2. Lecture outline Golden rule of public finance Case of the Great Britain Single budgeting vs. double budgeting Seignorage Refinancing

3. Golden rule of public finance There are two main classical argument in favor of debt:  Debt burden is transferred to future generations  Taxes are paid by those who benefit from These two points suggest that future generations finance current budget expenditures to the extent that these expenditures are useful for them. Out of budget expenditures only capital expenditures provide benefit for the future generations

4. Golden rule of public finance There are two main classical argument in favor of debt:  Debt burden is transferred to future generations  Taxes are paid by those who benefit from These two points suggest that future generations finance current budget expenditures to the extent that these expenditures are useful for them. Out of budget expenditures only capital expenditures provide benefit for the future generations. Therefore, according to Musgrave capital expenditures should be financed through public debt(Musgrave, Richard. The Theory of Public Finance. A Study in Public Economy, McGrow Hill Book Company, 1959)

5. Golden rule of public finance According to Musgrave:  It is unfair that the current generation finances the construction of railway which will by exploited by the future generation  Although future generation cannot pay now, it is possible to borrow from them. Debt can be used to allocate burden of capital investments across generations. Current loans mean future taxes and therefore involve future generation into financing of current investments.  Net value of the government does not change.

6. Golden rule of public finance Golden rule of the government finances – to borrow in order to invest Its central message is to finance current expenditures by taxes and capital expenditures by debt However, for the Golden rule to work the government should have its budget with a little surplus. In this case debt will go to finance investments and budget deficit does not exist.

7. The case of the Great Britain Great Britain practices double budgeting – current and capital expenditures In the late 90s the government of the Great Britain admitted that it could not follow the Golden Rule of public finance. In particular, the current expenditures exceeded current revenues by 1 percent of GDP, which meant unfair burden transferred to future generations This was also true from the point of investments which were below international level even after privatization process.

8. The case of the Great Britain Since 1997 the government follows these guidelines in its capital expenditures:  Golden rule is followed in context of business cycle. For example, if at the certain phase of business cycle there is need to cut expenditures, they will be cut from current expenditures  Creation of Fund of Britain helps to double the share of government investments in GDP from 0.5 % to 1 %. It also helps at time of recession  Budgeting and accounting maintain the golden rule of public finance. This creates the incentives for using the assets effectively

9. Double budget of the Great Britain in 2006-2007 (bln. pounds) Current budget Current revenues520 Current expenditures502 Amortization17 Net1 Capital budget Investments50 Minus revenue from selling actives-4 Minus amortization-17 Equals: net investment29 Net borrowing29 Net public debt at the end of the year489

10. The case of the Great Britain In the medium term the government aims at maintaining healthy public finance and fair distribution of tax burden over generations In the short run, the government will focus on the monetary policy and let automatic stabilizers to smooth business cycle fluctuations To achieve this, the government should follow Golden rule of public finance-to borrow in order to invest, not to cover current expenditures and rule of sustainable investments- ratio of net debt to GDP does not exceed 40% over one business cycle

11. Single budgeting vs. double budgeting Single budgeting is a simple method of controlling operations of the government bodies However, the focus on current financial flows may lead to reduced real price of government expenditures. The pay offs of investment projects are underestimated. It allows frauds in fiscal management. It seems that double budgeting helps to avoid all these issues, but the governments do not hurry to adopt it.

12. Single budgeting vs. double budgeting Problems of implementing double budgeting:  It is difficult to separate current expenditures from capital expenditures  Net wealth of the government (actives minus passives) cannot serve as a measure of society’s efficiency  Double budgeting does not allow to implement performance based budgeting  Budget process becomes complicated

13. Debt vs. printing money Printing money is done by the Central Bank. It issues money to finance the government budget deficit-this is called “seignorage” However, to limit irresponsible seignorage practices, normally central bank is not allowed to finance deficit directly or even through buying bonds from the government. Instead it buys government bonds from commercial banks, which buys them from primary market. As a result, money supply increases and puts pressure on the inflation rate. Seignorage allows the government to cover deficit without redistributing money from private sector to the government sector.

14. Seignorage in Canada On the balance sheet account of the Bank of Canada, the issued banknotes are shown as liability and they are balanced by government bonds on the assets side. Seignorage is difference between interest payment on bonds and cost of issuing banknotes. For example, what is seignorage from issuing 20 dollar banknote? If corresponding bond pays 5 percent per annum and costs of issuing 20 dollar banknote is 4 cents, then seignorage= 20*0.05-0.04= 0.96 per 20 dollar banknote. In recent years Bank of Canada issued 35 billion dollars and purchased government bonds. These bonds paid 2,2 billion dollars per annum. Bank spent 130 million to issue banknotes and other operational expenses.

15. Side effect of seignorage If the government used seignorage to finance its budget deficit, then the tax burden and debt related issues will not exist. Indeed, printing money at low cost and selling them to commercial banks at face value would be easier and faster than collecting taxes and attracting debt. However, according to quantity theory of money, in the long run, increasing money supply by 1 percent causes inflation rate to increase by 1 percentage points. where, M-money supply, V- velocity of circulation, P- price level, Y-income

16. Side effect of seignorage If printing money causes inflation, then it can considered as indirect tax on money holders. This is cheaper than taxing economy directly. Inflation decreases wealth of money holders. It also decreases wealth of bond holders. Therefore, inflation decreases nominal debt of the government by cutting purchasing power of borrowed funds. For example, assume that the investor buys 3 year bond of the government bond in 1977. The bond pays 7 percent annually and real interest rate equals 3 percent. Therefore, the investor’s expectation of the rate of inflation is 4 percent. Otherwise, he would not buy the bond. But in 1977-1980 inflation rate was 8 percent. As a result, the investor lost 8-7 = 1 percent. So, this is gain for taxpayers and the government.

17. Complete financial market Complete financial market- the market which provides risk-free assets (e.g. government bonds) If the market is incomplete, then the government depends on only central bank credits or international debt. Complete financial market allows to place government bonds easily and with less costs. Central Bank also needs complete financial market. Using government bonds CB controls reserves of banking system and changes money supply. Government bonds are risk free assets and are used in REPO operations of commercial banks.

18. Refinancing Difference between private and public debt is that individuals try to return the debt in their lifetime. However, in the case of the government, lifetime is not limited. This allows the government to attract new debt to cover the old one. This is called refinancing. Refinancing was favorite tool of policymakers since 1930s. However, by 1980s things turned to be worse than seemed. The growth of debt exceeded GDP growth. Nowadays in many countries it is impossible to achieve balanced budget. Consequently, the modern view on debt is not to balance the government budget, but to keep deficit and debt within the limits defined by the tax potential of the government.

19. Refinancing Primary deficit- excess of non-interest expenditures over non-interest revenues. Total deficit- excess of all expenditures over all revenues The main debt does not include interest payments, but the total debt does: Main debt= ∑ Primary deficit + initial main debt Total debt= ∑ Total deficit+ initial total debt

20. Refinancing Borrowed or attracted funds are spent to pay for three types of expenditures: to pay debt due, to pay interest and to cover budget deficit. Paying debt due is refinancing main debt. Paying debt due and interest is refinancing total debt Refinancing main debt does not depend on budget outcome and does not count towards nominal debt that will be accumulated by the start of the next year.

21. Refinancing Does it means that refinancing can delay the payment of debt forever? No. Eventually the government will have to increase taxes. One instance when the government has to increase taxes is when GDP growth rate is less that interest rate on debt already attracted. For example, assume that GDP growth is 2 percent and consequently savings increase up to 2 percent. Interest on bond is 5 percent, which means at debt to GDP ratio close to one, further refinancing will be impossible.

22. Thank you for your attention!