How to Measure the Fiscal Deficit [1 ed.] 9781455246663, 9781557751928

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and

Copyright © 1991. International Monetary Fund. All rights reserved.

How

TO

MEASURE THE FISCAL DEFICIT ANALYTICAL AND METHODOLOGICAL ISSUES

Copyright © 1991. International Monetary Fund. All rights reserved.

Edited by

Mario I. Blejer and Adrienne Cheasty

INTERNATIONAL MONETARY FUND

1993

How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Copyright © 1991. International Monetary Fund. All rights reserved.

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

How

TO MEASURE THE FISCAL DEFICIT

Copyright © 1991. International Monetary Fund. All rights reserved.

ANALYTICAL AND METHODOLOGICAL ISSUES

How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

© 1993 International Monetary Fund Library of Congress Cataloging-in-Publication Data

Copyright © 1991. International Monetary Fund. All rights reserved.

How to measure the fiscal deficit : analytical and methodological issues / edited by Mario I. Blejer and Adrienne Cheasty. p. cm. Includes bibliographical references. ISBN 1-55775-192-7 : $22.50 1. Fiscal policy—Developing countries. 2. Budget deficits— Developing countries. I. Blejer, Mario I. II. Cheasty, A. HJ1620.H69 1993 339.5'09172'4—dc20 92-10723 CIP Both this book's cover and its interior were designed by the IMF Graphics Section. The following symbols have been used throughout this book: . . . to indicate that data are not available; — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; — between years or months (e.g., 1991—92 or January—June) to indicate the years or months covered, including the beginning and ending years or months; / between years (e.g., 1991/92) to indicate a crop or fiscal (financial) year. "Billion" means a thousand million. Minor discrepancies between constituent figures and totals are due to rounding. The term "country," as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis. Price: $22.50 Address orders to: External Relations Department, Publication Services International Monetary Fund, Washington, D.G. 20431, U.S.A. Telephone: (202) 623-7430 Telefax: (202) 623-7201 Cable: Interfund

How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Contents Foreword Richard D. Erh • vii Acknowledgments • L\ Part I. 1.

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Part II.

Overview Measuring the Fiscal Deficit: Overview of the Issues Mario 1. Blejer and Adrienne Chcasty • 3 The Adequacy of Summary Measures of the Fiscal Deficit

2.

Fiscal Deficit Measurement; Basic Issues Vito Tansi • 13

3.

Are All Summary Indicators of the Stance of Fiscal Policy Misleading? G.A. Mackenzie • 21

4.

Measurement of Fiscal Performance in IMF-Supported Programs: Some Methodological Issues AUtin Isv • 52

5.

Fiscal Impulse Measures and Their Fiscal Impact Shectal K. Cliand • 85

Part MI.

Conventional and Adjusted Fiscal Deficits

6.

The Cash Deficit: Rationale and Limitations Jonathan Levin • 103

7.

Government Arrears in Fiscal Adjustment Programs Jack Diamond and Christian Schiller • 113

8.

Credit Subsidies in Budgetary Lending: Computation, Effects, and Fiscal Implications Michael A. Wattleworth • 147 v

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CONTENTS

9.

Part IV.

Coverage of the Public Sector

10.

Toward Defining and Measuring the Fiscal Impact of Public Enterprises Peter Stella • 207

11.

Amalgamating Central Bank and Fiscal Deficits David J. Robinson and Peter Stella • 236

12.

Impact of Public Financial Institutions on Fiscal Stance Oded Liviatan • 259

Part V.

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Effects of Inflation on Measurement of Fiscal Deficits: Conventional Versus Operational Measures Vito Tanzi, Mario I. Blejer, and Mario O. Teijeiro • 175

The Public Sector's Intertemporal Budget Constraint

13.

The Deficit as an Indicator of Government Solvency: Changes in Public Sector Net Worth Mario I. Blejer and Adrienne Cheasty • 279

14.

Measurement of the Public Sector Deficit and Its Implications for Policy Evaluation and Design Willem H. Buiter • 297

15.

Budgetary Impact of Privatization Ali M. Mansoor • 345

16.

Government Contingent Liabilities and Measurement of Fiscal Impact Christopher M. Towe • 363

How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Copyright © 1991. International Monetary Fund. All rights reserved.

Foreword ASONEOF ITS primary functions, the IMF assesses the impact of each member government's macroeconomic policies on the member's own economy as well as the spillover effects of those policies on other members. The IMF is also called upon to provide policy recommendations conducive to sustained economic growth, price stability, and external equilibrium. In addition to monetary and exchange rate policies,fiscalpolicy is at the core of the IMF's work. The IMF's Fiscal Affairs Department provides extensive analytical and technical assistance to IMF members. As this volume shows, the Fiscal Affairs Department also conducts a research program that both enriches and is enriched by the work with member governments and that makes an original contribution in the area of economic policy analysis. I believe that the studies in this volume enhance our understanding of the complex ways in which a country's fiscal policy can influence economic developments in the present and future. The papers collected here make it clear that there does not exist any single, unique way of assessing the impact of fiscal policy on an economy. At the same time, the papers provide analytical insights and valuable suggestions about concepts and methodologies that may be useful in different circumstances, in different countries, and for different purposes. Thus, the studies included in this volume will be particularly useful for those engaged in analyzing and formulating policy choices for political leaders. One of the major tasks of political leaders in any country is to develop a public consensus on fiscal policy. As seen in many industrial and developing countries, failure to do so usually leads to excessive fiscal deficits and other fiscal problems. Developing a public consensus is not easy, particularly given the distributional struggles inherent in decisions on fiscal expenditures and revenue. But that task is made even more difficult in the absence of a straightforward fiscal concept that can serve as a generally understood and accepted overall guide to fiscal policy. More refined analytical concepts enable the fiscal expert to provide better advice to political leaders but, at the same time, make the political leaders' job of public persuasion more difficult. Addressing vii

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viii

FOREWORD

this dilemma more explicitly is another research task that lies ahead, but this volume provides an excellent starting point.

Copyright © 1991. International Monetary Fund. All rights reserved.

Richard D. Erb Deputy Managing Director International Monetary Fund

How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Acknowledgments wish to thank the contributing authors for consenting to inclusion of their papers in this volume, as well as for cooperating actively in preparing the papers for publication. Eight of the 16 papers included have previously appeared in various IMF publications; in addition, Chapter 13 appeared, in an earlier version, in a recent issue of the Journal of Economic Literature. The views expressed in all of the papers are those of their respective authors and should not be interpreted as those of the IMF. The editors express their gratitude to Miguel A. Kiguel and Professor Efraim Sadka for commenting on the manuscripts in the initial stage of their preparation for publication. The editors also wish to thank James McEuen, Margaret Karsten, and Elisa Diehl for valuable editorial help, and Alicia Etchebarne-Bourdin for assistance in electronic manuscript preparation; all are with the IMF's External Relations Department. Both the reviewers' substantive comments and the editorial suggestions led to a significant improvement in the organization and presentation of the chapters in this volume. Preparing a volume like this one for publication is a demanding and time-consuming task, sometimes requiring efforts above and beyond the call of duty. The editors are particularly indebted to Ahwerah Vichailak and Luzmaria Monasi, who provided indispensable secretarial assistance. Last, but not least, the editors wish to express their gratitude to the Director and the many staff members of the IMF's Fiscal Affairs Department who provided guidance, encouragement, and support for this project.

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THE EDITORS

ix

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Part I

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Overview

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

1 Measuring the Fiscal Deficit Overview of the Issues

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Mario I. Blejer and Adrienne Cheasty A PRIMARY GOAL offiscalpolicy is to equilibrate the public sector's financing requirement with the private sector's demand for investment and a sustainable balance of payments. Although fiscal policies may fail because of inappropriate design, in practice they can also fall short of their desired objectives because conventional measures of the budget deficit miscalculate the true pre-emption of resources by the public sector. The correct measurement of the public sector's net use of resources is therefore an important prerequisite for managing the macroeconomy. Although the deficit measure is relevant primarily as an indicator of the macroeconomic consequences of fiscal policy, the set of consequences that policymakers desire to assess may itself determine the "correct" deficit measure. In other words, there is no such thing as the fiscal deficit, but rather a series of alternative measures, each with advantages and disadvantages. Because the selection of the appropriate fiscal deficit measure is so critically linked to the understanding and management of the macroeconomy, the staff of the International Monetary Fund is devoting increasing attention to the methodology underlying fiscal policy choices. The papers collected in this volume, which have been prepared as part of the research program of the IMF's Fiscal Affairs Department, address specific questions encountered during the IMF's operational work. Part II of the collection contains discussions and critiques of various attempts to encapsulate in summary indicators an appropriate assessment of the effect of the government's fiscal stance on the rest of the economy. On the assumption that these summary indicators have been appropriately selected, the three subsequent sections focus on the 3

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MEASURING THE FISCAL DEFICIT: OVERVIEW

methodological aspects of measuring the government's resource balance. The papers of Part III explore the definition of the deficit in a public sector of a given coverage. In Part IV the coverage (or size) and composition of the public sector are analyzed. The papers of Part V deal with the relevant time horizon for assessing the magnitude of the deficit.1

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The Adequacy of Summary Measures of the Fiscal Deficit In the introductory chapter of Part II, Vito Tanzi presents the basic issues and shortcomings inherent in any summary indicator of government activity. He points out in Chapter 2 that conventional measures of the deficit have at least three limitations in gauging the extent of excess demand emanating from the public sector. First, different taxes and expenditures affect demand differently, so that for a given deficit the composition of the budget is important. Tax revenues, moreover, are not a completely independent policy variable but are subject to feedback from the rest of the economy. Finally, the excess demand stemming from the deficit depends not only on the size of the deficit but also on the manner in which it is financed. Setting the stage for the rest of the book, Tanzi reviews some of the other issues that complicate the interpretation of summary deficit measures. He considers a popular alternative to the overall deficit, the government current account deficit, and some further definitional issues of deficit measurement. These, including the treatment of arrears, the coverage of the public sector, the effect of inflation on the measured deficit, and the time dimension of measurement, are discussed in greater detail later in the book. Sandy Mackenzie, in Chapter 3, appraises two recent criticisms of summary fiscal indicators. The first is that of Willem Buiter (presented in Chapter 14 of this book), who claims that conventionally measured public sector balances are too narrowly defined because they omit elements such as changes in the real value of public assets and liabilities 1 Two components of the traditional public sector—state and local governments and the social security system—are not given full coverage here. The fiscal contribution of the former is clear-cut; the fiscal issues raised by the social security system could fill another book. Intertemporal aspects of social security accounting in the public sector are discussed in Chris Towe's paper (Chapter 16 in Part V); Atkinson (1985) provides a general survey of social security issues.

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MARIO I. BLEJER and ADRIENNE CHEASTY

5

arising from relative price and exchange rate variations and from fluctuations in the present value of future tax payments. The second, made by Laurence Kotlikoff, is that conventional deficits do not reflect changes in the distribution of wealth between generations. Mackenzie argues that these defects of summary indicators have been exaggerated. Because it is not practical to include all changes in public sector net worth in a comprehensive measure, and because liquidity constraints and aversion to indebtedness are indeed important, conventionally measured public sector deficits are certainly not irrelevant. The moral to be drawn from these criticisms is simply that summary indicators must be used with care. In practice, of course, summary indicators are extensively used for policy analysis and in monitoring stabilization programs. In Chapter 4, Alain Ize stresses that, for a summary indicator to be appropriate in an operational sense, the type of impact it is being used to measure should be clearly specified. He distinguishes between measures of discretionary fiscal stance, fiscal strength, fiscal sustainability, fiscal vulnerability, and efficient measures of fiscal conditionality (that ideally would target policies rather than outcomes). Ize recognizes that practical constraints require truly operational fiscal indicators to remain as simple, selective, and uniform as possible and offers some concrete suggestions on how to standardize the use of these indicators. A family of measures that has long been used to assess the impact of government activity on the economy is the fiscal impulse. The fiscal impulse has, however, been subject to numerous criticisms, which are summarized by Sheetal Chand in Chapter 5. Chand addresses one of the most important criticisms—that impulse measures lack a consistent, analytical economic framework—by deriving a fiscal impulse indicator from a standard aggregate demand model and showing that it is robust to typically used consumption function specifications.

Conventional and Adjusted Fiscal Deficits Even if the validity of utilizing a summary measure of government activity is accepted, much more work needs to be done on defining the components and scope of the summary measure. The concept of budgetary balance most widely accepted internationally is that of the conventional deficit, which defines the resource use of the public sector that remains to be financed in each fiscal year after the government has offset its income against its outlays. All countries record some variant of this deficit. Perhaps the most frequently used variant is the

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MEASURING THE FISCAL DEFICIT: OVERVIEW

public sector borrowing requirement, which measures government's use of new financial resources net of repayment of previously incurred debt. A borrowing requirement, by definition, is a cash-based deficit, whereby only the outlays of the government for which cash has been disbursed and only actual cash revenues received during the fiscal year are included in the budget balance. In Chapter 6 Jonathan Levin, the primary author of A Manual of Government Finance Statistics (IMF (1986)), the IMF's standard guide for public sector statistics, lays out the rationale for, and the limitations of, the conventional cash deficit. He emphasizes that the cash deficit measures the most direct impact of government on the economy in a given period. The cash deficit also has the advantages of being a useful indicator for government liability management and of permitting the ready identification of the government component of the broader monetary objectives being pursued in the economy. Some of the limitations of this measure, outlined by Levin, are discussed further in other chapters of Part II. A primary limitation of the cash deficit measure is that governments often are not constrained to limit their expenditures to what they are able to finance on a cash basis in a given fiscal period. Lags in payment that exceed the normal accounting period generate public sector arrears, and these arrears pose specific problems in interpretation and measurement of the fiscal deficit. On the one hand, reductions in the cash deficit could imply simply the forced financing of government expenditure by accumulation of arrears to suppliers and creditors. On the other hand, an increase in the cash deficit could arise merely from a reduction in amortization arrears. In Chapter 7, Jack Diamond and Christian Schiller discuss the implications of these types of arrears. In particular, an assessment of the impact of arrears on the measurement of the deficit, and of their potential adverse implications for the speed of fiscal adjustment, is presented. The authors point out that the implications of arrears reach beyond the government accounts: they may also have allocative and distributional consequences. Thus, when arrears are important, they have to be recognized in formulating fiscal adjustment programs, since it will be important to capture not only the monetary effect of budgetary changes but also the actual net resource pre-emption by government—the true consequence of its policy decisions, regardless of whether or not the government has actually paid for its transactions. A further problem with the conventional cash deficit is that it takes as given the set of relative prices at which government transactions are performed. This use of actual prices, if they are distorted, can present a drastically misleading measure of the impact of the budget

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MARIO I. BLEJER and ADRIENNE CHEASTY

7

on the economy. In Chapter 8, Michael Wattleworth discusses an important source of such distortions: the low-interest lending activities of the government. Government lending, which has been sizable in many industrial countries, can involve substantial implicit subsidies that the cash deficit does not capture. The implicit subsidies continue to influence fiscal impact for many years after the government's lending activities are suspended, as long as outstanding balances of loans remain. Although net lending activities are phased out, implicit subsidies can still grow. Thus, attempts to detect the implicit subsidies in current net lending activities are inadequate and must be supplemented by appropriate consideration of the implications of past lending. Wattleworth suggests a straightforward methodology for incorporating implicit subsidies in the budget into a practical deficit measure. The choice of relative prices impinges on the effectiveness of the deficit as an indicator of fiscal impact, but the presence of inflation also has important and widely recognized implications for accurate measurement of budgetary consequences. In Chapter 9, Vito Tanzi, Mario Blejer, and Mario Teijeiro consider the impact of inflation on the deficit. When inflation is high, a large portion of interest payments on government debt could actually represent amortization of the debt. The inclusion of these amortization components together with interest expenditure would imply that the conventional measure of the deficit overstates the size of the true fiscal imbalance. The authors discuss, as an adjustment for this problem, the "operational deficit"—defined as the conventional deficit less that part of the debt service that compensates debt holders for actual inflation. They delineate practical problems in measuring such a concept, including difficulties in estimating expected inflation. Moreover, because the fiscal deficit itself may affect inflation and because the automatic rollover of the inflation component of interest payments is not in practice guaranteed, the operational deficit—which does not take these risks into account— can be only a lower-bound estimate of the relevant government deficit in high-inflation countries.

Coverage of the Public Sector The papers in Parts II and III of this volume take the identity of government as understood. At the practical level, however, difficulties arise in defining the precise scope and components of government for purposes of measuring the fiscal deficit. Governments frequently perform operations that are usually carried out in other sectors. Like-

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MEASURING THE FISCAL DEFICIT: OVERVIEW

wise, traditionally non-governmental agents can be used as instruments of government policy. Part IV contains three studies that analyze the fiscal content, which can be significant, of public enterprises, the central bank, and public financial institutions—entities that have not normally been included in the conventional definition of government. In these papers, attempts are made to provide methodologies for disentangling the para-fiscal components of these entities' operations from their core characteristics. Peter Stella in Chapter 10 makes the point that public ownership is not a sufficient criterion for distinguishing governmental enterprises from private firms. Rather, the distinction should be based both on the behavior of enterprises (those that respond quickly to market signals and those that are in a position not to) and on their impact on public finances. The paper focuses on the measurement of this impact, covering specific issues such as accrual versus cash accounting in enterprises and the separation of subsidy and tax elements in enterprise pricing. In many countries, important quasi-fiscal activities are carried out by the financial public sector, including the central bank and a multitude of publicly owned financial intermediaries. In Chapter 11, David Robinson and Peter Stella make the case for consolidating central bank quasifiscal operations with those of the government in order to obtain a deficit measure that will provide a more complete indication of the size of the required fiscal adjustment. They show that, if the central bank undertakes only monetary activities and is profitable, its net result is automatically included in the fiscal deficit. This is also true when quasi-fiscal activities affect only the central bank's profit and loss account. If other quasi-fiscal activities, such as net lending (which affects only the composition of a central bank's assets), are undertaken, the fiscal deficit can be an unreliable indicator. The same occurs if the central bank makes losses, because these are practically never covered by a transfer from the budget. Thus, procedures to consolidate specified central bank activities in an expanded fiscal deficit can be important. Other public financial institutions often engage in a variety of activities (such as preferential credit allocations and interest rate subsidies) that go beyond the pure liquidity management that is the distinguishing characteristic of the private commercial banking sector. They may also operate in the capital market under special conditions such as government guarantees and implicit monopoly over segments of the market. This being the case, the operations of these institutions could exert pressures on financial markets not conceptually different from those arising from the financing of explicitly governmental activities.

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The special nature of public financial institutions and their relation to the public sector deficit is discussed by Oded Liviatan in Chapter 12.

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The Public Sector's Intertemporal Budget Constraint The concerns described so far have long been recognized as important issues in fiscal analysis. Recent developments, however, have radically changed the way in which the deficit is viewed. The debt crisis has highlighted the issue of long-run government solvency; privatization programs have focused attention on the consequences of financing current expenditure by the sale of assets; and the large swings in exchange rates and domestic price levels that characterized the economies of many countries in the 1980s have shown that governments' financial positions can be affected in important ways by price and valuation changes. All of these issues have motivated the investigation of the intertemporal characteristics of the public sector's budget constraint. Part V of the volume includes four studies centered on the time dimension of deficit measurement. The increasingly diverse literature on the deficit as an indicator of government solvency is surveyed by Mario Blejer and Adrienne Cheasty in the first of these studies, Chapter 13. After a discussion of the intertemporal shortcomings of the conventional deficit, they review in detail government balance-sheet approaches that incorporate changes in public sector net worth. Specific problems in the construction of a government balance sheet—such as the valuation of financial and real assets, contingent claims, and the present value of the tax program— are presented. The following three papers cover concrete issues that become important in an intertemporal framework. In Chapter 14 Willem Buiter describes the ideal, comprehensive and consolidated public sector balance sheet at current market or implicit prices. He provides a welldefined conceptual framework encompassing all the components to be taken into account in a global specification of government net worth. These elements are then related to the measurement question, and implications are drawn for policy assessment and design. One of the important ways in which a government balance-sheet approach differs from the conventional deficit measure is in the treatment of asset sales. Because of its intertemporal nature, the government balance sheet permits the full spectrum of implications of asset sales to be perceived. Viewed from this perspective, privatization of public assets will not necessarily change the net worth of government, despite

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MEASURING THE FISCAL DEFICIT: OVERVIEW

providing sometimes significant budget revenues at the time of sale. Ali Mansoor, in Chapter 15, analyzes the budgetary implications of government asset sales, pointing out that, for the fiscal position truly to improve, privatization must lead to efficiency gains in the economy. For example, the transfer of a public monopoly to the private sector, if its monopoly power is left intact, may worsen the budgetary position because of the losses in public sector wealth and the possibility of insufficient improvements in overall productivity. Therefore, when the size of the public sector is changing, the conventional deficit measure, which incorporates capital revenues as if they were recurrent, may provide a distorted image of government's long-run financial strength. The government's long-run financial strength may also be undermined by an accumulation of contingent claims, guarantees, and entitlements that are reflected in the conventional deficit only when and if they are called. In Chapter 16, Chris Towe describes some of the main options available for dealing with this problem, most of which involve the computation of the present value of future commitments. This computation is more difficult in the public sector than elsewhere because the government typically does not set up appropriate reserves to offset its accumulation of risks. A full-fledged government balancesheet approach would make this shortcoming immediately evident. The complexity of the calculations involved, however, implies that more limited deficit concepts are still far from irrelevant.

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References Atkinson, Anthony B., "Income Maintenance and Social Insurance," in The Handbook of Public Economics, ed. by Alan J. Auerbach and Martin Feldstein (Amsterdam and New York: North-Holland, 1985). International Monetary Fund, A Manual on Government Finance Statistics (Washington, 1986).

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Part II

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The Adequacy of Summary Measures of the Fiscal Deficit

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2 Fiscal Deficit Measurement Basic Issues

Vito Tanzi have had to face two realities in the past decade. The first is the debt crisis, which has sharply reduced the developing countries' access to external resources and has made it highly desirable for them to grow at a sustained pace so as to reduce their debt burden over time. The second is that excess demand, originating from the public sector, has been at least partially responsible for the balance of payment difficulties that many of these countries have encountered. These two realities require that the public sector's claims on the economy be reduced while at the same time the productive capacity of the economy is stimulated. But, before designing the optimal fiscal policy for an economy that achieves stability with growth and social justice, a fundamental question must be addressed: How does one measure this excess demand originating from the public sector?

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MANY COUNTRIES

The Conventional Deficit The common or conventional measure of the fiscal deficit, defined as the difference between total government expenditure and government's current revenue, may have shortcomings as a measure of excess demand. Three important limitations come to mind: (1) the differential impact on demand associated with different tax and expenditure categories; (2) the endogeneity of tax revenue; and (3) the impact of different sources of deficit financing. The first of these limitations has a long history. Haavelmo's (1945) balanced-budget theorem, which recognized the different demand 13

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FISCAL DEFICIT MEASUREMENT: BASIC ISSUES

effects of a dollar's change in taxes and in real government expenditure, is an early version of it. Bator's (1960) later argument that transfer payments and real expenditures of the government have dollar-perdollar different demand impacts is another. In the 1960s this argument was very popular. It perhaps received the most explicit expression in a book written by Bent Hansen (1969) that dealt with fiscal policy in seven Organization for Economic Cooperation and Development (OECD) countries. The problem is that, although one should recognize that different taxes and expenditures may have different demand effects, it is difficult to agree on specific and objective weights to be assigned to these differences. This difficulty may explain why the early enthusiasm for this approach quickly vanished; today, hardly any attention is paid to these differences—except, perhaps, in traditional and large econometric models of the economy. Another reason is that by putting the emphasis on demand effects, this approach reflects an essentially Keynesian view of the role of fiscal policy. The second limitation, the endogeneity of tax revenues, also has a long history; it goes back at least to work done in the 1950s by Gary Brown (1956) and others. The question here is the following: Should one take as the index of a country's needed fiscal adjustment the deficit that the country actually has in a given period, or should one adjust that deficit for the effect of the business cycle on revenue and expenditure? Obviously, as economic activity declines in a recession, tax revenues are likely to be lower than in a full-employment situation, other things being equal. Some expenditures—unemployment compensation, for example—are also sensitive to the cycle and may rise during a downturn. This point is certainly potentially important. Behind it is the assumption that, since a recession increases the unused capacity in the economy, a larger public sector demand can be accommodated or may even be desirable to achieve full employment. It is a point that has been at the center of an ongoing debate for guiding fiscal policy in industrial countries. The full-employment budget surplus, a concept introduced in the 1962 Economic Report of the President of the United States and one that played a large role in determining economic policy in the Kennedy and Johnson era, was an expression of this aspect (United States (1962)). The problem is that in today's world the concept of a full-capacity level of output has lost much of its precise meaning for a variety of reasons, but mainly because of the greater openness of many economies. Certainly, this concept is suspect for developing countries, where capacity utilization and full employment are ambiguous and difficult-to-define concepts. In these economies—and, perhaps, also in

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VITO TANZI

15

many industrial countries—the major constraint on output is often not the labor supply or even the productive capacity of the capital stock, but the availability of foreign currency. A government that attempted to push aggregate demand because of unutilized domestic resources would soon run into a foreign exchange constraint. Thus, again, although the point is an important one, its relevance for developing countries is likely to be limited. Third, it is certainly true that different sources of financing have different demand effects. Clearly, central bank financing, commercial bank financing, bond financing, foreign financing, domestic suppliers' financing, and so on will affect aggregate demand differently. This is an aspect that has not received the attention it deserves. Most observers have not recognized the various ways in which the fiscal deficit can be financed in developing countries.1 I have some difficulty, however, in accepting the conclusion reached by some economists that one should focus only on bank-financed deficits. There are certainly lots of other reasons to focus on different measures. Most important among these is to prevent public debt, both domestic and foreign, from growing at too fast a pace. In fact, very recent literature has focused on the effect of fiscal policy on the ratio of public debt to national income (see Spaventa (1987), Blanchard (1990), and Blejer and Cheasty (Chapter 13 of this volume)). Another reason is the need to limit the crowding out of private sector investment. It has also been argued that borrowing by the government on behalf of public enterprises should be excluded from the deficit, because that part of credit to government is strictly not for government purposes. In other words, if those public enterprises had been private, and if they had done the same amount of borrowing in the capital market, the fiscal deficit would have been lower while the total demand for loanable funds would have been the same. This is an argument that has attracted a lot of attention in Italy, where the image of the "government as a banker" that merely intermediates between the financial market and the public enterprises has been discussed. Several Italian authors (see survey in Ruggiero (1985)) have pressed for the exclusion of this particular part of the deficit. The problem with the above argument is that it implicitly assumes that the public enterprises would do exactly the same amount of borrowing, and presumably would produce the same output at similar costs, if they were private enterprises. It also assumes that they would 1 For a discussion of public finance in developing countries, see Tanzi (1991, pp. 91-103).

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borrow, at presumably identical conditions, regardless of the losses that they might be making. This is unlikely to be so. Many of these enterprises survive because the government is there to provide funds, and one can add that what they produce and the way they produce it are certainly influenced by their "publicness." In reality, public enterprises have contributed significantly to total fiscal deficits and to credit expansion. If the government were not there, many of those enterprises would disappear, or at least they would borrow much less because they would have to pay considerably higher interest rates on loans that they obtained from the capital market. Thus, although the argument has some validity for those public enterprises that are run on efficiency criteria and that may be as efficient as private enterprises, it certainly has its limitation when it is generalized to all enterprises.

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The Current Account Deficit The fiscal deficit on current account is an alternative deficit concept that has received a lot of attention. This is the difference between government revenue and "current" government expenditure. It is argued that this difference measures the government's contribution to the total saving of the economy and, thus, to growth. On the surface this deficit concept appears very attractive and thus has many supporters. After all, governments are supposed to mobilize resources and to contribute to growth, and many assume that the government's contribution to growth is measured predominantly through its effect on total investment. This assumption is, of course, a direct outcome of the Harrod-Domar type of literature that was so popular in the 1950s and 1960s. On closer scrutiny, however, this concept quickly loses much of its magic—in practice, at least, if not in theory—for several reasons. First, whether the government spends on current expenditure or on what is conventionally classified as investment, the short-run impact of that expenditure on the balance of payments disequilibrium will be the same. One could go further and argue that, at least in the short run, investment spending by the government may have a larger negative impact on the balance of payment than other kinds of spending. The main reason is that the import content of investment spending is often higher on average than the import content of current spending. Second, investment may be as wasteful as current spending. One could even argue that an unproductive investment that relies heavily on imported capital equipment is likely to contribute far less to both the welfare of the citizen and the growth of the economy than much

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current spending, especially when the current spending contributes to human capital. The economic history of many countries is full of horror stories of highly wasteful public investment projects that, after getting a country into foreign debt, became useless white elephants. As development economists have often argued, some current spending on health, education, administration, and so on can have important effects on growth at least over the longer run. More recently much emphasis has been placed on the need to spend on recurrent costs, so that the existing infrastructure of developing countries can provide or continue to provide badly needed services. If a country favors investment over these highly desirable recurrent expenditures, it may badly misallocate available resources and reduce the rate of growth. There are too many examples of new roads being built at very high cost while the existing roads are allowed to deteriorate to such an extent that they become impassable, and of hospitals that cannot provide the services for which they were built because of lack of nurses or equipment, and of vehicles not used because of lack of spare parts or gasoline. Finally, the dividing line between what is classified as current and what is classified as capital expenditure is, in the real world, an arbitrary one that can be moved up and down depending on the picture that policymakers may wish to present to the world. (The rules that determine which expenditures should be classified as capital expenditure vary from country to country and, apparently, even in the same country over time. Even the comparison of capital expenditure by, say, the Governments of Germany and the United States is difficult to make for these reasons.) Thus, in conclusion, I am skeptical that current account budgetary deficits may tell us much, although I would certainly be concerned about a country that is running a fiscal deficit even when investment expenditure, however defined, is netted out. For sure, the current account deficit will tell us nothing about the impact of fiscal policy on the balance of payments, and perhaps not much about the impact of fiscal policy on growth.

Other Issues There are many other issues that arise with the conventional measures of fiscal deficit. Some of them are of particular relevance within the context of an adjustment program. I would like to mention a few. Should one adjust the conventional measure for the impact of inflation? When the rate of inflation is high, there are considerable problems,

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FISCAL DEFICIT MEASUREMENT: BASIC ISSUES

both with deficit measures that include a correction for inflation and with those that exclude that correction. Another big problem encountered in the use offiscaldeficit measures is in the treatment of arrears. Normal cash measures do not show these arrears; therefore, a country could increase its public expenditure but delay payments, thus showing no change in the "overall deficit" while it would in fact be increasing aggregate demand. Arrears have become particularly relevant in connection with foreign debt. One should always specify in a measure of the deficit whether unpaid interest payments on foreign debt are being registered as deficit or not. For example, what happens to a deficit measure when interest on foreign debt is rescheduled? Other problems arise from the fact that very often one measures the fiscal deficit only for the central government. Other parts of the public sector, however, may show a large fiscal deficit. One such part that has attracted considerable recent attention, but still little analysis, is the fiscal deficit of central banks. In some Latin American countries, central banks have become important fiscal agents. Through central bank operations, governments promote domestic spending without having the budget reflect this contribution to aggregate demand. The fiscal deficit may appear also in public enterprises, in local governments, in social security institutions, or in stabilization funds or marketing boards. If these various components of the public sector were not interconnected—as is, for example, the case in the United States, where the federal government, the Federal Reserve System, and the local governments are essentially independent and where public enterprises are virtually nonexistent—one could perhaps still emphasize the deficit of the central government and attribute to it a central role.2 The trouble is that when these various components are interconnected, as they often are in many developing countries, one may find that when the deficit is squeezed out of the central government it may reappear in the central bank or in the public enterprises or (possibly) in the local governments or in some other public institutions. In these circumstances an adjustment program that focuses on the deficit of the central government may not bring about the necessary adjustment if the reduction in the central government deficit is fully or partially compensated by an increase in the deficit in other parts of the government. 2

But even in the United States the budget, as now presented, includes the social security funds. In recent years, this has helped to reduce the size of the federal deficit as normally shown.

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One final problem worth mentioning is that fiscal deficits may be reduced through once-and-for-all changes. For example, a country may sell public assets; or it may introduce once-and-for-all measures such as tax amnesties; or public sector wages may be squeezed well below their long-term political and economic equilibrium; or temporary taxes may be levied. These various measures achieve the objective of reducing the size of the deficit in the short run, but they do little or nothing toward a permanent improvement of the fiscal situation. For this reason, in some cases it would be desirable to present a measure of the fiscal deficit that would remove the impact of such short-term measures. This adjustment would give an underlying or core deficit that would better reflect the fiscal situation of the country over the longer run. Such a correction would be desirable, although in many cases it might be difficult to do in practice.

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Conclusions A deficit may be like an elephant: one always recognizes it when one sees it, even though it may be difficult to measure or describe it in a way that is satisfactory to everybody and for every purpose. Many different concepts have been identified, and several are discussed in this book. Each could be justified for some use; none is useful for all uses. The conclusion must be that it is difficult to measure precisely the impact of fiscal policy on aggregate demand, inflation, and other macroeconomic variables. The use of just one number to assess that impact should be de-emphasized, and a much closer scrutiny of the whole fiscal situation should be made. This examination should take into account the links between the short and medium run. It is almost always difficult to tell where the short run ends and the medium run begins; economic policy often becomes a series of short-run programs whereby the preoccupation with the next few months distracts policymakers from basic adjustment. Manyfiscalpolicies have long-run implications, however, especially because of their impact on expectations. For these and many other reasons, attention should be diverted from one-number measures of the deficit, and more attention should be paid to the structural aspects of fiscal policy.

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References

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Bator, Francis, The Question of Government Spending (New York: Harper, 1960). Blanchard, Olivier J., Suggestions for a New Set of Fiscal Indicators, Department of Economics and Statistics Working Paper 79 (Paris: OECD, April 1990). Brown, E. Cary, "Fiscal Policies in the Thirties: A Reappraisal," American Economic Review, Vol. 46 (December 1956), pp. 857-79. Haavelmo, Trygve, "Multiplier Effects of a Balanced Budget," Econometrica, Vol. 13 (No. 4, 1945), pp. 311-18. Hansen, Bent, assisted by Wayne W. Snyder, Fiscal Policy in Seven Countries, 1955-1965 (Paris: OECD, 1969). Ruggiero, Edgardo, "A Survey of the Literature on Crowding Out in Italy" (unpublished; Washington: IMF, April 1985). Spaventa, Luigi, "The Growth of Public Debt: Sustainability, Fiscal Rules, and Monetary Rules," Staff Papers, International Monetary Fund, Vol. 34 (June 1987), pp. 374-99. Tanzi, Vito, Public Finance in Developing Countries (Aldershot, Hants, England and Brookfield, Vermont: Edward Elgar, 1991). United States, Economic Report of the President, Together with the Annual Report of the Council of Economic Advisers (Washington: U.S. Government Printing Office, 1962).

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3 Are All Summary Indicators of the Stance of Fiscal Policy Misleading? G.A. Mackenzie balance of the public sector's financial operations is an unreliable indicator of the stance of fiscal policy has long been recognized by economists.1 Its unreliability stems from its endogeneity with respect to the level of economic activity—that is, the sensitivity of most revenue and some expenditure components to the business cycle. Various indicators of the stance of fiscal policy have tried to purge the balance of its endogenous component; the IMF's cyclically adjusted deficit is one of a number of measures used. An additional and much discussed problem with the unadjusted deficit is its failure to take account of the effect of inflation in eroding the real value of the government's net financial liabilities. In a reflection of both these concerns, the Organization for Economic Cooperation and Development (OECD) regularly publishes an indicator that is adjusted for the influence of both inflation and the business cycle.2 Even inflation and cyclically adjusted indicators have been criticized for their lack of comprehensiveness. Boskin (1988a), in his work on the U.S. federal government deficit, has argued that the items now excluded from it can have significant macroeconomic effects, and that certain other items have not been properly measured.3 Buiter (1985),

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THAT THE UNADJUSTED

Note: This chapter draws on an earlier version of the author's paper (Mackenzie (1989)). 1 "Public sector" is used throughout this paper to refer to government in general— that is, both narrow and broader definitions of government. 2 See Heller, Haas, and Mansur (1986) and OECD (various years). For a discussion of inflation adjustment, see Tanzi, Blejer, and Teijeiro (Chapter 9 in this volume). 3 Boskin (1988a) presents a summary of his and other economists' work on this issue.

21

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

however, has argued that a proper measure of the deficit would take into account all changes in the public sector's net worth, from whatever source, and has proposed that national and international authorities prepare comprehensive balance sheets of the public sector's assets and liabilities. This would entail inclusion in the measure of the changes to net worth brought about by, among other causes, an increase in the value of the government's property or mineral rights (for example, arising from a discovery of natural resource reserves). Furthermore, Buiter has argued that adjusting deficits for the impact of inflation or of the business cycle is not enough to make the conventional figure a useful guide to an assessment of the stance of fiscal policy.4 Kotlikoff (1984, 1986, 1989) has gone one step farther, arguing that even the comprehensive public sector accounting proposed by Buiter would not yield a useful indicator. This second and more fundamental critique takes the view that the basic accounting labels—such as tax or nontax revenue, transfer payments, and interest payments—are economically meaningless. Kotlikoff proposes what he calls the economic deficit, but this is not a notion that can be summarized by a single number or index. The economic deficit is increased when resources are shifted from younger to older generations. This shift increases aggregate consumption and reduces the rate of capital formation because the marginal propensity to consume of the elderly, who have fewer years left over which to consume their wealth, is higher than the marginal propensity to consume of the young. Kotlikoff argues that many fiscal policies in the United States (for example, the less than fully funded social security system, or the capital incentives introduced in 1981) would not affect the conventional measures of the deficit but would have massive effects on the economic magnitudes that really matter—the aggregate savings rate and the rate of capital formation. The purpose of this chapter is twofold: first, to give a brief exposition of these critiques of the more conventional indicators of the stance of fiscal policy; second, to assess the usefulness of the alternatives that Buiter and Kotlikoff have proposed. However strong the critiques, the conventional indicators will probably continue to be constructed, but it is still useful to consider exactly how and under what conditions they may be unreliable. If they are often or generally misleading, then the question of whether new indicators can be derived from the alternatives proposed by Buiter and Kotlikoff takes on great importance. 4

See "General Discussion" in Buiter (1985, pp. 68-70).

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The chapter begins with a discussion of how the stance of fiscal policy can be defined and estimated and then proceeds first to present, and then to appraise, the critiques of Buiter and Kotlikoff. Conclusions are presented in the final section. An Appendix compares the cyclically adjusted balance used by the IMF with an alternative based on a simple Keynesian model that allows for differences in the weights placed on expenditure and revenue.

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Definition and Measurement of the Stance of Fiscal Policy A statement to the effect that the stance offiscalpolicy is conservative is usually supposed to mean that the current set of policies is more restrictive in its effect on the economy than some other set of policies. Thus, fiscal policy stance can only be understood by reference to some norm or base case; to say that a policy implying a budget surplus of X percent when the economy is at a level of activity Z is restrictive requires at least an implicit comparison with some other set of policies—for example, those implying a balanced budget. To apply the concept of the stance of fiscal policy, two questions raised by this definition must be answered. First, how is one set of fiscal policies characterized, and distinguished from another? Second, what is meant by an expansionary effect and its opposite? A difficulty that besets attempts to answer either question is the uncertainty about the period of time over which the two sets of fiscal policy and their effects on the economy are to be compared. These questions can be approached analytically with the aid of a simple, general model.5 Suppose, for the sake of argument, that an economy can be represented by the following linear system: Y = B • X + C • r-1 + D • FP + E • OP,

(1)

where Y, X, F-l, FP, and OP represent, respectively, the endogenous variables, exogenous variables, lagged endogenous variables, fiscal policy variables, and other policy variables. The endogenous variables would include the price level, the level of real output, the level of employment, and so on. The fiscal policy variables would include the level of government expenditure in each 5

This exposition is similar to that in Blinder and Goldfeld (1976).

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

period—at least, where that level is not partly determined by variations in other economic magnitudes, such as unemployment insurance payments—as well as variables capturing the effect of current tax and benefits legislation. In equation (1) it is assumed that these can be represented as exogenous policy variables in a linear system. In practice, however, they would be built into the structure of the model and would therefore not be so easily isolated. Nonetheless, it may be easier to conceive of them as being separate policy variables whose values can be altered in the same way as other exogenous variables. To characterize one set of fiscal policies and to compare it with another set, it is necessary to determine two sets of values for FP. However, even determining just one set—the one that characterizes fiscal policy in the base case—poses certain problems. Thus, it is not always obvious what constitutes current policy. For example, under current policy, should government expenditure on goods and services be assumed to be constant in real terms? Or should it grow, and if so at what rate? If such expenditure is thought to be determined in real terms, what mechanism of indexation should be used to convert it to nominal terms? Whatever assumption is made must be somewhat arbitrary, and it remains to be seen whether the conclusions that are drawn from a comparison offiscalpolicies would in practice be affected by the assumption that is made.6 Once fiscal policy in the base case and in the alternative case has been characterized, it is also necessary to specify what is meant by an expansionary impact. This is not as straightforward as it might seem. A change in fiscal policy might initially increase real gross domestic product (GDP) above its levels in the base case but subsequently decrease it. An overall effect could be calculated by measuring the present discounted value of the difference in GDP in each period that is the result of the new fiscal policy set. Alternatively, the impact on real GDP in the first year only might be taken into account. Suppose that we are interested in the impact of fiscal policy on real GDP in the first period. Solving equation (1) for the reduced form of the equation, with real GDP in period 1 (y11) as dependent variable, yields the following: y11 = F • Y-1 + G • X + H • FP + J • OP.

(2)

6 These and other conceptual difficulties in the assessment of the stance offiscalpolicy are discussed in Heller, Haas, and Mansur (1986).

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The indicator of the stance of fiscal policy (IFPS) would then be IFPS = H • (FP2 -

FP1),

(3)

where FP2 and FP1 are the new set and the base case set of fiscal policy variables, respectively. In other words, the fiscal policy stance is the product of a series of multipliers and changes in fiscal policy instruments. For example, if the changed instruments are transfer payments to pensioners and defense expenditures, the coefficients in H represent the reduced-form multipliers for these two expenditure categories. None of the various summary indicators of the fiscal stance, with the exception of the weighted indicator devised by Blinder and Solow (1974), takes this form, so that from a strictly theoretical standpoint neither the IMF's nor the OECD's summary indicator appears to be adequate.7 It does not follow, however, that these indicators may not be good proxies for the indicators that would be derived from more complex models. The difference in form between the IMF's measure and a modelbased measure can be illustrated with the elementary Keynesian model: C + E + G = Y

(4)

C = B0 + B1 • (Y - T)

(5)

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T = t0 +

t1Y,

(6)

where C stands for aggregate consumption, E for autonomous expenditure, G for government expenditure, Y for aggregate income, and T is a simple linear tax function. It then follows that dY = (dG - B1dT)/(1 -

B1);

(7)

with a balanced budget change, where dT = dG, one has dY = dG. 7

(8)

Buiter (1985) has made this point. Blinder and Goldfeld (1976) have discussed the same problem with respect to the full-employment surplus indicator. The weighted standardized budget surplus was described in Blinder and Solow (1974). Chand (1977) has offered an extensive discussion of summary indicators; see also his contribution to this volume (Chapter 5).

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In this particular case, the indicator of the fiscal stance is simply equal to dG and has the same sign as the change in government expenditure. It is straightforward to show that, even when the purely exogenous component of the change in revenue (dt0) exceeds dG, dY can be positive. With the indicator of fiscal policy used by the IMF for its World Economic Outlook report (IMF (1988)), the stance of fiscal policy will be either unchanged, more expansionary (less contractionary), or less expansionary (more contractionary)—that is, the thrust offiscalpolicy will be neutral, expansionary, or contractionary—according to whether the change in government expenditure minus the change in tax revenue from one period to the next equals, exceeds, or falls short of the change in what is termed the cyclically neutral balance.8 This condition may be stated as follows:

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FIM = [(G2 - G1) - (T2 - T1)] - [(Gn2 - G nl ) - (Tn2 -Tn1)],

(9)

where FIM stands for fiscal impulse measure, G and T are actual expenditures and tax revenues, Gn and Tn are cyclically neutral expenditures and revenues, and the subscripts 1 and 2 denote time periods. Cyclically neutral expenditure is defined as gp •Yp,where gp represents the ratio of actual government expenditure to income in a base period in which actual and potential income were deemed to be equal, and Yp represents potential income. Cyclically neutral tax revenues are in turn defined as t • Y, where t represents the ratio of revenues to income in the base period. The fiscal impulse measure can be broken down into its expenditure and revenue components, so that it is possible to speak of the sources of the fiscal impulse. The contribution of the expenditure side (CG) is given by CG = [(G2 - G1) - (Gn2 - G nl )],

(10)

and that for the revenue side (CR) by CR = [(T2 - T1) - (Tn2 - T nl )].

(11)

To revert to the notation of the simple Keynesian model, if period 2 is the reference period, then dG is positive when G2 exceeds its 8 The IMF's measure and other measures are reviewed in Heller, Haas, and Mansur (1986; see especially pp. 10-11). The presentation here differs somewhat from theirs.

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previous value by more than the growth in cyclically neutral expenditures, and similarly for dT. If dG = dT, however, then the impulse is zero—the stance of fiscal policy is unchanged. Thus, in the World Economic Outlook presentation the multiplier effect of revenue and expenditure is the same. It follows that measures of the stance of fiscal policy derived from a Keynesian-type model and the IMF'sfiscalimpulse measure could differ not only in magnitude but in sign. The Appendix to this chapter explores the question of whether this could be a serious problem in practice.9

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Comprehensive Public Sector Accounting and Indicators of the Fiscal Stance In two papers, Buiter (1985 and Chapter 14 of this volume) has criticized the conventional measure of the deficit and the fiscal stance indicators constructed by the IMF and the OECD, among others. Instead, Buiter advocates the use of comprehensive accounting for the public sector, which measures all changes in net worth of the public sector from whatever source.10 He faults the conventional measure of the deficit, even when that measure is expressed in real terms, because it excludes changes to the net worth of the public sector stemming from changes in the real values of the outstanding stocks of public assets. Changes in net worth that are excluded are those resulting from, among others, the impact of inflation on the real value of assets and liabilities whose value is fixed in nominal terms; the depreciation of real assets; exchange rate variations when assets and liabilities are denominated in foreign currencies; changes in relative prices (for example, changes in the value of public mineral rights resulting from a change in the relative price of minerals); and changes in the present value of future tax payments under current tax laws and of future expenditure commitments under current expenditure programs. In Chapter 14 of this volume, Buiter does not dismiss out of hand cyclically and inflation-adjusted deficits, noting that "inflation accounting in the public sector is long overdue" (p. 339). He also argues that a traditional contracyclical fiscal policy can be interpreted as a device 9

Schinasi (1986) has compared the IMF and OECD measures of fiscal impulse. As noted in the introduction of this chapter, Buiter is not the only economist to have argued for a more comprehensive definition of public sector net worth for the purposes of measuring the deficit. However, his proposed definition is particularly broad (see Chapter 14 of this volume). 10

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

to reduce the gap between permanent and current income, a policy that increases economic welfare when consumers are liquidity constrained. In the other paper, however, Buiter (1985) asserts the need for longterm budgeting that takes into account the future path of revenues and the financibility of the deficit, but he rejects conventional measures of the deficit, whether adjusted or not, on the grounds that none of the simple indicators of the fiscal stance can be derived from a model rich enough in features to be taken seriously. Buiter recommends that national and international authorities begin constructing comprehensive balance sheets, presumably with the aid of a macroeconomic model, so as to encompass these kinds of changes to net worth in the measure of the deficit. This would be a prodigious but worthwhile task because conventional measures of the public sector balance may seriously misrepresent the options open to a government. Is this proposal practicable, and, if it is, what purpose would it serve? In particular, could the measure of the change in net worth derived from this estimate replace the conventional indicator, or even the inflation-adjusted and cyclically adjusted version of the conventional indicator? Unlike the conventional accounting measure, the comprehensive measure would require that assumptions be made about such macroeconomic phenomena as the rates of growth of real and nominal GDP, the evolution of the general price level and of interest rates, as well as the price of assets owned by the government. Changes in net worth from some of the sources noted above would be more easily estimated than others. For just two examples of difficult valuation problems, consider changes in the value of a missile system or in the value of national parks or natural reserves. More tractable would be the valuation of mineral royalty rights, but much uncertainty would attach to the estimate. Changes in net worth resulting from increases in the present value of future expenditures under an entitlement program could be estimated with the aid of a macroeconomic model, but inevitably the assumptions that would need to be made about the model's exogenous variables and policy instruments would be somewhat arbitrary, as noted in the previous section. In particular, the future course of expenditures under an entitlement program may be determined by current legislation, given the macroeconomic environment, but the same is not true of other expenditures. Nonetheless, at least some of these changes in net worth could be used to augment the conventional measure. The question remains whether the more comprehensive measure would be a better indicator of the stance of fiscal policy. To illustrate some of the implications of

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a broader measure, consider the case of a hypothetical economy that enjoys a discovery of a substantial reserve of petroleum in the public domain. The discovery will increase the public sector's net worth, because it increases the value of the government's mineral rights. This increase will not be reflected, however, in either the flow of funds deficit or any of the conventional indicators of the fiscal stance, including those correcting for the effects of inflation and the business cycle. Does the exclusion of changes in the value of such assets from the public sector balance or from the indicators make them misleading? If the increase is included, then the public sector's balance is greater, other things being equal, and the stance of fiscal policy, as calculated by the IMF and OECD indicators, is less expansionary (more restrictive) than it otherwise would be. Note that this conclusion does not require that any of the petroleum be extracted. But has there been a contractionary shift in the stance of fiscal policy? The discovery increases both the public sector's net worth and the permanent income of the economy. Some time can pass before any of the mineral is actually extracted, and unless the economy's residents treat the discovery as effectively adding to their personal wealth and determine their consumption expenditures on the basis of that wealth, the resource discovery will not lead to an increase in consumption. Nonetheless, the permanent income or wealth of the economy is now higher, and an increase in aggregate consumption is both feasible and possibly desirable.11 An increase in public expenditure or a discretionary reduction in taxes will allow such an increase to take place, so that the application of a simple rule—such as "avoid policies resulting in large positive stimuli to the economy as measured by a conventional indicator of the stance of fiscal policy"—could be quite inappropriate. In such circumstances, a large stimulus may be good policy. Nonetheless, an expansionary fiscal policy will have the same effects on the economy after the discovery as before—some combination of effects such as an increase in domestic absorption and interest rates, and a decline in the external current account balance—and the failure to implement an expansionary fiscal policy will not reduce domestic absorption or lead to a contraction of output. Moreover, inclusion of the change to net worth resulting from the resource discovery in the measure of the deficit and in an indicator of the fiscal stance will mean that this indicator can no longer be used as a guide to the impact of fiscal policy on current macroeconomic activity. 11 It is feasible to the extent that the economy can borrow externally; it is desirable if the level of consumption before the discovery was not excessive.

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Suppose that instead of a resource discovery, the price of petroleum increases, so that the value of a publicly owned petroleum reserve is increased. Should this increase also be included in the measure of the public sector balance and in indicators of the fiscal stance? In this case, unlike the first case, it cannot be said that the permanent income of the economy is necessarily increased. Such an increase would depend on whether the economy is a net importer of petroleum and on the scale of its net imports in relation to its reserves. To take a specific example, if the increase in the present value of the annual net oil import bill were to exceed the increase in the value of the petroleum reserve, permanent income would undoubtedly fall.12 Thus, although the public sector balance sheet looks better, the private sector's balance sheet would look worse. In this case it would be the more broadly defined indicator that would give the wrong signal, and a policy based on the rule "avoid large increases in public sector net worth" could give the wrong results. Some analysts have proposed augmenting the conventional deficit by a measure of the change in the present value of the unfunded liabilities of the social security system.13 At present, both cash-based measures of the government's financial operations and those based on national accounting treat the operations of the social security system on a cash basis, in the sense that only current operations, not changes in the government's accrued liabilities, are reflected in either measure. Should these changes be reflected in an indicator offiscalpolicy stance? The answer to this question turns partly on semantics and partly on assumptions about the way the accrued liabilities would affect economic behavior. If the change in the accrued liabilities results from a policy introduced in the current year, it is arguable that any change in economic behavior they bring about should be attributed to fiscal policy. Thus, for example, if one of the fiscal policy variables in the model outlined above represents policies affecting the social security system, and a change in these policies affects current macroeconomic activity, then the policies ought to be included. If, however, the increase in accrued liabilities results from policies taken in the past, it would not be included in the measure of fiscal policy stance determined by the model, unless the assumption was made that increases in the unfunded liabilities in relation to the trend rate of growth of GDP 12 The argument needs to be qualified to take account of the possibilities of substituting other goods for petroleum. The argument supposes that these are not very great. 13 For example, Bossons and Dungan (1983) made such a suggestion in their study of public sector deficits in Canada.

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constitute discretionary fiscal policy by definition, analogous to the definition of cyclically neutral expenditure in the IMF's fiscal impulse measure. The crucial issue is whether the increase in unfunded liabilities would affect economic behavior. Many economists believe that consumption in the United States has been increased by the failure to adopt a fully funded social security system, although the estimates of the size of the increase vary greatly.14 A case can certainly be made for broadening the conventional measure of the deficit to include this change in net worth of the public sector, but it would be difficult to determine the size of the weight to be attached to it in an indicator of the stance of fiscal policy. The values of mineral or resource rights and of unfunded entitlement program liabilities are two examples of changes in public sector net worth that are not reflected in conventional measures. Others include contingent claims on government resulting from public insurance programs and contingent liabilities entailed by the possibility of default by beneficiaries of public lending programs, and the decline in net worth entailed by the depreciation of infrastructure and other publicly owned real assets. These phenomena can have significant implications for public policy, but unless their change can be shown to contribute to the impact of government operations on aggregate demand or financial markets, they do not belong in an indicator of the stance of fiscal policy.15

Concept of the Economic Deficit Kotlikoff (1986) has argued that accounting labels such as "taxes," "expenditure," "transfers," and "borrowing" are ill-defined and essentially arbitrary terms with no general basis in economic theory, and that neutral terms like "receipt" and "payment" would be more appropriate. The conventional nomenclature is arbitrary because receipts and payments may be labeled in a number of different ways. Nonethe14

Boskin (1988a) discusses this issue. Boskin (1988a, p. 90) states: "It is unclear whether those who have attempted to generate greater information on government assets and liabilities really believe that a net worth variable is the appropriate one (whether adjusted for inflation or cyclical conditions) to enter as a measure of the government's economic impact. . . .It is my opinion that such estimates are useful primarily to provide measures of national wealth and to place concern about government liabilities in better perspective." 15

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

less, the choice of nomenclature affects the calculated value of the deficit. Kotlikoff gives an example of a transaction between the government and an individual that comprises a receipt by the government in one year of $1,000 and a payment to the individual of $1,500 ten years later. The receipt in year zero could be labeled "taxes," and the payment in the tenth year "transfers." Alternatively, the receipt could be labeled "borrowing," and the payment "repayment of principal plus interest." With the first set of labels the deficit in year zero is $1,000 less than it would be without the transaction, and $1,500 more in the tenth year. With the second set, the deficit in year zero is unaffected, and in the tenth year it is increased by the part of the $1,500 that represents interest payments. However, the change in nomenclature obviously has no effect on the behavior of the economy, because the individual's consumption possibilities are unchanged (Kotlikoff (1986)). This argument overlooks what appears to be a crucial difference between taxation and government borrowing: taxes must be paid, but generally no one is obliged to lend to the government. Moreover, with the possible exception of social security contributions, the receipt by government of revenue is not paired with an obligation to make a payment at some future date. Finally, even if the classification of various items such as "revenue," "expenditure," and "financing" is not clearcut, classifications are not usually changed from one year to the next. Taking this last point first, it is an easy matter to demonstrate that with one set of labels a change in fiscal policy can leave the deficit unchanged, whereas with another set of labels the change in policy does alter the deficit. Consider a policy that entails an expansion in the coverage or an increase in the generosity of benefits of a pay-asyou-go old-age state pension program. The expansion of this pension system has no impact on the deficit when the conventional accounting definitions are used because the expenditures and revenues of the government will increase by equal amounts. However, if contributions are treated as loans to the government and expenditures on pensions are treated as repayment of loans and interest, then the deficit will be affected. Turning to the first and second points, Kotlikoff's treatment of social security contributions as loans assumes that such contributions do earn an implicit return, albeit an uncertain one, and also—which may be more controversial—that the obligation to participate in a public pension plan and to make social security contributions does not reduce the wealth of the participant any more than the purchase of a bond would. In effect, the contributions are treated as if they created an

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obligation on the part of the government to repay the contributors. In the terminology of the IMF's government finance statistics (GFS), the contributions are a repayable receipt of the government (IMF (1986, p. 97)). The obligatory nature of the transaction is of little economic significance to Kotlikoff. Although many economists would assume that an increase in social security contributions, whether through an increase in rates or an extension in the coverage of the system, would reduce disposable income and hence reduce consumption expenditure, Kotlikoff takes as axiomatic the view that consumption in any period is determined by lifetime income—that is, by wealth. If social security contributions effectively give title to a future income stream of equal present value, they do not reduce wealth. Consequently, they do not reduce the consumption of contributors in any period. The expansion of a pay-as-you-go system is an instance of a fiscal policy that creates what Kotlikoff would call an economic deficit, since it increases consumption expenditures and reduces the resources available for capital formation. Specifically, when the social security system's expenditures are increased, the elderly, retired generation benefits from an increase in its wealth; it receives pensions without having to make contributions. Kotlikoff assumes that this generation spends all or most of the increase during its lifetime. Meanwhile, the younger, working generation, which "pays" for the increased expenditure, does not reduce its consumption proportionately, because its wealth is unaffected. As a result, aggregate consumption expenditure increases. In a fully employed economy, the resources available for investment are reduced. The conventional measure of the deficit through flow of funds accounting has been criticized for not taking into account unfunded liabilities of the social security system, as noted earlier. Kotlikoffs critique is more basic, since the creation of an economic deficit does not depend on the need for future increases in rates of contribution to preserve the financial balance of a pay-as-you-go system. Even if rates can remain indefinitely at their initial levels, an increase in consumption and a shift in resources to the elderly take place. Moreover, the assumption that the propensity to consume of the elderly is higher than that of the young is unnecessary. All that is necessary is that perceived wealth increase, and this does happen, given Kotlikoffs assumption that the contributions of the younger generation are akin to the purchase of securities. Economic deficits can be created by a reform that replaces one kind of tax with another, even if the yield of the new tax is no different

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

from that of the old. For example, a shift from a tax on income to a tax on consumption would shift resources from the elderly, who are net dissavers—they are in the phase of the life cycle at which their consumption expenditure exceeds their income—to younger generations, who are accumulating wealth and spending less than they earn.16 Changes in the economic deficit in the sense intended by Kotlikoff can even be created by governmental measures that would not be regarded as having anything to do with fiscal policy. An instance would be the introduction of an environmental measure that restricted the use of industrial capital and consequently reduced the value of the existing stock of capital. How would an across-the-board reduction in personal income taxes be treated in this framework? The answer is not obvious—it would depend, among other things, on how the reduction in taxes was distributed across generations, on the degree of progressivity of the tax system, and on the distribution of income. Above all, it would depend on how the reduction in revenue was to be financed. If the reduction is financed by the issue of bonds now, combined with a subsequent increase in taxes later, the impact of the tax reduction also depends on the distribution of the burden of the future tax increase. When the same people who benefit from the tax reduction pay the subsequent increase in taxes, the reduction in taxes has no effect on the economy. The increase in current income resulting from the reductions leads to an increase in financial saving, and in the private sector's holdings of public debt of equal amounts. There are no liquidity constraints to be relieved by the increase in current income, and permanent income is unchanged. Hence, there is no increase in consumption. If older persons benefit from the tax reduction, however, subsequent generations pay for it, and consumption increases because the marginal propensity to consume of the first group, as we have seen, will be higher than that of the second. If the tax reduction is to be financed by the creation of money, the impact of the reduction on consumption will depend on the distribution across generations of holdings of money and other financial assets whose values are fixed in nominal terms. Nonetheless, the use of inflationary financing would have many ramifications beyond its impact on consumption. 16 Taking a simple example in which a proportionate tax on income is replaced by a proportionate tax on consumption, the tax rate on consumption has to be greater than the rate of the tax on income to generate the same revenue, since aggregate income exceeds consumption. The elderly must then pay more tax under the new regime because their consumption exceeds their income.

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The discussion to this point suggests the following conclusions. First, no simple model could determine with any precision the magnitude of the impacts of different measures on consumption and capital accumulation. The most it might do is to indicate whether the impact is positive or negative. Second, the analysis is irrelevant for an understanding of the short-run impacts of fiscal policy in an economy that is experiencing deficient aggregate demand or is significantly cashconstrained; the available evidence on cash constraints in the United States and other economies has to be assessed before Kotlikoff's critique can be fully evaluated. The presence of liquidity constraints would change the analysis. Thus, suppose that the taxes paid by a given generation are shifted forward in time from midlife to early adulthood, when current income is typically lower. The life-cycle model would imply that consumption would be high relative to income in the earlier period if households can borrow on the strength of their future income. However, if they cannot borrow, their consumption in this period would be less than it would be if they could borrow. In these circumstances, a tax reduction now that is financed by an increase in taxes in the later period is akin to a loan, and it is quite possible that consumption will increase. It is important to understand, however, that this increase depends on current income being low relative to future income, and that liquidity-constrained households behaving as the life-cycle model predicts would not invariably increase their consumption by the full amount of the tax reduction. Recent studies suggest that a significant proportion of consumers in the United States are liquidity constrained, essentially because consumption is more sensitive to fluctuations in current income than would be predicted by the life-cycle model in the absence of cash constraints.17 For example, Hall and Mishkin (1982) found that some 20 percent of consumption is by liquidity-constrained households. Mariger (1986) estimated afigureof 19 percent with his preferred model. Flavin (1981) also found that liquidity constraints are an important determinant of consumption. In view of the relative ease with which consumer credit is obtained in the United States, and the relative absence of institutional rigidities affecting credit markets, it is arguable that liquidity constraints would likely be more important in most other economies, and in particular in less industrialized economies. Rossi (1988), who reported results on tests of consumption behavior for a sample of 17

Some of these studies were reviewed by Ebrill and Evans (1988) and Hubbard and Judd (1986). Boskin (1988b) also discusses this issue.

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

developing countries, concluded that liquidity constraints are a significant influence. It is also arguable that there is a psychological dimension to the liquidity constraint—some people do not like to borrow, even if "objective" criteria imply they can afford to do so. These studies do not, however, point unambiguously to the conclusion that Kotlikoff's approach is invalid. If 80 percent of consumption in the United States is by households that do not experience liquidity constraints, and these households smooth consumption over time in the manner predicted by the life-cycle hypothesis, tax reductions could be mostly offset by increases in household savings, and vice versa, unless they affect different generations. Altonji and Siow (1987) did not find much evidence against the assumption of perfect capital markets. Moreover, the existence of liquidity constraints taking the form of credit rationing or differential borrowing and lending rates does not automatically rule out the possibility that consumption will not be affected by a tax cut; for example, it is possible that lenders may reduce the maximum value of loans in response to a tax cut, on the grounds that future tax increases will increase the likelihood of default if credit limits are not reduced by an amount proportionate to the increase in current disposable income entailed by the tax cut (Hayashi (1987)). Another related and problematic assumption underlying the Kotlikoff approach pertains to the interpretation by households of the government's financing constraint. Would households automatically assume that a tax reduction now would be financed by a tax increase of equal present value at some future date? Any tendency to discount the future at a rate higher than the rate at which the government borrows implies that a tax reduction increases household wealth, and using the reduction to finance consumer durable expenditure—not consumption expenditure in the life-cycle model—would not be irrational behavior.

Appraisal and Conclusions It is worth emphasizing that any measure of the stance offiscalpolicy must be specific to one particular model of the economy. Thus, in "ultrarational" models in which the unexpected announcement of a future increase in government expenditure raises long-term interest rates and depresses investment and aggregate output in the present, even the sign of a conventional fiscal impulse measure would be wrong (see Buiter (1985, pp. 48-49)). Kotlikoff's critique of fiscal indicators based on standard accounting labels is itself dependent on a neoclassical model of the economy and

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assumes that liquidity constraints are unimportant. A tax reduction now that is financed by an increase later, however, is not a matter of indifference to cash-constrained households contending with imperfect credit markets. In a cash-constrained world, the component of wealth contributed by current income is important, and buying on the installment plan raises the purchase price. In such a world, summary indicators of the budget stance derived from flow of funds accounts can serve a purpose. Nonetheless, there are somefiscalpolicy changes—such as a substantial change in the tax regime—whose impact on aggregate demand no simple model could capture and that would not be reflected in a change in the budget balance. The summary indicator approach is probably most reliable for modifications to existing tax regimes and expenditure programs, rather than for wholesale tax reforms and substantial changes in the composition of expenditure. In any case, the summary indicator approach is not intended to capture the impact offiscalpolicy on the rate of capital accumulation. Two other criticisms of the summary indicator approach also deserve comment. It is often argued that the indicator approach is misguided because of its failure to consider the sources of financing of the public sector's operations. Thus, in the simple monetarist model, fiscal policy cannot be expansionary unless it is validated by an increase in bank financing. Does it follow that it is useless to determine whether the fiscal stance has changed? This question is partly one of semantics, but there is a point to the exercise regardless of the way an increased deficit is financed. That is because, even in a simple monetarist world with the money supply held constant, an expansionary fiscal policy has some impact on the economy. A tax reduction leading to an increase in the deficit is associated with higher interest rates and capital market pressures. An increase in the deficit entailed by a fortuitous decline in inventory investment is not associated with these effects.18 It is quite true that an expansionary fiscal policy does not result in an expansion of output in all models. Nonetheless, even in ultrarationalist models, expansionary fiscal policy is invariably associated with capital market pressures and interest rate increases. Whatever the model, the autonomous component of the public sector balance has an effect that 18 To use the IS-LM framework, in the first case the IS curve shifts to the right against a fixed and vertical LM curve, and interest rates must rise to crowd out interest-sensitive expenditure. In the second case, the IS curve shifts to the left, and the comparative static result is that interest rates decline.

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

differs from its endogenous component. For this reason, the separation of fluctuations in the public sector balances into their autonomous and cyclical components is a valuable exercise, even though the distinctions made are inevitably arbitrary. A second criticism is that the various summary indicators are easily misused. Thus, a given measure shows that policy became more restrictive at a time when inflation accelerated, and the inference is made that the measure countenances a more expansionary policy, which most people would regard as clearly inappropriate. This inference is incorrect. The estimation of the fiscal stance and its evolution implies nothing about which stance is appropriate. It does not follow that because the fiscal stance has been tightened, it should not be tightened further. The moral to be drawn from this criticism is that summary indicators should be used with care.

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Appendix: The World Economic Outlook Fiscal Impulse Measure Would the IMF's World Economic Outlook indicator be misleading even in a simple Keynesian world? The answer depends on the model's parameters—the tax rate and the marginal propensity to consume— but it would also depend on the way fiscal policy is implemented. Fiscal policy can be characterized by using the categories of the fiscal impulse decomposition presented in the text, and one of four states must prevail. When the thrust on both sides of the budget is either expansionary or contractionary, the two measures would at least give the same qualitative result; problems arise only when changes are in the opposite direction (Table 1). How often would changes in opposite directions occur, and how often would the offsetting movements be large enough to change the sign of the impulse? Table 1. Comparison of Fiscal Policy Thrust of Impulse Measure and Simple Keynesian Model Expenditure Impulse Revenue Impulse

Expansionary

Contractionary

Expansionary

Same qualitative result

Ambiguous

Contractionary

Ambiguous

Same qualitative result

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An examination of the revenue and expenditure impulses calculated using the fiscal impulse method at the central government level for the major industrial countries in the period from 1978 to 1987 shows that revenue and expenditure impulses have been of opposite sign more often than not; specifically, there were 37 instances of opposite signs out of a possible total of 67 (Table 2).19 Nonetheless, in some 29 of these instances of opposite sign, the absolute value of the expenditure impulse equaled or exceeded that of the revenue impulse. For example, in the case of France, where the impulses were of opposite sign in seven years out of ten, the absolute value of the expenditure impulse equaled or exceeded the absolute value of the revenue impulse in six of the seven years. In particular, in 1981 the expenditure impulse was a positive 1.4 percent of GDP, and the revenue impulse a negative 0.2 percent. In these cases, the fiscal impulse measure and the measure derived from the simple Keynesian model would give the same qualitative result. In the eight remaining instances of opposite signs, the absolute value of the revenue impulse exceeded the absolute value of the expenditure impulse. Here there is a possibility of conflict between the fiscal impulse measure and the simple Keynesian measure, since the expenditure impulse gets a higher weight than the revenue impulse. Thus, in the United Kingdom in 1986, the revenue impulse is a positive 0.9 percent, which offsets the negative expenditure impulse of 0.7 percent. If the weight attached to revenues were half that of expenditure, then the Keynesian measure would be negative. Nonetheless, even in these cases of opposite sign, the difference between the two measures would not typically be very great. In most of these cases the absolute value of the impulses as a percent of GDP is not very large for either revenue or expenditure, and the fiscal impulse as a percentage of GDP is small. The sign of one measure could differ from the other, but neither measure would be large, and in view of the margin of uncertainty attaching to such calculations, the difference would not be significant. Similar patterns are evident in the expenditure and revenue impulses calculated at the general government level (Table 3). Out of a possible 67 instances, 35 are of opposite sign. However, in 16 of these the absolute value of the expenditure impulse equals or exceeds that of the revenue impulse, so that the fiscal impulse and the simple Keynesian measure would give the same qualitative result. Again, in most of the remaining 19 instances of opposite sign, where the two measures could 19

When the value of the expenditure or revenue impulse rounds to zero, the impulses are treated as having the same sign.

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Table 2. Fiscal Impulse and Its Components at the Central Government Level (In percent of GDP)a

Country United States Fiscal impulse Revenue impulse Expenditure impulse

1978

1979

1980

0.1 0.2

-0.8 -0.6 -0.2

1.4

-0.4

-0.1

1981

1982

1983

1984

0.4

—

-0.4

-0.8

0.4 1.1

0.8

0.8

-0.8

1.7 1.2 0.4

0.8

0.8

0.7 0.5 0.2

1.7 0.1 1.6

-0.3

0.3 0.2 0.2

-0.2

Canada Fiscal impulse Revenue impulse Expenditure impulse

1.0

0.1

-0.1 -0.6

-1.1 -1.9

0.4

-0.5

0.6

0.8

1.4 0.6 0.8

United Kingdom Fiscal impulse Revenue impulse Expenditure impulse

2.0 1.3 0.7

-0.9 -0.8 -0.1

-1.7 -1.4 -0.3

-1.6 -1.8

-0.4 -0.4

0.3

—

1985

1986

1987

0.7

0.4

-0.1

-0.4

-0.5 -0.1 -0.4

-1.3 -0.6 -0.7

-1.5 -0.7 -0.8

-0.5

0.2 0.9

-0.1

-0.7

-0.6

0.4 0.6

0.5 0.8

-0.3 -0.2 -0.1

—

-0.5

0.5

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Japan Fiscal impulse Revenue impulse Expenditure impulse France Fiscal impulse Revenue impulse Expenditure impulse Germany Fiscal impulse Revenue impulse Expenditure impulse Italy Fiscal impulse Revenue impulse Expenditure impulse

0.2 1.5

1 .1 - 0 .5 1 .6

0.8 0.2 0.5

0 .1 - 0 .6 0 .6

-1.3

0.2

-0.1 0.4

- 0 .1 0 .1

- 0 .6 - 0 .1 - 0 .5

-0.6 -0.4 -0.1

- 0 .7 - 0 .6 - 0 .1

-0.3 -1.0

0. 1 0. 8

- 0 .1 0 2

-0.2

-0.6

0.7

-0. 7

- 0 .2

-0.4

- 0 .5 0 .1 - 0 .6

-0.7 -0.3 -0.4

-0. 2 0. 2 -0. 4

0 .3 02 0 .1

-0.4 -0.1 -0.3

0 .5 - 0 .5

-0.3

1.5

0. 1 -1. 2 1. 3

- 0 .7 0 .3 - 1 .0

-0.1

- 1 .4 - 1 .1 - 0 .3

-0.4 -0.2 -0.2

-0.9

-0.5 -0.9

-0.3 -0.5

0.9

0.4

0.2

-0.6 -0.6

1.2

0.2

-0.2

-0.5

—

1.4

-0.2 0.1

— —

-0.2

-0.1

0.1

0.6 0.2 0.5

-3.1 4.5

-0. 5 -0. 5

0.1

0.8 0.9

0.8

—

-0.6 — 0.3

Source: IMF staff estimates. GNP for Canada, the United Kingdom, and the United States. For definition of central government operations, see International Monetary Fund (1988, pp. 75-76). a

GA. MACKENZIE

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

give contradictory results the absolute value of both measures is relatively small, so that the difference between the two measures would not in general be significant. Nonetheless, there are some instances of opposite sign where the absolute values of the two impulses are large. For example, in Italy in 1982, a positive expenditure impulse of 1.2 percent of GDP is offset by a negative revenue impulse of 2.6 percent of GDP. With no difference in weights, the overall impulse represents a withdrawal of stimulus of 1.4 percent of GDP; but if the revenue impulse has a weight of only half that of expenditure, no withdrawal of stimulus would be estimated. Thus, the fiscal impulse measure does not often give seriously misleading results in a simple Keynesian world, although it is important that the impulse be disaggregated into its expenditure and revenue c o m p o n e n t s so t h a t different weights can be applied to them if necessary. What of a slightly more complicated Keynesian model in which each of the different categories of revenue and expenditure has a different multiplier? Would the fiscal impulse measure give a different result than the indicator derived from the reduced form of the model? With a model with many expenditure and tax multipliers, the possibility increases that the fiscal impulse measure and the indicator derived from the model would give results that were substantially different. This is particularly true if both the multipliers of revenue and expenditure measures differ substantially from one another, and if the composition of revenue and expenditure measures differs substantially from one year to the next. For example, the weight that would be derived from the model for transfer payments would be less than the weight derived for expenditure on goods and services. Nonetheless, if the marginal propensity to save of transfer recipients is low, the difference between the weights will not have much practical importance. Even if the difference between the weights for the various expenditure and revenue categories is significant, the practical importance of distinguishing between them depends on whether or not the expenditure and revenue categories tend to vary together. If they do not, then the fact that an expansionary shift in the stance of fiscal policy might in one year be brought about by a reduction in income tax and an increase in welfare payments, and in another by a reduction in social security contribution rates and an increase in military expenditure, would pose problems for the fiscal impulse measure. Determining how much of a difference disaggregation would make to the indicator of the fiscal stance would require a fully specified model of the economy, from which the multipliers or weights to be

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G.A. MACKENZIE

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attached to the various categories of expenditure and revenue could be determined—an exercise beyond the scope of this chapter. Nonetheless, some insight into the limitations of the aggregated approach on the expenditure side can be gained by a simple experiment that applies a lower weight to transfer payments than the weight applied to the other expenditure categories. One indicator can be constructed by applying the lower weight separately to the component of transfer payments deemed to represent the discretionary component of fiscal policy, and the higher weight to the sum of the discretionary components of the other expenditure categories. This indicator can then be compared with an indicator constructed by the application of a weighted average of the two weights to the discretionary component of total expenditures. This latter indicator makes no allowance for the possibility that the discretionary component of transfer payments could move in the opposite direction from the discretionary component of the other expenditure categories. This exercise was carried out for the major industrial countries using data from 1979-86. The discretionary change in each expenditure category was determined by taking the difference between the growth of actual expenditures—less unemployment insurance benefit payments—and the growth of trend expenditures, with the trend value constrained to equal the actual value in 1978.20 Nontransfer expenditures were assigned a weight of 1.0, and transfers a weight of 0.5. The first and disaggregated indicator can be expressed as

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IFPSli = 0.5 • (TRi - TRTi) + 1 • (Gi - GTi), where TR is the increase in transfer payments, G is the increase in other expenditures, and the subscript T stands for trend. The second measure can be expressed as IFPS2i = [w • 0.5 + (1 - w) • 1] • [(TRi - TRTi) + (Gi - GTi)],

where w is given by the average ratio of transfer payments to total expenditures for the 1978-86 period. The ratio IFPS2/IFPS1 is in most years close to unity for the major industrial countries in the 1979-86 period, but there are many instances when the ratio is significantly different. Expressed as a per20

Trend expenditures were then assumed to grow at the same rate as nominal potential GDP; that is, real potential GDP plus the rate of change of the GDP deflator. This is the World Economic Outlook procedure.

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Table 3. Fiscal Impulse and Its Components at the General Government Level (In percent of GDP)a

Country

1978

1979

1980

1981

1982

1983

1984

1985

— 0.1

-0.5 -0.2 -0.3

0.7

-0.2

-0.5 -0.7

0.9

0.2

0.6 0.4 0.2

0.6 0.5 0.1

0.6 0.1 0.5

1.3

-0.2

0.5

-0.6

1.3

1.5

2.0

1.5 0.2 1.3

-0.1

-0.4

1.1 0.5 0.6

1.5

-0.8

-0.7 -2.3

1.4

0.2

-0.9 -0.9

-2.0 -1.8 -0.2

-2.7 -2.2 -0.6

-0.7 -0.5 -0.2

1.3 0.7 0.6

0.6 0.1 0.5

United States Fiscal impulse Revenue impulse Expenditure impulse

-0.2

Canada Fiscal impulse Revenue impulse Expenditure impulse

1.4 0.4 1.0

United Kingdom Fiscal impulse Revenue impulse Expenditure impulse

1.9 1.4 0.5

—

1986

1987

0.7

0.2

-0.6

-0.1 0.2

-0.8 -0.8 -0.1

-1.0 -0.9 -0.1

-0.6 -0.1 -0.5

0.2 0.9

-0.2

0.1

-0.5

-0.6

-0.7

1.5

-0.5

0.5

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Japan Fiscal impulse Revenue impulse Expenditure impulse

1.7 0.2 1.5

-0.5 -1.9

-0.4 -1.3

-0.8 -1.5

1.4

0.9

0.8

France Fiscal impulse Revenue impulse Expenditure impulse

1.1 0.2 0.9

-0.9 -4.7

-1.4 -2.0

3.9

0.6

0.4 0.6

0.8 0.2 0.5

-0.2 -0.3

Germany Fiscal impulse Revenue impulse Expenditure impulse Italy Fiscal impulse Revenue impulse Expenditure impulse

-0.2

0.2

-0.5 -0.3 -0.2

-0.2 -0.3

1.4

0.7

-0.8

-0.9 -0.7 -0.2

-0.2 -0.1

-0.7 -0.8

0.1

-1.2 -0.6 -0.6

—

0.1

-0.8

-0.2 -0.7

-0.9 -1.1

— 0.5

-0.5 -0.5

2.2

1.6

0.6

0.3

-0.2 -0.1 -0.1

-0.5

—

-0.5 -0.2 -0.3

-1.9 -0.6 -1.2

-0.4

-0.9 -0.3 -0.6

0.2 0.8

0.2 0.4

-0.9

0.6 — 0.6

-0.6

-0.3

1.8

-1.1

-1.4 -2.6

-1.5 -2.3

0.8 1.0

-0.2

-0.9 -0.9

3.0

1.2

0.8

-0.2

1.4

—

-0.7 -0.5 -0.2

0.5

1.2

Source: IMF staff estimates. GNP for Canada, the United Kingdom, and the United States. For definition of central government operations, see International Monetary Fund (1988, pp. 75-76). a

G.A. MACKENZIE

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

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centage of GDP, however, the differences between the measures in these years are less than or equal to 0.2 percent in 48 instances out of 54. However, in two cases—Japan in 1982 and France in 1979— the difference exceeds 1.0 percent (Table 4).

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Table 4A. Normalized Weighted Expenditure Impulse at the General Government Level (In percent of GDP) Country

1979

1980

1981

1982

1983

1984

1985

1986

Canada United States Japan France Germany Italy United Kingdom

-0.4 -0.4 1.4 5.2 0.7

1.0 0.7 0.9 0.8 0.4

-0.2

—

1.6 0.2 0.7 22 -0.3 3.2 -0.9

2.2 0.1 -1.2 1.6 -1.3 1.3 -0.3

0.5 — 0.1 0.6 -0.9 0.7 0.7

1.2 0.7 -0.6 0.2 0.5 -0.3 0.3

1.5 1.4 -0.4 -0.1 -0.5 1.6 -0.7

-0.1 0.2 0.1 -0.6 -0.6 — -0.5

Source: IMF staff estimates. Note: The values in Table 4A are constructed by dividing the expenditure impulses shown in Table 3 by the values in Table 4B.

GA. MACKENZIE

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Table 4B. Ratio of Unweighted to Weighted Measure of Thrust of Expenditure Policy at the General Government Level Country

1979

1980

1981

1982

1983

1984

1985

1986

Canada United States Japan France Germany Italy United Kingdom

0.88 0.80 0.99 0.75 0.76

1.31 1.18 1.04 0.72 0.34

0.19

-19.33

0.93 1.29 1.08 0.98 1.04 0.95 0.62

0.89 1.26 0.15 0.96 0.94 0.96 0.61

1.21 7.06 2.33 0.95 1.01 1.09 0.85

1.12 0.77 0.99 1.07 1.11 0.61 1.51

0.99 0.89 0.50 0.94 1.21 0.86 0.75

0.96 1.00 -0.71 0.69 1.05 1.33 1.15

Source: IMF staff calculations; for details, see the text. Data on transfer payments come from OECD, National Accounts, 1974-86, Vol. II, Detailed Tables.

ARE SUMMARY FISCAL INDICATORS MISLEADING?

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Table 4G. Difference Between Unweighted and Normalized Weighted Expenditure at the General Government Level (In percent of GDP)

Country Canada United States Japan France Germany Italy United Kingdom

1979

1980

1981

1982

1983

0.1 0.1 —

0.3 0.1 —

-0.1

-0.2 — 1.0

-1.3 -0.2

-0.2 -0.3

— 0.1 — —

0.2

-0.2

-0.2

-0.1

0.1 0.1 0.1 — — 0.1

0.4

0.1

-0.1

-0.1 0.1

1984

1985

1986

0.1

—

-0.2

-0.2

—

— — 0.1 0.1 0.2

0.2 —

-0.1

-0.1 -0.2 0.2

0.2 —

-0.1

G.A. MACKENZIE

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ARE SUMMARY FISCAL INDICATORS MISLEADING?

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References Altonji, Joseph G., and Aloysius Siow, "Testing the Response of Consumption to Income Changes with (Noisy) Panel Data," Quarterly Journal of Economics, Vol. 102 (Issue 2, May 1987), pp. 293-328. Blinder, Alan S., and Stephen M. Goldfeld, "New Measures of Fiscal and Monetary Policy, 1958-73," American Economic Review, Vol. 66 (December 1976), pp. 780-96. Blinder, Alan S., and Robert M. Solow, "Analytical Foundations of Fiscal Policy," in The Economics of Public Finance, ed. by Alan S. Blinder and others (Washington: The Brookings Institution, 1974), pp. 1—115. Boskin, Michael J. (1988a), "Concepts and Measures of Federal Deficits and Debt and Their Impact on Economic Activity," in Economics of Public Debt, ed. by Michael J. Boskin and Kenneth Arrow (New York: St. Martin's). (1988b), "Consumption, Savings, and Fiscal Policy," American Economic Review, Papers and Proceedings, Vol. 78 (May), pp. 401—07. Bossons, John, and D.P. Dungan, "The Government Deficit: Too High or Too Low?" Canadian Tax Journal, Vol. 33 (January—February 1983), pp. 1-29. Buiter, Willem H., "A Guide to Public Sector Debt and Deficits," Economic Policy, Vol. 1 (November 1985), pp. 13-79. Chand, Sheetal K., "Summary Measures of Fiscal Influence," Staff Papers, International Monetary Fund, Vol. 24 (July 1977), pp. 405-49. Ebrill, Liam P., and Owen Evans, "Ricardian Equivalence and National Savings in the United States," IMF Working Paper 88/96 (unpublished; Washington: IMF, 1988). Flavin, Marjorie, "The Adjustment of Consumption to Changing Expectations About Future Income," Journal of Political Economy, Vol. 89 (October 1981), pp. 974-1009. Hall, Robert E., and Frederik S. Mishkin, "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households," Econometrica, Vol. 50 (January 1982), pp. 461-82. Hayashi, Fumio, "Tests for Liquidity Constraints: A Critical Survey and Some New Observations," in Advances in Econometrics: Fifth World Congress, Vol. 2, ed. by Truman F. Bewley (New York: Cambridge University Press, 1987). Heller, Peter S., Richard D. Haas, and Ahsan H. Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper 44 (Washington: IMF, 1986). Hubbard, R. Glen, and Kenneth L. Judd, "Liquidity Constraints, Fiscal Policy, and Consumption," Brookings Papers on Economic Activity: 1 (1986), The Brookings Institution, pp. 1—50.

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51

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International Monetary Fund, A Manual on Government Finance Statistics (Washington: IMF, 1986). , World Economic Outlook (Washington, 1988). Kotlikoff, Laurence J., "Economic Impact of Deficit Financing," Staff Papers, International Monetary Fund, Vol. 31 (September 1984), pp. 549-82. , "Deficit Delusion," The Public Interest, No. 84 (Summer 1986), pp. 53-65. , "From Deficit Delusion to the Fiscal Balance Rule: Looking for an Economically Meaningful Way to Assess Fiscal Policy," NBER Working Paper 2841 (Cambridge, Massachusetts: National Bureau of Economic Research, February 1989). Mackenzie, G.A., "Are All Summary Indicators of the Stance of Fiscal Policy Misleading?" Staff Papers, International Monetary Fund, Vol. 36 (December 1989), pp. 743-70. Mariger, Randall P., Consumption Behavior and the Effects of Government Fiscal Policies (Cambridge, Massachusetts: Harvard University Press, 1986). Organization for Economic Cooperation and Development (OECD), Economic Outlook (Paris, various years). Rossi, Nicola, "Government Spending, the Real Interest Rate, and the Behavior of Liquidity-Constrained Consumers in Developing Countries," Staff Papers, IMF (Washington), Vol. 35 (March 1988), pp. 104-40. Schinasi, Garry J., "International Comparisons of Fiscal Policy: The OECD and the IMF Measures of Fiscal Impulse," International Finance Discussion Papers, No. 274 (Washington: Board of Governors of the Federal Reserve System, February 1986).

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4 Measurement of Fiscal Performance in IMF-Supported Programs Some Methodological Issues Alain Ize fiscal balance remains the principal fiscal indicator used in the design and monitoring of most IMF programs. In highinflation countries, the inflation-corrected balance—the operational balance—has been widely used over the past decade as a necessary complement to the conventional public sector borrowing requirement (PSBR). In countries with highly unpredictable real domestic interest bills on public debt, particularly countries that are undergoing shock stabilization programs, the primary balance has in turn provided a more stable alternative to the operational balance. Finally, a growing but still limited use of "structural" or "core" deficits has been made to measure the underlying fiscal balance obtained after isolating the impact on the deficit of temporary fiscal shocks, particularly those caused by short-term fluctuations in the macroeconomic environment.1 Cyclically corrected balances, which are routinely computed in the monitoring of industrial countries' fiscal performance,2 are seldom used for developing countries because of data limitations that aggravate the difficulties of interpretation often present in these exercises. The set of indicators that are thus routinely used in IMF developing country work—the conventional, operational, and primary definitions of the overall fiscal balance—face several limitations, however. First,

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THE CONVENTIONAL

1 On the use of fiscal indicators in IMF programs, see Tanzi (1989), IMF (1986), and Chapters 3, 9, and 13 of this volume. 2 On the measurement of fiscal impulses, see Heller, Haas, and Mansur (1986).

52

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even after correcting interest payments for inflation, the operational balance remains influenced by changes in the underlying macroeconomic environment, in particular by fluctuations of output, the real exchange rate, the real interest rate, and some other key macroeconomic prices such as the international price of the country's main exportables. Furthermore, changes in the inflation rate can have important fiscal repercussions onfiscalrevenues and expenditures in addition to those on domestic interest payments. Thus, changes in traditionally measured fiscal balances may reflect endogenous or exogenous macroeconomic fluctuations as well as discretionary fiscal policies. In the context of an IMF program, it is then not possible to assess, from these indicators alone, whether a deviation from program targets was the result of policy slippages or unexpected macroeconomic developments. Second, since no distinction is made between temporary and permanent changes in taxes and transfers to the private sector, traditional fiscal balances implicitly assume that the aggregate demand impact of temporary and permanent fiscal policies is the same. This assumption would be correct only if private consumption were to be affected equally by temporary and permanent changes in disposable income, which in turn would require all agents to be liquidity constrained—an unlikely hypothesis even in economies with underdeveloped financial systems. Third, traditional aggregate indicators do not distinguish between two clearly different sources of fiscal disequilibria—the aggregate demand pressure exerted by the public sector on current available resources (the "fiscal stance") and the perceived probability of a default on public domestic debt (defined here as "fiscal strength"). The policy implications of an excessivefiscalstance will usually differ substantially from those of an unsustainable fiscal policy. Fiscal indicators must therefore be appropriately discriminating. Afinalgeneral difficulty with traditional deficit measurements is that they do not necessarily generate adequate adjustment incentives when used as benchmarks of fiscal conditionality. The extent and quality of a member country's adjustment response to an IMF program may be altered by the nature of the fiscal indicators used to measure that response. Although the linkage between fiscal measurement and adjustment incentives is generally recognized in IMF operations, few attempts have been made so far to analyze its implications in the selection of efficient fiscal benchmarks. This chapter attempts to fill some of these gaps by proposing operationally useful fiscal indicators that address the limitations mentioned above. It echoes to some extent similar attempts made recently by other multilateral institutions, particularly by the Organization for

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

Economic Cooperation and Development (OECD),3 in stressing the need for identifying discretionary fiscal policies, for integrating intertemporal considerations in the measurement of fiscal impacts, and for establishing clearer distinctions in the measurements of fiscal stance and fiscal sustainability. It goes one step further, however, by addressing these issues in the context of program conditionality. It also focuses on developing countries rather than on industrial countries, a distinction that is operationally relevant. Finally, it integrates the issue of sustainability within a broader concept of "fiscal strength" that incorporates a dimension of "fiscal vulnerability." This dimension reflects the need for the public sector to conduct monetary policy at a sustainable fiscal cost and to withstand pressures for an explicit or implicit default on its debt as a result of unexpected exogenous macroeconomic disturbances or a sudden drop in creditors' confidence. Unlike the OECD studies, no attempt is made to review or discuss indicators of fiscal distortions, a topic that is acquiring increasing relevance in the context of structural fiscal adjustment but that is beyond the scope of this chapter. The chapter is divided into five sections. The first deals with the measurement of discretionary fiscal policies. The second focuses on intertemporal aspects of measuringfiscalstance, including the implications of using a private consumption demand that is based on permanent income, rather than current income, to assess the economic impact of budget deficits, and of adding a Blanchard intertemporal index of stance to the battery of usual IMF fiscal indicators. The third section deals with the need to differentiate between fiscal stance and fiscal strength. Two equivalent indicators of fiscal sustainability are proposed that stress, alternatively, fiscal adjustment and economic growth. Two possible indicators of fiscal vulnerability are also suggested. Fiscal conditionality is taken up in the fourth section. A fifth and concluding section suggests practical ways to standardize the fiscal indicators used in IMF operations so that they remain as simple, selective, and uniform as possible.

On the Measurement of Discretionary Fiscal Policies Unless an extreme view is taken that the fiscal impact of unexpected disturbances in the macroeconomic environment should necessarily 3 See Chouraqui, Hagemann, and Sartor (1990); Blanchard (1990); and Gramlich (1990).

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be fully offset by corrective fiscal policies, the origin of a deviation of the fiscal balance from a target must matter. A deviation caused by exogenous shocks or some other unexpected developments should generally have different implications from a deviation caused by policy slippages. The net fiscal impact of discretionary fiscal policies must therefore be identified in some simple fashion.

Policy Slippages Let Dt be the fiscal balance obtained in period t. It is a function of the fiscal policies, Pt, followed during period t and of the macroeconomic environment that prevailed during the period, Et. Hence, D

t

= Dt (Pt, Et).

(1)

Let P*t and E*t be the fiscal policies and macroeconomic environment that were envisaged for period t in the context of a program agreement for that period. The fiscal balance that was targeted under the set of fiscal policies and macroeconomic environment P*t and E*t is denoted D*t(P*t,E*t). The deviation with respect to target may then be expressed as

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Dt (Pt, Et) - D*t (P*t, E*t) = [Dt (P t , Et) - Dt (P*t, Et)] + [Dt (P*t, Et) -Dt(P*t,E*t,)]

+ [Dt (P*t, E*t - D*t (P*t, E*t)]. (2)

The first term on the right-hand side of equation (2) gives the difference between the actual fiscal balance and a hypothetical fiscal balance that would have been obtained by following program policies under actual macroeconomic developments. It thus measures the magnitude of policy slippage. The second term introduces an additional estimate corresponding to the fiscal balance that would have obtained under program policies and program environment. The difference between the fiscal balance under program policies and that under the actual environment represents the deviation caused by changes in the economic environment. Finally, the third term is a residual term that picks up all unidentifiable shifts and disturbances, particularly those caused by projection errors in the formulation of program targets. Estimating equation (2) thus requires four series of budgetary figures: the realized budget, the program budget, the hypothetical budget that

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

would have been obtained under initial program policies and the actual macroeconomic environment, and the budget that would have been obtained under initial program policies and the initial program environment. The impact of programmed discretionary fiscal policies must therefore be quantified, and a set of elasticities must be used to revise the fiscal balance with respect to changes in macroeconomic parameters such as output, inflation, the real interest rate, the real exchange rate, and the international price of main exported commodities. Policy Actions A similar decomposition can be made for the previous year's fiscal balance instead of the program balance:

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Dt(Pt,Et) - Dt-1(Pt-1, Et-1) = [Dt(Pt,Et) - Dt(Pt-1, Et)] + [Dt(Pt-1, Et) - Dt(Pt-1, Et-1)] (3) + [Dt(Pt-1, Et-1) - D t-1 (P t-1 , Et-1)]. In this case, the first term on the right-hand side of equation (3) reflects the change in fiscal policies from t—1 to t, rather than the policy slippage (or overperformance) with respect to target. The second term reflects changes in the macroeconomic environment, and the third term is an unexplained residual. This decomposition can be used to monitor fiscal developments outside a program agreement. It can also be used in forecasting exercises when the previous period is taken as a base, and the forecast for the next period rnust be adjusted on the basis of projected changes in the macroeconomic environment and fiscal policy actions. The methodology is somewhat similar to the one proposed by Blanchard's (1990) OECD study,4 except that the impact of discretionary fiscal policies is measured by Blanchard as At(Pt, Et-1) - D t - 1 ( P t - l , E t - l ) , which can be rewritten as [Dt(Pt, Et-1) - D t (P t-1 , Et-1)] + [Dt(Pt-1, Et-1) - Dt-1(Pt-1,

Et-1)].

4 This decomposition is also similar in spirit to the methodology proposed by Marshall and Schmidt-Hebbel (1989).

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Hence, Blanchard's index does not isolate an unexplained residual but includes it instead within the fiscal policy term. The residual term, however, is often substantial and can significantly bias interpretation of the results. A more adequate two-tier decomposition to isolate the impact of discretionary fiscal policies should be carried out on the basis of [Dt (Pt, Et)—Dt (P t _ 1 , Et)] rather than [Dt (Pt, Et_1) - Dt_1

(Pt-1, E t - 1 )]. Thus, instead of expressing the current fiscal balance with last year's macroeconomic parameters and then subtracting last year's actual fiscal balance (as recommended in the OECD study), it is more appropriate to subtract, from the current year's actual balance, the hypothetical current-year balance that would have occurred with last year's fiscal policies.

Onetime Transfers and the Fiscal Stance Although it is commonly agreed that an index of fiscal stance should measure the aggregate demand impact of fiscal policy, several indices have been used or proposed that fall between two extremes.

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Accounting Versus Model-Based Definitions of Fiscal Stance At one end of the spectrum, it is argued that a pure accounting definition of the deficit, such as the PSBR, is all that is needed. At the other end, the view is that no definition of thefiscalstance is meaningful unless it is grounded in a fully specified model of the economy that treats differently the impact that discrete budgetary items have on private consumption and on private savings; that fully identifies sources of government financing; and that accounts for differences across countries with respect to the severity of liquidity constraints, the degree of intertemporal foresight, and the institutional framework.5 Neither extreme seems to have complete operational relevance. Conventional accounting measurements that identify the macroeconomic impact of a deficit with its financing requirements (PSBR) have been found to lose much of their economic significance in countries with high inflation. In these countries the PSBR increases in step with inflation, but the causal link between the deficit and inflation ceases to be clearly unidirectional. Without a deeper analysis of causality, the 5 A good overview of the issues involved in estimating the impact of budget deficits can be found in Buiter (1985).

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high correlation between deficits and inflation loses its informational content. Moreover, the correlation between the conventional fiscal deficit and real economic developments, particularly the link with the current account of the balance of payments, is blurred by inflation. Measurements of the fiscal deficit that adjust for inflation (such as the operational deficit), which were devised to circumvent this difficulty, are a step in the direction of model-based definitions because they implicitly assume that agents do not suffer from money illusion and that inflation is not at all times a purely monetary phenomenon. At the other end of the spectrum, deficit measurements based on fully specified models are also not entirely satisfactory. In the absence of a universally agreed model, these measurements become model dependent and lose their comparability. Model-based measurements also become more difficult to interpret as the complexity and size of the underlying model grows. Useful and fully operational fiscal indicators must therefore lie somewhere between the extremes of a pure accounting definition and a full model-based specification. For example, some simple adjustments to accounting definitions can improve their economic content. But the issue is where to draw the line between corrections that clarify the interpretation of the indicator and are easy to carry out and corrections that unnecessarily complicate the computation of the index without adding much to its content. Wealth-Based Versus Income-Based Definitions of Fiscal Stance In addition to inflation correction, which is clearly needed for highinflation countries, another possibly useful correction is to differentiate between temporary and permanent taxes and transfers to the private sector. In particular, large onetime taxes and transfers to the private sector—such as the central bank's absorption of financial losses made by a commercial bank, the coverage of exchange risk guarantees, or large swings in real interest payments on domestic public debt—can frequently add several points of gross domestic product (GDP) to a fiscal deficit in the year in which these taxes and transfers were made. Usual PSBR or operational balances implicitly assume that these temporary transfers would have the same impact on private consumption and private savings as that of any other public expenditure. This would only be true, however, if all agents were fully liquidity-constrained or totally myopic, so that changes in consumption would exactly match

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short-run changes in disposable income. Although empirical studies have usually discarded the extreme Ricardian view that private consumption is invariant to changes in taxes and transfers that leave public expenditures unchanged, they have consistently shown, in both industrial and developing economies, that the propensity to consume out of permanent income, or wealth, is substantially higher than the propensity to consume out of temporary income.6 If so, including these onetime transfers in the definition of the deficit would tend to overstate the real impact of the fiscal stance. The underlying issue is whether to base the measurement of the fiscal deficit on a view of private consumption that stresses current disposable income or on one that stresses permanent income. A view of the deficit that is based on wealth would compute the fiscal impact of transfer payments in a way that would clearly differ from conventional treatments. Take first the frequent case of a central bank that absorbs financial losses made by a commercial bank (on this issue, see also Chapters 11 and 16 of this volume). If government intervention was anticipated, the bonds issued by the central bank to substitute for the assets of the bankrupt financial institution do not alter private wealth and should not, therefore, lead to an increase in private consumption. The exception is if recipients of the bonds are tightly liquidityconstrained, which is unlikely because they were already holding the counterpart of the bonds as financial assets before the commercial bank went bankrupt. If government intervention was not anticipated, the bonds do represent a windfall gain to the bond recipients. However, a wealth-based view of the deficit would still suggest that, in the short run, most of the capital gain would be saved. Yet the spending behavior of commercial bank debtors that caused the bank to go bankrupt by defaulting on their loans is not likely to be greatly altered by the government's intervention; if it were, the implication would be that debtors were planning to repay their debts rather than to default. Thus, rather than counting the entire coverage of the loss as a flow expenditure during the period in which the bonds are floated, as current IMF practice implies, a wealth-based view of the deficit would incorporate in the current fiscal stance only the fraction of the bonds that would translate into an increase in private consumption during the period. In particular, if the propensity to spend out of wealth is close to the average real interest rate, only the flow of interest payments on the newly issued bonds should be included in the deficit, rather than 6

See, in particular, Hayashi (1982), Campbell and Mankiw (1987), and Haque and Montiel (1987).

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the stock of bonds itself. A similar reasoning would apply to other once-and-for-all transfers to the private sector, such as the coverage of exchange losses. Consider next the case of high real domestic interest rates that derive from a large risk premium associated with the expectation of a forthcoming default on public debt. This situation has arisen recently in many countries with a large domestic public debt and high inflation as well as in most recent shock stabilization attempts, since expectations of an exchange rate collapse and of a resumption of inflation linger for some time after the introduction of the shock program. As long as high interest rates prevail, a conventional deficit measurement would raise the deficit correspondingly. But, when a default finally takes place, generally because of sharply negative real interest rates, a conventional measurement would indicate an abrupt fiscal improvement. Private sector spending behavior is likely, however, to offset most, if not all, of these measured swings in the fiscal balance. High ex post real interest rates are not expected to last, since a default will eventually occur or credibility will be restored. In either case, the public should perceive the income gains received ex post on holdings of public debt as temporary. If financial wealth holders are not liquidity constrained, most of these gains should be automatically reinvested and should not therefore be counted as part of the fiscal stance. Ex ante, in contrast, the higher interest income that is perceived as long as a default does not take place is expected to be offset by the capital loss that will occur once a default occurs. Thus, because there is no net wealth effect, private consumption should remain mostly unchanged, and offsetting changes in private savings should neutralize most of the economic impact of the swings in the budget deficit. The wealth impact of the high interest payments will occur, instead, only over time and only to the extent that the higher interest bill forces public debt to rise. In this case, however, the deterioration in the fiscal balance is due to an increase in the stock of debt over time, rather than to the direct impact of high interest rates. Consider finally the case of fluctuations in real interest rates caused by changes in monetary policy rather than by variations in the risk premium perceived by investors. The traditional income-based view of the deficit considers the payment of interest on public debt as an income effect, to be included in the measurement of the fiscal deficit, and puts the substitution effect of changes in real interest rates in the realm of monetary policy. From the perspective of wealth, however, the dividing line between fiscal and monetary effects becomes blurred. A rise in the real interest rate reduces private wealth by lowering the

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capitalized value of labor income, hence lowering consumption and raising private savings. Over time, as long as real interest rates remain high, private consumption will rise with wealth and will eventually stabilize at a permanently higher level. The income effect of higher interest payments on private consumption is thus a steady-state effect, whereas in the short run private consumption should fall because of a negative wealth effect. The inclusion of the current interest bill in the definition of the deficit therefore collapses the dynamic adjustment of private consumption within a single period and identifies, somewhat arbitrarily, the short-run wealth effect of changes in real interest rates as a monetary effect. Agents who are not liquidity constrained, however, are not likely to alter their consumption significantly in response to changes in real interest rates that are perceived to be strictly transitory. In any event, it would seem more appropriate, from a wealth perspective, to include in the fiscal stance the interest bill at an equilibrium real interest rate rather than at the current interest rate. Similar arguments would apply to the lengthening of the average maturity of public debt. A conventional measurement of the deficit would tend to penalize a government that would raise its interest bill by extending the maturity of its debt, but a wealth-based view of the deficit would look more benignly on the possible fiscal implications of this operation. In this case, the rise in the average interest bill reflects a reduction in the average liquidity of public debt instruments, and the impact of higher interest receipts on private wealth should be mostly offset by the loss associated with the decline in the implicit option value of these instruments.

Operational Alternatives Although wealth issues are clearly important in practice, liquidity constraints cannot be totally ignored. Furthermore, high interest rates on public debt may be associated with an increase in demand for durable consumption goods because durables may be used as investment outlets that offer a hedging alternative to financial instruments when uncertainty about future interest rates is high. For these reasons, ignoring capital gains and losses altogether—and simply replacing, in the domestic interest bill, the current interest rate with an equilibrium interest rate—could be misleading. When choosing a stance indicator, one is thus faced with two options: first, a single indicator may be designed to provide a midpoint estimate between a strictly static, liquidity-constrained measurement and a full, intertemporal wealth

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approach; second, a conventional deficit measurement and a wealthbased measurement that ignores temporary transfer payments can be simultaneously used as upper and lower bounds of the truefiscalstance. The first approach is the one proposed by Blanchard (1990) in the OECD study. He suggests taking the usual operational deficit, adjusted by using the average value of the next three years' taxes and transfers instead of current values. For consistency, however, domestic interest payments would also need to be taken as forward-looking averages of the difference between nominal rates and expected inflation. Thus, operational balances should be obtained by deflating debt stocks by an average forward-looking price index rather than by a spot index, as current practice implies.7 Such an index could, however, yield a false impression of precision because liquidity constraints may vary widely among countries, over time, and across types of taxes and transfers. An alternative might be to estimate private consumption functions for individual countries so as to obtain country-specific coefficients for temporary and permanent income. These coefficients could then be used as weights to derive a single index of the fiscal stance from the sum of a conventional fiscal balance and a wealth-based balance. The latter would be derived from the permanent expected values of taxes and transfers and a long-run real interest rate.8 When country-specific coefficients are not available because of data limitations, a cross-country average estimate could be used instead (see Haque and Montiel (1987)). Because they rely on econometric estimates, however, these measurements would become model specific and thus somewhat limited in acceptability. Although the alternative approach of using two extreme indicators would be less precise, it would nevertheless provide a practical way of alerting policymakers to the existence of temporary fiscal disturbances with effects on the fiscal stance potentially different from regular revenue and expenditure effects. Because it would continue to rely on conventional measurements, an approach using two extreme indicators would also blend better with current IMF practice. This approach would have the additional advantage of simplicity, since the distinction between conventional and wealth-based measurements 7

Because it is less likely for the average bond holder to be liquidity constrained than it is for the average taxpayer or average recipient of other transfers (particularly social transfers), domestic interest should be more forward-looking than taxes and transfers. 8 When central bank profits are consolidated within the fiscal balance, the same longrun real interest rate should be used to value the returns on government paper and the cost of servicing central bank bonds.

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would simply amount to including or dropping temporary taxes and transfer payments from the calculation of the fiscal balance and expressing the domestic interest bill at an equilibrium long-run real interest rate rather than at the current rate.

Fiscal Strength When it signs a program agreement with a member country, the main objective of the IMF, as a lender of last resort, is to induce policies that maximize the probability that the country will be able, at some future date, to go back to a sustainable growth path with renewed access to world capital markets. For this to be possible, countries must remain solvent. The public sector, as a separate entity, must itself also remain able to honor its financial obligations. Fiscal solvency—or, as defined here, fiscal strength—is thus an essential aim of IMF programs.

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Fiscal Stance and Fiscal Strength Strength and stance are distinct fiscal dimensions that need not always be perfectly correlated. Although an expansionary fiscal stance maintained for a long period should eventually bring the public sector to the brink of insolvency, it need not be associated in the short run with weakening fiscal strength. Instead, a temporary deterioration of the fiscal balance could coincide with an improved perception of fiscal strength if the deterioration is associated with structural reform of the public sector. In other words, some fiscal transactions that affect the fiscal stance may not have a significant impact on fiscal strength. Take, for example, the case of onetime transfers such as the coverage of financial losses or the high real ex post interest rates associated with a large risk premium. As argued above, the impact of such transfers on the current fiscal stance may be small. They could, however, have a significant negative impact on perceived fiscal strength if the resulting increase in public indebtedness raises the probability of a default on public debt. Consider, in contrast, the case of a temporary decline in the world price of oil that affects an oil-exporting public sector. If the country as a whole has limited reserves and does not have normal access to world financial markets (as is generally the case in the context of IMF-supported programs), then the country is liquidity constrained, and the temporary shortfall in oil revenue has an immediate impact

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

on the fiscal stance that must be offset through fiscal or monetary policies. But fiscal strength, as determined by the sustainability of the underlying fiscal position, need not be significantly undermined if the disturbance is temporary. Finally, take the case of temporary public expenditure in goods and services. Because such expenditure exerts immediate pressures on the current supply of goods and services, it should be accounted as a flow item when measuring the fiscal stance. The impact of such expenditure on fiscal strength, however, should be limited to the additional indebtedness, which, if the spending is temporary, should remain small. Yet, in terms of the macroeconomic implications, an expansionary fiscal stance often looks similar to weakening fiscal strength. Both generally lead to balance of payments difficulties. An expansionary fiscal stance leads to a balance of payments crisis when the deterioration of the current account caused by excess aggregate demand is not offset by capital inflows, which would be the case if the country is liquidity constrained and does not have current access to world financial markets. Weakening fiscal strength leads to a loss of international reserves when falling confidence in the value of public debt causes capital flight and a contraction of foreign credit. Similarly, inflationary pressures can result from a short-run fiscal expansion or from perceptions of fiscal insolvency. In the former case, inflation is caused by excess demand; in the latter, by supply-side pressures as high interest rates and a depreciation of the exchange rate forced by capital flight filter into domestic costs. Finally, high interest rates and falling investment levels may also occur in both cases—through crowding out in the context of fiscal expansion, and through increasing risk premiums in the case of weakening fiscal strength. Although the symptoms of expansionary fiscal stance and weakening fiscal strength may be similar, it is, from a policy perspective, essential to identify correctly the fiscal origin of observed macroeconomic disequilibria. If the origin is weak fiscal strength, rather than an excessive fiscal stance, a strong but structurally inadequate fiscal adjustment may produce an unnecessary downturn in economic activity, together with a worsening of the balance of payments caused by accelerated capital flight. Conversely, if the source is an excessive fiscal stance, an in-depth structural adjustment may not correct existing macroeconomic imbalances. Appropriately discriminating fiscal indicators are thus needed. Sustainability A government's fiscal strength—hence, the value of its debt— depends on the perceived sustainability of its fiscal position. Sustain-

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ability in turn depends on the extent to which the government will need to adjust its current fiscal policies in the future in order to avoid an explosion of its debt. Let s be the average expected ratio to GDP of the public sector primary surplus, as determined by current trends; d be the ratio of debt to GDP; f the average expected real rate of interest on public debt; and g the average expected growth rate.9 The expected change over time in the debt-to-GDP ratio should follow the simple dynamic equation: d = (f-g)d - s.

(4)

If g > f, this system is stable and converges to a finite ratio of debt to GDP, no matter what the level of initial indebtedness is. If g < f, the system is unstable and will require a change in fiscal policies in order to remain on a nonexplosive saddlepath. Future fiscal surpluses must adjust to match the initial market value of public debt, d0, which, by integration of equation (4) may be written as d0 = So"

Se-v-Vdt.

(5)

Let s* be the ratio to GDP of the primary surplus that would be required to stabilize the debt-to-GDP ratio at its current level:

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s* = (f - g)d0.

(6)

The difference between s* and s reflects the magnitude of the required fiscal adjustment, the "primary gap": p = (f - g)d0 - s.

(7)

The primary gap is equal to the measurement of the deficit given by equation (4) at the initial debt-to-GDP ratio and at the average expected future value of the primary surplus, the real interest rate on public debt, and the growth rate. If it is negative, such a simple index provides an indication of the fiscal effort that the government would need to 9 As formulated in equation (4), public debt includes monetary liabilities. The average real rate of interest should thus be a weighted average of the real interest rate paid on interest-bearing instruments and the negative inflation rate applied to monetary balances. The assumed inflation rate that underlies the sustainability index must therefore be specified.

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

exert, given its current debt and fiscal policies, to ensure that the debt burden does not rise and, hence, that it will continue to honor its financial obligations. If the index is positive, it indicates the margin that the government currently has for expanding its deficit while preserving solvency. Fiscal strength, as determined by the sustainability of the fiscal position , will thus be worsened by any combination of: (1) an increase in the debt-to-GDP ratio (caused, for example, by the absorption of financial losses or by a worsening of the terms of trade that gives rise to a real depreciation in the presence of large public sector external debt);10 (2) a permanent expected deterioration of the current primary surplus; (3) a decline in the expected growth rate of the economy; and (4) an increase in the real rate of interest paid on public sector debt (owing to an increase in the world interest rate or a higher risk premium on local currency instruments). In his OECD study, Blanchard (1990) proposes a set of sustainability indicators that differ according to their time horizons. He suggests using different forward averages of the expected tax-to-GDP ratio: the current year alone, a three-year forward average, and a fifty-year forward average. The indicator suggested above is similar in spirit, except that it does not assume, as Blanchard does, that the current expenditure-to-GDP ratio is necessarily permanent. It is also less specific in defining a time horizon. In particular, onetime fiscal expenditures (such as the absorption by the central bank of commercial bank's financial losses) should be included only in the initial debt-to-GDP ratio but not in the estimate of the average future primary deficit. Also, the ratio of expenditures to GDP tends to fluctuate much more widely in developing economies than in industrial countries, and expenditure adjustment is an essential component offiscaladjustment. The concept of a primary gap therefore seems more appropriate than that of a tax gap, as in Blanchard. Moreover, a breakdown by time horizon, as suggested by Blanchard, may be excessively refined for use with developing economies. A single and rough indicator that would isolate temporary and permanent components of fiscal revenues and expenditures, as suggested above, should be sufficient in work with developing economies. 10

Note that changes in public sector net worth owing to financial gains and losses should not enter in the primary surplus but should simply be incorporated in the valuation of net public sector debt. Counting these gains and losses as revenues or expenditures would confuse stocks and flows.

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An alternative indicator could also be used to stress growth rather than fiscal adjustment. Let n* be the minimum growth rate needed to sustain the current debt-to-GDP ratio. Then, from equation (4), n* = r - s/d0.

(8)

Besides stressing supply-side adjustment as a complement to demand adjustment, this indicator would also have the advantage of not requiring an estimate of a specific expected growth rate. It would instead provide a simpler benchmark to assess the minimum need for growth under a given fiscal outlook.

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Fiscal Vulnerability A government's fiscal position may be sustainable in the absence of exogenous shocks but could become unsustainable if shocked. It is necessary, then, to assess the public sector'sfiscalvulnerability. Shocks can be of a direct fiscal nature: unexpected fluctuations in public sector revenues or expenditures, such as a fall in the world price of oil in the case of an oil-exporting public sector, or a rise in world interest rates in the case of a public sector with a large external debt. Shocks can also have an indirect fiscal impact, in particular when a government that is suddenly forced to tighten its monetary policy can only do so at an unsustainable fiscal cost, given the large size and short-term liquidity of its domestic debt. The fiscal impact of exogenous shocks is often amplified by the public's reactions to bad news or by purely self-fulfilling speculative runs against government securities, forcing the government to default on its obligations.11 When the demand for government paper collapses at a time when a negative fiscal shock raises public sector borrowing requirements, the government faces several options: (1) it may raise the premium on its domestic debt; (2) it can use liquid foreign assets to finance its deficit or to repurchase part of the debt; (3) it can raise taxes; or (4) it may default by monetizing the debt, by letting the exchange rate depreciate, 11

The literature about runs on banks originated with Diamond and Dybvig's (1983) seminal contribution. Obstfeld (1984) presented a model that relates self-fulfilling confidence crises to the collapse of an exchange rate regime. More recently Calvo (1988), Calvo and Guidotti (1989), and Alesina, Prati, and Tabellini (1989) have proposed models of domestic debt that incorporate multiple equilibria and have explored the implications for debt management.

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

by unilaterally lengthening the term structure of the debt, or by openly repudiating the debt. As shown by Calvo (1988), option 1 collapses into option 4 when the government is unable or unwilling to raise the tax revenue it would need to pay the interest premium. Because the immediate fiscal incidence of raising the premium becomes stronger as the average maturity of the debt shortens, the likelihood of a default should be directly related to the liquidity of the debt. Option 2, in contrast, is limited by the ratio of liquid reserves to liquid liabilities and by the magnitude of the negative fiscal shock. Again, if most of the public debt is short term and the debt is large, the size of the speculative run can easily swamp available reserves. Finally, option 3 faces a stock-flow problem unless a lender of last resort can intervene rapidly enough to let the government borrow against the value of its future tax receipts. The likelihood of a fiscal crisis, then, bears a direct relation to the liquidity of the government's balance sheet. Balance-sheet liquidity in turn is dependent upon (1) the stock of international reserves held by the central bank and the degree of the government's access to international financial markets; (2) the average maturity of the public debt; (3) the rate of inflation; and (4) the variability of fiscal revenues and expenditures. As the average maturity shortens, the size and suddenness of a speculative attack can increase. As inflation increases, however, a larger share of the principal is repaid every period in the form of nominal interest payments that, until they are reinvested, are liquid and can participate in a speculative attack. Finally, as the variability of fiscal revenues and expenditures increases, a larger portion of liquid assets must be kept available to finance the short-term fluctuations of the deficit, and therefore fewer reserves can be committed to defend the currency against a speculative attack.12 12

Alternatively, for a given initial level of reserves, the greater is the variability of the deficit, the smaller is the level of reserves left after an adverse fiscal shock, and thus the greater are the chances of a speculative attack. In some cases, the presence of a well-functioning dual exchange market could have a stabilizing influence on financial markets. In the absence of a dual exchange market, a run on government paper may induce an irreversible regime switch, such as a discrete depreciation followed by an inflationary outburst, or an open repudiation of debt. The irreversibility of these events may increase the likelihood of self-fulfilling runs because agents cannot keep holding government obligations under the expectation that, as markets return to normality, they will be able to recoup their capital losses. Instead, in the presence of a dual exchange market, the spread between the parallel and official rates can widen and absorb temporary speculative pressures. The spread becomes a reflection of the perceived value of government debt and should adjust like any stock price. As speculative pressures subside, the implicit price of public debt should recover, thereby providing a justification for holding public bonds instead of joining the run.

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Several indicators of fiscal vulnerability can thus be suggested. An indicator to measure the vulnerability of the fiscal accounts to exogenous disturbances can be defined as / = aJR,

(9)

where g0 — g0. The country must deviate further from its optimal schedule. It is intuitive—and can be easily proven for a simple class of utility functions as shown in the next subsection—that the country will be better off if it forgoes the program payoff because V(g1, R1, 0) > V(g1, R, P).

(21)

For a given payoff and a given revenue target, a fall in revenue raises the fiscal sacrifice implied in meeting the program target. The locus of policy choices such that the country is indifferent between adopting program targets or opting to follow its unconstrained optima is a schedule such as S* in Figure 2. It implies that as revenue falls, the target level of reserves should also fall. The country would thus be indifferent between choosing E1 and E*1.

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Figure 2. Choice of Efficient Conditionality in the Presence of Exogenous Shocks

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But suppose that fiscal revenue turns out to be larger than expected, t = t2 > t0, and the country's unconstrained optimum becomes E2. At E2, the program target becomes irrelevant because the country will choose, by itself, a policy mix that is better than the one implied in the program. Thus, as illustrated by this simple model, outcome targeting can lead, in a context of significant exogenous shocks, to program failure or program irrelevance. Even when a program does actually succeed in altering the country's choices, it will do so in an inefficient manner because the payoff given to the country is larger than the one needed to induce an equivalent policy shift, for any revenue outcome. This can be seen in Figure 2. Let E be the intersection of the S and R schedules. At any point—say, E3—between Eo and E, the program is successful in altering the country's policy mix from E3 to E3. On the basis of this payoff, however, the country could have been induced to choose £3, which, from the IMF's perspective, would be more desirable.

The Case of an Iso-Elastic Welfare Function Assume that the member country's welfare function is of the CobbDouglas variety:

U = (a + gf (b + Rf (c + P)\

(22)

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First-order maximization conditions are then a/7 = -y(a + g\ (23)

(3(7 = y(b + R),

so that the optimal unconditional policy mix is R = Pg a

+ [a -

ab

P)•

(24)

With the budget restriction, R + g = £, equation (24) implies that g =

R =

a t + k a + (3

a + p

t - k,

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(25)

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FISCAL PERFORMANCE IN IMF-SUPPORTED PROGRAMS

where ab — Bα k = -------------a +ß

Hence, the country adjusts both its expenditure and its reserves downward, in response to falling revenue. An optimal conditionality target, for a fixed program payoff, implies that the member country's utility, conditional on the payoff, must be equal to its unconditional utility, for any level of revenue. After some manipulations, this may be written as

(a + t - Rfib + Rf{c + Py = h{t + a + b) a+( V,

(26)

where aaßß h = --------------------(a + ß) a + ß , or

)( )( )(

) ) )

) ) )

b+R c (27) = n ----------------. ---------------( a + b + t ( c+p ( It is clear that the solution to this equation must be of the form Copyright © 1991. International Monetary Fund. All rights reserved.

1 _

b

+ R a + b + t

b + r = e(a + b + t).

( ( (

(28)

Equation (24), the optimal conditionality policy mix, can thus be expressed as E

e α - b (29) R = -------------g + -----------------1-E (1 - € ). ( ) ) the country's optimal conditional It is easy to check that( ep/ot > 0, so that policy schedule rotates in the same direction as the unconditional schedule, as the country's preference shifts from expenditure adjustment to reserves adjustment.

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References Alesina, Alberto, Alessandro Prati, and Guido Tabellini, "Public Confidence and Debt Management: A Model and a Case Study of Italy," NBER Working Paper 3135 (Cambridge, Massachusetts: National Bureau of Economic Research, 1989). Blanchard, Olivier J., Suggestions for a New Set of Fiscal Indicators, Department of Economics and Statistics Working Paper 79 (Paris: OECD, April 1990). Buiter, Willem, "A Guide to Public Sector Debt and Deficits," Economic Policy, Vol. 1 (November 1985), pp. 13-79. Calvo, Guillermo A., "Controlling Inflation: The Problem of Nonindexed Debt," IMF Working Paper 88/29 (Washington: IMF, March 1988). , and Pablo E. Guidotti, "Indexation and Maturity of Government Bonds: A Simple Model," IMF Working Paper 89/46 (Washington: IMF, May 1989). , and Manmohan S. Kumar, Domestic Public Debt of Externally Indebted Countries, Occasional Paper 80 (Washington: IMF, June 1991). Campbell, John Y., and Gregory N. Mankiw, "Permanent Income, Current Income, and Consumption," NBER Working Paper 2436 (Cambridge, Massachusetts: National Bureau of Economic Research, November 1987). Chouraqui, Jean-Claude, Robert P. Hagemann, and Nicola Sartor, "Indicators of Fiscal Policy: A Re-examination," Department of Economics and Statistics Working Paper 78 (Paris: OECD, April 1990). Diamond, Douglas W., and Philip H. Dybvig, "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, Vol. 91 (June 1983), pp. 401-19. Gramlich, Edward M.,"Fiscal Indicators," Department of Economics and Statistics Working Paper 80 (Paris: OECD, April 1990). Haque, Nadeem U., and Peter Montiel, "Ricardian Equivalence, Liquidity Constraints, and the Yaari-Blanchard Effect: Tests for Developing Countries," IMF Working Paper 87/85 (Washington: IMF, 1987). Hayashi, Fumio, "The Permanent Income Hypothesis: Estimation and Testing by Instrumental Variables," Journal of Political Economy, Vol. 90 (October 1982), pp. 895-916. Heller, Peter S., Richard Haas, and Ahsan Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper 44 (Washington: IMF, September 1986). International Monetary Fund, A Manual on Government Finance Statistics (Washington, 1986). Marshall, Jorge, and Klaus Schmidt-Hebbel, "Economic and Policy Determinants of Public Sector Deficits," Working Paper Series No. 321 (Washington: World Bank, December 1989).

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Copyright © 1991. International Monetary Fund. All rights reserved.

Obstfeld, Maurice, "Rational and Self-Fulfilling Balance of Payments Crises," NBER Working Paper 1486 (Cambridge, Massachusetts: National Bureau of Economic Research, November 1984). Tanzi, Vito, "Fiscal Policy and Economic Restructuring in Latin America," IMF Working Paper 89/94 (Washington: IMF, November 1989).

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5 Fiscal Impulse Measures and Their Fiscal Impact

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Sheetal K. Chand FISCAL IMPULSE MEASURES, either directly computed or as variants of cyclically adjusted balances, have long been used to measure the changing impact of the budget on the economy (Chand (1977); Heller, Haas, and Mansur (1986); and the references therein). These measures were developed to provide more accurate indications of budget impact than could be provided by simply observing movements in the actual budget balance. But they have also long been the subject of numerous criticisms, especially with regard to their adequacy in assessing fiscal impact (Blanchard (1990), Blinder and Solow (1974), and Chapters 3 and 14 in this volume). Any summary measure is invariably open to the criticism that a fuller, more comprehensive approach will provide superior indications. Nevertheless, this criticism should not preclude recourse to summary indicators, which can be of considerable utility provided that appropriate safeguards are employed. The purpose of this chapter is to assess whether, in light of the criticisms, the fiscal impulse measure is worth using, and under what conditions. The analysis begins by presenting a basic version of the fiscal impulse measure that has found some popularity. Because this measure lacks an obvious rationale—a lack that has fueled the criticism—an attempt is made to supply a justification by using a simple analytical framework. Next, possible effects of the major criticisms are noted in the context of the same analytical framework. This helps to identify in a more insightful manner the limitations surrounding the unqualified use of the fiscal impulse measure. The basic conclusion is that a version of the fiscal impulse measure is useful in indicating the approximate directions of fiscal impact. Certain of the criticisms that have been made are valuable, however,

85

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IMPULSE

MEASURES AND THEIR IMPACT

in defining the essentially empirical circumstances that influence the inferences with regard to fiscal impact.

A Fiscal Impulse Indicator One version of the widely employed fiscal impulse indicator is that used in the IMF's World Economic Outlook: FI = (AG - g0AYP) - (AT - t()AY),

(1)

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where FI stands for fiscal impulse, G for government expenditure, g() is the base-year ratio of government expenditure G to potential gross national product (GNP) YP, T is revenue, t0 is the base-year ratio of government revenue to actual GNP, and the operator A denotes first difference or change (IMF (1984, Supplemental Note 1); Heller, Haas, and Mansur (1986)). This indicator is derived from the "eyelically neutral budget model," which involves a distinction between the changes in government revenue and expenditure that are associated with cyclical fluctuations in the output of an economy and the changes that reflect policy decisions. A convenient way of deriving the fiscal impulse indicator is to begin with the so-called cyclical effect of the budget (CEB), which involves subtracting, from the actual budget deficit for any year, a budget deficit deemed to be cyclically neutral for that year: CEB = (G - T) - (g0YP - t0Y).

(2)

The cyclically neutral balance is stated in the last term on the righthand side of equation (2). This is determined by applying the baseyear ratio of government expenditure to current-year potential output, and the base-year ratio of budget revenue to current-year actual output. On taking first differences in the CEB and rearranging, the fiscal impulse indicator set out in equation (1) is derived. This indicator, which refers to changes in the cyclical effect of the budget, is more robust than the CEB, since it does not depend on an (arbitrarily) chosen base year. It closely approximates an alternative indicator of fiscal impulse (the socalled Dutch budget impulse), where the impulse is determined by reference to the preceding year's budget balance as base (the equivalences are shown in Chand (1977)): FI = (AG - nG

-1) - [AT -

(AY/Y

-1)T

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-1).

(3)

SHEETAL K. CHAND

87

Here n = AYP/YP -1 is the rate of growth in potential output. Dividing through by the previous years GNP and rearranging, the following expression for the fiscal impulse to be used subsequently is derived:

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FI/Y

1

= (AG/G

-1

- n)g* - (AT/T

-1

-

AY/Y

-1)t*,

(4)

where g* = G -1/T -1 and t* = T -1/Y -1 are the respective shares of government expenditure and revenue in the previous year's GNP. The fiscal impulse indicator is used—for example, in the IMF's World Economic Outlook—to assess the annual contribution, whether expansionary, neutral, or contractionary, of budgets to aggregate demand. An advantage claimed for this indicator is that it generates assessments based on certain tests that arc incorporated in the formula and that serve to control for the effects of the cycle on the budget. Thus, the actual change in government expenditure is compared with the unitclastic growth rate in such expenditure obtained from applying the potential growth rate of the economy to the preceding year's level of expenditure (see the first term on the right-hand side of equation (4)). Actual expenditure in excess of this standard is deemed expansionary, on the grounds that it would be adding proportionately more to aggregate demand. For revenue, the actual change is compared with the unit-elastic growth that would have occurred from applying the actual (not potential) rate of growth of the economy to the preceding year's level of revenue. An actual growth in revenue that exceeds this standard is viewed as contractionary because it would depress aggregate demand. Combining the expenditure and revenue effects in a single formula such as equation (1) or (4), the indicator involves testing the actual change in the budget deficit against a normative neutral change, as given by the movement in the cyclically neutral budget (or by the preceding year's budget balance, depending on the formula). If the actual change in the budget deficit is bigger than the normative change, the fiscal impulse is viewed as expansionary. Such an outcome could be the result of excessive growth of expenditure or deficient growth in revenue, or some combination of the two, where "excessive' and "deficient" arc determined in the formula by reference to built-in criteria. Fiscal impulse indicators arc easily calculated to provide a quantitative evaluation. On standardizing as a percentage of the previous year's GNP, the impulse could be viewed as a growth rate—the initial fiscal contribution to the growth in aggregate demand. Nevertheless, although simplicity is a highly desirable feature in a summary indicator, the above description of its construction lacks an immediate, intuitive

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

rationale. There are many issues that can be raised, of which a few are noted here. Why should actual growth in government expenditure be tested against a potential output growth rate? Is it appropriate simply to subtract the revenue impulse from the expenditure impulse? Why should the growth in revenue be tested against an actual output growth rate, but not its potential rate? Is the underlying conception of an economy fluctuating cyclically around a well-defined trend, with corresponding fluctuations in the budget balance (in the absence of policy adjustment), a valid portrayal of reality? The resolutions attempted in the literature do not appear compelling, and they have been strongly criticized by Buiter (see Chapter 14), Blanchard (1990), and others, who have argued that this fiscal indicator and its variants are not model based. Obviously, if such indicators lack rigorous justification, their use is suspect. Some attempts have been made to derive fiscal impact measures analytically.1 Unfortunately, most of the measures derived are generally much more complex, either in their construction or conceptualization, and this detracts from their use as simple summary measures.2 While simplicity might explain the persistent use, by both governments and international financial institutions, of the type of simple measure set out in equations (1) or (4), unless an explicit model-based derivation is forthcoming, their use surely cannot be justified. Moreover, in the absence of models, adequate criteria for discriminating among alternative fiscal impact measures cannot be derived. It would, therefore, seem worthwhile to attempt an analytical derivation for a simple measure of the sort considered in the World Economic Outlook exercise, which is undertaken next.

A Model-Based Rationale for the Fiscal Impulse Indicator The required derivation of a fiscal indicator such as that in equation (4) for the purpose of assessing aggregate demand effects is provided here by using a very simple IS model. The national income accounting 1 See, for example, Blinder and Goldfeld (1976) or Blanchard (1990). A discussion of some of the approaches is provided by Blejer and Cheasty in Chapter 13 and by Chouraqui, Hagemann, and Sartor (1990). 2 Blanchard (1990) has presented certain simple measures and subsequently evaluated them.

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SHEETAL K. CHAND

89

identity for a closed economy and the budget deficit identity are set out in equations (5) and (6), respectively: Y = C +I+ G

(5)

G - T = D.

(6)

Private investmentIand government expenditures G are assumed to be exogenously given, whereas consumption C is a proportional function of current disposable income: (7)

C = c(Y - T).

In stressing the importance of current disposable income and taxes, the above Keynesian consumption function assumes that consumers are liquidity constrained. Allowing for asset holdings and capital markets, however, other influences on consumer behavior are possible. Alternative life-cycle or permanent income models of consumer behavior may then be used. The latter possibilities, which may be more realistic, are noted here because they could bear important implications for the analysis (see the next section). Let tax revenue be a linear function of GNP, (8)

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T = tY,

where t is the effective tax ratio, T/Y. The reduced form for this simple Keynesian-type model, described by equations (5)—(8), follows on substituting equations (6), (7), and (8) in equation (5) and solving for Y: Y = a(I + G),

(9)

where a = 1/[1 - c(l - t)]. Totally differentiating the reduced-form solution for Y and expressing the result in incremental form yields AY = a-1 (AI + AG) + (I-1 + + (1t

G-1)[-a2-1c-1At 2 ) aA c . ] 1 1

(10)

The increment in Y is influenced by changes in the two assumed exogenous variables I and G and also by shifts in the multiplier a,

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

induced by movements in the effective tax ratio t or the marginal propensity to consume c. Thus, a in equation (9) can be viewed as expressing the underlying relationship between levels before the multiplier is modified, whereas equation (10) indicates the outcome when the changes take place. The pre-change multiplier in equation (10) is denoted by the lag (— 1). For the demonstration that follows, it is convenient to re-express equation (10) as equation (11), making use of the relationship between Y, I, and G specified in equation (9): AF = a_, (A/ + AG) + Y_, + (l-t_ 1 )a_ 1 Ac].

[-a_1c_1kt (11)

On taking first differences of equation (8), which is now to be viewed as a reduced-form equation that incorporates the solution Y, the change in tax revenues resulting from change in the effective tax ratio is (12)

Atr_x = AT - t_xHY.

Similarly, by using equation (7), the change in consumption as a consequence of a shift in the propensity to consume (this is the only parameter change for the purpose of deriving an expression for Ac) is

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AcF_! =

AC

- c_iAr.

1-t-i

(13)

Substitute the preceding two expressions into equation (11), divide through by F_ x, and express each macroeconomic aggregate in percentage-change form to yield, after some manipulation, AF Y-i

=

a-i

+

[(

A/_

c-i

( c_,

/ - i

i-i

^C

+

AG O-i

AY Y.h

6-i

)

- ct_1

^yr

( r_,

AF Y-t. )

)]•

(14)

Here the lowercase lagged symbols—i_1? g_ly t_1, and c_x—respectively represent the preceding year's shares in GNP of investment, government expenditure, tax revenue, and private consumption expenditure. According to equation (14), the percentage change in GNP can be expressed as the product of the underlying multiplier a _ x and a weight-

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91

ed sum (or difference) of the percentage changes in investment and government expenditures and in tax revenue or consumption that are in excess of the percentage change in GNP. Essentially, the effect on the multiplier of any changes in the tax and consumption parameters is captured in the form of excesses or shortfalls in rates of growth of revenue and consumption from actual income growth. (In the event of a unit-elastic response of revenue or consumption to GNP, the excesses or shortfalls would not be present, and the multiplier would remain unchanged.) Now deviations in the actual growth rate of Y can be denned with respect to any norm n (for example, the previous year's rate of growth or a ten-year moving average, or some other construct). Bearing in mind these possibilities, it is convenient for the discussion that follows to view n as some trend rate of growth. If parameters are unchanged, the only way the actual growth rate of Y can deviate from the norm will depend on how the rates of growth of investment and government expenditure, respectively, deviate from that norm. From equation (11), A1 AF i-1 = a_1 -----------( l-1 Y-1

AG

+ ----G-1

g-1 , )

which in balanced-growth equilibrium reduces to

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n = na_1 (i_1 + g_x).

(15)

Subtracting equation (15) from equation (14) yields AY - n = a_x -----Y-i - c-1t-1

AT

T-1 ( -------

{(

AI ------- n) i-1 I-1

Ar

)]

+ --------Y-i

[(

AG

g-1 + ------G-1 - n )

AC AY C_1 ------ - ------. ( G_1 Y-1

)}

(16)

Equation (16), which has been derived explicitly from a model, shows a close correspondence between its fiscal terms and the fiscal impulse measure stated in equation (4).3 The principal differences are that the fiscal impulse measure does not include the multiplier a_1, indicating 3

The two fiscal terms shown in square brackets correspond exactly to the formula stated in equation (4). However, an additional term, involving the coefficient (1—c)t*, is applied if the propensity to consume is less than unity. Otherwise, this term disappears.

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

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that the effects measured are first round impacts, and that the measure does not weight the revenue component by the propensity to consume c. The last omission is potentially serious, since if c is less than unity, which is normally to be expected, the fiscal impulse measure would understate the first-round expansionary fiscal impact. Provided that c is reasonably constant, the difference between FI and its more accurate counterpart would amount to one of scale, and FI would still be informative as regards first-round effects, especially with respect to their direction. Equation (16) shows the appropriateness in the fiscal impulse measure of testing the growth in a policy instrument such as government expenditure by reference to the normative growth rate n, whereas the more passive instrument of revenue is tested by reference to the actual growth in Y. Thus, the derivation supports the underlying concern of the fiscal impulse measure with identifying the active effects of fiscal policy on aggregate demand by eliminating induced effects on the budget from the overall rates of growth of the budget variables. The induced effects can only influence aggregate demand insofar as the multiplier is modified, for which the fiscal impulse measure has a builtin detection procedure. If revenue T grows at the same rate as income Y, and so does the other endogenous variable C, the terms involving these variables disappear, and a reduced form with a - 1 constant results.

Some Criticisms and Their Implications for the Use of the Fiscal Impulse Measure The simple model described here can, of course, be criticized. At best it is a partial model that focuses on the income-determination process in a limited manner. Channels of influence and feedback involving interest rates, inflation rates, exchange rates, and both general and specific expectations have been left out. Implicitly, the temporal scope of the model is short run and neglects stock movements and the effects offlowson them. Even in a simple framework, however, questions arise about the appropriate behavioral specification or theory to incorporate. There is also the issue of the intended use of the indicator. Is it for assessing the sustainability of a budget stance? Or is the purpose to examine the distortionary effects of adjustments in fiscal variables? The earliest, and still the most widespread, use of the fiscal impulse measure is to assess the aggregate demand effect of fiscal policy. The question examined here, in light of the derivations in the preceding

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93

section, is how well the fiscal impulse measure performs this latter task. At the outset it is clear that the use of the fiscal impulse measure involves a large number of more or less explicit approximations. Among the more interesting for economic analysis are the implicit assumptions that consumers are liquidity constrained, that they suffer from inflation illusion, and that investment expenditures can be assumed to be exogenous. Furthermore, although not essential, it is assumed that there is an exogenously determined trend rate of growth of the economy and that, for the typical short-run for which assessments are to be provided, the inflation-generating process can also be assumed to be exogenous (inertia). Making the latter assumption converts the nominal incomedetermination equations, such as equation (9) or (16), into real income equations. All such assumptions are in principle testable. To the extent that any of these are not appropriate, the basic model would have to be modified. This would result in possibly different multiplicands and multipliers. But the necessity of distinguishing between active and passive influences, so as to separate out the effect of the budget on aggregate demand, remains. The procedures used in constructing the fiscal impulse measure would still be appropriate, although the precise forms could vary. To illustrate, suppose consumers are not liquidity constrained, so that they are able to take a longer view in determining their current consumption behavior. The simple Keynesian consumption function of equation (7) is no longer valid and would have to be replaced by a more complex formulation that allows for longer-term considerations. Thus, reducing taxes may not increase current perceived disposable income by the full amount if the tax cut is expected to be reversed subsequently. The intended stimulative effect on consumption is then reduced. This effect would be captured, in the new model's version of equation (16), by the term describing consumption behavior: the rate of growth of consumption would be affected differently and, hence (by employing the embedded test), the active contribution of consumption behavior, which in this instance would be less. The selected theory would suggest ways in which consumption is influenced and would facilitate the calculation of this influence for inclusion in the new variant of equation (16). In this rendition, however, the fiscal impulse measure would not be affected. In general, the more complex is the theory, the more elaborate is the multiplier expression, which may involve nonlinearities. This would add more complex terms to equation

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

(16), but the initially nested terms involving government expenditure and revenue would remain.

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A Critique of Some Alternative Measures Blanchard (1990) has rejected the cyclically adjusted indicator, both as an indicator of discretionary action and (even more critical) as an indicator of fiscal impact. He agrees that it is useful to know how much of the change in the fiscal profile is due to discretionary actions and proposes a familiar indicator that involves standardizing the fiscal balance at the previous year's level of unemployment and comparing the outcome with the previous year's fiscal balance. But he rejects that such an indicator can permit any valid inferences about fiscal impact. Instead he has proposed two different indicators of fiscal impact, one of which assumes that consumers are myopic, with their behavior determined by current taxes and income. The measure of myopia that he derives from his model consists of government expenditure less revenue, which has been weighted by the marginal propensity to consume, and, insofar as consumption is influenced by interest income, less a similarly weighted flow. Because the measure involves government expenditure, revenue, and interest on the public debt, he proposes the inflation-adjusted deficit (the primary deficit that results from removing interest payments from expenditure) as a simple indicator of fiscal impact. For consumers who show foresight, as required in life-cycle theories, Blanchard has proposed (as a simplification of the more complex measure generated by his model) an actual deficit measure involving the subtraction from government expenditure of an average of the tax revenue expected for the current and future period. The horizon of the latter can be variously determined, but Blanchard's preference is for a two-year period, on the grounds that consumers generally take account of income expected in the short to medium term. Unlike Blanchard, who is constructive in his proposals and willing to make compromises and approximations, Buiter (1985) has placed heavy stress on the role of expectations in consumption behavior, which he uses to reject any role for deficit measures in assessing fiscal impact. A broadly similar assessment has been made by Auerbach and Kotlikoff (1987). These are extreme positions about consumer responses, however, and they have not been confirmed by empirical studies. Hence, for practical policymaking it can be reasonably assumed that transactors are more or less myopic in their behavior and are

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generally more heavily influenced by income and taxes in hand rather than in prospect. This is not to deny the possible role that a major future occurrence, such as a change in future pension benefits, may exert on current behavior (for example, saving). It is important to understand the context in which the fiscal impact is being assessed, which may call for a qualification to the assessment but not necessarily for the abandonment of the impact measure. The indicators proposed by Blanchard cannot be regarded as an effective replacement for the fiscal impulse indicator. The contention here is that the latter indicator contributes more than do Blanchard's two indicators of discretionary fiscal change and fiscal impact, even when these are taken together. First, the fiscal impulse indicator can be interpreted as providing an indication of the discretionary change in policy. This is because of the criteria employed in determining the fiscal impulse: whether expenditures grew faster than potential output, and similarly for revenue in comparison to actual output (the so-called unit-elastic criteria). The assumption is that a purely passive policy would merely be reflected in the operation of the automatic stabilizers of the budget. It would, of course, be possible to design the automatic stabilizers in such a way that budget responses are more than equiproportionate—for example, if the chosen tax system is progressive, revenue could grow faster than output. In such a case, where the authorities choose to enact a progressive tax system to generate expected needed revenue over the foreseeable future (rather than adopting the revenueequivalent approach of having a proportional tax system but introducing new discretionary changes each year), the literal construction— that no new discretionary changes take place after the first year—is not very helpful. Discretionary actions have clearly been taken, albeit on a deferred basis, but their multiyear impact is hidden in Blanchard's measures. The fiscal impulse measure in effect deals with multiyear policies by allocating any automatic consequences in excess of those implied by the unit-elastic criteria to the category of discretionary change. This is much simpler than undertaking the detailed estimations of elasticities, and so forth, needed in Blanchard's measure to demarcate the current year's discretionary component. Furthermore, using the unit-elastic criteria, the fiscal impulse measure distinguishes the passive from the active component of the fiscal outcome, which makes the transition to a measure of fiscal impact immediate. If the fiscal impulse is positive, the interpretation would be that fiscal policy has become more expansionary. The fiscal impulse is a more satisfactory measure of fiscal impact than the version proposed by Blanchard

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

because it identifies the active contribution of fiscal policy. Increases in Blanchard's fiscal deficit measure would always indicate a more expansionary fiscal impact. The fiscal deficit could have widened, however, because of a recession rather than as a result of policy; the distinction between induced cyclical effects cycle and policy measures, even if deferred, is central to the fiscal impulse. Having shown earlier that the fiscal impulse measure can be derived from an analytical model, we note that it too involves some approximations, just as with Blanchard's measures. These cannot be treated as shortcomings that apply only to the fiscal impulse measure, but rather as an inevitable price when seeking simplicity. The alternative would be a more complex measure that may have the advantage of corresponding exactly with an analytical formulation but that would impose more onerous data and other requirements.

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Conclusions The derivations in the earlier sections are based on a simple closedeconomy model of the short run that endogenizes national income. Would the form of the fiscal impulse measure have to be changed if the economy were open? Fortunately not, because it is easy to demonstrate that the effect of trade would be merely to add terms in equation (16). Of course, the multiplier expressions and the weights to be attached to the fiscal impulse components in an exact derivation would change, but the summary approximation would stand. The situation is more complicated with inflation, particularly given the implications of inflation for servicing the public debt. The test for neutral government expenditure in the fiscal impulse calculation is that it grow by the same amount as the nominal value of potential output. Suppose the rate of inflation were to increase by 10 percent, and this raises the nominal value of output by the same amount. According to the indicator, an increase of 10 percent in government expenditure would keep expenditure neutral. If there is significant debt service, however, the fact that interest rates are likely to rise by a full 10 percentage points could result in a bigger increase in expenditure. This the indicator would assess as expansionary, which would not be correct because the higher interest payments simply serve to compensate debt holders for the erosion in the real value of their principal. Debt holders could have been compensated instead by writing up the face value of debt, which would not have affected expenditure. The simplest way of dealing with this problem is to undertake thefiscalimpulse calculations

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97

for the primary budget balance, arrived at by excluding government interest payments altogether. Knowing the determinants of aggregate demand enhances understanding of macroeconomic performance. These determinants can conveniently be classified into ones for structural and direct impact. As is well known, the budget can exert profound effects on private behavior: tax rules could affect the pace of investment or the level of private consumption; prospective fiscal deficits could exert a Ricardian effect of depressing current consumption; the perceived net worth of government and the sustainability of fiscal deficits could influence expectations of future inflation and tax burdens, resulting in a modification of current and anticipated spending patterns; more generous social security provisions could lead to lower private savings; and so forth. Such influences are structural, since they affect the terms or conditions of private decision making. In the context of equation (16), they would change the growth rates of private consumption or investment. In contrast, the fiscal impulse indicator attempts to capture direct demand effects that the budget exerts through its spending, net of taxes. An initial fluctuation in aggregate demand is usually found to affect macroeconomic performance—at least in the short run of a year or so, before it plays out. Insofar as capacity utilization is influenced by demand, the indicator can be potentially informative about output effects. Depending on the transmission channels, other macroeconomic variables—such as afloatingexchange rate, inflation, or interest rate—can also be affected. All these variables are likely to exhibit a time-varying response pattern, with the precise time path depending on many other factors, including policies. It would not be correct to set up, as a criterion of the usefulness of the fiscal impulse indicator, its stand-alone ability to explain fluctuations in output and in other macroeconomic variables, as is sometimes done. Rather, the approach should be to identify and to isolate the contribution of other factors and policies so as to determine more appropriately how much of the residual is explained by fiscal impulses. For this purpose, equation (16) provides a useful starting point because it specifies some of the major variables that are likely to affect the determination of output. Unlike structural effects, which are less amenable to short-run manipulation, the direct impact effects of the budget can be used to counteract other sources of fluctuations in demand in an attempt at smoothing output, as in a Keynesian compensatory fiscal policy. The fiscal impulse indicator could then be used to provide a quantitative assessment of budgetary offset, which goes beyond indicating whether the budget is contractionary or expansionary in terms of its initial

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FISCAL IMPULSE MEASURES AND THEIR IMPACT

impact on demand. However, there are many pitfalls attendant to the mechanical pursuit of a compensatory fiscal policy. Structural changes, whether in the fiscal area or more broadly, can affect the underlying relationship between potential supply and demand. Continued stability may then require a realignment in the fiscal balance. For example, it is now widely believed that in the United States during the 1970s the underlying level of demand was too high, resulting in accelerating inflation. Government policies had inappropriately led to a negative (net-of-tax) real rate of interest, which stimulated private spending. With hindsight, such policies should have been accompanied by a smaller trend fiscal deficit than was observed. Superimposed on the larger underlying deficit, the fiscal balance exhibited fluctuations. Ideally, it is only after the needed fiscal consolidation is achieved that fluctuations in the budget balance, induced by automatic stabilizers or even an active compensatory policy, will promote the policy goal of a more stable macroeconomic performance. Applied prematurely in an inherently inflationary situation, a compensatory policy can paradoxically become destabilizing because it attenuates the natural brake of recessions, with adverse consequences for inflation.4 In the preceding case, the pursuit of a more appropriate secular policy offiscalconsolidation would have generated consistently negative fiscal impulses that would have cumulated to the amount of underlying or structural change in the fiscal balance required. Applying the fiscal impulse measure conveys information of use in formulating and monitoring the needed fiscal policies. Disenchantment with an incorrectly applied compensatory fiscal policy should not be an excuse for throwing the baby out with the bath water.

4

Over the nine-year period 1973-81 for which fiscal impulse calculations are readily available for the United States (see IMF (1981)), the average inflation rate as measured by the GDP deflator was 8.1 percent, or the same as the average treasury bill rate. The period-average real rate of interest for private buyers of bills was thus zero and presumably negative on a net-of-tax basis. The period-average prime lending rate amounted to 10.7 percent, which is positive in real terms but negative if account is taken of the tax deductibility of interest expense and the high tax rates then prevalent. A bias was thus created in favor of borrowing, excessive consumption, and real asset acquisitions (inflation hedges). However, the cumulative fiscal impulse over this period amounted to -0.5 percent of GNP, indicating virtually no change in the underlying fiscal balance. Thus, there was no sustained fiscal offset to excessive private spending, which would have been needed to restrain rising inflation.

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References

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Auerbach, Alan J., and Laurence J. Kotlikoff, Dynamic Fiscal Policy (New York: Cambridge University Press, 1987). Blanchard, Olivier J., Suggestions for a New Set of Fiscal Indicators, Department of Economics and Statistics Working Paper 79 (Paris: OECD, April 1990). Blinder, Alan S., and Stephen M. Goldfeld, "New Measures of Fiscal and Monetary Policy, 1958—73," American Economic Review, Vol. 66 (December 1976), pp. 780-96. Blinder, Alan S., and Robert M. Solow, "Analytical Foundations of Fiscal Policy," in The Economics of Public Finance, ed. by Alan S. Blinder and others (Washington: The Brookings Institution, 1974). Buiter, Willem H., "A Guide to Public Sector Debt and Deficits," Economic Policy, Vol. 1 (November 1985), pp. 13-79. Chand, Sheetal K., "Summary Measures of Fiscal Influence," Staff Papers, IMF, Vol. 24 (July 1977), pp. 405-49. Chouraqui, Jean-Claude, Robert P. Hagemann, and Nicola Sartor, "Indicators of Fiscal Policy: A Reassessment," Economics and Statistics Department Working Paper 78 (Paris: OECD, April 1990). Heller, Peter S., Richard D. Haas, and Ahsan Mansur, A Review of the Fiscal Impulse Measure, IMF Occasional Paper 44 (Washington: IMF, May 1986). International Monetary Fund, World Economic Outlook (Washington, 1981 and 1984).

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

Part III

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Conventional and Adjusted Fiscal Deficits

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

6 The Cash Deficit: Rationale and Limitations

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Jonathan Levin IN THE SEARCH for comprehensive concepts portraying government interaction with the rest of the economy, it is important to keep in mind the starting point for many such concepts—the government's overall cash deficit or surplus, hereafter referred to as the cash deficit—and the underlying conditions on which it rests. Founded on the principle that government is different from other institutions and must be measured separately and differently from them, the cash deficit is restricted to the transactions of units carrying out the functions of government. Although the operations it summarizes reflect past occurrences and carry implications for the future, the cash deficit measures only the direct impact of government cash payments and receipts in the current period. Finally, the cash deficit draws a balance of these receipts and payments, showing only whether the government is able to cover outlays for public policy objectives during the current period without drawing down the liquidity holdings it has built up in the past or creating debt obligations it will have to repay in the future. Some alternative concepts of the deficit reflect particular departures from the institutional coverage or the cash basis of the cash deficit. Others prefer to rearrange the array of components used to calculate the cash deficit. An examination of the rationale and limitations of the cash deficit may lead to a better understanding of its role as a summary measure and as the point of departure for other deficit concepts. As the capstone of an extensive body of statistics covering the government's revenues, grants, expenditures, lending minus repayments, and financing, the cash deficit can best be understood in terms of the basic characteristics of these underlying statistics. To explore these

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DEFICIT: RATIONALE AND LIMITATIONS

characteristics as they relate to the cash deficit and the formulation of other deficit concepts, this chapter examines the rationale and implications of (1) the coverage of the transactors whose operations are to be counted, (2) the cash basis of the transactions to which the count is restricted, and (3) the particular array of payment and receipt transactions for which the cash deficit balance is struck.

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The Borders of Government Government is different from other institutions. Government has a monopoly of force, permitting it to impose regulations and exact compulsory levies on other sectors of the economy. Government is concerned not with the maximization of its profit or utility, but with public policy, so that it distributes funds through transfers, provides free services to the community and to individuals, and lends to promote public policy objectives when it appears that the market will not do so at acceptable rates. In short, the government carries out nonmarket functions for nonmarket motives. To facilitate the measurement and analysis of government as an aggregation of units with homogeneous motivation and behavior, the government sector is defined by its function: to promote public policy by the provision of nonmarket services and the transfer of income, paid for primarily with the proceeds of compulsory levies on other sectors. One nonmarket service provided by government is regulation, which can have powerful effects on the rest of the economy without the passage of any financial flows through government. Although the measurement of government finance does not encompass the effects of regulation, the analysis of these effects is obviously critical to the conduct of government and to the proper working of the economy. Government is distinguished from the enterprise sector by the fact that government does not provide market goods or services. Government units that sell (and are distinguishable on the basis of complete accounts) are classified outside government, in the corporate or quasicorporate enterprise sector. Government is distinguished from financial institutions by the characteristic of financial intermediation. Government units that have the authority both to incur liabilities and to acquire financial assets in the capital market are classified outside government, in the financial institutions sector.

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The delineation of government by its characteristic functions, however, is complicated by the government's exercise, in addition, of ownership or control. For a variety of reasons, governments have found it useful to acquire or control particular nonfinancial enterprises and financial institutions. To follow the broader scope of activity that may result, the identification of such units, and their grouping with government as part of a public sector, can be helpful in some circumstances. Such units are designated as nonfinancial public enterprises or public financial institutions in the IMF's A Manual on Government Finance Statistics (IMF (1986)) and the United Nations' (1986) A System of National Accounts (see also Levin (1991)) if the government holds 51 percent of their equity—either directly or through other enterprises or institutions—or holds less than 51 percent of their equity but exercises control over them. The assumption in grouping together nonfinancial public enterprises or public financial institutions is that their behavior may differ from institutions in the private sector and may carry different implications for government and the economy. Where this is not the case, separate measurement of public sector institutions other than government may have little merit. Because some aspects of public policy may be reflected in the activities of various parts of the public sector—the government, the nonfinancial public enterprises, or the public financial institutions—it is sometimes useful to measure together all or selected parts of the public sector. The differences between nonmarket, market, and financial activities, however, raise methodological problems about the meaning of some combined measures in such consolidation. The elimination of data for significant flows between parts of the public sector in the course of the consolidation process presents additional difficulties. For particular analytical purposes, therefore, an appropriate measure of public activity may be a consolidated picture of the nonfinancial public sector, or of the nonmonetary public sector—excluding the central bank and other public monetary institutions—or of the entire public sector. The choice may be influenced by the activities carried out by the various institutions in the public sector and by the relationships among them. Political relationships cannot always be contained by their definitions, however, and the assumptions of characteristic spheres of activity can give way to the exigencies of political circumstance. Central controls can lead to a decentralization of functions, and accounting systems can be bypassed. Activities normally characteristic of government can be found to be carried out by enterprises and financial institutions that might ordinarily be expected to be seeking to maximize

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DEFICIT: RATIONALE AND LIMITATIONS

profits. In such circumstances, several alternatives for the realistic portrayal of government activities are possible. • Most government-like activities carried out by enterprises and financial institutions are reflected in the government's accounts through government provision of subsidies, capital transfers, or lending to these units. When this is so, no adjustment of the government's accounts is necessary. • Other activities clearly uncharacteristic of enterprises or financial institutions—such as the collection of taxes—are undertaken for government in an agency capacity. These activities are ascribed not to the enterprise or financial institution but to the government. When data permit the separation of such activities (and their offsetting inflows or outflows) from other activities of the units carrying them out, they are consolidated with statistics for the other activities of government. Identification of the offsetting inflow or outflow, however, may sometimes be difficult. When the proceeds of taxes collected by an enterprise are not remitted to government, for example, an implicit transaction consisting of a government subsidy to the enterprise is recognized as having taken place. • When government-like activities are not clearly separable from the remaining activities of enterprises or financial institutions that carry them out, consolidation of all their activities with those of the government may be necessary, portraying a larger portion of the public sector than the government alone. This may be the case, for example, when such government-like activities are financed not with funds coming from the government but with credit from elsewhere. Although they may eventually result in government outlays, such government-like activities have an impact on the economy in the current period. This effect is revealed not by the government's accounts but by the accounts of the relevant enterprises or financial institutions, reflecting their operations and the credit extended to them. Although consolidation of data for government with data for enterprises and financial institutions runs the danger of combining activities that are basically dissimilar, this generally can be avoided by showing separately activities of a current nature and combining only saving, capital transactions, and financing. The resulting statistics can then portray the appropriate portions of the public sector, the nonfinancial public sector, or the nonmonetary public sector.

Cash-Basis Data Cash-basis data measure the most direct impact of government operations on the economy in the current period. Proposals for the modifi-

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cation or replacement of cash-basis data stress the importance of other influences in addition to payments and receipts and the need to view future periods as well as the current one. Besides portraying the management of government finances, data on government payments and receipts provide what is probably the best single measure of the impact of government finances on the behavior of the rest of the economy. There are other important government influences on private sector behavior, however. On the government expenditure side, these may include government purchase commitments, actual delivery of goods, authorization of payment, and the accumulation of unpaid bills. On the government receipt side, they may include the accrual of tax liabilities, the issuance of tax assessments, and the arrival of due dates. Statistics on each stage registered in the government accounts constitute important supplementary measures of government finance. In addition, however, where it is believed that other stages—such as government purchase commitments or taxes due—have a greater impact on private sector behavior than government payments or receipts, recommendations are sometimes made for using data for these stages in place of cash data. Many of these stages represent variations on an accrual basis, which differs from the cash basis essentially in the periodization of activities. Whereas the cash basis registers transactions when payment is made, the accrual basis assigns receipts and disbursements to the periods in which they are deemed to apply—for example, when the money is earned, when the resources are used, or when the liabilities arise. Accrued data will differ from cash data, therefore, because of unmet liabilities—either private or governmental—and resources, such as capital assets, paid for in one period and used in another. One major government influence on the rest of the economy that is not reflected in government finances is regulation. Although health, safety, and environmental regulations can impose substantial costs on some enterprises, with the resulting benefits accruing to the community, employees, customers, or neighboring inhabitants, these costs are not measurable by the flow of funds through government. Wage and benefit regulations, for example, can mandate significant flows between employers and employees. The costs, benefits, and effects of such regulations may be the subject of considerable study and debate, but they do not fall within the scope of government finances. Enterprise costs that are not paid to government do not constitute taxes, and household receipts that do not come from government are not government expenditures. Attempts to combine such redistributions with flows that pass through government cannot be complete, because the

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extensive nature of government regulation gives rise to effects that cannot be readily captured, and may serve to obscure the delineation of actual government payments and receipts. Because government activities and motivations are nonmarket in character, the amounts of government payments and receipts may not always reflect what may be taken to be their market value. Attempts are sometimes made, therefore, to gauge the market value to recipients of particular government activities. This may include, for example, the value to recipients of government lending at below-market rates, or of government provision of loan guarantees. Estimation of such values provides an important underpinning for analysis and determination of policy. Assigning values to most government activities, however, must remain a difficult, perhaps heroic, task so long as such activities take place outside the market. Moreover, although a comparable market may exist, the entry of government activities could significantly affect market prices. The national accounts, which must value government output to arrive at totals for the economy as a whole, find it necessary to value government output by the amount of government inputs, as part of a comprehensive valuation of the product of government on an accrual basis. Partial attempts to combine actual government payments and receipts with the values assigned to selected government activities have many disadvantages, however, among them loss of the actual payments numbers and the doubtful significance of the resulting combined totals. One influence on private sector behavior that is not fully reflected in cash-basis data for government finances in the current period is the anticipation of future government activities and their effects. To the extent that future levels of taxation, benefit payments, and debt operations influence private sector economic behavior in the current period, cash-basis data on current-period government finances present an incomplete guide to the impact of government. Anticipation of future government activities is, of course, also a vital component of responsible government management. Some implications for future developments are contained in current-period payments and receipts—as in data for borrowing, lending, capital expenditures, and social security contributions, for example—but additional analysis is clearly required. Perhaps the chief disadvantage of cash-basis data in this connection is the failure to reveal the accrual of hidden liabilities. Some accruing liabilities, such as those for unpaid bills, emerge as the difference items between cash and accrual data and may be shown as supplements to each. Other hidden liabilities require more extensive analysis, including actuarial and demographic calculations in connection with pension

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or social insurance programs and the examination of risk factors in connection with contingent liabilities. A full analysis of such influences on future government activities requires separate study of each element—social programs, debt, contingent liabilities, environmental deterioration, and the like—and their combination to identify the resulting overall prospects. This can then serve as a basis for appropriate government planning and analysis of possible anticipation as an element in private sector behavior. Combination of elements affecting such projections with currentperiod government payment and receipts, like other combinations discussed above, risks the loss of actual payment numbers for concepts best shown separately.

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The Deficit Concept Besides its limitation to the actual receipts and payments in each period of institutions performing the particular nonmarket functions identified as governmental, the cash deficit represents the balance struck on the basis of a particular array of transactions. The government's deficit equals the portion of expenditure and of lending undertaken for policy purposes that exceeds its receipts from revenue, grants, and loan repayments. This array serves two purposes. First, it indicates whether the government is covering its policy objectives with the money coming to it in the present period, without drawing down the liquidity holdings it accumulated in the past or issuing obligations it will have to pay off in the future. Second, it provides a summary measure, as a starting point, for analysis of the government's impact on the rest of the economy, on the assumption that the component categories from which the cash deficit is calculated engender a relatively homogeneous behavioral response. It assumes, for example, that economic units—households and enterprises—react differently to the receipt of interest, which is classified in government expenditure (above the deficit or surplus line), than to the return of capital, which is classified in government financing (below the line). With the behavioral rationale in mind, even intractable questions such as whether to classify indexation payments on government debt as interest, above the line, or as amortization, below the line, can be approached empirically on the basis of the predominant behavioral response. From the starting point of the cash deficit, analysis of government impact proceeds to the different kinds of government borrowing—from

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abroad, from the central bank, from other monetary institutions, from other financial institutions, and from the nonfinancial sectors—each bringing different financial effects and in some cases leading to measures labeled as different deficit concepts. In some budget concepts that go well beyond the summary measure to the components of the cash deficit, the differing effects of government taxes, wages, purchases, transfers, interest payments, capital expenditures, and lending are also delineated for analysis and are assigned weights depending on their assumed or calculated effects on aggregate demand. The components of government activities are also arrayed to measure the government's current account surplus or deficit, comparing current receipts with current expenditures to show the resulting government saving or dissaving. Should an excess of current expenditures over current receipts be covered with the government's proceeds from the privatization of public enterprises, for example, the current account deficit would register the dissaving. The cash deficit also constitutes the starting point for adjustments normalizing the deficit to conditions in the economy as a whole— measuring its appropriateness, for example, in relation to full employment, the business cycle, or the effects of inflation. Because the cash deficit presents a measurable goal for internal government management with identifiable implications for the broader monetary objectives, it has been adopted in many instances as a performance target—supplemented frequently by ceilings on unpaid bills and central bank or monetary system net claims on government—in programs to contain the financial demands on an economy seeking to overcome inflationary and balance of payments difficulties. The effectiveness of selective targets is sometimes hampered, however, by their need to followfixeddefinitions so as to remain measurable, despite the fact that some activities may be shifted to units that are not covered. Difficulties may arise from items close to the borderline of categories classified above the deficit or surplus line as determining the cash deficit—grants and lending minus repayments, for example. Grants received from other governments or international organizations may be given either for particular projects—counted in expenditures, above the line—that might not otherwise be undertaken or for more general support to reduce or cover a deficit. Opinions vary, therefore, about whether grants should be classified above the line, as deficitdetermining, or below the line, as deficit-financing. The separate identification of grants permits the calculation of deficits either including or excluding the receipt of grants. So long as the deficit used is properly

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identified to avoid confusion, either choice can serve particular purposes in particular circumstances. A related problem arises with some government borrowing, which remains classified in financing, below the line, although it may contain a sizable grant element. A fifty-year loan at concessionary interest rates, for example, adds to the government's future payment obligations but creates far less of a burden than a short- or medium-term loan at commercial rates. Although this may be taken as one more instance of all distinctions breaking down at the margin, it may also illustrate the rationale for moving the margin, as when limits are set on government borrowing only below particular maturities. Problems with the definition of the cash deficit arising from government lending are different in character. They arise not because government lending may contain large grant elements and may not be repaid, since lending is classified, like expenditure, above the line as a cost of carrying out public policy, and repayments, when they occur, reduce the deficit, as revenues would. Difficulties arise, rather, in the case of government onlending, when, instead of extending a government or central bank guarantee to facilitate a public enterprise's borrowing abroad, the government may itself borrow, at the lower rate available to it, and on-lend the funds to the public enterprise. Because the government itself takes on the debt to the foreign lenders directly, its financing abroad increases, as does its lending. This increases the deficit when the onlending occurs and decreases it in the later period when the lending is repaid. From the view of the economy as a whole, whether the operation is carried out through onlending or a government guarantee may be essentially equivalent, with each government operation counterbalanced by movements in the accounts of the public enterprises concerned. So long as performance criteria are selective and only partial in their coverage, however, economically equivalent occurrences can have contrary effects, satisfying or violating the ceilings depending on whether the assumptions of continued operating methods prove valid. Paradoxically, programs undertaken to promote economic conditions permitting fewer controls may be weakened by the setting of performance controls with too limited a coverage. To some extent, of course, this reflects the more limited availability of current data for activities outside government. It underscores, however, the need to recognize the limited scope of the government's cash deficit, which measures only the direct impact of the government's receipts and payments in the current period, and which must be supplemented with data for

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other sectors and for other government influences when more complete analysis of the economy is required.

Conclusions Whereas the rationale for the cash deficit is applicable in the circumstances and for the objectives on which it is based, recognition of departures from these circumstances and a desire for expanded analytical objectives has given birth to numerous variations on the concept of the cash deficit. Such additional deficit concepts may be necessary for several reasons: (1) to expand coverage to other institutions performing government functions; (2) to embrace government actions found to be affecting private sector behavior other than through current-period payments and receipts; (3) to reflect cyclical or inflationary variations in overall economic activity; or (4) to adjust for borderline variations in the character of some categories of government operations. The applicability of each deficit concept can be determined empirically, on the basis of observed compliance with its assumed conditions and of behavioral relations found to be analytically significant. As the starting point for such further analysis, the cash deficit has a defined, delimited, role to play alongside the various adaptations of its rationale to altered circumstances or expanded objectives.

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References International Monetary Fund, A Manual on Government Finance Statistics (Washington, 1986). Levin, Jonathan, "Transactor Coverage: Borderline of General Government— Nonfinancial Enterprises or Establishments," in "A Discussion of Public Sector Accounts," Chapter 16 of The IMF's Statistical Systems in Context of Revision of the United Nations' A System of National Accounts, ed. by Vicente Galbis (Washington: IMF, 1991), pp. 223-28. United Nations, Department of Economic and Social Affairs, Statistical Office of the United Nations, A System of National Accounts, Studies in Methods, Series F, No. 2, Rev. 3 (New York, 1968).

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7 Government Arrears in Fiscal Adjustment Programs

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Jack Diamond and Christian Schiller SEVERAL YEARS AGO the existence of government expenditure arrears, indicating delays in a government's payments to its suppliers and creditors, emerged as an important fiscal issue.1 Given accounting conventions, it became evident that the presence of arrears could lead to an underestimation of expenditure and, correspondingly, of the impact of government operations and the size of the fiscal problem facing a country. Because arrears can be viewed as a form of "forced financing" to the government, the government's borrowing requirement may also be underestimated, yielding a distorted picture of the sources of credit expansion in an economy. Arrears were also found to create problems in the context of adjustment programs. It was discovered that, when fiscal adjustment was less than programmed or there had been unprogrammed shortfalls in other sources of financing, a buildup of arrears could become a means by which governments reconciled the constraint on domestic bank financing. Such an unprogrammed accumulation in government internal and external arrears could circumvent the desired fiscal adjustment. This chapter stresses the significance of government expenditure arrears, with particular emphasis on how the problem may be identiNote: The authors benefited greatly from discussions with their colleagues in the Fiscal Affairs Department and would like especially to acknowledge the helpful comments and suggestions of Peter Heller, Kevin O'Connor, and Hjordis Bierman. Earlier versions of this chapter appeared as Diamond and Schiller (1987, 1988, 1991). 1 Another, no less important and often interrelated, problem is revenue arrears to the government—for example, taxes levied but not collected and uncollected loan repayments due to the government. This chapter will deal with the implications of this other "arrears" problem only tangentially.

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fied, quantified, presented in fiscal tables, and integrated into policies of fiscal adjustment.

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Quantitative Significance of Arrears The significance of government domestic arrears for fiscal policy emerged in the 1980s when implementing adjustment programs in developing countries. Although arrears were recognized as a problem in many developing countries, for reasons discussed later, obtaining accurate data on arrears was found to be extremely difficult. Nevertheless, a brief description of the available data on arrears serves to illustrate the dimensions of the problem that was emerging. It was found that government domestic arrears were factors of importance in the financial programs of at least 17 of the 66 countries that had IMF-supported adjustment programs during the period 1980 to mid-1985 (IMF (1986a)). Twelve of these countries were in Africa; two were in the Western Hemisphere; two were in Europe; and one was in Asia. It was not possible, because of problems of identification and quantification, to show the entire outstanding stock of government arrears in these countries. Changes in the stock of arrears (both domestic and foreign), which had been quantified during IMF-supported programs, can be used, however, to give some sense of the magnitude of the flow of arrears relative to both total government expenditure and total government financing (Table 1). These statistics are meant simply to illustrate the character and significance of the arrears problem. Considerable caution is required in appraising these data. For reasons discussed below, the definition of arrears varies among countries, and it may well be that "identified" and "verified" arrears understate the true magnitude of outstanding arrears. Even intertemporal comparisons for any one country are difficult because one often observes changes in coverage and definition as well as institutional changes in procedures for recording arrears. Even with these caveats, the size and importance of the arrears problem during this period can be appreciated from the statistics of Table 1. In 7 of the 14 countries shown, changes in arrears were the equivalent of 10 or more percentage points of total recorded expenditures. Such a change is likely to have a considerable impact on the rest of the economy, yet it cannot easily be discerned from the budget accounts conventionally used to analyze the impact of the budget. As a source of financing, the change in recorded arrears was 10 percent or more of the total financing requirement of the government's recorded

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Table 1. Government Arrears in Program Countries Change in Identified Arrears as Percent of Year

Expenditure

Cash deficit

1983/84

+ 3.0

+ 16.0

African country 1

1982 1983

+ 0.5 + 2.1

+ 4.9 + 14.1

African country 2a

1982 1983 1984

+ 2.2 + 10.1 -7.0

+ 7.1 + 59.2 -39.9

African country 3 b

1980/81 1981/82 1982/83 1983/84

+ 1.9 -1.6 + 2.1 -2.1

+ 5.6 -6.2 + 6.4 -8.9

African country 4c

1980 1981 1982 1983 1984

-0.1 -0.1 -0.2 -2.5 -5.1

-0.2 -0.3 -0.5 -8.2 -23.9

African country 5

1980 1981 1982 1983 1984

+ 4.0 -1.2 -10.4 -7.7 -0.9

+ 20.3 -6.4 -53.2 -22.1 -3.7

African country 6d

1980 1981 1982 1983 1984

+ 1.1 -0.5 + 6.3 -7.7 -0.9

+ 3.6 -1.2 + 22.8 -22.1 -3.7

African country 7

1979/80 1980/81 1981/82 1982/83 1983/84

+ 2.6 + 2.0 + 12.1 -1.4 -12.6

+ 9.1 + 4.6 + 47.1 -3.5 -29.0

African country 8d

1979/80 1980/81 1981/82

+ 4.3 + 8.0 -9.8

+ 35.0 + 28.4 -28.0

Country

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Latin American country 1

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Table 1 (concluded) Change in Identified Arrears as Percent of Year

Expenditure

Cash deficit

1982/83 1983/84

+ 2.7 -9.1

+ 10.2 -32.9

African country 9

1980/81 1981/82 1982/83 1983/84

+ 6.0 + 18.5 -9.2 + 1.5

+ 15.8 + 42.3 -15.4 + 3.5

African country 10e

1980/81 1981/82 1982/83 1983/84

+ 3.0 + 8.5 + 8.7 -0.7

+ 4.1 + 26.0 + 32.1 -32.4

African country 11

1980 1981 1982 1983

+ 2.8 -1.5 -11.0 + 2.6

+ 9.6 -4.1 -22.7 + 11.5

African country 12

1982 1983 1984

+ 3.8 + 10.0 + 7.6

+ 12.5 + 109.2 + 171.1

European countryf

1980 1981 1982 1983 1984

+ 1.4 + 5.8 -1.9 + 5.2 + 1.7

+ 6.8 + 100.0 -16.6 + 53.5 + 6.6

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Country

Source: IMF staff estimates. Coverage relates to the nonfinancial public sector; it also includes arrears on external amortization payments. b Identified arrears up to 1984/85 include only arrears on interest. Expenditure up to 1984/85 is a mixture of checks issued and commitments; deficits prior to this time may be underestimated because data on the accumulation of domestic arrears are unavailable. "Unallocated expenditures (net)" was 5.6 percent of the total cash deficit in 1980/81, 6.2 percent in 1981/82, 13.1 percent in 1982/83, and 16.4 percent in 1983/84. The latter is calculated as a residual, including unrecorded expenditure items, change in paycheck arrears, and check float, along with statistical discrepancies. c Change in deferred payments, including payment of arrears. d Includes arrears of central government and decentralized agencies. e Domestic arrears only. f Change in accounts payable. a

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cash deficit in at least one of the years shown in Table 1. For 11 of the 14 countries, the change in arrears reached over 20 percent of total financing in at least one year; in 4 countries it was over 50 percent in at least one year, and in 1981 the increase in recorded arrears in the European country appeared to have been equivalent to the overall government financing requirement. Aside from its magnitude, the change in arrears displayed a much greater degree of volatility over time than other fiscal aggregates. For example, consider the impact of such fluctuations in arrears on small economies such as African country 7, which increased arrears in 1981/ 82 by 12 percent of total expenditure and reduced arrears by almost 13 percent in 1983/84; or African country 9, which increased arrears in 1981/82 by 18.5 percent of expenditures and in the following fiscal year reduced them by 9.2 percent. Undoubtedly, some of these delays in payment were short—perhaps a few days—and others were prolonged. Although it would be preferable to focus on the latter when measuring the volatility of changes in arrears, in practice it was found that this group of delayed payments could not be separated in the data. In part, these fluctuations in arrears were frequently associated with the constraints imposed by the need to meet credit targets, but in part the discovered volatility also reflected changes in recording procedures or changes in valuation (particularly if arrears were on external obligations, which are sensitive to exchange rate changes). Unfortunately, the variability discovered in the series is also likely to reflect the fact that changes in arrears often function as a "balancing item" in the fiscal accounts. Whatever the reason, the size of the change in arrears, coupled with its volatility, implied considerable adjustment on the part of the private sector in accommodating such changes. It also suggested that, for many countries, the elimination of arrears posed considerable obstacles to fiscal adjustment.

Problems of Identification In principle, the concept of arrears appears uncomplicated: arrears equal the total outstanding obligations due for payment that the government has failed to discharge. Normally, claims that have been referred to adjudication, or are found wanting in documentation, should be excluded. Similarly, so-called arrears arising from pay revisions with retrospective effect are also excluded. The aim is to isolate those payments for which claims have been established but which are kept pending for prolonged periods, usually for lack of necessary funds. The

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GOVERNMENT ARREARS IN FISCAL ADJUSTMENT PROGRAMS

only obvious discretionary issue is the definition of when the time lag between the creation of a payment obligation and its discharge becomes so abnormal as to imply the existence of arrears or, in the case of a prolonged delay, a default. In practice, the identification and measurement of arrears based on the notion of a "greater-than-normal" delay is rarely straightforward. Although legal requirements usually fix the date for payment, there can be considerable administrative lags in the processing and recognition of the legal obligation to pay. Obviously the emergence of arrears signifies either a government's unwillingness or its inability to discharge its payments obligations during a given period of time. The accumulation of domestic budgetary arrears in some countries may, in part, reflect the monetary arrangements or legal requirements that limit a government's access to central bank credit. For example, in those Francophone African countries sharing a common central bank, legal limits are placed on a government's central bank borrowing; once that limit is reached, arrears become the balancing item between total commitments and other sources of finance. In most other countries (for example, with British institutional arrangements), legal limits on the government's ability to borrow from the central bank rarely apply, and therefore the government typically has no difficulty in staying current in its domestic obligations. Domestic arrears, however, have recently become evident in some of these countries, especially when limits have been placed on government domestic bank financing (or domestic statutory limits have been placed on spending or credit to the public sector). Such limits have made it tempting for the government to accumulate arrears to circumvent these limits. Similar differences are evident in the reasons for the incurrence of foreign arrears. In most non-Francophone countries of Africa and Latin America, foreign arrears reflect a shortage of foreign exchange, which constrains the externalization of government payments to meet foreign currency commitments. Yet, because within limits many Francophone countries (particularly in Africa) have access to the French Treasury, the problem of externalization of payments tends not to be the binding constraint in meeting their external obligations. Rather, for these countries the problem remains one of obtaining local funds with which to meet these obligations. As a consequence, in causal terms, domestic and foreign arrears in many Francophone countries have arisen from a common source. Countries may also differ substantially in the means available to identify and quantify arrears. It is not possible in this chapter to describe comprehensively the many forms in which arrears may origi-

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nate or be identified. In some cases, differences are grounded in the type of budgetary accounting systems from which a country's accounting practices have evolved. This chapter will focus on the characteristics of the types of accounting systems typically found in African countries following the French and British budgetary traditions. Of course, many of the difficulties involved in identifying and quantifying arrears in these countries are also common to a number of Latin American and Asian countries.

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The British System In its simplest form, the spending procedures of the British budgetary and accounting system involve the following steps. After receiving the authorization to spend, ministries or spending departments may enter into commitments with suppliers for the purchase of goods and services. After verification, the deliveries of these goods and services signify an obligation to pay on the part of the government. Payment orders are usually prepared and issued by the receiving ministry after certification that delivery has been made. Spending departments are usually required to maintain commitment ledgers and to record payment order releases against authorized appropriations (sometimes called vote books). Although the comparison of actual deliveries with payment orders issued is expected to be carried out by spending departments as part of their day-to-day operations, this is usually not monitored government-wide. On the basis of these payment orders, checks or warrants are issued by the treasury or the ministry payment officers and sent to the suppliers. When these checks are presented at the banks, and the treasury or ministry accounts debited, the government can be said to have discharged its payment obligations. Normal delays in the government's meeting these obligations obviously arise from inevitable time lags in its spending procedures. Typically, delays in final payment are a manifestation of delays at earlier stages, and not the last stage, in the spending process—that is, in the recording of deliveries, the issuance of payment orders, the processing and preparation of payment checks, or the actual issuance and release of checks (Table 2).2 2 Although the concept of arrears in this accounting system, as in the French accounting system, is typically held to signify the existence of delays over and above some normal level at the last stage of the payments process, it is important to stress that delays can also originate at any of the earlier stages.

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Table 2. Arrears and Time Lags in the Stages of the Expenditure Process British System

Stage Authorization

Budgetary appropriations authorized

*

Contracts signed and procurement begun

**

{ { {{ {

Payment order {

{

Data Availability * Budgetary appropriations authorized French System3

Contracts signed and procurement begun (engagements)

**

Work completed and bills received

** Work completed and bills received

**

Spending agencies verify and issue payment orders

** Spending agencies verify ** and issue payment orders (verification, liquidation, ordonnancement)

Commitment

{

Data Availability

Points at Which Arrears May Emerge

(1) Delays in recording deliveries

GOVERNMENT ARREARS IN FISCAL ADJUSTMENT PROGRAMS

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Payment order

Gash

{ { { {

{ { { {

Treasury processes payment orders and issues checks

* Treasury processes payment orders and issues instrument of payment or makes entry in deferred payments account

*

(2) Delays arise at this level if payment orders are not sent and received by treasury (3a) Delays arise at this level if payment orders received are processed with entry to deferred payments account (French system)

Exit from deferred payments account as checks are issued

(3b) Delays in issuing checks (British system)

Checks are received and cashed (difference equals check float)

Checks are received and cashed (difference equals check float)

Checks cashed

* Checks cashed

(4) Arrears proper are identified at this stage if there are excessive delays caused by * insufficient funds to encash checks (increase in check float)

*Data available, usually in consolidated form; **data available only on disaggregative basis. In the French budgetary and accounting system, administrative accounting pertains until the treasury processes payment orders and issues instruments of payment; at that point, treasury accounting commences.

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a

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In an ideal world—with current data available on goods delivered, payment orders issued, checks issued, and checks cashed—it would be comparatively easy to identify deviations from normal lags in the system. In some countries following the British budgetary and accounting system, however, the most current (and often the only) data available will be checks-issued expenditure data, so that it is possible to identify only the check float (that is, the recorded difference between total checks issued and total checks cashed). This would still leave unsolved the difficulty of separating the normal level of check float from the component that truly signifies a buildup in arrears arising from normal processing delays. In other cases, the only expenditure data available are likely to be either on a commitment (prior to deliveries) basis or on a payment-order basis (subsequent to deliveries), giving rise to a discrepancy between the latter totals and the total of checks cashed. In cases in which only commitment data are available, some of this discrepancy should in principle not be classified as arrears—for example, the amount of commitments for services not yet delivered. Even the emergence of a significant difference between the value of payment orders issued and the amount of checks cashed—the total of unpaid obligations—overstates the magnitude of arrears, consisting of both the normal check float and those obligations that the government has not yet discharged. The latter may reflect normal lags in the preparation of payment orders and check issuance, but it may also reflect obligations that the government either cannot discharge (arrears proper) or refuses to discharge (claims disputed by the government). Thus, in the British accounting system, it is usually quite difficult to measure arrears accurately from the available statistics, which are often incorrectly referred to as the check float. Because arrears may embody any one of the earlier stages between the commitment of an order and the issuance of a check, some crude rules of thumb are typically used to identify deviations of the available check float measure from the levels that have normally prevailed in the past. For example, past levels of check float are often related to some otherfiscalaggregate, such as total revenues or the sum of total expenditure and check float. Significant deviations are typically imputed as a crude measure of arrears. The French System The identification of government arrears in countries that have adopted the French budgetary and accounting system encounters dif-

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ferent problems. A common feature of the French system is the need to distinguish between two separate stages of the accounting system: the administrative accounting phase (comptabilite administrative) and the treasury accounting phase (comptabilite du Tresor). Whereas the former covers the initial stages of expenditure implementation (from the point at which goods and services are ordered until a payment order is issued), the latter encompasses the financial phase (from the arrangement of payment through the discharge of the government's payment obligation). (For a comparison with the British system, see Table 2.) In the administrative accounting phase, expenditures are first recorded as commitments (engagements) when a purchase order or contract is signed. Commitments are generally proposed by the spending agency, usually with the approval of the Ministry of Finance.3 After the service has been rendered (or the goods are delivered) and the corresponding bill is received, the spending agency verifies that the service was actually performed (verification) and establishes the exact amount of the claim (liquidation). Then a payment order is prepared by the spending ministry and sent to the treasury (ordonnancement). This is the last stage at which expenditures are recorded in the administrative accounting system. Normally, the payment orders are recorded by budgetary items. The treasury executes the financial phase of the expenditure process and records this in its accounts. The monthly statement of accounts (balance generale des comptes du Tresor) shows the position of each account and their movements from the beginning of the fiscal year.4 After a payment order has been received by the treasury and acknowledged as valid (visement) and the check is signed and released (mandatement), the expenditure is recorded in the accounts of the treasury, thus debiting the expenditure account. The counterentry can be made in various accounts, depending on the manner in which (and how quickly) the government discharges its payment obligations; frequently, a financial account or a third party account (if the payment 3 In general, the Ministry of Finance has a representative in all spending agencies who must approve all proposed commitments to ensure that they are in agreement with the budget allocations. In many countries following the British system, a similar checkpoint exists in the form of treasury financial officers assigned to the spending departments. Unfortunately, in many countries the control exerted on the spending department is ineffective. 4 These movements are used to adjust the ordonnancement data, which are typically the raw material for the processing offiscalaggregates in the IMF's Government Finance Statistics (GFS).

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is to be credited directly to the payee's account with the treasury) is credited. In many countries an important means of payment is the cash voucher (bon de caisse), which is used for expenditure either on personnel or on goods and services. The cash voucher can be cashed at the treasury or at any local branch of the treasury. The cash vouchers are used not only for general budgetary expenses, but also for extrabudgetary accounts and local governments. The treasury may decide to defer payment on payment orders received that are otherwise perfectly regular and valid. In this case the credit entry is made in the deferred-payment (virements differes) account. When payments are actually made, these accounts are debited by the credit of the financial account concerned. A special kind of deferred-payment account is the account for expenses to be settled in the following month.5 Thus, in the French system, in principle it is relatively easy to identify government arrears with regard to the expenditures that have entered the accounting system of the treasury. One has only to take the balances of the accounts recording expenditures that are to be paid. These typically include the deferred-payment accounts (arrieres de paiement) and the account that records the outstanding amount of cash vouchers. In many countries, experience shows that the deferredpayment accounts have been frequently used as balancing items between expenditure commitments and available financial resources. Arrears reflected in the outstanding amount of cash vouchers differ somewhat from other treasury arrears. The instrument of payment has been issued, and it is up to the payee to present these vouchers to the cashier in the treasury. In this way the treasury has no real control over the amount of outstanding cash vouchers and cannot ensure that the outstanding amount of cash vouchers does not exceed the normal float. The situation is, however, different if the treasury continues issuing cash vouchers but does not accept them if presented to the cashier. Because cash vouchers are not transferable, the holder of the

5 This account operates as follows. Suppose a payment order pertains to December but payment is made in January. In December, the payment order is debited to expenditure and a counter credit is made to the account for expenses to be settled in the following month. In January, the account for expenses to be settled that month is debited and afinancialaccount credited. After the January accounts are closed, both entries in the account for expenses to be settled will be merged and the account balanced. Meanwhile, however, when considering December final accounts, one finds a credit balance to the account for expenses to be settled next month, which is typically treated as outstanding payment arrears.

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cash voucher has no choice but to wait until the treasury has sufficient financial resources to discharge its obligation. If the cash voucher were transferable, it could easily become a means of payment and so increase domestic liquidity. Such a situation has in recent years arisen in one African country, which in many respects follows procedures similar to the British accounting system, where checks were released in excess of financial resources. Consequently, government checks started to circulate at a discount in the economy as a means of payment. As with the British system, the identification of the emergence of arrears in the French system is complicated by delays in processing incoming bills before the issuance of payments orders (for example, recorded expenditure commitments awaiting issuance of a payment order). At this stage of the expenditure process, arrears are not reflected in treasury accounts but only in the administrative accounting system. They can be measured only with information from spending agencies on the amount of unprocessed bills, a comparatively difficult and timeconsuming procedure. In both systems, the determination of the time interval at which a delayed payment constitutes a true arrear is further complicated in practice by other features of government payment procedures. For example, the government may enter into commitments with suppliers for the immediate purchase of goods and services or into contracts providing for future delivery. In the latter case these contracts give rise to government liability for payment at some future time, generally set out in the purchase contract. Indeed, in the case of capital projects there may be a significant lag between the delivery of goods or completion of work and the point at which the government's legal obligation to pay becomes operative. In this way changes in the composition of expenditure can distort the definition of a normal delay in payment. In some countries the difficulty has been compounded by domestic contractors offering the government what amounts to suppliers' credits. Furthermore, if difficulties are encountered in identifying when a delay in payment can be regarded as arrears, there are also problems in defining the time period in which the government's delay in payment has become so protracted as to constitute a default. Those expenditures that have been committed outside the regular commitment process and that have not yet been recorded in the accounting system are difficult to identify. In some Francophone countries arrears of this nature have been reported as expenditures still to be regularized (depenses en cours de regularisation). They often reflect extrabudgetary expenditures and expenditure overruns, the latter stemming frequently from unrealistic provisions in the budget.

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Instances of underbudgeting (for example, electricity, telephone, and water) are sometimes the result of a government's inability to take necessary adjustment measures, although it is constrained by basic accounting principles to make the budget balance by law. Another aspect of identification arises with respect to arrears on debt service. A number of Francophone countries have established amortization funds to manage the servicing of government debt. In this case debt arrears are reflected neither in the treasury accounts nor in the administrative accounting system but must be obtained from the accounts of the amortization fund. To sum up, it is simpler to identify arrears in the French accounting system, which reflects a greater degree of centralization in processing expenditure data, than in the British system. Both accounting systems offer indicators of potential and realized changes in arrears that provide diagnostic data on the emergence of arrears, although they differ significantly in coverage. In the French system, expenditures are centrally recorded as soon as delivery is made and the claim is examined and judged to be appropriate and legal, even though no check has been issued. Hence the French system, when functioning properly, offers a direct, although perhaps incomplete, indicator of the emergence of arrears relatively early in the expenditure process. The British accounting system, in contrast, does not offer this intermediate indicator of changes in arrears. A comparison of actual deliveries with payment orders issued is likely to be carried out only in a piecemeal fashion by the spending departments as part of their dayto-day operations. To consolidate such data usually requires a special exercise.6 Consequently, to estimate the change in arrears under the British system, reliance is typically placed on data generated at a late stage in the expenditure process, on the change in check float, which often contains only a small component of arrears.7 Although the French system tends to offer a more comprehensive indicator of arrears, this also may only reflect a part of total arrears. In one Francophone country, for example, the recorded stock of arrears at the level of the 6

In at least one Anglophone African country, for monitoring purposes, spending departments were required to report commitments and cash expenditures, which, when compiled, provided a better coverage of arrears. 7 Arrears may also occur when "payments" are recorded in the government accounts but no cash actually changes hands. For example, one country following the British type of accounting system has operated with deposit accounts that record payments to be made to public enterprises but are not made, owing to lack of cash, and are shown as outlays deposited back with the government.

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treasury dropped by about 50 percent in 1983. A subsequent inventory of payment arrears showed, however, that the total amount of government arrears had not changed. Although payment orders issued awaiting settlement had decreased, delays at an earlier stage of the expenditure process had increased.

Taxonomy of Government Arrears To identify and address the problem of government arrears, it is useful to develop a taxonomy by which to classify arrears. The following criteria are useful: (1) the economic type of payment to which the arrear relates; (2) the payee to whom the payment is due; and (3) the residence of the government's creditor.

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Economic Type of Payment An arrear may develop with respect to a government's expenditure on goods and services, its transfer payments, and its interest and amortization payments. A government expenditure normally comprises two corresponding flows between the government and the rest of the economy: a physical flow of goods and services to the government and a flow of money to the rest of the economy. When the government excessively delays its payments, and thus the flow of money to the rest of the economy, expenditure arrears are created. In this way, while the government initiates an income-creating flow of goods and services from the rest of the economy to the government, there is no reverse injection of money into the economy. Government transfer and interest payments do not involve aflowof goods and services to the government but, like expenditures on goods and services, add to the income of their recipients. If transfers or interest payments are postponed, the income of the beneficiaries increases only on an accrual basis, not on a cash basis. Amortization payments do not affect the income of the rest of the economy but result in the substitution of money for a claim on government. If amortization payments are delayed, this liquidation does not occur; instead, a formal claim on government is replaced by a more uncertain one, reflecting the arrears. Thus expenditure-related arrears—that is, arrears related to payments for goods and services or arrears on transfer and interest payments—reflect an income-creating process (at least on an accrual basis) as well as an increase in claims

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on government in the financial portfolio of the rest of the economy.8 It can also be argued, however, that arrears in amortization payments involve only a liquidity effect, leading to the substitution of a formal claim on government by a more uncertain one in the portfolio of the rest of the economy. This difference between amortization and expenditure arrears has led to additional differences in statistical presentation, as discussed later. It is also useful to distinguish between amortization arrears due to banks and those due to nonbank institutions. Unpaid amortization payments on domestic government debt held by domestic banks are typically counted automatically as part of the banks' claims on the public sector (that is, are automatically refinanced) and therefore usually appear in the monetary data as net claims on the public sector. Including them as arrears in the presentation of the fiscal accounts would result in double-counting the same source of domestic financing, and thus arrears to banks should be shown in the presentation of the fiscal accounts only as a memorandum item. As for expenditure-related arrears, arrears on interest payments, particularly on those due to foreign creditors, have recently become prominent and, along with arrears on amortization, have given rise to debt-rescheduling arrangements by the Paris Club. Such arrangements have helped to limit the extent of foreign interest arrears. Arrears on wages are seldom incurred, mainly for political reasons. In one African country, however, the government deliberately accumulated paycheck arrears over a given period; in effect, the government preferred to reduce the wage bill through a progressive stretching out of the period between wage payments rather than by an explicit reduction in wage rates. Arrears on investment expenditure are typically related to the domestically financed component of expenditure and may reflect an overambitious investment program, poor expenditure control, an unexpected shortfall in foreign financing, or the inability of the central government to reimburse public enterprises for investments undertaken on its behalf.

8 It has been argued that in an inflationary environment, the part of interest payments corresponding to the inflation rate will not be seen as income by those who receive the interest payments, but rather will be seen as an implicit repayment of principal. As a consequence, the macroeconomic effects of arrears on the inflationary element in interest payments is likely to be similar to arrears on amortization payments. See Bierman (1985) on the debate whether the inflationary component of interest payments is equivalent to amortization of the public debt.

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Arrears by Payee The government may create arrears to the private sector or to other units within the public sector. Experience shows that if governments intentionally respond to spending pressures by accumulating arrears, they are likely to begin doing so with other public sector entities—for example, by not paying utility bills. It may be thought that, since public enterprises are owned by the government, arrears to public enterprises do not affect the overall financial position of the government. Nevertheless, such a mechanical accounting procedure masks the very real problem of a lack of financial discipline. Similarly, if one takes a broader view encompassing the entire public sector, as is often done in IMFsupported programs, it has also been argued that such arrears are in any case consolidated. Again, such a consolidation would merely hide an important policy problem. Moreover, insofar as the public enterprise has minority private shareholders, or is making losses financed outside government, or as a result of government arrears is forced to build up arrears with its suppliers, the impact on the rest of the economy may be significant. Arrears to the private sector have often induced the private sector to hold back tax payments, creating tax arrears. This, in turn, has sometimes resulted in a logjam of arrears throughout the economy.

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Domestic Versus External Claims Another important distinction is that between domestic and external arrears. The criterion for this classification is whether the creditor resides within the country or abroad. Often the distinction coincides with whether the claim on the government is denominated in local or foreign currency. As a result, the existence of domestic arrears usually reflects a corresponding shortage of budgetary resources, whereas external arrears reflect a shortage of foreign exchange, constraining the central bank in the externalization of government payments to meet foreign commitments (Table 3). Because such imbalances are likely to occur simultaneously and to be mutually determined, it is not possible to say that external arrears typically coincide with balance of payments difficulties and that domestic arrears arise from a budgetary imbalance.9 Of course, from the government's viewpoint, regardless of 9 For an analysis of domestic arrears in developing countries, taking into account external constraints, see Boissieu (1985).

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Table 3. External and Domestic Arrears External

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Domestic

Foreign exchange available

Foreign exchange not available

Budgetary resources sufficient

No arrears problem

Only external arrears problems; blocked account an issue

Budgetary resources insufficient

External and domestic arrears problem

External and domestic arrears problem

the residence of its creditor, its obligations must be discharged in domestic currency. This distinction is lessened if the domestic currency is externally convertible; in such cases, the emergence of domestic and external arrears generally reflects a budgetary problem. Also, in the case of countries belonging to a currency union, such as the East Caribbean Central Bank or the West African Monetary Union (CFA franc area), where domestic currencies are convertible and where in the latter case union member countries within statutory limits enjoy access to borrowing from the French Treasury, the distinction between domestic and external arrears is lessened.10 In countries where government revenue is sufficient to cover expenditure or where the central bank is authorized to extend credit to the government as needed, but where there is a shortage of foreign exchange, the externalization of payments rather than the domestic counterpart poses a problem. In such countries blocked accounts for the domestic counterpart of external obligations have been found useful (see below, in the section on "Arrears and Fiscal Adjustment Programs," under "External Arrears").

Problems of Presentation To provide an accurate analysis of the impact of government operations on an economy, it is necessary to evaluate the magnitude, sources, 10 For this reason, the Paris Club assesses the debt-relief requirements of these countries on the basis of budgetary data, not on the basis of balance of payments data.

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and financing of government deficits. Although there are many ways of measuring the deficit, a recommended treatment in the IMF's Manual on Government Finance Statistics (IMF (1986b)) is to define the deficit as

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Fiscal balance = (revenue + grants) - (expenditure on goods, services, and transfers) — (lending — repayments). If this measure of the deficit is to be fully compatible with the financing data derived from the monetary survey, it should be measured on a cash rather than an accrual basis.11 Arrears should not be treated explicitly but should be shown as a memorandum item, since by definition they reflect outlays not yet consummated on a cash basis.12 Although such a definition captures the monetary impact of the budget, it does not—in the presence of an accumulation of arrears— fully capture the budget's income-creating impact.13 Expenditure measured in cash terms will exclude any buildup of arrears, even though this buildup may have set in motion corresponding income-creating effects. Government purchases of goods or services will most likely have an impact on incomes and on domestic credit, even when payment is not made. That is, arrears are accumulated as the government effectively finances its deficit through an involuntary expansion of suppliers' credits or forced credits from employees, creditors, or other agents in the economy. In terms of policy, the credit expansion should be correctly attributed to the originating sector (specifically, the government). In recognition of the importance of such distortions in formulating policy, two alternative presentations of the fiscal position have been used to overcome the drawbacks of a purely cash-basis presentation in the presence of arrears. First, expenditures have been shown on a commitment basis, with the difference between total cash financing and the resulting deficit shown as a financing item. As indicated earlier, the difference, in considerable part, reflects a combination of check float and arrears. This has meant that total financing, by including a noncash component, is not immediately reconcilable with monetary statistics. The second approach is to show the overall deficit on a 11

The exception is the adjustment of expenditure data from an accrual to a cash basis, typically required in Francophone countries; see IMF (1986b, pp. 91-92). 12 In balance of payments statistics, in contrast, data are generally shown on a commitment basis, and arrears are shown as a financing item. 13 Conversely, the cash deficit overstates the income-creating impact of government operations when arrears are reduced.

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commitment basis, with separate lines for the net change in expenditure arrears, including check float and a corrected overall deficit on a cash basis: (a) (b) (c) (d) (e) (f)

total revenue and grants (cash basis) total expenditure (commitment basis)14 (a - b) overall deficit (commitment basis) net change in expenditure arrears (including check float) (c + d) overall deficit (cash basis) financing (cash basis).

This approach has a number of practical presentational problems.

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Combining Estimates with Actuals The accuracy and usefulness of the above presentation depend critically on the ability to identify and quantify the change in arrears and to bring to bear some of the issues raised earlier. In many cases all that is available, particularly in the British system of accounting, is the change in the so-called check float measure. The question then arises whether this change could be considered normal, in which case it should be excluded from the presentation of the fiscal accounts, or whether it indicates a significant change in arrears.15 In other cases specific arrears (for example, on external debt-service payments) can be identified, but the total change in arrears may still be difficult to quantify. In these cases an expenditure arrears line is shown as "identified expenditure arrears"; when the arrears on amortization payments can also be identified, these can be shown as a memorandum item, with total identified arrears divided into their expenditure and amortization components. Treatment of Arrears on Amortization The suggested fiscal presentation does not explicitly treat government arrears on amortization payments because all financing items 14

Preferably on the basis of payment orders issued. This question was addressed in the discussion of the British system of accounting, in the section entitled "Problems of Identification," where rules of thumb, necessarily of an approximate nature, were suggested for judging whether a change in check float should be considered normal. It is possible that, in any given period, an unusual change in the check-float measure may reflect a structural change in the true level of the cash float, rather than a significant increase in arrears. 15

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are shown on a cash basis. As a consequence, the accumulation and the reduction of amortization arrears are shown asymmetrically in the suggested fiscal presentation. Because all financing items are on a cash basis, there is no way to represent the accumulation of amortization arrears, except as a memorandum item. When the government discharges its overdue obligations, however, the payment is shown as a financing item. This can be illustrated by the following example. Assume that in period t the government spends 10 units on goods and services but does not pay for them, and a debt amortization payment of 15 also falls due, which the government is unable to honor. In period t + 1, the government receives 25 units in revenue and discharges all its overdue obligations. The fiscal presentation should reflect these financial obligations as in Table 4. This example shows that, although an accumulation of expenditure arrears is reflected in the fiscal presentation in the form of a higher overall balance on a commitment basis, the incurring of amortization arrears is not immediately obvious from the fiscal table. Because cash amortization payments equal amortization payments due plus the change in amortization arrears, however, this presentational problem could be mitigated by disaggregating the line for repayment of amortization to show two sublines for repayments due and for change in amortization arrears, as shown in Table 5.

Table 4. Summary of Government Operations (In domestic currency units) Item Revenue Expenditure Overall balance (commitment basis) Change in expenditure arrears (decrease —) Overall balance (cash basis) Financing Repayment of amortization arrears Other Memorandum item Change in amortization arrears

Period t

Period t + 1

0 10 -10

+ 25

+ 10

-10

0 0 0 0

+ 15

+ 15

-15

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+ 25

-15 -15 0

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Table 5. Summary of Financing Operations (In domestic currency units) Item

Period t

Financing Repayments (cash) Repayments (due) Change in amortization arrears (reduction - ) Other

0 0 (-15)

-15 -15 (0)

( + 15) 0

(-15) 0

Period t + 1

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Changes in Commitments During the Financial Year Because arrears are defined as the difference between the government's recorded obligations due and its discharge of these obligations in a timely fashion, problems are encountered in presenting the change of arrears when commitments change during the fiscal year. Such changes may arise with regard to external debt-service commitments because of exchange rate revaluations and debt-rescheduling agreements. In the latter case, it is important to quantify the additional financing to the budget arising from debt rescheduling and to present such financing as a memorandum item. The difference between total commitments after debt rescheduling and discharged rescheduled commitments is the change in arrears shown in the relevant lines of the fiscal table. An example illustrating some of these presentational problems is the case of the fiscal outcome for an African country. During the fiscal year the government benefited from debt rescheduling that lowered its debt-servicing commitments. Despite this, within the fiscal year it also accumulated arrears with respect to both rescheduled foreign interest and amortization payments. The situation is described in Table 6. In Table 7, the arrears on interest payments are shown as the difference between the deficits on a commitment and cash basis, and arrears on amortization payments are shown as a memorandum item. To obtain consistent comparison over time and to gain a better picture of fiscal adjustment, it is also helpful to show commitments before debt relief and to show explicitly the exceptional financing obtained as a result of debt rescheduling.

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Table 6. Summary of Debt-Service Payments of an African Country (In millions of local currency) Debt-Service Commitments Before After Debt Actual DebtIncrease Payment rescheduling rescheduling Relief Service Payments in Arrears Interest

140

72

68

32

40

Principal

253

127

126

68

59

Table 7. Provisional Fiscal Outcome of an African Country Millions of Local Currency

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Item Total revenue and grants Total expenditure and net lending Interest Overall deficit (commitment basis, before debt relief) Change in arrears on external interest (increase +) Overall deficit (cash basis, before debt relief) Financing requirement Debt relief Interest Amortization Memorandum item Change in arrears on foreign amortization (increase +)

1,170 1,624 140

-454 40

-414 414 194

(68) (126) 59

Macroeconomic Effects of Government Arrears The emergence of government arrears is likely to have ramifications on the allocation and distribution of resources within the economy, both through effects on factor prices and incomes and through macroeconomic effects. Much depends on two factors affecting the behavior of economic agents in the economy: the first is the extent to which arrears are anticipated; the second is the extent to which creditors are constrained on financial markets and thus limited in their ability to neutralize the impact of arrears. The most obvious allocational effect, in

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the short run, is that arrears constitute an alternative form of financing additional government expenditure. If forced taxation through the printing of money is not feasible, the government's share in total output is limited by the amount the rest of the economy is prepared to release to the government by paying taxes or by extending credit. The buildup of arrears increases the government's absorption of resources above this level. This initial effect, however, may be offset if the rest of the economy limits resources transferred to government by holding back on tax payments and other fees and charges. At the same time, it should not be forgotten that there are often other transactions that compensate the accumulation of arrears to certain suppliers (for example, the prepayment of goods to other suppliers). This arguably poses similar problems in financial management. There may also be important distributional consequences of a buildup in arrears arising from the government's being able to delay payment to one sector much more easily than to another.

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Goods and Services The development of a chronic pattern of arrears may also influence the costs and prices in the economy. When arrears first emerge as a means of more than temporary government financing of purchases, the effective interest cost of financing arrears is wholly borne by the suppliers of goods and services (be they producers, importers, or wage earners), since the "forced" financing is presumably unanticipated. Over time, and in the face of further likely arrears by the government, those economic agents providing goods and services to the government may begin to adjust their pricing and production behavior to take account of such payment delays. Vendors dealing with the government may begin to charge higher prices to make up for refinancing costs, a risk premium, and bribes to speed up the payment process. Thus the government may have to pay prices above the market price and, with limited budgetary outlays, may be forced to reduce the quantities of goods and services it purchases. The additional premium on prices is likely to be determined by the vendors' expectations about the length of the payment delay, the prevailing interest rate, the risk that the government will default, the vendors' risk preference, and the amount of bribe necessary to speed up the payment process. Similarly, there is also a possibility that creditors will bid up the interest rate charged on loans to the government if they anticipate that the government will not pay back these loans as scheduled.

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The implicit interest costs of arrears are independent of whether providers of goods and services bid up prices to account for the delays in payment. The degree to which prices are increased only determines the distribution of the financial burden of the payment delay—for example, as between the government, by paying increased prices (and ultimately the consumers of its services, through reduced services or higher taxes or fees), or the vendors, through a squeeze in their profit margins. To the extent that arrears are reflected in higher prices on those expenditure items on which arrears are frequently incurred, it is likely that existing fiscal data provide a biased picture of the true weight of interest costs in the budget because they do not take into account the implicit interest costs in the category of expenditure on goods and services.

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Wages and Transfers In examining the macroeconomic effects of government arrears, it is necessary to evaluate how government arrears are created and how the payee reacts to payment delays. For example, the change in aggregate demand brought about by the creation of arrears in wage payments to government employees will depend largely on their perception of the postponement of wage payments and their underlying consumption behavior. 16 If, for example, the spending decisions of government employees are determined by their actual cash income, and if the government stretches out the period between paydays so that civil servants receive only 11 monthly salaries in a 12-month period, then their private consumption will drop by1/12.In contrast, if their underlying consumption behavior is more accurately described by a permanent income model of consumption behavior, and if government employees regard delays in salary payment as only transitory, civil servants may perceive only the interest forgone on the deferred payment as a cut in permanent income. Their consumption outlays would then drop only marginally, and the temporary cash shortage would be made up by dissaving. If the civil servants do not have confidence in being able to recover the loss in cash income incurred by the payment delay, 16

If the level of government wages is significantly higher than the wage level in the rest of the economy, a cut may be desirable both on allocational and distributional grounds (although it would be preferable to cut wages more openly). Conversely, if government wages are relatively low, wage arrears may impair the government's productivity, have adverse distributional effects, and provide incentives for corruption as well as for the acceptance of jobs outside the civil service.

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however, the drop in their permanent income will be considerably more than just the forgone interest, and private consumption will fall accordingly. A similar analysis can be applied to other government payments to private households. Delays in transfer payments to private households and in interest payments on government bonds held by the private nonbank sector will tend to reduce private consumption. The fall in consumption will be determined by the relevant consumption function and the perception of the private household as to whether the payment delay represents a transitory or permanent change in government policies. In its normal purchases of goods and services from vendors, the government sets into motion an income-creating process that increases aggregate demand. The effects of the government's incurring arrears in payments will depend on the way in which vendors initially finance the production of the goods and services to be supplied to the government. If this financing takes the form of borrowing from the banking system, the impact will be no different than if the government had made the payment on time with proceeds borrowed from the commercial banks, except that the vendors will bear any interest costs.17 Thus the overall effect on aggregate demand will be very similar to that arising from bank-financed government expenditures. Alternatively, vendors might perceive the incurrence of government arrears as only a temporary phenomenon and thus reduce their cash balances below the level warranted by the prevailing interest rates and their volume of transactions. In this case, the increase in government expenditure would be financed by a higher velocity, and aggregate demand might increase. A similar strong effect on demand may be expected if vendors satisfy their financing needs by external shortterm indebtedness. While some countries' arrears have been passed on to other domestic suppliers of their raw materials, in other countries companies have adjusted to the government's inability to meet its obligations by creating arrears to the foreign parent company. In the latter case, the government has indirectly financed its expenditure by what amounts to an inflow of foreign short-term capital, with no concurrent deterioration in the overall cash balance of payments.18 17 This depends, of course, on the commercial banks' not being able to use government obligations to satisfy reserve requirements. 18 Of course, this analysis assumes that there are no secondary repercussions when the capital inflow may be matched by an increase in the current account deficit, leaving the overall balance of payments unchanged.

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Finally, companies frequently adjust to the emergence of government arrears by incurring arrears on their tax liabilities. Insofar as the vendors not paid by the government in turn retain funds equivalent to the taxes owed to the government, the government in practice is financing its expenditure by forgoing tax revenue, such that the macroeconomic effects are similar to any other tax-financed expenditure (although the timing may be different). Two additional aspects are worth mentioning. First, if the creation of arrears takes place at a very late stage of the expenditure process, by increasing the stock of outstanding checks beyond the normal check float and beyond the government's short-term capacity to honor them, then significant monetary effects can be expected. Because government checks are normally highly liquid, an increase in broad money creation takes place, and if the demand for money does not grow at the same pace, eventually this will create pressure on prices and on the balance of payments.19 Second, the accumulation of government arrears may have a serious impact on the confidence of private enterprises and households in the soundness of government financial operations. Private consumers and investors might anticipate increases in the nominal tax rate, inflation, or, more generally, a deterioration in the financial situation of the country over the medium term. As a consequence, the expectation will be that permanent incomes and profits drop, reducing current consumption and investment expenditure.

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Principal Repayments The macroeconomic effects of arrears on amortization payments are likely to be less than those arising from expenditure arrears, since the former do not set in motion an income-generating flow of goods and services from the rest of the economy to the government or engender any expectation of accrued income. To assess the effects of amortization arrears is difficult because much depends on the response of creditors, which in turn hinges on whether such arrears were anticipated. In the extreme case of the creditor not anticipating the arrears, it could be argued that if the government fails to make a domestic amortization payment on time, the only immediate effect will be a substitution of a formal claim on government by another one. The total amount of claims of the private sector on government remains unchanged. 19 This is dependent on the private sector assumption that the government will ultimately discharge its outstanding obligations.

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The above argument assumes that government will continue to pay interest on the loan, and that the portfolio owner believes that the government will finally repay the loan. Typically, creditors might try to raise the interest rate somewhat in order to compensate for the higher risk now associated with this part of their portfolio. If the government stops paying interest and so increases the perceived probability of default, however, domestic amortization arrears may lead to decreasing private sector wealth (assuming that so-called Ricardian equivalence does not hold and that, therefore, government loans are regarded as net wealth by the private sector).20 Of course, when wealth is an argument in the consumption function, the creation of domestic arrears on amortization payments will tend to reduce consumption and imports. Balance of payments consequences can be expected from the creation of amortization arrears to external creditors, but this reaction is likely to differ among countries, depending on their track record on arrears. In the period when the amortization payment falls due, the capital account goes into deficit, but this capital outflow is financed by the creation of arrears, which are shown as exceptional financing. In the medium term, however, the government's credit rating could be damaged, and the inflow of official capital could very likely dry up.

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Arrears and Inflation Do government arrears have an impact on the rate of inflation? At first glance, it appears rather unlikely because typically no money creation takes place at the time the government begins to incur arrears. Nevertheless, there may exist indirect links between the buildup of arrears and the rate of inflation. First, as described above, suppliers are likely to react to the incurrence of government arrears by bidding up the prices at which they are prepared to sell goods and services to the government. In more general terms, in an environment characterized by financial instability (as reflected in the government's inability to make payments on time), economic agents will include high risk premiums in the calculation of the price at which they are prepared to render goods or services. Second, if the provider of goods and services is able within the overall credit ceiling to bridge the delay in payments by borrowing from the banks, this may add pressure to the credit 20 Under Ricardian conditions, the future taxes implied by government debts are fully perceived by the private sector and completely offset the private sector's claims on the government (see Schiller (1985)).

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market and, as in the case of additional government borrowing, push up interest rates. If this effect induces the central bank to relax monetary policy or attracts capital inflow, the outcome would also be pressure on prices. Third, if arrears are accumulated against public enterprises (as is often the case) and are of sufficient magnitude, the financial position of the public enterprise sector may worsen. If this results in higher credit from the central bank, arrears will end up creating inflationary and balance of payments pressures.

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Arrears and Fiscal Adjustment Programs To address the problem of arrears in the context of a program of fiscal adjustment, several alternatives are available, depending on the circumstances giving rise to arrears. It has been operationally useful to distinguish between domestic and external payments arrears. The distinction arises in part because, although the government discharges its debt-service obligations in domestic currency, the final payment of external obligations has to be undertaken by the central bank as part of its management of foreign exchange. This feature, related to constraints on discharging obligations, necessitates different treatment in adjustment programs. Thus, whereas a government can in principle usually discharge its obligations in domestic currency, even though this means borrowing from the central bank, foreign exchange may not be available to discharge the central bank's corresponding external obligations. As suggested earlier, an exception to this general rule arises in some Francophone African countries that use a common central bank and have financing constraints placed upon them (see Table 3). In these countries domestic arrears have been a recurring problem.

Domestic Arrears In those countries with arrears, experience suggests that several operational difficulties must be overcome if outstanding arrears are to be eliminated and further accumulation of arrears is to be prevented. Programming arrears reduction generally requires certain preconditions: (1) a clear definition of what constitutes arrears, including institutional coverage and the stage of the payment process; (2) a complete inventory of arrears based on this definition; and (3) a timely method of monitoring changes in this inventory. In practice, all three preconditions are difficult to meet.

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Overdue obligations that have arisen from dubious authorizations and are yet to be regularized, or isolating that part of the check float that can truly be considered as constituting arrears, make it difficult and time consuming to identify domestic arrears, especially when they have arisen from ministries undertaking unauthorized expenditures. Another factor that many countries must face is the problem of interlocking arrears. In such cases, although the government has undischarged payment obligations to a domestic supplier or enterprise, that enterprise in turn has unfulfilled tax liabilities to the government. The size of these mutual commitments is often in dispute; the result is a bargaining situation in which each side tries to gain advantage by writing off the larger outstanding obligation. Obviously, from a financial programming viewpoint, the magnitude of arrears reduction is affected by whether the government's undischarged commitments are treated gross or net of the tax obligations due to it. One of the by-products of the establishment of an inventory of government expenditure arrears is that recording and quantifying the network of counterclaims aid in their resolution. Data problems in some countries have been found to be so severe that even when an arrears problem is recognized, it has not been possible to prevent the incurrence of new payment arrears or the reduction of outstanding arrears. As a result, countries should not tackle arrears before the basic data problem is overcome, preferably through the introduction of an effective within-year expenditure or arrears-monitoring system. Unfortunately, such a system is likely to take time to institute and may involve unacceptable reporting lags. Such a system would of necessity have to come to terms with the particular budgetary procedures of the country. To get a realistic picture of the movement in government arrears, it has generally been found necessary to trace the changing stock of commitments, payment orders, checks issued, and checks cashed and to have a reporting system at the different stages of the expenditure process. Once these preconditions are met, programming a reduction in arrears also requires a clear decision on the method to reduce them. For example, the government may decide to reduce arrears by issuing government securities rather than by discharging its commitments in cash. In such cases it seems necessary to ensure that the maturity of the bonds, the level of their interest rates, and the degree of their negotiability would not differ from that of other financial instruments. At the same time, the authorities should recognize that the conversion of arrears into government debt would be equivalent to any other rescheduling of debt in terms of its potential expansionary impact and

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would necessitate an equivalent reduction in any target for credit to government. Whatever the approach adopted with respect to arrears, experience suggests that it is important to take account of the particular circumstances of the country that have led to the emergence of arrears. Two principal causes can be distinguished, structural and systemic. In the first case, arrears may arise from a structural imbalance in the budget owing to overly optimistic revenue estimates, unrealistic financing projections, or underbudgeting of expenditures. In such cases it is difficult to believe that any mechanism to control expenditure would be adequate to solve the problem. Arrears can be regarded not as a problem in their own right but as a symptom of a more fundamental problem. The source of arrears, however, may be systemic, arising from a breakdown of orderly payment procedures. Two particular institutional scenarios are worth distinguishing. In the first, the treasury is not in full control of the spending process, so that powerful spending departments are able to make unauthorized commitments. In the second case, the treasury does exert control over the spending process but does not honor its commitments. In the former case the solution to the arrears problem may be difficult, although not impossible, to resolve because it is symptomatic of a more general problem of expenditure control. In cases where the treasury's accounting system is sound, arrears reflect the lack of political will to restrain public spending. In these cases, the political commitment is unlikely to be forthcoming until it is realized that arrears signify not only the breakdown of financial accountability, but also give rise to important gaps in information essential to plan future policies and to evaluate present policies. Recognizing these disadvantages, the authorities should, in undertaking fiscal adjustment, be encouraged to take steps to eliminate arrears, preferably combined with an appropriate monitoring system for broad aggregates of government expenditures. To be effective, this monitoring system should ideally be placed on a continuous review basis, with arrears prevention as its primary concern. Wherever possible, the monitoring system should be as comprehensive as possible, including commitments and data on payments. In this way it may be possible to detect deviations from programmed fiscal adjustment at an early stage, allowing more timely corrective action. External Arrears On the whole, external arrears—especially those with respect to debt servicing—can be more easily identified, inventoried, and moni-

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tored than domestic arrears. To limit the problem of external arrears, an approach found useful involves separating the domestic counterpart of foreign obligations from their actual externalization in order to prevent the accumulation of arrears on the domestic counterpart of external payments. When foreign exchange is in short supply, a special blocked account for the domestic counterpart of scheduled official external payments may prove beneficial. To avoid arrears, the government should then prepare a schedule of transfers from the budget to these accounts. The magnitude of such transfers should be calculated so as to ensure that adequate provision is made from domestic budgetary resources for the domestic counterpart of such obligations, regardless of the availability of foreign exchange to complete the externalization of these payments.

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Conclusions The importance of arrears in any macroeconomic analysis of the impact of government should be evident from the discussion presented here. To sum up, at first glance it would appear that any delay in payment, as a form of compulsory financing of its expenditures, has benefits for the government. It is as if suppliers had bought government bonds at a zero interest rate for the period until payment is made. The persistent use of such compulsory financing should be recognized, however, as involving distinct drawbacks for the government. Apart from the more general drawbacks arising from the repercussions on private sector expectations and confidence in the financial soundness of government, there are also likely to be adverse effects on the government's cash position as some suppliers respond to government payment arrears by reciprocal arrears on their tax liabilities. Other suppliers may react by bidding up the prices at which they will provide the government with goods and services. As a consequence, the price that government has to pay is inflated by the supplier's risk premium and implicit interest rate. This will increase the size of the government's cash deficit, and the general price level may well be raised. The efficiency impact on the rest of the economy is likely to be exacerbated if suppliers have to incur increased credit to bridge the delay in payments. In this case it could be argued that the effect on the rest of the economy may differ little whether the government has or has not actually paid a supplier, since the latter in all probability had to obtain credit and has definitely used resources to provide goods and services to the government, whether or not the government has

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discharged its formal obligations to him. From the perspective of macroeconomic policy, however, it is important to attribute correctly both the expansion in aggregate demand and credit to the initiating sector. In the case of the government's accumulating payment arrears, the government rather than the supplier should be recognized as initiating the expansion in aggregate demand. Similarly, from the financial programming viewpoint, the buildup of arrears, by disguising the level of the government's use of resources, lowers the recorded cash deficit and, hence, also the recorded credit to government. By concentrating on the net effect of cash flows in the presence of a government that is accumulating arrears, the recorded deficit can remain constant while the level of government spending is actually increasing. This distortion has been recognized in formulating fiscal adjustment programs, when it is important to capture not only the monetary effects of budgetary changes but also their income-creating or Keynesian impact (see Tanzi and Blejer (1983)). The latter, which focuses on the impact of fiscal policy on the gap between domestic income and expenditures, would place emphasis on an accrual rather than a cash definition of the deficit and would concentrate on the change in government commitments, regardless of whether they were discharged in cash. Even when the economic implications of government arrears are recognized as sufficiently important to necessitate firm policy action, this chapter has identified two types of problems that need to be overcome. The first arises from practical accounting problems, often encountered in developing countries, that lead to severe data constraints. The second arises from the considerable political and administrative effort likely to be required in implementing a policy of arrears reduction. In light of these operational obstacles, countries should combine the programming of arrears reduction with an appropriate monitoring system for broad aggregates of government expenditures, with arrears prevention as the primary concern. In this context, the problem of the domestic counterpart of external arrears can be tackled by programming and monitoring transfers to special blocked accounts at the central bank. To be effective, all such methods must be based on a firm commitment to view the avoidance of arrears as an integral part of fiscal adjustment.

References Bierman, Hjordis, "A Note on the Concept of the Public Sector Deficit in Stabilization Analysis for High-Inflation Countries" (unpublished; Washington: IMF, Fiscal Affairs Department, 1985).

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Boissieu, C, "Constraints externes et arrieres de paiement interieurs dans les pays en developpement," Economies et Societes (September 1985), pp. 135-45. Diamond, Jack, and Christian Schiller, "Government Arrears in Fiscal Adjustment Programs," Finanzarchiv (1987), pp. 229-59. , "Government Arrears in Fiscal Adjustment Programs," in Measurement of Fiscal Impact: Methodological Issues, Occasional Paper 59, ed. by Mario I. Blejer and Ke-young Chu (Washington: IMF, June 1988), pp. 32-47. , "Expenditure Arrears," in Public Expenditure Handbook: A Guide to Public Policy Issues in Developing Countries, ed. by Ke-young Chu and Richard Hemming (Washington: IMF, 1991), pp. 159-64. International Monetary Fund (1986a), Fund-Supported Programs, Fiscal Policy, and Income Distribution: A Study by the Fiscal Affairs Department, Occasional Paper 46 (Washington, September). (1986b), A Manual on Government Finance Statistics (Washington). Schiller, Christian, "Government Expenditure and Portfolio Crowding Out" (unpublished; IMF, Fiscal Affairs Department, 1985). Tanzi, Vito, and Mario I. Blejer, "Fiscal Deficits and Balance of Payments Disequilibrium in IMF Adjustment Programs" (unpublished; Washington: IMF, Fiscal Affairs Department, June 1983).

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8 Credit Subsidies in Budgetary Lending: Computation, Effects, and Fiscal Implications

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Michael A. Wattleworth BECAUSE OFFICIAL CREDIT programs offer more lenient terms to borrowers than are available in the market, or in many cases than those at which the government itself borrows, they contain a pure loan component, reflecting the government's role as a financial intermediary, and a pure grant component, reflecting the government's role as a distributional agent. Because interest paid and received both appear above the line in the unified cash budget, the annual cost of these subsidies is reflected in the observed fiscal balance but is nowhere identified overtly.1 But because these subsidies are spread over the entire lifetime of the loans, their total magnitude is easily overlooked and usually grossly underestimated, and they contribute to the creation of long-term structural deficits that restrict the short-term flexibility of fiscal policy. This chapter examines the role of credit subsidies in government direct lending. The emphasis is on the presentation of a simple technique to measure the actual financial cost to the government of these subsidies.2 The discussion focuses on an important way by which govNote: The author wishes to acknowledge Etienne Gilard, who, as a summer intern at the IMF in 1982, contributed substantially to the background work for this study, and to thank his colleagues in the IMF, who provided many valuable comments and suggestions. An earlier version of this chapter was published in Measurement of Fiscal Impact: Methodological Issues, ed. by Mario I. Blejer and Ke-young Chu, Occasional Paper 59 (Washington: IMF, 1988), pp. 57-70. 1 See United States (1967), pp. 335-45; and A.S. Carron (1981), p. 269. 2 The methodology has been applied to Korean data with satisfactory results. The results of the application are summarized in a longer paper by the author (see Wattleworth (1983)).

147

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CREDIT SUBSIDIES IN BUDGETARY LENDING

ernments intervene in the financial intermediation process—namely, through direct provision of loans—and the fiscal implications of this type of intervention. The scale of such lending operations is not widely appreciated. Even in a strongly market-oriented economy, such as that of the United States, the federal government is the largest financial intermediary—with outstanding loans at the end of 1987 of $234 billion.3 Governments can, however, and do, intervene in more or less pervasive ways, with greater or lesser fiscal implications. The central purpose of this introductory section is to describe some of the other forms of intervention, which are beyond the scope of this chapter, and how some of them are related to subsidized official lending. Examples of more pervasive interventions include a government's ownership of the banking system, or its imposition of differential deposit and lending rate ceilings throughout the financial system to the relative advantage of certain sectors. Depending upon how these credit subsidy schemes are financed, they would generate either a larger or smaller supplementary fiscal deficit, which should be added to the conventionally measured deficit to capture the true aggregate demand impact of fiscal operations.4 As this is a far more intractable issue operationally, it will not be addressed here. Similarly, government loan guarantees, which do not affect the cash deficit unless default occurs but which do involve substantial subsidies and governmental intervention in credit markets, are beyond the scope of this study.5 Finally, it should be emphasized that the method employed below to separate official lending into its "pure loan" and "cash grant" equivalents is limited to the expenditure side of the budget. This subsidy mechanism on the outlay side is, in principle at least, completely interchangeable with the operation of so-called tax expenditures on 3 This is the size of the direct loan portolio; another $507 billion in guaranteed loans was outstanding, while government-sponsored enterprises had an additional $581 billion of loans outstanding. Thus, directly and indirectly, the government had influenced the allocation, on subsidized terms, of $1,322 billion of outstanding credit, equivalent to 29 percent of GNP in 1987. See United States (1988). 4 The theoretical case for this argument is developed in McKinnon and Mathieson (1981). 5 For an introduction to loan guarantee analysis, see United States (1978 and 1979). Methods developed to measure the value of loan guarantees are largely based on the contingent claims method; see, for example, Jones and Mason, "Valuation of Loan Guarantees" in United States (1981d), pp. 349—77. Other papers in this volume are also of interest. More recent work by the Office of Management and Budget of the U.S. Federal Government simply estimates the subsidy inherent in guaranteeing loans as the difference between the amount the borrower pays and the amount required to reinsure the loan.

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the revenue side that result from the tax deductibility of interest income and payments.6 The two methods, however, are equivalent neither in practice nor in their budgetary treatment. In particular, the relative size of the government sector in the economy would always be smaller if tax expenditures were used. An example may clarify the differences; for present purposes, the complications of maturities and discounting are dispensed with in the tax expenditure case, since the effect of these is the same from both the tax and expenditure perspectives. First, assume that the government, which pays 7 percent on its borrowings of similar maturities, makes a direct loan of $100 million to a final borrower at 3 percent interest for 15 years, while the best market rate available to this borrower would have been 10 percent on a similar loan. The total amount of the subsidy is 7 percent annually. This can be further divided into two parts. The explicit portion (4 percent a year) represents the differential amount the government must actually pay; the implicit portion (3 percent a year) includes the additional benefit received by the borrower, compared with his opportunity cost.7 The focus in this chapter is on the explicit portion of the subsidy. Assuming a simple annuity structure, the direct cost to the government of this arrangement would involve an interest outlay of just over $39 million in excess of interest income over the period of the loan. Stated in terms of present value of the total debt service (discounted at 7 percent), such a credit subsidy would be worth about $23.7 million, which is defined as the subsidy (or grant) value of the loan.8 Alternatively stated, at current government interest rates, the loan could be sold by the government to private sector lenders in a secondary market for $76.3 million. In this case, the government is agreeing to a "concealed" subsidy of $23.7 million when it enters into the loan contract. It is committing itself to a deficit in this loan operation in the first year, and for the subsequent 14 years. Of course, the government would not have to finance the implicit subsidy directly, but it would 6

This point is made in various places. See, for example, either United States (1977), p. 87, or Aragon (1980), p. 374. Also, for an example of how this mechanism works through industrial development bonds or industrial revenue bonds in the United States, see United States Office of the President of the United States (1981), pp. 184-86, and United States (1981b). 7 This distinction is also made in Aragon (1980), p. 373. 8 The subsidy (or grant) element—a concept introduced later—is defined as the subsidy value stated as a percentage of (the present value of) the loan's face value—here equal to 23.7 percent (see Organization for Economic Cooperation and Development (1980), p. 241).

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be offset economically by efficiency losses owing to the associated misallocation of resources in the economy. Alternatively, the same subsidy operation could have been financed by forgone tax revenues. That is, the tax system could have been adjusted so that interest income to the lender was tax exempt. Lenders in the 70 percent tax bracket or above (in the example) would then have found it profitable to lend at 3 percent tax exempt, even though the borrowers' opportunity cost rate was 10 percent. Whether such lending would actually occur depends on the other alternatives available to the prospective lenders. In any case, the direct cash cost to the budget in this case would be the amount of tax revenue forgone, and, even more than in the previous case, this is not clear under the usual accounting conventions. Once again, the real economic cost of such a program would usually be greater than the realized financial cost to the government. These additional costs are inherently more difficult to measure directly because they depend on the borrowers' opportunity costs, which are usually not observable, and, because they are funded by resource misallocations and inefficiencies, they cannot readily be measured indirectly from the financing side. In fact, most governments operate both types of direct lending and tax expenditure schemes simultaneously, so that a comprehensive measure of official credit subsidies should take both mechanisms into account. However, because this chapter focuses on official lending and its terms, credit subsidies based on tax expenditures are beyond the scope of this study.

Computation of Budgetary Credit Subsidies No generally accepted objective method exists for estimating the subsidy value in official direct lending programs, mainly because of the difficulty of precisely establishing the private rates that would have been paid by borrowers in private markets without government intervention. Moreover, for some programs—for example, those addressing a "total" market failure—there may be no alternative private rate at all. Still, it is the premise of this chapter that the concealed subsidies are usually so large that an attempt at estimation must be made, even if the resultant measure is not precise. By focusing on the explicit portion of the total subsidy, the most intractable of the operational obstacles can be avoided at the final borrower stage. The resultant estimate is, of course, biased downward in terms of the value received by the borrower because it omits the implicit portion of the

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subsidy. In practice, it may also be preferable to consciously underestimate the calculated explicit subsidy so that the direction of bias in the answer is known. A method for estimating the value of the credit, or interest, subsidy is first presented in the simplest of cases, then complications are introduced, andfinallyissues relevant to the operational use of the technique are discussed. Conceptual Framework First, assume that a loan of amount A is made at interest rate i; it is disbursed in full immediately and amortized over JV years, to be repaid in equal annual installments of principal plus interest. If P is defined as the value of this annuity, then

{[ [ {[ [ [ [ {[ [ {

i

P = A -----------------------. l

]} ]} ] (1+i)N ] } ] ]}

(i)

1 - -----------------(1+i)

if

1 1 - ------------------

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DN = ---------------------, i

then

] ]

A P = ------DN .

(2)

(3)

The variable DN is defined as the discount factor that gives the present value of one unit (if the loan above is for A dollars, then it is one dollar) payable yearly for N years. Alternatively, 1/DN is the annual payment N necessary to pay off a loan of one dollar over N years. Analogously, if the same loan were made at market rate i\ then under market conditions the equation would be

{II {I

A P* = A ------------------------= -------DN i i

1 -

I) I) II)

-----------------(l+i*)N

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(4)

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Since the presumption is that i* > i, the subsidy element each year is l l S = P* - P = A --------(5) - ------. DN ) (DN ( ) ( ) If both loans, however, were ) made in terms fixed until maturity, (

then S, which gives the annual subsidy, grossly understates the present value of the total subsidy involved in making the loan at the lower rate because this would accrue every year, for N years. Thus, it is necessary to calculate the capitalized value of this stream of annual differences in payments, where the discount rate used is based on the market (or "true" opportunity) cost of capital: D'

N A = S • D*N = A l - ------, D ) ( N

(6)

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( ) ( ) where A = the grant (or subsidy ) value in the loan.

The proper interpretation of A is that the two situations are identical in the following sense: it is precisely equivalent either to grant the Nyear loan at rate i when the opportunity cost rate is i or to grant the iV-year loan at rate % and to provide a cash grant of A. Thus, provision of a "low-interest" loan is equivalent to providing a "pure loan" combined with a "pure subsidy." Alternatively, one can think of the reduction of i below % as inducing an excess expansion of credit in the amount of A, which is defined as the credit subsidy. Another form of presentation is a table of cash flows (Table 1) designed to obtain the present value of the total debt payments.9 This is useful because it allows the structure of the loan to be changed easily, so that the new subsidy value can be computed. Such a technique is necessary when attempting to sum subsidies across a wide variety of lending programs because lending terms frequently differ dramatically. Education or construction sector loans, for example, often involve grace periods, whereas housing loans rarely do. For example, if A = $10,000,000, i = 10 percent a year, N = 20 years, and i = 12.5 percent a year, then A = $1,494,334, which is 14.9 percent of the loan's face value. 9

This approach to the problem was inspired by an excellent book by Harvey (1983).

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Table 1. Cash Flow of Simple Annuity Loan

Receipts

Annual Payments

Receipts

Discount Factor with Market Interest Rate

Years

(1)

(2)

(3)

(4)

Net Present Value (5) = (3)x(4)

0

A

—

+A

1

A

1 to AT

—

Annual Net

-A/

A/D

N

DN

D*N

-A-O*

( ( ( ( DN

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Total (A)

A

--------

}

D"N}

1-----------------DN}

}

Now, if the above loan were structured so that the payback period was preceded by a grace period (of n years) during which nothing was payable, then the cash flow table would appear as shown in Table 2. Continuing the previous example, if n = 5 years, the new subsidy value is $5,280,002, or 52.8 percent of the loan's face value. Thus, the addition of a "pure" grace period can be seen to affect the subsidy calculation dramatically, raising the subsidy element by 38 percent of the loan's face value. Consider next a loan with a grace period of n years, but with interest only payable during the grace period at rate in. In this case, the cash flows would be as shown in Table 3. To continue the example, if in = iN = 10 percent a year, then the subsidy value would be $1,719,391, or 17.2 percent of the loan's face value. Alternatively, if in < iN, say in = 8 percent a year in this example, then A becomes $2,431,505, or 24.3 percent of the loan. Note that the results in this extended example (Table 4) conform to an intuitive a priori impression about the relative "softness" of the loan terms.10 Finally, consider a case in which the loan is set up like a bond— that is, interest only is payable throughout the life of the loan and the principal is repaid in one lump sum at the maturity date (Table 5). I0 It is worth noting here that an alternative methodology (the effective rate of interest (ERI)) introduced later would give roughly the same ordinal ranking of the alternatives. Thus, the ERI on the last loan is 6.05 percent a year, on the third option 9.09 percent a year, and on the first two it equals the quoted loan rate of 10 percent a year.

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Table 2. Cash Flow of Loan with Full Grace Period Discount Factor with Market Net Annual Receipts Payments Receipts Interest Ratea Annual

Years

(1)

(2)

(3)

(4)

0

A — —

—

+A —

D*n

1 to n n to n+N

—

1

A —

D*N+ N - D*N -A/DN(D*n+N - D*n)

-AIDn

A/DN

Net Present Value (5) = (3) x (4)

( ( ( (

) D*n+N- D*N ---------------------DN ) ) a ) n ton+JV.) In The subtraction of the discount rates may appear confusing in years ) the former example, Dn was used to obtain the present discounted value of the stream ) of net payments for the simple loan. The problem now is just that this stream occurs Total (A)

A 1 -)

n years in the future, so it must be discounted again by l/(l+i*) n :

] [-----------------------------------------------------------] [ -------------------------[[(li + i )n}] Dn =------------------------[ }] [ ------------------] ]- [}--------------------[-------------------------------------------(l +[ i*)n [ [ ] [} ] ] (i + i*)N ] [--------------------[(l + t*)n[]-----------------------------------------i ] ] [ D] [ ] ] -------------------(l + i*) 1 (1 + i')n+N

1 -

D'N+n

=

i

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l

D'N+n

1 (1 + i*)n+N

- D; =

Ds+n -D:

=

- D\ =

(1)

1

1 -

D'N+n

} } } }

i

1

1

l

-

(2)

(3)

l

[ [ [

n N

(4)

(5)

Although a fairly simple loan structure has been retained for purposes of exposition, the principles involved remain the same, even if loan structures are different and more complex. Most generally stated, the subsidy value of a loan is the difference between the present value of its disbursements and the present value of its service payments, discounted at the market rate of interest. The grant element is denned as the value of the subsidy or grant as a percentage of the present value of the disbursements. According to these definitions, therefore, a loan made at the market rate of interest carries a subsidy value and grant

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Table 3. Cash Flow of Loan with Interest-Only Grace Period Discount Factor Net with Market Annual Receipts Payments Receipts Interest Rate Annual

Years 0

1 ton n to n+N

]

Total (A)

Table 4.

(1)

(2)

(3)

(4)

A —

—

+A -in . A

1

A

D* n

-A . in . D*n -A/DN(D*n+N - D*n)

—

Simple annuity With grace, where

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in . A AIDN

-A/DN

D'N+n

- D*n

[ [ [ [ )] [ [ Loan Structures'" )] Comparative Subsidies in Different [ Subsidy[ Element )] (A)

Loan Structure

in = *N

Net Present Value (5) = (3) x (4)

With grace, where in < % With grace, where no payments

A

D*+N - D"n l - in . Dn* ---------------DN

Subsidy Value (A) (In U.S. dollars)

(As percentage of face value)

1,494,333

14.9

1,719,391

17.2

2,431,505

24.3

5,279,959

52.8

a

Based on the extended example in the text.

element of zero, while a pure grant has a subsidy element of 100 percent. For a "soft" or "concessional" loan, the grant element lies somewhere between these extremes. The Development Assistance Committee (DAG) of the Organization for Economic Cooperation and Development (OECD) and the External Debt Division of the World Bank regularly compute the degree of concessionality in their own and other foreign lending by computing the grant element (based on a fixed discount rate of 10 percent a year) and simply defining any loan for which this value is greater than

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CREDIT SUBSIDIES IN BUDGETARY LENDING

Table 5. Cash Flow of Bond-Type Loan

Years 0 1 to N N

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Total (A)

Receipts (1) A -

Annual Payments (2)

Annual Net Receipts (3)

i. A A

+A -A . i -A

Discount Factor with Market Interest Rate (4)

Net Present Value (5) = (3)x(4)

1

A

D*N

- i. A

(1+i*)

-N

-A

.

.

D*N

(1+i)-N

A [1 - (l + i*)-N - . i D*N]

25 percent as a concessional loan.11 Most lending covered is assumed to be structured around equal principal repayments. The major difficulty with the DAG and World Bank procedure is that the unchanged discount rate of 10 percent a year is too arbitrary and rigid. Other rates would have been (and will be) more appropriate at various times, depending on the conditions prevailing in world capital markets. For example, in the early 1980s, the 10 percent rate clearly was much too low and presumably resulted in significant underestimates of concessional lending. Moreover, the massive volume of loans analyzed by these organizations requires that simplifying assumptions be made regarding the uniform structuring of loans, particularly that all loans are disbursed immediately. Calculations done by the author suggest, however, that grant elements—and particularly, grant equivalents (the subsidy values)—are quite sensitive to the way loans are structured. Therefore, elements of error (of unknown magnitude) are introduced when the analysis is not done on a disaggregated basis in order to retain a high degree of accuracy. Since the emphasis of these organizations is on the grant element, the problem is less critical than when the focus is on calculating subsidy values. Both of these difficulties, however, introduce an element of uncertainty into the published concessional lending figures and make unambiguous interpretation of them rather difficult. Before turning to a discussion of the problems that arise in practice, mention should be made of the general relationship between the sub11 See, for example, Organization for Economic Cooperation and Development (1980), p. 241, and World Bank (1981), pp. vi-vii.

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Figure 1. Subsidy Element and Interest Spread Subsidy element (Percent of loan face value)

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Opportunity cost interest rate

sidy element of a loan and the interest spread between its quoted rate and the opportunity cost interest rate. The regularity and shape of this relationship has important implications for applications of the subsidy estimation technique and for interpretation of the results. Figure 1 shows the subsidy (or grant) element as a function of this spread for a bond, where A = 100, i = 15, and n = 20. This function crosses the zero axis when the opportunity cost rate of interest (i*) is set equal to the effective rate of interest (ERI) on the loan (see below), which in this case also equals the quoted rate. When i* is below the loan's ERI, then profits can be made in the government's borrowing-cumlending operations. This is indicated in the chart by negative subsidy

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CREDIT SUBSIDIES IN BUDGETARY LENDING

Figure Z. Comparative Patterns of Subsidy Element and Interest Spread

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Subsidy element (Percent of loan face value)

Opportunity cost interest rate

rates at these levels.12 Alternatively, when i* rises above the ERI on lending, then positive subsidy rates are implied; the higher the i*, the more of the loan that really is a grant. Note, however, that the relationship is highly nonlinear. Even a relatively small interest spread (5 percent) gives a reasonably large (25 percent) subsidy element. Similarly, once a certain spread has been attained (say, 20 percent, that is, when i* equals 40 percent), then increases in the spread do not give rise to much additional subsidy flows. In the limit, of course, when i* is infinitely high, the subsidy element approaches its maximum limit of 100 percent. Figure 2, which presents the same relationship for different types of loan structures, shows that this shape is not unique to the bond struc12 Of course, the formulas work wheni*< ERI on the loan. In applications, all such loans should be included in the analysis, so the government's position on balance can

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ture assumed. Specifically, this figure plots the examples given earlier in this section: for A = 10,000,000; i = .10; N = 20; and i* = .125; A1 plots the simple amortized loan, andA3the bond. The same general terms are assumed in plotting A4, but a grace period of five years is added, and the equal principal payments structure is used. Amortized loans with a grace period are shown in A2.A, A2.B, and A2.C; the same general terms are assumed, but the five-year grace period added is characterized differently: it is assumed in A that full interest (0.10 percent a year) is paid during the grace period; in B that reduced interest (0.08 percent a year) is paid; and in C that nothing is paid.

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Complications in the Application The preceding section glosses over a number of difficulties that need to be addressed when the method is applied. It is necessary to know a great deal about specific program borrowers to properly estimate the income transfers, the impacts on credit allocation, and the total interest subsidies involved. For example, official lending operations conducted with afixedsupply of total credit result in income transfers to inframarginal borrowers of the difference between the interest expense they would have incurred on private credit and that paid to the government, while the amount transferred to submarginal borrowers is whatever income is yielded by their projects after repayment of their government loans. Moreover, loans to this latter group create a real transfer of credit, while lending to the former involves no reallocation of credit at all, unless these borrowers incur more indebtedness than they otherwise would have in private markets. Therefore, precise quantification of the economic role of official lending operations requires reliable information about the credit status of the borrowers, the alternative interest rates they would have paid in private markets, the interest rate elasticity of their credit demands, and the profitability of their projects.13 be derived. In an earlier application to Korean data (see Wattleworth (1983)) many loans analyzed involved negative subsidies at thei*rates used. 13 Break (1982), pp. 288-89. The terms "sub-" and "infra-" marginal require some explanation. Ifi*were the market-clearing interest rate with afixedsupply of credit, then submarginal borrowers would be those along the demand schedule below i*; inframarginal borrowers would be those along the demand schedule above i*. The upshot of this argument is that a meticulous study will probably have to be program-specific. For an excellent example of such an analysis, see von Furstenberg (1976).

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CREDIT SUBSIDIES IN BUDGETARY LENDING

Of course, most of these data do not exist, and their estimation over a wide spectrum of groups at the microlevel is not practical. Furthermore, even if available at any point in time, their usefulness would be limited by many factors that will be discussed in the following section (for example, different stages and lag patterns among programs). Thus, it seems inevitable that if any useful descriptive figures are to be generated at the aggregate level, while minimizing the data requirements and assuring some simplicity in the analysis, then a less ambitious goal than estimating the total subsidies must be accepted. In these circumstances, it makes sense to focus on the explicit subsidy transfer alone and forgo the desirable aim of measuring the larger flows and real impacts. This narrower focus solves some, but not all, of the difficult operational problems. If the method is applied directly to government lending, taking the A,i, N, and n, from observable official loans and using the government's marginal borrowing rate for i*, then the major assumption required is that the borrowers are inframarginal relative to the government's borrowing rate. This seems to be true for most capital-scarce countries. Figure 3 helps to set the context of this discussion, depicting the explicit subsidy measure as well as the inframarginality assumption. If dD and SS are the market demand and supply schedules, then G would be the free market solution without government intervention; OC of credit would be extended at rate iFM. If the government decides to make D'D of credit available and selects recipients at random from among all those who demand credit at the government's subsidized lending rate (if), then the fraction D'D/iGL of all those demanding credit at any rate of not less than iGL receive official subsidized loans, with the remaining demand satisfied in the unassisted private market along D'd. However, D'd determines only the residual quantity of credit supplied in the market. To fix the rate that unassisted borrowers must pay to private lenders, the total demand for credit must be obtained by adding back in the quantity channeled to the subsidized borrower, D'D. The intersection of this combined schedule (d'D) with the original supply schedule determines the rate for unsubsidized borrowers i'FM, who demand OA of credit, out of a total of OE, where AE equals D'D. In most applications, i'FM would not be directly observable, but it would be some weighted average of rates in various markets—for example, in many developing countries—on the unorganized money market and in the banking system. The value of the total interest subsidy (explicit plus implicit) is represented by the area IGDD'.

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Figure 3. The Explicit Subsidy Measure Interest rate

Credit extended per period

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Source: Adapted from von Furstenberg (1976), Figure 1.

If iGB represents the government's marginal borrowing rate, then YBDD' represents the value of explicit credit subsidies received by government loan recipients. In most applications, the present value of this area would be approximated by the present value of the slightly different area ACDD' (equals TAD'X) on the assumption that all borrowers are inframarginal to the government's borrowing rateiGB(that is, all lie on demand schedule dD above B). In terms of practical applications, therefore, selection of the government's marginal borrowing terms remains as the final major operational issue, and this issue is far from trivial because the results are very sensitive to variation in the i*'s.14 The major alternatives available are 14

One should not infer from the whole line of reasoning in this section that a government should simply charge its own borrowing rate on its lending. Clearly, a misallocation of resources in the economy would still result, and the implicit credit subsidies would not be removed. As Break (1965), pp. 36-39, has shown, if this were done, the resultant

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the terms on official external and internal borrowing. In general, the internal rate should be preferred because it entails the same currency in which the lending occurs, thus minimizing errors that might be introduced through incorrect estimates of exchange risk.15 In applications, however, economists may have to use an external borrowing rate because a domestic counterpart is unavailable. In such cases the exchange risk problem must be addressed, as previously mentioned. Moreover, even though governments still issue a large amount of fixed-term foreign bonds,16 this market may be effectively closed to some countries. They may have access only to floating rates, or to adjustable rate markets (for example, the Eurodollar market). In this case there are three alternatives available, none of which is entirely satisfactory. First, the observed rate could be used, assuming that it would not change, at least on average, over the period of analysis. Second, forecasts could be made of expected changes in the rate, perhaps by using different values to determine a range of subsidy values. Finally, if there seemed to be too much uncertainty in either of the former strategies, it might be preferable to forgo estimation of the capitalized value of the subsidy stream and simply do the analysis on an annual basis. Computationally, this is much easier and involves only the calculation of the service payments on outstanding loan balances at the mean lending rate and again at the mean borrowing rate, and then the subtraction of one from the other. The difference is the subsidy value for that particular period.17 It is well known that unanticipated inflation can result in a shift in real income from lenders to borrowers as the real value of debt contracted in government lending programs would be overexpanded and social welfare would be reduced. 15 This latter statement is based on the presumption that for instruments that are identical except for their currency of denomination, the only reason for an interest rate differential between them should be expected changes in the exchange rate between the two. This is known as the Fisher hypothesis. While there may be other reasons for departures from Fisher parity (for example, transactions costs, differential taxation, political risk), a major determinant is assumed to be exchange risk (see Blejer (1982), p. 271). The use of government bond yields as estimates of i' is only a proxy solution. The ideal measure of the government's margin of cost of the use of resources would be the social rate of discount. But there is no consensus on how this should be measured. See Larkins (1972), p. 34. 16 The share of adjustable rate notes in total bonds floated has been small historically, although maturities have shortened somewhat (see Williams, Johnson, and others (1982), pp. 49 and 55). 17 For an application of this approach, see United States (1981c), pp. 35—36.

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fixed nominal terms is eroded. However, if the government is both borrowing and lending at fixed rates over similar periods then, as a first approximation, it can be assumed that there are no net inflationary effects on the subsidy calculations because what is lost on the lending side is gained on the borrowing side. Similarly, if it is assumed that nominal interest rates are adjusted to incorporate fully actual inflationary developments under flexible rate loans, then more rapid rates of amortization will be implied than would have occurred under comparable fixed-rate loans.18 But again, if the government is both borrowing and lending in this way, then the net effect on the subsidy transfer should largely net out. Only if there were some mixed combination of structures would there seem to be a significant impact on the real value of the subsidy transferred through the government. The more common configuration surely would be the case of foreign borrowing at variable rates but domestic lending on fixed terms. In this case, an increase would be expected in the real value of the subsidy transferred through the government due to inflation, and calculations based solely on nominal values would, therefore, underestimate the real transfer. Since the capitalized value of the subsidy stream is being computed, attempts to correct for these effects would have to include inflation forecasts over the relevant time horizon.

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Effective Rate of Interest The most important operational issue in the foregoing analysis is selection of the correct opportunity cost interest rate,i*.In some cases, the correct choice of the discount rate may be so difficult that it cannot be done with any confidence. Or, it might be that all rates are floating and an annual type of analysis must be used. In these instances, an alternative approach that does not involve a discount rate, that is, the ERI, might be preferred. The ERI bears the same relationship to the former analysis as the calculation of the internal rate of return does to the net present value in project analysis.19 The analogy results because a loan is just like a "backward project" in the sense that the benefits of the "project" (loan disbursements) come initially, while the costs (debt-service payments) are spread over the lifetime of the loan. 18

See Appendix II, "Inflation and Debt Service," pp. 42-45 in Nowzad, Williams, and others (1981). 19 See Harvey (1983), p. 12.

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The ERI is defined as that rate of interest which, if used as a discount rate, would reduce the net present value of the loan to zero. Thus, the ERI is the same as the rate of interest on any loan on which interest must be paid on outstanding balances at all times (and on which there are no other costs payable). 20 Therefore, there usually is no need to calculate the ERI because it is the same as the quoted rate on the loan. However, when loans include special arrangements, such as grace periods during which payments are reduced below interest at the quoted rate, then the ERI diverges from this quoted rate and thus must be calculated directly. Calculation of the ERI involves solving the following equation for r: n

E E E

LDt - DSP, = ------------------------------= 0,

(i+r)t

t = o

(7)

where

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LD DSP t n

= = = =

loan disbursements debt-service payments time period maturity.

Estimation of credit subsidies using ERIs is done in the same way as was described above for annual subsidies. The ERIs in both government borrowing and lending are calculated; then, the cost of servicing the outstanding balance of loans is calculated for each. The difference between the borrowing and lending cost is the subsidy.

Rationale and Economic Effects Official credit programs are usually claimed to be necessary to correct failures in private capital markets. Such failures have been assumed to exist wherever potential borrowers cannot acquire credit at a "reasonable" cost. This may be due to inadequate flows of information, making risk assessment difficult and inaccurate; it may be due to monopolistic elements in the intermediation process or to other factors 20

See Harvey (1983), p. 7.

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that inhibit the mobility of capital;21 it may be due to inherent flaws in specific security instruments;22 or it may result from the complete absence of financial institutions, as is sometimes the case in rural areas. Related rationales (which also could justify other budgetary expenditures) are those relating to the exploitation of economic externalities, pursuit of social goals (including the stabilization of the economy), and alteration of the market-determined distribution of income. The first type of rationale is particularly prevalent in developing countries because it arises naturally in the planning context. Frequently, for example, governments attempt to divert credit into sectors that are believed to generate more backward and forward linkages in the economy, or where there may be other reasons for the divergence between private and social costs, such as that arising in the field of education which has prompted the establishment of official student loan programs.23 Although any or several of these reasons may legitimately give rise to a specific official credit program, many such schemes still exist long after the original conditions that motivated their adoption have changed. When such programs operate in areas where there are no longer significant market failures, the official assistance is best understood as a reallocation of credit, usually at subsidized interest rates, to specific activities or borrowers.24 A large part of these flows also may be pure income transfers because the loans would have been made anyway by the private market, but at significantly higher rates of interest. This process undoubtedly results in important sacrifices of economic efficiency, as it siphons credit away from other uses that have stricter risk or return criteria, while delivering it to users selected, at least partially, on the basis of noneconomic criteria. One of the major recognized economic effects of many official lending programs is, therefore, some sacrifice in the rate of economic growth. 21

For example, in the United States, state chartering of savings and loan associations and banks historically prevented excess loanable funds in surplus regions from flowing to areas of excess demand; see Plantes and Small (1981), pp. 14-15. 22 Such as originally existed in U.S. residential mortgage instruments, which lacked liquidity and carried onerous terms for borrowers and associated high risks for lenders before the government created the Federal Housing Administration and Federal National Mortgage Association (a secondary market); see Aragon (1980), p. 359. 23 For a somewhat different, but related, discussion of the reasons frequently given by the local authorities for direct credit market intervention in developing countries, see Johnson (1975). 24 United States (1982c).

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CREDIT SUBSIDIES IN BUDGETARY LENDING

As suggested above, however, this does not necessarily follow when social and private returns are not equal, because then a well-designed official credit program could encourage investments with high social returns, even though private returns were relatively low. But even if government officials were able to select projects with high social (but low private) returns, it can be argued that interest rate subsidies are inefficient instruments in this context because they also distort factor prices in the process.25 If government intervention in credit markets were substantial, these distortions would encourage inappropriate capital-intensive production techniques in existing production processes and movement into new products that were more capital intensive. Thus, the economy would start down the wrong technological path, making subsequent reversals of development strategy more difficult. The opposite side of the same issue is, of course, that such "successful" credit programs increase unemployment, frequently in economies with a surplus of labor. Relatively cheap loans over significant periods of time can also profoundly affect the financial structure of private enterprises in the sectors involved, creating, for example, relatively high ratios of debt to equity. This configuration of the corporate sector's balance sheet can then inhibit the free conduct of monetary policy, since an abrupt raising of interest rates could bankrupt the business sector if rates on outstanding debt were adjustable.26 While one might legitimately wonder why it is necessary to be concerned about these matters, given the growth performance of some countries that have high debt-equity ratios (for example, Japan and Korea), the argument here relates to the riskiness or vulnerability of the resultant structure—that is, extremely high debt-equity ratios may not be a problem during rapid inflation and growth, but they may become a severe handicap if growth and inflation slow quickly, or if the cost of capital rises abruptly. Moreover, there is the question of what the growth rate might have been without the distortions. These results are somewhat impressionistic because surprisingly little empirical work has been done on the real economic effects of direct government lending programs. Much of what is known is based on the experience of the United States and is presented in an excellent survey article by Aragon.27 25

Fry (1981), p. 38. This process has been amply demonstrated in international capital markets and sovereign external debt since the onset of the debt crisis in 1982. 27 Unless otherwise indicated, the remainder of this section comes directly from Aragon's (1980) article; the interested reader should refer to it directly for greater depth and thoroughness. 26

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The available evidence does not permit firm conclusions, even for the United States, and, of course, what does seem evident may not be readily transferable to widely different economies that are characterized by significantly smaller and less unfettered capital markets. The major uncertainties concerning the economic impact of official credit programs are summarized by Aragon into two basic questions: (1) Do official credit programs produce lasting changes in the composition and volume of credit? (2) Do such changes produce predictable shifts in the allocation of economic resources? Earlier studies, covering the period from the mid-1950s to the mid1960s, concluded that the answer to both questions was yes; however, these studies analyzed only the first-round effects of the lending programs and not the various financing and portfolio reactions of private agents that tended to offset the original flow of credit. Studies adding these effects into the analysis (carried out during the mid-1970s) produced conclusions that contradicted the earlier work with regard to most aggregate, long-run effects, although the short-run effects, which were significant, were similar. Other studies found that, even when changes were produced in the overall composition of credit, subsequent transformations of real assets frequently did not occur. For example, one study found that mortgage loans financed a variety of financial assets and other nonhousing real assets. With regard to stabilization issues and the contribution toward full employment, Aragon concludes that the effect of credit programs seems to vary according to the specific goals and assumptions of particular schemes and, for all purposes, the stance of monetary policy. Specialized program objectives, such as income redistribution, often conflict with maximization of economic efficiency and growth, as already suggested. Programs aimed at improvement of capital market efficiency and the provision of high-risk capital, however, have sometimes promoted innovation, investment, and growth. Increased spending was found most likely to occur when credit was extended to marginal or needy borrowers, especially in market-perfecting programs directed at small businesses. These, however, were only the initial results. The final impact on overall spending depended crucially on the level of accommodating monetary expansion. When the money supply remained relatively fixed, federal credit activities in the United States simply resulted in private displacement of lenders and borrowers—that is, "crowding out" occurred.28 This 28 As Weidenbaum (1976), p. 162, explains: "This . . . occurs for a variety of reasons. The total supply of funds is broadly determined by household and business saving and the ability of banks to increase the money supply . . . . The normal response of financial markets to an increase in the demand for funds by a borrower, such as is represented

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tended to offset any expansionary impact.29 Additional national income tended to result only when the money supply was expanded. Moreover, there usually has been an important asymmetry between creditprogram crowding out and budgetary deficit-financing crowding out. Budget financing needs have generally been highest in periods of deep recession, while those credit programs have been greatest during periods of expansion. Therefore, the probability of crowding-out effects would seem to be greater for credit than for budget financing, although this would not necessarily be the case if largefiscaldeficits were accompanied by tight monetary policy. Whether increased spending translated into real output, or simply nominal income, growth tended to depend on the relative elasticities of supply in various sectors and the sectoral distribution of the credit. When resource utilization was high in favored sectors, expanded official credit resulted only in price increases and almost no change in real output, even without concurrent monetary expansion. This resulted from the fact that the shift in expenditure composition raised prices in the stimulated sector, but the high prices were not offset by price deflation in the sectors that were crowded out. For example, increases in mortgage credit frequently resulted in decreased business credit. The increased demand for housing in periods of tightness in the housing market was simply inflationary, as there was no offset in business sector prices. If accompanied by a supportive monetary policy, the official credit activity in the mortgage field tended to be even more inflationary. Tempering all these results, however, are a number of particular problems that make empirical work on the aggregate economic effects of credit programs extremely difficult and definitive conclusions virtually impossible. First, generic differences in purposes among programs result in different impacts on real and financial variables—for example, market-perfecting credit programs should have different impacts from income-redistributing credit programs. Second, credit programs have different growth stages that alter the degree and diffusion of their impact—therefore, the effects may depend partly on how long the by a federal credit program, is an increase in interest rates so as to balance out the demand for funds with the supply of savings. But the Federal Government's demand for funds is 'interest-inelastic' . . . and the interest-elasticity of savings is relatively modest. Thus, weak and marginal borrowers will be 'rationed' out of financial markets in the process, while the Treasury and other borrowers pay higher rates of interest." 29 Estimates of the extent of crowding out are very difficult to make and somewhat uncertain. One such estimate, however, found that for every $1 billion in loan guarantees extended by the federal government, between $736 million and $1.3 billion in private investment was crowded out in 1980. See Bennett and Di Lorenzo (1983).

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program has existed. Third, both the financial and real effects of specific credit market interventions have complex, lagged patterns, which can only be evaluated within the context of comprehensive econometric models. Since the level of aggregation must be high, only the very largest of such programs can realistically be evaluated at all. Finally, overall financial and economic conditions, as well as the mix of fiscal and monetary policy, largely determine the effects of credit programs. Despite all the difficulties, however, there seems to be a consensus that several undesirable consequences can be associated directly with official credit programs, such as displacement of private borrowers and lenders; encouragement of foreign borrowing; insertion of a policy "wedge" into market decisions; creation and maintenance of large, inefficient bureaucracies; complications in the coordination of stabilization policies; and, sacrifice of economic efficiency without corresponding increases in the total supply of investible funds, so that the overall rate of economic growth suffers.

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Fiscal and Budgetary Implications The foregoing sections have shown that it is the time dimension of lending that distinguishes it from other government expenditure items. Since subsidized credit schemes are common in a wide variety of countries (both developing and industrial), currently observed fiscal deficits may simply reflect, to a surprisingly large degree, past credit subsidy commitments. Using the estimation methods described above on Korean data from the 1970s, explicit interest subsidies in direct government lending were found to have been a major determinant of the government's fiscal position, equal to at least half of the central government's deficit, on average. Moreover, because the lending process contributes to the creation of long-term structural deficits, the short-term flexibility offiscalpolicy may also become severely restricted. Figure 4 depicts an eight-year government program that annually lends an amount designated as 100 at 5 percent a year interest. This scheme is financed by government borrowing at 10 percent a year. It is assumed that both the lending and borrowing involve five-year bonds (the principal due in one lump sum at maturity, while annual payments of interest only are due prior to maturity); lending occurs on January 1 and repayment on December 31. As the figure shows, the annual subsidies grow to an equilibrium level, which remains even after no new net lending occurs and current new loan commitments are being met fully with repayments from past

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Figure 4» The Structural Fiscal Burden Built into Official Subsidized Lending Programs

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Annual subsidy

5

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loans (as in years 6-8). The only way these annual subsidies can be stopped is by terminating the program and retiring the debt (years 9-12). Note also that in each year in which government intermediation is undertaken at these relative terms (years 1-8), the government commits itself to an explicit interest subsidy of 18.95, which is the present value of the annual subsidy stream discounted at 10 percent a year, or the government's opportunity cost of funds. Alternatively, the total subsidy being given at the outset of the eight-year program is 111.23. The concealed nature of such credit subsidies does not make them any less subsidies, and, like any government outlay, they are always financed by taxes, borrowing, or monetary growth at higher levels than would otherwise have occurred, or by other expenditures being lower than they would otherwise have been. Their concealed nature may mean, however, that they are more difficult to control than other expenditures because they may escape scrutiny when austerity forces budget cuts to be made. This is not to argue that all government lending programs should be ended. As explained earlier, there are circumstances in which credit subsidies are appropriate and justifiable. Still, they should be required to vie for the limited public resources on an equal basis with other competing claims. This suggests that their true magnitude—that is, the present discounted value of the subsidy stream—should be entered explicitly in the budget in the originating year as an expenditure item.30

References Aragon, George, "Federal Credit Programs," in Federal Finance: The Pursuit of American Goals, Vol. 6 of Special Study on Economic Change, U.S. Congress, Joint Economic Committee, 96th Congress, 2nd Session (Washington: Government Printing Office, December 1980), pp. 358-99. Bennett, James T., and Thomas J. Di Lorenzo, Underground Government: The Off-Budget Public Sector (Washington: Cato Institute, 1983). Blejer, Mario I., "Interest Rate Differentials and Exchange Risk: Recent Argentine Experience," Staff Papers, IMF, Vol. 29 (June 1982), pp. 270-79. Break, George F., Federal Lending and Economic Stability (Washington: Brookings, 1965). 30 The U.S. administration has proposed that the U.S. Congress adopt this procedure. See United States (1988), p. 6b-8.

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, "Issues in Measuring the Level of Government Economic Activity," American Economic Review, Vol. 72 (May 1982), pp. 288—95.

Brunner, Karl, ed., Government Credit Allocation: Where Do We Go From Here? (San Francisco: Institute for Contemporary Studies, 1975). Carron, Andrew S., "Fiscal Activities Outside the Budget," in Setting National Priorities: The 1982 Budget, ed. by Joseph A. Pechman (Washington: Brookings, 1981), pp. 261-69. Fry, Maxwell J., "Interest Rates in Asia" (unpublished; Washington: IMF, June 25, 1981). Harvey, Charles, Analysis of Project Finance in Developing Countries (London: Heinemann, 1983). Healy, James P., "The Institutional Framework for Financial Policy in Korea" (unpublished; Washington: IMF, August 1981). International Monetary Fund, Government Finance Statistics Vol. 6 (Washington, 1982).

Yearbook,

Johnson, Omotunde E.G., "Direct Credit Controls in a Development Context: The Case of African Countries," in Government Credit Allocation: Where Do We Go From Here?, ed. by Karl Brunner (San Francisco: Institute for Contemporary Studies, 1975), pp. 151-80.

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Jones, E.P., and S.P. Mason, "Valuation of Loan Guarantees," in U.S. Congressional Budget Office, Conference on the Economics of Federal Credit Activity, Part II: Papers (Washington: Government Printing Office, September 1981), pp. 349-77. Larkins, Dan, $300 Billion in Loans: An Introduction to Federal Credit Programs, Domestic Affairs Study 6 (Washington: American Enterprise Institute, September 1972). McKinnon, Ronald I., and Donald J. Mathieson, How to Manage a Repressed Economy, Essays in International Finance, No. 145 (Princeton, New Jersey: Princeton University Press, December 1981). McMurray, David W., "Evaluating Alternative Financing Packages," World Bank External Debt Division Working Paper 1982-3 (Washington, June 1982). Nowzad, Bahram, R.C. Williams, and others, External Indebtedness of Developing Countries, Occasional Paper 3 (Washington: IMF, May 1981). Organization for Economic Cooperation and Development, Development Assistance Committee, Development Cooperation (Paris: OECD, November 1980). Plantes, M.K., and D. Small, "Macroeconomic Consequences of Federal Credit Activity," in U.S. Congressional Budget Office, Conference on the Economics of Federal Credit Activity, Part II: Papers (Washington: Government Printing Office, September 1981), pp. 1-65.

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Premchand, A., "Study Examines Government Lending Programs in OECD and Selected Developing Countries," IMF Survey, Vol. 11 (August 2, 1982), pp. 234-37. United States, "Feasibility of Explicit Recognition of the Interest Subsidy in Connection with Separate Budgeting of Loans," in President's Commission on Budget Concepts, Staff Papers and Other Materials Reviewed by the President's Commission (Washington: Government Printing Office, 1967), pp. 335-45. , Congress, Congressional Budget Office, Loan Guarantees: Current Concerns and Alternatives for Control (Washington: Government Printing Office, August 1978). , Loan Guarantees: Current Concerns and Alternatives for Control: A Compilation of Staff Working Papers (Washington: Government Printing Office, 1979). , Federal Credit Activities: An Analysis of the President's Credit Budget for 1981 (Washington: Government Printing Office, February 1980). (1981a), Federal Credit Activities: An Analysis of the President's Credit Budget for 1982 (Washington: Government Printing Office, April 1981). (1981b), Small Issue Industrial Revenue Bonds (Washington: Government Printing Office, April 1981). (1981c), "The Benefits and Costs of the Export-Import Bank Loan Subsidy Program" (mimeographed; Government Printing Office, March 1981). (1981d), Conference on the Economics of Federal Credit Activity, Part II: Papers (Washington: Government Printing Office, September 1981). (1982a), The Federal Financing Bank and the Budgetary Treatment of Federal Credit Activities (Washington: Government Printing Office, January 1982). (1982b), Federal Credit Activities: An Analysis of the President's Credit Budget for 1983 (Washington: Government Printing Office, March 1982). (1982c), Reducing the Federal Deficit: Strategies and Options (Washington: Government Printing Office, 1982). United States, Office of the President of the United States, Office of Management and Budget, Special Analyses: Budget of the United States Government, Fiscal Year 1978 (Washington: Government Printing Office, 1977). , Special Analyses: Budget of the United Sates Government, Fiscal Year 1982 (Washington: Government Printing Office, 1981). , Budget of the United States Government, Fiscal Year 1989 (Washington: Government Printing Office, February 1988).

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van Wijnbergen, Sweder, "Short-Run Macroeconomic Adjustment Policies in South Korea: A Quantitative Analysis," World Bank Staff Working Paper 510 (Washington: World Bank, November 1981). von Furstenberg, George M., "Distribution Effects of GNMA Home Mortgage Purchases and Commitments Under the Tandem Plans," Journal of Money, Credit, and Banking, Vol. 8 (August 1976), pp. 373-89. Wattleworth, Michael A., "Credit Subsidies in Budgetary Lending" (unpublished; Washington: IMF, 1983). Weidenbaum, M.L., Subsidies in Federal Credit Programs, Reprint No. 4 (Washington: American Enterprise Institute, September 1972). , "An Economic Analysis of the Federal Government's Credit Programs," in U.S. Congress, House Committee on Banking, Currency, and Housing, Hearings on Loan Guarantees and Off-Budget Financing, 94th Congress, 2nd Session, November 10, 1976 (Washington: Government Printing Office, 1976), pp. 153-73. Williams, Richard C, with G.G. Johnson and others, International Capital Markets: Developments and Prospects, 1982, Occasional Paper 14 (Washington: IMF, July 1982). World Bank, External Debt Division, World Debt Tables, December 1981, EC-167/81 (unpublished; Washington, December 1981).

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9 Effects of Inflation on Measurement of Fiscal Deficits: Conventional Versus Operational Measures

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Vito Tanzi, Mario I. Blejer, and Mario O. Teijeiro INFLATION AFFECTS GOVERNMENT revenue and expenditure in different ways; as a consequence, it generally changes the size of the fiscal deficit. While there is now a sizable literature that discusses the relationship between tax revenue and inflation, there are very few writings that discuss the impact of inflation on the level of public expenditure.1 A priori it would seem realistic to assume that different parts of the budget would respond differently to inflationary pressure. These reactions often depend, however, on political considerations, union power, indexation rules for wages and pensions, and so forth. It is thus difficult to generalize the automatic relationship between the level of public expenditure and the rate of inflation; one major exception is the behavior of nominal interest payments related to the servicing of the public debt. For this category of expenditure it is now generally recognized that an increase in expected inflation almost always brings about a fairly automatic increase in nominal interest payments. Note: An earlier version of this chapter was published under the title "Inflation and the Measurement of Fiscal Deficits," in Staff Papers, IMF, Vol. 34 (December 1987), pp. 711—38. Another version appeared as "The Effects of Inflation on the Measurement of Fiscal Deficits," in Measurement of Fiscal Impact: Methodological Issues, ed. by Mario I. Blejer and Ke-young Ghu, Occasional Paper 59 (Washington: IMF, 1988), pp. 4-19. 1 Another, no less important and often interrelated, problem is revenue arrears to the government, for example, taxes levied but not collected and uncollected loan repayments due to the government. The chapter will deal with the implications of this other "arrears" problem only tangentially.

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The growth of interest payments in an inflationary situation is often explained by the Fisher effect, which indicates that during an inflationary period the nominal rate of interest tends to approximate the real rate that would have prevailed in the absence of inflation plus the expected rate of inflation. Although in actual situations nominal interest rates may increase by more or less than the level hypothesized by Fisher, there should be no question that when the expected rate of inflation rises, the nominal rate of interest also rises unless artificially constrained by governmental action. An increase in the rate of expected inflation can lead to quick and dramatic increases in nominal interest expenditure when the domestic public debt is a substantial proportion of gross domestic product (GDP). Let us consider an example. Assume for simplicity's sake that all government debt is in the hands of just one individual. This individual derives all his income from the interest payments that he gets from the government and bases his behavior as a consumer on that income. Assume also that the debt is in instruments of short maturity. Assume that the size of the debt is $1 million. With expected price stability and a 5 percent nominal (and real) rate of interest, the income of the individual, and the interest expenditure of the government, would be $50,000. With an expected inflation rate of 10 percent, and assuming that the Fisher effect holds, the nominal rate of interest would become 15 percent. Thus the nominal interest income received by the individual would rise from $50,000 to $150,000 and, of course, the interest expenditure by the government would also increase by the same amount. 2 Thus, an increase in the rate of inflation from zero to 10 percent has increased interest expenditures by the government by 200 percent. This example allows us to focus on the main question to be analyzed in this chapter: how would an individual who sees his nominal interest income increase by 200 percent react to this increase? Three alternative reactions can be hypothesized.3

2 To simplify the presentation, in all these examples the effect of compounding and the complications created by the existence of progressive income taxes levied on nominal interest incomes are ignored. See, for details, Tanzi (1976). 3 There is a large and growing literature on inflationary accounting of fiscal deficits and on the different deficit definitions that should apply in the presence of inflation. See, among others, Chapter 14 of this volume, Gukierman and Mortensen (1983), Eisner and Pieper (1984), Eisner (1986), and Miller (1982). Given its important operational implications, this issue has been the subject of much research among IMF staff members. Some recent contributions include Bierman (1985); Catsambas (1986); Heller, Haas, and Mansur (1986); Mackenzie (1984); Molho (1986); and Tanzi (1985a).

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The first assumes a perfectly rational individual. He realizes that, while his nominal interest income has increased by 200 percent, his real income has not changed at all because $100,000 of the $150,000 of nominal interest income is just a compensation for the erosion of the real value of his financial capital. We shall call this compensation the monetary correction. This is a return of capital rather than a return on capital, since a 10 percent inflation rate reduces the real value of his financial capital by $100,000 after one year. The proponents of this school would argue that the individual would treat this $100,000 in exactly the same way as he would have treated an amortization payment equal to $100,000, since in a real economic sense, though not in an accounting or legalistic sense, it is amortization. His behavior as a consumer will continue to be determined by the real value of his permanent income that presumably has not changed.4 In other words, he will save all the monetary correction. Thus, one should not treat this monetary correction any differently from normal amortization payments. As amortization payments are not part of the fiscal deficit, the monetary correction should also not be part of the deficit. This is the argument made by Eisner (1986) in his recent book. The second alternative assumes that the individual does not distinguish at all between real interest payments and monetary corrections, regardless of how high is the expected rate of inflation. Therefore, as a consumer, he would treat the full $150,000 interest payments received when the rate of inflation is 10 percent in the same way as he would treat the $50,000 interest payments received when the rate of inflation was expected to be zero. He would thus behave as if his real income had, in fact, increased from $50,000 to $150,000. Under this assumption, which is the one implicit in the conventional measure of the fiscal deficit, monetary corrections are treated as income while amortization payments are not considered income for those who receive them or ordinary expenditure by the government and are thus not assumed to increase the deficit and to affect aggregate demand. The conventional measure of the deficit is thus highly sensitive to the rate of inflation whenever the size of the domestic debt is significant. In the third alternative, one can assume that both of the previous alternatives present an unrealistic version of reality. As the rate of expected inflation rises, the conventional measure provides a progressively more distorted measure of the size of fiscal adjustment needed 4 Whether his behavior as an investor will continue to be the same is a different issue discussed later.

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by the country to achieve economic stability.5 By the same token the "perfect rationality" approach is equally likely, for reasons explained later, to underestimate the size of the needed fiscal adjustment. Unfortunately, while it is easy to criticize these two polar versions of the measure of the fiscal deficit, it is very difficult, or perhaps impossible, to propose an alternative measure that does not suffer from the shortcomings ascribed to the first two alternatives.

Effects of Inflation on Fiscal Deficits

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Conventional Definition of Fiscal Deficits Fiscal deficits, as conventionally defined on a cash basis,6 measure the difference between total government cash outlays, including interest outlays but excluding amortization payments on the outstanding stock of public debt, and total cash receipts, including tax and nontax revenue and grants but excluding borrowing proceeds.7 In other words, not all outlays related to public debt servicing are included in the measure of the deficit: interest payments are added to non-debt-related expenditures but amortization payments are excluded. On the other hand, current revenues are accounted as government income while proceeds from borrowing are excluded. In this manner, fiscal deficits reflect the gap to be covered by net government borrowing, including direct borrowing from the central bank. Fiscal deficits so defined do not provide, therefore, a direct measure of monetary expansion or a measure of gross government pressure on credit markets, as borrowings required to finance amortization payments are not included as part of the deficit.8 5

By fiscal adjustment we mean here the increase in the ratio of government revenue to GDP, or the reduction in the ratio of noninterest government expenditure to GDP. Thus,fiscaladjustment is related to the so-called primary deficit, that is, the conventional fiscal deficit net of interest payment. 6 See International Monetary Fund (1986). 7 This definition differs from that in A System of National Accounts (SNA) in two important respects: it is calculated on a cash basis, while the SNA definition is based, in principle, on accrual concepts; and it considers net lending to the private sector as expenditure contributing to the determination of the deficit. See United Nations (1968). 8 A measure of needs of monetary transfers from the central bank would be given by the difference between total expenditures and total receipts (including receipts from the sale of bonds). A measure of gross financing needs would be given by the difference between total outlays and total receipts excluding borrowing proceeds. As this is a cash concept, changes in the size of arrears do not affect its size.

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Under this definition there are two kinds of financial government operations, each involving domestically held debt, that do not affect the current fiscal deficit: first, any operation that only involves changes in the composition of government debt, for example, the replacement of long-term bonds by short-term treasury bills and vice versa; second, any operation that involves the monetization of existing government debt. The first type of operation reflects debt-management policy designed to get a particular maturity structure of the government debt. The second type of operation reflects open-market operations by the central bank, that is, pure monetary policy. Thus, the conventional definition of fiscal deficit is independent of the maturity structure of the outstanding domestic government debt and of the degree of debt monetization that the central bank may pursue for purely monetary policy purposes. This conclusion is not valid for the longer run, as both debt-management policy and open-market operations will eventually affect the size of the deficit.

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Effects of Inflation on Interest Payments and on Conventional Fiscal Deficits When incorporated into expectations and, thus, reflected in nominal interest rates, inflation has a direct impact on the nominal interest service of the public debt. To isolate this effect from the other consequences of inflation on the government budget, assume (1) that noninterest expenditures grow pari passu with inflation, and (2) that through discretionary actions policymakers adjust the tax system to a new inflationary environment so as to maintain constant the ratio of tax revenue to gross domestic product.9 Clearly, a similar assumption cannot be adopted for interest payments on government debt. The growth of nominal interest payments on existing domestic debt is generally beyond the control of the fiscal authorities, as it is tied to the evolution of market interest rates and to indexation clauses.10 Often, however, 9 The assumption about the de facto behavior of tax revenue is somewhat unrealistic especially when the rate of inflation accelerates or decelerates (see Tanzi (1977)). Reduction of collection lags and adjustment of tax bases and increases in the tax rates of some excises are measures that would prevent the deterioration of revenues in real terms. Indexation of brackets and deductions would prevent the fiscal drag. 10 Obviously, the government may try to control interest rates or suspend indexation clauses. This alternative could, however, be ruled out for an extended period of time owing to its undesirable consequences in terms of sectoral transfers, misallocation of resources, and capital flight.

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as indicated earlier, the increase in nominal interest payments does not represent a real transfer of purchasing power from the government to the debt holders. Rather, as long as the real rate of interest does not change, that increase tends to compensate the latter for the erosion in the value of their principal caused by the higher inflation rate. Debt holders are, therefore, no richer in real terms because of the higher level of nominal interest rates, although, in relative terms, they might be if inflation has reduced the real incomes of other groups. In Appendix I, the effect that an increase in the rate of inflation produces on conventional fiscal deficits in the presence of a floating interest debt instrument is formally illustrated. The exercise assumes that government revenues and non-debt-related expenditures follow the evolution of the price level. In other words, it assumes that the primary deficit is not affected by the rate of inflation.11 The presence of a full Fisher effect is assumed, such that nominal interest rates completely adjust to the expected rate of inflation to yield a constant expected real rate of return. Moreover, actual and expected inflation are assumed to be equal and all the debt is domestically held.12 Under these assumptions, it is shown that when inflation accelerates, the nominal interest bill rises more than proportionally to the price level, leading to an increase in the fiscal deficit in terms of GDP. The contrary happens if the rate of inflation decelerates.13 The explanation is that while inflation, by assumption, does not affect the real value of revenues and noninterest expenditure and, therefore, does not affect the primary deficit, it increases the real value of interest payments to compensate those who hold government bonds for the reduction in the real value of the stock of the outstanding debt. The magnitude of this effect depends on both the rate of inflation and the size of the stock of floating interest domestic debt. A similar demonstration provided in Appendix II indicates that conventional deficits are not affected by inflation when the public debt is either linked to an index (and the monetary correction is then considered as amortization) or when it is denominated in foreign currency.14 11

The primary deficit is the difference between government expenditure, excluding all interest payments, and government revenue. 12 Of course, if the actual rate of inflation diverges from the expected rate, the ex post real rate will change. 13 See Table 1 in Appendix II for a numerical example. 14 This is applicable to index-linked domestic debt as long as the increase in the nominal value of the debt due to indexation is excluded from the conventional definition of the deficit. If the indexed part is included, the results are the same as with floating debt.

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To show this result, the exchange rate is assumed to follow the evolution of domestic prices.15 When inflation accelerates, the depreciation of the currency leads to an increase in the domestic value of the external debt that is proportional to the change in the country's price level. Since the real value of the stock of debt remains, therefore, unchanged, interest payments will increase at the same rate as domestic prices, thus maintaining constant their share of GDP. Therefore, in the presence of inflation, and provided that the domestic debt is in short-term instruments, the share of the conventional fiscal deficit relative to GDP becomes a function of (1) the rate of inflation, (2) the size of the domestic public debt, and (3) the domestic and external composition of total public debt. Countries whose public debt is held all in foreign currencies will not have their fiscal deficits as shares of GDP affected by their inflation rate, irrespective of the magnitude of such debt. Countries whose debt is held in the form of floating interest domestic debt will, on the contrary, have a fiscal deficit that depends on the rate of inflation and on the magnitude of their public debt. This asymmetry results only from the convention that while all nominal interest payments (including the inflation premium contained in the nominal interest rate) are considered expenditures, and thus contribute to the fiscal deficit, amortization payments are not considered expenditures and thus do not contribute to the increase in the deficit as conventionally measured. During high inflation, the rate at which a country is implicitly forced to amortize its debt increases but the de facto amortization is not recognized as such. The higher is the rate of inflation the faster is the implicit amortization. The consequences of inflation on the deficit in the presence of some other types of debt instruments also deserve comment. When longterm fixed interest bonds have been the main instrument of government financing, the nominal interest bill will not be affected by a burst of inflation that had not been anticipated at the time the bonds were sold. This means that initially, the interest bill and, thus, the fiscal deficit tends to fall as a share of GDP.16 When those long-term instruments become due, however, their amortization will have to be financed by

15 That is, no change in the real exchange rate takes place. Furthermore, it is assumed that foreign inflation is zero. 16 In this case, the government has an inflationary gain at the expense of the holders of long-term bonds. There is an implicit capital levy on those who hold the public debt. This capital levy can be considered part of the inflation tax levied by the government on its monetary and other nominal liabilities.

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the issuance of new bonds. These will bear a higher interest rate that will reflect the increased expected inflation rate.17 As mentioned above, the case of domestic index-linked debt is almost identical to the foreign debt case, provided that the adjustment of the principal for inflation (the monetary correction) is treated as amortization and is thus not considered an interest expenditure.18 Index clauses, be they tied to domestic prices or to the value of the foreign exchange, adjust the value of the principal, affecting the nominal magnitude of present or future amortization payments. Interest payments are also affected, up to the extent that the (fixed) interest rate has to be applied on an inflation- (or exchange rate-) adjusted principal. This effect, however, tends to increase interest payments only in proportion to the domestic rate of inflation, leaving the interest bill and the deficit unaltered in terms of GDP.19 The magnitude of the adjustments produced by index-linked debt is, in principle, similar to that produced by foreign debt. The potential source of difference may be related to changes of the real exchange rate, a possibility quite relevant in many countries, particularly when those changes take place for macroeconomic or for stabilization purposes.20

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Macroeconomic Implications of Conventionally Defined Fiscal Deficits An important conclusion arising from the preceding analysis is that countries (1) with identical rates of inflation, (2) with the same total 17 Long-term fixed interest domestic debt may be found to be relevant only in countries with very low levels of inflation or where inflation is a new phenomenon. In the United States the high level of public debt accumulated during World War II consisted of longterm bonds carrying low interest rates in anticipation of very low rates of inflation after the war. The inflation rate that accompanied the postwar period, though low, was enough to substantially reduce the burden of the debt until the late 1970s. 18 Neither the guidelines of the IMF's Manual on Government Finance Statistics nor those of the National Accounting System recommend including indexation payments or accruals as deficit-determining expenditure. 19 This assumes that the index used for the monetary correction does not diverge from the one reflecting the rate of inflation of GDP. It also assumes that real GDP does not change. 20 Other types of debt instrument are the so-called zero-coupon bonds. They constitute a particular case that creates conceptual difficulties, even in the absence of inflation, arising from the distinction between accruals and realizations; however, they are likely to be irrelevant in high-inflation countries, as the risk associated with the expected real return on that type of asset will grow significantly with inflation.

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public debt in terms of GDP, and (3) with identical ratios of tax revenue and noninterest expenditure to GDP may, nevertheless, show very different conventional fiscal deficits depending solely on the composition of their debt. The question then arises about the economic implications of thefiscaldeficit as conventionally defined, and about the merits and the shortcomings of such a definition.

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Measurement of the Fiscal Deficit and Inflation The measurement of the fiscal deficit in a noninflationary context is supposed to provide policymakers with an indication of the net impact of the government budgetary activity on aggregate demand and on financial markets. It is intended to indicate the magnitude of additional resources over the ordinary government revenue that the government must attract from the private sector, or from external sources, to finance its own operations. The conventional definition is, thus, designed to be a measure of the government contribution to aggregate demand and, through this, to the external current account disequilibrium, or, alternatively, it may measure the crowding out of the private sector in financial markets.21 Under this definition, amortization payments are not added to other government outlays in the computation of the deficit, because of the implicit assumption that those amortization payments will not be regarded as income by those who receive them. Thus, one basic assumption is that the behavior of the bondholders as consumers will not be changed by the amortization payments. Furthermore, and this is another important assumption, bondholders are expected to willingly reinvest those receipts in new government bonds issued at current market conditions. In other words, their behavior as financial investors will also not be affected. Amortization services are, therefore, not expected to create additional pressures on financial or goods markets. In a noninflationary context, however, government interest payments should be treated differently from amortization payments. Interest payments are assumed to be regarded, by those who receive them, as 21 In a medium-term framework, monetization of the deficit would lead to inflation or reserve losses or both; foreign financing would lead to appreciation of the real exchange rate and current account disequilibrium as well as inflation if the nominal exchange rate is not allowed to appreciate; domestic financing would push interest rates up, crowding out domestic investment or encouraging capital inflows and a consequent current account deficit. In the short run, changes in the deficit may also affect the level of economic activity.

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just any other type of income to be consumed or saved depending on their propensity to consume. The payments are a return on wealth rather than a return of wealth. Thus they can be consumed without reducing the bondholder's accumulated net wealth. Therefore, interest payments would be similar in their macroeconomic effects to any other type of expenditure.22

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The Bondholder as a Consumer The situation becomes more complicated in the presence of inflation. As already argued, in an inflationary environment, interest payments reflect—at least partially—compensation for the erosion in the real value of invested capital. The part of interest payments that simply reflects the erosion of the principal constitutes, therefore, an implicit repayment of the principal.23 One can argue that, in a true economic sense, this part is similar to the amortization payment and that a rational bondholder would treat it in the same way. The relevant question, then, is whether such an inflation-induced portion of interest payments should be treated as other deficit-determining government expenditures or whether it should be treated in the same way as amortization payments. The answer rests largely on the use that individuals are expected to make of the monetary correction. If they do not consider these interest payments as income (that is, they do not suffer from money illusion), they should treat them in the same way as they would treat explicit amortization payments. As a consequence, these payments might have monetary, current account, or crowding-out implications similar to those of explicit amortization payments.24 Bondholders might reinvest these proceeds in additional government bonds, at existing market conditions, provided that these bonds retain their relative attractiveness as earlier. In such a case, the conventional measure of the deficit is likely to overstate the aggregate demand impact of the deficit on the economy, and an argument could be made for correcting that deficit for the effect of inflation. Notice that these considerations apply equally 22 It is well known that real expenditures may have different effects on demand from transfer payments. This distinction is ignored in the discussion. For a discussion of this issue, see Borpujari and Ter-Minassian (1973) and Hansen (1969). 23 This issue is similar to that encountered in the taxation of interest income during inflation; it has been argued that only real interest should be taxed (see Tanzi (1976)). 24 This, of course, does not necessarily mean that there would not be any such implications at all; just that they would be the same as for explicit amortization payments.

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to nominal interest payments and to payments arising from the formal indexation of the principal. To analyze the potential different impacts on the economy of the inclusion or exclusion of the inflationary debt service, a useful starting point is the national income identity from which the impact of government deficits on the current account is frequently derived:25 CA = DG + DP,

(1)

where CA is the current account deficit, DG is the government fiscal deficit, and Dp is the private sector net balance, all in nominal terms.26 The government deficit could be defined as

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DG = G + I - T,

(2)

where G is nominal government expenditures, including the real component of interest payments, I is the monetary correction,27 and T, the current tax and nontax revenues. It is observed from equation (1) that when the private sector is in balance (DP = 0), the current account deficit equals the fiscal deficit. Under noninflationary conditions, a certain stability of the private sector balance may be expected at least in the short run; then, the relationship between changes in the government fiscal deficit and changes in the current account becomes obvious. With inflation, however, government deficit and private sector surplus may become correlated. An increase in the public sector deficit caused by the increase in interest payments that simply compensates for inflation would raise by an equivalent magnitude the private sector surplus if those payments are fully reinvested in public bonds by the private sector. In that case, the current account would remain unaltered and, since there is no need for other financing, the increase in the public sector deficit is unlikely to result in further demand pressures. This point can be better illustrated if the public and private sector balances are defined in terms of their financing: DG = FG + AMS + ABS

(3)

DP = FP - AMD + ABD,

(4)

and 25

A further discussion of some of these aspects is contained in Appendix II. Notice that DP < 0 indicates an increase in private sector net nominal savings. 27 Or, alternatively, for the accrued increase in the nominal value of indexed debt, if it were treated as deficit-determining expenditure. 26

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where FG is foreign financing to the public sector,ABSis the net increase in domestic government borrowing, and AMS is the (nominal) increase in the supply of base money. The left-hand side of equation (3) represents the fiscal deficit as conventionally measured,28 while the righthand side summarizes the financing alternatives for the fiscal deficit. FP in equation (4) is foreign financing to the private sector, AMD is the increase in the private sector money holdings, and ABD is the increase in the holdings of government bonds. Equation (4) simply indicates that the deficit or surplus of the private sector must show up in changes in its net financial asset position. Assuming, for simplicity, zero net foreign financing to both the private and public sectors (that is, FG = FP = 0) and replacing equation (4) by equation (1), we obtain CA = DG - AMD - ABD.

(5)

It is clear from equation (5) that changes in the conventionally defined deficit will affect the current account only if those changes are not matched by changes in the same direction in the nominal demand for either money or government bonds. A more specific result could be obtained by assuming AMD = 0 and replacing equation (2) by equation (5), as follows:

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CA = (G - T) + (I - ABD),

(6)

which implies that if all the increase in the deficit arises from higher inflation-induced interest payments on the outstanding debt, I, and if this is fully matched by an equivalent increase in the nominal holdings of bonds (to maintain the real value of the stock constant), then I = ABD; therefore, the higher deficit does not have current account implications. It could be said, therefore, that inflation, by creating the possibility of a significant correlation between increases in government deficits as conventionally defined and increases in private sector nominal savings represented by an increase in the nominal demand for bonds, eliminates, or at least weakens, the link between changes in conventionally defined budget deficits and changes in the current account.29 That this argument has some empirical validity is demon28 It could also be identified with a definition in which the accrued increase in the value of indexed principal was treated as interest payments. 29 What is implicitly assumed here is that the issuance of new bonds is limited to the refinancing of the inflationary component of the debt service; issuance of bonds over and above that level would clearly crowd out the private sector from financial markets.

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strated by the fact that in countries with high rates of inflation and high (conventional) fiscal deficits little correlation is often observed between the size of the fiscal deficit (as a share of GDP) and the size of the current account deficit. Such correlation is obvious, however, for countries with low rates of inflation.

The Bondholder as an Investor The relevant question then becomes, should the interest payment that represents the monetary correction (I) be included in the deficit concept to provide an accurate estimate of the latter's potential impact on the economy? The answer is not as straightforward as the above discussion may lead one to believe. It depends largely, though not completely, upon whether the monetary correction can indeed be refinanced under the same conditions as assumed above.30 In this regard, the factors affecting the determination of the private sector demand for government bonds become crucial.

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The Bondholder as Consumer and as Investor One way of dealing with the question is by considering the behavior of a typical bondholder as a consumer and as an investor. For his behavior as a consumer not to be affected by the monetary correction, it is sufficient to assume that he does not suffer from money illusion. In the absence of money illusion, the inflationary component of interest payments will not affect aggregate consumption and, thus, the current account of the balance of payments; however, when the rate of inflation is not high, or when it is changing, or when inflation is a new phenomenon or is being repressed by various government policies so that there are doubts about the underlying rate of inflation, money illusion is likely to be present in at least some of the bondholders so that the importance of this assumption must be kept in mind. The complete absence of money illusion can be accepted only when the rate of inflation has stabilized for some time and is relatively high. Although a good case can nevertheless be made that a high conventional deficit resulting mainly from the effect of inflation on nominal interest payments may not have any direct effect on the bondholder 30

By the same conditions, it is meant at a given real rate of interest and at given liquidity characteristics.

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as a consumer, it is very likely that it is going to influence him as an investor. The point to be understood is that a high conventional deficit will increase the nominal payments that the government makes to bondholders (that is, it will accelerate the pace at which the debt is being implicitly amortized) exactly at the time when their perceptions of expected rates of return on different assets and of the risks associated with those returns are changing rapidly. Thus, it is unlikely that, under such circumstance, the government will be able to refinance the inflation-induced component of interest expenditure at exactly the same real conditions (that is, equal real rate for identical maturity) as it would have in the absence of inflation. Full bond refinanceability of inflation-induced interest service would require that a stable demand for bonds in real terms exist and that the rate of inflation not be an argument in that function. These two conditions would imply that the private sector is willing to hold in its portfolio the same real amount of government bonds, denominated in domestic currency, without changes in conditions vis-a-vis other domestic or foreign financial assets, regardless of the magnitude of the inflationary process. If such behavioral assumption holds, the government would be able to issue and place, without changing rates of returns and liquidity conditions, new nominal bonds to finance the part of the debt service that compensates bondholders for inflation. This issue of new bonds would not change the real stock of bonds outstanding and, since it would be willingly held, would not change spending patterns or create pressure on interest rates. How plausible is it that the demand function for government bonds does not include inflation as an argument? Although this is essentially an empirical question, most of the theoretical arguments based on portfolio theory support the existence of such a function.31 These arguments were developed for large industrial countries without high rates of inflation. There are, however, some channels through which inflation may reduce the real demand for bonds. These include (1) money illusion effects that would induce bondholders to increase their consumption and, much more likely, (2) the possible perception of increased default risk that would accompany a higher nominal stock of debt and a high rate of inflation, and (3) tax considerations. If, indeed, inflation reduced the real demand for bonds, inflationinduced interest payments (as well as indexation payments) would not 31

There is very little empirical evidence about the independent role of inflation in the determination of the real demand for bonds. Some preliminary results based on portfolio analysis for the United Kingdom are presented in Perraudin (1987).

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be fully refinanceable at the existing conditions. The sale of these bonds would require either higher real interest rates or higher liquidity of the bonds. This would result in higher demand pressures throughout the economy. Therefore, in this case, inflation-induced interest payments should not be excluded from deficit calculations. Whether they should be completely included in these calculations is a different issue. Money illusion is difficult to rationalize on a significant scale and beyond a short period of time when the rate of inflation is high and stable. But when inflation is a new phenomenon, or when the rate of inflation is changing rapidly, there must likely be some of these effects. For sure, some individuals will be unable to distinguish between real and nominal interest payments so that their consumption will be affected. The notion of default risk associated with the level of the nominal debt is, however, more plausible and needs elaboration. An increase in risk perception related to growth in the stock of real debt does not need explanation; with respect to nominal debt, it could be rationalized mainly on the basis of the relative increase in the weight of public debt compared with other sources of revenue and financing. This includes three elements of the growth of public financial debt: (1) its growth in relation to government tax revenues, because these are likely to lag the inflationary process in actual situations; (2) its growth relative to the monetary base, because, given the reduction in money demand as inflation accelerates, the monetary base falls in real terms; and (3) its growth relative to the capacity to borrow abroad, because inflation is likely to reduce foreign confidence. If inflation brings about a fall in the capacity to raise taxes, to collect the inflation tax on the monetary base, and to borrow abroad, it will also increase the risk of default on the public debt or, at least, the public's perception of such a risk. As such it may reduce the willingness of individuals to lend to the government. This attitude on the part of the public will be reinforced by the fact that the deterioration of the inflationary situation will increase the probability of adoption of adjustment programs that might include capital levies on bondholders, higher income taxes on interest incomes, and restriction on capital movements. It could be argued that, under certain circumstances, the demand for government bonds may actually rise in real terms as inflation increases. This may happen first because individuals may attempt to get out of non-interest-bearing money and may thus increase their demand for interest-bearing assets. More important, however, this may happen when government bonds are fully indexed or bear returns closely

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INFLATION AND MEASUREMENT OF FISCAL DEFICITS

related to the rate of inflation. In such case, there might be little risk in holding government bonds as long as the bondholders continue to have confidence in the government's ability and willingness to continue meeting its financial obligations. Government bonds may come to be seen as more desirable investments than other available alternatives because the risk associated with the return on specific real assets (like stocks or real estate), as well as nonindexed financial assets, is expected to increase owing to the higher variability of relative prices in inflationary situations.32 The strength of this argument is weakened, however, when the rate of inflation becomes high and when the alternative of financial investments abroad is feasible, especially when the possibility that the government might change its treatment of indexed bonds or that it might default is introduced. In either case, indexed government bonds may be seen, at least by some investors, as less attractive investments than the foreign alternatives, so that financial savings may be channeled abroad. The dollarization of the economy may be one of the results of this shift. Capital flight might be another. Another important factor that leads to a reduction of the real demand for government bonds in a period of high inflation is introduced by the tax system. Income taxes are generally, though not always, levied on nominal incomes. Thus, when individuals receive nominal interest payments, they are taxed on the total of these payments without an adjustment for the effect of inflation. This fact, per se, would induce a shift from financial assets (including government bonds) toward real assets or foreign investments, since the unrealized capital gains on real assets are tax free while the foreign investments are often totally tax free. Furthermore, since it is difficult, if not impossible, to evade taxes on incomes derived from government bonds and it is much easier to evade taxes on incomes derived from private sources, there will be a fall in the demand for government bonds unless they are tax exempt. In fact, to induce bondholders to continue holding these bonds, governments have at times increased their real return by making them tax free. There are two additional factors that should be considered when analyzing the stability of the real demand for public debt. One is related 32 On the relationship between high inflation and the variability of relative prices, see Blejer (1983) and Hercowitz (1981). There is, however, evidence that relative price variability may result in a reduction in economic activity and in a contraction of real income (Blejer and Leiderman (1980)). In such case, the real demand for bonds may be negatively affected, offsetting the positive effect of indexation described above.

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to the overall confidence inspired by the economic policies followed by the government. In general, the persistence of high rates of inflation is likely to lead to an erosion in the confidence of economic agents on the ability of the authorities to conduct sound economic policies. Such an erosion in confidence leads to a fall in the credibility of the government that may, in turn, lead to a desire to reduce the exposure of individual portfolios to assets linked directly to government policies. A credibility crisis will tend, therefore, to shift preferences away from government bonds and, most likely, toward foreign or speculative domestic assets. As already mentioned, tax considerations are likely to contribute to the shift. The second consideration relates to financial innovation. Although new financial instruments are introduced constantly into the system, it is in periods of high and sustained inflation that many new alternatives to the existing instruments enter the market responding to the demand for inflation hedges. In those circumstances, the demand for government bonds may not be stable enough to warrant the assumption of full refinanceability of the whole volume of inflation-induced interest payments.

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Liquidity Effects Another important consideration that bears on the question of whether debt service should be included or excluded from the deficit measure is the potential impact of the volume of nominal government debt on the general monetary condition of the economy. Even if full refinanceability of the debt service were assured, its relevance could still be challenged from a conceptually different angle. When the rate of inflation accelerates and becomes high, the government is likely to be forced to increase the effective real return on its liabilities through an improvement in the quality of debt instruments, that is, by increasing their liquidity.33 Such an increase in liquidity would enhance the "moneyness" of the public debt. This possibility of substitution would accelerate the reduction in the demand for the monetary base with inflationary and, depending on the behavior of the exchange rate, balance of payments consequences similar to those associated with an 33

In the absence of this increase in liquidity, the government may have to increase the real interest rate by much larger amounts. A shortening of the maturity structure of public debt has been observed in several countries experiencing high rates of inflation.

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increase in its supply.34 If, as inflation accelerated, this substitution process were carried to the extreme, the government debt could become the relevant money supply in the system and its inflationary service could be equivalent to indexing the money supply. Again, this effect on the demand for money associated with the increasing liquidity of public debt has been observed in countries with very high rates of inflation. In conclusion, even though the inflationary component of the debt service (whether arising from interest or indexation payments) is likely to put less pressure on financial or goods markets than the real component of interest payments or other government expenditures, the many qualifications to that conclusion and, in addition, the likely monetary consequences of this type of expenditure make it doubtful whether a complete exclusion of inflationary debt services from deficit calculations is warranted.

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An Alternative Definition: The Operational Fiscal Deficit After recognizing the shortcomings of the conventional definition of the fiscal deficit in an inflationary context, the question to be asked is whether there are alternative measures that would solve some of its analytical problems. An alternative that has been proposed and sometimes used is the so-called operational fiscal deficit. In general, it is defined as the conventional deficit minus the part of the debt service that compensates debt holders for actual inflation. Or, alternatively, it is equal to the primary deficit plus the real component of interest payments. Only real interest payments, that is, the part of interest payments that exceeds the product of the outstanding debt and the actual inflation rate, are included among the government expenditures that determine the operational deficit. The economic rationale of this definition is the assumption that inflation-induced interest payments are similar in their effects to amortization payments. Conventional deficits exclude amortization payments from deficit calculation, regardless of the way in which those payments are financed. The 34

In addition to reducing the real demand for money in a once-and-for-all fashion, the introduction of close monetary substitutes also increases the elasticity of the moneydemand function, which implies a larger sensitivity of money balances to further changes in the rate of inflation. It also implies a fall in the revenue from the inflation tax.

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operational deficit concept gives the same treatment to the portion of the debt service that just compensates for inflation. In addition to the challenges discussed in the previous section to the notion that the debt service that compensates for inflation is fully refinanceable, the actual calculation of the operational deficit requires precise estimation of the part of interest payments that compensates for inflation. Such operation often involves great technical difficulties: for instance, there may be several inflation indices that would be chosen to calculate real interest rates; a selection has to be made of the more appropriate one. And, of course, none of these indices may reflect the expected rate of inflation. Another problem is faced when interest rates are negative in real terms. To apply a general index in these circumstances would mean to adjust downward the conventional deficit measure by a magnitude larger than the actual interest payments. What is the appropriate adjustment under such circumstances? Is bond refinanceability better measured by actual interest payments or by the inflationary erosion of the principal value of outstanding public debt? In this particular case, even a third possibility has been suggested, namely, to reduce the computable interest payments to an amount equivalent to a (trend) real interest rate calculated over the outstanding public debt; the difficulty in choosing the appropriate methodology originates from the evaluation of which alternative better reflects bondholders' behavior.35 In spite of these difficulties, the operational deficit definition can provide, along with the conventional deficit, useful information to policymakers when the rate of inflation is very high. It would, in principle, reflect a lower-bound estimate for the public sector deficit, which will turn out to be the relevant one only if the refinanceability of the debt service is feasible to the assumed extent and if this refinancing does not itself have inflationary implications.

Conclusions Relevance of the Issues Involved In the presence of floating interest domestic debt, inflation brings about three types of difficulties to the conventional definition of fiscal 35

In some cases, the suggestion to adjust the deficit measure for inflation has gone far enough to correct for the inflationary impact on all public debt, including the noninterest-bearing monetary base; such proposal would additionally amount to considering as fiscal revenue the inflation tax on the monetary base. The problem with this extreme formulation is that it omits inflation as one of the variables to be explained by fiscal deficits.

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deficits: (1) that of evaluating the precise meaning and implications of the fiscal deficit; (2) that of evaluating fiscal performance over time when the rate of inflation or the composition of the debt is changing; and (3) that of comparing the deficits of countries with different rates of inflation and different uses of debt instruments.

Meaning of Deficit

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The fiscal deficit is, under any circumstances, a crude tool for assessing the impact of fiscal policy on the economy. When supported by relevant economic analysis, however, it can be an indicator of the need for and the extent of adjustment either on the expenditure or on the revenue side of the budget. In spite of its obvious limitations, it is generally considered a useful tool for interpreting economic developments and for meaningful discussions of policy choices. Nevertheless, the fact that countries with identical but substantial rates of inflation, with identical ratios of receipts and noninterest expenditure to GDP, and with equal debt-GDP ratios may show very different fiscal deficits when the composition of their total debt is different, raises complex questions as to the interpretation of this concept under inflationary circumstances. For this reason, as the rate of inflation accelerates, it becomes essential to supplement in various ways the information provided by the conventional deficit.

Evaluation of Fiscal Performance over Time The complications introduced by an acceleration or deceleration of inflation in the interpretation of conventional fiscal deficits make it difficult to evaluate fiscal performance over time. A pure debtmanagement action that changes the composition of the public debt without affecting its size can illustrate the nature of the problem. Under inflationary circumstances, debt-management policies that modify over time the debt structure between floating interest domestic debt and foreign debt, for example, would affect the apparent magnitude of the conventional deficit, changing the image of the country's fiscal performance.36 Changes in the availability of foreign financing or in the level of reserves may allow for large changes in the stock of floating interest 36 Real interest rate differences explained by exchange risk premiums are, however, legitimate elements in the computation of the deficit.

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domestic debt that, under inflationary circumstances, would bear important consequences for the conventional deficit figure.37 Therefore, such policy action would project an image of fiscal improvement when, in fact, there may not have been any basic change in the fiscal policy of the country. Comparison of Fiscal Policies Across Countries The factors already described will also affect any exercise of comparability across countries should such comparisons be made. As an example, countries that have identical debt-GDP ratios, similar but high inflation rates, and otherwise identical fiscal positions may show quite different levels of conventional deficits if the set of government debt instruments is different. This problem may be serious when the comparison concerns countries with high and accelerating inflation. It may also be of some relevance for comparability among countries with milder inflation, provided that their total debt-GDP ratios are high and that the structure of their debt differs significantly.

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General Conclusions This chapter has discussed and analyzed various ways in which the conventional definition of the fiscal deficit is affected by high rates of inflation. It has shown that, as the rate of inflation rises, the picture emerging from the conventional measure may, under certain circumstances, become somewhat blurred since the conventional measure may magnify the size of the fiscal adjustment that a country needs. For example, a country with a high rate of inflation and a high domestic debt ratio that, say, shows a conventionally measured deficit of 20 percent of GDP, is unlikely to require an increase in revenue or a reduction in noninterest public spending of that magnitude to restore fiscal balance. Normally a smaller adjustment would suffice as the fiscal adjustment undertaken would reduce the rate of inflation and, thus, interest payments. Ex post, the conventional deficit would decrease by more than the ex ante fiscal adjustment. On the other hand, it is unlikely that, under inflationary conditions, a definition that fully subtracts from the conventional deficit the infla37

That is, greater recourse to foreign financing would help to reduce the deficit as conventionally measured, provided that such financing is used to repay floating interest on the domestic debt.

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tion-induced interest payments is fully comparable to the deficit of countries with low inflation and is thus the relevant one to guide fiscal policy. Such alternative definition may give the impression that no fiscal adjustment is required—a conclusion that is often invalid in highinflation countries. In other words, while in high-inflation countries the conventional measure may overstate the size of the fiscal adjustment required, the operational measure in all likelihood understates that adjustment because a measure that corrects the deficit ex post for the effect of inflation (as is the case with the operational deficit) may miss its ex ante impact on inflation. The implicit conclusion that follows is that when the rate of inflation of a country rises and becomes high, the usual interpretation given to single and standard measures of fiscal deficits should be qualified. In high-inflation countries both the conventional measure of the deficit and the measure that adjusts the deficit for the effect of inflation should be provided. Each of these measures has shortcomings and each is based on specific behavioral assumptions. Both, however, jointly provide more information than either one in isolation.38 Whether the fiscal adjustment required comes closer to the conventional measure or to the inflation-corrected measure should be determined on a case-by-case basis that takes into account the behavior of prices, the current account of the balance of payments, the financial resources available to finance the deficit, and the main identifiable cause of inflation. As a practical matter, the size of the debt service that compensates bondholders for the reduction in the real value of their assets arising from inflation should be made explicit so as to indicate that part of the deficit whose impact depends mainly on portfolio decisions regarding the public's demand for government bonds, and on the potential effects of these bonds on the monetary and liquidity conditions of the economy.

Appendix I: Impact of Inflation on the Deficit in the Presence of Alternative Types of Debt Instruments In this appendix, a formal demonstration is developed to show the differential impact of inflation on conventionally defined deficits in the presence of alternative types of debt instruments. 38 Furthermore, it would also be worthwhile to provide a measure of the primary deficit that is a measure that excludes the total interest payment in order to focus on the variables (current revenue and noninterest expenditure) that are, to some extent, under direct government control and that must reflect thefiscaladjustment that must be made.

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To keep the demonstration as simple as possible, it is assumed that (1) real income is constant over time; (2) the budget is initially in equilibrium, being (real) interest payments financed by a surplus from all other operations; (3) nominal interest rates on the public debt change immediately following changes in the inflation rate, so as to keep the real rate of interest constant; (4) expected and realized inflation rates are equal; (5) government policies keep revenues and noninterest expenditures growing at the same rate as inflation; and (6) the rate of inflation is constant. Initial equilibrium in the budget implies that Do - Go—Ro + Sor = 0,

(7)

where Do Ro Go So r

= fiscal deficit in the initial period - revenues in the initial period = noninterest expenditures in the initial period = stock of public debt at the beginning of the initial period = real rate of interest.

Floating Interest Debt

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The assumption of full adjustment of the nominal interest rate (t) to inflation implies that i = (i + ^ ( i + r) - 1 = IT + r (1 + IT).

(8)

The fiscal deficit in period n (Dn) would then become

E E E n

Dn = (Go - i?o)(l + ir)" + [So +

Dn_,.][T7 + r ( l + TT)]. (9)

The first term of the right-hand side of equation (9) reflects the assumption that government revenues and noninterest expenditures 0 grow pari passu with inflation. The secondi =term represents the amount of interest payments in period n; the stock of debt on which nominal interest is paid in period n is equal to the stock of debt in period 0 (So) plus the accumulated deficits until the beginning of period n.

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INFLATION AND MEASUREMENT OF FISCAL DEFICITS

Equation (9) implies that, given equation (7), the deficit in period 1 is D1 = (G o - R0)(l + IT) + Sor(l + ir) + S^ = (1 + ir)[G 0 - Ro + Sor] + S0TT = So.

(10)

For period 2, equation (9) becomes D,

=

(G o

-

K 0 )(l

+ IT)

2

+

2

[So + S O IT][^ + r ( l

+

ir)]

= (1 + ir) [G 0 - RO + Sor) + S o ir(l + ir) = Soit(l

(11) + if).

As a general result, Dn

=SOTT(1 +

IT)n-1

(12)

Given the assumption of a fixed real income level—that is, that nominal GDP grows at the same rate as inflation—we have GDPn = GDP0 (1 + ir)n.

(13)

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It can therefore be concluded that the deficit in terms of GDP, TT S0 Dn (14) = ---------------------------( GDP0) (-----------------------1 + IT) , GDPn ( ) ( ) ( ) ( ) the rate of inflation and of the initial becomes a positive function of ( ) ( stock of floating interest debt )in terms of GDP. Table 1 reproduces the

numerical results of equation (14) for alternative rates of inflation and of floating interest debts in terms of GDP.39

Foreign Debt In the case of foreign debt, as well as in the case of domestic-indexed debt in which indexation is not treated as deficit-determining expendi39

It is possible to arrive at somewhat different results depending on whether inflation rates are denned on an annual, monthly, or daily basis. What the relevant rate is depends upon the time profile of government revenues and expenditures; for the construction of Table 1, inflation rates have been defined on a daily basis, reflecting the implicit assumption of a uniform daily flow of revenues and outlays.

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Table 1. Impact of Inflation on Conventional Fiscal Deficits in the Presence of Floating Interest Domestic Deb f Floating Interest Domestic Debtb

Rate of Inflation Monthly

1

2

3

4

5

6

7

Annually

12.7

26.8

42.5

60.0

80.0

100.0

125.0

3.6 7.1 10.6 14.2 17.7 21.3 24.8 28.4 31.9 35.5

4.7 9.4 14.1 18.8 23.5 28.2 32.9 37.6 42.3 47.0

8 151.8

10

15

213.8

435.0

791.6

11.4 22.8 34.3 45.7 57.1 68.5 79.9 91.4 102.8 114.2

16.7 33.5 50.2 66.9 83.6 100.4 117.1 133.8 150.6 167.3

21.8 43.6 65.4 87.2 109.0 130.9 152.7 174.5 196.3 218.1

20

Fiscal deficits as percentage of GDP 10 20 30 40 50 60 70 80 90 100 a

1.2 2.4 3.6 4.8 6.0 7.1 8.3 9.5 10.7 11.9

2.4 4.7 7.1 9.5 11.8 14.2 16.6 19.0 21.3 23.7

5.8 11.7 17.5 23.4 29.2 35.1 40.9 46.8 52.6 58.5

7.0 14.0 21.0 28.0 35.0 41.9 48.9 55.9 62.9 69.9

8.1 16.2 24.3 32.4 40.5 48.7 56.8 64.9 73.0 81.1

9.2 18.4 27.7 36.9 46.1 55.3 64.5 73.8 83.0 92.2

It is assumed for simplicity that there is no fiscal deficit when inflation is zero and that tax revenues and noninterest expenditures grow in proportion to the price level. The methodology and assumptions for the construction of this table are explained in the text and follow equation (14) in Appendix I. b As percentage of GDP.

VITO TANZÏ, MARIO I. BLEJER, and MARIO O. TEIJEIRO

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INFLATION AND MEASUREMENT OF FISCAL DEFICITS

ture, the rate of interest is not affected by domestic inflation;40 total interest payments will, however, grow with inflation because the nominal value of the stock of debt in domestic currency terms grows as the exchange rate depreciates. Equation (9) has to be reformulated, therefore, in the following terms:

E E E n

Dn = (Go - R0)(l + it? + [S0(l + df +

Di(I + d) n "ir. (9')

The second term of the right-hand side reflects the interest payments; the interest rate (r) is applied over the initial debt indexed by the currency's depreciation rate (d) and over the debti =accumulated out of subsequent deficits, indexed also up to the end of period n. Taking into account the assumption that d = r, equation (3') for period 1 becomes D1 = (G o - Ä 0 )(l + Tl) + S 0 (l + 7T)r = (1 + 7T)[G0 - Ro + Sor]

= 0

and for period 2,

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D2 = (Go - R0)(l + IT)2 + S 0 (l + i7)2r = (1 + ir)z[G0 - Ro + Sor] = 0. The budget therefore stays balanced as the increase in nominal interest payments is equal to the increase in the original excess of revenues over noninterest expenditures.

Appendix II: Inflation and National Accounts This appendix indicates the distortions and consequent limitations of national account figures in the presence of inflation. It is the usual practice to adjust the measures of GDP or gross national product (GNP) by inflation so as to obtain a measure of changes in output in real terms. A similar adjustment is not usually performed, however, for the sectoral income and expenditure flows from which indicators like the 40

Foreign inflation is assumed to be zero.

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201

personal savings ratio, the budget deficit, and the current account are built. The usual identity between output produced and sold is GDP = C + I + G + X - M,

(15)

which states that gross domestic product equals private consumption plus investment plus government expenditure plus exports minus imports; government expenditure is defined as excluding all transfer payments, be they interest payments or subsidies. Therefore, it comprehends only government purchases of goods and services. Real GDP is estimated deflating the components on the right-hand side by either an average GDP deflator or by applying price indices relevant to each component.41 Alternatively, the adjustment of nominal to real figures could be done on a GNP figure, which is obtained by adding or subtracting net factor income from abroad to GDP.42 GNP = GDP ± FI

(16)

GNP = C + I + G + CA,

(17)

or

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where FI = factor income from abroad CA = current account. Another usual presentation of the national accounts involves sectoral flows; assuming that GNP equals national disposable income, personal disposable income (Yd) would be Yd = GNP + R - T = C + S, 41

(18)

Differences between both methods may be significant in the presence of changes in the terms of trade if foreign trade is important. 42 In this case, the problem of choosing the appropriate indices to deflate the nominal figures is compounded if factor payments (that is, interest on foreign debt, workers' remittances) are important. In general, changes in the terms of trade, or in foreign debt interest rates, or in migrant remittances may produce serious divergences between the volume and purchasing power measures of the national product.

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INFLATION AND MEASUREMENT OF FISCAL DEFICITS

where R = transfers received by the private sector, including nominal interest payments on the public debt T = taxes paid C = private consumption S = private savings. Therefore, G = GNP + R - T - S

(19)

and, replacing C in equation (17),

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CA = (G + R - T) + (I - S).

(20)

Equation (20) states that the result of the current account of the balance of payments must be equal to the deficit of the public sector plus the net balance of the private sector. As usually presented, these sectoral flows are not adjusted for inflation. In the public accounts, interest payments are included in nominal terms as transfers (R) and they are implicitly considered as disposable income of the private sector (see equation (18)) except for interest payments abroad. In the presence of inflation, the deficit of the public sector may not be identified any longer with increases in the public debt in real terms. Similarly, savings of the private sector would reflect an increase in its assets in nominal rather than in real terms. Equation (20) is an identity that suggests important relations between the accounts of the government, the private sector, and the current account. Attempts have been made to bring a behavioral content into these identities in the context of the fiscal approach to the balance of payments. Even in the absence of inflation, testing the hypothesis that changes in fiscal deficits would be followed by similar changes in current account disequilibria is a joint test involving an assumed constancy of the net balance of the private sector. This may change owing to many factors, be they associated to changes in fiscal policies (for example, tax changes) or to exogenous shocks. The test would then implicitly make the hypothesis that either the net private balance does not change or, that if it does ex ante, the unavailability of foreign credit to the private sector and the lack of accommodation of domestic credit policies would leave the ex post net balance of the private sector unaltered.

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The assumed independence between changes in the fiscal deficit and the behavior of the net balance of the private sector may be further complicated under inflationary conditions. Changes in the size of conventional fiscal deficits caused by changes in the inflationary service of the public debt may be reflected by changes of similar magnitude, but of opposite sign, in the net balance of the private sector. This result would be obtained if bondholders willingly reinvested the inflationary service of the public debt so as to keep their stock of real bonds unaltered in real terms. Inflation may also weaken the relation between conventional fiscal deficits and current account disequilibrium, as it would increase the nominal demand for the monetary base. An inflation tax on the monetary base is an alternative source of financing the deficit, which is likely to be intensively used when the availability of foreign credit and reserves is exhausted. In general, there is a strong presumption that fiscal deficit will influence current account developments when the country has its foreign financing possibilities opened, foreign reserves are plentiful, and it is desired to avoid the crowding out of the private sector in financial markets. However, when foreign financing becomes tight and foreign reserves are exhausted, the size of the current account deficit may be limited. Inflation may then become the main consequence of fiscal deficits. In any of these stages, the refinanceability of the inflationary service of the public debt reduces the need for either foreign financing or monetization of deficits, without crowding the private sector out of financial markets.

References Bierman, Hjordis, "A Note on the Concept of the Public Sector Deficit in Stabilization Analysis for High-Inflation Countries" (unpublished, Washington: IMF, 1985). Blejer, Mario I., "On the Anatomy of Inflation: The Variability of Relative Commodity Prices in Argentina," Journal of Money, Credit and Banking, Vol. 15 (November 1983), pp. 469-820. , and Leonardo Leiderman, "On the Real Effects of Inflation and Relative-Price Variability: Some Empirical Evidence," Review of Economics and Statistics, Vol. 62 (November 1980), pp. 539-44. Borpujari, Jitendra G., and Teresa Ter-Minassian, "The Weighted Budget Balance Approach to Fiscal Analysis: A Methodology and Some Case Studies," Staff Papers, IMF, Vol. 20 (November 1973), pp. 801-31. Catsambas, Thanos, "Budget Deficits, Inflation, Accounting, and Macroeconomic Policy" (unpublished; Washington: IMF, July 1, 1986).

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INFLATION AND MEASUREMENT OF FISCAL DEFICITS

Cukierman, Alex, and Jorgen Mortensen, "Monetary Assets and InflationInduced Distortions of the National Accounts—Conceptual Issues and Correction of Sectoral Income Flows in Five EEC Countries," Economic Papers, Commission of the European Communities, No. 15 (June 1983), pp. 1-115. Eisner, Robert, How Real Is the Federal Deficit? (New York: Free Press, 1986). , and Paul J. Pieper, "A New View of the Federal Debt and Budget Deficits: Reply," American Economic Review, Vol. 74 (March 1984), pp. 11-29. Hansen, Bent, assisted by Wayne W. Snyder, Fiscal Policy in Seven Countries, 1955-1965: Belgium, France, Germany, Italy, Sweden, United Kingdom, United States (Paris: Organization for Economic Cooperation and Development, 1969). Heller, Peter S., Richard D. Haas, and Ahsan H. Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper, No. 44 (Washington: IMF, 1986). Hercowitz, Zvi, "Money and Dispersion of Relative Prices," Journal of Political Economy, Vol. 89 (April 1981), pp. 328-56. International Monetary Fund, Manual on Government Finance Statistics (Washington, 1986). Mackenzie, George A., "Conventionally Measured and Inflation-Adjusted Deficits as Indicators of the Stance of Fiscal Policy in Inflationary Periods" (unpublished; Washington: IMF, 1984). Miller, Marcus, "Inflation," in The 1982 Budget, ed. by John Kay (London: Blackwell, 1982), pp. 48-74. Molho, Lazarus E., "Inflation and Fiscal Targets in Stabilization Programs," (unpublished; Washington: IMF, 1986). Perraudin, William, "The Impact of Inflation Upon Portfolio Choice: A Duality Approach Using United Kingdom Data," IMF Working Paper WP/87/30 (Washington: IMF, 1987). Tanzi, Vito, "Inflation, Indexation and Interest Income Taxation," Quarterly Review, Banca Nazionale del Lavoro, Vol. 116 (March 1976), pp. 64-76. , "Inflation, Lags in Collection, and the Real Value of Tax Revenue," Staff Papers, IMF, Vol. 24 (March 1977), pp. 154-67. , Inflation and the Personal Income Tax: An International Perspective (Cambridge, England: Cambridge University Press, 1980). (1985a), "The Deficit Experience in Industrial Countries," in Essays in Contemporary Economic Problems, The Economy in Deficit, ed. by Phillip Cagan (Washington: American Enterprise Institute, 1985). (1985b), "Monetary Policy and Control of Public Expenditure," Chapter 10 in Public Expenditure and Government Growth, ed. by Francesco Forte and Alan Peacock (Oxford; New York: Blackwell, 1985). United Nations, Department of Economic and Social Affairs, Statistical Office of the United Nations, A System of National Accounts, Studies in Methods, Series F, No. 2, Rev. 3 (New York, 1968).

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Part IV

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Coverage of the Public Sector

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10 Toward Defining and Measuring the Fiscal Impact of Public Enterprises

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Peter Stella PUBLIC ENTERPRISES IN many countries have an important fiscal impact. This impact may be indirect, through the implication of the overall financial performance of the public enterprise sector on government finances, or direct, through specific policies carried out by the enterprises. The latter aspect may take various forms, ranging from the generation of monopoly profits to finance government operations to the direction of resources toward certain sectors in accord with government expenditure policy. As noted by Short (1984), the large size of the public enterprise sector in many countries suggests that it has been a major cause of stabilization problems and has contributed to inflation and balance of payments difficulties. This chapter outlines components of a conceptual framework for analyzing the fiscal impact of public enterprises and to clarify the important issues likely to arise in such an analysis. An underlying theme is that different measures of public enterprises are appropriate for different purposes. A particular focal point will be the implications of public enterprise behavior on aggregate demand and adjustment during a macroeconomic stabilization program. The chapter first discusses conceptual similarities and differences between public and private enterprises and between government and public enterprise operations, describing lines of cleavage along which various entities may be separated into analytically useful constructs. It then treats various measurement issues that arise when public enterprise and general government operations are merged. A third section discusses the need to analyze the determinants of public enterprise deficits before arriving at policy conclusions, especially when enterprises are not facing market prices or when the government imposes

207

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FISCAL IMPACT OF PUBLIC ENTERPRISES

constraints on their behavior. The final section summarizes the main conclusions.

Distinguishing Between Government, Public Enterprises, and the Private Sector

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The reader hoping to find here a definitive taxonomy of economic entities may be disappointed, for there are no definitions of "public enterprise," "government entity," and "private enterprise" that would always serve in all countries for all purposes. Moreover, the various entities included under these definitions may not consistently share readily identifiable characteristics. Furthermore, although objective definitions may be useful, the proper lines of demarcation change according to the purpose of the definition. For example, the distinguishing characteristic of public enterprise to be considered here is the fiscal impact. Whether a firm is legally public, private, or its management politically appointed is not particularly relevant. The fiscal criterion raises some immediate questions, however. Although most private enterprises have a fiscal impact, at least through their role in generating tax revenue, there are public enterprises that have relatively little fiscal impact. Both considerations illustrate how it is difficult to isolate factors inherent in various entities that would lead to a satisfactory delineation.

Government and Enterprises A definition presented in A Manual on Government Finance Statistics (GFSM) separates nonfinancial public sector enterprises from general government on the basis of the nature of the activities they perform rather than legal or institutional classification (International Monetary Fund (1986), pp. 20-21): Nonfinancial public enterprises are government-owned and/or government-controlled units which sell industrial or commercial goods and services to the public on a large scale or are corporate. . . .They may also include government agencies which are mainly engaged in selling industrial or commercial goods and services to the public on a large scale. . . . Having earlier defined the function of government as "the implementation of public policy through the provision of primarily nonmarket

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services and the transfer of income, supported mainly by compulsory levies on other sectors" (p. 2), the GFSM adds (p. 21): Nonfinancial public enterprises are separated from the general government sector because they are engaged in activities different in nature from government and encounter production, cost, andfinancingproblems involving nongovernmental considerations. Government departments that act in the market should be classified within the sphere of nonfinancial public enterprises. Similarly, as the GFSM states, if the nonfinancial public sector enterprises are active in executing government policy, the nonfinancial government sector, which includes both the general government and the enterprises, may be an analytical construct superior to general government (p. 25):

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The nonfinancial government sector consists of the general government sector plus the nonfinancial corporate and quasi-corporate public enterprises. . . . It is founded mainly on the belief that government influence and impact on the economy operate also through the enterprises it owns and/or controls and which it may use as instruments for the execution of significant government policies. The distinction between government and enterprises therefore lies in the nature of the goods and services provided. Naturally, any transactions occurring between the general government and public enterprises—for example, government transfers to cover operating losses and tax revenue received from enterprises—would be included in the general government accounts. The fundamental question is, to what extent should transactions taking place outside the general government framework be incorporated into an analytical measure offiscalactivity? For example, should enterprise deficits that are financed by the domestic banking system or foreign sources be counted as part of the overall fiscal balance? Similarly, should an enterprise surplus that exceeds the revenue surrendered to government be subtracted from the overall deficit? This study accepts the distinction between government and enterprises that is derived from both the nature of the goods and services supplied and the differing character of tax revenues, receipts from compulsory levies, and income from sales in the market. The distinction is not without gray areas, however. For example, many governments have mandatory social security or retirement schemes. The revenues and expenditures of each system are typically considered as part of government operations. This classification is correct in most cases because contributions are not voluntary and the amounts received as benefits may be determined by political considerations

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FISCAL IMPACT OF PUBLIC ENTERPRISES

rather than by the size of contributions or investment results. In their actual functioning, however, government social security administrations may closely resemble private retirement programs. Two Rationales for Defining Public and Private Enterprises In addition to distinguishing between government and enterprises, it is important to define public enterprises and private enterprises. Two motivations are given for this: first, to identify differences in the behavior of enterprises and the underlying structural reasons explaining the differences; second, to analyze the impact of enterprises on the distribution of wealth and income in an economy.

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The Behavioral Dimension Conventional arguments claim that state ownership is a necessary condition for an enterprise to be classified as public. Although state ownership may be a common element among many public enterprises, it need not be found in all. Publicly owned enterprises may exhibit behavior that is profit-oriented, precisely like the behavior of a private enterprise under similar circumstances, or they may behave with clear disregard for profit maximization.1 In addition, from a legal standpoint, the degree of government ownership can vary considerably, as can the relationship between ownership and control. Majority ownership is not a necessary condition for effective control. The dividing line between public and private ownership has shifted over time. In eighteenth-century Britain, Adam Smith criticized the concession by the state of private trading monopolies. These monopolies were privately owned but bore resemblance to many contemporary state-owned trading monopolies found in socialist states. Similarly, modern state-regulated private utilities may exhibit the same behavior as state-owned utilities. Some state corporations—notably petroleum companies that are active in international markets—behave very much like their private competitors. Thus, state ownership is not a sufficient condition for distinguishing between public and private enterprises. 1 In many cases, laws designed to protect shareholder interests prevent managers of private firms from engaging in non-profit-maximizing behavior. In Israel, managers of public enterprises are explicitly permitted to take into account other than strictly business considerations in making decisions.

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.

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Making a distinction on the basis of behavior rather than ownership, however, is important for serving several purposes. One purpose is to compare economic performance between economies with large public sectors and those with small ones. Another is to model the reaction of an economy to government economic policy or to external shocks. If it is known that a certain set of enterprises reacts in a distinctive way that is separate from the standard private response, it is important for policy purposes to model this sector separately. Models constructed to predict reactions to policy measures are based on assumptions about the behavior of enterprises outside direct government control. Public and private firms will react differently to market signals, which makes it important to know the relative significance of the two sectors within an economy. If an analytical "public enterprise" category exists between government and private enterprises, special focus will have to be directed toward this category. Such attention is already given to the government and private enterprise sectors, for example, when financial adjustment programs are formulated through an asymmetric approach that includes appropriate mechanisms for the government, on the one hand, and the private sector, on the other. This asymmetric approach, which emphasizes direct control in government and indirect controls in the private sector, is a natural outcome of one sector being more closely in tune with and responsive to market signals. Changes in monetary policy that influence interest rates are enough to influence demand in the private sector, where firms will quickly incorporate the new price in their decision making. The government, however, is less likely to respond to the opportunity cost of capital—although in principle it should—owing to its administrative structure. Government departments are generally set up to achieve their policy functions with the least possible expenditure, and changes in government expenditure will not automatically result from a change in the marginal cost of borrowing. Instead, adjustment programs intended to increase government saving impose specific changes in expenditure and revenue policy. Such specificity is not desirable with private sector adjustment when, in general, it is more efficient for macroeconomic adjustments to come in response to changes in price signals. An important question in countries where public enterprises play a significant role is the reaction of these enterprises to a change in price signals—most often through exchange rates and interest rates. Although the distinction between public and private enterprises should not be related strictly to ownership, there are important incentives

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FISCAL IMPACT OF PUBLIC ENTERPRISES

that cause private firms, subject to taxation, to behave differently from publicly owned ones. Since the after-tax return is the variable private shareholders care about, there exists an incentive for private firms to adopt strategies to reduce tax liabilities. That incentive is not present in the case of government ownership. Furthermore, with government ownership, the government as shareholder is able to exert direct influence over firm policy. At one extreme, a publicly owned enterprise may be completely insensitive to price changes. This is possible because such enterprises are frequently not held accountable for their operating result to the same extent as private sector firms. A devaluation of the real exchange rate, for example, may not lead to a shift in the input mix away from tradables toward nontradables—as a private firm would do—but rather to an increase in borrowing. This would produce the opposite of what the devaluation policy intended and would serve to crowd out other firms. If the public enterprise was in competition with private firms, it might experience increased sales owing to relatively inflexible prices and thereby increase its market share exactly at a time of growing inefficiency.2 The increased borrowing would also crowd out government borrowing or increase the cost of credit to the government. A second element in most adjustment programs involves raising interest rates to bring the supply and demand for credit into balance. Apart from the price effect of interest rates, credit rationing may also play a role in the allocation of credit. The extent to which nonprice credit rationing takes place at high interest rates is an important topic in macroeconomic research. It has been suggested that as interest rates rise, the probability of default increases, and lenders may therefore choose to ration credit instead of raising interest rates further.3 In these circumstances, enterprises that have explicit or implicit government guarantees, such as public enterprises, are likely to receive favorable treatment to the detriment of the rest of the economy. Thus, in designing adjustment programs, it is important to ensure that both government and enterprises will react in the intended fashion. Impact on the Distribution of Income and Wealth The second aspect of the distinction between public and private enterprises is the ultimate impact of their profit results on the public 2 If relative prices change, the optimal point on the transformation curve changes, implying a change in the optimal mix of inputs. If the public enterprise has not changed its choice of inputs, it will be off the correct point on the transformation curve. 3 See, for example, Stiglitz and Weiss (1981).

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treasury. Changes in the value of the government's future revenue or expenditure streams have important fiscal implications. The operating result of any firm has its most direct impact on the factors of production employed. With respect to capital, the firm's shareholders and creditors are directly affected by any change in the firm's fortunes. Similarly, the government, as a shareholder in a publicly owned firm, feels the impact of the firm's profit outcome. However, governments may lend to, subsidize, or give explicit or implicit credit guarantees to privately and publicly owned entities in order to support their operations. The treasury or state banking system would suffer a loss if it gave government credit or credit guarantees to a firm that subsequently went bankrupt. For example, if the privately owned Chrysler Corporation had gone bankrupt after receiving credit guarantees from the U.S. Government, the loss would have been borne by the treasury and had its impact on American taxpayers and recipients of U.S. government services, with the distributional consequences of the event difficult to calculate. Bankruptcy was avoided in the case of Chrysler by the stockholders and prior creditors receiving an implicit government transfer (that is, a transfer that never appeared in the government cash accounts). Chrysler was able to borrow funds in the market and continue operations only because the U.S. Government was willing to accept its debt as a contingent liability.4 Loan guarantees are fairly common in instances of public enterprise debt. The economic consequences for the treasury, regardless of whether the firm is public or private, are quite similar. Therefore, both public and private enterprises may have an important impact on government finances. Implications of Public Behavior and Ownership Two separate motivations have been given for separating enterprises into the groups identified as public and private, even though enterprises could very well be categorized as public for one purpose and private for another. One motivation, based on the behavior of enterprises, is for predicting an economy's reaction to policy changes and external shocks. The second reason, based on the consequences of enterprise operations, is for measuring the distribution of wealth and income 4

The U.S. Government currently prepares an annual Special Analysis (F) of Federal Credit Programs (United States, Office of Management and Budget, Special Analyses, Budget of the United States Government), which includes federally guaranteed loans.

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within the economy. The net personal benefit received from transactions mediated through the government differs from individual to individual and affects the market's distribution of resources. Consequently, changes in government wealth versus private wealth imply redistribution among individuals. Both of these notions are related to the concept of the "soft budget constraint" (see Kornai (1986)). In contrast with the archetypical private firm, public firms often are immune from bankruptcy and therefore do not need to emphasize the importance of generating enough revenue to cover costs. The behavior of such a firm will likely differ from that of a firm with a strict budget constraint. The widespread existence of soft budget constraints could lead to macroeconomic problems. If public firms plan and spend well beyond their revenue, they generate aggregate demand that can bring about current account problems, pressures on prices, and shortages. While private firms may also plan expansion that exceeds the available finance, the response of market signals—through credit markets, for example—is likely to be more rapid, as is the adjustment process for firms with a hard budget constraint. Public enterprises may also play an important role in a country's total investment. Tanzi (1987b) argues that, for a number of reasons, public investment may lead to a lowerthan-potential growth rate. To help avoid these problem areas, it is important to estimate the extent of public enterprises in an economy. The impact of the soft budget constraint on the allocation of resources is also important. Firms—whether nominally public or private—with implicit government backing create potential claims on public resources. Contingent government backing for selected enterprises reassures the firm's suppliers, creditors, and customers that the firm will remain in business or, if it fails, that its debts will be paid. This allocates resources toward certain industries and away from less favored firms and sectors, with part of the cost borne by the government. The impulse for efficiency is also derived from the possibility of management replacement. A firm operating in a less than perfectly competitive market may make profits without subsidies or transfers of any kind but may not be as efficient as possible. In a private market, such performance could bring about a corporate takeover or a replacement of management. This potential for replacement is usually not present for public firms, where it is difficult to properly judge performance. Many enterprises could correctly be labeled both public and private. A publicly owned corporation that has government-guaranteed debt,

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which operates efficiently in competition with private enterprise, may have important implications for government finances yet may behave in a fashion quite similar to a private firm. Thus, by the criterion outlined above, it would be considered private from a behavioral point of view but public from the standpoint of the distribution of income and wealth in the economy. Similarly, a publicly regulated private utility may exhibit behavior that is not attuned to market forces, but also not be a direct drain on the public treasury because it is able to adjust its selling prices and have sufficient market power. It would be considered public from the behavioral standpoint and private from the standpoint of its impact on the distribution of income and wealth.

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Public Production Versus Public Provision One way to arrive at a distinction between public and private enterprises is to ask why there are public enterprises at all. The reasons for government intervention are well known. The government has a role in the provision of public goods when it is impossible or inefficient to exclude individuals from consumption. In such cases, a private firm would not be able to capture the full benefits of production, the market would not provide the correct amount of the good or service, and therefore the government would have a raison d'etre. Rather than charging individuals the full cost for the good or service, the government finances provision of the public good through compulsory levies on other sectors. The classic example of this is national security, where exclusion is not possible and the market would not generate the optimal amount of the good.5 The cases of purely public goods are rare; most goods and services provided by governments lie within the spectrum between purely public and purely private. If the unregulated market cannot be expected to generate the optimal provision of a good or service, public enterprises may be called upon to execute the government intervention. If exclusion is desirable and a good bears the characteristics of a private good, the price of the good should fluctuate in relation to marginal cost. As marginal cost changes, the price should be changed. From a managerial standpoint, this is less possible with public goods. A government agency is typically charged with accomplishing its policy 5 James Buchanan and others have argued that one should not be too ready to conclude that a government can bring about the best allocation of resources. Their theory is about government failure, which complements theories of market failure.

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assignment within a budget representing the minimum amount of expenditure necessary to achieve the task. Budget allocations are made for specific purposes based on detailed accounting of projected expenditures. This type of management is also practiced in public corporations. There, as argued in Levy (1987), an enterprise's task may be defined through the interplay of a number of constituencies—legislators, bureaucrats, interest groups, and competing government agencies. In contrast, private enterprises typically operate with much more flexibility by changing their product prices and input mix during the fiscal year. This is rational if the enterprise is faced with rapidly changing relative prices for inputs and a changing mix of optimal inputs. The added flexibility is often particularly important when the enterprise is involved in the actual production of the good. Government practice in the production of public goods and services, including both public production and public provision combined with private production, has varied widely over time and across countries and types of goods. Although privatization is usually thought of as a modern phenomenon, a description of seventeenth-century Europe suggests it was then, in a certain form, quite common (De Vries (1976)), p. 214):

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The sale of offices was common to many states, but nowhere did it figure so prominently as in France. Tax assessors, refuse collectors, registrars of births, marriages, and deaths, mayoral and other municipal offices (after 1692)—in short, every imaginable office was sold. Even in the military sphere the private sector was important. Before 1600, Europe's standing armies were relatively small, and those that were put into the field "consisted chiefly of mercenary soldiers and recruits brought together by a military contractor; they would be released at the end of the campaign" (p. 204). Perhaps the most infamous practice was that of the "tax farmer," who purchased the right to collect taxes and could keep all money collected over a specified amount that was owed to the treasury. This system, according to De Vries, existed in the Dutch republic in the seventeenth century and generated enough social discontent to cause the most significant riots in the republic's history. Public opinion of what is appropriate for private production also varies. Baumol (1984), in sketching the outline of a theory of public enterprise, argues that there are some areas, such as the armed forces and tax collection, where private incentives may be incompatible with the public welfare. The notion of a bureaucratic armed force seems preferable to one that would be interested in generating business, pre-

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sumably through the instigation of wars, but why a public armed force would not be interested in the same role is less clear. One explanation is that there are important economies of scale in organizing military command and control systems, which would suggest a natural monopoly. That the monopoly is reserved for the government could relate to strategic considerations, since defense secrets play an important role and require strict controls. Another reason is that there could be potential conflict between shareholder interests and the national interest. In theory, a private firm could be purchased by individuals who oppose the state. The power to wield the nation's armed forces may be too great to delegate. The case of tax collection is also interesting. Under the system described above, the private collector had the correct market incentive to collect tax revenue. The marginal revenue collected went to the private agent, however, and not to the state. In such a system, the tax collector has an incentive to expand resources until the marginal revenue garnered is equal to the marginal cost of collection. As discussed in Stella (1992), this incentive structure is inefficient from society's point of view because it leads to overexpenditure on revenue collection. In other areas, public production is specifically designed not to allocate resources according to market mechanisms. Public hospitals in some cases do not charge according to cost, and space is often rationed by nonprice mechanisms. These benefits might be provided under similar rationing mechanisms by charitable or nonprofit organizations, but they are atypical of private firms. Fundamentally, what may be important is accountability. Society must choose the areas where it will hold political leaders accountable and those it will leave to the private sector. When there is competition among producers of a particular good or service, the market can operate very well in holding producers responsible for their products simply through consumer response to product price and quality. In cases where products are expensive and purchases infrequent, as with automobiles, appliances, and homes, the market may not function smoothly nor a consumer have the opportunity to punish or reward individual producers at frequent intervals. Nevertheless, the market will tend to reward good producers. With monopolies, however, this mechanism is deficient. When there is restricted competition and management is appointed by the government, the political system may allow the public to replace bad management or bring about changes in the production of goods and services. In particular, the armed forces and foreign policy

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administration are areas where it makes sense to have monopolies that are subject to political rather than private accountability. At the other end of the spectrum from the seventeenth-century states that were privatized lie modern states where virtually the entire economy is owned and run by the government. In state-controlled economies, what is important from the behavioral standpoint is the extent to which an enterprise responds to market signals versus centrally directed planning. It is likely that only those companies with international competitors will exhibit market-directed behavior.6 There would be little distinction between the impact of public and private enterprises on public finances in an economy that is publicly owned. Often it is the production technology in relation to the size of the market that dictates whether the efficient number of firms is one or several. In markets characterized by monopoly or oligopoly, prices will not be set equal to marginal cost7 by unregulated firms, and fewer than the optimal amount of goods will be sold at higher than optimal prices. Although there are several ways to deal with this problem, a common approach is state production through public enterprises. The conflict between efficient production with natural monopoly and efficient pricing explains, in part, why it is more common for governments to be involved in the production and distribution of electricity than in the production of agricultural goods where the production technology is more likely to approximate constant or declining returns to scale (given a fixed supply of land). Government involvement has often started when industries have required large capital investments that could be financed only by the government, or when private investors have been concerned that future pricing policy would not generate the average return on capital. This would be a natural concern if there was substantial fixed cost and declining marginal cost—that is, if average cost exceeded marginal cost and the firm would suffer a loss if compelled to charge efficient prices. Under these circumstances, the government would be forced to choose a price between marginal and average cost and decide whether to subsidize a private firm to produce at the chosen level or keep the decision-making process under the control of government. The government can intervene in the presence of monopoly and oligopoly in other ways. One method is to regulate the private firm by 6

See Hall (1988) for empirical justification. For an interesting discussion of recent Chinese efforts to induce profit-seeking behavior among enterprises, see Blejer and Szapary (1989). 7

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imposing a maximum price on the product. Another option is to control the amount produced by the firm. Both of these techniques, however, may put the firm at an unprofitable point (where price equals marginal cost but is less than the average cost) and cause an eventual erosion of the capital invested. Still another method is to guarantee the firm a specific rate of return, but this may not provide any incentive for innovation or cost reduction. Because of these limitations, many governments have attempted solutions through direct control or government ownership. It is important to recognize the different incentives facing equity and debt holders and how they affect the choice between government and private ownership. A private investor will be willing to accept the additional risk that is associated with equity only if he is given the opportunity to realize higher returns. In a situation where the government is unlikely to permit a firm to generate high returns—through political interference in the setting of prices—investors may prefer to finance the project or firm with fixed-interest debt, leaving the government to hold equity. An example of this practice is private ownership of publicly regulated utilities. In many cases, particularly where pricing is on a cost-plus basis, the characteristics of publicly regulated utility equity are very similar to fixed-interest debt. In any event, where production of the good is important to the government, it is likely to be organized under the direction of a semiautonomous entity rather than by a government agency. This is because the managerial structure of public enterprises allows for greater flexibility in the choice of inputs.8 Even when government policy forces them to behave similarly, publicly and privately owned enterprises are distinct. For example, it is fairly common for governments to require enterprises to service certain high-cost areas of a country or region at fixed prices that imply a subsidy. Thus, the U.S. Postal Service charges the same price for firstclass delivery of letters throughout the country even though the perunit cost varies substantially. In the private sector, according to Stiglitz (1988), the American Telephone and Telegraph Company before 1983 was required to provide service to anyone who paid a government-set fee, even if the company lost money doing so. The difference in the two cases is that, although the government is often willing to directly subsidize a public enterprise providing a service, it usually will not subsidize a private firm. Instead, the private firm typically will be 8 For government agencies it is often easier to measure inputs than outputs. It is natural, therefore, for the government to emphasize control of inputs.

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permitted to make monopoly profits in other areas if the government wishes to maintain the stock of capital and level of investment in the industry. Therefore, the loss to the public enterprise is paid for through the fiscal system, and the loss to the private firm is paid by consumers and, indirectly, by taxpayers through the implied tax revenue of a lowered return on capital. To summarize, what is relevant in analyzing the fiscal impact of enterprises is that firms—whether owned by government or the private sector—may fall within the same behavioral category if they operate in the same fashion.9 Similarly, both kinds of enterprises having the same kind of impact on the public finances should be considered equivalent.

Measuring Public Enterprise Activities Once it has been determined that a meaningful distinction exists between public and private enterprises, based on their behavior and their impact on public finances, the question of measurement can be addressed. There are two conceptually separate issues. One is the measurement of the net impact of enterprises, and the other is the identification of gross revenue and expenditure flows from enterprises that are comparable with government flows.

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General Considerations When classifying enterprises according to behavior, it is correct to use value added as the measure. For determining the importance of the public sector in production, the natural criterion is the fraction of value added produced by the public sector. Measuring the impact of enterprises on the public finances is more complicated. What is important is the identification of gross flows of government-like activities and their fiscal impact. For example, using the case of the telephone company discussed above, correctly measured, those customers receiving services at less than cost are, in effect, recipients of transfers from the government; those who pay prices above the economic cost (which includes the normal rate of return on capital) as a result of the government-granted monopoly should be 9 The entire discussion presumes transactions between government and enterprises would be reflected in the government accounts.

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identified as paying taxes. Although these adjustments might not affect the fiscal balance, the government's gross revenue and expenditure figures would be understated without the corrections. It may also be argued that implicit subsidy and tax calculations should be carried out for some private as well as publicly owned enterprises. This is substantially at variance with current practice, which, particularly in macroeconomic analysis, makes no attempt to separate the transfer and tax elements. However, as discussed in the following section, the information is often essential for judging enterprise performance and for constructing policy remedies. There are certainly serious problems in using only a single summary statistic to interpret the significance of public enterprise operations, and therefore implicit expenditure and revenue flows should be calculated. The extent to which a government policy mandating certain enterprise expenditures or subsidies affects the fiscal deficit is often unclear. If the effect is reduced tax revenue, obtained by the treasury from the enterprise, the overall government balance would already reflect the policy, although the gross revenue and expenditure figures would be understated. Such activities are often termed "tax expenditures," because the cost of the policy does not show up on the expenditure side of the budget but in an unspecified loss in general tax receipts. In cases where the government wants enterprises to undertake certain loss-making expenditures, it may limit competition by either restricting entry by competing firms or requiring all firms to make the same expenditures. When entry is restricted by the government, monopoly profits may be used by firms to cover losses in other areas. If the firm is allowed to charge monopolistic prices as the result of government restrictions, the government's accounts will probably not reflect the social cost of the program. In this case, consumers of the product that is priced according to the monopolist's profit-maximizing criteria bear the cost by experiencing a lower level of welfare. Here again, the gross subsidy and revenue figures would be understated. When it is known that government policy requires enterprises to subsidize certain consumers or suppliers, the amount of the subsidy should be taken into account. There are other interesting issues concerning the measurement of gross flows. Clearly, gross sales revenue generated by enterprises is not comparable to revenue generated by government taxes. However, it could be argued that public sector prices contain implicit subsidies and taxes. The GFSM (International Monetary Fund (1986), p. 102) states: "Taxes also include the profits transferred to government from fiscal monopolies. . .which reflect use of the government's taxing

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power to collect excise-like revenue. . . ." As argued in this study, these fiscal monopolies may be publicly or privately owned. A problem exists, however, when an enterprise does not transfer profits to the treasury. Often this is the result of an intricate system of subsidies and transfers within the organization. In some cases, profits wind up being paid to employees. Even if they are made and transferred, profits may be lower than their full potential because of hidden subsidies. In an instance of enterprise losses, the subsidy element may be obscured through the enterprise's ability to borrow from domestic and foreign sources apart from the government. Consider, for example, an enterprise that is undertaking government policy by subsidizing the consumption of a particular product. Whether the subsidy is paid directly from government to consumers or indirectly from government through a public enterprise, the expenditure would be reflected in the operating balance of the general government. Quite often, however, subsidies are carried out through public enterprises through controlled prices, with less transparent consequences. If the enterprise is involved in producing a single good, it may market the good at a below-market price. And if the enterprise makes a loss that is covered by the budget, the subsidy is transparent. If, however, the firm has the ability to borrow from the domestic banking system or abroad, the impact of the subsidy policy may not be registered in the government's accounts. Furthermore, the enterprise will be able to borrow at a lower rate if it has the implicit guarantee of the government. Alternatively, government-owned banks or the central bank may be compelled to lend to it. If these financial institutions are not covered by the fiscal deficit measure, the true deficit will be understated.10 In these cases the amount of the subsidy should be added to government expenditure. If an enterprise is profitable in other areas, for example, owing to a monopoly granted by the government, it may use profits from some of its operations to cross-subsidize other activities. For example, it is not uncommon for state oil monopolies to tax gasoline but to subsidize kerosene or other petroleum products that are believed to be consumed extensively by the poor. The government accounts reflect only the net revenue from these operations, resulting in a downward bias in both the revenue and expenditure flows. In another case, a state oil monopoly and state lottery were known to be sources of undocumented financing of government expenditure, with only the net transfers/revenues 10

Incertain countries central bank deficits are quite important; see Chapter 11.

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being recorded in the government accounts. It caused the treasury and the public enterprise to engage in a long-running dispute over just what was the net amount owing to the government. Similarly, a government, through its agricultural marketing board, was able to effectively use its producer pricing policy to transfer income to politically sensitive regions of the country where certain crops were grown. Such subsidies can be difficult to detect, but they could have important macroeconomic significance. It should be noted that the concern here is with measuring not the gross versus net activities of enterprises, but only the gross flow of government-like activities. With an agricultural marketing board, for example, for fiscal purposes it would not be necessary to amalgamate the gross value of purchases from farmers with treasury outlays for civil service salaries, or to combine the gross value of receipts from agricultural sales with tax revenue. When policy includes a subsidy or tax element, the quantitative measure of the subsidy is the difference between buying and selling prices as reflected in the operating position of the enterprise. If the operating result is a combination of effective subsidies and taxes (owing to the exercise of government-granted monopoly power), it would be necessary to measure the gross value of the subsidies and the gross value of taxes. The effect of public enterprises operating with prices and exchange rates artificially set by government can seriously distort government statistics. When statistics that convert foreign exchange items into local currency by using an overvalued exchange rate are recorded, all revenues that relate to export earnings are undervalued. The figures for airport taxes, customs duties, and domestic taxes on imported products, such as fuel, may also be affected. For public enterprises, many of which are export monopolies, the exchange rate may seriously undervalue export proceeds. In addition, it may cause the firm's capital stock and inventories to be undervalued, making credit more difficult to obtain and understating economic depreciation and replacement cost.11 On the expenditure side, any allocations of foreign exchange received at the official rate understate the nation's opportunity cost. In general, the performance of any enterprise that is a net foreign exchange earner 11 Ifmuch of the equipment and capital is imported, for example, in a mining operation, the replacement cost of heavy construction and extraction equipment, transport vehicles, spare parts, and processing facilities will be seriously undervalued. In economic terms, the value of the asset is equal to the present discounted value of the future earnings it generates, and if the domestic currency is overvalued, the asset will be undervalued.

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would therefore be understated, while, on the other side of the ledger, any net user of foreign exchange would have its profitability overstated. An example from one country may illustrate how this problem can lead to the wrong outcome. With high inflation and an unchanged nominal exchange rate, the country's real exchange rate had appreciated very significantly over a period of six months. The main export was an agricultural crop marketed by a state monopoly, with a government-set price for farmers that was intended to generate a surplus for the marketing board after allowance for processing, marketing costs, and an operating margin. This surplus, a function of the world market price, was counted by the government as tax revenue. The sale proceeds, in dollars, were converted at the official exchange rate, which at the time was roughly one-sixth of the parallel market rate, resulting in a gross underestimate of the tax revenue. At the same time, other public enterprises were receiving foreign exchange at the official rate for the purchase of raw materials and intermediate inputs, and consequently their operating costs were greatly understated. The government was able to allow retail prices of the public enterprise products to rise in line with the overall rate of inflation by imposing substantial excise and sales tax increases. The net effect in the government accounting showed declining real taxes from the agricultural export and rising real taxes from goods produced by the public enterprises. The reality of the situation, however, should have been reflected in rising export tax revenue and an increase in subsidies to public enterprises, with no change in revenue from excise taxes because the real prices of the goods had not risen. Usually, the preferred solution to this type of problem is for the country to bring the exchange rate in line with its actual relative price. But how should the analyst treat cases where this is not an option in order to correctly interpret the situation and generate a meaningful data time series? If shadow prices are available, it would be correct to value flows of goods and services at shadow prices.12 For the exchange rate used to value allocations of foreign exchange by government or government-controlled financial entities, an alternative exchange rate could be used. The parallel market rate might also be an option, although this could be quite different from the rate that would obtain if the market was unified and allowed to operate freely. Another alternative would be to calculate a real effective exchange rate, based on a 12 For a discussion of integrating shadow prices into the theory of optimal policy and the appropriate method for calculating macroeconomic social opportunity costs, see Dreze and Stern (1988).

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representative year, in order to determine a shadow nominal exchange rate, which could then be used to revalue transactions that were known to have taken place in foreign currency. Although the task may seem overwhelming, the practice of foreign exchange budgeting has taken hold in many countries with histories of overvalued exchange rates. Their budgets often specify the foreign and local components of many expenditures, which facilitate the conversion exercise that is often necessary. When an accurate understanding of the public sector, if not the entire economy, is vitiated by use of the official exchange rate to value transactions, policy errors are quite likely. Then the effort invested in constructing accounts from a sound economic basis can reap substantial benefits. Similar problems in determining subsidies and implicit taxes also arise with private firms and with disequilibrium exchange rates. However, the special treatment that is often given public enterprises— through access to foreign exchange at preferential rates or a requirement to surrender foreign exchange at official rates—results in public enterprises with close ties to government having a higher incidence of problems. Thus far, two separate reasons have been offered for including the operations of public enterprises in the overall measure offiscalactivity. One is that these enterprises exhibit nonmarket behavior and perform some government-like activities. The other is that the enterprises— whether publicly or privately owned—have explicit or implicit consequences for public finances. In general, it is not the gross value of expenditure and revenue of public enterprises that should be included in the government accounts but rather the gross value resulting from government-like activities or, in the case of firms that do not execute government policy, only the change in the net worth of the governmentowned enterprises.

Cash Versus Accrual Accounting Another difficult problem to be addressed is that of cash versus accrual accounting. The GFSM recommends that government statistics be presented on a cash basis. Statistics presented this way are useful in the monetary approach to the balance of payments and in financial programming. The alternative approach is accrual accounting, which has certain advantages—as well as drawbacks—for aggregate demand calculations but is clearly superior for calculating government net worth. A practical problem with accrual calculations involves the activi-

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ties that take place without the knowledge of the government, however, and which government accountants are unable to account for. Transactions that cannot be known with precision by the government include the earning of income, which implies tax obligations, and changes in the unemployment rate, which imply future expenditure.13 The nature of the cash versus accrual issue is more problematic, however, for the enterprise sector. Gash accounting can be a very misleading guide to the operating performance of firms that produce or sell market goods and services. One of the clearest illustrations of this is in the treatment of capital expenditures. In calculating the operating result of an enterprise, the cost of capital is determined by depreciation rather than by the value of new capital purchases. This distinction can be quite important when large investment projects are undertaken by the government or public enterprises. One approach for clarifying the accounts is to distinguish between current and overall balances of the public enterprises. However, the definitions of current and capital expenditure are different for government and enterprises. In their current accounts, the government would not include depreciation as an expense, whereas enterprises would. Also, in their capital accounts, gross capital accumulation would be shown by the government, but the net figure would be shown by the enterprises. There are a number of critics14 who decry the failure to account for government capital transactions in a manner consistent with business practice and query whether this differential treatment is warranted. In business, the purpose of accounting for depreciation is to allow for an accurate estimation of the firm's profitability. Because capital expenditures include the acquisition of new assets that are not fully consumed in one financial year, it does not make sense to add the gross value of capital expenditure to other expenditure when calculating the total or unit cost of the good being produced. If, as in the government's 13

The existence of contingent claims on the government raises an important issue. If the debt of a publicly owned enterprise is given an explicit or implicit government guarantee, the stock of such debt outstanding becomes a contingent liability of the government and cannot be ignored when assessing government net worth or the required future tax effort. This is also true for private firms that issue government-guaranteed debt or operate under an implicit government guarantee. Thus, regardless of the degree to which an enterprise is executing government policy, debt that has been guaranteed by the government must be recognized as a contingent liability of the government. The potential significance of such liabilities is illustrated by the recent savings and loan crisis in the United States. 14 See, for example, Boskin (1982) and Chapter 14 of this book.

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case, however, one is not concerned with profitability or change in net worth, but rather with the borrowing requirement and impact on credit markets, then it would be logical to include the total value of expenditure. The primary motivation for constructing government accounts on a cash basis is an interest in the net borrowing requirement. Furthermore, it should be recognized that there are practical obstacles to deriving government accounts on an accrual basis. In comparing the operating balance approach of enterprises with the conventional measure of the government deficit, the role of depreciation is, as mentioned above, illustrative. Whether the cash accounting system will show larger or smaller capital expenditures depends on the relation of current to target capital stock. This is shown in Table 1. If the government is trying to achieve a desired capital stock that is greater than the current stock, then gross investment must exceed depreciation. This implies that the government deficit on a cash basis would be higher than if recorded on an accrual basis like the accounts for an enterprise. If the current stock of capital is already the desired stock, then gross capital expenditure would equal depreciation, and the two measures would be the same. If the desired government capital stock was below the actual, then depreciation would exceed gross investment and the overall deficit would be understated. More generally, the cash measure shows a larger (smaller) deficit if gross capital expenditure exceeds (is less than) depreciation. Advocates of net worth accounting for government are, clearly, also in favor of accrual versus cash accounting. The argument in favor of accrual accounting for government transactions is usually made along the following lines. What matters for individual decision making is expected lifetime income. Changes in government net worth imply changes in the future tax obligations of the individual. Even though these changes may not be the result of a specific government policy or have immediate liquidity effects, they may be quite significant in Table 1. Comparison of Capital Expenditure Under Cash and Accrual Accounting Recorded Expenditure If desired capital stock > Actual If desired capital stock < Actual

Gash Accounting

Accrual Accounting

Gross capital expenditure > Economic depreciation Gross capital expenditure < Economic depreciation

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present value terms. For example, if the government holds substantial mineral wealth, an increase in mineral prices would generate higher nontax revenue and lower future taxes. In the same way, on the expenditure side, a change in mortality rates might have a significant impact on future social security payments. An important, though somewhat ignored, aspect regarding the appropriateness of using the net present value approach is that it assumes that the government will ultimately realize the capital gains. A key factor upholding the validity of accrual accounting is the expectation that the income will eventually be realized. While this might occur with financial assets, it certainly does not happen with all real assets. For example, if national park admissions policy is to charge only the marginal cost associated with each visit, then the increased attractiveness of a park resulting from the propagation of a near-extinct species may never be realized, as it would in a private park through increased admission fees. Although the increased value of the future earnings of the private park would be capitalized in an increase in its present value, no such effect would be felt by the government with its asset. If the policy remains marginal cost pricing, the government's net worth will be unaffected. Also illustrating the implications for net worth is the case of a government petroleum monopoly. If an external event leads to scarcity of oil and an external price increase, the government will realize a capital gain only if it raises prices, even though marginal costs of production have not changed. If the country is self-sufficient in oil production and sells oil to foreign customers, the increased revenue from abroad will improve the government's financial position and serve to transfer income away from net domestic consumers for the benefit of taxpayers. To the extent the government does not pass through the entire external price increase to domestic customers (a fairly frequent policy measure), it will not realize the full potential increase in its net worth. In this case, the government is providing the consumers with an implicit subsidy. In cases where the income will never be realized, accrual accounting is not justified. One area where this distinction is important is the loan performance of state-owned financial institutions, where, in many cases, loans are kept on an accrual basis even though there is a high likelihood of default and of the income never being received. In perfect capital markets, a real capital gain occurs when the expected real return on an asset increases unexpectedly. This is necessary to equilibrate the market while investors bid up the value of the asset until it is expected to earn only the average rate of return. Because the government is not operating as a profit maximizer, it is not certain

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that it will act to realize capital gains. There is no reason for the price of a government asset to be bid up if it will never be sold. Therefore, the motivation for using accrual-based accounting for revaluing government assets is less clear. While the foregoing considerations weigh against strict accrual accounting, it must be acknowledged that an important problem with cash accounting is that so-called paper transactions—that is, accounting changes that have no real impact—may have a large impact on the observed overall balance. For example, the government or an enterprise may choose to rent, rather than purchase, a piece of capital equipment in order to reduce expenditure. Alternatively, capital spending may be postponed. Both decisions would reduce the overall cash deficit, although they may not represent optimal fiscal policy. In general, it is proper to design accounts using alternative methods. Thus, a consistent cash basis approach would be useful for gauging the public sector's impact on credit markets. Another approach would treat only the government's cash deficit and the current deficit of the public enterprises on an accrual basis, making some adjustment for capital expenditures that would be unlikely to earn a market rate of return. The way in which a particular government policy is reflected in its accounts depends on how it is designed and whether the affected firms are public or private. Consider, for example, a regulation that imposes strict pollution standards on firms within an industry. Neoclassical theory would suggest that if compliance with these standards involves additional expenditures that are not incorporated in the value of the final product, a lower rate of return on capital will result, eventually causing a decline in the industry's relative size. If the firms in the industry are all private, government revenue derived from the industry will also decline, the amount depending on the tax rate and other factors. Should a public enterprise be involved, the treasury will feel the impact of the declining rate of profit to an extent determined by the degree of government ownership through a reduced nontax revenue or a reduced operating surplus in the public enterprise accounts. To take a concrete example, whether worker benefits are paid by the government or are mandated by the state for employers to pay will determine whether a given policy appears in the accounts as a loss of tax revenue or an increase in government expenditure.15 15

Summers (1989) points out that the dead-weight loss associated with mandated benefits may be less than identical benefits provided by the state and funded through taxes.

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Determinants of Public Enterprise Deficits Public enterprises are often criticized at a macroeconomic level for frequently contributing to the overallfiscaldeficit. A proper assessment of the fiscal impact of public enterprises therefore requires analysis of the determinants of the final result of their financial operations. A deficit, for example, is not prima facie evidence of a fiscal problem. Nor should profit necessarily be the accepted measure by which to judge public enterprise performance, since economic efficiency, particularly in areas where public enterprises are often found, does not necessarily imply profitability. The proper assessment of public sector operations also requires a careful inspection of intrasector transfers and pricing on a disaggregated level. This is because there is often a complex web of transactions among public enterprises and between the enterprises and government. Often, the operating result of public enterprises does not adequately measure their efficiency because they are frequently compelled to optimize under constraints that do not confront their private sector counterparts. Governments often utilize public enterprises to carry out important policy tasks. A public transport company, for example, may be directed to serve rural districts at a high cost in order to help carry out the government's commitment to rural development. A subpar performance for these enterprises is almost guaranteed if the reference point used to judge the outcome is unconstrained optimization. Conversely, a government may give favorable treatment to the state enterprises, for example, by directing government agencies to buy from them. These types of policies make analysis of public enterprise results difficult. However, in order to arrive at a proper judgment of whether the public enterprise sector is in need of reform, an understanding of some of the potential problems is essential. Another common criticism of public enterprises is that they are inefficiently administered. It needs to be clarified whether this perception stems from exogenous constraints imposed on the enterprises or from poor management or corruption. The bottom line itself is of no use in this respect. If the matter is approached conceptually, it may be possible to distinguish between several types of efficiency. The firm may be operationally efficient at market prices for its inputs. It may be operationally efficient at shadow prices.16 Apart from being opera16 Although in some cases the proper shadow price is easy to determine, in others it is quite difficult and depends on unobservable preferences.

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tionally efficient, however, the firm may or may not charge efficient prices. In general, from an economic point of view, firms that are engaged in monopolistic or oligopolistic competition will not price their products efficiently. The prices set by private firms will, understandably, not take into account any redistributive goals of government unless the firms are included in the overall incentive structure. Public enterprises, however, are sometimes compelled to charge prices that are below marginal cost in order to fulfill a political goal of the government. Clearly, a firm in such a situation will not be able to fund its operations. The fact that efficiency cannot be inferred from the overall bottom line of public enterprises implies that they are also difficult for the government to monitor. Although conventional wisdom is that governments representing diverse constituencies are, by nature, inherently poor managers, this misses a very important point. Indeed, the management of common stock mutual funds may adequately represent thousands of different investors. The key ingredient is that the general goals of the investors are more or less the same over a few fairly easily measured parameters, primarily risk and return. If the government was predominantly interested in attempting to encourage profit maximization, for example, in order to reduce the tax burden, it would not be difficult for it to set up the proper incentives for enterprises. However, it is quite likely that government will have objectives that differ from the strict maximization of enterprise profits. This makes it difficult to evaluate public enterprises and for the government to control their management and performance. Market forces, through competition, act to reveal poor performance in private firms, decreasing their value and eventually causing them to either improve their production process through better management or be eliminated entirely. This mechanism is usually not allowed to operate with public enterprises, however. Of course, if government policy compels a firm to make a loss, the government should fund the loss. However, the lack of a mechanism to enforce good performance and the fact that it is difficult to measure good performance are obstacles to efficient government control.

Conclusions A number of recent authors17 have emphasized that the design of fiscal policy must, to a greater extent, take into account the microeco17

See, for example, Tanzi (1987a).

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nomic issues—that is, the precise nature of the fiscal problems and the quality as well as the quantity of adjustment that is needed for successful reform. This chapter has looked at one element that often forms part of the fiscal problem, the public enterprise sector. In conclusion, the final section will summarize the main topics discussed. No single definition of public enterprise is satisfactory for every purpose and in every country, but two areas of distinction are useful for analysts and policymakers. One is based on the behavior of enterprises. Firms that respond quickly and efficiently to market signals may be distinguished from enterprises that do not. Often those in the latter category are publicly owned and have soft budget constraints. Not all of these firms are publicly owned, however, nor are all publicly owned firms slow in adjusting to market forces. Knowledge of those portions of the economy that either respond like the private sector or behave more like government agencies is useful for a number of purposes. In designing economic policy, for example, it is crucial to know which sectors in the economy need to be controlled by direct mechanisms and which can be influenced indirectly through the price system. Those enterprises categorized as the public enterprise sector will require direct controls on expenditures contributing to the overall deficit—as is the case with government—but they will not be expected to respond in the usual manner to indirect measures or changes in exchange rates and interest rates. Government and public enterprises are often structured in such a way that they are not particularly responsive to market signals. It is therefore important that they be considered suitable for direct controls. The second area of distinction between types of enterprises is their impact on the public finances. Often privately and publicly owned enterprises receive state guarantees or assistance. Their operations therefore affect the net worth of the government and thereby individuals' future tax and government benefit streams. Firms that may not satisfy the behavioral criterion for public enterprises may fall in this category if they have issued government-backed debt or received subsidies from the government. There are several complications in measuring the fiscal impact of public enterprises. One is that enterprise accounts are often properly prepared using an accrual basis that conflicts with the cash basis procedure recommended for government accounts. Accrual accounts are appropriate for measuring profitability and the net worth of a firm, but they are not useful for constructing the public sector's net borrowing requirement. Although the use of the public sector borrowing requirement measure is often criticized, it is appro-

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priate for gauging the public sector's impact on credit markets and for consistently analyzing the contribution of the public sector toward money creation. In this context, public enterprise cash accounts play an important role. In gauging the public sector's impact on the economy, however, it would be more appropriate to measure enterprise activities on an accrual basis. This would give a truer reflection of the performance of the enterprise sector. A major difference arises in the treatment of capital expenditure. For government, on a cash basis, all gross capital expenditure is shown as an expenditure, while depreciation is not. With accrual accounting, however, depreciation is shown as an expense. Whether this asymmetrical treatment is warranted is often a matter of judgment. For a profitable public enterprise, it is sensible to treat the capital expenditure as likely to increase the value of the firm and therefore not to record it as a current expenditure. For a notoriously loss-making enterprise, however, the increase in capital may not lead to future income generation. In this case, the proper treatment would more likely be the cash concept. What is important is the net value added by the marginal capital expenditure. If the value added is positive and the investment sound, one could argue that the expenditure should not simply be added to the public sector deficit but instead treated separately in a public sector capital account. If the investment is a bad one, some account should be taken of the present discounted cost to the government. Historical performance is often a useful guide in judging how to treat a firm's capital expenditure. Another difficulty with accrual accounting is the treatment of unrealized capital gains. The market value of a privately owned firm will rise if there is an improvement in the firm's prospects. This capitalization effect would also occur for publicly owned firms if shares in those firms were ever to be sold. Some publicly owned assets will never be sold, however. It therefore seems of dubious merit to revalue such government assets. If the increase in the value of the firm will never be realized (for example, by the government never selling the firm or by gaining an increased stream of income from the assets), it would be incorrect to attribute the increase in present value to the government accounts. How to treat government contingent liabilities is another problematic issue.18 The likelihood of a default on guaranteed debt is a function of the firm's current and future performance. Although the impact (in terms of expected value) of the subsidy changes over time, the value 18

Foran in-depth treatment of government contingent liabilities, see Chapter 16.

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for accrual purposes must be determined at the time of the guarantee. Here, again, the distinction between cash and accrual accounting can be quite large. When it comes to measuring public enterprise performance, in many cases, enterprises execute a complex system of subsidies and taxes that may be obscured in an aggregate measure, such as the operating balance. Ideally, it would be best to measure the subsidy and tax elements separately in order to represent the fiscal system in a true light. Although this may be difficult, it is often of immense value in policy analysis, especially in those cases where such analysis may potentially be led astray because enterprise activities are measured at artificial prices or exchange rates. It is widely acknowledged that public enterprises play an important fiscal role. It is also apparent that their operations and accounts raise special questions for the analyst, who must first understand the important differences that exist between government and public enterprises. Then, in order to develop sound fiscal policy recommendations, it is necessary to carefully identify the fiscal role and to examine enterprise operations closely.

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References Baumol, W.J., "Toward a Theory of Public Enterprise," Atlantic Economic Journal, Vol. 12 (March 1984), pp. 13-19. Blejer, Mario I., and Gyorgy Szapary, "The Evolving Role of Fiscal Policy in Centrally Planned Economies Under Reform: The Case of China," IMF Working Paper, No. 89/26 (Washington: IMF, March 1989). Boskin, Michael J., "Federal Government Deficits: Some Myths and Realities," American Economic Review: Papers and Proceedings of the Annual Meeting, Vol. 72 (May 1982), pp. 296-303. De Vries, Jan, The Economy of Europe in an Age of Crisis, 1600-1750 (Cambridge, England: Cambridge University Press, 1976). Dreze, Jean, and Nicholas Stern, "Policy Reform, Shadow Prices, and Market Prices," IMF Working Paper, No. 88/91 (Washington: IMF, October 1988). Hall, Robert E., "The Relation Between Price and Marginal Cost in U.S. Industry," Journal of Political Economy, Vol. 96 (October 1988),

pp. 921-47.

International Monetary Fund, A Manual on Government Finance Statistics (Washington: IMF, 1986). Kornai, J., "The Soft Budget Constraint," Kyklos, Vol. 39 (No. 1, 1986), pp. 3-30.

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PETER STELLA 235 Kotlikoff, Laurence, "From Deficit Delusion to the Fiscal Balance Rule: Looking for an Economically Meaningful Way to Assess Fiscal Policy," IMF Working Paper, No. 89/50 (Washington: IMF, June 1989). Levy, Brian, "A Theory of Public Enterprise Behavior," Journal of Economic Behavior and Organization, Vol. 8 (March 1987). Short, R.P., "The Role of Public Enterprise: An International Statistical Comparison," in Public Enterprise in Mixed Economies: Some Macroeconomic Aspects, by Robert H. Floyd, Clive S. Gray, and R.P. Short (Washington: IMF, 1984). Stella, Peter, "Tax Farming—A Radical Solution for Developing Country Tax Problems?" IMF Working Paper, No. 92/70 (Washington: IMF, September 1992). Stiglitz, Joseph E., Economics of the Public Sector (New York: W.W. Norton and Co., 2nd ed., 1988). , and Andrew Weiss, "Credit Rationing in Markets with Incomplete Information," American Economic Review: Papers and Proceedings of the Annual Meeting, Vol. 71 (June 1981), pp. 393-410. Summers, Lawrence, "Some Simple Economics of Mandated Benefits," American Economic Review: Papers and Proceedings of the Annual Meeting, Vol. 79 (May 1989), pp. 173-88. Tanzi, Vito (1987a), "Fiscal Policy, Growth, and the Design of Stabilization Programs," in External Debt, Savings, and Growth in Latin America, Papers Presented at a Seminar Sponsored by the International Monetary Fund and the Instituto Torcuato Di Telia, ed. by Ana-Maria Martirena-Mantel (Washington: IMF, 1987). (1987b), "The Public Sector in Market Economies of Developing Asia," Asian Development Review, Vol. 5 (1987), pp. 31-57.

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11 Amalgamating Central Bank and Fiscal Deficits

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David J. Robinson and Peter Stella CONVENTIONAL MEASURES OF a country's fiscal situation, and perhaps particularly measures of budgetary imbalances, do not always accurately capture the economic realities of fiscal policy. For example, the conventional measure does not make allowance for the budgetary effect of high interest rates incorporating an inflationary expectation component. This issue is examined in the first section. In this chapter, the concern is the problems that arise in interpreting fiscal data when central banks experience deficits. Though rarely seen in developed economies, significant central bank deficits are not uncommon in developing countries. As shown in Table 1, countries with relatively sophisticated financial markets have experienced such deficits. Although in many cases the roots and macroeconomic effects of these deficits seem similar to those of fiscal deficits run by the central government, the question as to how they should be treated is currently being debated.1 The aim of this chapter is to argue that some central bank activities are fully or partly fiscal in nature, and draw conclusions with respect to their proper analytical treatment.

Note: The authors would like to thank the participants in an IMF Special Fiscal Studies Division seminar, especially Mario I. Blejer and Mario O. Teijeiro, for helpful comments. An earlier version of this chapter was published in Measurement of Fiscal Impact: Methodological Issues, ed. by Mario I. Blejer and Ke-young Chu, Occasional Paper 59 (Washington: IMF, 1988), pp. 20-31. 1 Various writers have recently analyzed the phenomenon of central bank quasi-fiscal deficits in the context of specific countries. See Onandi and Viana (1987), Reyes (1987), and Rodriguez Aguilera (1987). Piekarz (1987) looks at the issue more generally from the Argentine perspective.

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DAVID J. ROBINSON and PETER STELLA Table 1. Central Bank Losses in Selected (In percent of GDP) 1982

Country b

Argentina Costa Ricac Philippinesd Uruguaye

-5.6 -4.2

Countries*

1983

1984

1985

1986

-0.9 -4.9 -3.6 -7.6

-2.5 -4.3 -5.2 -4.2

-2.2 -5.3 -2.6 -3.4

-1.6 -3.8 -2.8 -4.0

a

These estimates are based on various definitions of the concept of central bank losses and thus are not fully comparable. They are intended only to indicate the potential size of central bank losses. b Piekarz (1987). IMF staff estimate for 1983. c Rodriguez (1987); 1986 is preliminary. d IMF staff estimates. Percent of GNP. e Onandi and Viana (1987). Central bank deficit plus transfers from the central bank to the mortgage bank.

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The chapter begins with a discussion of the nature of central banks and the reasons why they are traditionally outside government budgets. A distinction is then drawn between "purely monetary" activities— broadly speaking, traditional central bank activities undertaken to further the aims of monetary policy—and "quasi-fiscal" activities—those that are not specifically related to monetary policy and would, in many countries, be undertaken by the central government. It is argued that activities deemed quasi-fiscal should be included in most measures of government activity. Several of these activities that are especially relevant are then discussed in some detail. At the outset, two points should be stressed. First, as is perhaps obvious, the impact of a particular central bank's activities on the central government accounts depends very much on the accounting system in the individual country. It is not the intention in this chapter to provide detailed guidance on how accounts should be amalgamated in every conceivable set of circumstances. Rather, using a stylized accounting system as an example, an attempt is made to examine the underlying principles involved, which can then be applied as appropriate. Second, in discussing fiscal deficits, one must choose a particular deficit definition. To borrow from Tanzi, Blejer, and Teijeiro (see Chapter 9, p. 178): Fiscal deficits, as conventionally defined on a cash basis, measure the difference between total government cash outlays, including interest out-

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AMALGAMATING CENTRAL BANK AND FISCAL DEFICITS lays but excluding amortization payments on the outstanding stock of public debt, and total cash receipts, including tax and nontax revenue and grants but excluding borrowing proceeds. . . . In this manner, fiscal deficits reflect the gap to be covered by net government borrowing, including direct borrowing from the central bank.2

This is the basic definition adopted in this chapter. Central bank losses should be incorporated in measures of the fiscal deficit; however, not all central bank activities affect the profit-andloss account. Those other central bank quasi-fiscal activities whose impact is not already included in the central bank profit-and-loss statement should be examined by the analyst to determine whether they should also be incorporated. Perhaps most prominent among these latter activities is central bank quasi-fiscal lending. It is not proposed, however, that central bank accounting be done on a cash basis, that is, on the same basis as the fiscal accounts. Therefore, it should be recognized that the resultant deficit measure is likely to be a combination of cash and noncash elements.

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Role of Central Banks Central banks, as a general rule, operate outside the direct control of central governments. Behind this separation are usually historical and institutional factors. Although it is clear why the operational activities of central banks are carried out in a separate institution, it is less clear why the determination of policy is similarly separate. While the degree of real policy independence varies widely across central banks, the reason behind the persistence of at least a show of independence could be a recognition that monetary policy should be insulated from the vagaries of politics. Nevertheless, this does not logically preclude an accounting amalgamation for analytical purposes such as is proposed here. Although almost all central bank activities are quasi-fiscal in the sense that they have at least an indirect impact on government finances (as is also true for public sector entities), this does not warrant the claim that all central bank activities should be treated in a fashion identical to fiscal activities. Central bank and fiscal deficits should be amalgamated for certain analytical purposes, but that does not imply central bank accounts should be done on the same basis as fiscal 2

For a complete discussion see International Monetary Fund (1986).

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accounts. For this reason, in this section a distinction is drawn between "monetary" and "quasi-fiscal" as a prelude to the argument that they be treated in a somewhat different fashion. Central banks undertake a wide variety of activities. Some, such as open market operations, can be considered purely monetary, and in almost every country would be undertaken by the central bank. They represent, in part, switches in the asset portfolios of the government and the private sector. Others—for instance, the provision of subsidized credit to particular sectors or the funding of development schemes—are, on the other hand, activities that in many countries would be undertaken directly by agencies in the central government. In these cases, it may be difficult to see why an activity administered by the central bank is different in an economic sense from one administered by other government agencies and, therefore, why, if the latter are included in a measure of the central government deficit, the former should be excluded. The question of what precisely constitutes a central bank has been a controversial one. Indeed, central banking is often described by its practitioners as an art rather than a science, and the functions of central banks have evolved over time. The following list, derived from de Kock (1974), enumerates activities that would generally be accepted as properly within the jurisdiction of a central bank: 1. The regulation of currency, in accordance with the requirements of business and the general public, for which purpose the bank receives a full or partial monopoly of the note issue. 2. The provision of credit facilities, in a variety of forms, to commercial banks, discount houses, etc., in its capacity as the bankers' bank, and the acceptance of the responsibility of lender of last resort.3 3. The control of credit in accordance with the needs of business and the economy, and in order to carry out the broad monetary policy adopted by the government. 4. Bank supervision and regulation. 5. The performance of banking and agency services for the government. 6. Custodian of the commercial banks' cash reserves. 7. The custody and management of the nation's international reserves. 3

Two points should be made here. First, central bank lending designed to allocate credit to specific enterprises should not properly be termed rediscounting but rather quasi-fiscal lending. Second, if rediscounting takes place at subsidized interest rates, it can be considered—at least in part—a quasi-fiscal activity. See also discussion below.

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8. The settlement of clearance balances between banks, and the provision of facilities for the transfer of funds between important centers. These activities fall into two groups: those that central banks perform either as the direct result of a government-granted monopoly or as a fulfillment of government policy (numbers 1-4) and those that are essentially banking services (numbers 5—8). The economic impact of the first group is rather more complex than that of the second. The second group has clear-cut inputs and outputs, and could, in principle, be done by the private sector. In providing banking services, the central bank is essentially the same as any other public enterprise.4 In this chapter, the activities enumerated are generally—with some qualifications discussed below—considered monetary activities. All other activities are considered quasi-fiscal in nature.

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Central Bank Accounts and Economic Impact of Central Bank Activities In this section, to establish a framework for further analysis, the accounting conventions used in central banks are reviewed. The economic impact of various central bank activities is then discussed. Central banks typically publish two types of accounts: a profit-andloss account and an overall balance sheet. The profit-and-loss account shows a breakdown of current expenditures and revenues, and the distribution of the operational surplus (or the financing of a deficit). The overall balance sheet shows the composition of the central bank's assets and liabilities. The two accounts are clearly linked: a central bank operational profit (after taxes, transfers, and so forth) will result in an increase in its assets, matched, on the liabilities side of its balance sheet, by an increase in its net worth. A portion of the central bank operational profit (but not of any loss) is usually transferred to the government. Therefore, to understand the impact of central bank activities on central government, a discussion of the sources of revenue and items of expenditure typically included 4

This implies that the financial results of these activities should have the same impact as those of other public enterprises in the budget. As shown below, provided the central bank makes a profit, this will be the case.

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in the profit-and-loss account and the effect of central bank activities on its overall balance sheet follows.

The Profit-and-Loss Account Revenue Almost all central banks have a monopoly in issuing currency and creating reserves—this right almost defines a central bank.5 As the cost of production of notes and coin is much less than their exchange value, the central bank captures the difference, seigniorage, during the money creation process. The same is true of the creation of reserves, a virtually costless procedure. To quote Meyers (1985, p. 27):

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Like monarchs of old, the Federal Reserve makes money by making money. It does this first by purchasing Federal Reserve Notes at the cost of production (less than 3 cents per note) and by issuing the notes at par. These non-interest-bearing IOUs (Federal Reserve Notes) are then exchanged for interest-bearing assets (government securities). The interest on these securities in most cases provides a substantial part of a central bank's income. In countries where central banks are allowed to lend directly to the private or public sector, or both, interest on these loans is often an important component of income. In many cases, the central bank requires commercial banks to hold reserves equal to prescribed fractions of their deposits at the central bank (often at a below-market interest rate). These can then be reinvested in government bonds, or used to finance other central bank activities, such as rediscounting, providing a further source of income.6 Another method by which the central bank may generate substantial income is through the administration of a multiple exchange rate system, where the central bank profits from the monopoly purchase and sale of foreign exchange. This is analogous to an export-import tax 5

See Smith (1936). Many of the sources of revenue mentioned above fall under the rubric, "inflation tax." Although central banks are rarely charged with the maximization of revenue from this tax, in many developing countries the ease of collecting this type of tax has led it to become a major source of government finance. While it is well understood that the revenue obtained from the tax depends on the elasticity of the tax base, for example, see Auernheimer (1974), it is often the case that central banks appear to have exceeded the revenue-maximizing rate of inflation. (For an interesting discussion of why this might happen, see Khan and Knight (1982).) 6

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scheme in a country with a unified exchange rate or a tax on the sale and purchase of foreign exchange. Depending on the accounting conventions in the country, the revenue obtained from such operations may be transferred to the treasury directly or be added to central bank revenue. If it is transferred, gross government tax revenue would not be understated whereas, in the latter, tax revenue would be understated and, if the profits come to the treasury as central bank profits, nontax revenue would be overstated. Aside from these sources of income, central banks receive income from other activities, including fees for acting as fiscal agents to the government,7 charges for check clearing, and miscellaneous receipts, such as rents. A further potential source of revenue (or loss) is the effect of exchange rate changes on the value of the foreign assets held by the central bank.8 Such valuation changes, however, are usually excluded from the computation of profits and losses of the central bank; instead, changes on the asset side of the central bank's balance sheet are matched by changes in a revaluation account on the liabilities side. This is discussed further below.

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Expenditure Central bank expenditures can be divided into three categories. First are the general administrative expenditures on wages and salaries, benefits, equipment, and premises. Second are interest payments on deposits of commercial banks at the central bank and any other central bank borrowing? Third, and most difficult to analyze, are quasi-fiscal expenditures—expenditures on activities that are additional to the central bank's monetary and exchange system responsibilities. These can take many forms: common examples are the provision of subsidized credit (either directly or indirectly through a rediscount scheme) to priority sectors, notably exporters and agriculture; contributions to development funds; expenses arising in connection with bailouts of ailing banks or industries; and exchange rate subsidies on particular types of transactions, such as debt-service payments or essential imports. The dividing line between quasi-fiscal and monetary opera7 For instance, administering certain government accounts, serving as a depository for government funds, and managing the public debt. 8 The analysis of foreign assets in this chapter assumes that they are owned by the central bank. Interest on reserves, in the same way as interest on other central bank assets, is credited to the profit-and-loss account.

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tions, however, is often not easy to draw. For example, central bank rediscounting of bonds is generally considered a monetary activity (see also the discussion below, under "Economic Impact of Central Bank Activities"); however, it often takes place at subsidized interest rates, giving it a quasi-fiscal dimension. As noted in the case of central bank revenue, the way in which quasifiscal expenditures are captured in the accounts is often unclear. In most cases any subsidy will remain implicit; for example, the cost of granting loans at below-market interest rates is typically not calculated (see Chapter 8). Losses incurred in bailing out ailing industries may be reflected in an overvaluation of the central bank's assets rather than a reduction in operational surplus. (Although it should be noted that, in some cases, central banks are required to exclude bad or doubtful debts from the computation of net profits. In addition, if reserves are increased by an appropriate amount, the surplus for distribution would be reduced.) Other items may remain off-balance sheet, for example, exchange rate or loan guarantees. The provision of foreign exchange at an overvalued exchange rate can also be considered an implicit subsidy.9

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Distribution of Profits or Losses In almost all countries, the governing central bank law regulates the distribution of net profits among three beneficiaries: central bank reserves, the government, and—if the central bank is only partially owned by the government—dividends to shareholders.10 Among the three, in recognition of the financial autonomy of the central bank, priority is usually given to central bank reserves. Thus, for instance, in some cases the law prescribes that all net profits will go to the government once the reserve fund reaches a certain level; in others, that a varying percentage of net profits go to each, depending on the ratio of net profits to the bank's capital. In some cases the moneys transferred to the government must be used in a particular way, usually to service or retire the national debt. Although a proportion of net profits transferred to the government is often substantial, a potential asymmetry exists in that a net loss 9 Under a unified exchange rate, this will only generate a loss if the balance of payments is in deficit. If the balance of payments is in surplus, the central bank will make a profit. 10 For example, in Belgium, profits can also be distributed to the bank's personnel; in Switzerland, profits are distributed to the cantons as well as to the federal government.

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would not in general result in a transfer from the government (as might be the case, for example, in a public enterprise) but would instead be met by a reduction in reserves. A further point is that, unlike commercial banks, there is no reason why a central bank cannot continually make losses and have a persistently negative net worth. Therefore, unlike other public sector entities, central bank losses need not be "funded."

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Overall Balance Sheet of t h e Central Bank The overall balance sheet shows the composition of the bank's assets and liabilities. The liabilities of the central bank typically include the note issue, deposits by the government (in the central bank's role as fiscal agent), deposits by the private sector (usually owing to legal regulation or the central bank's role as the banks' banker), and loans raised by the central bank (which can be in foreign currency). On the asset side, the central bank may hold a variety of assets. Resulting from its monetary activities—intervention or rediscounting—it may hold government or private sector bonds and foreign exchange. It may extend credit to the government, to finance the government deficit. And finally, it may undertake quasi-fiscal activities, including the extension of credit to the private sector. To make the accounts balance, the difference between the bank's assets and liabilities is shown on the liability side of the balance sheet. This item—which is broadly equivalent to "other items net" in the central bank monetary accounts—has three important components. First, it includes the revaluation account that reflects valuation changes in the net foreign assets of the central bank. Second, it includes the net worth of the central bank, the cumulation of its profits, plus interest, over time. And third, it includes the central bank's original capital, physical assets (such as buildings), and reserves. Economic Impact of Central Bank Activities In this section the economic effects of central bank activities and how they differ from those of central government activities are reviewed. Since—almost by definition—quasi-fiscal activities have the same impact as equivalent government activities, the focus will be on what have been defined as monetary activities. As outlined earlier, monetary activities can be divided into two groups: first, provision of banking services to the government and private sector, and second, explicitly

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monetary operations,11 which largely involve changes in the central bank's asset portfolio. The first group of activities can be discussed simply, since in performing them the central bank is very similar to a public enterprise. The bank provides services for the public and private sectors, for which it receives fees. Its expenditures and revenues have exactly the same effect as those of any other public enterprise and should be treated accordingly.12 The second group, which includes revenue from seigniorage, open market operations, and lending to the private sector through, for instance, the discount window, has somewhat more complex economic effects. The most straightforward is the revenue from seigniorage.13 This revenue transfers real resources from the private sector to the central bank, reducing private aggregate demand. In addition to their role in the generation of seigniorage, intervention and rediscounting raise another question. Intervention through open market operations involves the central bank either buying or selling securities in exchange for base money, usually to influence the path of the money supply or interest rates. Rediscounting involves the temporary extension of resources to the private financial sector to allow it to overcome temporary liquidity shortages without sharp movements in interest rates. Both intervention and rediscounting can result in the extension of credit to the private sector. An important question is whether this credit extension is similar to, for example, a government loan to a particular industry (which would be considered as net lending) or whether it is qualitatively different. It is argued here that a distinction can be drawn, based on three differences: motive, availability, and the prospects for repayment.14 Open market operations are aimed at achieving a particular monetary result. There is no intention to provide reserves to any particular sector of the economy, and the central bank does not attempt to distinguish the ultimate receiver of liquidity. Rediscount policy, however, does provide reserves to specific private sector entities. Its purpose is money management: credit is provided (subject, 11

Activities 1—4 in the preceding section. Under the conventions established in the IMF's Manual on Government Finance Statistics, expenditure of public enterprises is netted against revenue and the resulting deficit or surplus is shown in government expenditure or revenue. As demonstrated in the next section, this is effectively what happens in the case of the central bank. 13 Effectively, revenue from seigniorage is payment for the liquidity services of money. 14 The following analysis treats rediscounts at market interest rates. As noted below, subsidized rediscounts can be considered both monetary and quasi-fiscal in nature. 12

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in many cases, to various regulations) to whichever banks require it. In general, there is no attempt to channel the funds to any particular end use (although certain activities—for example, speculation in foreign exchange—-may be discouraged). Finally, assets acquired through rediscounting are likely to be serviced and ultimately repaid. Lending by government is, however, usually made for a specific policy purpose and directed toward particular enterprises that usually could not raise loans on the same conditions from the private sector. Such lending, therefore, involves at least implicitly an element of subsidy and may ultimately not be fully repaid. There are really two elements to this argument. The first is that government net lending cannot be treated as if it creates an asset and liability of equal but opposite magnitude, and because of this it is conventional to include it in government expenditure.15 The second is that government expenditure should measure, in some sense, the gross volume of resources the government directs toward public policy purposes. In this vein, intervention and rediscounting are not equivalent to government net lending or government expenditure in the sense that they do not direct resources to any particular sector for public policy purposes. These central bank monetary operations are much more like simple switches in assets that do not affect government net worth. For these reasons, open market operations and rediscounting should not be considered equivalent to government net lending. Such central bank operations are undertaken for the purpose of overall management of monetary conditions and should simply be considered as (mutually offsetting) portfolio adjustments.16

Amalgamating the Accounts of the Central Bank and Central Government In this section some of the theoretical and practical issues involved in amalgamating the accounts of the central bank and central govern15

The United Nations accounting system, however, treats net lending as financing, on the grounds that it is also wrong to treat net lending as a transfer that will never be repaid. Clearly the truth—in terms of net worth—lies somewhere between the two. The net worth of the government is only reduced to the extent that the expected net present value of the loan falls below its face value. In an extreme case—where an exactly equivalent loan would have been readily granted by the private sector—the government is essentially acting as a commercial bank. A deficit caused by such lending activity would not have expansionary or crowding-out effects. 16 The interest on holdings of private sector bonds and on rediscounts does directly affect aggregate private demand and is properly to be considered central bank revenue.

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merit to produce a deficit measure consistent with the principles underlying the conventional deficit measure are considered. The analysis is divided into three parts, each covering different types of activities. The first covers activities that affect only the profit-and-loss account of the bank; the second, activities that affect the bank's balance sheet; and the third, three activities that are worthy of special attention: direct lending to government, exchange guarantees, and the implications of different accounting conventions in government and central banks.

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Activities Affecting the Profit-and-Loss Account Central bank activities that affect solely the profit-and-loss account of the central bank include the banking services side of monetary activities and certain quasi-fiscal activities, for instance, subsidized credit refinancing for exporters, which is unwound over a short period. If the central bank makes a profit and provided that the amount the central bank transfers to its reserves is not excessive (reserves policy is discussed further below), the net operating surplus of the bank will accrue to the government and reduce the deficit. Therefore, the net result of these activities is effectively already included in a conventionally measured deficit.17 It would thus seem that, for measuring thefiscaldeficit, no distortion will arise if the central bank performs banking services, or if it undertakes quasi-fiscal activities of a kind such that the entire impact is felt on the central bank's profit-and-loss account in the year in question. Two points should be made, however. First, leaving such activities in the central bank accounts will understate the gross level of government expenditures and revenues, frequently taken as a proxy for the level of government intermediation in the economy. Second, as noted above, the cost of quasi-fiscal activities undertaken by the central bank is rarely transparent.18 For instance, in providing subsidized credit, the 17

This analysis implicitly assumes that central banks remit 100 percent of marginal profit (when the bank is making a profit) and zero percent of the marginal loss (when it is making a loss). It may be, however, in a particular country, that the marginal rate of transfer of central bank profits is less than 100 percent. In such cases, even were the central bank making profits, the transfer of a quasi-fiscal activity between the government and central bank would not be completely neutral. This potential qualification is ignored in what follows. 18 There are analogous problems with certain central government activities, for example, measuring the net value of public asset sales—that is, the gross sales proceeds minus the value of the asset sold.

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central bank effectively accepts a lower rate of return on its assets, rather than provide a subsidy directly. Isolating quasi-fiscal activities in the central bank accounts would make these costs more transparent, thus aiding scrutiny of the activities by the authorities. To conclude this section, two further questions are discussed— central bank reserve policy, and what happens when central banks make losses. Earlier the role of the central bank's reserve policy in determining the residual transfer to government was noted. Obviously, if the central bank increases its transfer of profits to the government by reducing its transfers to reserves—and therefore its net worth—then government revenue can be higher, and the conventionalfiscaldeficits will be lower. Consequently, in interpreting the fiscal deficit, it is important to be sure that the central bank reserve policy is appropriate or at least will not be manipulated. Clearly, the central banks' auditors can potentially play a useful role in determining whether reserve transfers are adequate. Subject to an appropriate reserve policy, developments in the central bank's profit-and-loss account are fully transmitted to the government accounts since the residual profit is transferred to the government. The question arises, however, as to what happens when the central bank makes a loss, no profits are transferred, and the loss is covered by balance sheet operations—for instance, a reduction in reserves, or printing money, with an equivalent reduction in central bank net worth. In this case, central bank losses are not fully transferred to the fiscal deficit and an asymmetry exists. To deal with this problem, symmetry must be restored. If central bank net profits go to the government, then central bank net losses should result in a transfer from the government. Thus, the impact of the entire central bank loss should be included in the government accounts, for instance, by a transfer from government, thereby increasing the fiscal deficit.19 Should there be no change in financing arrangements, then two corresponding effects on the central bank accounts will occur. On the liabilities side, there will be no reduction in net worth, as the losses are borne in full by the government. On the assets side, central bank credit to government will increase by the amount of the losses, ensuring that the balance sheet continues to balance. 19 In Brazil, for example, where the monetary authorities traditionally carry out certain fiscal activities, the central administration makes a budgetary allotment for this purpose. (In the early 1980s, however, the allocation began to fall short of actual quasi-fiscal spending.)

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This procedure illustrates the philosophy underlying the approach used in this chapter. The central bank is considered to be a basically sound institution, which will not make losses on its core operations. It can, however, be asked to undertake loss-making operations by the government. The impact of these operations must be unscrambled from the accounts in such a way as to allow the full cost to fall on the government budget, leaving a financially sound central bank. There are some circumstances, however, where central banks apparently undertaking only monetary operations can run deficits. This problem is considered later in the chapter.

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Activities Affecting the Central Bank's Balance Sheet This subsection is concerned with activities whose costs do not immediately (or fully) fall on the profit-and-loss account, but are instead reflected in a change in the composition of the central bank's assets and liabilities. Examples are central bank loans to commercial banks or industry that are financed by changes in high-powered money or by central bank borrowing. Some theoretical considerations are needed at this point. The economic cost of an activity can be considered as the amount that would have to be paid to the private sector to undertake the activity in question. Thus, for example, the cost of net lending to the private sector is the sum that would have to be paid to a private commercial bank to undertake the lending itself, and would, in theory, be equal to the expected discounted future loss arising from the loan, adjusted for risk. Thus, to maintain its financial integrity, when undertaking a quasi-fiscal activity, the central bank would ideally increase its reserves sufficiently to cover that cost, effectively reducing its profit transfer to government and increasing the fiscal deficit by the same amount. If it did this, the fiscal deficit would fully reflect the cost of the quasi-fiscal activities undertaken by the central bank in the sense of their impact on net worth.20 Two problems arise, however. First, in practice, there is no easy way to measure the ex ante economic cost under uncertainty.21 Second, 20 For example, suppose a central bank wished to make a loan of $100 to an enterprise and that similar claims on that enterprise were discounted by 25 percent in the market. When making the loan, the central bank would increase its reserves by #25 to cover its potential loss, reducing its income and thus the profit transfer to government by the same amount. 21 For a thorough presentation of a technique to measure the subsidy element in budgetary lending in the case of certain repayment, see Chapter 8.

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even if a suitable technique was available, such a treatment would be inconsistent with that of the cash deficit definition presented above, where, for instance, net lending is included in full in government expenditure. The cash deficit reflects thefinancingrequirement of the government, rather than the change in its net worth. For consistency, therefore, central bank lending to the private sector must be treated in a similar way. Merely incorporating all central bank lending to the private sector into the fiscal deficit would ignore an important distinction, however. Central banks can hold private sector assets as a quasi-fiscal activity, involving, for instance, a direct loan to a particular private sector entity and as part of their normal "monetary" activities, including rediscounting and intervention.22 If all changes in central banks' holdings of private sector assets were treated as net lending, these two activities would be treated as having similar economic effects. As argued in the previous section, normally, intervention for monetary purposes should not result in an increase in a consolidated deficit measure, financed by the issue of high-powered money. Rather, it would seem appropriate for both the purchase of the private sector debt instrument and the sale of high-powered money to be regarded as financing items, and cancel each other out. To preserve the aforementioned distinction among types of central bank lending, the ideal solution would be to transfer quasi-fiscal lending from the central bank to the government accounts, with a counterbalancing change in net credit to government from the central bank. For consistency, one would also remove the corresponding interest payments on these assets from the profit-and-loss account—although, for calculating the fiscal deficit, this is again not necessary if the net revenues from it will effectively be transferred to the government.23 Another potential source of changes in the central bank's balance sheet is changes in the value of its foreign exchange holdings due to changes in the exchange rate. In such a case, changes in exchange rates will usually cause changes in the domestic currency counterpart of net foreign assets, resulting in an unrealized profit (or loss). This 22

A substantial proportion of the open market operations of the Bank of England has involved the purchase and sale of commercial bills. 23 Classification problems, of course, may once more arise, and gross central government revenues and expenditures may be distorted. The approach has a theoretical difficulty. If the central bank increases its reserves to some extent as a consequence of its lending, then double counting will occur: the reserves increase will increase the fiscal deficit, as will the full amount of lending.

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valuation change could be treated in any of three ways: as central bank income, as an increase in central bank reserves, or it could be effectively frozen in a revaluation account. In almost all cases, unrealized valuation changes are excluded from central bank income, on the grounds that the valuation changes attract no new resources into the country and do not decrease claims on resources by those inside the country. The expansionary effects of government expenditure "financed" by such unrealized profits are similar to those of expenditure financed by central bank credit. Thus, unrealized valuation changes should not be considered as revenue enhancing or reducing, as they would be if they were included in central bank profits. The impact then will generally fall on the central bank balance sheet. If it were added to reserves, however, it would bias the reserves figures. Therefore, valuation changes are most appropriately excluded from reserves, as well as net income, and frozen in a revaluation account. Should the unrealized gains become realized, a different situation would exist. Compared with the situation that would have obtained with no revaluation gain, purchasing power in the private economy is reduced by the amount of the valuation gain, and thus expenditure "financed" by realized gains is similar to expenditure financed from revenue. If the central bank's accountants took note of the capital gain, it would be hypothecated to reserves: thus, other transfers from income to reserves would be correspondingly reduced, and transfers to the government would increase, reducing the fiscal deficit. In some cases, the central bank does not keep track of capital gains and losses that are due to the sale of previously purchased foreign exchange. Rather than shifting the accounting entry from revaluation account to profit account, no change is made. In practice, this means the gain is never effectively realized. Nevertheless, it is a true gain, as the liabilities of the consolidated central bank or government are lower after the gain than otherwise would be the case. One ad hoc way around this accounting problem would be to attribute valuation gains or losses to central bank income over a period of several years. Activities of Special Interest Direct Lending to Government In countries without developed financial markets, direct lending may be the only practical method of domestic government finance. An

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important question here is the rate of interest on central bank lending to government. If the interest rate is low, or even zero, the cost of financing the government deficit will be understated. To force the government to recognize explicitly the costs of financing its deficit, it would be more appropriate to charge market-related interest rates. However, if central bank profits are transferred to the treasury, this would not of itself discourage the government from borrowing more from the central bank, if it is prepared to ignore the monetary consequences, as higher interest costs would be matched by higher revenues. If the volume of government borrowing leads to a rate of monetary base expansion greater than that desired by the central bank, the bank may be forced to take costly measures to reduce liquidity growth. This may involve selling interest-bearing stabilization bonds or paying market-related interest rates on excess reserves of the banking system. In cases where interest rates are quite high, interest on required reserves might also become necessary to avoid undue bank taxation and potential disintermediation. In essence, the government is using the central bank to finance its deficit and, in effect, the interest paid by the central bank on reserves and stabilization bonds is equivalent, in an economic sense, to interest paid on government debt. In this case the central bank is motivated by monetary reasons but the result is a quasi-fiscal operation.24 Though some central banks are prohibited from direct lending to the central government, the central bank may acquire government debt in the market and thereby achieve much the same result as direct lending. Central banks may also increase the market demand for government debt by allowing it to be held by banks to satisfy reserve or liquidity requirements, thereby reducing the interest rate the government needs to pay to sell it. Thus, manipulations of reserve or liquidity requirements, as well as open market operations involving government securities, may have implications for the central government deficit even though they might be considered "purely monetary" operations. A similar potential for reducing recorded government expenditures arises with purchases of foreign exchange by the government through the central bank. Subsidized exchange rates may be given for selected government purchases and debt service. 24 If the central bank makes a profit, the interest paid on these bonds correspondingly reduces the transfer to government. Consequently, the interest costs do increase the fiscal deficit.

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In cases where the operating conventions mentioned above serve to reduce nontax revenue received from the central bank, the gross expenditure and revenue flows of the central government are understated although the overall deficit remains unchanged. In cases where central banks are running deficits, however, in addition to influencing the gross flows, the central government deficit is reduced. It is clear that in such cases government deficit figures must be treated with some caution.

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Central Bank Exchange Rate Guarantees Unlike most other central bank activities, guarantees have no immediate effect on either the profit-and-loss account or the balance sheet. Nevertheless, in many cases, notably in Latin America, they have eventually resulted in very large losses. A foreign exchange rate guarantee is a form of insurance contract. For a specified premium, the insured obtains a guarantee of foreign exchange at a certain price on a given date. If a premium is charged that is above the actuarial value of the contract, then the insurer stands to make a profit in return for reducing the insured's risk. Of course, if a lower premium is charged, and many guarantees were offered for free, an ex ante subsidy is provided. In many cases in Latin America, exchange rate guarantees were offered as a way to facilitate foreign borrowing by domestic residents. These guarantees fixed the debt service in domestic currency terms, thereby reducing the risk to the creditor that the debtor would default solely on account of a real exchange rate depreciation. Had the central bank acquired the foreign currency counterpart of such borrowings, it could have diversified its own risk by holding external foreign assets. Because much of the borrowing was tied to imports, and also for other reasons, central banks did not keep foreign exchange backing for their guarantees. (Inasmuch as these might be considered contingent liabilities, one would not expect that full backing is necessary.) In cases where firms borrow abroad and seek an exchange rate guarantee, they are usually attempting to insure themselves against the real exchange rate depreciation that might result from a large nominal depreciation. This is a larger problem for the firm the lower is the proportion of the firm's earnings derived from goods priced in world markets. Unfortunately for the central bank, the demand for such guarantees increases when there are expectations of a devaluation; at such times, guarantees are quite risky. At the same time, however, if

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the firm is borrowing abroad, this can be expected to alleviate pressure on the central bank to supply foreign exchange in the short run. As the demand for guarantees increases, especially as firms roll over nonguaranteed debt, the bank's foreign exchange exposure increases. With the growth of guarantees, the incentive not to adjust the nominal exchange rate increases, as this would inevitably involve substantial losses for the central bank. Large losses resulted in cases where the central bank, usually because of a rapid rate of base money creation, could not maintain the rate, devalued, and the guarantees were called. From the perspective of the central bank's balance sheet, when a guaranteed debt-service payment is made, the value of its foreign assets falls by an amount equal to the foreign currency payment multiplied by the new exchange rate, which is greater than the amount of base money used by the private sector to purchase foreign exchange.25 Thus, foreign assets fall by a larger amount than base money and the difference is a reduction in the net worth of the bank. What are the economic impacts of such a policy? And here we are speaking of the policy rather than a particular realization. In any insurance scheme there is the potential for the insurer to take losses from time to time. This is true even if the fundamental policy is profitable. In most cases, though, the central bank traded guarantees for access to foreign exchange at favorable rates and, therefore, did not charge premiums related to the cost of the service it was providing. Assessing the expected present value of gains and losses of such a policy is very difficult. It also raises the question to what extent contingent liabilities should be measured and included in the accounts. Unfunded social security schemes and government guarantees of public sector enterprise or private debt are other examples of off-balance sheet items that may represent very important claims on future government resources. A current debate in commercial banking practice and regulation in the developed countries is to what extent reserves should be held against contingent liabilities (thereby reducing the net return on total assets). The difficulty is that the liability can only be expressed in expected value terms—it is in the indefinite future and is most probably not accounted for in the current budget or perhaps even in the budget planning horizon. Such liabilities can be quite important, however. The adoption of an actuarially unsound program, that is, where the premiums charged are not enough to cover the expected future pay25 Which, of course, equals the foreign currency payment multiplied by the old, guaranteed, exchange rate.

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ments, may have more of an ultimate impact on the future tax burden of the private sector than any change in the current budget. Ideally, the central bank accountant could measure the expected gains and losses, attribute the budgetary cost to the adoption of the policy rather than to a particular realization, and thereby develop a correct measure of the ex ante subsidy. A similar issue arises in the context of government-provided bank deposit insurance. Here the public-good aspect of preventing bank runs must be weighed against the potential moral hazard problem. Unfortunately, central banks do not usually relate premiums to the value of the guarantee as they are often under severe pressure to obtain foreign exchange and are willing to extend these guarantees probably with the knowledge that a debt rescheduling would be necessary should the guarantees be called upon. How should this situation be treated? As a practical matter a calculation of the fiscal impact of an issuance of contingent liabilities is very difficult. However, while it may be that there is no alternative to calculating losses as they are realized and financed (the bank could borrow the difference between the domestic currency value of the foreign exchange payments it would have to make and the value it receives from the government or private sector), one should remain cognizant that when the loss is realized, a contingent liability is extinguished. This points out a principle that is important to recognize. To measure the impact of guarantees on aggregate demand, one must return to the adoption of the policy and determine the ex ante subsidy. For it was the ex ante subsidy that affected economic decision making. Therefore, although the correct focus should properly be on the policy of exchange guarantees and, in an expected value sense, this is the potentially debt-creating activity, there seem to be no practical alternatives to including losses from guaranteed payments in the public sector deficit as they are realized. Of course, in many cases, the central bank does not freely offer guarantees. In the context of a debt rescheduling, it has been the case that governments or central banks were forced to assume the external transfer portion of private sector debt even when it was not guaranteed by the government. In such cases, the central bank is virtually forced to take a loss if the exchange rate guarantee is at an overvalued rate. The future losses generated by such an agreement should be viewed as part of the cost of a debt rescheduling and, therefore, should be part of a deficit measure, especially if the direct impact on the government's deficit is to reduce debt-service payments.

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The main issue with respect to exchange rate guarantees is the treatment of contingent liabilities in circumstances when they are likely to become realized. This is akin to the situation with public enterprise debt. If the enterprise is operating efficiently and borrowing to finance profitable expansion, a government guarantee is less likely to be a problem than if the borrower is a loss-making enterprise that is a drain on the government budget. It is uncharacteristic for governments to charge insurance premiums to firms in such cases that reflect true economic costs. Therefore, a guarantee may create a loss in expected value terms, and yet not be realized until some time later. Government net lending is treated as expenditure in the deficit definition used in this chapter while government loan guarantees are not. At times this distinction appears arbitrary. Government practice in granting loan guarantees is such that it generally validates this distinction.

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Implications of Different Accounting Conventions in Government and Central Banks The conventional government deficit concept as presented here is based on a cash-accounting system. Gash accounting is both useful and practical for government. It is useful in that it will be consistent with the deficit financing in any given period. It is practical because government is often unaware of its accruing receipts (for example, tax receipts due) and expenditures. It should be noted, however, that conventional fiscal deficits are not based entirely on the cash concept. This arises, on the one hand, from noncash accounting in the central government where expenditures are typically recorded on a checksissued basis, which creates a problem of adjustment to the monetary figures—check float—and on the other, by the fact that public sector entities, including the central bank, presumably base their payments or receipts to government on the basis of their accounting surplus or deficit, which may not be on a cash basis. Central bank accounting systems typically follow the normal business practice of being on an accrual basis. This practice allows an easier calculation of the net worth concept. The analyst must therefore be careful in comparing the two deficit measures.26 26

An extensive discussion of this issue may be found in Chang (1985).

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Conclusions The chapter has shown that if a central bank undertakes only monetary activities, and provided it is profitable, its net result will be included in the fiscal deficit automatically. This is also true of a profitable central bank if it undertakes quasi-fiscal activities that only affect its profitand-loss account. If it undertakes other types of quasi-fiscal activities, however, such as net lending, which show up initially only as a change in the composition of the central bank's assets, the fiscal deficit as conventionally measured can be an unreliable indicator. It will also be unreliable if the central bank makes losses. Ideally, government accounts should incorporate quasi-fiscal revenues and expenditures, leaving the central bank accounts covering only monetary activities. Such an approach, however, presents many practical difficulties owing to the differing accounting systems used in government and central banks. There is no elegant solution to these problems; however, some supplementary indicators could be developed to provide additional information. First, central bank losses in the profit-and-loss account could be amalgamated into an adjusted fiscal deficit by the addition of a transfer from government to the central bank financed by credit from the central bank. Second, an estimate of the size of central bank quasi-fiscal activities falling outside the profit-and-loss account could be made, and the activities removed from the central bank accounts and amalgamated into the adjusted fiscal deficit. Such a hybrid deficit would involve inconsistencies in the sense that a net-worth concept might be mixed with a cash concept, but would have value as a supplementary indicator showing the approximate impact of central bank quasi-fiscal activities on the economy. Experience in a number of countries has shown that the existence of exchange rate guarantees can result in heavy losses for central banks. Further supplementary indicators—showing, for instance, the value of such guarantees outstanding, and the losses that would result if they were called at the current exchange rate—could provide useful information. There is no simple way, however, to include guarantees in a conventional deficit measure unless and until they result in actual losses.

References Auernheimer, Leonardo, "The Honest Government's Guide to the Revenue from the Creation of Money," Journal of Political Economy, Vol. 82 (May-June 1974), pp. 598-606.

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Chang, Roberto J., "Monetary Authorities' Net Results as Part of Government Deficits" (unpublished, Washington: IMF, September 1985). de Kock, Michiel Hendrick, Central Banking (London: Crosby Lockwood Staples, 4th. ed., 1974). International Monetary Fund, A Manual on Government Finance Statistics (Washington, 1986). Khan, Mohsin S., and Malcolm D. Knight, "Unanticipated Monetary Growth

and Inflationary Finance," Journal of Money, Credit, and Banking,

Vol. 14 (August 1982), pp. 347-64.

Meyers, Roy T., The Budgetary Status of the Federal Reserve

System,

U.S. Congressional Budget Office (Washington: Government Printing Office, 1985). Onandi, Dionisio, and L. Viana, "El Deficit Parafiscal: Un Analisis de la Experiencia Uruguaya" (paper presented at the seminar, "Efectos Monetarios de la Politica Fiscal," held in Brasilia, sponsored by the Central Bank of Brazil, August 1987). Piekarz, Julio A., "El Deficit Cuasifiscal del Banco Central" (paper presented at the seminar, "Efectos Monetarios de la Politica Fiscal," held in Brasilia, sponsored by the Central Bank of Brazil, August 1987).

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Reyes Heroles, Jesus, "Operaciones 'Cuasifiscales' en un Contexto de Estabilizacion: Un Apunte Sobre la Experiencia de Mexico en 1986-87" (paper presented at the seminar, "Efectos Monetarios de la Politica Fiscal," held in Brasilia, sponsored by the Central Bank of Brazil, August 1987). Rodriguez Aguilera, Ana, "Actividades Cuasifiscales de la Autoridad Monetaria: La Experiencia de Costa Rica" (paper presented at the seminar, "Efectos Monetarios de la Politica Fiscal," held in Brasilia, sponsored by the Central Bank of Brazil, August 1987). Smith, Vera C , The Rationale of Central Banking (London: P.S. King, 1936).

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12 Impact of Public Financial Institutions on Fiscal Stance Oded Liviatan of the government is a key element in analyzing such macroeconomic conditions as stability and growth. Conceptually, the government's budget balance measures whether the expenditure undertaken for public policy purposes exceeds government receipts without increasing obligations for future repayments or running down liquidity holdings. In practice, however, governments do not implement all public policy stimuli through the budget. For various reasons, they prefer to do that through other institutions, such as the central bank, public enterprises, and financial institutions. The larger the share of public policy left for other institutions, the less control the parliament has over government policy and the less straightforward the deficit statement is as an economic indicator. Both government revenue and government expenditure appear lower than would be necessary if the government were to achieve all its policy ends explicitly. This chapter presents some economic considerations to justify including certain activities of public financial institutions within a more comprehensive measure of the fiscal balance in order to better assess the overall stance of fiscal policy and the impact of government activities. The chapter first describes how the activities of financial institutions relate to public policy. It then considers how the share of public policy activity by financial institutions, as part of their overall operations, has changed over time and place, and discusses why governments cultivate such activity by these institutions rather than performing it

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THE OVERALL DEFICIT

Note: The author wishes to thank Mario I. Blejer, Adrienne Cheasty, and Sandy Mackenzie for helpful comments.

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themselves. The chapter also examines the fiscal activities of various financial institutions. It clarifies and recommends a broader definition of the public sector deficit and concludes with case studies of the Philippines and the former Socialist Federal Republic of Yugoslavia, which illustrate how using this definition improves the assessment of the impact of government activity.

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Lending Outside the Government Sector for Public Policy Purposes The motivation that leads the government to engage in lending activities is based on the same reasoning used for direct government expenditure, that is, the pursuit of public policy goals. The motivation that leads the public to use government financing, instead of other resources, is based on the concessional element that government financing contains. To measure the extent to which the government promotes its policies through lending, the value of the loan must be seen as having two components: a "pure loan component," representing the government's role as a conventional financial intermediary, without any goals other than profitable liquidity management; and a "pure grant component," representing the government's role as a public policy promoter, undertaking actions to achieve specific goals not readily achieved through the market. A comprehensive measure of government policy impact should therefore include, in addition to the government's current receipts and expenditures, the pure grant component embodied in its financing activity. Government financing activity comprises three types of lending: direct lending—budgetary loans provided directly to the "real" sector; indirect lending—budgetary loans provided first to various financial institutions and thereafter, under government instructions and on concessionary terms, to the real sector; and government-controlled lending—concessional loans made byfinancialinstitutions to the real sector that are financed by "off-budget" government-mobilized resources. The IMF Manual on Government Finance Statistics (GFSM) (International Monetary Fund (1986)) includes under the category of government lending activities both direct government lending and indirect lending made by those units that receive all their funds from the government and are not authorized to raise funds elsewhere. Governmentcontrolled lending, in spite of its public policy motivation, is classified in the GFSM as part of the activity of the financial institutions sector and does not appear in government statistics at all. Methodologically,

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the GFSM's approach has two drawbacks: first, inasmuch as it includes the total amount of direct and indirect budgetary lending, it inserts a pure loan component into the deficit that does not relate to public policy; second, it neglects an important aspect of government activity, that is, the intervention of government in the capital market through the financial institutions sector. To achieve economic or other goals, practically all governments consider it necessary to intervene in the capital market by channeling cheap credit toward preferred sectors and activities. In most developing countries, the domestic capital market is characterized by a low elasticity of supply, which cannot, on its own, adequately support a rapid process of development. Among the explanations given for the level and shape of domestic capital supply in these developing countries being different from most developed countries are the following: (1) higher risk aversion among savers and financial intermediaries because of previous experience with unstable government policies, external shocks, or cultural aspects; (2) greater actual risk in capital market activities as a consequence of inadequate enforcement of contracts, lack of reliable financial information about borrowers, exceptional vulnerability of borrowers to weather or unstable markets for their goods, and erratic macroeconomic policies; (3) higher transaction costs owing to poor communications and other infrastructure, small unit values, and lack of adequate information; (4) low profitability resulting from controls, high taxation, and government portfolio regulation; and (5) lack of competition in the financial sector. In these developing countries, it is likely that if the government increases its demand for domestic funds in order to finance development programs, the rate of interest will increase to such a high level that private investments in fixed assets will drop sharply, causing the net increase in investment to be relatively small. Governments could extend the supply of investment funds and improve supply elasticity by implementing various steps to increase the efficiency of their capital markets. For example, they could eliminate barriers to competition, apply tax reforms, modernize legal systems, and improve bank regulation and supervision. The response to such policy actions takes time, however, and many governments want faster results. They concentrate, therefore, on intervention designed to channel existing financial resources to preferred sectors and activities. The common types of intervention are lending requirements imposed on banks; refinancing schemes; lending at preferential interest rates; credit guarantees; and lending by special public or quasi-public financial institutions (SPFIs).

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The SPFIs have been perhaps the most common means of directing credit. Virtually all developing and high-income countries have at least one SPFI, and many have special institutions for each priority sector. Kenya, for example, has eight SPFIs—one each for agriculture, tourism, and housing, four for industry, and one that serves the former East African Community. The importance of these institutions varies from country to country. In 1987, industrial public financial institutions in Malaysia and Thailand accounted for less than one-tenth of credit outstanding to manufacturing, whereas in Mexico and Turkey, they accounted for about one-third. Morocco's three sectoral institutions accounted for 79 percent of all long-term finance. In some developing countries, all formal credit for agriculture and housing is provided by SPFIs (see World Bank (1989)). In industrial countries, however, the degree of SPFI activity has gradually diminished. This evolution has corresponded to the rise of "universal banking," which combines commercial banking activity (collecting deposits and making loans) and investment banking activity (issuing, underwriting, placing, and trading company securities). Consequently, the governments in many industrial countries have been left with diminished power to pursue their policies through the financial institutions sector. Outside this small group of industrial countries, a considerable part of lending by the financial institutions sector is made for public purposes on concessionary terms and is directed by individual governments. Moreover, most of the extrabudgetary funds used to finance these institutions (particularly foreign funds on concessional terms) could have been channeled directly to the government. The question of why governments do not lend directly, rather than using the services of SPFIs, is addressed in another section, following a brief discussion on the development of SPFIs.

Evolution and Activities of SPFIs Most of the types of SPFI that we are familiar with today appeared prior to the 1900s. Almost a century ago, in several European countries and Japan, the leading commercial banks developed close links with industry and played a crucial role in raising long-term finance and promoting industrial concentration and efficiency. Moreover, several different kinds of privately owned financial institutions were formed in order to meet the financial needs of farmers, traders, savers, and homeowners, which the commercial banks had tended to neglect.

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These institutions included savings banks, credit cooperatives, farmer banks, mortgage banks, building societies, and loan associations. They provided the models for SPFIs that were established in many developing countries during the late 1960s and early 1970s. Initially, these SPFIs were privately owned, operated for profit, and run as much as possible like the investment banks of industrial countries. Since the mid-1970s, after a long sequence of international shocks and their domestic aftermath, many enterprises in developing countries became unable to service their debts. Consequently, the portfolios and financial performances of developing country SPFIs deteriorated markedly; many of them became insolvent, and some had to be closed. The narrow specialization of these institutions made it difficult for them to diversify their risks, making them particularly vulnerable to business cycle fluctuations. To diminish the impact of the financial crisis on the overall economy, governments assumed control of most of the SPFIs and began using them more extensively as vehicles for public policy.1 Since then, SPFIs have continued to act as intermediaries in the same way as private financial institutions, by creating long-run financial assets for the community to hold and accepting long-term financial claims. Nevertheless, at present, SPFIs operate in the capital market under conditions different from those of private financial institutions. In general, SPFIs have been focused by government on providing services that, for whatever reason, other institutions have found not worthwhile or too risky to provide. As can be observed in many developing countries, SPFIs provide cheaper long-term finance than other institutions: for industry, to promote investment and enhance industrialization; for agriculture, to raise output and speed the introduction of new technologies; for small enterprises, to generate employment; for exporters, to bridge the period between production and payment; and for housing, to provide affordable homes for poor households (see World Bank (1989)). Lending by SPFIs is usually directed to preferred sectors on attractive terms. Consequently it is likely to be less profitable and more exposed to risk than lending by other financial institutions, which puts the SPFIs at a disadvantage in mobilizing voluntary resources from the domestic financial market. Accordingly, the survival of SPFIs frequently depends on government subsidies, monopoly power over particular 1

In industrial countries, the macroeconomic developments of the 1970s led to the imposition of credit controls on the SPFIs, but in general, no other institutional changes were implemented.

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segments of the market, preferential access to government-mobilized resources, or other forms of preference or protection from competition, including exclusive access to specific external loan funds. Governments channel resources to SPFIs in various ways. For example, governments provide tax preferences that favor long-term saving through SPFIs. They impose requirements on lending to SPFIs by other financial institutions and enterprises. In industrial countries, as part of portfolio investment requirements, they force banks and enterprises to purchase SPFI bonds. They may also supply credit guarantees, especially to foreign lenders, and direct various specialized saving schemes to SPFIs.

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Why Governments Use the Services of SPFIs As mentioned above, governments in many countries work through SPFIs quite extensively to promote their public policies, even though most of the funds received by the SPFIs could have been channeled directly to government. There are three reasons why governments use SPFI services so extensively: institutional, economic, and political. Regarding the institutional aspect, some foreign lenders, particularly the World Bank, prefer to deal with SPFIs as intermediaries rather than with governments. Lending to existing institutions minimizes administrative policing and red tape. Furthermore, by transacting directly with such institutions as agricultural development banks and housing banks, lenders can either simply add resources to an existing fund or directed credit line or establish a new credit line to channel term financing for fixed investment through the SPFIs. The economic reason relates mostly to the conditions in the capital market. In general, the more the capital market becomes distorted and the supply of capital becomes shallow, the more extensively the government will try to use the services of SPFIs. Under certain conditions, SPFIs may operate more efficiently than government in raising funds or channeling credit to preferred sectors and activities. Local savers who want to diversify their portfolios may prefer to purchase claims on SPFIs rather than on the government because they consider the two types of claims to be different. Claims may indeed be different if, as is commonly held, the follow-up procedures of fixed-investment projects (the principal SPFI activity) are carried out more efficiently by the SPFIs than by the government. Consequently, the use of SPFI services could have a positive impact on capital supply.

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The political reason for using SPFI services relates to a government's desire to produce a budget that can easily be approved by political institutions as well as be accepted by foreign and domestic lenders. Political parties differ in their preferences toward economic sectors and activities. Consequently, channeling government funds through the budget to specific targets can raise considerable objections from political groups or parties, causing parliamentary approval of the budget to be delayed (or to entail budgetary compensation for competing parties). Furthermore, lending government money to the public is registered "above the line" in government accounts and therefore contributes to the budget deficit. The government activity of raising funds for that purpose in the domestic or foreign capital markets is registered "below the line" and adds to the government debt outstanding. An increase in either the budget deficit or the government debt deters potential lenders and could reduce the available government financing funds or increase the interest rate the government would have to pay to attract new financing for its operations. The off-budget borrowing and lending of SPFIs is thus often seen as more discreet and politically palatable than direct government financing.

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Separating Public-Oriented Activities from the Financial Institutions Sector For government statistics to provide accurate indicators of the impact of the government on the economy, they should include all activities devoted to the pursuit of public policy objectives in the economic, social, and political spheres. In the financial institutions sector, such accuracy would imply including in government accounts publicly oriented activities that are financed by extrabudgetary funds, as well as the budget-funded operations. This section attempts to pinpoint those activities of the financial sector that divert nonbudgetary resources toward the pursuit of public policy goals. The GFSM breaks down the financial institutions sector into four subsectors: the central bank, commercial banks, insurance companies and pension funds, and other financial institutions. In differing circumstances, each subsector can become an instrument of the government. Robinson and Stella (see Chapter 11) argue that some central bank activities are fully or partly fiscal in nature. They draw a distinction between its "purely monetary" activities and its "quasi-fiscal" activities that are not specifically related to monetary policy and would in many

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countries be undertaken by central government. For example, they suggest that central bank lending designed to allocate credit to specific enterprises should properly be categorized as policy-motivated or quasi-fiscal lending rather than rediscounting; or if rediscounting takes place at subsidized interest rates, it can also be considered a quasifiscal activity. Robinson and Stella depart from the GFSM coverage of government by arguing, on economic grounds, that central bank activities deemed quasi-fiscal should be included in most measures of government activity. Inasmuch as financial institutions other than the central bank are largely or entirely government owned or controlled, the GFSM classifies them as public financial institutions. However, for the analytical purpose of assessing the impact of public policy, the ownership criterion is inadequate. Financial institutions must be classified "behaviorally"; that is, a financial institution should be defined as public as long as it carries out public policy.2 In other words, the activity of financial institutions whose managers implement public policy instructions should be classified within the government accounts. Commercial banking activity can be grouped into two classes: shortterm transactions that have almost nothing to do with public policy and are usually undertaken on market terms; and other transactions that are basically on long and concessionary terms, relate to public policy, and are usually (but not always) undertaken by governmentowned banks. The latter class of activity consists mainly of lending for trade and investment, with funds to which the particular institutions have exclusive access. This access includes preferential use of government-mobilized resources, such as specific external loan funds. In several countries, commercial banks are obliged to lend money to public sector enterprises or to politically powerful private businessmen. This forced lending should be counted as a public policy choice, and along with all other transactions falling into the public policy domain— using government-mobilized resources and made on concessionary terms—it should be incorporated into government accounts. An extreme example of such analytical classification is considering as an SPFI activity a private bank's lending on concessional terms that is financed by government-guaranteed World Bank loans. 2

Stella (see Chapter 10) uses much the same criterion for public enterprises. He argues that if, in making decisions, the enterprises' managers take public policy considerations, in lieu of strictly business ones, into account, those enterprises should be considered public enterprises.

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Insurance companies and pension funds mobilize household savings by receiving contractual premiums and investing the funds in other assets on a profitable basis. Insurance companies include incorporated, mutual, and other bodies providing various forms of insurance. Pension funds provide income upon retirement for specific groups of employees through an organized fund that engages in financial transactions in the capital market. Only if these institutions' activities were on nonmarket terms—usually because of a specific government requirement—would a concessional element arise. For these types of institutions, government involvement is often indirect, through a requirement that they hold government paper. The difference between the interest rate the institutions receive on such forced holdings of government debt and the market rate is an implicit tax, and in a full economic accounting, it would be shown as government revenue. Other financial institutions include savings banks, development banks, mortgage banks, building and loan associations, and finance and investment companies. They either accept time or savings deposits— though not a significant quantity of demand deposits—from the public or incur nonmonetary liabilities and acquire financial claims on their own accounts in the capital market or abroad. Any of those activities undertaken on concessional terms and for public policy purposes should be recorded as an SPFI transaction. Two more points should be mentioned here. First, there are limited lending or saving bodies that derive all their funds from the government and have no authority to incur liabilities to others. Such bodies include housing loan funds that are completely funded by the government, and regular departments or special funds set up within the government that have lending activities but no authority to accept deposits or other liabilities to the community. These bodies, which are considered in the GFSM as part of general government, are typically not included among SPFIs. Second, the net lending of financial institutions to the government is not considered execution of public policy, but as financing; consequently, such lending is recorded in the government's budget below the line. However, as discussed in the case of pension funds, such financing can involve a permanent transfer to the government. The relationship between the financial institutions sector and government statistics is shown in Figure 1. Activities of the financial institutions considered to be outside of the government, and therefore separate from government accounts, are represented by circles, which highlight the dual nature of these institutions. Figure 1 disguises the difficulties policymakers have in identifying those institutions, however, because the distinction between fiscal-policy-motivated and pure

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Figure 1. Contribution of the Financial Institutions Sector to General Government Accounts

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monetary activities is typically not easy to make. In some cases, the capital market is not efficient enough to provide a clear-cut comparison between market and nonmarket operations, and sometimes it is in the interest of transactors to represent one type of activity as another. Figure 1 also shows the criteria used to allocate the non-budgetfinanced activity of SPFIs among the above-the-line transactions of the government budget. These criteria will be treated in the next section.

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The Overall Public Sector Deficit An important element in classifying government transactions is the choice of receipts and payments to be counted in determining the government's deficit or surplus. For an economically meaningful deficit concept, all the measures (in money terms) the government uses for achieving its economic, social, and political goals should be written above the line, and what is borrowed from domestic or external sources to finance policy should be written below the line. Because SPFI lending promotes public policy, even if it is not funded from the budget, it should be classified above the line according to the same accounting principles used for government direct lending, in particular, and other transactions registered there. In practice, there are three contending treatments of direct government lending: first, defining all lending as financing and placing it below the line; second, dividing lending into "pure loan" and "pure grant" equivalents and defining them as below- and above-the-line transactions, respectively; and third, placing all lending above the line. The first approach is used by the United Nations' (1986) A System of National Accounts (SNA). It groups under financing all transactions affecting claims and therefore gives a symmetric treatment to both lending and borrowing. Such an approach, however, eliminates the fiscal issue created by the existence of financial institutions by assuming that lending is made only for liquidity management or for acquiring profitable financial assets, and not for achieving any specific public policy objective; by definition, consequently, all government lending goes below the line. As this study has shown, however, government lending activity is used for achieving public policy goals. Hence, the SNA approach runs the risk of underestimating the impact of the government on the economy. The second approach, described by Wattleworth (see Chapter 8), groups with above-the-line transactions only the part of the lending that qualifies as a grant element; the residual, which is the "market

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value" of the original lending, is grouped with below-the-line transactions. The argument here is that the market value of government lending could be obtained by borrowers in the capital market without governmental intermediary action and therefore should not be defined as government policy. The grant element, however, is equivalent to a government transfer and consequently needs an equivalent treatment. Although, in principle, a grant element should be treated as a subsidy or a transfer—that is, a gift financed by a tax—the grant element can be difficult to calculate. In practice, the question arises, what is the appropriate interest rate upon which to base the "gift" calculation? In a country with a wide and efficient capital market, the domestic interest rate reflects the government's marginal cost of raising funds in the domestic markets or, in foreign financial markets, of financing the gift. Furthermore, any borrower can instantly estimate and even realize the value of the gift. In countries with an inefficient capital market (where some borrowers have no direct access to the foreign or domestic capital markets, or have incomplete information about market conditions), the domestic interest rate reflects neither the alternative rate of the government nor the relevant rate for private borrowers and therefore cannot be used for calculating the grant element. Wattleworth divides the grant element into "explicit" and "implicit" portions, the former relating to the amount the government must actually pay and the latter including the additional benefit received by the borrower, compared with his opportunity cost. The deficit calculation made by Wattleworth is based on the explicit grant element, a process which seems to have two major drawbacks. First, it ignores the private rates that would have been paid by borrowers in private markets without government intervention. Second, it ignores the fact that the government changes the level and composition of foreign and domestic borrowing in accordance with its macroeconomic policy. As a result, the interest rate paid by the government for financing its loans to preferred sectors could be far below the domestic interest rate on its marginal loan. The third approach, which is recommended by the GFSM, draws a distinction between transactions involving liabilities to the government and transactions involving government liabilities to others. It states (p. 104): Because the government is sovereign,. . .actuated by motives of public policy rather than by profit or liquidity management, there is an asymmetry between a government's asset position and the liability position of a borrowing government. Lending is undertaken. . .to pursue such policy objectives as provision of housing, reconstruction of war damage, or the

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carrying out of other development projects for which private capital may not be available. This asymmetry in the nature of government lending and borrowing requires asymmetric treatment of government's lending and borrowing, classifying lending, with expenditure, as determining the deficit, and borrowing asfinancingthe deficit. Consequently, what the GFSM classifies above the line is the total amount of "net lending," which represents all government lending activity minus all proceeds from repayments of that lending. Given the existence of three different ways of treating lending, the question remains, what approach should be adopted for estimating the government deficit or surplus? From an economic standpoint, the second approach, which views only the grant component of net lending as a public policy measure and therefore recommends including only that component above the line, is clearly superior. From a practical point of view, however, because it is usually impossible to isolate the grant component from total lending, especially in developing countries, it must usually be assumed that net lending is a good approximation of the grant element. The less developed is the country, the closer is the grant element to the net lending estimation. Consequently, if the starting point is the GFSM's deficit or surplus estimation, the way to determine the economically correct deficit is to add to it the SPFIs' net lending.3

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Illustrations of the Broader Deficit This section illustrates how, owing to particular economic conditions, the conventional (narrow) deficit definition may impel misleading conclusions about a country's fiscal stance. It describes, first, the case of the Philippines, where SPFIs finance most of their activities from international sources, and, second, the case of the former Yugoslavia, where SPFIs receive the bulk of their financing from the central bank. In each country, an inadequate statistical base precludes the calculation of an accurate overall public sector deficit; therefore, the estimates provide only the direction that errors of interpretation might follow rather than accurate measures of the true impact of government. 3

In some developing countries, inadequate statistics make the estimation of SPFI net lending almost impossible. In those cases, it is recommended that information about the net lending to SPFIs by foreign institutions, such as the World Bank, be used and incorporated into the government's deficit. Although this additional information does not cover all of SPFI net lending, it can usually be considered a good approximation of the total amount.

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The Philippines In the Philippines, government-owned banks own 40 percent of banking institution assets. Of this share, almost half is held by the Philippines National Bank (PNB), 45 percent is owned by the Development Bank of the Philippines (DBP), and the remainder belongs to other special government banks. The PNB is a commercial bank, which, unlike privately owned banks, devotes a major part of its activities to providing long-term funds to the economy. Most of its funds come from time deposits and loans from the central bank and international sources. The field of development finance is dominated by the DBP, which provides long-term loans for high-priority development projects. The DBP also promotes private development banks by making available long-term funds and equities. Most of the DBP's funds are borrowed from the government and international sources, including multilateral and bilateral aid agencies and foreign private financial institutions. The Philippine economy in the mid-1980s was in a state of severe financial crisis. The origins of the crisis were rooted in public policy, which was based on a distorted incentive structure that favored the development of inefficient industries with low economic returns. These industries rapidly accumulated external debt but generated little additional capacity to service it. The economic crisis was sharply reflected in the financial sector. From 1981 to mid-1987, 3 commercial banks, 128 rural banks, and 32 thrift institutions failed, while the 2 largest government-owned banks became de facto insolvent (see Nascimento (1990)). Until 1983, the DBP and the PNB, like most of the other banks, expanded substantially their loan portfolios because of the increased availability of foreign and domestic financing. In 1983, the financial position of both institutions weakened considerably due to the large amount of nonperforming assets in their portfolios. Difficulties were compounded when guarantees made by these institutions, mainly on external borrowing, were called, and the external debt payments could no longer be financed by further borrowings. The collection rate on loans made by the DBP deteriorated, mainly because of the large number of government-initiated projects in its loan portfolio. The relationship between the economic crisis and the fiscal stance was not evident in the conventional measure of the government deficit, shown in Table 1 as the general government balance. The level and changes of this deficit suggest that the government had only a minor impact on such economic developments as the deterioration in the external accounts and the increasing rate of inflation. Such a result

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Table 1. Alternative Public Sector Deficits in the Philippines Item

1980

1981

1982

1983

1984

1985

In percent of GDP

General government balance ... Annual change in foreign debt of DBPa and PNBb ... (— = increase) ... Overall deficit

-2.9

-3.3

-1.0

-1.0

-0.9

-2.7 -5.6

-4.3 -7.6

-3.1 -4.1

-4.0 -5.0

0.9 0.0

33.5 40.4 73.9

36.6 31.9 68.5

Memorandum items In billions of pesos

DBP's foreign debt PNB's foreign debt Total foreign debt

6.7

12.2 18.9

10.3 16.7 27.0

15.1 26.3 41.4

23.0 30.0 53.0

Source: IMF. Development Bank of the Philippines. b PhilippinesNational Bank.

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a

clearly contradicts the real situation described above, however. Only by incorporating the foreign-borrowing activities of the DBP and the PNB into the conventional measure of the deficit can the government's role in creating the crisis be seen. In 1981 and 1982, the overall public sector deficit was twice as high as the conventional deficit; in 1983 and 1984, it was five and four times higher, respectively. Only in 1985, after the government adopted a new economic program with financial restructuring, did the impact of the public banks become contractionary and offset the expansionary impact of the "conventional" part of the budget.

Former Yugoslavia By the 1980s, the public sector no longer formally governed enterprises and banks in the former Yugoslavia. Workers ruled the enterprises, and enterprises were often co-owners of banks. Within this unusual institutional framework, government policy still had a substantial impact on the operations of enterprises in the areas of employment, pricing, and investment. The government-enterprise linkage could affect enterprise performance strongly enough to generate losses and was often represented by an implicit contract between the government

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and enterprises that these losses would be converted into commercial banking losses, ultimately to be covered by the Yugoslav central bank, the National Bank of Yugoslavia (NBY). Because the losses were derived from government policy-related activities and the enterprise operations were not included in the accounts of the Yugoslav Government, lending by the NBY to cover banking losses from enterprise financing should have been treated like government net lending and included in abovethe-line budget transactions. The economy of the former Yugoslavia began to deteriorate sharply from the middle of the 1980s. Economic growth averaged only 1 percent a year during the first half of the 1980s, while inflation more than doubled, reaching 76 percent by 1985. In 1987, inflation accelerated to 170 percent a year, and toward the end of 1989 it reached a monthly rate of over 50 percent. The source of the inflation was immediately evident, with huge changes in the money supply indicating that heavy pressure to print more money was being exerted by some source on the central bank. Table 2 presents alternative definitions of the Yugoslav public sector budget deficit for the years 1984-88. It includes the conventional deficit, which takes no account of the implicit contract between government and enterprises, and the overall deficit, which modifies the conventional deficit for enterprise losses. According to the conventional

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Table 2. Alternative Public Sector Deficits in the Former Yugoslavia Item

1984

1985

1986

1987

1988

In percent of GDP Conventional public sector balance Inflation-adjusted balance Gross losses of socialized enterprises Overall public sector deficit Inflation-adjusted overall deficit

1.0 1.0

1.4 0.6

1.9 0.8

-2.3 -1.3 -1.3

-3.0 -1.6 -2.4

-3.3 -1.4 -2.5

1.6

-0.2 -7.5 -5.9 -7.7

3.7 1.6

-6.6 -2.9 -5.0

Memorandum items Money supply (Ml) Consumer price index

In billions of dinars; end of year 1,272 1,864 3,896 7,786 25,194 Yearly average change 53

73

89

Source: Lahiri (1989).

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ODED LIVIATAN

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definition, the Yugoslav budget showed a small surplus in all years, giving the impression that the very high rate of inflation had nothing to do with the fiscal stance. According to that analysis, the pressure that caused the monetary authority to print a huge amount of money must have come from a source other than the government. The broader definition of the budget deficit reveals that the former Yugoslavia's special enterprise-financing arrangements concealed the fact that substantial pressure on the NBY had been imposed by the fiscal stance. Furthermore, the inflation-adjusted overall public sector deficit, by controlling for inflation, shows, consistently with other economic indicators for the former Yugoslavia, that the pressure had been enhanced.4

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Conclusions Governments are motivated by political, institutional, and economic considerations to implement policy indirectly through a specific group of financial institutions (SPFIs). This segment of public policy is not included under the conventional definition of the government deficit, unless it is directly financed through the government budget. In accordance with an economic approach to presenting government accounts, all policy measures (in money terms) a government uses to achieve its economic goals should be included as above-the-line transactions. If these transactions add up to a deficit, the government must finance it by either foreign or domestic resources. Policy goal promotion might therefore imply pressure on the domestic capital market, interest rates, money supply, and the balance of payments, all of which have an impact on price and economic growth trends. As long as part of public policy is excluded from consideration in above-the-line transactions, the origins of economic events, such as inflation, balance of payments crises, or economic growth deceleration, cannot be easily traced. Furthermore, when economic trends change gradually, the incomplete government policyfigurescould signal policymakers to take inappropriate steps along the way; permanently wrong 4 The NBY covered other bank losses in addition to those directly linked to enterprise performance, and the impact of public policy on the magnitude of the loss was ambiguous. Since the criterion used in this study is to include above the line only those transactions relating to public policy, the ambiguity precludes these other losses from the deficit calculation. Accordingly, it must be borne in mind that because the ambiguous losses were neglected, the total deficit was underestimated.

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IMPACT OF PUBLIC FINANCIAL INSTITUTIONS ON FISCAL STANCE

figures could even lead them to create a vicious-circle dynamic. The cases of the Philippines and the former Yugoslavia provide good examples of the wrong signals that can be given by conventional government accounts. The SPFI activity that needs to be added to the government budget statistics is concessional lending that is being financed by governmentmobilized off-budget funds. Ideally, only the pure grant component of SPFI net lending should be included with above-the-line budget transactions. When this is impossible—as in many developing countries that make extensive use of SPFIs—a reasonable alternative is to incorporate all of SPFI net lending above the line. A government's organizational change can also distort the conventional deficit figures, even if thefiscalstance has not changed. Likewise, inasmuch as the government of one country uses its SPFIs more intensively for policy purposes than another country, the intercountry comparison of government activity will be misleading and could confuse international donors, including governments and international financial institutions.

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References International Monetary Fund, A Manual on Government Finance Statistics (Washington: IMF, 1986). Lahiri, Ashok, "Yugoslavia—Can Exchange Rate and Monetary Policy by Themselves Reduce Inflation?" (unpublished; Washington: IMF, September 1989). Nascimento, Jean-Claude, "The Crisis in the Financial Sector and the Authorities' Reaction: The Case of the Philippines," IMF Working Paper, No. 90/26 (Washington: IMF, March 1990). United Nations, Department of Economic and Social Affairs, Statistical Office of the United Nations, A System of National Accounts, Studies in Methods, Series F, No. 2, Rev. 3 (New York, 1968). World Bank, World Development Report 1989 (New York: Oxford University Press for the World Bank, 1989).

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Part V

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The Public Sector's Intertemporal Budget Constraint

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How to Measure the Fiscal Deficit, edited by Mario I. Bléjer, and Adrienne Cheasty, International Monetary

13 The Deficit as an Indicator of Government Solvency: Changes in Public Sector Net Worth Mario I. Blejer and Adrienne Cheasty

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REGENT DEVELOPMENTS IN the analysis of net public resource use have changed the way in which the deficit is viewed and the uses to which the deficit measure is being put. This change in perspective has generated awareness of additional deficiencies in traditional measures of the deficit, refocused attention toward balance-sheet-based deficit measures, and opened up a long menu of methodological issues of government balance sheet measurement. These are the topics of this chapter.

Intertemporal Shortcomings of the Conventional Deficit Developments in private sector consumer theory have been paralleled (albeit with a lag) by changes in people's understanding of public sector behavior. It has always been clear that the public sector (being less liquidity-constrained than any private individual) does not finance its expenditure completely out of current income. However, several recent developments in the world economy have highlighted that the government, even if infinitely lived, is constrained—like private consumers—by the size of its permanent income. The debt crisis has shown that there are perceived limits on governments' ability to repay borrowing from future generations to finance present consumption. The U.S. social security debate has highlighted Note: An earlier version of this chapter appeared as Blejer and Cheasty (1991).

279

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THE DEFICIT AS AN INDICATOR OF GOVERNMENT SOLVENCY

the implications for today of government commitments to spend or repay tomorrow. One can only conclude that governments face an intertemporal budget constraint not unlike that of private agents. It has also become clear that governments' consumption paths are determined by wealth as well as by income: privatization programs that seemed to improve the financial position of public sectors have shown that governments can dissave to finance consumption in any period. Finally, it is now recognized that price and valuation changes can significantly affect governments' consumption paths. This has been amply illustrated by the effect on governments' financial position of swings in the value of the dollar over the 1980s, the various Latin American hyperinflations, and the development of debt buyback schemes through which governments have profited by the fall in value of their debt.1 Some deficiencies in traditional measures of the deficit become evident when government behavior is recast in an intertemporal rather than an annual framework and when attention is shifted from shortrun demand management to sustainability of the deficit. Deficiencies include the omission of valuation adjustments, the treatment of asset sales, and the treatment of the financial implications of entitlement programs and government guarantees. Specifically, the problems are as follows. • The conventional deficit includes no provision for valuation changes in government assets or liabilities, although these could conceivably change the sign of the budget balance in any fiscal year. Adjustments to the deficit that separate amortization from interest payments on public debt in inflationary regimes are a partial recognition of the impact that prices can have on the nominal deficit. A government's ability to pay can also be affected in real terms by inflation, devaluation, changes in the terms of trade or in relative prices, and real capital gains or losses in the purchasing power implicit in government assets and liabilities. None of these effects, however, is captured by a summary of government transactions during a given fiscal period.2 1

Comparisons with developments in consumer theory cannot be taken too far. Few attempts have been made to situate government behavior in an optimizing framework. Buiter (Chapter 14 in this volume), however, presages such an advance in his illustration of a case where a rule of government consumption to maintain a constant net worth would not be optimal. 2 Because the government has little control over valuation changes, there are arguments for omitting them from deficit measures to be used for policy design.

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Table 1. Argentina: The Sale of the Tokyo Embassy (In percent of GDP) Revenue

1988a

1989 (Q:2)

1989 (Q:4)

Current Capitalb

17.6 0.9

13.0 3.8

18.2 0.3

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Source: Gentro de Estudios Macroeconomicos de Argentina, Buenos Aires (unpublished). a GDP ratios for 1988 are quarterly averages for the full year. b Includes proceeds from asset sales.

• Conventional deficit measures usually include receipts from privatization and the sale of other assets as a revenue item. As a result of structural programs or pressures to cut the flow deficit, nonfinancial tangible and even intangible assets that were not previously considered disposable have been converted into liquid assets. When assets such as land, embassies, or aircraft are sold, they provide the government with immediate cash to alleviate the current year's financing burden. The amounts can be important and can help to overcome drastic temporary downturns in tax revenue (as in Argentina during its recent hyperinflation; see Table 1). However, the government is worse off by the replacement cost of the assets (arguably their realized market sale value; Goldsmith (1985, p. 92)). The problem that asset sales pose for the deficit differs depending on whether the government previously purchased the assets through the budget or whether the assets had "always" formed part of the public patrimony (for instance, mineral rights). Treating as revenue the sales of previously purchased investment goods in the measured deficit is justified by the unorthodox treatment of capital expenditure in government accounts. Unlike private sector capital (and the treatment of public capital in the United Nations' A System of National Accounts (SNA; 1968)), which is depreciated over its lifetime, public capital is fully expensed in the fiscal year in which it is purchased.3 This merging of the current and investment accounts, which makes it consistent to include the full value of an asset sale as a revenue item, can be justified when assessing the annual financing needs of government (see Stella, 3

"On both a gross and a net basis the NIPA [National Income and Product Accounts measure for the United States] measure was shown to understate the size of government saving mainly because NIPA treats capital outlays as a current rather than a capital account item" (Ott and Yoo (1980, p. 195)).

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THE DEFICIT AS AN INDICATOR OF GOVERNMENT SOLVENCY

Chapter 10 in this volume). However, these combined accounts are not a reliable indicator of the sustainability of the government's policy stance. Including revenues from assets other than investment goods to "improve" a government's ability to pay is incorrect by any private sector accounting practice. When the government sells land or mineral rights, for example, it has merely changed the composition of its portfolio: it has the cash but no longer has the asset. If it earned the market value of the asset, then it is no better or worse off than before the sale.4 • "Revenues" that create liabilities for the future or "expenditures" that represent the liquidation of past liabilities can figure importantly in the accounting measure of the conventional deficit. On the revenue side, the traditional deficit often includes the net position of social insurance programs. However, social insurance contributions supposedly confer entitlements on contributors and, as such, commit the government to higher future spending. Thus, social security contributions do not represent free and clear revenues, and their inclusion in the deficit overstates the government's ability to pay. On the other hand, because the contributions are contingent claims (contingent not only on contributors' attaining old age or ill health but also on changes in government legislation), the magnitude of outlays they will eventually require is difficult to determine.5 Analogously, the conventional deficit can be dramatically inflated in any year by the government's payment of previously guaranteed debt, or insurance contracts, such as exchange guarantees or bailouts of underwritten entities (like insolvent public enterprises or the U.S. savings and loan industry). In reality, such payments are stock adjustments—the sum of the accumulated risk costs borne by the government over the life of the guarantee. Unlike the private sector, which mitigates 4

This is strictly true only when the value of the asset to the private sector is the same as to the government. If efficiency is higher in the private sector, the gain from the sale of the asset will be greater than or equal to the loss of its income stream (depending on whether the government or the private sector captures the capitalized value of the efficiency improvement). See Mansoor (Chapter 15 in this volume). When the gain is nonzero, the inclusion of a revenue item (positive or negative) would be appropriate. The other side of the coin is that the private sector is made neither better nor worse off by the sale of public assets: the composition of its portfolio has changed, but its perception of its net worth should not be affected. 5 The discussion here does not depend on whether programs are funded or unfunded; however, the size of net future government expenditures will obviously depend on future social security revenues.

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the impact of bad debts by accumulating loan loss reserves as offsetting stocks, the government usually fails to make provision for expected defaults. Hence, the costs of risk bearing are not spread out over the life of the risk but are charged only upon realization of the risk's downside. The problem in measuring the conventional deficit is not just that meeting current entitlements or paying up for past guarantees boosts the deficit but also that, at any time, the conventional deficit provides an overoptimistic indicator of government's long-run ability to pay because it does not factor in the expected future cost of entitlements and contingent liabilities assumed by the government. Moreover, the calculation of the expected cost of contingent claims is complicated by the possibility of moral hazard: even if the entitlements and guarantees are not funded or provisioned against, the government's assumption of liability may change private sector behavior. Eisner (1990, p. 15) rephrases the problem clearly:

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It may be pointed out that loan guarantees or deposit insurance indirectly finance real spending just as they might if treasury expenditures were made up front. In a sense, the explicit and implicit deposit insurance or guarantees raised the budget deficit at the time the S&Ls made the loans that ultimately turned bad. . .the expenditures were made then. They then financed the now half-empty office buildings or homes worth only a fraction of their construction costs. Current government borrowing to finance the purchases of S&L assets only makes explicit an element of deficit or debt that was implicit earlier in the commitment of backing to S&L liabilities. Towe (see Chapter 16, p. 363) takes these problems one step further, recasting them in terms of their implications for budgetary control: . . .Since the issuance of such contingencies may have severe future cash flow implications, by relying on conventional accounting methods, budgetary authorities may not be provided with the means to adequately monitor and control the government's overall fiscal position. Clearly, appropriate accounting for contingent claims requires an intertemporal framework.

The Deficit as an Indicator of Government Solvency: Changes in Public Sector Net Worth The so-called deficiencies described above are similar in that they do not affect the current year's borrowing requirement.6 Moreover, 6

However, they may well have an impact on the government debt.

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although the consequences of these issues generate ample debate, their combined effect on aggregate demand in any single year would be virtually impossible to measure. Hence, the main reason for tackling these difficulties is to refocus the deficit measure as an indicator of the long-run sustainability of government policy—in other words, of the solvency of government. According to Bean and Buiter (1987, p. 27): A government is solvent if its spending programme, its tax-transfer programme, and its planned future use of seigniorage are consistent with its outstanding, initial financial and real assets and liabilities (in the sense that the present value of its spending programme is equal to its comprehensive net worth).

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In other words, over its lifetime, although a government can shift consumption between periods by alternately saving and borrowing, it will be unable to consume more than its total income plus its initial endowment.7 Under this definition, the "fiscal deficit" would be equivalent to the dissaving (reduction in the net worth) of government in any year. Like the net worth of a firm, the net worth of a government is specified in its balance sheet, and the overall fiscal deficit in any period is equal to the difference in balance sheets at the beginning and end of the period. The following subsection discusses the methodological and measurement difficulties that bedevil the specification of the government balance sheets.

Existing Government Balance Sheets Government balance sheets have two bases: one with roots in government financial statistics and the other inspired by national income accounting. Financial balance sheets based on governments' net financial asset position can be extrapolated from studies that reconcile annual flow deficits with changes in outstanding public debt (see, for instance, Eisner (1986, p. 16)). The most important methodological issue for this type of balance sheet is the treatment of valuation changes in government assets and liabilities. 7 Although governments are normally considered infinitely lived, to raise the issue of solvency seems to imply a terminal point. Practically, solvency is irrelevant in that present value calculations at a positive discount rate assign a weight approaching zero to transactions in the distant future.

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Alternatively, government balance sheets on an SNA basis attempt to put the government on a par with the other sectors of the economy in the country's income and wealth accounts, with the purpose of determining the sectoral distribution of the components of wealth. Goldsmith (1985) presents the most comprehensive international collection of SNA-based government balance sheets. Here, measurement problems are more extensive, encompassing as well the valuation of a government's real and intangible assets. Some of the difficulties are not conceptually different from measurement problems in other SNA sectors—for instance, the choice of deflators and price indices, the derivation of stocks from flows,8 and the treatment of inventories. This chapter covers only measurement issues of particular relevance or sizable importance to the public sector. Continual time series of SNA-based balance sheets are rare; except for the change in net worth series presented by Ott and Yoo (1980, pp. 190-91), there appear to be no studies that compare the change in balance sheets from one year to the next with flow-based deficits. Moreover, although SNA-based balance sheets provide valuable initial estimates of governments' permanent income, they include only a subset of assets and liabilities and thus may not be a good indicator of the sustainability of fiscal policy.

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An Ideal Government Balance Sheet Buiter (Chapter 14 in this volume; see also Bean and Buiter (1987, p. 28 ff.)) describes the ideal "comprehensive consolidated public sector balance sheet at current market or implicit prices." To capture the complete array of ways in which a government can increase or run down its net worth in a global balance sheet, its assets should include financial assets; real capital (including nonmarketable social overhead capital and equity, which is mainly in public enterprises and is partly marketable); land and mineral assets (discovered and undiscovered, which are partly marketable); the present value of the future tax program (including social security contributions); and the imputed present value of seigniorage. Liabilities should include government debt (domestic and foreign, indexed or not), the stock of high-powered money, and the present value of social insurance and other entitlement 8 For a brief comment on the perpetual inventory method and its shortcomings, see Goldsmith (1985, p. 333).

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THE DEFICIT AS AN INDICATOR OF GOVERNMENT SOLVENCY

programs (including guarantees). Government net worth is then the balancing item. While Buiter's construct provides a clear conceptual framework for defining government net worth, it is far from operational. Even at the conceptual level, the definitions of capitalized values of tax and spending programs are subject to enormous controversy. And the valuation of tangible assets presents special difficulties when it must be undertaken on the massive scale necessary to encompass complete public sector holdings. Moreover, since public assets are less frequently traded than private assets, their prices may be difficult to identify. Indeed, were public assets traded, their prices and those of their currently traded substitutes might be very different from private sector prices in a thinner market (not augmented by government purchases and sales).9 Despite these problems, valuable work has been done on many items in the comprehensive balance sheet. In particular, Eisner and Pieper (1984); Eisner (1986); and Boskin, Robinson, and Huber (1987) present improved balance sheets containing many innovations that address the deficiencies in deficit measurement detailed above.10 Specifically, efforts have been made (1) to assess the magnitude of valuation changes in financial net assets for a more accurate picture of government liquidity; (2) to provide a more economically correct estimate of capital formation and the capital stock through a more realistic depreciation scheme than the current system of annual expensing; (3) to include public land and mineral rights in the balance sheet so as to provide a more comprehensive picture of a government's ability to pay; and (4) to create a framework for assessing the eventual impact of contingent claims on the budget. However, the remaining element of the comprehensive balance sheet, (5) the present value of the tax program, presents conceptual difficulties large enough to cast doubt on the interpretation of any measure of government net worth. Valuation of Financial Assets Budget deficits have been considered damaging, in an intertemporal sense, because they add to the public debt and thereby erode the 9

See Eisner (1980) on establishing the prices of capital assets. Boskin's work forms part of a large ongoing project to refine government accounts; Eisner (1988b) has incorporated his work in a proposal for improved global national income accounts. 10

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sustainability of the government's expenditure path at current levels of tax revenue. However, as Eisner (1984, p. 140) points out, "the 'underlying reality. . .that every dollar of deficit. . .adds a dollar to debt' is simply not true in a real sense if prices are not constant. And if interest rates fluctuate, the statement is not true even with reference to the market value of nominal debt." In particular, positive inflation rates erode the real value of public debt; thus, governments that are net debtors can have rising net worth even while they continue to run deficits. Moreover, increasing interest rates erode the market value of previously issued fixed-interest debt. Thus, to arrive at the change in net worth that can be attributed to changes in the values of (net) financial assets, the change in the nominal par value of the assets from one balance sheet to the next should be augmented by the difference between the real and nominal values of net financial holdings and by the difference between their face value and their market value at the time the net worth is calculated. These adjustments have been more widely applied than any other balance sheet reconciliation item because economists, even when they were not concerned directly with net worth measures, were troubled by the discrepancy between measures of net government spending and measures of changes in net government liabilities (see Muller and Price (1984, p. 8) and Eisner and Pieper (1984, p. 12)). Adjusted series for public debt appear in Miller (1982); Eisner and Pieper (1984; recalculated in Boskin, Robinson, and Huber, (1987)); De Leeuw and Holloway (1985); and Eisner (1986). Eisner (1980) presents revaluation estimates for a range of government assets and liabilities. Russo (1987, p. 12), however, has objected to the par-to-market adjustment on the grounds that, unless the government raises taxes to prepay its debt, the public debt is always amortized at its face value; neither gains nor losses from shifts in market valuation over the life of the loans are ever realized.11 Hence, he claims, such shifts, however large their effect may be in any year, are irrelevant to the sustainability of the deficit. Valuation of Real Assets Whereas some valuation problems are common to all assets, specific issues arise in the valuation of depreciable assets and land and mineral rights. 11 Prepayment of debt may not be unusual. It occurs, for instance, in the secondary foreign debt market or any time consols are retired.

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Real capital and depreciation. Because the capital stock is estimated by accumulating annual government capital formation,12 it is sensitive to the form of depreciation assumed across vintages of capital—that is, to the assumption of the rate of net investment by government. The impact of different depreciation schemes on estimates of the capital stock is discussed in Boskin, Robinson, and Roberts (1985). The validity of any depreciation scheme depends on how closely it approximates economic depreciation. These authors apply a geometric depreciation scheme with rates inferred, where possible, from the ratio of new to used asset prices on the argument that "equipment depreciates faster than straightline in the early years, and structures depreciate more slowly" (p. 16).13 Goldsmith (1985), Ott and Austin (1980), Eisner, and the Bureau of Economic Analysis of the U.S. Department of Commerce (BEA) use straight-line depreciation in their calculations, whereas Kendrick (1976) uses double-declining depreciation. Land. Methods of land valuation have concerned policymakers since governments started to collect taxes, giving rise to a large body of literature at the microeconomic level. The problem for the government balance sheet is one of aggregation: the information required for the micro-oriented techniques is too detailed to be applied to all public sector holdings. There are also pitfalls in making global inferences from partial data; for many reasons, public sector land (such as military land) is not a close substitute for private land; and, as mentioned above, if all public land were marketable, land prices might be very different from what they are. In fact, as Boskin and Robinson (1985, pp. 931-32) point out, global estimates of the value of U.S. federal land are simply extrapolations (using different combinations of price indices and adjustments for changes in total acreage and in land composition) of a 1946 estimate made by J.E. Reeve and others (1950; quoted in Boskin and Robinson): "These studies. . .demonstrate how successive refinements of basic data often hang by a very slender thread [p. 931]. . . .A new benchmark estimate for the value of federal land in a particular year is especially important [p. 935]." 12 "The two main ingredients [in the perpetual inventory method of estimating the capital stock in the government sector] are a retirement pattern to yield gross stock and a depreciation method which will reasonably estimate net stocks" (Ott and Austin (1980, p. 266)). 13 The SNA recommends excluding military asset expenditure from capital formation. However, Goldsmith (1985, p. 67) notes that statistics usually do not permit the exclusion.

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Describing the valuation of government land in other countries, Goldsmith (1985, p. 119) cites difficulties in valuing nonagricultural land, which is often consolidated with the value of the buildings erected on it (so that a proportional valuation factor must be assumed), as well as in assessing the share of forest on so-called agricultural land. Mineral rights. The inclusion of mineral rights in the government balance sheet is arguably even more important than the inclusion of government land because governments view changes in the pace of their direct exploitation, sale, or lease as opportunities for improving their short-term financial position. Thus, the sale of an asset or exhaustible resource gives a misleadingly optimistic picture of government wealth accumulation because the revenue is not offset by the cost of the depletion of the asset.14 It is also true, however, that the large fluctuations in oil prices observed over the last two decades could create volatility in government net worth from year to year if applied directly to valuations of the stock of mineral rights—unhelpful volatility since only a small portion of stocks would be sold. In the pioneering study by Boskin and Robinson (1985, p. 924) on the valuation of federal mineral rights, estimates of expected unproven (as well as proven) gas and oil reserves were included—in the spirit of Buiter's forward-looking, comprehensive public sector balance sheet.15 The inclusion of undiscovered reserves is important for the correct interpretation of government revenues because the lease of mineral rights typically begins with the sale of exploration rights to unproven fields. The government earns revenue (bonuses) by exploiting firms' expectations about reserves even if the fields prove to be dry. As before, the revenues are not free and clear but come from the government's having ceded an (expected) asset. Two measurement complications make accounting for exhaustible resources more difficult than accounting for the government's capital stock. First, stocks of undiscovered reserves must be recalculated each time discoveries are made, and the relationship between proven and unproven reserves may not be linear. Second, including an estimate of mineral rights with estimates of the value of land is problematic 14"

[National balance sheets for about a dozen countries]. . .are nearly worthless unless they include the value of subsoil assets, particularly oil and gas" (Goldsmith (1985, p. 69)). 15 The paper contains a valuable exposition of measurement techniques (comparing the present value method, the land price method, and the net price method of determining a base year value to anchor the perpetual inventory calculation). Capital gains (an important issue in the case of exhaustible resources) are included through the assumption that prices grow with the interest rate. Estimates of federal mineral rights are extended to state and local levels in Boskin, Robinson, and Huber (1987).

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Table 2. United States: Influences on Federal Net Worth (In billions of current U.S. dollars) Item a

1. NIPA balance 2. Change in value of federal land 3. Change in value of oil and gas rights 4. Augmented balance (lines 1 + 2 + 3)b

1979

1980

-16.1

-61.3

+ 17.2

+ 36.9

+ 93.8

+ 208.8

+ 94.9

+ 184.4

Sources: Line 1, United States (1989); lines 2 and 3, Boskin and Robinson (1985). National Income and Product Accounts. b Line 4 is illustrative only; it has not been checked for inconsistencies in definition. a

because it is not clear to what extent the value of land internalizes the value of the minerals underneath.16 Ignoring these complications, Boskin and Robinson's work (1985; Table 2) suggests the implications for the fiscal deficit of changes in the value of real assets.17

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Valuation of Entitlements, Contingent Claims, and Guarantees Particularly in the United States, the proper treatment of social security obligations in the fiscal accounts has generated much discussion.18 Towe (Chapter 16) describes the main options, from the most restrictive method (the accumulated benefit-cost approach) to that most comparable to net worth (the actuarial balance). Although these accounting treatments have been developed mainly for social security programs, they can be applied to much broader ranges of entitlement schemes and insurance programs. The accumulated benefit-cost approach to valuing the net impact of an entitlement or insurance program is used in the private sector, where the expected liability of the program is defined only with respect 16

These complications are exacerbated for reproducible natural resources, such as forests and fisheries (Goldsmith (1985, p. 68)). 17 If net worth series are calculated over a longer period, it would be more appropriate to adjust Table 2 for general inflation. 18 See, for example, "Scoring Political Points on Social Security Tax," New York Times (New York), January 15, 1990, p. A12.

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to current participants and according to current rules (see also Boskin, Robinson, and Huber (1987, p. 44)). This approach would narrowly restrict the consideration of contingencies (and therefore of government solvency) to the question of whether present participants will continue to pay their expected subscriptions or premiums and become eligible (for example, by living long enough) to collect their expected benefits. The somewhat less restrictive actuarial fairness approach to valuation defines the deficit or surplus in a contingency program as the difference between the (aggregated) expected present value of the payouts to each of a program's participants over the program's duration and the expected net present value of their payments, thus allowing consideration of expected changes in policy and participation. "Fairness" requires that over each participant's lifetime the program be in balance. Actuarial balance requires that expected (present value) payments to all present and future participants be equivalent to total expected contributions (adjusted for operating expenses and any relevant endowment or reserve). If expected payments exceed expected contributions, the program has a negative net worth. Boskin, Robinson, and Huber (1987) estimate the U.S. social security balance on the basis of this criterion calculated over 75 years. However, they use these estimates to illustrate the extreme sensitivity of present value calculations to assumptions about contingencies: "[M]oving all of the economic and demographic projections from intermediate to either optimistic or pessimistic [assumptions] results in a change which is larger than the privately held national debt" (p. 45). The calculation of program deficits under any of the above criteria also requires an estimate of probabilities. Degrees of certainty in payments can vary widely among programs and have been used as classification criteria—for instance, to distinguish between pension schemes, where expected outcomes are smooth and predictable once the demographics have been identified, and deposit insurance to financial institutions, where the risks are highly correlated, leading with a small probability to extremely high payouts (Boskin, Robinson, and Huber (1987, especially p. 15)). Moreover, risks may be even higher than guarantees or premiums paid would suggest, if political or other pressures force the government to treat noninsured agents on a par with insured agents during a systemic crisis.19 Boskin, Robinson, and Huber 19

Robinson and Stella (Chapter 11) cite the case of debt rescheduling, where the public sector is often forced to assume the external transfer portion of private sector debt even when the debt has not been guaranteed by government.

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THE DEFICIT AS AN INDICATOR OF GOVERNMENT SOLVENCY

(1987) derive backward-looking estimates of probabilities for defaults on loans from the U.S. Small Business Administration but caution that "in the case of an insurance program. . ., where the risks of default across borrowers are highly correlated and very rare, a model based on historical experience can be misleading" (p. 32). The approaches described measure only the first-order present value of the contingency program. Thus, according to these criteria, all programs in which guarantees are issued without charge (often the case with exchange guarantees (see Robinson and Stella, Chapter 11)) are deemed to be in deficit—although the government would not have issued them without the expectation of some social benefit, such as risk spreading. The value of the social benefit might conceivably be estimated (in some cases, by comparing costs in a market without the guarantees (see Wattleworth, Chapter 8)) and imputed to the government accounts, but it will usually be impossible to assess the impact of the social benefit on other elements of the government balance sheet.20 A final point made by Towe (Chapter 16) concerns the treatment of reserves that are sometimes set up to finance contingency programs. Although these reserves seem to offset any deficit in the program, they do so only when they are not held in the form of other government liabilities.

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Valuation of the Present Value of the Tax Program Eisner (1984, pp. 139—40) takes the view that changes in the value of contingent claims are likely to be met by changes in taxes (or other redistributory legislation) and hence that, if these claims are included in the deficit, the measure of the fiscal stance might be out of line with the private sector's perception of its claims on the government. But if Ricardian equivalence is broadly defined, this view could be generalized to all potential reductions in government net worth, and the present value of the tax program simply replaces net worth as the balancing item in the comprehensive balance sheet. If Ricardian equivalence does not hold, the government's power to control its long-run net worth by altering tax and expenditure legisla20 The difficulty in capturing the second-order effects of government policy on government balance sheets may, of course, be generalized to any revenue or expenditure program whose impact is diffuse. This issue could become particularly relevant in budgeting for pollution control and environmental management, which might have important effects—albeit unpredictable and far in the future—on government real assets.

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tion21 suggests that, even if the government has a negative net worth in terms of today's policy package, it is not insolvent in the private sector sense. Rather, it must adjust the tax program by the amount of its "permanent deficit"22 to return to sustainability. The indeterminacy of the net worth measure inherent in the flexibility of the government's power to tax is the main philosophical problem with balance sheet or net worth concepts of the deficit. In light of this indeterminacy, it is not clear that net worth measures will be less arbitrary than flow measures. Thus, the government's control over resources conceivably encompasses all of private sector income and wealth. The sustainability of government policy then depends on its impact on the total wealth of the economy—in other words, on private agents' view of their net worth.23 Kotlikoff (1989, p. 2) recognizes this broad interrelationship in his proposal to substitute a "Fiscal Balance Rule" for present indicators of budget sustainability:

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[The Fiscal Balance Rule] says take in net present value from each new young generation an amount equal to theflowof government consumption less interest on the difference between (a) the value of the economy's capital stock and (b) the present value difference between the future consumption and labor earnings of existing older generations. . . .[O]ne can use existing data to check whether it is being obeyed and, therefore, whether future generations are likely to be treated better or worse than current generations. In other words, if the present labor force pays for government consumption by paying taxes augmented by its interest earnings on the capital stock net of that part that finances dissaving by the old, government policy will not run down the economy's capital stock, and future 21 One good example is the large drop in U.S. social security obligations following legislation in 1982 (Eisner (1986, p. 37)). 22 The permanent deficit (defined by Bean and Buiter (1987, p. 31)) is the real perpetuity equivalent of the difference between the present value of real government spending plans and net worth: "Although ex-ante permanent deficits will not actually materialize, let alone be permanent, they represent the permanent adjustment that must be made, relative to the ex-ante inconsistent plans, to the flows of spending, tax receipts, or seigniorage revenue in order to achieve solvency." 23 Abramovitz (in private correspondence) puts the point succinctly: "The government's 'total income' is not an exogenous datum. It is a function of economic growth, which itself is influenced by government budget policy both on the expenditure and revenue sides. . .and by politics. How large a portion of future income will politics permit the government to obtain—and from whom?"

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generations will be as wealthy as past generations. Under this criterion, the fiscal deficit is defined as government consumption in excess of taxes plus interest. Shortcomings of Net Worth Concepts of the Deficit: A Tentative Conclusion

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The jury is still out on whether net worth calculations of the deficit are superior to traditional flow measures. On the one hand, it is clear that they correct for several blatant errors in treatment in currently accepted economic indicators. On the other hand, they fall between two stools. The measures are not broad enough to internalize the indeterminacy created by the government's power to change the present value of tax and entitlement programs. However, they are very broad measures: all of the authors surveyed have stressed the huge movements in net worth that can be occasioned by valuation changes in assets, such as land, that the government has no immediate intention of liquidating. Hence, net worth measures could be dangerous if used as indicators for near-term fiscal policy. Even in the long run, as Stella (Chapter 10) points out: [A]n important, though somewhat ignored, aspect regarding the appropriateness of using the net present value approach is that it assumes that the government will ultimately realize the capital gains. A key factor upholding the validity of accrual accounting is the expectation that the income will eventually be realized. While this might occur with financial assets, it certainly does not happen with all real assets. . . . In cases where the income will never be realized, accrual accounting is not justified.

References Bean, Charles R., and Willem H. Buiter, The Plain Man's Guide to Fiscal and Financial Policy (London: Employment Institute, October 1987). Blejer, Mario I., and Adrienne Cheasty, "The Measurement of Fiscal Deficits: Analytical and Methodological Issues," Journal of Economic Literature, Vol. 29 (December 1991), pp. 1644-78. Boskin, Michael J., and Marc S. Robinson, "New Estimates of the Value of Federal Mineral Rights and Land," American Economic Review, Papers and Proceedings, Vol. 75 (December 1985), pp. 923-36. Boskin, Michael J., Marc S. Robinson, and John M. Roberts, "New Estimates of Federal Government Tangible Capital and Net Investment," NBER Working

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Paper 1774 (Cambridge, Massachusetts: National Bureau of Economic Research, December 1985). Boskin, Michael J., Marc S. Robinson, and Alan M. Huber, "Government Saving, Capital Formation and Wealth in the United States, 1947-1985," NBER Working Paper 2352 (Cambridge, Massachussets: National Bureau of Economic Research, August 1987). De Leeuw, Frank, and Thomas M. Holloway, "The Measurement and Significance of the Cyclically Adjusted Federal Budget and Debt," Journal ofMoney, Credit and Banking, Vol. 17 (May 1985), pp. 232-42. Eisner, Robert, "Capital Gains and Income: Real Changes in the Value of Capital in the United States, 1946-77," in The Measurement of Capital, ed. by Dan Usher (Chicago: University of Chicago Press, 1980). , "Which Budget Deficit? Some Issues of Measurement and Their Implications," American Economic Review, Papers and Proceedings, Vol. 74 (May 1984), pp. 138-43. , How Real Is the Federal Deficit? (New York: Free Press, 1986). (1988a), "Deficits, Monetary Policy and Real Economic Activity," in The Economics of Public Debt, ed. by Kenneth J. Arrow and Michael J. Boskin (New York: St. Martin's Press, 1988), pp. 3-40. (1988b), "Extended Accounts for National Income and Product," Journal of Economic Literature, Vol. 26 (December 1988), pp. 1611-84. , "That (Non) Problem, the Budget Deficit," Wall Street Journal, June 19, 1990, p. 15. Eisner, Robert, and Paul J. Pieper, "A New View of the Federal Debt and Budget Deficits," American Economic Review, Vol. 74 (March 1984), pp. 11-29. Goldsmith, Raymond, Comparative National Balance Sheets: A Study of Twenty Countries, 1688-1978 (Chicago: University of Chicago Press, 1985). Kendrick, John, The Formation and Stocks of Total Capital (New York: Columbia University Press for NBER, 1976). Kotlikoff, Laurence J., "From Deficit Delusion to the Fiscal Balance Rule: Looking for an Economically Meaningful Way to Assess Fiscal Policy," NBER Working Paper 2841 (Cambridge, Massachusetts: National Bureau of Economic Research, February 1989). Milgram, Grace, "Estimates of the Value of Land in the United States Held by Various Sectors of the Economy, Annually, 1952 to 1968," in Institutional Investors and Corporate Stock—A Background Study, ed. by Raymond W. Goldsmith (New York; Columbia University Press for NBER, 1973), pp. 343-77. Miller, Marcus, "Inflation-Adjusting the Public Sector Financial Deficit," in The 1982 Budget, ed. by John Kay (Oxford; New York: Blackwell, 1982), pp. 48-74.

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Muller, Patrice, and Robert W.R. Price, "Structural Budget Deficits and Fiscal Stance," OECD Economics and Statistics Department Working Paper 15 (Paris, July 1984). Ott, Attiat F., and Thomas D. Austin, "Capital Formation by Government," Ch. 7, in The Government and Capital Formation, ed. by George M. von Furstenberg (Cambridge, Massachusetts: Ballinger, 1980), pp. 265-317. Ott, Attiat F., and Jang H. Yoo, "The Measurement of Government Saving," Ch. 5, in The Government and Capital Formation, ed. by George M. von Furstenberg (Cambridge, Massachusetts: Ballinger, 1980), pp. 177-241. Russo, Benjamin, "The Real Market Value of the Net Federal Debt: Interest Rate Effects, Money Illusion, and the Efficacy of Fiscal Policy" (unpublished; Chapel Hill: University of North Carolina, 1987). United Nations, Department of Economic and Social Affairs, Statistical Office of the United Nations, A System of National Accounts, Studies in Methods, Series F, No. 2, Rev. 3 (New York, 1968). United States, Executive Office of the President, Council of Economic Advisors, Economic Report of the President (Washington: Government Printing Office, January 1989).

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14 Measurement of the Public Sector Deficit and Its Implications for Policy Evaluation and Design Willem H. Buiter

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THIS CHAPTER STUDIES budgetary,

financial, and monetary policy evaluation and design in a framework of comprehensive wealth and income accounting. Although the focus is on the public sector accounts, inevitably some attention is paid to the private and overseas sectors. Construction of stylized comprehensive balance sheets for the public sector and for its "flow" counterpart (the change in real public sector net worth) forms the basis for a comparison of these balance sheets with the conventionally measured balance sheet and theflowof funds accounts. The conventionally measured public sector balance sheet typically contains only marketable financial assets and liabilities. On the asset side, it omits such items as the value of the stock of social overhead capital, the value of government-owned land and mineral rights, and the present value of planned future tax revenues. On the liability side, it omits the present value of social insurance and other entitlement programs. The conventionally measured financial surplus of the public sector, even when evaluated at constant prices, presents a potentially misleading picture of the change in the real net worth of the public sector. One reason is that capital gains and losses on outstanding stocks of Note: The author is Professor of Economics at Yale University; he was a visiting scholar in the IMF's Fiscal Affairs Department when this paper was prepared. An earlier version of the paper appeared as Buiter (1983). The author is indebted to John Makin and Marcus Miller, in addition to IMF staff members, for their helpful comments. All views expressed are strictly the author's and do not necessarily represent the views of the IMF.

297

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

government assets and liabilities are not included in the flow of funds. For example, the following are omitted: capital gains or losses that are due to changes in relative prices (for example, changes in the real value of mineral rights), changes in the real value of nominally denominated public sector debt that are due to inflation, and changes in the real value of foreign-currency-denominated assets and liabilities that are caused by changes in exchange rates. A second reason is that changes in tax and entitlement programs, in the future revenue base, and in discount rates and the like may significantly alter the planned or expected future streams of taxes and benefits and their present value. Capital gains and losses on such implicit nonmarketable assets and liabilities are part of the HicksSimon concept of income, but they are excluded from the flow of funds accounts. The differences between the conventionally measured accounts and the comprehensive accounts can be very large. In inflationary periods, large public sector deficits (conventionally measured) may be more than offset by the inflation-induced reduction in the real value of the government's nominal liabilities. Changes in the current account deficit of the balance of payments (conventionally measured) may be offset or enhanced by changes in the value of external assets and liabilities associated with exchange rate changes. Changes in social security legislation may alter the future flows of benefits and contributions. With efficient forward-looking financial markets, such policy changes will not merely alter future rates of return when the financial implications of current legislation become visible and directly measurable—for example, through changes in the amount of public sector borrowing. They will also have an effect on current financial asset prices and rates of return: larger anticipated future deficits may raise current interest rates. After presenting the comprehensive and conventionally measured accounts for the public sector, the private sector, and the overseas sector, this chapter proposes some general rules for policy design. These rules derive from a reasonable policy norm or objective and from rather minimal and uncontroversial assumptions about private sector behavior. To translate these general (and, indeed, perhaps rather vague) rules into concrete policies is a task that is well beyond the scope of this chapter because a wealth of country-specific knowledge would be required in each case. The essence of the argument is that, in a first-best world, private agents, governments, and international organizations would decide on spending, saving, lending, production, and portfolio allocation pro-

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grams, constrained only by comprehensive wealth or permanent income. Single-period or other short-run "budget constraints" would not represent further effective or binding constraints on economic behavior. The perfect internal and external capital markets required to implement the first-best solution, however, do not exist. Private agents are constrained by the illiquidity and nonmarketability of certain assets (for example, pension rights, human capital, and expected future tax cuts). Dearth of suitable collateral often renders infeasible the borrowing required to spend in line with permanent income. These cash-flow constraints, illiquidity, credit rationing, lack of collateral, nonmarketability of certain assets and liabilities, and a host of other capital market imperfections force the actions of private agents and national governments to depart from the behavior that would be optimal if comprehensive net worth or permanent income constraints alone had to be taken into account. Flow of funds accounting on a cash or transaction basis and the analysis of balance sheets consisting only of marketable claims are useful precisely because they will help to identify the conditions under which the behavior of economic agents is likely to be constrained by factors other than comprehensive net worth. Within a national economy, conventional accounting helps to decide when and how the national authorities, through appropriate fiscal, financial, and monetary measures, can help private agents to avoid or overcome obstacles to spending and saving in line with permanent income (for households) and impediments to production in pursuit of long-run profit or social net benefit (for enterprises). Within the international economy, conventional accounting serves to identify the conditions under which international organizations should extend or restrict credit to national governments to enable them to develop in line with their long-run potential. Exercises in financial evaluation, such as the IMF's financial programming, should, therefore, start from two sets of accounts. The first set contains the conventional cash-based flow of funds accounts; the income expenditure accounts of the United Nations' (1986)ASystem of National Accounts (SNA); and the conventional balance sheets of marketable assets and liabilities. The second set contains the comprehensive balance sheets or wealth accounts outlined in the chapter and their flow counterparts, describing the changes in real sectoral net worth over time and thus permanent income—that is, the ultimate accrual-based accounts. Both national governments and international agencies should design fiscal, financial, and monetary policies so as to induce an evolution of the conventionally measured balance sheet and flow of funds accounts

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

that permits private agents and national economies, respectively, to approximate the behavior that would be adopted if either comprehensive wealth or permanent income were the only binding constraint on economic behavior. The approach developed in this chapter implies that conventional financial planning is an essential input into optimal (or even merely sensible) policy design. It also suggests that a set of comprehensive wealth and p e r m a n e n t income accounts (or the best practicable approximation to them) should complement the conventional data base. Without the conventional accounts, of course, analyses based just on the comprehensive wealth and permanent income accounts will fail to take into account many of the actual binding constraints on economic behavior. "Stabilization policy," as viewed in this chapter, is potentially useful and effective even if goods and factor markets clear continuously. The existence of capital market imperfections that prevent private agents from spending in line with permanent private disposable income, and nations from spending in line with national permanent income, is necessary before there can be scope for stabilization policy—that is, policy actions or rules designed to permit smoothing of consumption over time by removing or neutralizing constraints on spending other than permanent income. Successful stabilization policy keeps disposable income in line with permanent income and ensures an adequate share of disposable financial wealth in comprehensive wealth. Another necessary condition for potentially desirable stabilization policy is that governments have access to capital markets on terms that are more favorable than those faced by private agents, or, more generally, it is necessary for governments to have financial options that are not available to private agents. With the necessary changes, the same condition applies in an international setting for certain international agencies vis-a-vis national governments. The existence of Keynesian effective demand failures that are due to disequilibria in goods and factor markets would, of course, strengthen the case for stabilization policy. This view of stabilization policy implies that the government's financing policies (changes in its tax, transfer, borrowing, and money creation mix) should be used for stabilization rather than for variations in its spending program on goods and services. The spending program should aim to achieve the best feasible public-private consumption mix based on national permanent income.

A Stylized Set of Public Sector Accounts Table 1 presents a stylized and simplified "comprehensive" balance sheet for the public sector. Many definitional problems are ignored; for

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Table 1. Comprehensive Consolidated Public Sector Balance Sheet (At current market or implicit prices) Liabilities

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Assets PKsocKsoc

Social overhead capital (nonmarketable)

BH

Net interest-bearing debt denominated in domestic currency, held by residents

pGKG

Equity in public enterprises (partly potentially marketable)

BF

Net interest-bearing debt denominated in domestic currency, held by nonresidents

pRRG

Land and mineral assets (marketable)

eB*H

Net interest-bearing debt denominated in foreign currency, held by residents

eE*

Net foreign exchange reserves

eB*F

Net interest-bearing debt denominated in foreign currency, held by nonresidents

T

Present value of future tax program, including social security contributions, tariff revenue, and the like (implicit asset)

pBH

Net interest-bearing index-linked debt, held by residents

pAM

Imputed net value of government's cash monopoly

pBF

Net interest-bearing index-linked debt, held by nonresidents

H

Stock of high-powered money

N

Present value of social insurance and other entitlement programs (implicit liability)

WG

Public sector net worth

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

example, throughout this chapter the terms "government" and "public sector" are used interchangeably (see Boskin (1982)). It is assumed that an extremely heterogeneous set of assets and liabilities can somehow be expressed in common value terms, despite the fact that some of the assets are not marketable (Ksoc) or, even if potentially marketable, may lack a current observable market price (KG). Some assets and liabilities are neither marketable nor tangible and merely represent implicit noncontractual (and reversible) political commitments (T and N). Referring to T, N, and AM as present discounted values of future streams of payments or receipts involves a rather cavalier use of certainty equivalence; the conditional mathematical expectations of the uncertain future revenues or outlays are discounted by using "riskadjusted" discount rates. If, for example, future tax revenues are highly uncertain, T would be correspondingly small. The relevant horizon is, in principle, infinite. For many purposes, it is better not to attempt to reduce marketable and nonmarketable, implicit and explicit, claims to a common balance sheet measure of value. Instead, each of the items in the balance sheet would be modeled as having potentially distinct behavioral effects. The proper way of handling this will depend on the specifics of the model and the application under consideration. For a preliminary examination of the problem of comprehensive wealth and income accounting in the public sector, however, the balance sheet in Table 1 is useful. Most of the items in the balance sheet are self-explanatory. Public sector overhead capital is assumed to yield an implicit rental rsocpKsocKsoc, which corresponds to the item pGsoc (public sector consumption of social overhead capital services) on the debit side of the public sector current account. The symbol pGKG represents the balance sheet counterpart of the operating surplus of the public enterprise sector in the public sector current account. This may well be a negative item for some of the secular public enterprise loss makers, in which case it should be moved to the liability side of the balance sheet. The present value of current and capital grants is not entered separately; it can be viewed as subsumed under N or T. Net foreign exchange reserves (E*) are entered separately as an asset rather than netting them out against B*F or B*F + BF/e + BF(p/e). For simplicity, only nominal capital-certain bonds and real capital-certain bonds are considered (see Miller (1982)). The treatment of money in this exposition of the comprehensive wealth accounting framework is somewhat unusual. The reason for adopting this approach is that it represents the simplest way of intro-

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ducing a nontrivial role for money. Specifically, it keeps the economy from becoming isomorphic to a barter economy when, in the fifth section ("Public Sector Accounts and Private Behavior"), the accounts of the public and private sectors are consolidated in the investigation of debt neutrality. Money, as a social asset that produces liquidity and convenience services, does not disappear when private and public sector assets and liabilities are netted out. The usefulness of the framework of comprehensive wealth accounting does not depend on the acceptability of this approach to modeling money. Money has value to the private sector because it yields a flow of imputed nonpecuniary liquidity and convenience services. Let p^ be the nonpecuniary rate of return on money. The value to the private sector of its money holdings is given by VM in equation (1): 00 00 1 r(s, t)ds d u . l VM(t) = ------- H(t)p-M(u, ƒt)e t S

(1)

p f/4 = i = r + ---.

(2)

p(t) t f S f S The assumption that the pecuniary and nonpecuniary yields on S money and bonds are equalized at the margin yields

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p

Equations (1) and (2) imply that H

yM = ---p .

(3)

Let Y\M be the present discounted value of the expected future flow of profits to the government from operating the printing presses. Assuming that cash can be produced without cost, the result is !

Or, equivalently, by

x

VM(t) =

S S S tS

-u

f (s,t)ds

H(t) pM(u, t)e S -----------------P (u, t)

du.

S S For any variable x, x(s, t) is the value of x expected Sat time t to prevail at time s. t

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT 1 + i(s,t)ds t)e- u IIM(t) =H(u, -------p(t)ƒ x

du.

2

(4)

f f f f t

f f f t

Integrating equation (4) by parts produces H(t)

+ n M (T) = ----------P(t)

(4')

AM(t),3

where x.

M

A (t)

1 + = --------i(u, t)H(u, t)eP(t) ff

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f f t

u

i(s,t)ds d u .

(5)

t t t t t

Thus, AM(t)—the net value of the government's cash monopoly— can be interpreted as the present discounted value of the interest income that the central bank expects to earn at each future date on a portfolio of government bonds that is equal in value to the stock of high-powered money at that date. The conventionally measured public sector balance sheet typically omits from Table 1 all nonmarketable and nonfinancial assets and liabilities—that is, Ksoc, KG, RG, T, AT, and^ M . The current and capital accounts of the public sector whose balance sheet is given in Table 1 are represented in Table 2 (see Ott and Yoo (1980)). They are stylized SNA accounts and have a number of significant shortcomings when used uncritically as a guide to the changes over time in the balance sheet—specially as regards the evolution of the real comprehensive net worth of the public sector and its components. c For simplicity, it is assumed that government consumption (G ) and the imputed rental services from social overhead capital have the same

2

Or, equivalently, M

n (t) = 3

u I I tII

1 f(s,t)

ds

H (u, t) e -tt du. -----------------t P (u, t) t t

It is assumed that for any variable x, x(th t2) = X^γ) for tx ^t2: the past and present are assumed to be known.

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price (p). 4 A uniform depreciation rate (8) for different types of capital is also imposed. Foreign exchange reserves are assumed to pay the same interest rate as other foreign-currency-denominated financial claims. All of these assumptions serve only illustrative purposes. The "public sector budget constraint," which was rediscovered by macroeconomic theorists in the early 1970s, is obtained by consolidating the current and capital accounts of Table 2. Imputed income and consumption are netted out. Deflating by the general price level yields the conventionally measured public sector financial surplus (at constant prices) given in equation (6): T

PKSOC.

Gc

bKsoc -------------------- ---------------

n

p

P

H F C -- ----t (B* +B* -E*) P

bKG - i --------------------------( ) P

- r(BH+BF)

PKsoc

BH+BF

PG

G

P ( G ) PR G PG R R + rG -------( K + r) -------P( ) P

1

PG G PR R -------(BH+BF) ksoc + --------k + -------= --------------P P p P H C (B*H+B*F-È*) - (BH+'BF) ---------P . P

(6)

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Even this "real" surplus, however, is likely to be a poor indicator of the change in the real net worth of the public sector, as defined from the balance sheet in Table 1. This change in the real net worth of the government is given in equation (7): PKsoc soc d WG k + PG KG + PR RG = -------------------------dt ( p ) P P P ( ) ( ) 1e F H F ( ) - -(BH +B ) - -(B'* +B* -È*)

H1 - (BH+BF) -- + - (t-N) + AM PKsoc p PKsoc p +p -------------KSOC

Pα

Ka

-----+ ( PG ---------------P soc (-------------------p) P P ---F ) ( PR P PR ( +H--- P BH+B G + ( -+ P --------------) ---- --) ----- ( P p) ) PR P) P ( p ) ( K

R

( ( ( (

)

( ( ( (

) ) ) )

)

4Consumption of the imputed services from social overhead capital can be viewed as ) ) a transfer (in kind) from the public sector to the private sector rather than as an item of public sector consumption. Alternatively, the services from the stock of public sector overhead capital could be an input into private production.

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

(B*H+B*F-E*)

--

(e p ) e ( ---- --)----5 --) -- ( e p(T-N) (p ) p --p

(7)

A comparison of the right-hand sides of equations (6) and (7) reveals that the difference between the "real," or constant, price surplus and the change in real net worth is due to capital gains and losses (ft) and to changes in the value of the implicit assets and liabilities (A), where

GGP. KG +

PKSOC P

a =( ------ -- ----) p)

PKsoc

PK

SOC

SOC

K

P

( B +B +H) ) (p (------------- ) (+p ((---- p )) H

and

—p(T-N) ---( P

F

+

( ( ( (

) ) ) )

------ -- --------P Pα P

PR RG ( ( ( (

PR P

----- ---

ép PR p H F -- (---- -- -----(B' +B" -E') ) (e p ) ( ) ( ) )

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A = -(f - N) + ÄM.

) ---) -----) P )

(8)

(8')

As regards ft, the statement that the change in wealth or net worth equals saving plus capital gains is not surprising. The importance of fully accounting for capital gains and losses on existing government assets and liabilities to obtain a correct understanding of the short-run and long-run implications of past, present, and prospective budgetary, monetary, and financial policies has not, however, been appreciated universally. Considerable interest attaches to behavior by an economic agent, sector, or group of sectors that leaves real comprehensive net worth unchanged. Such agents or sectors consume their permanent income, and their behavior is ex ante permanently sustainable. For policy design, policies aimed at keeping total national (public plus private) consumption in line with national permanent income—that is, policies 5 No behavioral significance should be attached to the specification of T and N in nominal terms.

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focusing on the consolidated public and private sector comprehensive balance sheet accounts—are of special relevance. These are considered in the fifth section, below. While there are certainly valid reasons for optimal consumption to depart from permanent income, such divergences must necessarily be temporary, with overshooting and undershooting of the permanent income benchmark canceling each other in terms of present value. The focus on spending behavior that is consistent with constant real comprehensive net worth should, therefore, come naturally in policy evaluation and design. It is noted that equations (7), (8), and (8') represent ex post or realized measures only. For planning, including consumption planning, the ex ante measures are relevant. They are obtained by replacing actual changes in prices with anticipated changes in prices in equations (7) and (8), and by substituting anticipated changes in the value of implicit assets and liabilities for actual changes in equations (7) and (8'). In what follows, anticipated capital gains and losses replace the ex post measures whenever planned private or public sector behavior is discussed.

Amortization of Public Debt Through Inflation and Currency Appreciation

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Let us consider, first, changes in the public sector balance sheet that are due to "pure" or general inflation, which is defined as a situation in which all money prices (including the prices of real capital assets) change at the same rate—that is, PKSOC

PG

PR

P

------- = --- --- ------- = -------- . pKsoc pG pR p

For reasons of space, ignore capital gains or losses on the implicit assets and liabilities T and iV that are caused by inflation. Inflation-induced changes in real public sector net worth (H') are given by ( B H + H ]

(j> _

+ p [ ] [ ] (B*H + B*F - E ) e M= ------

è)

(9')

p [ ] --- .

] P J \P e/ P The Closed [Economy

In a closed economy, the last term on the right-hand side of equation (9') can be ignored, BF = 0, and the reduction in the real value of the

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308

Table 2. Public Sector Income and Expenditure and Capital Finance Accounts (At current market or implicit prices) Credit

Debit p(Gc

+

G soc)

8(pKSOC +

KsocpGKG)

Current Account Government consumption T including imputed rental from social overhead capital Capital consumption rGpCjKc' + rRpRRG

Transfer and benefit payments

n i(B"

+ BF) 9

+ ei*(B "

Interest paid F

+ B* )

+ rp(ß 7/ + B11) SG

Surplus on current account

ei*E* rsocpK**K*oc

Tax receipts (including social security contributions) Profits from public enterprises and ownership of natural resources Interest received Imputed return from social overhead capital

MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

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Capital Account pKSOV(kmc + 8KSOC G + pG(K + 8KG) - [BU + BF + e(B*n + B*F - E*)

Gross investment in structures Net financial investment

SG

Surplus on current account

8(PKsocKsoc

Capital consumption

G

+ PGK )

+ p(É + 5 0 + H] pRRG

Net purchases of existing assets

WILLEM H. BUITER

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309

310

MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

outstanding stock of nominally denominated government liabilities is given by ft': (9")

p [BH + H] 8 = ---- [---------] Proper wealth p [ p ] accounting requires that the amortization of public debt through inflation should be put "below the line" in measuring the financing of the government's net "real" borrowing.6 Above the line, a higher rate of inflation will (if interest rates are free) swell the measured deficit as nominal interest rates rise with the rate of inflation. If the Fisher hypothesis holds and real interest rates are invariant with respect to the rate of inflation, the increased nominal interest payments associated with a higher rate of inflation will be exactly matched by the reduction in the real value of the government's stock of nominally denominated interest-bearing debt (ft'"), defined by

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(9'")

p BH 8 = --- -----Subtractionp of p ft'" from the conventionally measured deficit yields the deficit "at real interest rates"—what the conventionally measured deficit would have been if all interest-bearing debt had been index linked. In models that do not exhibit "pre-Ricardian" debt neutrality, changes in the real value of the stock of government interest-bearing debt are the major proximate determinant of "financial crowding out"— the displacement of private capital formation by government borrowing, holding constant the size and composition of the government's real spending program. The exact nature (degree, scope, and time pattern) of financial crowding out will, of course, be "model specific." A number of simple examples are analyzed in Buiter (1982c). The central (and obvious) point is that, other things being equal, private agents (whose portfolio demands are for real stocks of assets if agents are free from money illusion) will absorb additional issues of nominal government bonds equal to the erosion in the real value of their existing holdings caused by (anticipated) inflation without requiring any increase in the real rate of interest. Such government borrowing, therefore, does not raise the degree to which the public sector competes with the private sector for real investible resources. 6 Clear statements of this proposition can be found in Siegel (1979) and in Taylor and Threadgold (1979). See also Buiter and Miller (1981) and Buiter (1982b).

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311

The "other things being equal" clause of the preceding paragraph includes a given stock of real money balances. Additional monetary financing equal to the inflation tax on existing money balances, [(p /p)(///P)], leaves real money balances unchanged. A conventionally measured deficit equal to fl", financed by borrowing an amount [(p/p)(BH/P)] and by money creation equal to [(p/p)(i//P)], is therefore consistent with constant real interest rates and a constant degree of aggregate financial crowding-out pressure.7 Note that subtracting (1" from the conventionally measured deficit yields a somewhat wider concept of the deficit at real interest rates, since the real rate of return (ignoring nonpecuniary liquidity and convenience services) on highpowered money bearing a zero nominal interest rate is minus the rate of inflation.8 The argument for public sector inflation accounting in the closed economy can be summarized succinctly by using a simplified version of equations (1) and (2). Ignoring Gsoc, Ksoc, andß G , let us assume that PG = Py and define G1 = K° (net investment by public sector enterprises) and f = (T -n)/p (real taxes net of transfers and other benefits). If it is assumed, in addition, that r = i - p / p , then the conventionally measured government budget constraint is given by

t+Èl

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P

+ ff, e

G c + G , + bKa

+ rBH - r°K°.

_ - + (r+p\ B^ \

Pi P

(10)

The change in the real value of the stock of interest-bearing debt is given by T- (—+B") = Gc + G' + hKa - f + r (—+B") dt\p J \p j - rGK° - — . P

(11)

The deficit measure that is relevant for aggregate financial crowdingout pressure on private capital formation, given in equation (11), will depend on the amount of monetary financing permitted by the authori7 It is assumed that borrowing and money creation, per se, do not affect determinants of the demand for public debt other than expected real rates of return. 8 This is the ex post measure. The ex ante real yields are defined in terms of the expected rate of inflation.

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312

MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

ties. Useful benchmarks are monetary financing sufficient to keep the real money stock constant, Hip = (p/p)(H/p), and monetary financing consistent with a zero trend rate of inflation, Hip = -y(H/p), where 7 is the natural rate of growth.9 Equation (11) answers the questions of whether the fiscal stance (defined by Gc, G7, and f) and the monetary target (defined by Hip) imply aggregate financial crowding-out pressure {dldt)(BHlp + BH) > 0, or crowding-in pressure (dldt)(BHlp + BH) < 0. This issue can be addressed in the short run (for a single period), in the medium term (by applying equation (11) sequentially for as many periods as one is interested in), or in the steady state. Note that inflation-induced capital gains or losses on nonindexed bonds cancel the inflation premium in the nominal interest payments; in equation (11), all debt service is evaluated at real rates of interest.10 For aggregate crowding-out pressure on total national (private plus public sector) capital formation, a useful simple measure (noting that G' - kG) is

^ (—+B H -K G ) = Gc - f + r i—^ËH-KG) dt\p J \p J

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+

[r_(rG_6)]KG_if

(12)

The conventional deficit measure is further modified in equation (12) by subtracting net investment by public sector enterprises. Interest payments on net nonmonetary liabilities (BH+BH -KG) are evaluated at the real interest rate, r. If the net rate of return on public enterprise capital (rG - 8) exceeds the opportunity cost of borrowing (r), the "corrected" deficit is further reduced. If the opposite prevails, the corrected deficit is larger by an amount [r — (rG — 8)] KG. The decline in the real value of total tangible net worth of the public sector is given by

[] [BH + B ----- ] [p]

d_ = Ge - T + r dt [ H + BH ] [------------ + BH -- KG] + [r-(r°-*)]K°-&. [] [P]

(13)

''Money demand is assumed to be unit elastic in income and wealth. 10 The accounting framework does not indicate whether the real interest rate varies with the inflation rate.

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WILLEM H. BUITER

This could be called the inflation-corrected government current account deficit. Debt-service payments and receipts on all assets and liabilities (including money) are evaluated at real rates of return.11 Some idea of the magnitude of the overstatement of the government's true borrowing by the conventionally measured deficit under inflationary circumstances is provided by Table 3 for the United Kingdom and Table 4 for the United States. In 1981 the public sector borrowing requirement in the United Kingdom was £10.6 billion, and the public sector financial deficit rose to £7.5 billion. The inflation correction in that year amounted to about £11 billion, on the basis of a variety of estimates. The inflationcorrected deficit was actually a surplus. If it is noted that during 1981 the U.K. economy was also experiencing the worst recession since the 1930s, there can be no doubt that the inflation-corrected and cyclically adjusted (trend or permanent) deficit was actually a sizable surplus. It is a matter of some practical importance whether that constitutes wise countercyclical fiscal policy. The United States during the period 1979-81 also had an inflation-corrected balanced federal budget. Any reasonable cyclical correction for 1981 produces a large inflationcorrected cyclically adjusted surplus. High U.S. real interest rates in 1981 can be explained by the fiscal stance only if large anticipated future inflation-corrected cyclically adjusted deficits are postulated.

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The Open Economy In an open economy, governments can borrow and lend domestically or abroad. Their financial assets and liabilities can be denominated in foreign or domestic currency or can be index linked. Consider equation (9'). The real value of public sector debt denominated in domestic currency is reduced by domestic inflation whether this debt is owned by the private sector or the rest of the world. While, other things being equal, inflation also reduces the real value of foreign-currencydenominated financial claims, exchange rate depreciation increases it. 11 For certain purposes, crowding-out pressure per unit of capacity output or crowdingout pressure per unit of efficient labor is of interest (see Sargent and Wallace (1981)). This would involve replacing equation (11) by the following:

d (B + BHp-l\

dt (

Y

) =

Gc + G' + 8KG - f

Y

,

+ (r

-

y)

J B"BH\

rGKG

[ pY + y j - —

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H

- jr •

Table 3. United Kingdom: Correcting the Public Sector Deficit for Inflation, 1967-81

1967 1968 1969 1970 1971

81 77 70 67 59

1972 1973 1974 1975 1976

58 49 43 41 43

1977 1978 1979 1980 1981

47 44 42 36 38

Public Sector Financial Deficit In billions of In percent pounds sterling of GDP

1.9 1.3

4.6 3.0

1.5 0.9

3.8 2.0

-0.4

-1.0

0 1.4

0 2.4

-0.5 -0.7

-1.1 -1.3

0.3

0.5

2.1 4.2 6.4

3.2 5.8 7.7 9.9 7.3

1.5 2.8 4.7 7.7 8.3

2.4 3.8 5.7 7.3 6.6

4.2 5.1 6.6 5.4 4.1

5.9 8.1 8.1 9.7 7.5

4.1 4.9 4.2 4.3 2.9

10.5 9.1 6.0 8.4

12.6 12.2 10.6

Source: Miller (1982). a'Inflation correction 1 = annual rate of inflation times market value of public sector debt (midyear), bInflation correction 2 = annual rate of inflation times nominal value of public sector debt. cInflationcorrection 3 is based on the assumption of a long-run real interest rate of 2 percent.

Inflation Correction (in billions of pounds sterling) (2)b (3)c (l) a 0.5 1.4 1.2 2.1 3.0

0.6 2.0 2.0 2.7 3.2

1.0 1.2 1.3 1.4 1.5

3.3 3.0 7.0

3.2 4.0 9.3

10.3

11.9

7.5

7.4

1.7 2.3 3.3 3.9 5.0

10.1

9.3 6.4

6.2

12.3 9.6

10.8

13.8 12.1 11.7

5.8 6.5 8.2

10.5 11.8

MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

Public Public Sector Sector Debt Borrowing Requirement (PSBR) (market value; in percent In billions of In percent of GDP pounds sterling Year of GDP)

314

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Table 4. United States: Federal Deficits and Debt, Fiscal Years (Columns 1-4 in billions of U.S. dollars)a

Fiscal Year 1967 1968 1969 1970 1971

1967-81

Par Value of Public Debt Securities Held by Private Investors, End of Fiscal Year (in 1967 prices)

Inflation Correction

Ratio of Public Debt to GDP

(1)

(2)

(3)

(4)

(5)

8.7

204.4 217.0 214.0 217.2 228.9

204.4 208.3 194.9 186.8 188.7

5.9 9.1

0.26 0.25 0.23 0.22 0.21

194.4 194.5 173.1 188.1 220.8

16.1 28.1 27.6 21.8

0.21 0.20 0.18 0.20 0.22

241.7 249.9 240.8 238.7 244.3

28.5 37.6 59.1 79.5 69.2

0.23 0.23 0.22 0.22 0.23

25.2 -3.2 2.8

23.0

1972 1973 1974 1975 1976

23.4 14.9 53.2 73.7

243.6 258.9 255.6 303.2 376.4

1977 1978 1979 1980 1981

53.6 59.2 40.2 73.8 78.9

438.6 488.3 523.4 589.2 665.4

6.1

11.6 12.8 9.8 8.0

Source: United States (1982). Golumn 3 = column 2 deflated by consumer price index. Column 4 = column 2 times proportional rate of change of consumer price index. a

315

Total Federal Budget and Off-Budget Deficit for Fiscal Year

Par Value of Public Debt Securities Held by Private Investors, End of Fiscal Year

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

If purchasing power parity holds (pip - èle = pip" and through choice of units, ep = p), equation (9') becomes ft,

=

p_ (BH + BF + H\ p \ p )

+

£_ (B H+B F-E p \ p

\

I'

With purchasing power parity, reductions in the real value of foreigncurrency-denominated public sector debt can be calculated by multiplying the foreign rate of inflation by the real value of net foreigncurrency-denominated liabilities. Consider the following stylized representation of the position of a number of small, open developing countries that lack a significant domestic capital market. Government debt is largely placed abroad and tends to be denominated in foreign currency (typically U.S. dollars). In such countries, BH = BF = ÉH = BF = B*H = 0. The conventionally measured public sector deficit is12 — + - (B*F-È*) = Gc + G1 + §KG - f p p + -i

(B F-Em) - rGKG .

(14)

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If, in addition, only the government borrows overseas, (dldt)(BF — E) equals the current account deficit (in terms of foreign currency) of the balance of payments, as shown in equation (15): - (J3*F-£*) = -X + -i p p

(B^-E*).

(15)

Here, X denotes real net exports of goods and services (excluding debt service) plus net transfers and grants from abroad. Compare the current account balances of two countries, identical in real terms but facing different rates of world inflation. If r* is the world real rate of interest, i = r* + p Ip or - (B*F-È*) = -X + - (r*+A) P P \ p J

(B^-E*).

(15')

If the world real rate of interest is independent of the inflation rate and if purchasing power parity prevails, the current account deficit of 12Simplifying assumptions about the public sector accounts made earlier in this section are maintained.

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317

the country facing the higher rate of world inflation (p*/p*)1 will exceed that of the country facing the lower rate of world inflation (p*/p*)2 by an amount [(p*/p*)1 - (p*/p*)2]e[(B*F - E*)/p] that is equal to the difference in external debt-service payments. This difference in current account balances should, however, have no real consequences, since the higher debt-service item above the line is matched below the line by the larger reduction in the real value of its external liabilities; higher world inflation means faster amortization of external indebtedness. Thus (d/dt)[(e/p)(B*F - E*)],or the change in net real external liabilities, is the same in the two economies. The country facing the larger current account deficit because of higher world inflation should be able to borrow to finance its higher external interest payments (see Sachs (1981)). What has occurred in recent years is an increase in world real interest rates (r*). This increase does require adjustment rather than, or in addition to, mere financing, with the relative weights on adjustment versus financing depending on the extent to which the increase in world real interest rates is perceived as permanent rather than transitory. Also, to the extent that countries have borrowed on a long-term rather than a short-term basis (or at variable interest rates), unanticipated changes in interest rates will result in once-and-for-all real capital gains or losses on external debt. Finally, significant departures from purchasing power parity have been the rule, especially since the breakdown of the Bretton Woods system of par values. Thus, even with a given world real interest rate (r*), a country's real external indebtedness will increase whenever (p*/p*) - (p/p—e/e)—the excess of the world rate of inflation over the domestic rate of inflation minus the percentage depreciation of the exchange rate—increases. Many other kinds of open economy can be analyzed, starting from the general framework of equations (6), (7), and (9'), but the general principles should be clear from the simple example that was just analyzed.

Budgetary Policy and Monetary Growth: Eventual Monetization of Deficits If bond financing of deficits causes concern about the crowding out of private capital formation and, in the open economy, about possible adverse consequences for external indebtedness, monetization of deficits is a source of concern because of its inflationary implications. It has been seen that it was necessary to correct the conventionally measured budget deficit for the effects of inflation and exchange rate

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

appreciation on the real value of outstanding stocks of public sector financial assets and liabilities in order to assess changes in the extent to which the public sector competes with the private and overseas sectors for investible resources. Similar adjustments are required to understand the monetary implications of the deficit, as is shown in this section. The Closed Economy From the simplified government budget constraint in equation (10), the following expression is derived for the proportional rate of growth of the nominal money stock:13 H

T r rG

H = v[

c

+ G7 + 8 K G - f

Y

I

M

b\BH ÈH r + r +r

^

T-

G

GK

T

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(16) ~pY~ Y\ ---------------py Y is the income velocity of the circulation of money. To V = pY/H

evaluate the implications of the fiscal stance for monetary growth, it is necessary to specify paths both for public spending and taxation and for nonmoney financing. A particularly useful benchmark for financing policy is one that keeps constant the real values of all government assets and liabilities (other than money) per unit of output. This policy would be one of constant crowding-out pressure per unit of output. These constant liability-output (or asset-output) ratios need not be the historically inherited ones. The exercise can be applied to evaluating the longer-run implications for monetary growth after the debt-output ratios have acquired some desired long-run (or even steady-state) values. Given this rule, GI BH KG " BH " 7

and BH p B* = ^-p. 13

The money stock throughout this chapter is the high-powered money stock. Addition of a private banking sector will, in general, be required for practical applications but does not significantly alter the conceptual framework outlined here.

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Equation (16) then becomes H Gc -- r ( BH BH KG) --- = V --- ---- + ---- - --- (r-y) H Y pY Y Y

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+ [r - (r°-8)]^j.

(17)

Defining the longer-run fiscal stance by given constant values of BH/pY, ÉH/Y, and K°/Y and by given, but not necessarily constant, paths of Gc/Y and f/F, it can be seen from equation (17) that longer-run monetary growth is governed by a deficit concept that differs from the conventionally measured deficit in a number of ways. First, the reduction in the real value of the stock of nominal government bonds owing to inflation is subtracted from the conventional measure. Second, in a growing economy the real stocks of government assets and liabilities can increase at the natural rate 7 while leaving the asset-output or debt-output ratios constant. The net debt-service term in equation (17), therefore, involves the real growth-adjusted interest rate ( r - 7 ) . Under inflationary conditions, this rate can be significantly less than i = r + pip—the nominal interest rate. To infer the long-term implications for monetary growth (and thus for inflation) of the fiscal stance, a correction for inflation is applied only to the interest-bearing component of the government's nominal liabilities. The conventionally measured deficit should not also be reduced by the erosion of the real value of the nominal stock of high-powered money balances, {plp)(Hlp), because constancy of the real value of all (monetary and nonmonetary) government debt per unit of output is consistent with any deficit and any rate of inflation. Large conventionally measured deficits (even if cyclically adjusted) that correspond to small inflation-corrected deficits (or even surpluses)14 reflect current high inflation. They do not indicate the inevitability of high crowding-out pressure or high rates of monetary growth in the future. Even without correction for real growth, an inflationcorrected or "trend" surplus means that with zero money financing there would be (aggregate) crowding in, and that with a bond-financing policy of zero (aggregate) crowding in there would be negative monetary base growth. 14 That is, deficits corrected for the reduction that is due to inflation in the real value of the stock of nominal government bonds.

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MEASUREMENT OF THE PUBLIC SECTOR DEFICIT

Equation (17) alone does not lead to conclusions about the effects of, say, changes in fiscal stance on monetary growth. It is necessary to use positive economic models to incorporate the effect of any parameter changes on endogenous variables, such as velocity (V), real rates of interest (r and r G ), and even the natural rate of growth (7). Such an analysis is simplest in classical monetarist models, such as that of Sargent and Wallace (1981), in which velocity, the real interest rate, and the natural rate of growth are constants, but equation (17) can be incorporated in models of any type (see also Buiter (1982a and 1982b)).

The Open Economy From the budget constraint of the simplified open economy, the expression for the percentage growth rate of the nominal money stock given in equation (18) can be obtained as follows: H

„\GC + 8KG-T

(

p\(BH + BF\

(BH+BF\

H =v [ Y—+ r + p j [-jri+ i-r-) • gc^-rj-r.f.e-l^ Copyright © 1991. International Monetary Fund. All rights reserved.

(ËH+ËF\

e(È'H+B-F-Ê"\]

(18)

To evaluate the longer-run monetary implications of the fiscal stance, it is again assumed that all stock-flow ratios on the right-hand side of equation (18) are kept constant. Equation (18) then reduces to

H

,jGc-t

7/ = V\-T-

,

+ (r 7)

, (B"+BF

, ÉH+BF K°\

~ [-W+ -^Γ- - Y)

•HÉ-a-']№*)• + [r-

(r°-8)]^|.

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(19)

WILLEM H. BUITER

321

With purchasing power parity, this simplifies to F

H-V[Gr > 0

(30')

f = er

1 > e > 0.

(30")

Substituting equations (30') and (30") in equation (29) yields

[ BH---- ] [-------- ] [ pY ]

d ----

= gc -

BH

H

pY

pY

0Y+ (r-8) ---- -- ---- .

(31)

dt Y rate of growth of the money stock, assuming Similarly, the proportional that the authorities keep constant the stock of real bonds per capita or per unit of trend output, is given by

Ï-"H- e+