Public Sector Deficits and Macroeconomic Performance.

Public sector deficits are blamed for over-indebtedness, high inflation, and poor investment and growth performance. Easterly and Schmidt-Hebbel find deficits crowd out investment and are inversely related to interest rates. However, deficits are negatively correlated with per capita growth implying a positive correlation between high economic growth and fiscal surpluses. They are inversely related with total and private consumption implying that taxes crowd out private consumption. This finding contradicts the Ricardian hypothesis that suggests public consumption lowers private consumption. Moreover, debt financing is positively correlated with interest rates or with financial repression while money financing is inflationary. There is no clear cut relationship between public deficits and real exchange rates and trade deficits. If there were strong relationships between the two deficits this would imply changes in public saving are not offset by domestic private saving. The authors note that the effects of deficits on real exchange rates depend on whether the government spends more on tradables than on non-tradables. These evidences presented in Chapter 1 and the remaining chapters are based on ten representative countries (Argentina, Chile, Colombia, Cote d'Ivoire, Ghana, Mexico, Morocco, Pakistan, Thailand, and Zimbabwe) and using different deficit measures (such as deficits based on the consolidated total public sector, which includes the central bank, the accrual basis, and operational deficits, etc.). It is not that the authors just illustrate their findings based on their empirical investigations. They also explain why one might, on theoretical grounds, obtain results contrary to his/her expectations. For example, the effect of deficits on inflation is ambiguous because deficits are also financed by borrowing. The effects of deficits on interest rates are also ambiguous if public debt and other assets held by the private sector are highly substitutable and there are no financial repressions.

In Chapter 2 Carlos Rodriguez analyzes the effects of public sector deficits on the real exchange rate, balance of trade, current account, and external indebtedness. Assume that deficit due to tax cuts is financed by either foreign borrowing, domestic borrowing, or money creation. If the private sector reacts by investing the tax savings in foreign assets, the real exchange rate will not change and Ricardian equivalence results. However, the Ricardian equivalence may not hold due to borrowing constraints, distortionary taxation, uncertainties about future taxes, differences in planning horizons by the private and public sectors, risk-induced differentials between domestic and foreign interest rates, and differences in spending propensities of taxpayers and bondholders. If the deficit is financed with internal debt and the private sector purchases the increased debt by borrowing from abroad, total spending will not change but the real exchange rate and trade will be affected and the Ricardian proposition will not hold. If the cut in taxes is financed by the inflationary tax, private spending will not be affected. If the tax is on money, demand for foreign assets increases and this may result in short term trade surpluses. A dynamic analysis reveals that fiscal deficits may or may not affect external balances and one also needs to consider the changes in foreign assets in order to find stable relationships between real exchange rates and structural parameters.

A substantial portion of the book is devoted to case studies. In Chapter 3 Carlos Rodriguez presents Argentina's fiscal disequilibria that led to hyperinflation. High primary deficits led to continuous debt and money financing. These in turn led to high interest rates and inflation. In Chapter 4 Jorge Marshall and Klaus Schmidt-Hebbel analyze the fiscal adjustments of Chile after 1974. The authors conclude that fiscal policy shifts were responsible for most of cyclical variations and structural corrections of non-financial public sector deficits. Money-financed deficits lower interest rates while debt-financed deficits raise interest rates. On the other hand, money-financed deficits are strongly inflationary while debt-financed deficits are weakly inflationary. Increased public debt crowded out private investment. These results are in accord with conventional wisdom of public deficits. Colombia's case is dealt in Chapter 5 by William Easterly. Even though Colombia's deficit-financing methods are generally sound, financing the deficit by borrowing raises interest rates while financing it through money creation would be inflationary. Christophe Chamley and Hafez Ghanem consider Cote d'Ivoire's case in Chapter 6. Cote d'Ivoire's economy heavily depends on volatile export revenues of cocoa and coffee which are vulnerable to external shocks. Adverse effects of fixed exchange rates and expansionary fiscal policies led to low investment, slower growth, high external debt, and fiscal crisis. In Chapter 7, Roumeen Islam and Deborah Wetzel investigate the fiscal activities of the Ghanian government and the economic consequences of its policies on the economy. Government controls and excessive money creation led to slower growth, economic imbalances, and a 10% per capita income decline between 1957 and 1983. Less economic controls and lower deficits led to relatively sustained growth since 1983. Ricardo Faini in Chapter 8 argues that Morocco's unabated public expenditures, increased external borrowing, deterioration of the terms of trade, higher foreign interest rates, and plunges in phosphate prices and severe drought created strains on its economy. Despite these crises, Morocco's growth rates are high and steady and inflation rates are a lot lower than other equally highly indebted countries. Nadeem Ul Haque and Peter Montiel discuss Pakistan's macroeconomic policy in Chapter 9. Pakistan's deficits are very high with 15% of its expenditure going to interest payments. Interestingly, however, there are no debt-servicing and serious inflationary problems in Pakistan so far. Felipe Morande and Schmidt-Hebbel close the case studies with Zimbabwe. Public deficits are the major sources of current account deficits and foreign indebtedness. Government borrowing has also crowded out private investment and consumption. Inflation was in check until 1990 but expansionary monetary policy and drought-induced increases in prices lead to sharp. increases in inflation in 1991.

The authors in each case study summarize their empirical results with conclusions and policy implications. The main findings of the entire volume are also summarized in an overview by Easterly, Rodriguez, and Schmidt-Hebbel. Vito Tanzi presents the political economy of fiscal deficit reduction in an afterward. This book is written by experts in the field and sheds many lights on the dynamics of government deficits and their impacts on the general level of economic activity.

Seid Y. Hassan Murray State University