more likely to be negative when government spending is financed by issuing debt and less likely in the case of monetization. The evidence confirms concerns about the negative effect of higher debt and more expensive financing on private activity, countering the effectiveness of fiscal policy.