Lecture outline Healthy finances vs. functional finances Impact of deficit on inflation Reasons for financing government expenditures through public debt Healthy finances vs. healthy economy

Rules of healthy finances 1 st rule - budget should be balanced 2 nd rule - retain surpluses of budget to cover against rapid increases in debt 3 rd rule – short run fluctuations in expenditures should be covered through debt, long term expenditures- through taxes 4 th rule – income sources should be grouped according to types of expenditures- current and capital

Rules of healthy finances Some economists suggest that the short term extraordinary expenses of the government (e.g. natural disasters) should be covered through government debt (3 rd rule) However, although short term, consumer expenditures should not covered through debt since current benefit from debt is received only by current generation while its burden is spread across future generations Replacing entire debt financing with taxes is also not good idea because in this case the government will have less investment projects

Rules of healthy finances Every public debt should have amortization schedule. For example, the government may built a new road and finance it through debt. It will start paying principal of the debt after people start to use this road. In other words, bonds are paid back after investment brings profit to the society and government In this way, capital expenditures are finance through debt, not taxes. In other words, expectation of future payoffs justifies the transfer of expenditures to the future (4 th rule)

Rules of healthy finances Classical school suggests that at times of economic crisis it is better to print money to cover deficit. The cost of printing money is insignificant and therefore the government use seigniorage to finance its expenditures Advantage of seigniorage is that it does not create fiscal burden, but it leads to high rate of inflation Even so, the proponents of seigniorage claim that this inflation can be addressed by the issue of government bonds and selling them to non banking sector. This would decrease liquidity on the market and decrease inflation rate. Interestingly, the cash collected will not go budget, but to Central Bank. Obviously, costs of anti inflationary debt issue are born by future generations.

Functional finances Alternative school (e.g. Keynesians) was skeptical about permanent budget deficit They proposed the following principles of “functional finances” 1. Taxes should be collected and used in order to maintain growth of production at full employment and zero inflation ( not for extra income) 2. Debt should be attracted and paid only to change the ratio of cash to bonds in hands of population (not for paying debt or attracting extra funds) 3. Issue and withdraw money to link previous two principles

Functional finances First principle eliminates the possibility of inflation Second principle avoids crowding out effect A. Lerner (“The Burden of the National Debt.” In Income, Employment, and Public Policy, New York, W.W.Norton and Company, 1948) claimed that deficit and debt may increase with any current and future losses to economy. He argued that following the principles of functional finances automatically leads to balanced budget in the long run. Budget expenditures and revenues should enable creating GDP at full employment at given price level. In this context, debt or money emission is not good or bad things, it is just the instrument of achieving full employment and stable price level.

Healthy finances vs. functional finances Health finances differ from functional finances regarding only one objective: balanced budget Healthy finances method focus on balanced budget as target, while in the functional finances, balanced budget is seen as an instrument of achieving targets. It would be odd to have balanced budget when economy is experiencing deep recession While the government can print money to finance its budget deficit, it uses taxes to affect behavior businesses and it uses debt to manage banking reserves and interest rate

Impact of deficit on inflation In their research, Luis Catao and Marco Terrones (“Fiscal Deficit and Inflation: A New Look at the Emerging Market Evidence,” IMF Working Paper, May 2001) found that:  In the long run, deficit proportionally affects inflation  Only global inflation and high oil prices may affect inflation independent of deficit

Impact of deficit on inflation

It follows that to keep nominal debt increasing while price level is fixed, the government should increase present value of future budget surpluses Similarly, given the constant present value of future real surplus the growth of debt should be accompanied by increasing level of prices in order for the government to maintain its fiscal sustainability.

Reasons for financing government expenditures through public debt According to what we have covered above, in the long run the impact of debt on economy is not positive- it is either negative or neutral (Ricardian equivalence) Nevertheless, in practice, ministry of finance practitioners prefer to use public debt in order to cover budget deficit The followings are ways to cover budget deficit:  Cut expenditures  Collect more taxes  Keep taxes and expenditures constant and seek resources elsewhere

Fiscal conservatism In theory, taxes should be:  Fair (proportional to income)  Predetermined, not discretionary  Convenient to pay  Cost efficient (in collection) In theory, the government should limit its intervention to taxes which math the above criteria In practice, however, the government not only taxes economy, but also attracts debt, prints money and possess large amount of assets.

Fiscal conservatism Economists consider taxes to be the primary source of income followed by debt and money emission. Emission of money can happen through two ways- direct loan to the government by the Central bank or hidden emission through purchasing government bonds on the primary market Money emission is considered as the last instrument when nothing else works.

Fiscal conservatism Other ways of covering budget deficit:  Budget loans attracted from different levels of budgets of budget system  Revenues received after selling the government properties  Using government reserves surpluses  Foreign debt provided by private and public organizations abroad Nevertheless, public debt and money emission are the most popular ways to cover the deficit

Healthy finances in practice Between the Great Britain had budget surplus almost every year (Ritschl, Albrecht, “Sustainability of High Public Debt: What the Historical Record Shows”, 1996). This meant that it followed 1 st rule of healthy finances. So did the US during this period. On the contrary, Germany did not follow rules of healthy finances and managed to decrease its public debt to GDP ratios through defaulting on debts due. Only in 2011 Germany could achieve balanced budget.

Health finances vs. healthy economy Healthy finances and healthy economy are not the same thing. This is seen clearly at time of economic recession. 1 st rule of health finances (balanced budget) worsens economic recession Also, 1 st rule of health finances significantly limits the ability of the government to invest and hence help future generations to enjoy payoffs of investment. As a result, the government loses interest in long term investment initiatives. This is especially true when deficit is decreased.

Health finances vs. healthy economy Above discussion regarding 1 st rule of healthy finances is relevant to the 2 nd rule too (budget surplus to pay debts). Classical school of economists saw 2 nd rule of healthy finances as the only way to pay back debt. They argued that surplus should be large enough to cover all current liabilities of the government. For this reason, in early 1800s the governments of the UK and the US launched retained funds aimed at meeting debt obligations in the future. However, ironically these funds were then used to attract new debts for political reasons. Nowadays some countries still use retained funds: Canadian extraordinary fund, Italian retained fund, Norway oil fund and Russian Stabilization fund

Health finances vs. healthy economy The government should transfer to the retained fund the predetermined by law funds However, the government should incur significant costs associated with maintenance of these funds Also there is a big temptation for policy makers to use the fund to finance social projects. The existence of the fund makes it necessary to generate significant surpluses and collect more taxes

Excessive tax burden 3 rd rule of healthy finances allows the government to attract funds on voluntary basis because unlike paying taxes, buying bonds is voluntary action. 3 rd rule of healthy finances is especially important at times of recession or wars. During this period, increasing taxes is not welcomed by the electorate. So the government uses bonds instead and transferring fiscal burden to future generations. For example, after 2001 terrorist attacks, the US government issues so called Patriot Bonds. However, debt financed budget deficit may turn to significant tax burden to future generations. Some economists suggest to smooth this burden by spreading evenly tax rates over generations. This would eliminate necessity of changing tax rates chaotically.

Debt vs. tax There may be need to change taxes significantly in the short run due to following reasons:  Automatic stabilizers  Changes in economic environment  Short term unpredictable shocks Economists suggest to cover deficit caused by these short term fluctuations through debt because increasing taxes temporarily harms economy due to dead weight loss and “rule of square” However, if shocks are not temporary, the government cannot attract debt and will have to increase tax rates

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