Fiscal deficits are conventionally defined as the difference between budgetary expenditure and revenue. They are often expressed as a ratio of gross national product so as to allow intertemporal or intercountry comparisons. Although such a measure may appear objective, it is in fact subject to many important and complex issues, issues that can affect views about the stance of fiscal policy.
Concepts and definitions
• Scope. To reflect adequately a country’s fiscal policy, how broad should the measure of the fiscal deficit be? Almost all countries have fiscal activities that fall outside the scope of the central government budget, including extra-budgetary central government activities (such as lending operations), or those of public bodies (such as local government operations and pension funds). The size and net balance of these activities differs from country to country: for instance, in recent years the state and local government sector in the United States has had substantial surpluses in contrast to the large deficits of the central government.
Another issue is the fiscal stance of a country, including extra-budgetary expenditures. For instance, in two countries providing electricity on equally unprofitable terms, one through a public utility and the other privately, the government’s fiscal policy may look relatively unfavorable in the first, even though the impact of financing the shortfall from credit markets will be the same in both countries. A third issue is that the conventional definition of a deficit, even when extended to cover the whole public sector, ignores (a) expected future commitments by the government, (b) government capital gains and losses during the budget year, and (c) the fact that some public expenditure results in the accumulation of valuable real assets such as buildings and roads, and the sale of these assets can provide government revenue. The net position of the public sector will be affected by the future value of the public sector’s commitments (or liabilities) and its receipts (or assets).
• Timing of operations. Should the fiscal deficit be calculated on a cash or accrual (that is due but not settled) basis? In the mid-1960s consensus among experts in the United States reflected the then prevalent Keynesian view of how fiscal policy affects the economy. The accrual concept was considered preferable for appraising the appropriateness of fiscal policy because, as additional orders were received by industry, and before any cash payments had actually been made, employment and incomes had already been affected. Similarly, before a tax payment was made, individuals and corporations had already taken into account their tax liabilities and reduced their spending. In today’s world, however, the cash concept is equally important, particularly for purposes of assessing the financial market implication of a budget deficit.
• Changes in activity. The fiscal deficit not only affects but is also affected by the level of economic activity. On both the revenue and the expenditure side of the budget there are dynamic elements, built into the system, that are beyond the control of policy makers. In particular, in the absence of countervailing measures, a deficit is likely to increase automatically in a recession and fall in a boom. Therefore, the uncritical comparison of fiscal deficits over different years for a given country, or over different countries for a given year, may lead to wrong conclusions. For example, one country may be experiencing a strong economic expansion while another may be in the middle of a recession; in such a case one could not conclude from similar fiscal deficits that the two countries are pursuing comparable fiscal policies. The same argument obviously applies when the fiscal policy of the same country is compared over two different periods.
• Effect of price changes. Comparisons over time for the same country or between countries for the same year can also be affected by different rates of inflation. The basic argument for adjusting the fiscal deficit for the effect of inflation is that inflation brings with it a higher nominal rate of interest and reduces the real value of the outstanding public debt. A nominal interest rate is made up of a “real” element (that would have prevailed in the absence of inflation) and an inflationary component (which, if equal to the rate of inflation, would compensate the lender for the erosion in the real value of his principal). Traditional accounting practice treats the whole of interest payment (real plus inflationary component) as a current cost rather than partly as a repayment of principal. The result is that expected inflation raises the interest component of the budget and the size of the deficit as traditionally measured.
Inflation-adjusted measures of the fiscal deficit attempt to correct for inflation either by estimating the net reduction in the real value of the public debt held by the public, or by assuming that all interest payments above some (more or less arbitrary) value of real interest rate represent amortization. Once the fiscal deficit has been corrected for inflation, its apparent size falls, the ranking of countries by the size of the deficit changes and, more important, fiscal policy appears less expansionary than one would have assumed from the traditional measure. There are, however, many more complex problems concerning correction of deficits for inflation which cannot be discussed here. (They are discussed in the longer article referred to in the box.)
A more extensive version of this article is published in Phillip Cagan (Ed.), Contemporary Economic Problems: The Economy in Deficit, American Enterprise Institute, Washington, DC, 1985.
• Temporary policies. Comparisons can also be affected by policy actions that reduce the deficit of a country for a particular year but that do not reduce the underlying, or core, deficit. In a particular year a country may (1) “privatize” some of its public corporations by selling them to the private sector, as is being done in the United Kingdom and other countries; (2) sell an unusually high number of exploration rights as was done in the United States around 1982, (3) declare a tax amnesty that induces taxpayers to pay, once and for all, unpaid tax liabilities as was done in Italy, (4) sell zero-coupon bonds or bonds at a discount and not impute an interest charge as is being proposed in several countries, (5) postpone inevitable wage increases for public employees to the beginning of the following fiscal year, or (6) impose a temporary surtax, as was done in the United States in the late 1960s and as it has been done in France several times. All these measures have the effect of reducing the current year’s fiscal deficit without reducing the country’s longer run, or core, deficit (except for the decrease in future interest payments associated with the lower public debt resulting from the reduced deficit for the current year).
The issues discussed in this section indicate that all the measures of fiscal deficit leave something to be desired. However, when the rate of inflation is relatively low as in industrial countries, the conventional measure (Table 1), in spite of its obvious shortcomings, is still preferable for an assessment of the effect of fiscal deficits on financial markets. This measure is used in the section that follows.
Deficits and the credit market
One who believes that a relationship exists between the fiscal deficit of a country and that country’s real rate of interest might be tempted to use available data and estimates to test such a relationship for each country. A country-by-country approach, however, is unlikely to capture fully the relationship between the fiscal situation and the behavior of real interest rates for one particular and important reason: countries are all part of a credit market that is becoming progressively more international in character. Therefore, there are valid reasons to adopt an aggregative approach to fiscal developments in industrial countries.
(Percentage of GNP)
|Total major seven3||0.1||0.6||4.3||1.7||4.0||4.1||3.4|
|Total smaller countries||1.4||1.2||0.9||2.5||4.9||5.4||4.9|
|Total of above countries3||0.1||0.4||3.9||1.8||4.1||4.3||3.6|
General government deficit on a national accounting (i.e. accrual) basis.
Aggregated by relative size of GNP using 1982 weights and exchange rates.
General government deficit on a national accounting (i.e. accrual) basis.
Aggregated by relative size of GNP using 1982 weights and exchange rates.
In recent years, long-term real interest rates have risen not only in countries, such as the United States, where the size of the fiscal deficit has been increasing but also in countries, such as Germany and the United Kingdom, where the size of the fiscal deficit has been falling. One could, of course, argue that these synchronous increases in real interest rates were caused by common external factors, such as the increase in the price of oil, or policies of monetary restraint that affected all industrial countries. But it could also be maintained that the general increase in real interest rates was due to the growth in aggregated deficits as a proportion of aggregated savings. The latter approach would give substance to a criticism of US fiscal policy frequently advanced in Europe, namely that, given the size of the US economy, regardless of any fiscal action the European countries take, they would face high real interest rates as long as the fiscal deficit in the United States remained high. Putting it differently, as long as the US deficit were large and growing, it would take a very sizable reduction in the deficits of the other countries to make a dent in the aggregate deficit.
In some markets, such as the labor and the housing market, prices are likely to be determined by national or even regional supply and demand. Houses and, to a lesser extent, workers do not cross national frontiers, and their prices are only marginally affected, at least in the short run, by factors beyond the national border. Other prices, however, are set in markets that are broader. For example, the price of oil or gold is not determined by national demand and supply. The same is true for many other commodities that are internationally traded and that, apart from distortions created by import duties, subsidies, etc., respond to the law of one price. The price of gold is basically the same in New York, Hong Kong, Zurich, or London.
An international market
The market for money—the credit market—is much closer in character to the gold or oil market than to the housing or labor market. Helped by the recent technological revolution in the information and communication fields, financial managers are now able to follow closely and simultaneously developments in the money markets of different countries. This revolution had made it possible for these managers to have rapid access to much of the relevant information about domestic and foreign credit markets and to give instructions that, within minutes, can move enormous sums of money from one financial center to another. Some governments attempt to prevent these movements through regulations and capital controls, and these controls can temporarily insulate a national financial market from the rest of the world. Over the longer run (which may not be very long), however, these attempts generally fail unless government control is so extensive as to leave little scope for private initiative.
A strong argument can be made that the market for money is now an international market in which the price of money or credit—the interest rate—is determined by the intersection of truly international supply and demand curves. The annual flow of international lending (bank lending and bond issues) runs in the hundreds of billions of dollars. The size of the Eurocurrency market, 80 percent of which is in Eurodollars, in 1983 exceeded $2 trillion, that is more than ten times the level of US private savings.
The international character of the credit market has given birth to the theoretical concept of interest rate parity: namely that, adjusted for different rates of taxation and inflation, for different maturities and default risk, and for expected changes in the exchange rates, interest rates cannot diverge for too long across countries. When they do diverge, money moves out of the lower-than-equilibrium rate countries and into the higher-than-equilibrium rate countries. These capital movements continue as long as national interest rates diverge from the internationally determined equilibrium rate.
If the concept of interest rate parity is empirically valid (and if national credit markets are as integrated as described above), it has important implications for the effects of fiscal deficits on capital markets and, consequently, on interest rates. For example, fiscal pressures on interest rates within one country cannot be assessed by relating the demand for credit within that country to the supply of credit of that country. This may be so even when the country in question is as large as the United States. Thus, due caution is necessary in relating the US fiscal deficit to the supply of US savings, as has been done in many analyses that have sought to find a connection between the US fiscal deficit and the US real rate of interest.
The US demand for credit, whether originating in the public or the business sector, can be met by the US supply of credit as well as by the rest-of-the-world’s supply of credit. But, obviously, the US demand for credit must compete against the rest-of-the-world’s demand for credit. If the US demand for credit rises because of a higher fiscal deficit at a time when the rest-of-the-world’s falls, interest rates need not rise. Mutatis mutandis, given the US demand for credit, an increase in net investment or in fiscal deficits in Europe or Japan is likely to cause US, as well as foreign, interest rates to rise.
As the US credit market is the most efficient, largest, and least regulated, it may be argued that the US interest rate is the best indicator of the level of the international real rate. It is, in a broad sense, the best measure of the “opportunity cost” of investing money anywhere else. The differential between the US rate and that in other countries can be attributed to the various factors mentioned above.
The elements that make up the accompanying figure—in particular G, the combined fiscal deficits, and thus the governments’ demand for loanable funds—may be analyzed in greater detail. The general approach in this article would favor aggregating the fiscal deficits of all countries, and not only those of the industrial countries, in order to assess the total impact of governments’ credit demands. In a literal sense this would require the aggregation of more than a hundred countries. This is hardly feasible and not really necessary as by concentrating on the economies of the largest countries, one captures a sizable share of the total. For example, in 1983 the group of seven major industrial countries (United States, Japan, Germany, France, United Kingdom, Italy, and Canada, G-7 for short) accounted for at least 70 percent of the GNP of market economies. Moreover, the availability of data is far greater for this group than for other countries. For these reasons, the analysis below is limited to G-7 countries.
Real interest rate
The accompanying figure provides a graphic view of interest rate determination in an international setting for a given level of output. G represents the governments net demand for funds, assumed to be identical to the combined fiscal deficits of industrial countries. The slope of this curve suggests that a higher real interest rate (shown on the vertical axis) will result in higher interest payments and therefore is likely to be accompanied by a higher fiscal deficit (ceteris paribus). G + I, that is government demand plus investment, on the other hand, represents the total demand for credit; S represents the supply of credit (savings). The equilibrium real interest rate is shown by r, while D is the level of credit at which demand and supply are in equilibrium.
|Percent of G-7 GNP||Percent of G-7 gross private savings||Percent of G-7 net private savings|
|central gov. deficit (1)||general gov. deficit (2)||gross private savings (3)||net private savings (4)||central gov. deficit (5)||general gov. deficit (6)||central gov. deficit (7)||general gov. deficit (8)|
Fiscal deficit of G-7 countries
Table 2 provides basic data for the G-7 countries combined. The ratio of fiscal deficit to GNP was very low until 1975 when it grew sharply in the face of large increases in current public expenditure and a slowdown in economic activity. Between 1975 and 1979 the ratio of fiscal deficit to GNP fell considerably in the face of a slowdown in the relative growth of public expenditure and a sustained economic recovery that, in conjunction with high rates of inflation and progressive tax systems, raised the level of taxation. From the lower point reached in 1979 the combined deficit rose sharply, reaching very high levels by 1982-83. As a consequence, the demand for credit on the part of G-7 governments grew enormously.
Was this increase in fiscal deficits accompanied by increasing private sector savings? Columns (3) and (4) cast some light on this question and provide information on the S curve in the figure. Whether one considers gross private savings (Column (3) or net private savings (Column (4), the conclusion is that there was no evidence of a relation between fiscal deficits (or debt accumulation) and the savings behavior of the private sector. In fact, if anything, both net and gross private savings fell significantly in the 1979-83 period, that is the period when fiscal deficits were growing fastest.
Columns (5) to (8) also provide evidence of the degree to which, over the period, government borrowing was absorbing the supply of gross private savings. The relevant relationship is the one with net private savings because, although in theory depreciation allowances by enterprises could be used to buy government bonds, in practice, they are generally utilized by the enterprises themselves to replace depreciated investment or to make new investment. Columns (7) and (8) show that in the two most recent years a very large share of all net private savings was absorbed by the governments’ need to finance their fiscal deficits. Starting in 1979, the ratio of fiscal deficit to net private savings rose sharply, reaching very high levels in 1982 and 1983, and thus putting sharp pressure on capital markets.
While the G-7 governments were absorbing progressively larger shares of net private savings, what was happening to the other component of the total net demand for credit, namely investment? For the G-7 group, gross private domestic investment as a share of GNP fell from a level of 18–19 percent of GNP in the 1977–79 period to 17 percent in 1980–81 and to 15 percent in 1982–83. As a proportion of gross private savings, it fell from around 90 percent in 1976–79 to around 85 percent in 1980–81 and to around 75 percent in 1982–83. This trend is confirmed by data for funds raised by the private sector of the countries in the 1980–83 period. Thus, to some extent, the public sectors’ higher financing needs were offset by the private sectors’ lower needs.
This implicit accommodation of the private sector to the governments’ sharply higher financing demands did not prevent long-term real interest rates from rising sharply in 1981 and even more in 1982 and 1983, although in the absence of that accommodation they would probably have increased even more. For, the G-7 combined long-term real interest rates rose from around 1 percent in 1976–79 to 1.9 percent in 1980, 4.2 percent in 1981, 5.4 percent in 1982, and 6.0 percent in 1983. These increases continued into the first half of 1984 in the face of a rising demand for credit by the private sector within the United States as well as in some European countries. The increase in private demand was partly offset by the lower public demand associated with lower deficits. Since the second half of 1984, a slowdown in private economic activity in the United States has reduced the total demand for funds, and also interest rates.
Share of the United States
In 1983 the United States contributed 42.8 percent of total G-7 gross private savings and 35.5 percent of total G-7 net private savings—much higher percentages than in 1979 but close to those in 1972. The main factor was the appreciation of the exchange rate: as the dollar grew stronger, the share of US savings in the total also increased. Between 1979 and 1983 the share of the US fiscal deficit in the G-7 total rose sharply. By 1983 the US fiscal deficit was absorbing sharply higher shares of G-7 net private savings than in previous years. For example, the US central government fiscal deficit’s share of G-7 net private savings rose from 5 percent in 1979 to 11 percent in 1980, 12.6 percent in 1981, 25.1 percent in 1982, and 35.5 percent in 1983, more than a third of the total net private savings of the G-7 countries. If the general government is considered, the percentages are only marginally lower.
Between 1979 and 1983, while the central government fiscal deficit of the other six countries of the G-7 group rose from 4.6 percent to 5.6 percent of GNP, the US central government fiscal deficit increased from 1.2 percent to 5.8 percent of US GNP. If general government fiscal deficits are considered, the US deficit as a percentage of GNP rose from 0.6 percent in 1979 to 3.9 percent in 1983; for the other six countries, the increase was from 3.7 percent to 4.3 percent.
In either case, the US deficit has put pressures on the credit market of the G-7 countries. The fact that the G-7 countries were experiencing a downswing in economic activity is likely to have prevented a greater rise in real interest rates. Should the fiscal deficits of the G-7 countries remain as high as in recent years, while the US recovery spreads to the other countries, one would expect to see higher real rates. On the other hand, should the United States experience a significant slowdown, the higher public sector’s demand for credit could very well be neutralized by the lower private sector’s demand for credit. In addition, if slowdown and anticipation of depreciating dollar results in capital withdrawals, interest rates may have to be raised to finance the deficit. Which of these effects is likely to prevail is difficult to tell. Events in the rest of the world would also play a substantial role.
In spite of obvious difficulties in making an assessment of the fiscal situation of individual countries, and even more in comparing the fiscal situation of different countries, the statistical information available supports the conclusions that (1) over the past decade there has been a gradual and fairly general deterioration of the fiscal situation of the OECD countries as a group; and (2) in more recent years, and in relative terms, the US fiscal situation has deteriorated more than that of other countries.
Even though the size of the fiscal deficit has grown considerably in the United States, its magnitude, expressed as a share of gross national product, is not unusually high: it is still lower than that of several European countries and it is of the same order of magnitude as Japan’s, a country not usually associated with serious fiscal problems. However, given its size, developments in the US economy have important implications for other countries. Thus, the large absorption of the pool of savings of the industrial countries, due in part to the growing US deficit since 1979, is likely to have been an important factor in bringing about higher real interest rates.