Public Sector Deficits and Macroeconomic Performance.

• Author: Hassan, Seid Y.

Public sector deficits are blamed for over-indebtedness, high inflation, and poor investment and growth performance. Easterly and Schmidt-Hebbel find deficits crowd out investment and are inversely related to interest rates. However, deficits are negatively correlated with per capita growth implying a positive correlation between high economic growth and fiscal surpluses. They are inversely related with total and private consumption implying that taxes crowd out private consumption. This finding contradicts the Ricardian hypothesis that suggests public consumption lowers private consumption. Moreover, debt financing is positively correlated with interest rates or with financial repression while money financing is inflationary. There is no clear cut relationship between public deficits and real exchange rates and trade deficits. If there were strong relationships between the two deficits this would imply changes in public saving are not offset by domestic private saving. The authors note that the effects of deficits on real exchange rates depend on whether the government spends more on tradables than on non-tradables. These evidences presented in Chapter 1 and the remaining chapters are based on ten representative countries (Argentina, Chile, Colombia, Cote d'Ivoire, Ghana, Mexico, Morocco, Pakistan, Thailand, and Zimbabwe) and using different deficit measures (such as deficits based on the consolidated total public sector, which includes the central bank, the accrual basis, and operational deficits, etc.). It is not that the authors just illustrate their findings based on their empirical investigations. They also explain why one might, on theoretical grounds, obtain results contrary to his/her expectations. For example, the effect of deficits on inflation is ambiguous because deficits are also financed by borrowing. The effects of deficits on interest rates are also ambiguous if public debt and other assets held by the private sector are highly substitutable and there are no financial repressions.

In Chapter 2 Carlos Rodriguez analyzes the effects of public sector deficits on the real exchange rate, balance of trade, current account, and external indebtedness. Assume that deficit due to tax cuts is financed by either foreign borrowing, domestic borrowing, or money creation. If the private sector reacts by investing the tax savings in foreign assets, the real exchange rate will not change and Ricardian equivalence results. However, the...