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Some of Europe's top academic economists met in Paris on June 20- 21 to share ideas on tackling key policy issues The Economic Policy Panel, comprising 20 leading economists (from eight European countries) noted also as experienced policy advisers, will meet twice a year to discuss specially commissioned papers. These papers and the proceedings of the Panel will be published in a new journal, Economic Policy, which will offer a non- partisan European perspective on current economic issues. Lively, topical, and accessible to the non-specialist, Economic Policy will demonstrate how the best economic analysis can be used to improve the quality of public policy debate. Economic Policy is sponsored jointly by the Centre for Economic Policy Research in London and the Maison des Sciences de l'Homme and Ecole des Hautes Etudes en Sciences Sociales in Paris. CEPR has received grants from Citibank, the Esmee Fairbairn Charitable Trust, and the Alfred P Sloan Foundation to assist in launching Economic Policy. With world inflation increasingly under control, attention in recent years has shifted from monetary to fiscal policy. At home and abroad the size of the government's debt and budget deficit has assumed increasing importance in the policy debate. Willem Buiter (Yale and CEPR) addressed this issue in the first paper presented to the Panel,'A Guide to Public Sector Debt and Deficits'. In it he drew together the insights of recent research in which he has played a leading role. Buiter began by examining the history of the public debt in the United Kingdom and abroad. Contrary to popular belief this is now at historically low levels in the UK. The ratio of debt to Gross Domestic Product is at almost its lowest level in two hundred years, and well below the peaks reached after the Napoleonic and Second World Wars. Buiter suggested three reasons why deficits might be a matter for concern. First, there is a belief that they lead to faster monetary growth and inflation. This might happen if governments were tempted to reduce the real value of their nominal debt by engineering an unanticipated inflation. But this may be more difficult than it might seem, because inflation usually displays a considerable degree of inertia. Much government debt is short- term, and its real value may be unaffected by the inflation. Inflation will also make selling debt more difficult in the future. There may also be a limit to the amount of government debt the private sector is willing to absorb. A government that runs a continued deficit may eventually face the choice of either raising taxes (or reducing its expenditure) or increasing monetary growth, thus fuelling inflation. Buiter showed, however, that very high inflation rates would be necessary to avoid even modest changes in taxes. Governments would therefore be very unlikely deliberately to pursue the inflationary course. Consequently there is no simple link between deficits and inflation. The second possible reason for concern is that a large public debt may lead to insolvency and encourage debt repudiation. When is a government insolvent? Buiter argued that government solvency requires that the value of the government debt equals the present value of future budget surpluses. However, the appropriate concept of the surplus is the excess of income over current expenditure. Public sector investment should only enter the calculation if the return on public and private sector capital differs. Buiter also developed the allied concept of a 'permanent deficit'. This represents the long run adjustment to spending plans that must be made if the government is to remain solvent. This is very different from the conventional measure of the deficit. It includes on the income side the return from public sector capital, and uses real rather than nominal interest rates to calculate expenditure on debt interest. The third reason why deficits figure so prominently in public debate is the fear that large public sector deficits are likely to 'crowd out' private sector spending, especially investment. Buiter argues that one must specify the time scale over which the crowding-out occurs, since the effects are often very different in the short and long run. It is also important to distinguish between crowding-out due to high interest rates and that due to supply constraints. The former can be avoided by expansionary monetary policy while the latter requires measures to expand supply in the economy. Finally, the role of expectations is crucial, Buiter argued. Anticipations of future expansionary fiscal policy can have a contractionary effect now if they lead to a rise in long interest rates and a consequent decline in investment. Indeed the same mechanism can even cause a permanent increase in budget deficits enacted today to have contractionary effects. In the concluding part of his paper Buiter considered whether one can develop measures of the impact of fiscal policy on the economy. He argued that it is impossible to develop a 'model- free' measure of fiscal impact. Measures of fiscal impact can only be developed in the context of a theory of how the economy operates. Neither the actual, nor the various 'corrected deficit' measures proposed by the IMF, OECD and others provide appropriate measures of fiscal stance. In the ensuing panel discussion, Torsten Persson (IIES, Stockholm) drew attention to the conflicting pressures for a debt repudiation. On the one hand, a once-and-for all levy on capital had advantages since it allowed the government to raise revenue without using distortionary taxation, a good supply-side argument; on the other hand, default would give the government a bad reputation and raise the cost of future borrowing. Recent research, he suggested, has much improved the way we think about this issue. Rudiger Dornbusch (MIT) interpreted Buiter's results as implying the need for an urgent (temporary) fiscal stimulus in Europe, a conclusion which was sharply criticised by Patrick Minford (Liverpool and CEPR), who argued that no government could credibly commit itself to a fiscal boost of only temporary duration. Since even Buiter agreed that a permanent stimulus would be inflationary, the prime objective, Minford argued, should be to get the nominal deficit under control, as in the UK's Medium Term Financial Strategy. The Panel were convinced by Buiter's argument that simple measures of fiscal stance could be misleading. There was nevertheless a need to offer policy-makers useful and operational indicators. Fiscal policy also lay at the heart of the paper by Sweder van Wijnbergen (World Bank and CEPR), entitled 'Interdependence Revisited: A Developing Countries Perspective on Macroeconomic Management and Trade Policy in the Industrial World'. He analysed how the policies of the industrialised countries, particularly their fiscal and trade policies, affect the developing countries. Departing from the usual analysis of such linkages, which emphasise short-run cyclical effects, he focussed on longer-run questions of resource allocation and structural adjustment, which he argued should be at the centre of policy design. Van Wijnbergen noted that capital market linkages have led to increased financial integration of the world economy. This has introduced an important new channel through which macroeconomic developments in the industrial countries are transmitted to developing countries. Macroeconomic and trade policies in the developed countries directly affect the cost of debt servicing, the volume of capital flows and the ability of developing countries to earn foreign exchange. High real interest rates have dramatically increased the debt service burden on developing countries, and the appreciation of the dollar has depressed commodity prices. The high level of the dollar and high unemployment in Europe have led to renewed protectionist pressures. It is doubtful that protection creates more jobs, argued van Wijnbergen, and it imposes costs both on consumers in developed countries and exporters in developing countries. Recent debt service problems have added a new dimension. Capital flows allow a more efficient use of world savings, but servicing the resulting foreign debt could be seriously impeded if increased protection were to deny developing countries access to industrial countries' markets. Van Wijnbergen examined the quantitative significance of these considerations with the aid of a small empirical model of the world economy. His simulations suggested that an increase in OECD budget deficits of $75 billion would raise real interest rates by about two percentage points. The LDC terms of trade deteriorate by more than 2%, and output in the LDCs is 2.5% lower. A 10% tariff on developing countries' exports would affect producers in the developing countries rather than consumers in industrial countries, with the LDC terms of trade deteriorating by 7%. However LDCs suffer doubly from the tariff because real interest rates also rise between one and two percentage points. The tariff causes LDC growth to slow significantly. Van Wijnbergen presented two possible scenarios for the world economy, corresponding to 'optimistic' and 'pessimistic' assumptions about policies in the developed countries. The two scenarios demonstrate that fiscal restraint and an abatement of protectionist measures in the OECD benefit both the developed and developing countries (see table). VAN WIJNBERGEN'S POLICY SCENARIOS
Deficits reduced by $75bn Real labour costs fall by 2% each year No protectionist measures 'Pessimistic scenario' based on OECD policies which include: No change in budget deficits Real labour costs rise by 1% each year 10% import tariff The panel thought these results were innovative and important, even though in such a pioneering study there was inevitably room for disagreement about particular details of the analysis. Rudiger Dornbusch emphasised the dependence of the results on whether particular developing countries were net exporters or net importers of primary commodities and whether their external debt was at fixed or variable interest rates. He also noted that van Wijnbergen's analysis implied that the developing countries would almost certainly benefit from levying a tariff on OECD goods. Michael Wickens (Southampton and CEPR) suggested how van Wijnbergen's work could be developed, both by refining the econometric estimation and by extending the analysis itself. Specifically, since the real value of the dollar plays a key role in determining the terms of trade, the explicit inclusion of financial markets and the exchange-rate consequences of capital flows would enrich the analysis. Willem Buiter doubted whether fiscal deficits in the OECD had played a large role in the current plight of the developing countries; he argued that the massive US budget deficit had largely been offset by budget surpluses in other OECD countries. Louka Katseli (Centre of Planning and Economic Research, Athens and CEPR) asked whether the analysis implied European expansion should be encouraged not through fiscal relaxation but through a monetary expansion which would prevent further increases in real interest rates. Rescheduling of existing debt repayments and even threats of outright default have been frequent occurrences in the international debt crisis of the 1980s. The importance of real interest rates for developing countries which are heavy external debtors was taken up by Daniel Cohen (CEPREMAP, Paris). In his paper, 'How to Evaluate the Solvency of an Indebted Nation', Cohen argued that if the real rate of interest is below the rate of growth of exports no problem of solvency can arise. This is so because the lenders of one generation know they will always be able to sell their investment to the lenders of the next generation for the value of the principal plus interest. A country need allocate only an infinitesimally small fraction of its exports to debt repayment in order to ensure its debts are repaid in finite time. When real interest rates exceed the growth rate of exports this is no longer the case, however, and some positive fraction of exports will need to be allocated to debt repayment if the debtor country is to meet its obligations. Cohen formulated an index of solvency based on this idea. His measure is simply the fraction of exports which must be allocated to debt repayment if the country is to remain solvent. Using projections of interest rates and export growth Cohen calculated the solvency index for some of the more important debtor countries (see table). Cohen then used this index to examine in detail the experiences of Argentina and Brazil, both of which earned trade surpluses in 1983 and 1984. In the case of Argentina the trade surplus and Cohen's index are inadequate indicators of repayment capability because of the possibility of capital flight. Brazil, however, does not suffer from the same problem. The 1983 trade surplus appears to be adequate to repay the debt, but the 1984 surplus was much larger than necessary, suggesting that domestic policies were too tight. In contrast, Cohen's calculations suggest that several African countries are closer to insolvency than is frequently supposed. Louka Katseli argued that Cohen's index demonstrated the solvency of developing countries given the policies being pursued in the OECD. When the danger of insolvency arises, it is not necessarily correct to suppose that the developing country borrowers should undertake the entire adjustment required to restore solvency. Adjustment could be achieved instead by a change of policy in the OECD, for example by the adoption of a monetary-fiscal policy mix which brought down real interest rates. Mervyn King (LSE and CEPR) felt that Cohen's index did reflect the burden of debt repayments, but that considerations of solvency also depended critically on expectations and the confidence of current lenders. Once again, the issues of credibility, reputation, and their relation to possible default were relevant. The last three contributions presented to the Panel focussed on microeconomics. Paul Geroski (Southampton) and Alexis Jacquemin (Louvain) considered industrial policy in Europe in their paper 'Industrial Change, Barriers to Mobility and European Industrial Policy'. They argued that industrial policy, based on exploitation of the supposed links between concentration, scale economies, and productivity, had not been very successful to date. Economies of scale have not been dramatic, and fragmentation of the European market has allowed each country's national champions a cosy life in which they use their market power to forestall entry, competition, and change. In this they have effectively been assisted by the well-meaning but misguided policies of individual European governments who have pursued policies aimed at fostering dominant national producers, capable of exploiting economies of scale in order to compete with the American and Japanese. Geroski and Jacquemin argued that this emphasis on static productive efficiency was misplaced. Much more important is the ability to adapt and innovate in a changing environment. Yet markets alone do not always ensure that the most dynamic and innovative firms succeed. Incumbent firms can often take actions that will deter other firms from entering. One example is investment in excess capacity, which can be used to flood the market and drive out any new entrant. Similarly in declining industries with overcapacity, such as steel, individual producers may attempt to postpone reducing capacity or leaving the industry in the hope that other producers will do so first. Such strategic behaviour by producers creates barriers to entry or exit and inhibits change.
The Panel welcomed Geroski and Jaquemin's application of recent advances in the theory of industrial economics to the important question of sensible policy design. On particular details of the analysis, the Panel was less convinced. John Vickers (Nuffield College) noted that Geroski and Jacquemin argued that it was necessary to break down barriers in order to promote efficiency and change. Yet in many strategic situations, the optimal policy for a private firm was to convince others of its inflexibility by being seen to be locked into its current policy. Similarly, market forces may bring about too little research and development if subsequent profits can easily be competed away through imitation by other firms. Thus flexibility does not always go hand-in-hand with efficiency and productivity growth. Tony Venables (Sussex and CEPR) questioned whether a more integrated European market would necessarily be more competitive; it might simply allow the largest firms to enjoy yet more scale economies, thereby reinforcing their market power. The authors' assertion that scale economies had in practice been small provoked a lively exchange, but Geroski and Jacquemin remained unshaken in their view that the mass of evidence they had studied supported this conclusion. Capital formation is central to any discussion of the supply potential of an economy. In his paper, 'Capital Tax Reform in the United Kingdom and the United States', Mervyn King (LSE and CEPR) examined the taxation of income from capital, comparing the UK tax reform of 1984 and the current Treasury I and Treasury II proposals for a similar reform in the US. In both cases, the objective is to broaden the tax base, to reduce the considerable disparities in the effective tax rate on different types of investment and methods of finance, and to withdraw subsidies to investment, such as accelerated depreciation. The reforms aim to simplify the tax system and reduce distortions. King provided detailed estimates of effective tax rates in the UK and the US. Prior to the reforms, tax treatment of investment in machinery and of projects financed by debt issues was especially favourable. He confirmed that in both countries the reforms would dramatically reduce the disparity in effective tax rates. One perhaps unintended consequence of the reforms is an increase in the average tax rate on income from capital in both countries. The UK and US reforms do differ in one important respect: inflation indexation is substantial in the US but effectively abandoned in the UK. In his paper 'Why Taxes Matter - Reagan's Accelerated Cost Recovery System and the US Trade Deficit' Hans-Werner Sinn (Munich) argued that while King's analysis had focussed on the change in effective tax rates, in practice the change in tax base would be more important. Sinn stressed the accelerated depreciation provisions. To explore their effects, he had examined the introduction of accelerated depreciation in the US in 1981. Economic theory would suggest that, in a highly integrated world capital market, the introduction of such a 'tax break' in the US should lead to a once and for all reallocation of world capital towards the US. Sinn's illustrative calculations suggested that a capital inflow of $1 trillion to the US was required to offset fully the 1981 change in US tax treatment of depreciation. This was likely to have been a major explanation of the recent strength of the dollar and the associated US trade deficits. Conversely, abolition of accelerated depreciation under the Treasury I and Treasury II proposals would lead to a substantial capital outflow from the US and a decline in the dollar. Since the UK had also abolished accelerated depreciation, the dollar might depreciate less against sterling than against other currencies. In the ensuing discussion, Patrick Minford argued that it was not surprising that the reforms had raised the overall tax rate on income from capital. Without increasing the taxation of companies as a whole, it was sensible to switch taxation from labour to capital when unemployment was high. Georges de Menil (CEQC, Paris) questioned King's presumption that inflation indexation was desirable. Incomplete indexation provided a useful automatic stabiliser, de Menil argued. The Panel will meet again in London on November 11-12. Topics for discussion at this second Panel meeting will include: the Mitterrand experiment in France; when and how to privatize; and the Dollar and the EMS. The first volume of Economic Policy will consist of three issues in October 1985, April and October 1986. Each volume thereafter will consist of two issues. Subscriptions are available at the institutional rate of #16.00/$30.00/Ffr 240, and at an individual rate of #9.00/$15.00/Ffr 120 per volume. The special three-issue Volume 1 will be available at these rates for a limited period. Individual subscribers must order direct from Cambridge University Press. All orders can be placed using the form on the enclosed Economic Policy leaflet, which also gives details on methods of payment. Further information can be obtained from The Subscriptions Manager, Cambridge University Press, the Edinburgh Building, Shaftesbury Road, Cambridge CB2 2RU, England or 32 East 57th Street, New York, NY 10022, USA. |
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