Allocative and Stabilisation Aspects of 
Budgetary and Financial Policy

Willem Buiter's broad-ranging paper deals with the principles that should govern the design of budgetary and financial (including monetary) policy. He finds study of the subject deeply split between the neoclassical analysis of public finance, which deals with allocative efficiency, incentives and distribution in a world of continuous full employment and perfect capital markets, and the neo-Keynesian analysis of fiscal and financial stabilization policy, which often neglects allocative efficiency, incentives, incidence and distribution. Neither approach, he contends, advances our understanding of the real world. Stabilization, allocative and distribution policies are inextricably intertwined.

The presentation of public spending in the Financial Statement and Budget Report in the UK is criticised for being uninformative. It does not distinguish between "exhaustive" spending on goods and services, transfer payments and the cost of servicing the national debt, nor is the exhaustive spending total broken down into current (consumption) spending and capital formation. In Britain, General Government Capital formation has
declined dramatically since 1973. The obsolete and crumbling infrastructure depresses the quality of life and is likely to be a serious obstacle to sustained high economic growth.

As regards the financing of a given programme of spending on goods and services, Buiter maintains that no coherent set of economic arguments demonstrates that a continuously balanced budget is desirable, let alone optimal. Governments can do things private agents either cannot or do not wish to do: first, the institution of government is longer-lived than most private agents; second, government can tax. This permits the authorities to redistribute income and risk between individuals now and over time. Government can act as a superior financial intermediary, changing the composition of private sector portfolios over time and altering private disposable income flows. Government has a "comparative advantage" in borrowing to smooth out private income streams and facilitate risk sharing. Departures from budget balance are required for the government to exploit its position as the natural borrower or borrower of first resort. A further reason to depart from budget balance is to smooth tax rates over time, in order to minimise the total excess burden or dead weight loss imposed on the economy by taxes that are inevitably distortionary.

While capital market imperfections are the sine qua non of active financial policy, their combination with labour market and output market disequilibrium creates the widest scope and largest potential gains for active financial stabilisation policy. Absent real resource scarcities, financial crowding out is always avoidable and must therefore reflect incompetent financial and monetary policy design. The Keynesian intuition for counter- cyclical deficits is sound, but it requires stimulating supply side-friendly fiscal and financial responses to demand or supply shocks.

The comprehensive public sector balance sheet and the permanent income of the public sector are used to evaluate the sustainability of the fiscal stand (i.e., the consistency of current and future spending-taxation plans, monetary targets and debt burden constraints). Current consumption spending in excess of permanent income (a 'permanent deficit') is unsustainable. Some back-of-the-envelope calculations for the UK suggest an unsustainable 'permanent surplus' in 1982.

According to Buiter, there are no model-free measures of fiscal and financial policy impact on aggregate demand, output, employment or any other variable of interest. The conventional public sector financial deficit, the PSBR and the "full employment deficit" are poor indicators of fiscal impact, crowding out pressure, eventual monetisation, etc. Fiscal and financial policy since 1979 has contributed significantly to the depth and duration of the depression. While there has been some relaxation recently in the degree of tightness of fiscal policy, it is unlikely to create conditions for sustained recovery and growth so long as the myopic obsession with the PSBR persists and public spending on infrastructure remains low priority.

Allocative and Stabilisation Aspects of Budgetary and Financial Policy
Willem H Buiter

Discussion Paper no. 2, January 1984 (IM)