MACROECONOMIC POLICY IN SOUTH AFRICA TOPIC 3: FISCAL POLICY THE THEORY AND PRACTICE PART 1: THEORETICAL ISSUES: ORTHODOX

X KEYNESIAN VIEWS AND BEYOND

PART 1: THEORETICAL ISSUES: ORTHODOX KEYNESIAN VIEWS AND 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. and Nayyar, D. (2006) Stability with Growth Macroeconomics, Liberalization and Development, pages 63-72. Oxford: Oxford University 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 EFFECTIVENESS OF FISCAL POLICY VS. MONETARY POLICY 1.1 THE IS-LM MODEL FOR A CLOSED ECONOMY 1.2 THE OTHODOX KEYNESIAN PERSPECTIVE ON THE EFFECTIVENESS OF FISCAL POLICY AND MONETARY POLICY 1.3 ORTHODOX KEYNESIANS REASSERT THE IMPORTANCE OF FISCAL POLICY VIA THE EFFECTS OF A BOND-FINANCED FISCAL EXPANSION 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 FAVOUR 1.2 THE STRUCTURAL APPROACH TO FISCAL POLICY

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2. FISCAL POLICY AND KEYNESIAN INTERVENTION IS NOT DEAD 2.1 PAUL KRUGMAN AND THE RETURN TO DEPRESSION ECONOMICS 2.2 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 in terms of theory and policy Controversy over self-equilibrating markets The role for government intervention The central distinguishing beliefs within the orthodox Keynesian school:

The economy is inherently unstable and subject to random shocks Re-adjustment of the economy to Yf may take substantial time if left
to 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 more effective than monetary policy Part A, below, examines, firstly, the views of orthodox Keynesians on the efficacy of fiscal policy versus monetary policy in the 1950s. It then describes the underemployment equilibrium characteristic of orthodox Keynesian. Finally, the opinions of economists on the use of fiscal policy in more recent times are studied. THE IS-LM MODEL FOR A CLOSED ECONOMY AND THE EFFECTIVENESS 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 & employment C+I+G Y C(Y) + I(r) + G Y Thus: Consumption is a function of income Investment is a function of the interest rate, however, as we will note later, the orthodox Keynesians, following

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Keynes, emphasized that the relationship between the interest rate and investment is such that investment does not respond strongly to changes in the interest rate (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 and Keynes/orthodox Keynesians is on the determination of the interest rate: How is r determined within the orthodox Keynesian school? MD = MS equilibrium r

Transactions demand - f(Y) Precautionary demand - f(Y) Speculative demand - f(r)

Exogenously determined by central

We will comment more on the money market later when briefly revising the LM curve 2. The monetary sector and goods (or real) sector are linked via the interest rate. The interest rate is determined in money market, and the interest rate affects the goods (real) sector through investment expenditure (investment expenditure is expenditure by firms on, for example, capital equipment such as machinery to produce goods, buildings). As investment is a component of aggregate demand (AD), a change in investment expenditure will consequently affect aggregate output, employment and income in the economy. This effect is multiplied through induced consumption, in other words as household income changes, consumption by the households also changes. To summarise: MD and MS r I & Y So MD or MS r

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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 goods market where in a closed economy with no government sector, S=I or AD=Y. The IS curve depicts all combinations of r & Y that yield equilibrium in the goods market. Recall: derivation of the IS curve Downward sloping:- inverse relationship between r & I i.e. if r I and consequently, via the multiplier, equilibrium AD 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 to a change in the interest rate? If I is not very responsive (large in r small in I) then the investment schedule and IS curve would be relatively steep. If I is very responsive (small in r large in I) then the investment schedule and IS curve would be relatively flat. Figure 1 The Slope of the IS curve

 Value of the multiplier ( ) the larger the value of the , the

greater the effect of a change in investment on Y.

NOTE: In the1950s the orthodox Keynesians argued that, on the basis of empirical evidence, investment is fairly unresponsive to changes in the 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.

Slope of IS curv All factors affect the i/rate sensiti The effect of a d the case of ISF, larger change in
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The money market and the LM curve The LM curve traces the relationship between combinations of income and interest rates that are associated with equilibrium in the money market i.e. where the demand for money and supply of money are equal. The demand for money There are three motives for holding money Transactions demand f(Y) Active balances Precautionary demand f(Y) Speculative demand f(r)

Passive balances

ISS

r0

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Active balances: Transactions demand: As income increases, so the demand for goods and services increases, thus the demand for money increases to purchase these goods and services. Precautionary demand: We tend to hold money for unexpected purchases and it is assumed to be a postivie function of income. Passive balances (ie these balances are not being used to purchase g&s): By assuming people have different expectations regarding the future course of the interest rate, it is possible to postulate that the demand for speculative balances is inversely related to the interest rate (r). Why? The higher the current interest rate, the greater number of individuals who expect the interest rate to fall, and remembering that there is inverse relationship between the interest rate and the price of bonds, a fall in the interest rate will increase the price of bonds. So individuals tend to buy bonds at a relatively low price when the interest rate is seen as relatively high, as it is anticipated that the interest rate will fall and the bond price rise in the future. Thus purchasing bonds at a low price now allows capital gains to be incurred later: r PB (price of bonds) capital gains This affects the demand for money: individuals will buy bonds at a relatively high r and, therefore, have lower passive balances (a lower demand for money). The money demand curve: Slope of the money demand curve depends on the relationship between 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 low interest rates, expectations regarding the future path of the interest rate could converge. That is, all individuals believe that the only way the interest rate could move is upwards. Everyone then expects bond prices to fall in the future (capital losses) and consequently there is an infinite demand for money. The money demand curve becomes horizontal at a very low rate of interest. This is the liquidity trap case as 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 basis of empirical evidence, money demand was highly responsive to changes 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 for transactions and precautionary balances. The supply of money The money supply assumed exogenous determined by the central bank. Recall: derivation of the LM curve LM 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 lead to an increase in demand for active balances that must cause the interest rate to increase, in order to decrease speculative demand for money 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 income elasticity and the smaller (greater) the interest elasticity of the demand for money. Note: We noted earlier that in the1950s the orthodox Keynesians argued that, on the basis of empirical evidence, money demand was highly responsive to changes in the interest rate. At a very low rate of interest, at which all individuals expected the rate of interest to rise, a liquidity trap is relevant and, at such an interest rate, the LM curve is horizontal 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 and expectations. So, for example, expansionary monetary policy (increase in MS) shifts the LM curve to the right. Following an increase in money supply, and a given income elasticity of demand for money, any given level of income must be associated with lower interest rate to maintain equilibrium 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 of the interest rate and income which are consistent with equilibrium in both the money and goods markets. This equilibrium may not be at Yf. If Y<Yf then either monetary policy or fiscal policy could be employed in order to stimulate AD, output and employment in the economy (stabilize the economy) The orthodox Keynesian originally favoured fiscal policy over monetary policy as the preferred method of manipulating AD to achieve the full employment level of output in an economy. The reasons for this preference will be explained in following sections. We will, firstly, revise how fiscal policy and monetary policy affect the macroeconomy. Secondly, we will examine the reasons why the orthodox Keynesians thought, particularly in the 1950s, that fiscal policy was more effective in stimulating the economy and moving it to the full employment level of output. A. Fiscal policy The impact of fiscal policy on the macroeconomy: Both the goods and money markets are affected as is shown on Figure 6 below. Assume an G, this is represented by outward shift of the IS curve Y (via the multiplier) demand for active balances (MD) with fixed MS an r is required to restore money market equilibrium.

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The rising r cost of borrowing level of private investment. Crowding out argument Importantly from the orthodox Keynesian point of view, the extent of the fall in private sector investment depends on interest elasticity of investment. Eventually economy settles at r1 and Y1 in Figure 6. Figure 6 Expansionary fiscal policy

The effectiveness of fiscal policy in changing AD, output and employment: Fiscal policy will be more effective in influencing AD and, therefore, the level of output and employment when the crowding out effect is minimized. This occurs when: The increase in income raises MD very little and, consequently, the increase the interest rate is relatively small (a flatter LM curve) Investment is not particularly interest sensitive (a steeper IS curve) In the classical case (a vertical LM curve) fiscal expansion has no effect on income complete crowding out occurs. The increase in

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government spending completely offset by a fall in private investment of the same magnitude. This is known as the Treasury View. In the Keynesian case/liquidity trap (a horizontal LM curve) no crowding out occurs.

B. Monetary policy The impact of monetary policy on the macroeconomy: Both the goods and money markets are affected as is shown on Figure 7 below. Assume the central bank increases the supply of money: MS represented by outward shift of the LM curve. At the initial interest rate (r0) MS>MD, these excess money balances used to purchase bonds 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, output and employment: Monetary policy will be more effective in influencing aggregate demand and therefore the level of output and employment: The more interest-inelastic is the demand for money (a steeper LM curve) The more interest-elastic is investment (a flatter IS curve) 1.2 THE OTHODOX KEYNESIAN PERSPECTIVE ON THE EFFECTIVENESS OF FISCAL POLICY AND MONETARY POLICY

Orthodox Keynesians in the 1950s recommended the use of fiscal over monetary policy because their view was that: The demand for money is highly responsive to changes in the interest rate (ie the LM curve tends to be relatively flat) Investment is relatively unresponsive to changes in the interest rate (ie the IS curve tends to be relatively steep) Indeed there was early empirical support for the orthodox Keynesian view on the elasticities of the IS curve and LM curve. To explain the orthodox Keynesian view in more detail let us consider the 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 vertical IS 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 whole expect that the interest rate can only move upward. An increase in the interest rate leads to a fall in bond prices, and falling bond prices indicate that holders of bonds incur capital losses. So the public will not buy bonds at this low rate 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 not change, 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 approach that the liquidity trap situation is a special case that rarely operates. However, Keynes was of the opinion that even in normal times the transmission of changes in money supply via the interest rate to the goods/real sector was sluggish and unpredictable. For Keynes investment expenditure is typically very unstable due to the influence of the business expectations relating to an uncertain future. Fiscal Policy Fiscal policy is very effective. No crowding out occurs as is shown in the figure below.

Figure 9 Fiscal Policy in the Liquidity Trap

Case 2: IS curve is completely interest insensitive Monetary policy In this case a change in Ms and, hence, the interest rate does not lead to a change in investment. From the orthodox Keynesian perspective investment is not responding at all to changes in the interest rate and, thus, income is not stimulated. Policy and a completely interest

Figure 10 Monetary insensitive IS curve

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Fiscal policy Fiscal policy is effective. The interest rate does increase with the expansionary fiscal policy, however, there is no crowding out of private sector investment. From the orthodox Keynesian perspective this is because investment is not varying with changes in the interest rate.

Figure 11 Fiscal Policy and a completely interest insensitive IS curve

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Case 2: Fisca
Questioning of the Relative Effectiveness of Fiscal Policy in the Early 1960s By the early 1960s the empirical support for the orthodox view on the elasticities of the IS curve and LM curve became increasingly questionable. Moreover, Snowdon and Vane (2005, 109) note that the efficacy of fiscal policy relative to monetary policy was much stronger among British as compared to American Keynesians. The orthodox Keynesian belief in the effectiveness of fiscal policy over monetary policy was challenged by monetarists (see later topics). Monetarists argued that fiscal policy, without accommodating monetary policy, had minor effects on AD, output and employment in the long run. In the long run, they argued, the crowding out effect of fiscal policy operates and there is no change in output and employment. Textbooks, including Snowdon and Vane (2005, 145), note that as macroeconomic thought evolved over time a neoclassical synthesis developed (a synthesis of the ideas of Keynes with those of earlier economists (the classical school)), and part of this synthesis was a belief that both monetary policy and fiscal policy affected AD, output and employment. However, Snowdon and Vane (2005, 110) do go on to point out that there was a Keynesian response to the monetarist criticism that sought to 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 wealth effects of a bond-financed increase in government expenditure. 1.3 ORTHODOX KEYNESIANS REASSERT THE IMPORTANCE OF FISCAL POLICY VIA THE EFFECTS OF A BOND-FINANCED FISCAL EXPANSION

One method of financing an increase in government expenditure is for the government to borrow from the private sector by issuing bonds. The increased bond holdings by the private sector increases private sector wealth, which in turn increases private sector consumption expenditure and the demand for money. This analysis examines an extended version of the IS-LM model incorporating the government budget 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 relationship between government expenditure (G) and tax revenue (T). G is assumed independent of the level of income, while T increases with the level 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 income and employment by increasing government expenditure:

G shift of IS curve to the right and government

expenditure 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 IS curve The increase in money demand comes about from increase in wealth, not income, thus, there is a leftward shift of LM curve If the outward shift of the IS curve outweighs the leftward shift of LM curve output expands to Y2 and the deficit is removed (crowding out is absent) If the increased interest payments arising from bond finance are incorporated, the government expenditure function will shift downward beyond G1 output expanding beyond Y2

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Conclusion: The wealth effects make a bond-financed increase in government expenditure potentially very effective in raising income and employment

Figure 12 The government budget constraint and bondfinanced fiscal expansion

Debate: are bonds wealth creating or not? Economists have used the Ricardian debt equivalence theorem to argue that bond- financed government expenditure does not increase private sector wealth: The sale of bonds is merely a future tax liability which the private sector anticipates, and so the private sector merely saves more now to pay the future liability.

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So in issuing bonds to finance government expenditure, private sector 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 that bequests show that current generations care about the tax liability of future generations. However, this raises the question as to what extent current generations are so far-sighted? We now look in some detail at the orthodox Keynesian belief on the tendency for underemployment in modern economies. 2. ORTHODOX KEYNESIANS AND UNEMPLOYMENT

Snowdon and Vane (2005, 144-147) summarise the central features of orthodox Keynesian school in the mid to late 1960s. One of the central proposition noted is that the orthodox Keynesians view the unemployment of labour as chiefly involuntary. Unemployment is involuntary in the sense that people who are without work are prepared to work at wages that employed workers with comparable skills are currently earning. Another of the orthodox Keynesians central propositions is the belief that the economy can be either of two regimes. There is the classical regime in which the economy is supply constrained and in this situation supply creates its own demand (Says Law operates). The other regime is the Keynesian regime in which an economy is demand-constrained. That is, a situation exists in which there is unemployed labour due to a lack of aggregate demand in economy. Under these circumstances output and employment will increase if there are increases in real demand. So in the orthodox Keynesian world, we have involuntary unemployment caused by demand deficiencies. These demand deficiencies arise because modern industrialized economies suffer from a predisposition towards costly recessions. These recessions are viewed as being unwelcome departures from full employment caused by negative demand shocks. Further, in modern industrial economies prices and wages are not perfectly flexible, therefore deficiencies in aggregate 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, espoused the relative effectiveness of fiscal over monetary policy. To explain the orthodox Keynesian view on unemployment in more detail, we now consider the circumstances under which the IS-LM model will fail to self-equilibrate at full employment (Snowdon and Vane, 2005, 114-120).

2.1

UNDEREMPLOYMENT EQUILIBIRUM IN THE KEYNESIANS MODEL

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<Yf (IS and LM0) LD<LS (the real w,(W/P)0, is above market clearing level with the money wage (W) exogenously determined) If W and P are fully flexible (the classical assumption), then: Excess supply labour W costs for producers P real balances (real money supply) LM shifts out (excess real

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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 in prices, so that money wage falls at a faster rate then prices, so real wage falls to the market clearing level (W/P)1. Through the above process Yf attained. The indirect effect of falling wages and prices stimulating spending via a falling i/rate is known the Keynes effect. Orthodox Keynesians would argue that the process described above is subject to a long time lag during which unemployment persists, hence stabilisation policy is required. Unemployment in the Keynesian model could persist as a result of: Inflexibility of wages and prices long-term underemployment 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 wages fall 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 r

could be insufficient to stimulate investment enough to obtain Yf. 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 FALLS OUT OF FAVOUR As we have already noted above, by the early 1960s the early empirical support for the orthodox Keynesian view on the elasticities of the IS curve and LM curve became increasingly questionable. From the

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early 1970s onwards fiscal activism clearly became unpopular. Mohr and Siebrits (2009, 105-106) outline additional reasons as to why this occurred: 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: For

example, in a recession it could take so long to implement a tax decrease, that the stimulating affect on AD only takes place once the economy is out of the recession. This would then add to overheating and inflationary pressures in the expansionary phase of a business cycle. Monetarists argued that expansionary fiscal policy only crowds out the private sector in the long run. What concerned monetarists 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 are financed by money creation, they only fuel inflation. Some economists (the new classical school more detail in later topics) argued, that private sector agents would anticipate any policy actions that were systematic and respond to them in ways that neutralized their effects. An example of this the Ricardian equivalence theorem we referred to earlier: Government borrowing to finance a budget deficit must be repaid by government raising future tax revenue. Rational economic actors realize this, so they anticipate a higher tax burden for them (or their children) in the future. The rational response by economic actors is to reduce their consumption and increasing their saving by equivalent amounts, ensuring that they can meet future tax obligations. The result there is no change in AD as the expansionary fiscal policy has been offset by an equal increase in private sector savings. The Ricardian equivalence theorem is highly controversial Stiglitz et al (2006, 65) point out that there are only a few cases in which an incomplete version of the theorem holds. However, the theorem does highlight the possibility that private agents might well behave in a way which at least partially offsets the intended outcome of anti-cyclical fiscal policy. 2. The emergence of stagflation (unemployment and inflation occurring together)

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after the oil price shocks of 1973 negatively affected the popularity of fiscal activism. Demand management was seen to be ineffective in solving cost-push inflation. In the face of the stagflation suffered internationally in the 1970s, Keynesians were forced to re-examine their earlier views on fiscal policy. It became apparent that Given the nature of the inflationary process, tax increases could no longer be regarded as an instrument of antiinflationary policy. Conventional Keynesian thinking had advocated tax hikes to dampen demand, but such policies proved not only to be ineffective, but also counter productive. A rising income tax burden could lead to increased wage claims that are passed on to consumers in the form of higher prices (wage-cost-price spiral)

Government spending had to be kept in check, since increasing the tax burden associated with increased government spending could give further impetus to inflation.

3. Growing evidence to support the view that government implementation of fiscal policy was not consistent but based on ensuring political popularity. As a result of all these concerns, Mohr and Siebrits (2009) note that the policymakers turned their attention away from fiscal stabilization policy in the traditional Keynesian sense. Fiscal policy increasingly focused on structural measures aimed at increasing the growth and job creating capacity of the macroeconomy, as well as considering the redistributive effects of government budgets. Mohr and Siebrits (2009) call this approach to fiscal policy, the structural approach to fiscal policy.

1.2

THE STRUCTURAL APPROACH TO FISCAL POLICY

Key features of the now favoured structural approach to fiscal policy include (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 tax burden could lead to increased wage claims and, hence, higher prices) Excessive taxes are argued to create major disincentives 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 a sustainable 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 countrys debt to GDP ratio, it is essentially a race between the numerator (the real debt level) and the denominator (real GDP). Since real debt grows at the rate of the real interest rate, r, and real GDP grows at the rate of growth rate of real GDP, g, the debt to GDP ratio grows at the rate (r g). So if r < g, budget deficits need not result in a growing debt-GDP ratio and the debt accumulation process is not explosive, at least relative to GDP. However, when r > g, the debt process 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 Washington consensus. The term Washington Consensus was coined by a UK economist John Williamson in 1989 and he set out specific economic policies that he believed should comprise a standard reform package for crisis-ridden developing countries by Washington-based institutions - the International Monetary Fund (IMF) and the World Bank. The approach was indeed developed by these two influential US institutions. The policies which were adopted by the IMF and the World Bank amounted to a rejection of states activist role and the promotion of a minimalist, non-interventionist state. Deregulation and privatisation, 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 sort themselves out, government intervention is unnecessary. It is clear then, that fiscal activism became unpopular. The commonly favoured approach to fiscal policy now appears to be one associated with 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 is an approach appropriate to an economy operating in the classical regime in which output and employment is supply constrained rather than demand constrained. The question is: how far out of favour has activism fallen? 2. FISCAL POLICY AND KEYNESIAN INTERVENTION IS NOT DEAD

2.1 PAUL KRUGMAN AND THE RETURN TO DEPRESSION ECONOMICS Snowdon and Vane (2005, 147) note that Paul Krugman, a leading US and a Nobel Prize-winning economist, warned economists that after a period of less volatile business cycles, the 1990s witnessed The Return to Depression Economics. Krugman (1999) argued that in the 1990s for the first time in two generations, failures on the demand side of the economy insufficient private spending to make use of available productive capacity have become the clear and present limitation on prosperity for a large part of the world (cited in Snowdon and Vane, 2005, 147). Given the experience of the Japanese, the Asian Tiger and a number of European economies in the 1990s, Krugman argued that economists could not afford to be complacent - depression and deflation are possible. Moreover, a number of economists, including Krugman, believe that the Japanese economy found itself in a liquidity trap in the 1990s. Moving on from the 1990s, more recent events in the world economy serve to endorse Krugmans view of The Return to Depression Economics. The world economy is still emerging from what is argued to be the worst economic crisis since the Great Depression of the 1930s 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 States in February 2010, a Keynesian tone is clearly present. The following is from a report on his lecture: What has been lost above all, Krugman argued, is an appreciation of ideas developed in the 1930s most notably the economist John Maynard Keyness broad view that in certain circumstances government spending is the best tool to instigate an economic recovery. At a time when interest rates are minimal

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and can hardly be lowered to spur private investment, Krugman argued, Keynesian thought is especially vital, despite some loud arguments to the contrary. Krugman believes the United States has benefited from the $787 billion federal (government) stimulus package that was signed into law in February 2009; it consisted of a combination of spending programs on things like infrastructure, education and research, along with some state aid and tax cuts...Krugman thinks the legislation helped alleviate the recessions effects. (Downloaded from http://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 lowered to spur private investment. Of course, not all economists agree with Krugman, but his view illustrates that Keynesian economics is certainly not dead. 2.2 THE HETERODOX VIEW ON THE EFFECTIVENESS OF FISCAL POLICIES IN DEVELOPING ECONOMIES

Stiglitz et al (2006) differentiate the heterodox view from the Keynesian view. The Keynesians and heterodox approaches both argue that economies suffer from extensive periods of unemployment. The heterodox economists generally agree with Keynesians that there is an important role for government in economic stabilisation, however they argue for a wider variety of instruments. Moreover, the standard Keynesian approach tends to emphasise aggregate demand, the heterodox approach also notes the importance of the aggregate supply. A decrease in AD or AS can adversely affect the economy. The heterodox approach also observes the positive supply-side effects of many policies, whereas the traditional Keynesian approach stresses the impact on aggregate demand. For example, the heterodox economist note that policies aimed at stimulating aggregate demand also have a positive supply effect due to the productivity gains generated by dynamic economies of scale and the increased use of the underutilized resources. Heterodox economists also recognize the limitations in equity and insurance markets have created risk-averse and creditconstrained firms and the impact this has on supply, as well as providing a richer explanation for changes in demand.

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The heterodox view (see Stiglitz et al (2006)) argues that fiscal policy may be particular effective, especially in developing economies, for the following reasons: 1. The Ricardian Equivalence theorem is unlikely to hold particularly in developing countries. Both Keynesian and heterodox views on fiscal policy run counter to the Ricardian equivalence theorem. Keynesian economists note that increased government expenditure has a multiplier effect on the economy, as it induces people to spend more, and thus the economy is stimulated. The value of the multiplier will depend on the saving rates of the economy in poor countries they tend to be low so the multiplier will 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 and cash constrained, especially in developing countries. If these households and firms could spend more, they would do so. Thus, the Ricardian equivalence theorem is very unlikely to hold. For example, if government gives such households a tax cut, it is likely that most, it not all of it will be spent (their marginal propensity to spend could be as high as 1), and likewise if government provided improved unemployment benefits. When they spend their increased disposable income, it will not necessarily go to individuals who have an equally high marginal propensity to spend (such as landlords, etc), but the overall multiplier effect can be very high. Expansionary fiscal policy in an economy in which firms are cash or credit constrained may benefit from a financial accelerator. Increased government spending generates extra income in the economy and that includes increased profits for firms. Firms then spend this extra income on investment. Moreover the value of equity increases in the expectation of a stronger economy, making it easier for firms to gain access to credit that is used for investment. In developing economies, Stiglitz et al (2006), argue that there is likely to be a high proportion of businesses that are cash or credit constrained, as a large fraction of business is carried out by small and medium-sized enterprises (SMEs).

2. Crowding in is likely to operate rather than crowding

out.

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Heterodox economists, especially, but also Keynesians, emphasise that expansionary fiscal policy creates crowding in of the private sector rather than crowding out. For example, higher government expenditure could stimulate the economy and improve the economic situation, which leads to investment expenditure by firms being stimulated. Also an increase in government investment that complements private sector investment, such as government spending on infrastructure, can increase returns in the private sector and stimulate private sector investment and the economy. Stiglitz et al (2006)) give two cases of where this has occurred: recent experience in China and India shows the complementarities between public investment and private investment that suggests crowding in rather 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. The argument is that long-term investors look beyond the immediate size of the fiscal deficit and government debt. Short-term investors are worried about the governments ability to repay its debt in the very near term and such investors heighten market volatility they are not the type of investors government should want to attract. Long-term investors look beyond such issues, they are concerned with policies that lead to long-run sustainable growth. These investors recognise that decreasing government expenditure usually decreases output and employment this creates a pessimistic outlook and tends act as a disincentive to investment. If governments borrow to finance productive investments that generate returns in excess of interest rate charges, the economys growth will be enhanced and investors will have more confidence in it.