RDP 9002: Public Sector Growth and the Current Account in Australia: A Longer Run Perspective 4. Interpreting the Australian Experience

a. A Theoretical Framework

Our views reflect the following uncontroversial propositions:

1. relative prices are important in equating demand and supply over time and in satisfying the economy and sectoral wealth constraints;

2. expectations play a crucial role in the adjustment of prices and quantities to equilibrium.^[15]

   More specifically:

3. Investment and production decisions of firms are based on current and expected future profits. Expectation of the future path of the economy as well as real long term interest rates are important determinants of expected future profit. Short term nominal interest rates only matter if they reflect sustained changes in real interest rates. Capital market imperfections affect this relationship. Financial market deregulation in the 1980s has probably increased the relevance of this theory.^[16]
4. The trade balance is determined by relative prices, current income and expected future income.^[17]
5. Asset prices are determined by market-clearing conditions and arbitrage relationships (e.g. if domestic short-term nominal interest rates are above equivalent world interest rates, this reflects an expectation of depreciation of the nominal exchange rate).
6. On the supply side, firms employ factors of production based on marginal productivity relative to costs. The labour market is assumed not to clear since nominal wages are set independently of the short run conditions in the economy, although expected inflation plays an important role. The stickiness of nominal wages provide a good deal of the explanation for short run stickiness of goods prices and the resulting overshooting of asset prices, as in the Dornbusch (1976) model.
7. Money can have substantial short run real effects by changing short-run real rates of return that affect liquidity constrained individuals. In the long run, the rate of inflation is all monetary policy can affect. The effect on the balance of payments, of a monetary policy induced rise in interest rates, is ambiguous because the reduction in imports due to a fall in real income is offset by a deterioration in net exports due to the induced real exchange rate appreciation.^[18]
8. Consumption is based on the “life cycle model” in which households attempt to smooth consumption over their life-cycle. In this theory a temporary rise in income leads to a small change in consumption and a rise in saving as consumers spread the transitory income gain across their lifetime. A permanent rise in income in each period would lead to an increase in consumption in each period and therefore little change in saving.

A controversial (and extreme) extension of the life-cycle model is Barro's (1974) “Ricardian Equivalence Proposition”. This proposition argues that in a distortion-free world, consumers incorporate the government budget constraint into their own. Therefore they do not view government debt as part of wealth because of the future taxes implied in repaying the debt. A change in government spending on goods can affect consumption behaviour, but a change in the debt/tax mix for a given level of government spending will have no effect on consumption: it will only change private saving. It is worth elaborating this, Consider the case of a change in government spending on goods and services. Supposing the extra expenditure is on goods which consumers would have bought anyway (e.g. school lunches). In this extreme case, a permanent increase in government spending would have no effect on total saving or real interest rates, and therefore no effect on the trade balance or the current account. Consumption would fall instantly by exactly the extent that government spending rose. The means of financing the spending would be irrelevant. In the case of tax financing, the higher tax would merely be a transfer of purchasing power from the consumer to the government to purchase the goods that the consumer would have purchased. In the case of debt financing, consumers would willingly hold the additional bonds to save for the future taxes which will ultimately finance the debt. A similar argument can be made for a rise in transfer payments.

A temporary increase in government expenditure would raise interest rates, which would induce a temporary increase in private saving, a fall in investment and an appreciation in the real exchange rate which would imply a trade balance deficit. The funding of the temporary overall spending increase would have to be from abroad.

It is apparent that the assumptions required for full Ricardian equivalence are violated in one way or another.^[19] Limited access to financial markets, especially for borrowing against human capital, as well as differential rates of return between government borrowing and private borrowing is likely to cause deviations from the behaviour predicted by the theory. But the intuition provided by the theory may still be useful since the direction of change implied by the theory can still be relevant. Financial market deregulation in the 1980s and the greater availability of credit has probably increased the importance of the life cycle model in explaining consumption behaviour.

b. An Interpretation of the Recent Experience

In Section 3 we highlighted several stylized facts. The first is the gradual increase in taxation on households, which rose as a proportion of GDP throughout the period. This financed a gradual rise in government spending on goods and services during the 1960s which accelerated during the 1970s and then remained at a high level until 1986/87. The rising taxes also financed a rise in transfers. Transfers and government spending grew faster than taxes from 1974/75 to 1983/84, implying an increasing fiscal deficit.

During the 1960s as government spending rose (financed by taxes) with a relative stable fiscal deficit, private saving also rose, even though real interest rates were falling slightly up until 1969/70. If consumers thought that taxes would go on rising, this would be consistent with the life cycle theory with some Ricardian elements. In the Ricardian view, the perception of higher future government spending implies a fall in consumption and a rise in private saving. It is also consistent with alternative views, e.g., that fiscal policy was responding to a change in private saving rather than the other way around. One way of viewing this is that fiscal policy was subject to a balance of payments constraint. An exogenous increase in private saving would result in an improvement in the balance of payments which lessens the restriction on gradual fiscal expansion.

Understanding the period from 1972/73 is more difficult mainly because of our uncertainty about what the statistical discrepancy represents. If it is ignored, then during the 1970s private saving fell as government spending rose. This does not fit the Ricardian model, although this is consistent with the life-cycle theory if the period of lower growth in the 1970s was perceived to be temporary. Private consumption was maintained at the expense of savings. It is also consistent with the view that tax distortions combined with high inflation acted as a gradually increasing dis-incentive to save.

An attempt to capture this effect by constructing an after-tax real rate of return does not seem to support this argument, because from 1974/75 to 1981/82 there was a massive increase in real interest rates on bonds which dominates any distortion. Our measure of real interest rates relevant for saving decision is problematic because, as we stressed above, the rate of return to capital was positive during the 1970s and therefore the bond rate is probably a misleading measure of the total return to saving. It still may be useful to use the real return to bonds to calculate the distortion in this return due to the interaction of inflation and rising interest rates. For example, for a given real rate of return, the gap between pre- and post-tax real returns has widened from 1973 because of a rise in the average marginal tax rate and a rise in nominal interest rates, both of which worsen the distortion. The gradual increase in the wedge is positively correlated with the gradual decline in savings. Thus although we probably do not have the appropriate real return to savings, we do have some measure of the distortion. This is, of course, highly speculative.

The fiscal expansion in 1974/75 was followed a couple of years later by a rise in Australian real interest rates – even greater than the rise in world real interest rates. The decline in private saving and government saving may have pushed real interest rates up. It coincided with a deterioration in the trade balance, although the real exchange rate did not change much during this period. The link may be that the real exchange rate appreciation up to 1973, locked in by a wage explosion, prevented any real depreciation throughout the 1970s, keeping the exchange rate over-valued.

As shown in Appendix A, if the statistical discrepancy is allocated to consumption then the Ricardian model looks pretty good for the 1970s. The rise in private savings from 1961/62 to 1977/78 can be seen as Ricardian from 1973/74 onwards, although the earlier period (where there was no fiscal deficit) requires resort to more complex explanations relying on expectations of future tax increases. The problem with the Ricardian explanation is in explaining the movement in real interest rates, unless we appeal to other factors.

Finally we come to the period of fiscal restraint. This episode since 1984/85 has coincided with private saving falling a little from the peak of 1983/84, but trending upwards for the period as a whole. There was a rise in private investment and a rise in the statistical discrepancy. This doesn't look very Ricardian at first sight.

If the statistical discrepancy is included in consumption, the Ricardian explanation looks better although it still does not explain the fall in real interest rates. This fall in real interest rates is consistent with the life-cycle model. In the life-cycle model the fiscal contraction would partially increase consumption. But the rise in consumption would not be enough to offset the effect of the fiscal adjustment in reducing aggregate demand. The result would be lower real interest rates and a depreciation of the real exchange rate. The change in real interest rates should stimulate private investment and private savings which would further offset the fiscal adjustment. The depreciation of the real exchange rate should crowd in net exports. The balance of payments did not improve via this channel in the recent phase of fiscal adjustment because the real exchange rate actually appreciated, reflecting strong commodity prices and tight monetary policy.

An alternative to the life-cycle argument and especially the extreme Ricardian view can be based on another important difference in the post 1984/85 period: taxes and transfer payments have diverged. During the period up to 1984/85 the rise in taxes was offset by a rise in transfers, but transfers have fallen since 1984/85, while taxes continue to rise. The large fall in savings corresponding to the fiscal contraction implies that the rise in taxes has apparently been paid for out of private saving. This suggests that the apparently “Ricardian” behaviour could simply be Australians attempting to maintain a level of consumption they have always had. This also occurred in the 1970s during a period of below-average growth.

The result is that the recent fiscal adjustment has coincided with a decline in private saving (if the statistical discrepancy is included in consumption) and a rise in investment, with very little effect on the balance of payments. But there is an important change: although the balance of payments appears to have improved very little, it is more sustainable than before. An increase in investment can explain most of the continuing external imbalance and to the extent that we are now using foreign funding to increase investment rather than consumption, this is less worrying. Anything which contributes to higher future growth will imply a smaller required loss of consumption by future generations to service the outstanding stock of external debt. The remaining concern, however, would be that a good part of the improvement in the fiscal position has come from cutting capital expenditure, so to some extent the extra private investment is offset by reduced government investment.

We cannot rule out an alternative (or additional) explanation. The size of government outlays may not be the important issue. The evidence also suggests that the tax distortions driving saving and investment behaviour may be at least as important.^[20] This distortion is important for explaining the 1970s with a life-cycle model. Further evidence that the tax distortion has a significant effect on the economy can be found in the growth in corporate debt, detailed in Macfarlane (1989). Because firms could deduct the total interest payments rather than only the real component of interest, they had an incentive to borrow rather than raise equity. This did not necessarily change the amount of investment but would have affected the debt/equity mix.

Footnotes

These views are formalised in the MSG2 model of the Australian economy. The interested reader should refer to McKibbin and Sachs (1989), McKibbin and Siegloff (1988b) and McKibbin and Elliott (1989) for a formalisation of the MSG2 model. [15]

McKibbin and Siegloff (1988) find empirical support for this hypothesis. [16]

Early work on imports summarised by Macfarlane (1979) found empirical support for the role of relative prices in affecting import demand. Recent work by McKibbin and Cairns (1988) found that relative prices are empirically important although the elasticity is approximately −0.4, which is lower than in earlier studies. [17]

Empirical support for this in Australia is provided by both the Murphy (1988) and MSG models. It is also supported by the major global models surveyed in Bryant et. al (1988). [18]

For example see Carmichael (1982) for a detailed analysis. [19]

Kotlikoff (1989) argues that the U.S. evidence points to an important effect of tax distortions on savings behaviour. Feldstein (1989) points to the need for tax reform in the U.S. to stimulate savings. [20]