Between 1979 and 1984 the US government deficit, adjusted for the effects of inflation on the value of public debt, increased by 6.3% of national income. This represented 8% of gross world savings. Over the same period, the US balance of payments on current account deteriorated by $100 billion US, and US real interest rates rose from 1.2% to 8.1%. There was also a 45% appreciation in the real exchange value of the dollar, measured as the price of domestically produced or "home' goods in terms of foreign-produced goods. These developments had a major impact on the rest of the world economy.

Western Europe and Japan profit from high interest rates, since they are net creditors to the rest of the world, but these same high interest rates have contributed to sluggish investment performance, especially in Western Europe. The high exchange rate of the dollar has also fuelled a modest expansion of exports from Europe and Japan. At the same time US goods have become more expensive in terms of European and Japanese domestic output, and this has brought about a considerable deterioration in their terms of trade.

The effects on developing countries have been more dramatic. The real appreciation of the dollar has contributed to depressed commodity prices and a 20% deterioration in developing countries' terms of trade with the OECD between 1980 and 1984. Furthermore, according to World Bank estimates, a one percentage point increase in interest rates leads to an immediate $2.3 billion increase in annual interest payments by LDCs on their foreign debt. This increase in annual debt service climbs to $8 billion within five years. By comparison official development aid received by LDCs from OECD countries in 1984 was only $27 billion.

The extent to which US fiscal policy is responsible for the behaviour of interest rates and exchange rates has been the subject of much recent controversy. Whether a reversal of current trends in US budget deficits would lead to an orderly reduction of real interest rates and the value of the dollar is equally controversial. It is the dominant issue in the current international economic policy debate. This article discusses some of the economic effects of fiscal deficits and describes research undertaken on these issues by CEPR Research Fellows.

Government deficits can increase because of higher expenditure or lower tax revenues or a combination of the two. What are the effects of such an increased deficit on other sectors of the economy? Higher government expenditure, quite apart from its method of financing, directly increases the demand for goods and services in the economy. It will thus increase the volume of output and the price level and therefore interest rates. The mix of price and output increases will depend on the degree of slack in the economy. If the economy is close to full capacity or if supply is restrained by overly high real wages, output will not increase, shifting the entire adjustment to prices. The laws of arithmetic dictate that if the volume of total output is fixed, every extra unit of spending by the government means one unit less for the private sector. This is called "direct crowding out' of private expenditure.

Tax cuts which lower government revenue will obviously increase the government deficit. However, the effects of the deficit must be distinguished from the effects of a change in the tax structure. Even if a tax change were to leave total government revenue and the deficit unaltered, it could affect private expenditure by changing the incentives the private sector faces. This has certainly happened in the United States in recent years. The strength of US investment during 1983-84 can be attributed in part to the favourable treatment of capital in the tax legislation enacted in 1981. This change in the tax structure increased the demand for capital goods. The increase in investment implied increased current spending. The resulting higher interest rates, which make current goods more expensive relative to future goods, were merely the price response to this shift from future to current spending. The explanation of higher real interest rates therefore lies not only in the US fiscal deficit itself, but also in the tax-induced investment boom in the United States.

There is greater uncertainty over the effects of a deficit when the structure of government spending and taxation is unchanged and only the method of financing expenditure is varied. Suppose government savings decrease because of a switch from taxation to bond-financed expenditures. If the private sector does not offset this fall in goverment savings by increasing its own savings out of post-tax income by the same amount, then national savings will fall. This fall in national savings means that more is being spent now instead of being saved: expenditure shifts from the future to the present. Higher interest rates again represent the price response to such an intertemporal expenditure shift, triggered by increased budget deficits. This is called "indirect crowding out', because there is no greater direct competition between the public and the private sector in the goods markets.

The validity of indirect crowding out has often been questioned. Some economists argue that when governments cut taxes and issue bonds instead, the private sector will realize that the government will have to raise taxes at a later date to service and repay the bonds. Consumers, according to this view, will thus recognize that the additional government bonds they hold do not represent a net increase in wealth and so will not increase their spending. Instead, they will save all the extra income they receive from the tax cut, in order to offset their own increased future tax liabilities. They may also save more in order to leave larger bequests to their children, to the extent these children are liable to pay higher taxes in future. In both cases private savings will rise and total savings by the public and private sector will not be affected by the bond-financed deficit. Thus, the balance between savings and investment remains unchanged and interest rates will not rise: the switch from tax to bond financing is "neutral', according to this view.

This suggests that we should observe higher private sector savings when government deficits rise. Recent experience, however, does not seem to support this argument. Private savings should have increased as the industrial economies, especially the United States, climbed out of the 1980-82 recession, even if government deficits had remained unchanged. Private savings should therefore have increased more than government savings declined if debt financing is indeed neutral. But the increase in private savings in the United States between 1982 and 1984 was in fact much smaller than the increase in government deficits, and private savings did not increase at all between 1979 and 1984.

My own research, reported in CEPR Discussion Paper No. 21, and that of CEPR Programme Director Willem Buiter, reported in Discussion Paper No. 28, has focussed on reasons why private savings may fail to offset public sector deficits. One explanation focusses on the extent to which the private sector is concerned about future tax liabilities. Many do not expect to be alive themselves when these taxes must be paid and might not plan to leave their children larger bequests in order to compensate them for the higher taxes in future. In that case increased private savings will not completely offset public
sector deficits.

Some forms of tax cuts may actually reduce private savings through substitution effects, especially when the cuts are expected to be reversed in the future. This will be the case when an expenditure tax such as VAT is reduced, or when existing deficits are expected to be reduced in the future by the introduction of an expenditure tax, as has been suggested in the US. Such changes in the tax schedule effectively make current goods cheaper in terms of future goods. Since goods purchased in the future will be more expensive because of the tax increases, consumers have a clear incentive to increase their current spending. In these circumstances private savings will not increase to offset the government deficit and national savings will fall.

If private savings do not rise to offset completely increased government deficits, what effects will this have on interest rates, exchange rates, and on the national and international economy? Recent research (CEPR Discussion Papers Nos. 21 and 28) has attempted to trace these effects at a theoretical level, using simplified general equilibrium models of the world economy.

The conclusions are clear. If for whatever reason the deficit is not completely offset by private savings in the country that has increased its fiscal deficit, national savings must fall and the current account of the balance of payments will deteriorate. This cannot happen in all countries simultaneously. A current account deficit in the fiscal deficit country must be matched by a current account surplus elsewhere. To bring about this net increase in foreign savings, interest rates must rise to restore a global equilibrium between world income and expenditure. The net effect will be a shift from current to future expenditure abroad that exactly matches the shift from future expenditure to current expenditure in the country running the increased fiscal deficit.

The key to understanding the response of the real exchange rate lies in the patterns of expenditure at home and abroad, whose importance was first realized by Metzler in the 1940s. If private savings do not rise to offset the government deficit, total consumption in the deficit country will rise and, because of the induced effect on interest rates, foreign consumption will fall. Suppose first that consumers in the deficit country spend proportionally more of their income on goods produced in their own country than foreigners spend on these same goods. Then as total consumption rises in the deficit country and falls abroad, net demand for goods produced in the deficit country will rise and demand for goods produced abroad will fall. This demand shift will lead to an increase in the relative price of goods produced in the deficit country and causes its real exchange rate to rise. Alternatively suppose that consumers in the deficit country spend the same proportion of their income on home goods as foreigners spend on these goods. In this case net demands and relative prices will not change as a result of the deficit and there will be no effect on the real exchange rate. There seems little doubt that the first supposition is the more realistic. This will certainly be the case if a significant part of home goods are not tradeable, since that implies that foreigners cannot consume them at all. International budget comparisons show also that this condition is satisfied in practice. Net demand for home goods will therefore rise after a decline in savings and an increase in world interest rates induced by a fiscal deficit. As a result, the real exchange rate appreciates in response to a bigger deficit.

These responses to a deficit can therefore have serious international consequences. High interest rates inflict welfare losses on the developing countries, who are net borrowers. Moreover an increase in public or private spending in the industrial countries generally increases the demand for their domestic goods more than for imports from developing countries. The price of goods produced in industrial countries, therefore, rises relative to that of commodities produced in developing countries. This deterioration in their terms of trade inflicts further welfare losses on the LDCs.

It is important to assess empirically the international effects of fiscal deficits. This is another focus of research underway at CEPR. My own work attempts to quantify the effects of US deficits on world interest rates, the global distribution of savings and the structure of the terms of trade. These results will be presented to the first meeting of the Economic Policy Panel in June and will be published in the October issue of Economic Policy. CEPR Research Fellow Patrick Minford, in a separate global modelling exercise described in Discussion Paper No. 11, explores the intra-OECD effects of US deficits, while my analysis focuses on the linkages between the OECD, OPEC and the LDCs through trade flows and capital markets. Both analyses provide evidence that deficits have substantial effects on real interest rates and terms of trade. They suggest that as a rule of thumb, a $50 billion increase in the US deficit pushes up real interest rates nearly 1.5%. An effect of this magnitude clearly justifies the concerns outlined at the beginning of this article.

Warren McKibbin and CEPR Research Fellow Jeffrey Sachs explore a related issue in Discussion Paper No. 55. They show, using a simulation model, that improved coordination of fiscal and monetary policy within the OECD not only benefits the OECD itself, but also makes the developing countries substantially better off. Such coordinated policies to reduce inflation in the McKibbin-Sachs simulations involve more restrictive fiscal and more expansionary monetary policies. This mixture of policies results in lower real interest rates and so benefits the LDCs.

Future research needs to devote more attention to the stabilization aspects of fiscal policy, especially in Western Europe, and to fiscal policy and external balance in developing countries. Such region-specific studies should increase the realism and relevance of the global modelling exercises currently underway and improve our understanding of the international repercussions of fiscal policies.

Sweder van Wijnbergen

This is one of a series of articles describing research relevant to economic policy. Sweder van Wijnbergen is a senior economist in the Country Policy Department at the World Bank and a CEPR Research Fellow. The World Bank does not accept responsibility for the views expressed in this article, which are those of the author. Further details of this research can be found in CEPR Discussion Papers Nos. 11, 21, 27, 28, 36, 55, 56 and in International Economic Policy Coordination, the proceedings of the June 1984 conference organized by CEPR and the National Bureau of Economic Research (Cambridge University Press). Sweder van Wijnbergen's analysis of US deficits will be featured in the first issue of the new journal Economic Policy, available in October.