ECONOMIC

ANALYSIS
1
The Fiscal Policy Debate

Should policy be active or passive?

(i.e. to change or not to change y*)

Some say YES but….

Some say NO
2
The Do SOMETHING View
(activist - keynesians)

“ Governments should use

public policy
in order to arrive to full
“
employment

KRUGMAN
 WHY POLICY SHOULD BE ACTIVE
EVEN WHEN THE ECONOMY
(MIGHT) RETURNS TO FULL
EMPLOYMENT ALONE

Recession creates
unnecessary suffering
4
 WHY POLICY SHOULD BE
ACTIVE?

Recession creates
unnecessary suffering

Doing nothing might not solve

the problem 6
 Nevertheless some (classical
economists) believe that FISCAL

?
policy should NOT be active

7
The government should only define
property rights and protect them...

Milton Friedman

8
TWO
REASONS
WHY HE IS
THE
DEVIL..

9
10
 ARGUMENTS AGAINST ACTIVE POLICY

They are RETARDS

(we refer to delays)
1 - takes time to recognize the problem

2 - takes time to implement policy,

3 - the time it takes for policy to affect

economy Due to these long lags, critics of active policy argue that such
policies may destabilize the economy rather than help it.
‹#›
 Johnson increased
government spending,
decreased taxes but he
managed only to create
inflation

….BECAUSE OF LYNDON B. JOHNSON

FISCAL POLICY FAILURE…
 RIP
FISCAL
POLICY

1933 - 1965
Monetary Policy
was born…
Monetary Policies was preferred since
does not has some of this lags…

Fiscal Policy vs Monetary

!16
% Change 40
USA
30 Investment
20
GDP
10
0
Consumption
-10
-20
-30
1970 1975 1980 1985
17 1990 1995 2000 2005
 o n
As
re
n d
2
18
Probably the most important one…
But...
How to pay for
expansionary
policies ?
Basic Budget
Arithmetic
?
…IT MUST SATISFY...

G + Z + INT = T + Borrowing

AL
WA
YS
!
Borrowing = Deficit (DEF)
… some Kournikova
Arguments…
G + Z + INT = GovRev (T) + DEF
Because of this for many
economist he is…

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PUBLIC DEBT

PDt+1 = PDt + DEFt

… more Kournikova…
 I promise...

I will increase government spending

and transfer payments…and reduce
the budget deficit at the same time!
(without increasing taxes)
 THE PROBLEM SET
If the GOVERNMENT
SPENDING increases
could TAX REVENUES
increase ?
But enough in order
to finance the
increase in G ?
 Expansionary policies ALWAYS
increase the Public Debt

AL
WA
YS
!
 Expansionary policies
always increase the public
DEBT

But when it is justifiable to

do it ?

30
 Expansionary policies ALWAYS
increase the Public Debt

AL
WA
YS
!
 OK,
expansionary
fiscal policies
increase the
public debt…
and so what
 Expansionary policies ALWAYS
increase the Public Debt

AL
WA
YS
!
BUT IT IN USA IT DROP VERY FAST! WHY?
Expansionaries fiscal policies always
increase de budget deficit …in the
SHORT RUN
AL
WA
YS
!
1
Y* = (C0 − c′To + I + G)
1 − c′ + c′t′
But in the long run the budget deficit
MIGHT return to normal levels
 In order to START JUMP the
economy the fiscal effort has to be big
enough to convince households that
the economy is recovering.
 OK,
expansionary
fiscal policies
increase the
public debt in
the short (and
maybe also in
the long run)…
and so what
The Sustainability of
Public Debt is a big
concern
Why there was such a big
concern for the public
debt of PIIGS if it was not
too high ?
PUBLIC DEBT / GDP (2011)
Because the problem is
not how BIG it is but if it
is sustainable or NOT !
 Data shows that Defaulters usually are
40 %

NOT the countries that owe the most…

30 %
share of defaulters

20 %

10 %

0%
0 to 20% 20% to 40% 40% to 60% 60% to 80% 80% to 100% above 100%
Debt GDP ratio in year before default
 Why ?

47
 Conditions for a CONSTANT public debt/GDP ratio

(g - r) PD = D
Where r is the interest rate, PD is the public debt, g is the growth
rate of GDP and D is DEFICIT (to be studied in detail in GEE)

What happens if r > g ?

The government must run a
surplus…and if they cannot ?
Why the public debt
of the PIIGS turned
unsustainable ?
35
Portugal

30 France

Germany
25
Greece

Ireland
20
Spain

15

10

0
2006 2007 2008 2009 2010 2011 2012
Conditions for a CONSTANT public debt/GDP ratio

(g - r) PD/Y = D/Y

What happens if r > g ?

 Defaulters usually are not the
countries that owe the most…why?

40 %

30 %
share of defaulters

20 %

10 %

0%
0 to 20% 20% to 40% 40% to 60% 60% to 80% 80% to 100% above 100%
Debt GDP ratio in year before default
Why Japan can run a BIG public debt and no to
be worry about it ?
Italy is in trouble…
And if the Public DEBT is
unsustainable…

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 Merkel:
FISCAL
DISCIPLINE
is the ONLY
56
solution
 RIP
FISCAL
POLICY

1933 - 1965
2009 - 2011
 WHAT IS AUSTERITY
ROAD ?

To reduce the budget

deficit, how?
 DID AUSTERITY TOOK PIIGS TO THE
PROMISE LAND ?

PIIGS
 WHERE IS GDP HEADING
TO WITH
AN AUSTERITY PROGRAM?
 DID AUSTERITY TOOK PIIGS
TO THE PROMISE LAND ?

NO
63

Budget DEFICIT
 …and it was falling !!

PUBLIC DEBT/GDP
64
 Why ?

BECAUSE GDP FALLS UNDER AN AUSTERITY

PROGRAM, THEN GOV. REVENUE ALSO FALLS
AND THAT MIGHT INCREASE EVEN FURTHER
65
THE BUDGET DEFICIT
Now,
who
can
save
us ?
 Welcome to
Monetary Policy

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69
To be continued...

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