What effect do fiscal stabilization, public sector adjustment, and the design of policies have on macroeconomic balance and growth? The World Bank's Policy and Research Department staff and consultants studied fiscal accounts and macroeconomic indicators over 25 years and across many developing countries, with in-depth studies of 10 cases. The answers here confirm some established notions and contradict others.
The size of the government deficit---averaged over a period of, say, three years---is the most reliable indicator of overall macroeconomic stability. High deficits show up in at least one type of macroeconomic imbalance---inflation, a shortage of foreign exchange, the crowding out of the private sector, or a foreign debt crisis. The type of imbalance depends on the means of financing: respectively, printing money, running down foreign exchange reserves, domestic borrowing, or foreign borrowing.
Inflation and deficits show no simple correlation. But there is a long-run association between inflation and one means of deficit financing---money creation (figure 1). The relationship follows the typical "Laffer curve," where the average revenue to the government from money creation (as a share of GDP) first rises and then falls. This revenue (called "seignorage") is the change in money base divided by GDP. It includes the rising demand for money to keep up with the growth of the economy---even if there were no inflation---and the "inflation tax" on holdings of money.
Such revenue is highest for annual inflation rates between 70 and 160 percent. Above 160 percent, people run away from money (into inflation-protected assets) at a speed faster than the increase in inflation, so that inflation revenues, and seignorage, start to decline. Moreover, the higher the level of inflation, the more monetary financing exacerbates inflation. During 1965-89 an additional percentage point of GDP of monetary financing would have induced only five additional percentage points of inflation in Thailand (which had 5.7 percent annual average inflation) but 97 additional percentage points of inflation in Argentina (which was suffering from an average 115 percent annual inflation).
Though money creation and the resulting inflation are often tied to the government's financing requirements, the proceeds from the inflation tax are modest as a medium-term source of revenue. But governments desperately lacking other revenue sources and with short planning horizons often start bursts of accelerated money printing and inflation that yield abnormally high inflation tax revenue for a brief period. This revenue falls as soon as people reduce their money holdings in response to higher inflation. Over nearly 20 years across 51 countries, three-quarters of the annual observations of inflation tax revenue are less than 2 percent of GDP. In many countries, excise tax revenues on a single product (liquor, cigarettes, and gasoline) account for as much revenue as the inflation tax does!
Implications. The benefits of not printing money are large---reducing the macroeconomic uncertainty and relative price variability that characterize inflation experiences. The fiscal cost---giving up the inflation tax---is minor.
If financial markets are not repressed, higher deficits financed by domestic debt raise domestic real interest rates when external financing is not available. When domestic financial markets are integrated with world capital markets---as in Latin America before 1982 and again now---higher domestic public borrowing leads to external capital inflows and higher foreign debt, without affecting domestic real interest rates much.
The story is different when the government represses financial markets through domestic interest rate controls, compulsory public debt placements, and controls on external capital flows. If the nominal interest rate is fixed, for example, fiscal deficits will drive up inflation, leading to repressed (even negative) real interest rates. Such financial repression has been an all-too-common means of "financing" fiscal deficits. Egypt, Ghana, and Zimbabwe now maintain nominal interest rate controls that result in negative real rates.
Controlling interest rates is a costly way of mobilizing a small amount of "revenue," typically a mere 1 to 3 percent of GDP. The cost is reduced financial intermediation---a reduction in the rate at which savings are channeled through formal financial institutions to investors. Credit simply dries up for the private borrower. The evidence is the low ratio of private credit to GDP in financially repressed economies---about a third of that in unrepressed economies. The quality of private investment suffers as well---with credit rationed, governments typically end up choosing who gets credit and choosing less well than the market would.
Increased public saving can reduce real interest rates, but there is no evidence for the popular notion that lower real interest rates reduce the flow of private saving. Private saving (or consumption) simply does not respond much to changes in interest rates.
So, fiscal stabilization---if it reduces the real interest rate---will not depress private saving through this channel. Financial liberalization---allowing real interest rates to rise---will not raise private saving. But there is an important benefit from financial liberalization. Higher real interest rates induce a strong portfolio shift: people take resources invested abroad, held under the mattress, or held as consumer durables and deposit them in the domestic financial system at now-attractive interest rates.
A separate issue is how public saving directly affects private saving. There is no evidence for the bold hypothesis (known as "Ricardian equivalence" in economists' jargon) that private savers offset one to one the changes in public saving because they take into account changes in their future tax liability.
Likely reasons for the failure of the Ricardian hypothesis are constraints on borrowing, uncertainty about future incomes, and the lack of forward-looking behavior by private savers. The empirical evidence shows that when fiscal stabilization boosts public saving, the private sector reduces its saving by only a fraction of the increase.
Implications. Fiscal adjustment will not be offset by lower private saving. So, raising public saving will increase national saving and the resources for domestic investment. Financial liberalization will not, technically speaking, raise private saving. But it will bring more resources into the domestic financial system.
The conventional wisdom about deficits crowding out private investment is strongly reaffirmed. The paucity of private credit in high-deficit, financially repressed economies has even worse effects than the increase in interest rates in high-deficit, unrepressed economies, because the quality of investment suffers in the first group of countries. In both, deficits drive out private investment, as empirically confirmed in countries as diverse as Argentina, Côte d'Ivoire, and Thailand.
Other conventional wisdom---that deficits due to high public investment are less harmful---does not fare as well in the empirical work. In some countries, the effect of public on private investment is positive (Morocco, Pakistan, Thailand, and Zimbabwe), but in others it is negative (Chile, Colombia, Ghana, and Mexico). What probably matters most is the type of public investment. If public capital complements private capital (a public road or hospital)---that is, if it raises the profitability of private projects---increases in private capital formation are likely. But if public capital substitutes for private capital (a public steel mill or a textile company), private investment is likely to fall.
Fiscal deficits lead to current account deficits and resulting appreciations of the real exchange rate. This hurts exports and, by making imports cheaper, tempts governments to protect domestic producers through tariffs and quantitative restrictions. Conversely, fiscal stabilization and external adjustment go together. The causal relation between fiscal balances, external balances, and the real exchange rate is close for the 10 case studies of the research project (figure 2). The remarkable robustness of these relationships is the strongest evidence yet in the literature for the "fiscal approach to the balance of payments" (Rodriguez, forthcoming)---the idea that external deficits are due primarily to fiscal deficits.
Implications. The strong relation between public and external deficits complements the policy implication of deficits for private saving. Because fiscal adjustment raises national saving (as private consumers do not offset one to one the decrease in public consumption), a lower deficit increases the trade surplus as government consumption declines (and as long as domestic investment remains unchanged).
A second implication comes from the finding that the real exchange rate is driven by fiscal deficits. Devaluing the nominal exchange rate without correcting fiscal disequilibria contributes only to inflation, not to real exchange rate devaluations and external adjustment. And using the exchange rate as a nominal anchor without imposing fiscal discipline is a sure road to unsustainable current account deficits and external crises, as Argentina showed during the 1970s and 1980s.
There is a strong correlation between high deficits and low growth (box 1). Public deficits hurt private investment and growth through various channels. Inflation raises uncertainty and distorts relative prices, hurting investment and resource allocation. Deficits tempt governments into financial repression, which reduces financial intermediation and thus the amount of credit available to the private sector. Domestic debt finance raises real interest rates. Developing countries, such as Brazil, that shifted from external to internal financing of deficits---often because of external debt crises induced by previous fiscal mismanagement---had particularly poor growth in the 1980s.
And growth makes deficits less harmful. Countries like Pakistan and Thailand could sustain larger deficits because of high growth, while economic collapse worsened the negative effects of deficits in Argentina and Côte d'Ivoire. The reason: higher growth enables a government to borrow more without changing the ratio of debt to GDP. Higher growth also raises the confidence of lenders and makes the risk premiums on government debt lower. For example, under certain assumptions---a total public debt ratio of 30 percent of GDP, a ratio of money base to GDP of 10 percent, and an inflation rate of 5 percent---a growth rate of 5 percent implies a sustainable deficit of 4 percent of GDP. But if the growth rate is only 1 percent, the sustainable deficit would be just 2.4 percent. (If the public debt ratio and the inflation rate were higher---say, 60 percent of GDP and 20 percent, respectively, as in many developing countries---the sustainable deficit measure would rise significantly.) This ballooning deficit is mostly driven by the inflation component of the interest payments on public debt, which compensate holders of public debt for the capital loss imposed by inflation on the outstanding debt. To exclude the inflation compensation, a more relevant measure is often used in high-debt, high-inflation countries. This is the operational deficit, which subtracts the inflation component of interest payments from the conventional or nominal deficit.
Implication. The effect of good fiscal management on growth is a strong argument for a policy of low and stable public deficits. The virtuous cycle---where growth makes fiscal management easier---makes the argument even stronger.
The public sector's solvency is a necessary---and sometimes sufficient---condition for domestic and external stability. One way of assessing public solvency is to compare actual deficits with "sustainable" public sector balances, defined as those consistent with stable public debt to output ratios, low inflation, and nonrepressed financial markets.
Estimations for many countries (and the simple calculations made here) suggest that sustainable public deficits are in the range of between 2 percent and 6 percent of GDP---a range determined by country seignorage revenue, public debt stocks, real interest rates, and the rate of GDP growth. But successful performers show public sector balances that fluctuate between a surplus of 2 percent and a deficit of 2 percent, exceeding significantly the levels required for keeping public debt ratios constant. The experience of these and other countries has been that balanced public budgets contribute to national saving, minimize the crowding out of the private sector, and maximize credibility in public sector reform.
So, successful fiscal adjustment has proceeded in two stages. In the first stage, deficits are reduced to levels consistent with stable debt-output ratios---typically not beyond 2 percent of GDP---and normalized financial and monetary markets, as, for example, in Morocco. A second phase of deeper fiscal adjustment supporting a strong private sector response---as in Chile or Mexico---involves reaching public surpluses or only slight deficits.
Changes in external and domestic macroeconomic environments, such as lower terms of trade or low growth due to a drought, often affect public sector budgets, leading to the popular notion that fiscal policymakers face a constant uphill battle. But empirical analysis shows that shocks explain only a minor part of the medium-term (three- to five-year) variation and structural changes in public sector deficits. The major factor explaining changes is fiscal policy. For instance, 92 percent of the fiscal improvement in Ghana from the mid-1970s to 1990 was attributable to active fiscal policies, and fiscal policy during the 1980s in Zimbabwe more than offset the effects of shocks in explaining changes in the deficit.
Implication. Over the medium term, policymakers are to be blamed for fiscal crises and praised for fiscal improvements---luck is only a minor determinant of fiscal stance.
The answer is straightforward. Where the tax burden is relatively low, taxes should be raised through tax reform and the control of evasion. Where current expenditure is wasteful or capital spending finances low-return projects, spending should be cut. In successful adjusting countries, the following policies have helped:
William Easterly and Klaus Schmidt-Hebbel