Fiscal Policy - Theoretical Issues

8/3/2019 Fiscal Policy - Theoretical Issues

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MACROECONOMIC POLICY IN SOUTH AFRICAMACROECONOMIC POLICY IN SOUTH AFRICA

TOPIC 3: FISCAL POLICY THE THEORY AND PRACTICETOPIC 3: FISCAL POLICY THE THEORY AND PRACTICE

PART 1:PART 1: THEORETICAL ISSUES: ORTHODOX KEYNESIAN VIEWSTHEORETICAL ISSUES: ORTHODOX KEYNESIAN VIEWSAND BEYONDAND BEYOND

PART 1: THEORETICAL ISSUES: ORTHODOX KEYNESIAN VIEWSAND BEYOND

Reading:Lecture notes

Snowdon and Vane, Chapter 3 the latest edition - (pp 101 120 ) or Snowdon et al, Chapter 3 the earlier edition - (pp 89 107)Stiglitz, J.E., Ocampo, J.A., Spiegel, S., Ffrench-Davis, R. andNayyar, D. (2006) Stability with Growth Macroeconomics,Liberalization and Development, pages 63-72. Oxford: OxfordUniversity Press. In the booklet of readings handed out.

CONTENTS

PART A: ORTHODOX KEYNESIANS AND FISCAL POLICY

1. THE IS-LM MODEL FOR A CLOSED ECONOMY AND THE EFFECTIVENESSOF FISCAL POLICY VS. MONETARY POLICY1.1 THE IS-LM MODEL FOR A CLOSED ECONOMY1.2 THE OTHODOX KEYNESIAN PERSPECTIVE ON THE

EFFECTIVENESS OF FISCAL POLICY AND MONETARY POLICY1.3 ORTHODOX KEYNESIANS REASSERT THE IMPORTANCE OF FISCAL

POLICY VIA THE EFFECTS OF A BOND-FINANCED FISCALEXPANSION

2. ORTHODOX KEYNESIANS AND UNEMPLOYMENT

2.1 UNDEREMPLOYMENT EQUILIBRIUM IN THE KEYNESIAN MODEL

PART B: VIEWS ON FISCAL POLICY AFTER THE 1960S

1. FISCAL POLICY FALLS OUT OF FAVOUR1.2 THE STRUCTURAL APPROACH TO FISCAL POLICY


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2. FISCAL POLICY AND KEYNESIAN INTERVENTION IS NOT DEAD2.1 PAUL KRUGMAN AND THE RETURN TO DEPRESSION ECONOMICS2.2 THE HETERODOX VIEW ON THE EFFECTIVENESS OF FISCAL POLICIES IN

DEVELOPING ECONOMIES

PART A: ORTHODOX KEYNESIANS AND FISCAL POLICY

Keynes introduced the two issues that are recurrent debates both interms of theory and policy

Controversy over self-equilibrating markets

The role for government intervention

The central distinguishing beliefs within the orthodoxKeynesian school:

The economy is inherently unstable and subject to random shocks

Re-adjustment of the economy to Yfmay take substantial time if leftto its own devices

The aggregate level of output and employment is determined by AD

intervention aimed at altering level of AD Yf

If stabilisation policies are pursued fiscal policy tends to be moreeffective than monetary policy

Part A, below, examines, firstly, the views of orthodox Keynesians onthe efficacy of fiscal policy versus monetary policy in the 1950s. It thendescribes the underemployment equilibrium characteristic of orthodox

Keynesian. Finally, the opinions of economists on the use of fiscalpolicy in more recent times are studied.

THE IS-LM MODEL FOR A CLOSED ECONOMY AND THEEFFECTIVENESS OF FISCAL POLICY VS. MONETARY POLICY

1.1 THE IS-LM MODEL FOR A CLOSED ECONOMY

In a closed economy AD determined level of output & employmentC + I + G Y

C(Y) + I(r) + G YThus:

Consumption is a function of income

Investment is a function of the interest rate, however, aswe will note later, the orthodox Keynesians, following


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Keynes, emphasized that the relationship between theinterest rate and investment is such that investmentdoes not respond strongly to changes in the interestrate (investment is relatively interest rate inelastic).

Government expenditure is exogenous to model as it is

determined by fiscal policy.

Important points with regard to the orthodox Keynesian model:

1. A very important distinction between the classical model andKeynes/orthodox Keynesians is on the determination of theinterest rate:

How is r determined within the orthodox Keynesian school?

MD = MS equilibrium r

We will comment more on the money market later when brieflyrevising the LM curve

2. The monetary sector and goods (or real) sector are linked via theinterest rate. The interest rate is determined in money market,and the interest rate affects the goods (real) sector throughinvestment expenditure (investment expenditure is expenditureby firms on, for example, capital equipment such as machineryto produce goods, buildings).

As investment is a component of aggregate demand (AD), achange in investment expenditure will consequently affectaggregate output, employment and income in the economy. Thiseffect is multiplied through induced consumption, in other wordsas household income changes, consumption by the householdsalso changes.

To summarise:

MD and MS r I & Y

So MD or MS r

Transactionsdemand - f(Y)

Precautionarydemand - f(Y)

Speculative

Exogenouslydetermined b central


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r I Y (via the multiplier)But

Y MD r I & Y

Thus, the IS-LM model allows for equilibrium Y and r to be

determined simultaneously by the goods and money sectors.

The Goods market and the IS curve

The IS curve derives its name from equilibrium condition in a goodsmarket where in a closed economy with no government sector, S=I orAD=Y.

The IS curve depicts all combinations of r & Y that yield equilibrium inthe goods market.

Recall: derivation of the IS curveDownward sloping:- inverse relationship between r & I

i.e. if r I and consequently, via the multiplier, equilibriumAD and equilibrium output (Y):

r I equilibrium Y (via the multiplier)

The slope of the IS curve depends on:-

Interest rate sensitivity of I -i.e. how responsive is investment toa change in the interest rate?

If I is not very responsive (large in r small in I) then theinvestment schedule and IS curve would be relatively steep.

If I is very responsive (small in r large in I) then theinvestment schedule and IS curve would be relatively flat.

Figure 1 The Slope of the IS curve


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macpolsaFISCALpart1/P5All fact

the i/rat

Value of the multiplier ( ) the larger the value of the , thegreater the effect of a change in investment on Y.

NOTE: In the1950s the orthodox Keynesians argued that, on the basisof empirical evidence, investment is fairly unresponsive to changes inthe interest rate generating a relatively steep IS curve.

Shift in the IS curve:-The IS curve is drawn for a given level of G, taxation and expectations /business outlook.A change in any of these factors would cause IS curve to SHIFT, egs: a

more optimistic business outlook or an G higher level of income

at each interest rate IS curve shifts to the right.

The money market and the LM curve

The LM curve traces the relationship between combinations of incomeand interest rates that are associated with equilibrium in the moneymarket i.e. where the demand for money and supply of money areequal.

The demand for moneyThere are three motives for holding money

Transactions demand f(Y)

Precautionary demand f(Y)

Speculative demand f(r)

Active balances

Passive balances


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Active balances:Transactions demand: As income increases, so the demand for goodsand services increases, thus the demand for money increases topurchase these goods and services.

Precautionary demand: We tend to hold money for unexpectedpurchases and it is assumed to be a postivie function of income.

Passive balances (ie these balances are not being used topurchase g&s):By assuming people have different expectations regarding the futurecourse of the interest rate, it is possible to postulate that the demandfor speculative balances is inversely related to the interest rate (r).

Why?

The higher the current interest rate, the greater number ofindividuals who expect the interest rate to fall, and rememberingthat there is inverse relationship between the interest rate andthe price of bonds, a fall in the interest rate will increase theprice of bonds. So individuals tend to buy bonds at a relativelylow price when the interest rate is seen as relatively high, as it isanticipated that the interest rate will fall and the bond price risein the future. Thus purchasing bonds at a low price now allowscapital gains to be incurred later:

r PB (price of bonds) capital gainsThis affects the demand for money: individuals will buy bonds ata relatively high r and, therefore, have lower passive balances (alower demand for money).

The money demand curve:Slope of the money demand curve depends on the relationshipbetween speculative balances and r.

Figure 2 The Slope of the Money Demand Curve


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Of particular importance is the theoretical possibility that at very lowinterest rates, expectations regarding the future path of the interestrate could converge. That is, all individuals believe that the only waythe interest rate could move is upwards. Everyone then expects bondprices to fall in the future (capital losses) and consequently there is aninfinite demand for money. The money demand curve becomeshorizontal at a very low rate of interest. This is the liquidity trap caseas shown in the horizontal section of the curve below:

Figure 3 The Money Demand Curve and the Liquidity Trap


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Note: In the1950s the orthodox Keynesians argued that, on the basisof empirical evidence, money demand was highly responsive tochanges in the interest rate generating a relatively flat MD curve.

Position of the MD curve is given by the level of national income. If

national income (Y) changes, this will lead to a change in demand fortransactions and precautionary balances.

The supply of moneyThe money supply assumed exogenous determined by the centralbank.

Recall: derivation of the LM curveLM curve is upward sloping:-

Y MD with MS constant r to clear money market(equilibrium in the money market)

Given that money supply is constant, as income increases this will leadto an increase in demand for active balances that must cause theinterest rate to increase, in order to decrease speculative demand formoney and maintain equilibrium in the money market.


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The slope of the LM curve:-Slope of the LM curve depends upon the:

Income elasticity of MD

Interest elasticity of MD

The LM curve will be steeper (flatter) the higher (smaller) the incomeelasticity and the smaller (greater) the interest elasticity ofthe demand for money.

Note: We noted earlier that in the1950s the orthodox Keynesiansargued that, on the basis of empirical evidence, moneydemand was highly responsive to changes in the interestrate. At a very low rate of interest, at which all individualsexpected the rate of interest to rise, a liquidity trap isrelevant and, at such an interest rate, the LM curve ishorizontal see the Figure 4 below.

Figure 4 The LM Curve and the Liquidity Trap

Shift of the LM curve:-

The LM curve drawn for a given money supply, price level andexpectations. So, for example, expansionary monetary policy (increasein MS) shifts the LM curve to the right. Following an increase in moneysupply, and a given income elasticity of demand for money, any givenlevel of income must be associated with lower interest rate to maintainequilibrium in the money market.

The complete model and the role of fiscal and monetary policy


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Figure 5 The generalized IS-LM model

The equilibrium is given by the intersection of the IS and LM curves r* and Y* are determined simultaneously i.e. this is the only values ofthe interest rate and income which are consistent with equilibrium inboth the money and goods markets. This equilibrium may not be atYf.

If Y


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The rising r cost of borrowing level of private investment.

Crowding out argumentImportantly from the orthodox Keynesian point of view, the extent ofthe fall in private sector investment depends on interest elasticity ofinvestment.Eventually economy settles at r1 and Y1 in Figure 6.

Figure 6 Expansionary fiscal policy

The effectiveness of fiscal policy in changing AD, output andemployment:Fiscal policy will be more effective in influencing AD and, therefore, thelevel of output and employment when the crowding out effect isminimized. This occurs when:

The increase in income raises MD very little and, consequently,the increase the interest rate is relatively small (a flatter LMcurve)

Investment is not particularly interest sensitive (a steeper IScurve)

In the classical case (a vertical LM curve) fiscal expansion has no effecton income complete crowding out occurs. The increase in


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government spending completely offset by a fall in private investmentof the same magnitude. This is known as the Treasury View.

In the Keynesian case/liquidity trap (a horizontal LM curve) no crowdingout occurs.

B. Monetary policyThe impact of monetary policy on the macroeconomy:Both the goods and money markets are affected as is shown on Figure7 below.

Assume the central bank increases the supply of money:

MS represented by outward shift of the LMcurve.

At the initial interest rate (r0) MS>MD, theseexcess money balances used to purchasebonds

demand for bonds PB r I Y MD r Y Eventually economy settles at r1 and Y1 in

Figure 7.

Figure 7 Expansionary monetary policy


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The effectiveness of monetary policy in changing AD, outputand employment:Monetary policy will be more effective in influencing aggregatedemand and therefore the level of output and employment:

The more interest-inelastic is the demand for money (a steeperLM curve)

The more interest-elastic is investment (a flatter IS curve)

1.2 THE OTHODOX KEYNESIAN PERSPECTIVE ON THEEFFECTIVENESS OF FISCAL POLICY AND MONETARYPOLICY

Orthodox Keynesians in the 1950s recommended the use of fiscal overmonetary policy because their view was that:

The demand for money is highly responsive to changes in theinterest rate (ie the LM curve tends to be relatively flat)

Investment is relatively unresponsive to changes in the interestrate (ie the IS curve tends to be relatively steep)

Indeed there was early empirical support for the orthodox Keynesianview on the elasticities of the IS curve and LM curve.

To explain the orthodox Keynesian view in more detail let us considerthe effect of, firstly, expansionary monetary policy, and, secondly,expansionary fiscal policy, in the following situations:


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Case 1: The LM curve is perfectly elastic (liquidity trap)Case 2: The IS curve is completely interest insensitive (a verticalIS curve)

Case 1: LM perfectly elastic (liquidity trap situation)

Monetary policy:An increase in MS is hoarded; it is not used to purchase bonds.The reason for this:

Given that the interest rate is so low, the public as a wholeexpect that the interest rate can only move upward. Anincrease in the interest rate leads to a fall in bond prices,and falling bond prices indicate that holders of bonds incurcapital losses. So the public will not buy bonds at this lowrate of interest as they do not want to incur a capital loss.

If bonds are not bought, their prices do not change, and, thus,the interest rate is unaffected. If the interest rate does notchange, investment and income are not stimulated.

Figure 8 Monetary Policy in the Liquidity Trap


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It is often argued by critics of the orthodox Keynesian approachthat the liquidity trap situation is a special case that rarelyoperates. However, Keynes was of the opinion that even innormal times the transmission of changes in money supply via

the interest rate to the goods/real sector was sluggish andunpredictable. For Keynes investment expenditure is typicallyvery unstable due to the influence of the business expectationsrelating to an uncertain future.

Fiscal PolicyFiscal policy is very effective. No crowding out occurs as is shownin the figure below.

Figure 9 Fiscal Policy in the Liquidity Trap

Case 2: IS curve is completely interest insensitive

Monetary policyIn this case a change in Ms and, hence, the interest rate does notlead to a change in investment. From the orthodox Keynesianperspective investment is not responding at all to changes in the

interest rate and, thus, income is not stimulated.

Figure 10 Monetary Policy and a completely interestinsensitive IS curve


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Fiscal policyFiscal policy is effective. The interest rate does increase with theexpansionary fiscal policy, however, there is no crowding out ofprivate sector investment. From the orthodox Keynesianperspective this is because investment is not varying withchanges in the interest rate.

Figure 11 Fiscal Policy and a completely interest insensitive IScurve


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Case 2:

Questioning of the Relative Effectiveness of Fiscal Policy in theEarly 1960sBy the early 1960s the empirical support for the orthodox view on theelasticities of the IS curve and LM curve became increasinglyquestionable. Moreover, Snowdon and Vane (2005, 109) note that theefficacy of fiscal policy relative to monetary policy was much strongeramong British as compared to American Keynesians.

The orthodox Keynesian belief in the effectiveness of fiscal policy overmonetary policy was challenged by monetarists (see later topics).Monetarists argued that fiscal policy, without accommodatingmonetary policy, had minor effects on AD, output and employment inthe long run. In the long run, they argued, the crowding out effect offiscal policy operates and there is no change in output andemployment.

Textbooks, including Snowdon and Vane (2005, 145), note that asmacroeconomic thought evolved over time a neoclassical synthesisdeveloped (a synthesis of the ideas of Keynes with those of earlier

economists (the classical school)), and part of this synthesis was abelief that both monetary policy and fiscal policy affected AD, outputand employment.

However, Snowdon and Vane (2005, 110) do go on to point out thatthere was a Keynesian response to the monetarist criticism that soughtto reassert the importance of fiscal policy Snowdon and Vane (2005,110) cite the article by Blinder and Solow, 1973 on whether or not


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fiscal policy matters. This Keynesian response examined the wealtheffects of a bond-financed increase in government expenditure.

1.3 ORTHODOX KEYNESIANS REASSERT THE IMPORTANCE OF

FISCAL POLICY VIA THE EFFECTS OF A BOND-FINANCEDFISCAL EXPANSION

One method of financing an increase in government expenditure is forthe government to borrow from the private sector by issuing bonds.The increased bond holdings by the private sector increases privatesector wealth, which in turn increases private sector consumptionexpenditure and the demand for money. This analysis examines anextended version of the IS-LM model incorporating the governmentbudget constraint.

The figure below shows the traditional IS-LM model in the top panel

and the government budget position is depicted in the lower panel.The government budget position is determined by the relationshipbetween government expenditure (G) and tax revenue (T). G isassumed independent of the level of income, while T increases with thelevel of income (T is endogenous to the level of income).

The economys initial position is Y0 with a balanced government budget(G0 = T). Then suppose authorities attempt to increase level of incomeand employment by increasing government expenditure:

G shift of IS curve to the right and governmentexpenditure curve downwards. This opens up budget deficit=AB

Bond are issued to finance this deficit increase in private

sector wealth (owing to increased bond holdings) increase in

consumption an increase money demand

The increase in consumption outward shift of the IScurve

The increase in money demand comes about from increasein wealth, not income, thus, there is a leftward shift of LMcurve

If the outward shift of the IS curve outweighs the leftward

shift of LM curve output expands to Y2 and the deficit isremoved (crowding out is absent)

If the increased interest payments arising from bondfinance are incorporated, the government expenditure

function will shift downward beyond G1 output expandingbeyond Y2


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Conclusion: The wealth effects make a bond-financed increasein government expenditure potentially very effective in raisingincome and employment

Figure 12 The government budget constraint and bond-financed fiscal expansion

Debate: are bonds wealth creating or not?Economists have used the Ricardian debt equivalence theorem toargue that bond- financed government expenditure does not increaseprivate sector wealth:

The sale of bonds is merely a future tax liability which the privatesector anticipates, and so the private sector merely saves morenow to pay the future liability.


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So in issuing bonds to finance government expenditure, privatesector wealth is not created.

Several arguments have been raised against the Ricardian theorem:Eg: the future tax liability will land on future generations, so the

present generation will be wealthier and spend more. Barro(1989) countered this argument he is of the opinion thatbequests show that current generations care about the taxliability of future generations. However, this raises the questionas to what extent current generations are so far-sighted?

We now look in some detail at the orthodox Keynesian belief on thetendency for underemployment in modern economies.

2. ORTHODOX KEYNESIANS AND UNEMPLOYMENT

Snowdon and Vane (2005, 144-147) summarise the central features oforthodox Keynesian school in the mid to late 1960s. One of the centralproposition noted is that the orthodox Keynesians view theunemployment of labour as chiefly involuntary. Unemployment isinvoluntary in the sense that people who are without work areprepared to work at wages that employed workers with comparableskills are currently earning.

Another of the orthodox Keynesians central propositions is thebelief that the economy can be either of two regimes. There isthe classical regime in which the economy is supply

constrained and in this situation supply creates its owndemand (Says Law operates). The other regime is theKeynesian regime in which an economy is demand-constrained.That is, a situation exists in which there is unemployed labourdue to a lack of aggregate demand in economy. Under thesecircumstances output and employment will increase if thereare increases in real demand.

So in the orthodox Keynesian world, we have involuntaryunemployment caused by demand deficiencies. These demanddeficiencies arise because modern industrialized economies suffer froma predisposition towards costly recessions. These recessions areviewed as being unwelcome departures from full employment causedby negative demand shocks. Further, in modern industrial economiesprices and wages are not perfectly flexible, therefore deficiencies inaggregate demand, and the resultant involuntary unemployment,require the use of corrective, stabilising policy action. Initially, at least,


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the orthodox Keynesians, especially the British Keynesians, espousedthe relative effectiveness of fiscal over monetary policy.

To explain the orthodox Keynesian view on unemployment in moredetail, we now consider the circumstances under which the IS-LM

model will fail to self-equilibrate at full employment (Snowdon andVane, 2005, 114-120).

2.1 UNDEREMPLOYMENT EQUILIBIRUM IN THE KEYNESIANSMODEL

Figure 13 The general case with the Keynes effect


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The economy is in recessionary circumstances:

IS and LM intersect such that Y


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balances channelled into bond mkt, demand for bonds increase

and their price increases) r I expansion of the

goods market AD and Y moderates the rate of fall inprices, so that money wage falls at a faster rate then prices, soreal wage falls to the market clearing level (W/P)1.

Through the above process Yf attained. The indirect effect of falling wages and prices stimulatingspending via a falling i/rate is known the Keynes effect.

Orthodox Keynesians would argue that the processdescribed above is subject to a long time lag during whichunemployment persists, hence stabilisation policy isrequired.

Unemployment in the Keynesian model could persist as a

result of: Inflexibility of wages and prices long-termunderemployment of economy

The liquidity trap: excess balances would not be channeled

into the bond market no change in r and I, so no increase in

AD to moderate the fall in prices prices and money wagesfall proportionately and they would remain at (W/P)0.So AD is deficient, and persistent involuntary

unemployment results.

Investment is not sensitive to changes in r: the fall in rcould be insufficient to stimulate investment enough to obtainYf.So AD is deficient, and persistent involuntary

unemployment results.

PART B: VIEWS ON FISCAL POLICY AFTER THE 1960S

1. USING FISCAL POLICY AS STABILISATION POLICY FALLSOUT OF FAVOUR

As we have already noted above, by the early 1960s the earlyempirical support for the orthodox Keynesian view on the elasticities ofthe IS curve and LM curve became increasingly questionable. From the


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early 1970s onwards fiscal activism clearly became unpopular. Mohrand Siebrits (2009, 105-106) outline additional reasons as to why thisoccurred:

1. It seemed doubtful that it was possible to use anti-cyclical fiscal

policy effectively. This relates to three issues:

The implementation lags association with fiscal policy: Forexample, in a recession it could take so long to implement a taxdecrease, that the stimulating affect on AD only takes place oncethe economy is out of the recession. This would then add tooverheating and inflationary pressures in the expansionaryphase of a business cycle.

Monetarists argued that expansionary fiscal policy only crowdsout the private sector in the long run. What concernedmonetarists most with regard to fiscal policy is the financing of a

budget deficit. Appealing to the quantity theory of money,monetarists argue that if government budget deficits arefinanced by money creation, they only fuel inflation.

Some economists (the new classical school more detail in latertopics) argued, that private sector agents would anticipate anypolicy actions that were systematic and respond to them in waysthat neutralized their effects. An example of this the Ricardianequivalence theorem we referred to earlier:

Government borrowing to finance a budget deficit must berepaid by government raising future tax revenue. Rationaleconomic actors realize this, so they anticipate a highertax burden for them (or their children) in the future. Therational response by economic actors is to reduce theirconsumption and increasing their saving by equivalentamounts, ensuring that they can meet future taxobligations. The result there is no change in AD as theexpansionary fiscal policy has been offset by an equalincrease in private sector savings.

The Ricardian equivalence theorem is highly controversial Stiglitz et al (2006, 65) point out that there are only a few casesin which an incomplete version of the theorem holds. However,

the theorem does highlight the possibility that private agentsmight well behave in a way which at least partially offsets theintended outcome of anti-cyclical fiscal policy.

2. The emergence of stagflation (unemployment and inflationoccurring together)


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after the oil price shocks of 1973 negatively affected the popularityof fiscal activism. Demand management was seen to be ineffectivein solving cost-push inflation.

In the face of the stagflation suffered internationally in the

1970s, Keynesians were forced to re-examine their earlier viewson fiscal policy. It became apparent that

Given the nature of the inflationary process, tax increasescould no longer be regarded as an instrument of anti-inflationary policy. Conventional Keynesian thinking hadadvocated tax hikes to dampen demand, but such policiesproved not only to be ineffective, but also counter productive.A rising income tax burden could lead to increased wageclaims that are passed on to consumers in the form of higherprices (wage-cost-price spiral)

Government spending had to be kept in check, sinceincreasing the tax burden associated with increasedgovernment spending could give further impetus to inflation.

3. Growing evidence to support the view that governmentimplementation of fiscal policy was not consistent but based onensuring political popularity.

As a result of all these concerns, Mohr and Siebrits (2009) note that thepolicymakers turned their attention away from fiscal stabilization policy

in the traditional Keynesian sense. Fiscal policy increasingly focused onstructural measures aimed at increasing the growth and job creatingcapacity of the macroeconomy, as well as considering theredistributive effects of government budgets. Mohr and Siebrits (2009)call this approach to fiscal policy, the structural approach to fiscalpolicy.

1.2 THE STRUCTURAL APPROACH TO FISCAL POLICY

Key features of the now favoured structural approach to fiscal policyinclude (Mohr and Siebrits, 2009, 107):

Keeping government spending in check to avoid:

The crowding out of the private sector

Inflationary financing of budget deficits


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The negative effects of an excessive tax burden:

- The cost-push effect of higher taxes (a rising income taxburden could lead to increased wage claims and, hence,higher prices)

- Excessive taxes are argued to create majordisincentives to work effort (income taxes), saving(taxes on interest income), investment (taxes on profits)and, hence, economic growth.

Keeping the public debt and the burden of servicing it at asustainable level by avoiding high budget deficits.

The debt an economy can sustain is related to its economic size,hence, what we are interested in is a countrys debt to GDP ratio

(real debt/real GDP). When looking at the evolution of a countrysdebt to GDP ratio, it is essentially a race between the numerator(the real debt level) and the denominator (real GDP). Since real debtgrows at the rate of the real interest rate, r, and real GDP grows atthe rate of growth rate of real GDP, g, the debt to GDP ratio growsat the rate (r g). So if r < g, budget deficits need not result in agrowing debt-GDP ratio and the debt accumulation process is notexplosive, at least relative to GDP. However, when r > g, the debtprocess is explosive and the situation cannot be left unattended.

Mohr and Siebrits (2009) note that the structural approach to fiscal

policy is very similar to elements contained in the Washingtonconsensus. The term Washington Consensus was coined by a UKeconomist John Williamson in 1989 and he set out specific economicpolicies that he believed should comprise a standard reform packagefor crisis-ridden developing countries by Washington-based institutions- the International Monetary Fund (IMF) and the World Bank. Theapproach was indeed developed by these two influential USinstitutions. The policies which were adopted by the IMF and the WorldBank amounted to a rejection of states activist role and the promotionof a minimalist, non-interventionist state. Deregulation andprivatisation, and fiscal discipline were espoused. The Washington

consensus is argued to be synonymous with market fundamentalism. The unspoken premise is classical in nature markets can sortthemselves out, government intervention is unnecessary.

It is clear then, that fiscal activism became unpopular. The commonlyfavoured approach to fiscal policy now appears to be one associatedwith a paradigm that believes government spending and the debt-to-


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GDP ratio need to be reigned in and the markets be left alone. This isan approach appropriate to an economy operating in the classicalregime in which output and employment is supply constrained ratherthan demand constrained.

The question is: how far out of favour has activism fallen?

2. FISCAL POLICY AND KEYNESIAN INTERVENTION IS NOTDEAD

2.1 PAUL KRUGMAN AND THE RETURN TO DEPRESSIONECONOMICS

Snowdon and Vane (2005, 147) note that Paul Krugman, a leading US

and a Nobel Prize-winning economist, warned economists that after aperiod of less volatile business cycles, the 1990s witnessed The Returnto Depression Economics. Krugman (1999) argued that in the 1990sfor the first time in two generations, failures on the demandside ofthe economy insufficient private spending to make use of availableproductive capacity have become the clear and present limitation onprosperity for a large part of the world (cited in Snowdon and Vane,2005, 147). Given the experience of the Japanese, the Asian Tigerand a number of European economies in the 1990s, Krugmanargued that economists could not afford to be complacent - depressionand deflation are possible. Moreover, a number of economists,

including Krugman, believe that the Japanese economy found itself in aliquidity trap in the 1990s.

Moving on from the 1990s, more recent events in the world economyserve to endorse Krugmans view of The Return to DepressionEconomics. The world economy is still emerging from what is arguedto be the worst economic crisis since the Great Depression of the1930s it began with a severe financial crisis in the US in mid-2007.

In a lecture given by Paul Krugman at a university in the United Statesin February 2010, a Keynesian tone is clearly present. The following isfrom a report on his lecture:

What has been lost above all, Krugman argued, is anappreciation of ideas developed in the 1930s most notably theeconomist John Maynard Keyness broad view that in certaincircumstances government spending is the best tool to instigatean economic recovery. At a time when interest rates are minimal


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and can hardly be lowered to spur private investment, Krugmanargued, Keynesian thought is especially vital, despite some loudarguments to the contrary.

Krugman believes the United States has benefited from the

$787 billion federal (government) stimulus package that wassigned into law in February 2009; it consisted of a combination ofspending programs on things like infrastructure, education andresearch, along with some state aid and tax cuts...Krugmanthinks the legislation helped alleviate the recessions effects.(Downloaded fromhttp://web.mit.edu/newsoffice/2010/krugman-event.html(11/04/10))

Notice that he is suggesting that the US is in a situation similar to the

liquidity trap: interest rates are minimal and can hardly be loweredto spur private investment. Of course, not all economists agree withKrugman, but his view illustrates that Keynesian economics is certainlynot dead.

2.2 THE HETERODOX VIEW ON THE EFFECTIVENESS OF FISCALPOLICIES IN DEVELOPING ECONOMIES

Stiglitz et al (2006) differentiate the heterodox view from theKeynesian view.

The Keynesians and heterodox approaches both argue that economiessuffer from extensive periods of unemployment. The heterodoxeconomists generally agree with Keynesians that there is an importantrole for government in economic stabilisation, however they argue fora wider variety of instruments. Moreover, the standard Keynesianapproach tends to emphasise aggregate demand, the heterodoxapproach also notes the importance of the aggregate supply. Adecrease in AD or AS can adversely affect the economy. The heterodoxapproach also observes the positive supply-side effects of manypolicies, whereas the traditional Keynesian approach stresses the

impact on aggregate demand. For example, the heterodox economistnote that policies aimed at stimulating aggregate demand also have apositive supply effect due to the productivity gains generated bydynamic economies of scale and the increased use of the underutilizedresources. Heterodox economists also recognize the limitations inequity and insurance markets have created risk-averse and credit-constrained firms and the impact this has on supply, as well asproviding a richer explanation for changes in demand.
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The heterodox view (see Stiglitz et al (2006)) argues that fiscal policymay be particular effective, especially in developing economies, for thefollowing reasons:

1. The Ricardian Equivalence theorem is unlikely to hold particularly in developing countries.Both Keynesian and heterodox views on fiscal policy run counterto the Ricardian equivalence theorem.

Keynesian economists note that increased governmentexpenditure has a multiplier effect on the economy, as it inducespeople to spend more, and thus the economy is stimulated. Thevalue of the multiplier will depend on the saving rates of theeconomy in poor countries they tend to be low so the multiplierwill be relatively high. In contrast Ricardian equivalence suggests

there will be no stimulation.

The heterodox view, in arguing against Ricardian equivalence,stresses that many households and firms are credit andcash constrained, especially in developing countries. If thesehouseholds and firms could spend more, they would do so. Thus,the Ricardian equivalence theorem is very unlikely to hold. Forexample, if government gives such households a tax cut, it islikely that most, it not all of it will be spent (their marginalpropensity to spend could be as high as 1), and likewise ifgovernment provided improved unemployment benefits. When

they spend their increased disposable income, it will notnecessarily go to individuals who have an equally high marginalpropensity to spend (such as landlords, etc), but the overallmultiplier effect can be very high.

Expansionary fiscal policy in an economy in which firms are cashor credit constrained may benefit from a financial accelerator.Increased government spending generates extra income in theeconomy and that includes increased profits for firms. Firms thenspend this extra income on investment. Moreover the value ofequity increases in the expectation of a stronger economy,

making it easier for firms to gain access to credit that is used forinvestment. In developing economies, Stiglitz et al (2006), arguethat there is likely to be a high proportion of businesses that arecash or credit constrained, as a large fraction of business iscarried out by small and medium-sized enterprises (SMEs).

2. Crowding in is likely to operate rather than crowdingout.


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Heterodox economists, especially, but also Keynesians,emphasise that expansionary fiscal policy creates crowding inof the private sector rather than crowding out. For example,higher government expenditure could stimulate the economyand improve the economic situation, which leads to investment

expenditure by firms being stimulated. Also an increase ingovernment investment that complements private sectorinvestment, such as government spending on infrastructure, canincrease returns in the private sector and stimulate privatesector investment and the economy. Stiglitz et al (2006)) givetwo cases of where this has occurred: recent experience in Chinaand India shows the complementarities between publicinvestment and private investment that suggests crowding inrather than crowding out.

3. Government spending on productive investments will

strengthen an economy and build investor confidence.Again this is both a Keynesian and heterodox perspective. Theargument is that long-term investors look beyond the immediatesize of the fiscal deficit and government debt. Short-terminvestors are worried about the governments ability to repay itsdebt in the very near term and such investors heighten marketvolatility they are not the type of investors government shouldwant to attract.

Long-term investors look beyond such issues, they are concernedwith policies that lead to long-run sustainable growth. These

investors recognise that decreasing government expenditureusually decreases output and employment this creates apessimistic outlook and tends act as a disincentive toinvestment.If governments borrow to finance productive investments thatgenerate returns in excess of interest rate charges, theeconomys growth will be enhanced and investors will have moreconfidence in it.

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Fiscal Policy - Theoretical Issues