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1. Introduction
As the nascent recovery following the Global Financial Crisis (GFC) remains
tentative, policymakers within many advanced economies are pursuing fiscal
consolidation programmes as government debt and deficits reach unsustainable
levels (see IMF, 2010a). A policy agenda geared to sustainable fiscal balances
characterises the neo-liberal approach to the conduct of fiscal policy, which is
closely associated with the policy prescriptions of key Inter-Governmental
Organisations (IGOs), namely the International Monetary Fund (IMF) and the
Organisation for Economic Cooperation and Development (OECD) (see
Sharpe & Watts, 2012).1 The withdrawal of discretionary fiscal stimulus and a
Correspondence Address: Timothy P. Sharpe, Newcastle Business School, The University of
Newcastle, University Drive, Callaghan, NSW 2308, Australia. Email: timothy.sharpe@
newcastle.edu.au
1
The neo-liberal economic policy agenda, defined by Wacquant (2001, p. 404), consists of three
pillars: erasing the economic state, dismantling the social state, strengthening the penal state:
these three transformations are intimately linked to one another and all three result essentially
from the conversion of the ruling classes to neo-liberal ideology. The Washington Consensus provides a useful summary of neo-liberal polices (see Williamson, 1990).
# 2013 Taylor & Francis
587
2
Fiscal sustainability is often defined by reference to the algebra of debt and deficit dynamics (see
Blanchard et al. 1990; Buiter, 2010; Watts & Sharpe, 2013). Notwithstanding this, sound public
finance and fiscal sustainability are not operational concepts.
2. Financial Crowding-out
2.1. A Neo-liberal Perspective
Financial crowding-out theory has received wide coverage within the academic
literature and financial media, and is often referred to within the policy prescriptions of key IGOs.3 Most recently, the theory has been drawn on by neo-liberals to
promote expansionary fiscal contractions and fortify the imperative of fiscal sustainability within many advanced economies.
In essence, the expansionary contractions hypothesis claims that expansionary outcomes, in terms of increased output growth, increased consumption and
investment expenditure and lower unemployment rates, can be achieved via a
fiscal consolidation (reduction in government spending and/or an increase in
taxes) over the medium to long term (see Alesina, 2010; Giavazzi & Pagano,
1990). Financial crowding-out and credibility effects are positioned as key
demand-side mechanisms, inducing private investment and economic growth
under conditions of fiscal withdrawal (Briotti, 2005). The OECD and IMF frequently draw on the expansionary contractions hypothesis to validate fiscal consolidations within many advanced economies (see IMF, 2010b, 2010c; OECD,
2009, ch. 3; 2011, ch. 4).4
In a report entitled Preparing Fiscal Consolidation, the OECD (2010, p. 7)
presents three arguments justifying fiscal consolidations, all of which are
embedded in the fiscal sustainability literature. First, [h]igh public indebtedness
curtails the scope for countercyclical fiscal action, when needed. Second,
[b]allooning outlays on debt service could crowd out government spending on
growth enhancing programmes. Finally, [e]xcess supply of government bonds
may put upward pressure on interest rates and therefore crowd out private investment and compromise long-term output. The first and second propositions have
ties with the emerging literature on fiscal space (see Heller, 2005). The third
justification for fiscal consolidation relates to textbook financial crowding-out
theory. Culbertson (1968, p. 463) characterises the textbook view, to which
the OECD and IMF subscribe:
Fiscal policy provides additional spending in a world of sparse spending opportunities. But it does not provide a new source of finance in a world where spending is constrained by sources of funds of finance. The government expenditures
are financed in debt markets in competition with private expenditures. The case
least favorable to fiscal policy is that in which the additional government
3
Crowding-out arguments opposing government intervention can be traced back to Adam Smith,
John Stuart Mill and J.B. Say. The synthesis of Keyness General Theory into the IS/LM framework
by John R. Hicks and Alvin Hansen created more empirical interest in the impact of government
spending on interest rates, and subsequently on investment and income. For an overview, see
Spencer & Yohe (1970) or Bernheim (1989).
4
Amid weak GDP growth, IMF (2012a) has now largely abandoned the expansionary fiscal contractions argument. Further, IMF (2012a, p. 41) concedes that the [fiscal] multipliers used in generating
growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to
1.2. . .. [A]ctual [fiscal] multipliers may be higher, in the range of 0.9 to 1.7.
589
borrowing simply crowds out of the market an equal (or conceivably even
greater) volume of borrowing that would have financed private expenditures.
The data for all figures are drawn from OECD Economic Outlook No. 90, Annex tables, available
at: http://www.oecd.org/eco/outlook/economicoutlookannextables.htm.
that the [fiscal] stabilization is credible and avoids a default on government debt,
they can ask for lower premiums on government bonds (Alesina, 2010, p. 4). Furthermore, [i]f a country does not have fiscal credibility, it will have much more
difficulty in continuing its fiscal programme because creditors will refuse to continue lending or will demand a higher risk premium (OECD, 2010, p. 5).
591
However, this argument is inconsistent with the data and the economic commentary among sovereign non-Eurozone economies.
Eurozone economies have pursued relatively more severe fiscal
austerity measures than non-Eurozone economies. In most instances, these
593
not possess either of these characteristics; examples are France, Spain, Portugal,
Ireland and Greece.
Financial crowding-out theory was initially proposed and analysed in the
context of a convertible currency system, that is, the gold standard and the
Bretton Woods fixed exchange rate agreement (1946271). Mitchell (2009,
p. 9) notes that [e]conomic policy ideas that prevailed in the previous monetary
systems (based on convertibility) are no longer applicable in a fiat monetary
system.
MMT principles can be applied to inform Culbertsons (1968, p. 463) textbook view of financial crowding-out. First, spending is constrained by sources of
funds of finance. For the non-government sector, credit is constrained by the perceived creditworthiness of the borrower. A bank will lend to anyone it discerns as
able and willing to fulfil the obligations of the loan, although underwriting standards may vary over the business cycle. Government spending within sovereign
economies is not constrained by sources of finance. In a fiat currency system
money is a creature of the state (Lerner, 1947, p. 313). While it has no intrinsic
value it is accepted as a means of exchange because the government requires its
use to relinquish private tax obligations to the state (Mitchell, 2009, p. 9). Then, if
convertibility is abandoned and the government is the monopoly issuer of the fiat
currency, government spending is no longer revenue-constrained and government
saving is impossible. In a sovereign economy, government spending is only constrained by the availability of real goods and services, denominated in the national
currency (Mitchell, 2009; Mitchell & Muysken, 2008). On the other hand, government within non-sovereign economies are revenue-constrained since they are not
the monopoly issuer of the currency accepted in payment of taxes. Consequently,
government spending must be financed via taxation or borrowing in debt markets.
Second, government expenditures are financed in debt markets in competition with private expenditures. Recall the first point, government spending
within sovereign economies does not require financing. Instead, government
debt serves at least two distinct purposes.8 Government debt is primarily used
as an interest-rate maintenance mechanism within the interbank market (see Fullwiler, 2006; Mitchell, 2009; Mitchell & Muysken, 2008). Ceteris paribus, deficit
government spending increases the reserves within the interbank market via
increased deposits, which places downward pressure on the interbank lending
rate. This can potentially undermine the target policy rate set by the central
bank. Thus, in the presence of a corridor system and a desire to maintain a positive policy rate, the central bank must drain these excess reserves by selling,
typically under a repurchase agreement, an interest-bearing asset (government
debt); otherwise the interbank lending rate will fall towards the support rate, or
zero if no support rate is offered.9 If all bank reserves are remunerated at the
8
Government debt may also be desired by financial markets because it represents a risk-free interestbearing asset, which can be used as a benchmark for pricing other debt instruments or financial securities, and to balance the risk structure of investment portfolios; see Mitchell (2009) for a critique.
9
This point is often explicit in central bank documentation, in particular the Reserve Bank of
Australias account of the conduct of Open Market Operations (see RBA, 2011).
595
See OECD (2006) for the methodology. Since the revision of the Stability and Growth Pact in
2005, cyclically-adjusted measures are given more weight than headline measures in the EU
fiscal surveillance framework (Larch & Turrini, 2009).
597
Fisher-type test aggregates the individual unit root p-values from each cross-sectional unit to test for a unit root in the combined series. Following Maddala & Wu,
if the test statistics are continuous, the significance levels pi (i 1, 2, ... N ) are
independent uniform (0, 1) variables, and 2 log pi has a x2(2) distribution. The
combined p-value, defined by equation (3), is obtained from the additive property
of x2 variables which has a x2 distribution with 2N degrees of freedom.
N
log pi
(3)
pl = 2
i=1
Maddala & Wu (1999) use simulations, imposing various assumptions of stationary processes to find that the Fisher test is superior to LLC and IPS given its high
power and low size distortions. However, the LLC, IPS and Fisher tests assume
cross-sectional independence which is likely to be violated in this study. Therefore, the test statistics are no longer valid. Nevertheless, these tests are still
applied within the empirical financial crowding-out literature. To overcome
this, Maddala & Wu propose a bootstrap method, based on the Fisher test, to
derive the empirical distributions of the test statistics. In essence, a bootstrap
sample is generated under the null of a unit root (ri = 0) by drawing with replacement from the residual series obtained from regression equation (2). However,1it
cannot be re-sampled directly since the errors are potentially cross-correlated, thus
1 it = [11,t , 1 2,t , ..., 1 N,t ] are re-sampled to retain the cross-correlation structure of
the error term. This process is repeated 2,000 times to obtain the MW-Fisher test
statistic.14
For sovereign economies, the MW Fisher-Bootstrap results suggest that all
variables are stationary in levels, i.e. I(0), except GDEBT and GDEBTSQ
which are I(1) or stationary in first differences. For the non-sovereign economies,
BB, GDEBTSQ, DSER and DSERSQ are I(1), all other variables are I(0).15
Eviews program code for these calculations was obtained from Galimberti & Cupertino (2009).
Panel unit root results are available from the author upon request.
15
(4)
Optimal lag lengths on the differenced regressors are based on the Akaike information criterion (AIC) (see Pesaran et al., 2001). Each variable is specified as the
dependent variable, and the F-statistic is computed to test the null hypothesis of no
cointegration (5).
(5)
H0 :a1 = a2 = a3 = 0
Panel cointegration results (with SPR as the dependent variable) confirm long-run
cointegrating relationships among all fiscal proxies for both sovereign and nonsovereign economies (with and without fixed effects).17
599
short-run partial adjustments. vit is an error term. The optimal lag length on the differenced regressors is based on the AIC (see above).
However, it is well known that least squares dummy variable (LSDV) estimations yield biased and inconsistent results when applied to a dynamic panel
data setting since, by construction, the lagged dependent is correlated with the
error term (see Judson & Owen, 1999; Nickell, 1981). To overcome this, Anderson
& Hsiao (1982) recommend an instrumental variable (IV) estimation technique
using higher-order lags on the differenced dependent variable as instruments (see
also Christopoulos & Tsionas 2004). This IV technique is applied and diagnostic
tests are performed to ensure the models are well-specified, the errors are normally
distributed and serially uncorrelated, and the over-identifying restrictions are valid.
For brevity, the most robust models according to these diagnostic tests are reported.
Fiscal proxies are not statistically significant for sovereign economies. EDEFICIT is not significant
for non-sovereign economies. The results are similar where nominal government bond rates are used
as the dependent variable.
Coefficient
(t-statistic)
Coefficient
(t-statistic)
0.320385
(0.697283)
0.511455*
(1.847552)
0.156816
(0.863585)
20.010850
(20.075113)
0.508343**
(2.557915)
EDEFICIT
P
REER
SPI
CAB
ecm(-1)
Non-sovereign economies
0.016443
(0.144906)
20.036536
(21.571308)
0.304505
(0.359055)
20.148337
(20.845489)
20.581112***
(23.288259)
Variable
SPR(-1)
BB
BB(-1)
20.293342
(21.758614)
20.143607
(21.657589)
20.048250***
(22.745763)
0.415984
(0.746226)
20.206026*
(21.922980)
20.577679***
(24.210935)
CAFB
0.447827
1.726720
0.620564
4.468299
0.260508
3.388938***
0.772008
0.197733
3.878691
5.076173***
0.552645
0.060794
Coefficient
(t-statistic)
20.035055
(20.256901)
20.433839
(21.572457)
21.281997***
(26.573157)
0.054687**
(2.239606)
0.871491**
(2.265438)
0.361071
(0.813095)
20.330096***
(24.792311)
20.004038
(20.149124)
21.841284***
(24.176228)
20.050412
(20.874663)
20.477415***
(23.773267)
20.008431
(20.096663)
20.572826***
(25.102467)
0.118731
(1.283858)
22.648656***
(23.223896)
20.001891
(20.021073)
20.781945***
(23.666519)
0.943513
0.192079
0.918016
0.566378
1.370934
47.14221***
0.532711
0.749329
0.092082
28.55209***
1.387300
n/ab
EDEFICIT
P
REER
SPI
CAB
ecm(-1)
Diagnosticsa
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
Coefficient
(t-statistic)
Diagnostics
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
***,**,* significant at the 1%, 5% and 7% level respectively. All variables are in first
difference. No fixed effects included. Instruments are lags of DSPR.
a
Normality: Jarque-Bera normality test. AR(2): Test for the null of no second-order serial
correlation. F-statistic: Joint significance of coefficients. Specification: F-test for the null
of jointly irrelevant fixed effects. SS: Sargan statistic for the null of valid over-identifying
restrictions (q).
b
Just identified.
service indicator became a more important determinant of interest rates after the
formation of the European Monetary Union (EMU). MMT argues that by joining
the EMU a country relinquishes its fiscal-monetary sovereignty, and so can
become insolvent. Hence, rising debt servicing costs may signal an increased
risk of insolvency, which materialises as rising risk premiums on long-term
debt, potentially creating a positive feedback mechanism.19
19
Buiter (2010) makes a similar claim, though he does not adequately distinguish between a sovereign and non-sovereign economy.
601
Coefficient
(t-statistic)
Coefficient
(t-statistic)
0.391367
(1.288793)
0.775135**
(2.416351)
0.043272
(1.043154)
20.011469
(20.031246)
0.428627**
(2.222836)
0.109135
(1.130739)
20.000267
(20.909255)
20.092919
(21.269077)
20.014449
(20.532871)
20.124751
(20.285935)
20.035580
(20.265352)
20.457135***
(22.984946)
GDEBTSQ
P
REER
SPI
CAB
ecm(-1)
Non-sovereign economies
20.164651
(21.053452)
20.056198*
(22.018890)
0.548516
(0.798528)
20.120408
(20.833908)
20.772144***
(23.537225)
Variable
SPR(-1)
BB
BB(-1)
GDEBT
0.582559
3.461375
0.595858
0.671304
0.571173
3.011574***
0.102542
1.267687
0.545326
4.663766***
0.611987
0.799585
Coefficient
(t-statistic)
0.028038
(0.272266)
20.498575**
(22.115106)
21.153920***
(27.149814)
0.022507**
(2.380609)
20.374321***
(26.300810)
0.019303
(0.775162)
21.428634***
(23.627605)
20.017178
(20.353294)
20.497413***
(24.329741)
0.071135
(0.656737)
20.077215
(20.318792)
20.965106***
(25.491885)
20.027706
(21.213027)
0.000330**
(2.170639)
20.304101***
(24.243995)
20.007682
(20.222837)
22.017442***
(24.581051)
0.057002
(1.003809)
20.427859***
(22.909993)
0.966288
0.311372
0.940458
0.778511
3.042650
87.64894***
1.474584
0.514269
2.317936
55.67812***
0.511374
1.521704
GDEBTSQ
P
REER
SPI
CAB
ecm (21)
Diagnosticsa
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
Coefficient
(t-statistic)
Diagnostics
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
***,**,* significant at the 1%, 5% and 7% level respectively. All variables are in first
difference. No fixed effects included. Instruments are lags of SPR.
a
Normality: Jarque-Bera normality test. AR(2): Test for the null of no second-order serial
correlation. F-statistic: Joint significance of coefficients. Specification: F-test for the null
of jointly irrelevant fixed effects. SS: Sargan statistic for the null of valid over-identifying
restrictions (q).
20
Ricardian equivalence can be dismissed on the basis of its theoretical assumptions (see Bernheim,
1989).
Coefficient
(t-statistic)
Coefficient
(t-statistic)
0.371701
(0.984711)
0.591663**
(2.160374)
20.009018
(20.033289)
0.221195
(1.476541)
0.538004**
(2.249931)
0.435139
(1.111088)
20.030057
(20.520968)
20.149370
(21.802663)
20.037173**
(22.410456)
0.350221
(0.894346)
20.175639
(21.517867)
20.639626***
(23.186298)
DSERSQ
P
REER
SPI
CAB
ecm(-1)
Non-sovereign economies
20.041736
(20.373251)
20.037389
(21.581545)
20.144908
(20.196534)
20.158950
(20.858649)
20.704690***
(22.726045)
Variable
SPR(-1)
BB
BB(-1)
DSER
0.447200
2.218018
0.394208
4.954195
0.331266
3.334748***
0.438050
0.439980
0.040235
3.060203***
0.241229
1.798843
Coefficient
(t-statistic)
0.197074
(1.464493)
20.240386
(21.008456)
21.080795***
(26.201986)
0.295174**
(2.684237)
20.368577***
(25.768799)
0.014696
(0.536797)
21.805440
(24.642780)
0.002961
(0.054437)
20.574348***
(25.441394)
0.236723
(1.788941)
20.180177
(20.784047)
20.964326***
(25.587090)
0.060063
(0.393578)
0.012843**
(2.202309)
20.396428***
(26.611405)
20.003199
(20.136452)
21.769253***
(25.317290)
0.011711
(0.239201)
20.550065***
(25.562374)
0.969506
2.495697
0.978822
2.159288
1.763994
124.6736***
1.660319
0.602152
3.006993
60.15684***
1.758387
2.236528
DSERSQ
P
REER
SPI
CAB
ecm(-1)
Diagnosticsa
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
Coefficient
(t-statistic)
Diagnostics
2
R
Normality
x2(2)
AR(2) x2(2)
F-statistic
Specification
SS x2(q)
***,**,* significant at the 1%, 5% and 7% level respectively. All variables are in first
difference. No fixed effects included. Instruments are lags of DSPR.
a
Normality: Jarque-Bera normality test. AR(2): Test for the null of no second-order serial
correlation. F-statistic: Joint significance of coefficients. Specification: F-test for the null
of jointly irrelevant fixed effects. SS: Sargan statistic for the null of valid over-identifying
restrictions (q).
603
For creators of currency such as the US, former Federal Reserve Chairman
Alan Greenspan (1997) has unequivocally acknowledged that [c]entral banks can
issue currency, a noninterest-bearing claim on the government, effectively without
limit. . . . That all of these claims on government are readily accepted reflects the
fact that a government cannot become insolvent with respect to obligations in its
own currency. A fiat money system, like the ones we have today, can produce such
claims without limit. Martin Feldstein has reiterated the point in a recent interview:
French officials apparently dont recognise the importance of the fact that
Britain is outside the eurozone, and therefore has its own currency, which
means that there is no risk that Britain will default on its debt. . . . When interest
and principal on British government debt come due, the British Government can
always create additional pounds to meet those obligations. By contrast, the
French government and the French central bank cannot create euros. If investors
are unwilling to finance the French budget deficitthat is, if France cannot
borrow to finance that deficitFrance will be forced to default. (Russell, 2011).
Prior to the GFC, the validity of the crowding-out argument was rarely questioned
by the mainstream financial media. Yet, despite these measured statements by
Greenspan and Feldstein, and notwithstanding the empirical evidence, policymakers continue to insist that financial crowding-out is a significant problem.21
5. Conclusion
The impact of the GFC on deficit and debt ratios in many advanced western economies enables a rigorous assessment of the proposition derived from MMT that
institutional arrangements are central to the conduct of fiscal policy. Despite
similar trends in government debt and deficit indicators, the emerging data has
revealed differences in the response of long-term interest rates among advanced
economies. These disparities are most distinct between advanced Eurozone and
non-Eurozone economies.
Mainstream financial crowding-out theory, which is embedded within the
neo-liberal expansionary contractions literature and espoused by InterGovernmental Organisations, albeit with recent qualifications, cannot reconcile
these differences. On the other hand, MMT offers an explanation consistent
with the empirical evidence by making the necessary distinction between
sovereign and non-sovereign economies. However, this has not been recognised
within the extant literature.
Panel VECM results suggest that fiscal proxies (cyclically-adjusted financial
balance; the ratio of government gross financial liabilities to nominal GDP; and
the ratio of government net debt interest payments to general government revenues) are positive and significant determinants of the long-short interest rate spread
in non-sovereign economies, but are insignificant in sovereign economies.
21
Numerous market economists and media commentators have dismissed the claim put forth by John
Boehner, Speaker of the US House of Representatives, that government spending is crowding out
private investment and threatening the availability of capital (Rowley & Dorning, 2011).
Acknowledgment
Special thanks to Martin Watts. I am also grateful to an anonymous referee for
helpful comments on an earlier draft.
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