Fiscal Deficits and Macroeconomic Performance in Developing Countries

Author(s): William Easterly and Klaus Schmidt-Hebbel

Source: The World Bank Research Observer, Vol. 8, No. 2 (Jul., 1993), pp. 211-237
Published by: Oxford University Press
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FISCALDEFICITSAND
MACROECONOMIC PERFORMANCE
IN DEVELOPINGCOUNTRIES
William Easterly
Klaus Schmidt-Hebbel

Although fiscal adjustment was urged on developing countries during the 1980s
to lead them out of economic malaise, considerable uncertainty remains about
the relations between fiscal policy and macroeconomic performance. To illus-
trate how financialmarkets,private spending,and the external sector react to fis-
cal policies, the behavior of holdings of money and public debt, private
consumption and investment, the trade balance, and the real exchange rate is
modeled for a sample of ten developing countries. The studies find strong evi-
dence that over the medium term, money financing of the deficit leads to higher
inflation, while debt financing leads to higher real interest rates or increased
repression of financial markets, with the fiscal gains coming at increasinglyun-
favorable terms. Consumers respond differently to conventional taxes, uncon-
ventional taxes (through inflation or interest and credit controls), and debt
financing, in ways that make fiscal adjustment the most effective means of in-
creasing national saving. Private investment-but not private consumption-is
sensitive to the real interest rate, which rises under domestic borrowing to fi-
nance the deficit. Contraryto the popularpresumption,in some countriesprivate
investment increaseswhen public investmentdecreases. There is strong evidence
that fiscal deficits spill over into external deficits, leading to appreciation of the
real exchange rate. Fiscal deficits and growth are self-reinforcing:good fiscal
managementpreservesaccess to foreign lending and avoids the crowding out of
private investment, while growth stabilizes the budget and improves the fiscal
position. The virtuous circle of growth and good fiscal managementis one of the
strongest argumentsfor a policy of low and stable fiscal deficits.

F iscal deficitsreceivedmuch of the blamefor the assortedeconomicills

that beset developing countries in the 1980s: overindebtedness and the
debt crisis, high inflation, and poor investment performance and growth.
Attempts to regain macroeconomic stability through fiscal adjustment achieved
The World Bank Research Observer, vol. 8, no. 2 (July 1993), pp. 211-37
i 1993 The International Bank for Reconstruction and Development/THEWORLDBANK 211
 uneven success,raisingquestionsabout the macroeconomicconsequencesof
publicdeficitsand fiscalstabilization-or fiscaldeterioration.
One recurringquestionis whetherlargerpublicdeficitsare alwaysassociat-
ed with higherinflation.Sargentand Wallace's(1985)"monetaristarithmetic"
answeredthis questionaffirmatively.But the relationshipis blurredbecause
governmentsfinancedeficitsby borrowingas well as by printingmoney.The
relationshipis furthermuddiedby otherinfluencessuch as unstablemoneyde-
mand, inflationaryexchangerate depreciations,widespreadindexation,and
stubborninflationaryexpectations(Kigueland Liviatan1988;Dornbuschand
Fischer1991).And if largerpublicdeficitsare associatedwith higherinflation,
what are the tradeoffsin financingthe deficitthroughmoneycreation?
Interestrates are anotherambiguousfactor. Do deficitspush up domestic
real interest rates when governmentsrely heavily on domestic debt instru-
ments, or is this relationshipalso blurredby such factors as interestrate or
creditallocationcontrols(Easterly1989;Giovanniniand de Melo 1990)or the
high degreeof substitutabilitybetweenpublicdebt instrumentsand other as-
sets held by the privatesector?
Will consumersreducetheir spendingwhen taxes are raisedand increaseit
when taxes are lowered?Or will they offset only changesin governmentcon-
sumption-without reactingto changesin governmenttax or debt financing--
as positedby Ricardoand, morerecently,by Barro(1974)?Althoughthe issue
is still not settledempiricallyfor industrialcountries(Hayashi1985;Bernheim
1987; Leidermanand Blejer 1988), there is growing evidence that refutes
Barro'sRicardianequivalencepropositionfor developingcountries (Haque
and Montiel 1989;Corbo and Schmidt-Hebbel1991).
Anotherunresolvedissueconcernsthe effectsof governmentspendingon in-
vestment.Does a higherlevel of public capital spendingboost (crowdin) or
lower (crowd out) privateinvestment?Theory predicts,and the limited evi-
dence availablefor developingcountriesconfirms,that the effect dependson
whetherprivateandpublicinvestmentcomplementor substitutefor eachother
(Blejerand Khan1984;Khanand Reinhart1990;Easterlyand Schmidt-Hebbel
forthcoming).
If real interestratesdo rise in responseto higherdomesticdebt financingof
deficits,how does that affect privateconsumptionand investment?Although
theory arguesthat the effect is ambiguous-because of potentiallyoffsetting
substitution,income, and wealth effects-it predictsunambiguouslythat pri-
vate investmentwill declinewith higherinterestrates.A growingbody of ev-
idencefor developingcountriessupportsthe notion that privateconsumption
is insensitiveto real interestrates (Giovannini1983, 1985; Schmidt-Hebbel,
Webb, and Corsetti1992).Surprisingly,many studiesof developingcountries
show that private investmentalso does not respond much to interestrates
(Rama1990;Servenand Solimano1992).
Finally,how do fiscaldeficitsfeedinto externaldeficits?One expectsa strong
link betweenfiscaldeficitsand currentaccountdeficitsin financiallyopenecon-

212 The WorldBankResearchObserver,vol. 8, no. 2 (July 1993)

omies when consumers are not Ricardian. The role that fiscal imbalances
played in the overborrowing that led to the debt crisis of 1982 is widely recog-
nized (Dornbusch 1985; Sachs 1989). But evidence linking public deficits with
external deficits and appreciation of the real exchange rate is still incomplete.
This article examines these issues for a representativesample of ten devel-
oping countries. After reviewing alternative measures of the fiscal deficit and
the broad outlines of fiscal adjustment in the ten countries, the article focuses
on the relation of the domestic financing of deficits to inflation and real interest
rates. It looks as well at the direct and indirect effects of public spending, tax-
ation, and deficits on private consumption and investment, at the spillover into
external imbalances and the real exchange rate, and finally at some of the pol-
icy implications.

Analytical Framework
Governments can finance deficits by printing money (seigniorage), borrow-
ing at home, or borrowing abroad. This public deficit financing identity (writ-
ten for the broad public sector comprising general government, public
enterprises, and the central bank) is a useful starting point for tracing out and
quantifying the macroeconomic effects of public deficits:1
(1) Public deficit financing = Money financing + Domestic debt
financing + External debt financing.
The consequences of deficits depend on how they are financed. As a first
approximation, it can be said that each major type of financing, if used exces-
sively, results in a specific macroeconomic imbalance. Money creation leads to
inflation. Domestic borrowing leads to a credit squeeze through higher inter-
est rates or, when interest rates are fixed, through credit allocation and ever
more stringent financial repression-and the crowding out of private invest-
ment and consumption. External borrowing leads to a current account deficit
and appreciation of the real exchange rate and sometimes to a balance of pay-
ments crisis (if foreign reservesare run down) or an external debt crisis (if debt
is too high).
To quantify the effects of domestic deficit financing on inflation and real in-
terest rates for the ten sample countries, we applied a portfolio-balance model
for the demand for money and public debt instruments, linking it to the public
deficit financing identity in equation 1. Econometric estimations of demand for
money balances and domestic debt, which reflect substitution between these
two assets and a third asset (typically foreign currency or foreign interest-
bearing assets) in the portfolios of asset-holders, are the backbone for assessing
the effects of domestic financing of the fiscal deficit on monetary and financial
markets. Policy simulations are used to estimate the effects of larger deficits,
financed through either money creation or the issuance of domestic debt in-
struments, on inflation and real interest rates.

William Easterly and Klaus Schmidt-Hebbel 213

 Publicdeficitsare financedby surplusesfrom other sectors.So the public
deficitcan be rewrittenin termsof the economy'saggregateresourceor saving-
investment constraint:
(2) Publicdeficit= Publicinvestment- Publicsaving
= (Privatesaving- Privateinvestment)+ Foreignsaving.
Largerpublicdeficitsmust lead to some combinationof lower privatecon-
sumption(at a given level of privateincome),lower privateinvestment,and
higherforeignsaving.The questionis whatdeterminesthatcombination:which
of the three componentson the right side of equation2 bearsthe burdenof
higherpublicdeficits?The answerdependsbroadlyon fivefactorsthatinfluence
the privatedomesticand foreignresponseto publicdeficits:the flexibilityand
sophisticationof domesticfinancialmarkets,access to externalfinancing,the
sourceof domesticfinancing(moneyor bonds),the forward-lookingbehavior
of consumersand investors,and the compositionof the deficit.
The commonframeworkfor analyzingthe sensitivityof privateconsump-
tion and investmentto fiscalpoliciesis that of consumerand investorbehavior
constrainedby imperfectaccessto financialmarkets.The specificationof pri-
vate consumptionconsidersthree alternativehypotheses:the Keynesianhy-
pothesisthat only currenttaxationaffectsconsumption;the permanent(long-
term) income hypothesisthat only permanenttaxation mattersbecausecon-
sumersspend a proportionof the presentvalue of their expectedlifetimein-
come; and the Ricardian hypothesis that only permanent government
consumptionaffectsprivateconsumptionbecauseany increaseor decreasein
taxes is offset by an equivalentchangein the oppositedirectionin privatesav-
ing. The specificationof privateinvestmentconsidersthe direct and indirect
(throughhigherinterestrates)effects of the deficitas well as whetheran in-
creasein publicinvestmentcausesprivateinvestmentto rise or fall. Economet-
ric estimationscan quantifythe impactof the deficit(and of the composition
of the underlyingspendingand financing)on privateconsumptionand invest-
ment, includingthe indirecteffectsthroughinflationand real interestrates.
Specificationof the behaviorand sensitivityof the tradedeficitand the real
exchangerate to public deficitsand fiscalpolicy-relatedvariablesfollows the
frameworkof Rodriguez(1989).Througha two-steprelationlinkingthe deficit
and the realexchangerate,the analysisshowshow fiscalpoliciesaffectprivate
spendingand the accumulationof foreignassets.The fiscaldeficit(amongoth-
er determinantsof privatespending)affectsthe externaldeficit,whichthen de-
terminesthe real exchange rate that is consistentwith the clearingof the
marketfor nontradedgoods. Statisticalestimationof theserelationscan quan-
tify the impactof the deficitand its composition(publicspendingon traded
and nontradedgoods and services)on the tradebalanceand the real exchange
rate.
Data for the ten samplecountrieswere pluggedinto this common frame-
work for money and financialmarkets,privateconsumptionand investment,

214 The WorldBankResearchObserver,vol. 8, no. 2 (July1993)

and the tradedeficitand realexchangerate.Exceptfor some portfoliodemand
estimations,which were basedon quarterlydata, most of the estimationswere
performedusing annualdata, typicallycoveringthe 1960sthroughthe 1980s.
The quantitativeresultsof the countryanalyses,complementedby additional
cross-countryevidence,are summarizedfor money and domesticdebt financ-
ing. Qualitativeresultsarepresentedfor the effectsof deficitsandfiscalpolicies
on private consumptionand investment,the trade balance,and the real ex-
changerate. (The full set of quantitativeestimationresultsis availablein the
case studieslisted in the referencesection.)
Severalpolicy implicationsare derivedfromthis empiricalevidence.Relying
on a representativeset of case studies ratherthan on pooled cross-country
studiesor individualcase studiespermitsmorereliableinferencesto be drawn
about the unsettledissues regardingdeficitsand their macroeconomicconse-
quences.The countriesselectedfor study-Argentina, Chile, Colombia,Cote
d'Ivoire,Ghana,Morocco,Mexico,Pakistan,Thailand,and Zimbabwe-were
chosen for the diversityof their fiscaland other macroeconomicpolicies and
experiencesand for how well theyrepresentthe developingworldat large.The
sampleincludesfiscaladjustersand nonadjusters,high- and low-deficitcoun-
tries, large and small economies,low- and high-inflationcases, and countries
with and without well-developedfinancialmarketsand with and without ac-
cess to foreignfinancing.
One finalpoint on methodology.This articlefocuseson how publicdeficits
influencethe macroeconomy,but the case studiesalso examinedinfluencesin
the other direction.They found that foreign and domestic macroeconomic
shocksplay only a minorrole in cyclicalvariationsor long-runchangesin non-
financialpublicsectordeficits-fiscal policymakersget boththe blamefor fiscal
crises and the credit for fiscal adjustment(see Easterlyand Schmidt-Hebbel
forthcomingfor a summary).Ignoringthe feedbackeffectsthus seemsto be a
benignsimplification.

Deficit Measurement and Fiscal Performance

How the fiscal deficitis measuredhas an importantbearingon an analysis
of the macroeconomicimplicationsof deficits.2Two key dimensionsare the
compositionof the publicsectorand the economicrelevance-or quantifiabil-
ity-of varioustypes of deficitmeasures.
The compositionof the public sector can be definedin three alternative
ways:centralgovernmentonly;consolidatednonfinancialpublicsector,which
addslocal government,socialsecurity,andnonfinancialpublicenterprises; and
consolidatedtotal publicsector,which adds the centralbankand, sometimes,
publiccommercialbanks.Deficitmeasuresbasedon the most inclusivedefini-
tion of public sectorare the most accuratemeasuresof a country'sfiscalposi-
tion and public sector resourcetransfers,but they are not always readily

William Easterly and Klaus Schmidt-Hebbel 215

Figure 1. Patterns of Fiscal Adjustmentin Ten Developing Countries, 1978-88

Strong fiscal adjustment

Percentage of GDP
6
4 hile
C Ghana _

-4
0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0

Thailand
-12 -Mexico . ,

-16 I'* ,
1978 1980 1982 1984 1986 1988

Moderate fiscal adjustment

Percentageof GDP
6
4

-8 0_- ' Morocco

-12 N _ ,,_ Zimbabwe -

-16 I l l
1978 1980 1982 1984 1986 1988

Deteriorating or no fiscal adjustment

Percentageof GDP
6
4 C6te d'lvoire
0

Pakistan

-12 *-... -*_ . ., ,/ Argentina

-16 I I I I I
1978 1980 1982 1984 1986 1988

Note:Based on the consolidatednonfinancialpublic sector balancein each country.

Source:Countrycase studieslisted in the references.

216 TheWorldBankResearch
Observer,
vol.8, no.2 (July1993)
 available and are frequently subject to arbitrary accounting conventions that
sharply reduce their usefulness.
Nominal consolidated nonfinancial public deficits in the 1980s present one
picture for each of the ten sample countries (figure 1). Chile, Ghana, Mexico,
and Thailand show strong fiscal adjustment; Colombia and Morocco display
more gradual but steady improvement; and Zimbabwe demonstrates partial
adjustment in the late 1980s. Argentina, Cote d'Ivoire, and Pakistan show no
adjustment or even a deterioration in fiscal accounts.
But consolidated nonfinancial public sector deficits do not always show the
whole picture. They leave out an important fiscal element, the losses of the
central bank or other public financial intermediaries from quasi-fiscal opera-
tions that subsidize activities in the private sector. Among the ten countries,
deficits in quasi-fiscal operations are exclusively a Latin American phenome-
non. The central banks in Argentina and Chile extended emergency loans to
financial institutions and suffered losses from exchange rate guarantee pro-
grams. A comparison of quasi-fiscal deficits and conventional nonfinancial
public sector deficits in the two countries illustrates how misleading nonfinan-
cial public sector deficits are as indicators of overall fiscal policy when quasi-
fiscal operations are large (figure 2). In Argentina quasi-fiscal deficits were
roughly as large as conventional deficits during 1982-85; together they aver-
aged 25 percent of gross domestic product (GDP) a year. In Chile quasi-fiscal
deficits averaged more than 10 percent of GDP a year during the same period,
more than double the size of conventionally measured deficits.
There are also several options for measuring the deficit in ways that are
more or less economically relevant. The nominal cash approach permits broad
comparability of deficits across countries. A variant, the operational deficit, de-
ducts the inflationary component from nominal interest payments on public
debt. This deduction, which reflects the compensation of debt holders for ero-
sion of the real value of public debt caused by inflation, is an important cor-
rection for high-inflation, high-domestic-debt countries.
An accrual, or payments-order, approach measures income and spending ac-
tions when they occur, even if they do not immediately involve cash flows. Def-
icits measured on an accrual basis would be larger than those measured on a
cash basis when arrearshave been allowed to accumulate on government pay-
ments of interest, wages, or purchases of goods. Accrual-based deficits open
the door to a whole set of unconventional measures of the deficit based on con-
siderations of public net worth or intertemporalbudget constraints. Such mea-
sures would constitute the most meaningful gauge of a government's fiscal
position, but they are not observable.
There are other economically meaningful measures. One is the sustainable
public deficit of Buiter (1983, 1985, 1990) and van Wijnbergen (1989), a deficit
that can be financed without raising debt levels (relative to GDP) under feasible
rates of growth, real interest, and inflation. Another is the public sector sol-
vency measure of Hamilton and Flavin (1986), Grilli (1989), Wilcox (1989), and

William Easterlyand Klaus Schmidt-Hebbel 217

Figure 2. Consolidated Quasi-fiscal Deficits in Argentinaand Chile, 1979-89

Percentageof GDP

25 -x
F I Argentina
20 - 1
15 - ~ ~ ~ I
10 - ~ ~ I
15 - Ci/

10\

1979 1981 1983 1985 1987 1989

Source: Argentina,Rodriguez(1991);Chile,Marshalland Schmidt-Hebbel(1991).

Buiterand Patel (1990),which checksfor publicsectorsolvencyby comparing

the rate of growthof the publicdebt (relativeto GDP)to the real interestrate.
If the debt ratio systematicallygrows fasterthan the realinterestrate,the pub-
lic sectoris consideredinsolvent.
Despite the usefulnessof these measuresfor assessingoverall fiscal stance
and issuesof sustainabilityand solvency,the questionsaddressedin this anal-
ysis requirethe use of cash-basedoperational(or nominal)deficit measures
with the widestavailablecoverageof the publicsector.The analysisof deficits,
inflation,and interestrates uses consolidatedtotal (nonfinancialplus quasi-
fiscal)publicsectordeficits.The analysesof deficitsandprivatesectorresponse
and of deficitsand the real exchangerate use operationalconsolidatednon-
financialpublic deficits,becausethere are no long time-seriesdata for quasi-
fiscaldeficits.

Inflation, Real Interest Rates, and Financial Repression

The relationsbetweendeficitsand inflationand betweendeficitsand realin-
terestrates are far from simple (figure3). With low to mediumratesof infla-
tion, thereis no relationacrosscountriesbetweenlong-terminflation(1980}88)

218 TheWorldBankResearcbObserver,vol.8,no.2(July
1993)
Figure 3. Fiscal Deficits, Real Interest Rates, and InJfation in Ten Developing Countrie

Public sector deficit (percentage of GDP)

-
A. ------------------------
....... .. - - - - - - - - - - - - - - - - - - - - -20.0
--- - - - - - - - - - - - - - - - -

(A Zimbabwe
10.0

A \ Morocco
A Aote d'Ivoire \ -------------------\----------x--
.. v...................... . . .............. ....... ......
Chile
........................... ...... 7.5
----------------''''''''''''.....................................N
A

A \ \sVPakistan

Thailand

A Colombia 5.0

2.5

Financial repression cases A - ....Ghana....

Real interest rate

(percent)
_ I | I I I I ~ I ~ I I
10 5 0 -5 -10 -15 10 20 30
Note: Public sector deficits are for the total consolidated nonfinancial public sector in each of
for Argentina, Chile, and Mexico.
Source: For deficit data, see country case studies listed in the references; for inflation and nom
and public deficits.However, countrieswith the highestrates of inflation-
Argentinaand Mexico duringthe 1980s-had significantlyhigherdeficitsthan
countrieswith lower rates.Similarly,domesticreal interestratesshow no cor-
relationwith publicdeficitsacrosscountriesexcept in the case of high-deficit,
high-interestrate Argentina.
The lack of correlationacrosscountriesbetweendeficitsand inflationand
deficitsand interestrates is attributableprimarilyto the differentways that
countriesfinancetheir publicdeficits.To accountfor the effects of these dif-
ferences,a moredetailedunderstanding is neededof the linksbetweendomes-
tic deficitfinancingand inflationand interestrates.

Fiscal Deficits and Inflation

On averageover the long term, developingcountrieshave relied more on
money creation(seigniorage)to financedeficitsthan have industrialcountries
(table1). Variousfactors,includingunstabledemandfor money,exchangerate
depreciation,and widespreadindexation,blur the relationbetweenmoney fi-
nancingand inflationovershorterperiods.In the long run,however,an increas-
ingly unfavorabletradeoff between inflation and money creation becomes
evident,whichexplainswhy moneycreationis generallyusedonly as a last re-
sort. The last columnof table 1 shows the amountof additionalinflationre-
quiredto achievean additionalpercentagepointin long-runseignioragerevenue
relativeto GDP, derivedfromestimatesof how muchmoneypeopleare willing
to hold at differentinflationrates. The tradeoffis still favorablein countries
with low inflation(5 percentagepoints of additionalinflationin Thailand),
worsensin countrieswith moderateinflation(15to 20 percentagepointsin Co-
lombiaand Ghana),and becomesuntenablein countrieswith high inflation(97
percentagepointsin Argentina),wheremoneyholdersreplacemost of theirlo-
cal currencyholdingswith foreigncurrencyand interest-bearing assets.
for
Except Chile,these resultsare remarkablysimilarto those derivedfrom
more comprehensivemodelsfor the long-termeffectson pricelevels of transi-
tory deficitsfinancedby money creation (reportedin table 2). These models
also considerfeedbackeffects on inflationfrom asset substitution(and from
output,in the casesof ColombiaandPakistan).The fourcountrieswith results
show that financinga percentagepoint increasein the deficit (as a share of
GDP) throughmoneycreationboosts inflationfrom 10 percent(Zimbabwe)to
18 percent(Pakistan).
Consideringthe unfavorabletradeoffin most casesand the generalaversion
to high inflation,it is hard to believethat revenuemotivationsalone explain
chronichigh inflation.More likely,the causeis the inabilityof governmentsto
makecrediblecommitmentsto fiscaland monetarytargets,leadingto a loss of
confidenceand increasedsubstitutionaway from money (Blejerand Liviatan
1987;Kigueland Liviatan1988).

220 The WorldBankResearchObserver,vol. 8, no. 2 (July 1993)

Table 1. Money Creation and the Inflation Tax in Ten Developing Countries, 1965-89
Percentageincrease
in inflation to
Seignioragea Inflationb achieve a 1 percentagepoint
Country (percentageof GDP) (percent) increase in seignioragerevenue

Case study countries

Argentina 4.2 115.3 97
Chile 3.7 56.6 23
Colombia 2.1 17.7 15
C6te d'Ivoire 1.3 7.6
Ghana 3.1 31.6 20
Mexico 3.1 28.9
Morocco 1.7 6.1 8-26
Pakistan 2.0 8.0
Thailand 1.0 5.7 5
Zimbabwe 1.1 7.7 10
Average 10 countries 2.3 28.5 n.a.
Other countries
Average of 35 developing countries 2.1 n.a.
Average of 15 industrial countries 1.0 n.a.

Not available.
n.a. not applicable.
Note: The period covered is generally 1965-89, but coverage varies according to data availability.
a. Defined as the nominal change in the money base each month divided by the consumer price index for
that month. The typical method of calculating the ratio of the nominal change in the money base over the
entire year to the annual nominal GDP can seriously overstate seigniorage in high-inflation countries.
Although interest paid on reserves should also be subtracted to get a true estimate of seigniorage, the data
are generally lacking, and, in any case, few developing countries pay interest on reserves. An important
exception is Argentina, where the combination of high inflation and interest paid on reserves makes this
adjustment important.
b. Average annual rates of change in the consumer price index between 1964 and 1988.
Source:For Argentina, Colombia, Ghana, and Morocco, country studies listed in the references;for Chile,
Thailand, and Zimbabwe, calculated from seigniorage and inflation rates in columns 1 and 2 and long-run
money demand inflation semi-elasticities of country studies listed in references;for other countries, Easterly
and Schmidt-Hebbel (1991). Inflation data are from IMF (annual).

Fiscal Deficits and Interest Rates or Financial Repression

Real interest rates have risen in many developing countries following finan-
cial reform, often becoming positive for the first time in years. Argentina, Chile,
Colombia, Morocco, Pakistan, and Thailand introduced financial reforms in
the 1970s, and their real interest rates reached positive levels in the 1980s (table
3). Ghana, Mexico, and Zimbabwe maintained interest rate controls during
most of the 1980s (Mexico liberalized its rates in 1988) and reaped substantial
revenue from this implicit tax on financial assets, particularlyduring the inter-
national credit crunch following the debt crisis of 1982. Average annual revenue
for the three countries from financial repression of deposit interest rates during

William Easterlyand Klaus Schmidt-Hebbel 221

Table 2. Simulation Results for Long-termEffects of Fiscal Deficits on Inflation
and Real Interest Rates
(percent)
Effect of a 1 percentagepoint increase
in the deficit to GDP ratio
On the price level On the interest rate, with
Country with money financing domestic debt financing

Chile 14 0.1
Colombia 14 3.0
Morocco 0.2
Pakistan 18 1.1
Zimbabwe 10 2.7
- Not available.
Note: This table presents the long-term effects of a transitory (one year) increase in the public deficit,
financedby issuingeitherdomesticnoninterest-bearing debt.
monetaryliabilitiesor domesticinterest-paying
The resultsfor ChileandZimbabwearebasedon portfoliomodelscombinedwiththe publicsectorbudget
equation,whilethosefor Colombia,Morocco,andPakistanarebasedon macroeconomic-portfolio general
equilibriumspecifications.
Source:Countrycase studieslistedin the references.

Table 3. Evolution of Real Interest Rates following Financial Reform or Repression

in the 1980s
Tax revenue on deposits
Real interest rate
rate Off depositsa
on depositdue to financialrepressionb
Realptnterent
(percent) (percentageof GDP)
Country 1970-79 1980-88 1980-88

Argentina -17.2 4.8 n.a.

Chile -15.9 8.1 n.a.
Colombia -6.3 0.7 n.a.
Ghana -18.8 -18.3 0.5
Mexico -4.6 -8.4 1.6
Morocco -3.1 1.8 n.a.
Pakistan -3.4 2.1 n.a.
Thailand -05 6.5 n.a.
Zimbabwe -3.7 -4.3 0'.8

n.a. Not applicable.

a. Averageannualrealinterestrateson timedeposits,calculatedusingthe consumerpriceindex.
b. Averageannualrevenuecalculatedas the differencebetweendomesticreal interestratesand average
realinterestrateof OECD countries.
Source:Countrycase studieslistedin the references.

1980-88 ranged from 0.5 percent of GDP for Ghana to 1.6 percent for Mexico.
Holding down nominal interest rates under high inflation was a quick and easy
way to compensate for the loss of external financing after 1982.

222 The WorldBankResearchObserver,vol. 8, no.2 (July1993)

 There is a cost, however, in repressedprivate credit and investment, as other
studies have argued (Chamley and Honohan 1990; Easterly 1989; Giovannini
and de Melo 1990). There are large differences in domestic private credit be-
tween countries with deregulated financial markets and those with stringent fi-
nancial controls-for the sample countries, an average 30 percent of GDP in the
first group compared with 10 percent in the second during 1980-90 (figure4).
Mexico's experience well illustrates the effects of financial repression under ris-
ing inflation. Financial controls intensified after 1981 as inflation soared, and
the ratio of private credit to GDP dropped below already low levels. Following
financial liberalization, the ratio doubled in two years. In Ghana, private credit
was at a dismally low level in the late 1980s, reflecting years of financial re-
pression, including two episodes of outright expropriation of financial assets.
Countries that abstained from repressive interest rate controls, such as Chile
and Thailand, had very high levels of private credit, which may partially ex-
plain their superior investment and growth performance in the late 1980s.
The massive decline in private credit in Argentina reflects a more unusual
kind of financial behavior. The government oscillated between paying high in-
terest rates and depressingthe value of domestic liabilities through surprisede-
valuations and other undesirable methods, including the forced conversion of
time deposits into near-worthless government bonds in 1990. This tactic was
necessary because the high interest rates fueled the accumulation of more debt.
In a classic example of a debt spiral, the government borrowed more to meet
rising interest payments on the debt, which pushed interest rates and borrow-
ing up even higher in the next period, and so on. The following data from
Rodriguez (1991) chronicle the inevitable rise in interest rates at the outset of
successive economic plans, each of which opened with a devaluation.

Initial Nominal interest

devaluation rate (monthly)
Plan (percent) (percent)
Austral, June 1985 40 7
Primavera, August 1988 24 10
Bunge Born I, July 1989 200 17
Bunge Born II, December 1989 54 60
Erman Plan, January 1990 220 100

Simulation results for the long-term effects on real interest rates of a tran-
sitory percentagepoint increase in the deficit (relativeto GDP) financed through
domestic borrowing show wide variation, reflecting differences in the willing-
ness of asset holders to shift from alternative forms of savings (table 2). In
Chile and Morocco a 1 percentage point increase in the deficit could be
absorbed with only a modest 0.1 to 0.2 percentage point increase in real inter-

WilliamEasterlyandKlausSchmidt-Hebbel 223
Figure 4. Private Credit under Financial Liberalization and Repression
in Nine Developing Countries, 1980-90

Percentage of GDP F r--- Without interest rate controls

70-
70 ~~~~~~~~Chile--
60- 0

-
50 Thailand
C6te d'Ivoire
40 . - - - ' ' * -
-
__- ;
40 ... .

30 P-kisn
-

20 t ~~--~ ~ ~'---~ ~ ~ ~-_ Morocco l

10 Argentina

0 0 I I I I I I I I
1980 1982 1984 1986 1988 1990

With interest rate controls

Percentage of GDP
70

60

50

40

30-

20 -Zimnbabwe

10 S _w*_ Mexico
Ghana
0 -----r----i----r~l~ ---r~r I I I
1980 1982 1984 1986 1988 1990

Source: Country case studies listed in the references.

224 TheWorldBankResearch vol. 8, no.2 (July1993)

Observer,
est rates. Larger increases of 1.1 to 2.7 percentage points were required in
Colombia, Pakistan, and Zimbabwe (after interest decontrol) to convince mar-
kets to absorb the increase in domestic debt. With such a high tradeoff, these
countries would have only two choices when domestic borrowing triggers a
domestic debt spiral: to clamp down hard on interest rates, as Zimbabwe did
up to 1991; or to follow the more desirable course of fiscal adjustment, as Mo-
rocco and Colombia did.
These results for domestic debt financing and real interest rates (or financial
repression) and those for money financing and inflation indicate strong corre-
lation in both cases in developing countries. Increasinglyunfavorable tradeoffs
between these financing sources and the rates of return on government liabili-
ties-leading in extreme cases to hyperinflation, debt repudiation, or the vir-
tual disappearance of domestic capital markets-imply that there is no
alternative to fiscal adjustment for ensuring monetary and financial stability.

Private Response to Public Deficits

The macroeconomic effects of deficits are determined to a large extent by
the direct response of private spending-consumption and investment-to
changes in the deficit and its composition. The way governments adjusted their
fiscal imbalances during the 1980s-frequently by cutting public investment-
was often costly for private investment. In the ten sample countries, private
investment declined sharply from an average of 13 percent of GDP in 1981 to
9 percent in 1986. Meanwhile, consumption, both public and private, was rel-
atively insulated. Not even the sharp increases in public consumption of the
1970s-increases that had much to do with the subsequent fiscal crises-were
moderated during the adjustmentsof the 1980s. To provide some insight into
how the private sector responds to fiscal policies, we first identify the channels
of transmission between fiscal policies and private spending and then assess
their empirical relevance.

Private Consumption and Fiscal Policies

Fiscal policies affect private consumption and saving through two major
channels: disposable income and rate of return (real interest rate). An increase
in the deficit resulting from a cut in current taxes boosts private consumption
by increasing disposable income, according to the standard Keynesian hypoth-
esis that consumers increase spending when their current income rises. If the
tax cut is temporary, the effect will be minimal according to the permanent
income hypothesis, which states that only permanent (long-run) tax cuts sig-
nificantly affect consumer spending.
Both these hypotheses are wrong according to Barro's Ricardian equivalence
hypothesis, which claims that consumers react the same whether the govern-

WilliamEasterlyandKlausSchmidt-Hebbel 225
Table 4. Qualitative Effects of Fiscal Policy-Related Variables on Private Consumption an

Sensitivityof privateconsumptionto
Real
Disposableincome Publicsaving Publicsurplus interest Publ
Country Period Current Permanent Current Permanent Current Permanent rate Stock

Argentina 1915-84;1961-84 + . ..+ . .

Chile 1960-88 + + .. 0 . . 0 ..

Colombia 1971-86 + + 0 * . + .

C6Ote d'lvoire 1972-87 + .. . . 0 . . .

Ghana 1969/70-88 + + *. 0 .. 0 ..

Mexico 1981.1-1989.1V + 0 .. 0 .. . .

Morocco 1972-88 .. + .. . + 0 ..

Pakistan 1963-87 .. + . 0 0 . . ..

1972/73-87/88 . .. . . . ..+

Thailand 1971-87 + .. . . . . + ..

Zimbabwe 1965-88 + + .. + . .. 0 ..

+ and - correspond to statistically significant coefficients; 0 denotes a coefficient not significantly different fr
Note: Specifications and estimation techniques vary by country. The dependent variable "private consumptio
levels for Morocco and Thailand; both levels and log levels for Colombia; r.atio to national income for C6te d
Mexico, and Zimbabwe. The dependent variable "private investment" enters in levels for Argentina; log levels
Zimbabwe; log ratio to GDPfor Morocco; and either level, log level, or ratio to GDPfor Colombia. For Pakista
ratio. Because of data limitations, the dependent variable is the domestic investment to national income ratio f
Source: Country case studies listed in the references.
 ment finances its spending through debt or taxes because consumers foresee
that a tax cut today, paid for by a deficit and borrowing, will lead to a tax
increase in the future. In anticipation of that future tax increase, consumers
save rather than spend the income from the tax cut. So a tax cut that simply
substitutes debt finance for tax finance of unchanged government spending
would leave consumer spending unchanged-and would lower it as a share of
now higher disposable income. In short, according to this argument, higher
government deficits from tax cuts cause an offsetting increase in private saving.
The argument, first skeptically postulated by Ricardo and affirmed in the re-
cent literatureby Barro (1974), rests on two main and rather stringent assump-
tions: that consumers are concerned with their own future welfare and that of
their descendants and that consumers can shift consumption over time by bor-
rowing or lending whenever they wish.
There is another reason-unrelated to the Ricardian hypothesis-why a def-
icit increase resulting from a tax cut could cause private saving to rise. Under
conditions of strict credit and interestrate controls, with government having the
first claim on credit, an increase in the deficit (a fall in government saving) re-
duces the credit available to the private sector, forcing consumption to contract
and causing saving to rise. This effect, which may be hard to distinguish from
the Ricardian hypothesis, may be termed the direct crowding-out hypothesis.
The real interest rate determineshow consumers schedule their consumption
over time, assuming they have access to credit. The effect of the interest rate
on today's consumption is ambiguous according to the'offsetting substitution,
income, and wealth effects. An increase in interest rates causes consumers to
substitute consumption tomorrow for consumption today, but it also induces
consumers to feel richer and thus to spend more both today and tomorrow-
unless this wealth stems significantly from future income streams inflated by
the interest rise. Credit controls would block the effect of the real interest rate
on consumption.
Econometric estimates for the ten sample countries provide a sense of the
qualitative effects of these fiscal policy-related variables on private consump-
tion (table 4). For most of the countries both current (or transitory) and long-
run (or permanent) disposable income levels are found to be important deter-
minants of private consumption-and often by magnitudes halfway between
those implied by the Keynesian hypothesis and those by the permanent income
hypothesis.
Does public saving or the public surplus affect private consumption directly,
as implied by the Ricardian and direct crowding-out hypotheses? For most
countries it does not: permanent public saving does not significantly offset pri-
vate consumption in Chile, Mexico, or Pakistan; current public saving or sur-
pluses do not affect consumption in Colombia, Cote d'Ivoire, Ghana, or
Pakistan. In three cases, however, changes in public saving (or surplus) cause
consumption (or the saving rate) to move in the same direction, which is con-
sistent with both the Ricardian and the direct crowding-out hypotheses. Private

William Easterlyand Klaus Scbmidt-Hebbel 227

consumption rose with permanent public surpluses in Argentina and Morocco
and with permanent public saving in Zimbabwe. Although the coefficients
were significant and positive, they were much lower than those for permanent
income, implying-contrary to the Ricardian hypothesis-that tax cuts would
affect consumption and that public saving would have a positive net effect on
total saving.
These three cases could have supported the Ricardian explanation only if
these countries had freely operating financial markets, so that consumers could
shift their consumption over time in anticipation of future tax increases. In
fact, however, Argentina did not liberalize its financial markets until 1977, late
in the sample period, while Morocco and Zimbabwe had institutional arrange-
ments giving the public sector preferential access to domestic credit. These
facts suggest that direct crowding out of private consumption by public deficits
is the more likely explanation for the direct link between public deficits and
private consumption in these three countries. Corbo and Schmidt-Hebbel
(1991) achieved similar results for a different sample of developing countries.
The ten case studies provide little evidence that real interest rates favorably
affect private saving, a result consistent with findings for other developing
countries. The real interest rate showed significant effects in three countries.
Rising real interest rates depressed private consumption and boosted saving in
Mexico (signaling the dominance of the intertemporal substitution effect) but
increased consumption and reduced private saving in Colombia and Thailand.
The absence of significant results in five other cases suggests either that the
substitution, income, and wealth effects cancel each other out or that financial
market constraints prevent consumers from responding to interest rate swings
by shifting consumption across time. Borrowing constraints are also behind
Haque and Montiel's (1989) rejection of Ricardian equivalence for a set of de-
veloping countries.

Private Investment and Fiscal Policies

Fiscal policies affect private investment through three major channels: public
investment, public deficits, and the user cost of capital. Public capital could be
a close substitute for private capital, driving down the rate of return on private
investment. Public investment in steel plants is an obvious example. But gov-
ernments also invest in activities that do not attract private investment, but
that raise the return of other private projects, such as infrastructureprojects.
Thus, the higher the complementarity of public and private capital, the more
likely that public investment will have a net positive effect on private invest-
ment. If there is domestic financial repression of interest rates and the public
sector is given preferential access to domestic credit, the public deficit could
crowd out private investment. When interest rates are not regulated, deficit fi-
nancing through domestic borrowing tends to push up real interest rates, di-
minishing the profitability of investment by raising the user cost of capital.

228 The WorldBankResearchObserver,vol. 8, no. 2 (July 1993)

 (The user cost of capital is determined by the real interest rate, the price of
investment goods, and investment incentives.)
Consistent with the theoretical ambiguity of the relation between public cap-
ital and private investment, the case studies found sharply different results for
the qualitative effects of fiscal policy variables on private investment (see table
4). (For brevity, other investment determinants included in the estimations,
such as the marginal product value of capital, foreign saving, firm profits, or
banking credit to firms, are not discussed here.) For Pakistan each percentage
point increase in the ratio of public capital stock to output results in a 2.1 per-
centage point increase in the ratio of private capital stock to output. A similar
relation is found for Zimbabwe, but the effect is smaller than in Pakistan. By
contrast, an increase in public capital stock in Chile and Colombia tends to
lower private investment.
Some of the country studies used public investment rather than public cap-
ital stock, again finding opposite effects in different countries. For Ghana and
Mexico increasing public investment reduces private investment (although the
effect was weak for Mexico), while for Thailand private investment rises with
public investment. For Argentina no significant relation was found. The Mo-
rocco study found that public investment contributes to growth, from which
it is plausible to infer that private capital formation rises with public invest-
ment because growth boosts private investment.
Thus, only three countries provide direct evidence for the widespread pre-
sumption that public sector investment is good for private investment.
Aschauer's study (1989) for the United States found that increases in public
capital were associated with a large increase in private investment. It seems
reasonable to infer, then, that for countries with a negative relation between
public and private investment (Chile, Colombia, Ghana, and Mexico) or none
at all (Argentina),public investment is concentrated in activities that substitute
directly for private investment.
Public deficits have a negative effect on private investment in C6te d'Ivoire,
where the effect is weak, and in Thailand, where the effect is strong. For
Argentina, the analysis decomposed the deficit into its three major compo-
nents, finding that public investment does not affect private capital formation,
but that public consumption and public revenue do, in directions consistent
with the crowding-out hypothesis. The inference, then, is that deficits tend to
crowd out private investment through domestic financial markets in Argentina,
Cote d'Ivoire, and Thailand.
Although many studies have found that private investment is insensitive to
interest rates, the results for the sample countries show a surprisingly strong
relation in five of them, with only two-Colombia and Ghana-showing no
relation. The effect of interest rates on private investment is strongest in
Morocco and Pakistan, moderately strong in Zimbabwe, and weakest in Chile
and Mexico.

William Easterly and Klaus Schmidt-Hebbel 229

 Table 5. Qualitative Effects of Fiscal Policy Variables on the Trade Surplus and the Real E
o~~~~~~~~~~~~~~~~~~~~~~~~~~~ Sensitivity of the trade surplus toa
Public surplus Public expenditure
Country Period Total Primary Operational Consumption Investment

Argentina 1963-88 +
1964-87 ..
Chile 1960-88 .. .. +
Colombia 1970-88 .. + ..
1967-87 .. ..
COte d'Ivoire 1971-81 .. 0 .. .. ..
1979-89 .. + ..
1972-87 .. .. .. .. ..
1972-89 .. .. .. .. ..
Ghana 1970-88
Mexico 1970-89 .. .. +
Morocco 1974-88
Pakistan 1983/84-87/88 .
Thailand 1972-89 + .. ..
Zimbabwe 1965-88 .. .. + .. ..

+ and - correspondto statisticallysignificantcoefficients;0 denotes a coefficientnot significantlydifferentfrom zer

Note: Specificationsand estimationtechniquesvary by country.The dependentvariable"currentaccount or trade ba
C6te d'Ivoire,Mexico, and Thailand;in levels for Ghana, Morocco, and Pakistan;and as a log ratio to GDP for Zimb
levels for C6te d'Ivoire,Ghana, and Thailand;as levels distinguishingbetweenthe relativeexport price and the relative
import price for Argentina;and as naturallogs of the real exchangerate for Colombia.
a. The effects for Morocco and Pakistanare not the coefficientsfor one structuralequation but representthe gener
the currentaccount surplus(in Morocco) or the trade surplus(in Pakistan).For Morocco, the sign reflectsthe current
in governmentconsumption.For Pakistan,the sign reflectsthe trade surplusimprovementbased on the impact of a de
b. The effects for Morocco, Pakistan,and Thailandare not the coefficientsfor one structuralequation but represen
variableon the correspondingendogenousvariable.For Morocco, the reportedeffects combinethe simulationresultso
foreign-financedincreasein public expenditure.For Pakistan,the effect of an appreciationof the real exchangerate is
throughlower public investment,which causes domesticprices to rise with a fixed nominalexchangerate. For Thaila
domesticallyfinanceddeficits,which cause a trade deficit and a real exchangerate depreciation.
c. The coefficientfor Ghana is for aggregateprivateexpenditure.
Source:Countrycase studieslisted in the references.
Public Deficits, Trade Deficits, and Real Exchange Rates
For the 1980s real exchange rates are closely correlated with the behavior of
fiscal deficits in many developing countries, supporting Edwards' finding (1989)
that the real effects of nominal devaluations last only if the devaluations are
accompanied by fiscal adjustment. To provide more systematic evidence on the
links among the fiscal deficit, the trade deficit, and the real exchange rate, be-
havioral relations for these variables were tested for the sample countries using
Rodriguez's model (1989). Econometric estimates were derived for the sensitiv-
ity of the trade balance and the real exchange rate to various fiscal variables
(table 5).
Model estimates for eight countries-Argentina, Chile, Colombia, Cote
d'Ivoire, Ghana, Mexico, Thailand, and Zimbabwe-found significant evi-
dence that rising public surpluses are accompanied by rising trade surpluses. A
similar relation was found for Pakistan-reducing the fiscal deficit by reducing
public investment improves the trade balance- based on a comprehensive
macroeconomic model. That fiscal adjustment is a major determinantof exter-
nal adjustmentis also implied by the hypothesis that fiscal policy is an effective
instrument for increasing national saving, as the substantial evidence presented
in the preceding section shows.
The sample countries overwhelmingly demonstrate the sensitivity of the ag-
gregate real exchange rate to the trade surplus and to fiscal variables (see table
5). For eight countries-Argentina, Chile, Colombia, Cote d'Ivoire, Mexico,
Morocco, Thailand, and Zimbabwe- rising trade surpluses lead to deprecia-
tion of the real exchange rate. For Ghana a rising public deficit leads directly
to appreciation of the real official exchange rate. The only contrary result was
for Pakistan, where deficit reduction through reduced public investment leads
to appreciation of the real exchange rate because of the depressing effect of
lower public investment on domestic output. These findings, together with
those on the positive relation between trade deficits and fiscal deficits, strongly
support the hypothesis that real exchange rates move closely with fiscal deficits.
The studies also examined Rodriguez's hypothesis (1989) that, for a given
trade deficit, an increase in public spending affects the real exchange rate be-
cause such an increase implies a corresponding decline in private spending. If
the public sector has a higher propensity than the private sector to spend on
imports rather than domestic goods, a shift to more public and less private
spending implies increased demand for imports and a corresponding deprecia-
tion of the real exchange rate. Tests of this hypothesis show split results for
the sample countries: higher government spending leads to an appreciation of
the real exchange rate for Argentina, Cote d'Ivoire, Morocco, and Zimbabwe
and to a depreciation for Chile, Colombia, and Mexico.
These empirical results support the notion that the real exchange rate is sen-
sitive to both policy and external variables, with the fiscal deficit prominent
among them. The strong contribution of fiscal adjustment to external adjust-

William Easterlyand Klaus Schmidt-Hebbel 231

Figure 5. Fiscal and External Balances and Changes in the Real Exchange Rate,
1980-88 Averages for Ten Developing Countries

Balances (as percentage of GDP) Real exchange rate

"M ~~~~~120

-2 K 110

-4 100

-6 KY90

-8-8 exchange rate

~~~~~~~~~~~Real 880

-10 70
1980 1981 1982 1983 1984 1985 1986 1987 1988

mlFiscal balance m Currentaccount balance

Note: Depreciation of exchange rate is shown as a decrease.
Source: Countr case studies listed in references.

ment and, correspondingly, to depreciation of the real exchange rate is shown

in figure 5, which presents average values for these three variables in the 1980s
for the sample of ten countries. This average trend of steady fiscal improve-
ment from 1982 to 1988 was not confined to the sample countries. Other de-
veloping countries showed similar, though less pronounced, deficit reduction,
and industrial countries also cut their deficits in half during that period. Ac-
companying these fiscal adjustments were sharp reductions in current account
deficits, supported by massive depreciations of real exchange rates.

Conclusions and Policy Implications

Although correlations across countries between deficits and inflation and def-
icits and real interest rates were found to be weak at best, the sample countries
offer strong evidence that, in the medium term, money financing leads to higher
inflation and debt financing to higher real interest rates or increased financial
repression. As deficit financing mounts, the terms become increasinglyunfavor-
able to the extraction of these unconventional taxes from the private sector.
The evidence soundly refutes the Barro-Ricardianproposition that consum-
ers react the same to conventional taxes, unconventional taxes (inflation or
financial repression), and debt financing. The notion that private saving can be

232 The WorldBankResearchObserver,vol.8, no. 2 (July1993)

mobilized through higher real interest rates (resulting from increased debt fi-
nancing of deficits or from financial liberalization) was also rejected. Both find-
ings are in line with the recent empirical evidence on private saving behavior
in developing countries, which was noted in the introduction to this article.
Higher interest rates have a negative effect on private investment, however.
This finding is consistent with investment theory, but it contradicts some of
the empirical evidence showing that investment is insensitive to interest rates
in developing countries. Increasing public investment was found to reduce pri-
vate investment in some countries and to increase it in others. This result con-
firms previous studies showing that the net effect of public investment on
private investment depends on its composition-whether it is a complement to
or a substitute for private investment.
Strong evidence was also found in favor of the hypothesis that fiscal deficits
spill over into external account deficits, leading, in turn, to depreciation of the
real exchange rate.
Several policy implications can be derived from these findings:
* Fiscal deficits and inflation. For fiscal deficits financed by money creation,
the relation between deficits and inflation is indisputable. Considering the
unfavorable tradeoff between additional inflation and revenue, however, a
fiscal motivation hardly explains chronic high inflation in countries such
as Argentina, where revenue from the inflation tax is slight and comes at
the high cost of macroeconomic instability and high variability in relative
prices. The inflation tax (or seigniorage) is, at best, only a temporary
means of generating revenue. And because the inflation tax is a tax, there
is no reason to expect adjustment through inflation to be any less contrac-
tionary than conventional fiscal adjustment (see Dornbusch, Sturzenegger,
and Wolf 1990 for similar arguments).
* Fiscal deficits and-realinterest rates or financial repression. Financing defi-
cits through domestic borrowing pushes up real interest rates, which can
easily start a debt spiral leading to debt repudiation. If domestic interest
rates are controlled, however, the result is fiscal crisis: high fiscal deficits
are correlated with strongly negative real interest rates, and the loss of ac-
cess to external borrowing for financing fiscal deficits often leads to high
taxes on domestic financial intermediation. But the poor economic perfor-
mance that follows from strong financial repression, as depressed private
credit brings about the collapse of private investment, hardly recommends
this solution to fiscal crisis.
* Budget deficits and private consumption. The policy implication of reject-
ing the notion that consumers react the same to taxes or debt financing is
that increasing public saving-reducing public deficits-is the most effec-
tive contribution fiscal policy can make to increasing national saving.
However, increasing real interest rates through domestic debt financing or
financial liberalization will not increase private saving.

William Easterlyand Klaus Schmidt-Hebbel 233

 * Budget structure, deficits, and private investment. Real interest rates and
private sector credit do significantly affect private investment, so whether
there is financial repression or not, increasing public deficits reduces pri-
vate investment. The composition of public spending matters as well, since
increasing public investment depresses private investment in some cases-
typically when large public enterprises compete with private firms and
have preferential access to domestic financial resources. The policy impli-
cation is that the prospects for higher private investment and growth are
improved by privatizing or reforming public firms and marketing boards,
concentrating public investment on public and social infrastructure, and
deregulating domestic financial markets by removing credit ceilings and in-
terest controls, compulsory credit allocation, and preferential access of the
government to credit.
* Fiscal deficits, trade deficits, and real exchange rates. The evidence of a
strong relation between fiscal and external deficits complements the policy
implication derived from the finding that private saving does not offset
changes in public saving: fiscal adjustment is effective in boosting national
saving and, therefore, in increasing the trade surplus as well. Exchange
rates are driven by fundamentals and not the other way around, which
should serve as a reminderto policymakers that nominal devaluation alone
cannot restore macroeconomic balance. As Khan and Lizondo (1987) have
hypothesized, real exchange rates are also affected by whether government
spends more on tradables than on nontradables. Policymakers should pay
attention to the composition of government spending when deciding on an
accommodating exchange rate policy.
* Fiscal deficits and growth. The conventional notion that public investment
is good for private investment and growth received mixed support. Coun-
tries that were forced to shift from external to internal financing of defi-
cits--often because of a debt crisis induced by fiscal mismanagement-had
particularlypoor growth in the 1980s. Growth makes deficits less harmful:
countries such as Pakistan and Thailand could sustain larger deficits be-
cause of strong growth, while economic collapse exacerbated the macro-
economic effects of deficits in Argentina, Cote d'Ivoire, and Mexico. The
virtuous circle between growth and good fiscal management is one of the
strongest arguments for a policy of low and stable fiscal deficits.

Notes
William Easterly and Klaus Schmidt-Hebbel are on the staff of the Transition and Macro-
adjustment Division of the World Bank's Policy Research Department. The article is based on
work done for the World Bank researchproject 675-31. The authors thank Jorge Baldrich,Mario
Blejer,Vittorio Corbo, ShantayananDevarajan, Ricardo Ffrench-Davis,Nicolas Eyzaguirre,Stan-
ley Fischer, Ravi Kanbur, Johannes Linn, Paolo Mauro, Carlos Rodriguez, Vito Tanzi, Martin
Werner, two anonymous referees, and participants in the World Bank Conference on
Macroeconomics of Public Sector Deficits (Washington,D.C.), the tenth Latin American Meeting
of the Econometric Society (Uruguay),and seminars at CEMA-Universidad de San Andres (Buenos

234 The WorldBankResearchObserver,vol. 8, no.2 (July1993)

Aires), Central Bank of Chile (Santiago),Ministry of Finance of China (Beijing),and Ministry of
Finance of Costa Rica (San Jose) for useful discussions and comments. The authors are also grate-
ful for researchassistance from Maria-CristinaAlmero, Piyabha Kongsamut, and Raimundo Soto
and for interaction with the participantsin the research project.
1. The fully specified behavior-based models used in the analysis reported in this article can
be found in Easterly, Rodriguez, and Schmidt-Hebbel (1989); Rodriguez (1989); and Fischer and
Easterly (1990).
2. The most complete study to date on measurementsof the fiscal deficit is Blejer and Cheasty
(1991). Alternative measures are discussed in Blejer and Chu (1988), Buiter (1987), Eisner (1986),
Fischer and Easterly (1990), Kotlikoff (1988); and Tanzi (1985). IMF (1986) and United Nations
(1968) discuss cash and accrual deficits in more detail. Robinson and Stella (1988) and Teijeiro
(1989) survey issues concerning quasi-fiscal deficits.

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