Fiscal policy: pressures and progress

The sudden and untimely passing away of Dr. Raghbendra Jha last year was a big loss for the economics profession in general and for MFEME in particular. He had been an active contributor and supporter as a member of the international board of editors since the inception. His commitment and speed of response was exemplary and an inspiration for all who worked with him.

An outstanding expert in macroeconomics (Jha 2023) and public finance (Jha 1987) and passionate about the Indian economy (Jha 2012, 2018) he was working on many more contributions as Professor Emeritus, Arndt-Corden Department of Economics, Australian National University. We dedicate this special issue on fiscal policy to him.

The papers illustrate principles that can be found in his writings. Rigour is necessary, but context matters. Theoretical frameworks must be adapted to give insights for emerging markets (EMs). EM governments have a lot to do. Sometimes how things are done can be more important than what is done. Research can throw up surprising windows of opportunity for EMs.

The Indian post pandemic experience with fiscal policy illustrates the rewards of careful thinking and tweaking of policy to suit local conditions. After unexpected policy outcomes in this period, the academia has become more sensitive to the importance of context-sensitive policy. Careful research, which MFEME encourages and provides a platform for, is required to design and to deepen understanding of such policy.

After the pandemic broke out, the dominant thinking in advanced economies (AEs) was to protect households through income transfers and other schemes. This was expected to revive both demand and the economy. There was tremendous pressure from many analysts to implement similar policies for India. But Indian government debt was high relative to Asian peers, the tax base narrow and the population exceeded a billion. A large fiscal transfer scheme would have bankrupted the economy. And supply chain bottlenecks meant it would raise inflation rather than output. Excessive US transfers had just this consequence for itself and for the world.

Indian fiscal policy gave short-term targeted supportfor example, by using food stocks for distribution of free food grains to 60% of the population and temporary liquidity support with good incentive properties through a reformed and revived financial sector. Short and longer-term stimulus was given through a better composition of government expenditure and continuing feasible reforms. The expenditure multiplier higher is higher for such spending since monetary accommodation becomes feasible (Goyal and Sharma 2018).

Deficit ratios did rise sharply in 2020 as growth was negative, but consolidation resumed the very next year, unlike after the global financial crisis when the ratios remained high for many years, contributing to high inflation, outflows and unsustainability of debt (Goyal 2011). In 2013, the Indian economy was labelled as ‘fragile’ and thought to be heading towards a crisis. Careless fiscal policy can quickly raise risk premiums in an EM.

A rising share of spending on infrastructure and other supply-side actions such as excise tax cuts when oil prices rose,¹ by moderating inflation causing supply-shocks, enabled the central bank to keep real interest rates at neutral and trigger the snowball effect (Goyal 2021). This is the fall in debt and deficit ratios when real interest rates (r) are smoothly below growth rates (g). The condition often holds in EMs where growth rates can be high on transition paths, but frequent shocks disrupt it as policy rates are raised sharply in response. In India, unlike the opposite combination in the 2010s, good fiscal-monetary coordination helped in counter-cyclical smoothing of shocks in the 2020s. The working of this coordination will be further explored in the introduction to Issue 17.3 on monetary policy.

The first paper set in this volume is on government debt. This is a topical issue since pandemic time stimulus followed by attempts to protect populations from the geopolitics-linked rise in international oil prices has raised debt sharply in many countries. AEs are able to borrow as required, but low-income economies and EMs are often forced to cutback expenditure on social welfare and investment to service rising interest obligations, despite borrowing less. An alarming estimate is that in 2024 there will be a net outflow of up to $50 billion from developing countries to AEs because of foreign debt repayment obligations.² Some countries may be unable to pay. So restructuring debt for low-income countries is a pressing concern. Since loan-pushing is prevalent in good times, countries also need to ensure they do not fall into such debt traps. The specific policy set that enables countercyclical macroeconomic policy in EMs includes limiting government foreign debt (Goyal 2024).

It is not clear, therefore, whether debt helps or hurts. While the first paper finds the fiscal multiplier to be higher when debt is low, the second finds that debt if used well and kept below a threshold does raise growth. This is the ‘how’ of debt and public spending. The composition and quality of spending affects outcomes. Government spending may be even more effective at a low level of financial development, perhaps because there are few alternatives.

Debt

Somayeh Sedighi, Samaneh Raiss Shaghaghi & Gabriel Temesgen Woldu examine effects op discretionary fiscal policy on output by employing a Panel VAR model in MENA countries during 1990–2018. They find fiscal multipliers are larger when public debt is low, institutional quality is high and during recession periods. A contrarian result is the response of output to fiscal shocks is larger at a low level of financial development.

Subaran Roy & Chitrakalpa Sen point out that traditionally, a higher debt burden is expected to negatively affect economic growth, although empirical evidence is inconclusive. They re-examine the debt–growth relationship for 32 emerging economies using a dynamic panel while considering possible nonlinear impact of debt on economic growth. The results for their sample suggest that a large debt, if used efficiently, can lead to significant positive economic growth. The relationship remains unchanged even with controls for other macroeconomic variables. They identify three different threshold debt-GDP ratios for one, two and three period lags of debt and found an asymmetric impact of debt between above-threshold and below-threshold countries.

Fine-tuning fiscal policy

The second set of papers brings out the ‘how’ of fiscal policy. In resource-rich EMs it has to look beyond short-term bonanzas and remain firmly counter-cyclical. Budget balance is found to improve financial stability.

Babatunde Samson Omotosho investigates monetary–fiscal interactions in resource-rich emerging economies using a Dynamic Stochastic General Equilibrium model. There is evidence of an active monetary and passive fiscal policy and the presence of revenue substitution; a phenomenon that alters the automatic stabilizer role of fiscal policy. Once the response of fiscal policy to oil-related flows is muted, the revenue substitution effect is neutralized. Taxes respond positively to debt, ameliorating the stagflationary impacts of negative oil price shocks. The findings highlight the need for dynamic tax policies that are less sensitive to receipts from resource rent as a strategy for achieving debt sustainability and overall macroeconomic stability in resource-rich countries.

Zhandos Ybrayev, Olzhas Kubenbayev & Akylzhan Baimagambetov investigate the macroeconomic consequences of an alternative fiscal rule in the context of commodity price shocks for a commodity-exporting country. A DSGE model set-up is estimated using macroeconomic data from Kazakhstan to explain the business cycle in an oil-exporting economy. Their results demonstrate that when fiscal policy is procyclical in response to a transitory negative oil price shock, and if a majority of households are non-Ricardian, then a one standard deviation drop in oil prices causes an output decline of about 0.19%. In contrast, if the fiscal policy is countercyclical and conducted according to the structural balance fiscal rule, output increases by about 0.13% in response to the same shock. They also report that countercyclical fiscal policy is robustly effective when the monetary policy is characterized by an active inflation stabilization framework.

Tien Ho Thuy, Oanh Tran Thi Kim & Truyen Pham Thanh examine the effect of the budget balance on national financial security using the VAR model approach from 1995 to 2020 in Vietnam with macroeconomic controls. Impulse response functions and variance decomposition analysis indicate that budget balance has a positive effect in the short term and explains about 2.04% of Vietnam’s financial security index. Several policy implications are drawn out to enhance financial stability.

Testing theories in emerging markets

The third set of papers finds the theoretical frameworks that are valid can vary in different countries and time periods and underdeveloped EM markets can be surprisingly efficient. Skill as an EM macroeconomist may include not only selecting the right framework for analysing an issue, but also adapting the framework appropriately!

Taiwo Ajilore & Nuruddeen Usman adopt the Quantile Autoregressive Distributed Lags (QARDL) method to examine the existence of locational asymmetry in the nexus between fiscal and current account deficits in the WAMZ zone. The results of the long-run relationships, which use both variables as dependent variables, reject the null hypotheses of parameter constancy and establish the variability of a twin deficit hypothesis across different quantiles. In the short run, the Keynesian view is validated for Gambia, Ghana, and Nigeria, whereas the Ricardian equivalence framework is indicated for Serria Leone, Ghana, and Liberia, suggesting the acceptance of twin divergence hypothesis. In addition, causality analysis finds evidence for arobust bi-directional relationship along all specifications, validating the long-run relationship established in the QARDL cointegration tests.

Tanweer Akram & Syed Al-Helal Uddin present empirical models of Mexican government bond (MGB) yields based on monthly macroeconomic data. The current short-term interest rate has a decisive influence on MGB yields, after controlling for inflation and growth in industrial production. John Maynard Keynes claim that long-term government bond yields move in lockstep with the short-term interest rate, holds for MGB yields. This has important policy implications for Mexico and is relevant for ongoing debates in macroeconomics.

Evolution of policy

The final set of papers show that macroeconomic variables and financial structures can survive crises. Policies can improve and adapt despite volatility. The composition and efficiency of government spending is vital – that ‘how’ again.

Dorsaf Azouz Ghachem & Aymen Khamassi measure the systemic risk of the Tunisian financial system around the revolution period using the covar method and test its ability to predict future unemployment rates. Their results show that public systemic banks kept their ranks both before and after revolution. Conversely, private bank classification was partially reversed between the two periods. The top five ranks remain occupied by the two public banks and the three largest private ones in terms of size, capitalization, efficiency and loan activities. The global Tunisian systemic risk seems not to be able yet to predict the future unemployment rate evolution.

Jayeeta Roy Chowdhury & Arpita Ghose establish the role of efficiency of public infrastructure use by private/public production sectors, and the composition of public infrastructure (i.e. proportion of public infrastructure directed towards productivity-enhancing purposes), in the growth-process. For a small open economy with private/public production sectors and free trade, increase in efficiency of public infrastructure use by private/public production-sector increases balanced growth rate, ratios of economy-wide aggregate-level of (i) private to public capital and (ii) employment to public capital, under restrictions on efficiency – composition mix of public infrastructure and the free trade price, given other model parameters; i.e. the effect of efficiency-increase depends on public infrastructure composition. Thus, assessment of macroeconomic policy on employment should consider efficiency and composition of public infrastructure.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. This was feasible because excise taxes on oil had been raised when international oil prices fell in 2014. Relatively high taxes gave room to cut.

2. See https://data.one.org/data-dives/net-finance-flows-to-developing-countries/.