Over the past century, fiscal policy has been dominated by the Keynesian concept of increased government spending during a recession to stimulate the economy. Many governments have followed this course of action and accumulated large debts in the process. In some cases, countries have been able to sustain these debts, while in others, especially in developing countries, large fiscal deficits have contributed to financial crises. Why is it that some countries have been able to maintain large debts while others have not? Why have countries like Belgium and Italy been able to accumulate deficits far greater than those in Argentina without experiencing the same kind of crisis?

The authors argue that the ability of a government to pursue loose fiscal policy through borrowing is determined by the supply of funds available for it to borrow; the authors call this the country’s “financial depth”. When financial depth is limited, any funds devoted to finance government spending cannot be used for private investment. Since private investment projects yield more productive outcomes than government spending, increased government spending may actually slow down economic growth. Given that the supply of funds available to emerging countries is generally smaller than that available to advanced economies, emerging countries are less able to pursue an expansionary fiscal policy.

Private investment is crowded out whenever a government loan absorbs funds that would have otherwise been borrowed by the private sector. When the supply of funds is fixed, each additional loan to the government is one less loan to the private sector. If government borrowing causes the total supply of funds to decrease, however, such crowding out can even be greater than one-for-one. The authors develop an analytical model to show how this can occur. They identify two main channels by which increases in government spending reduce the supply of funds available: through a reduction in the aggregate liquidity of the country’s assets; and through a weakened perception of the government’s fiscal responsibility.

Suppose that some lenders decide to stop lending funds to a country. When this occurs, there is some threshold level of public debt at which the government will be able to just repay its loans. At debt levels above this threshold, the government will be unable to refinance its loans because the supply of funds is limited. A situation similar to a bank run will then occur, in which lenders will require a higher liquidity premium, lowering the liquidity of the country’s assets and further reducing the supply of funds available to the country. As a result, government borrowing above this threshold of debt may result in a more-than-proportional crowding out of private investment. As private investment is crowded out, the liquidity of the country’s assets is even further diminished. This process continues until either the government reduces spending or defaults on its debt.

Lenders are concerned about sovereign risk. Given the difficulty of enforcing repayments on government debt, lenders are sensitive to governments’ commitment to repay their debts, and few investors are willing to lend to fiscally-undisciplined governments. With less financial depth, it is more likely that these governments will experience crowding out; this counteracts the expansionary effect of government spending. Investors’ perceptions of a government’s fiscal responsibility can change with its actions. During a financial crisis, a government that spends freely will be considered a greater risk than investors had previously thought. A government that controls spending will receive a more favorable judgement. But a government whose perceived reliability has diminished will certainly see a decrease in its country’s financial depth. The timing of adjustment also matters: a government that controls spending during the beginning of a crisis will be viewed more favorably than one that reacts late.

To what extent do advanced and emerging economies differ in their ability to sustain fiscal deficits? A government pursuing an expansionary (Keynesian) policy will increase spending during a recession and decrease during an expansion, resulting in a counter-cyclical relationship between fiscal deficits and Gross Domestic Product (GDP). If government debt results in capital flights and the crowding out of private investment however, deficits and GDP will be pro-cyclical. The authors use their model to argue that a counter-cyclical relationship is more likely in advanced countries, while pro-cyclical deficits are more likely in emerging countries.

The different experiences of Italy and Argentina provide an example of this. During the 1990s, Italy ran fiscal deficits at approximately 15% of GDP, far greater than Argentina’s 4% deficit. But despite this difference, deficits during this period were counter-cyclical in Italy and pro-cyclical in Argentina. Looking at a broader range of countries, the authors find a similar pattern among advanced and emerging economies. Deficits tend to be more pro-cyclical in emerging markets. This trend, the authors argue, results from the limited financial depth (and thus greater crowding out) those countries face. On this basis, the authors argue that crowding out is generally higher in emerging countries, and that the difference is much more significant during financial crises. This claim is supported by empirical evidence, which suggests that emerging countries most often see their loose fiscal policies backfire.

The policy implications of this paper are clear. Many governments are tempted to increase spending during a recession, hoping to speed up a recovery. The success of this policy, however, will partly depend on investors’ willingness to finance the spending. When the supply of available funds is limited, increasing government spending can actually backfire, prolonging the recession and increasing the probability that the government will default on its loans. This paper argues that emerging markets and countries with populist, spending-prone governments - two characteristics that are often seen together - should be wary of accumulating large fiscal deficits, given their limited financial depth.

Report Source:
"Fiscal Policy and Financial Depth", a Working Paper by: Ricardo Caballero (MIT and NBER), Arvind Krishnamurthy (Kellogg School of Management, Northwestern University).
November 2004, pp.21