Keen Eye for Economic Trends: No magic bullet for fiscal consolidation

SATO Motohiro
Faculty Fellow, RIETI

The prospects for the goal of turning the primary balance of the national and local governments into surplus by FY2020 are becoming increasingly uncertain. Although the Cabinet Office estimates that even under the economic recovery scenario, which assumes successful results for the Abenomics policy, a deficit of 8.3 trillion yen will remain, there are schools of thought arguing that making fiscal consolidation efforts is unnecessary. According to this argument, fiscal soundness will be restored automatically, without any painful reform such as an expenditure reductions or tax increases.

One such school of thought is fiscal activism. According to Domar's theorem, the primary balance necessary for keeping the balance of public debts stable as a proportion of gross domestic product (GDP) depends on the difference between the growth rate and the interest rate. That is because while the value of the numerator (balance of public debts) increases in accordance with the interest rate level and the primary balance deficit, the value of the denominator (GDP) increases in accordance with the economic growth rate. So long as the economic growth rate is higher than the interest rate, the balance of public debts as a proportion of GDP does not expand even if the primary balance remains in deficit. In other words, fiscal sustainability is maintained in the sense that debts do not continue to grow too large compared with the economic size. Therefore, proponents of fiscal activism insist that the fiscal situation can be kept sustainable despite the estimate that debts will remain if the growth rate is raised through large-scale fiscal expenditures while the interest rate stays low due to the effects of the quantitative and qualitative monetary easing policy.

However, in reality, things are not so convenient. If the economy improves, companies are likely to increase capital investment. If fund demand from the government and companies increases, interest rates will rise. Indeed, according to the Cabinet Office's estimate, although the current interest rate (around 0%) is lower than the growth rate (2.5%), the interest rate over the medium to long term (4.4%) is expected to be higher than the growth rate (3.8%). Even if an attempt is made to keep the interest rate low through monetary policy, it is impossible to continue to fight against market forces (upward pressure on interest rates) indefinitely. According to Domar's theorem, fiscal sustainability cannot be maintained unless the primary balance is turned into surplus in this case.

Meanwhile, Sims' theory (Fiscal Theory of the Price Level), which has recently become popular, holds that fiscal consolidation can be achieved through inflation, rather than through economic growth. Assuming that fiscal collapse will be avoided, the government's long-term fiscal balance will be equal to the real present value of the balance of public debts (=nominal value ÷ price level) and the present value of the primary balance surplus over the period from the present into the future in real terms.

If the situation is to be compared to household finance, this means that the value of people's lifetime consumption is more or less equal to the value of their lifetime income. Under this condition, if the government chooses not to improve the primary balance, things will add up only when the real value of the balance of public debts is inflated away. If that happens, deflation will be overcome and the debts will be reduced at the same time. While this is also a very convenient argument, the key is expectations. If households expect that there will be no fiscal consolidation or tax increases into the future, consumption will grow. An increase in macro-level demand will contribute to higher prices.

However, it is possible that households will expect otherwise. They might expect that the deterioration in the fiscal situation could fuel concerns over the future. If confidence in public debts declines, interest rates will surge as a reflection of the default risk. Interest payment cost will grow, accelerating the deterioration of the fiscal situation. Under Sim's theory, the possibility of this situation occurring is excluded merely as an assumption, not as an outcome arrived at through reasoning.

Fiscal activism is based on the assumption that the growth rate will stay higher than the interest rate, while Sim's theory assumes that households will have optimistic expectations. However, both growth and expectations are subject to be formed via market mechanisms and cannot be directly controlled by the government. The only item that the government can control in an attempt to steadily achieve fiscal sustainability is the budget, namely, the primary balance. There is no magic bullet for fiscal consolidation.

>> Original text in Japanese

* Translated by RIETI.

April 1, 2017 Weekly Toyo Keizai

May 15, 2017