3 Why does fiscal sustainability matter?

3.1  Fiscal sustainability and economic growth

The sustainability of the government's finances can influence economic conditions and performance in several ways. The sustainability of the government's fiscal position can influence the cost of capital and its ability to issue debt. If the government's fiscal position is seen as unsustainable, then it will be more likely to come up against borrowing constraints. It will also increase the likelihood of a higher country risk premium being added to the cost of borrowing faced by both the government and private agents.

While in principle one would expect perceptions of the sustainability of the government's fiscal position and the level of government debt to impact on economic growth, this relationship would not be expected to be straightforward and would depend on what is happening in other parts of the government's budget constraint. Barro (1979) and subsequent empirical work on fiscal policy and economic growth (see for example Kneller, et. al. 1999) would suggest that the composition of government expenditure and the composition of taxes will also influence economic growth. For example, increases in the level of government debt that are used to fund increases in public infrastructure may have a different impact on growth than debt used to fund welfare expenditures. Similarly, if increases in the level of government debt are assumed to be repaid by future increases in taxes, then the composition of tax increases could also influence future economic growth rates.

Sustainable fiscal policy can in principle also be important to anchor inflation expectations. As Sargent and Wallace (1985) have demonstrated, if it is believed the government is unlikely to be able to continue issuing government bonds to finance spending, then this may raise expectations that outstanding debt may be financed by increasing the money stock. If, as a consequence, there are expectations of increased inflation in the future, then that would lead to higher inflation in the present period. The significance of this mechanism for New Zealand is however not clear. Reinhart and Rogoff (2010) find that relationship between government debt and inflation varies between advanced and emerging countries. Although some advanced countries have experienced higher inflation when government debt is higher, they find no significant contemporaneous relationship between government debt and inflation for advanced countries. For emerging countries, on the other hand, they find inflation has tended to rise sharply when government debt rises. These differences might be attributable to differences in institutional arrangements, between advanced and emerging countries pertaining to monetary policy.

Sustainable government finances allow the government the flexibility to borrow in response to a temporary adverse shock to the government budget without needing to cut spending programmes or raise tax rates. This "smoothing" of tax rates over time minimises the cost of raising tax revenue. Having certainty around spending programmes also assists individuals to make investment decisions. For example, certainty around government infrastructure investment will assist individuals and firms to plan their own investment.

Low government debt allows fiscal policy to play more of a stabilising role during economic downturns and dampen, or at least not exacerbate, economic cycles. The deviation of demand and output from equilibrium can influence long-term GDP, if for example negative deviations have a permanent impact on the capital stock or investment in skills (Barker et al., 2008). A low level of government debt would provide more scope to allow "automatic stabilisers," such as unemployment benefits, to provide automatic fiscal expansion during downturns without requiring specific government policy decisions.

Having a sustainable fiscal position also allows the government more flexibility to use discretionary fiscal expansion during economic downturns. However, for a small, open country like New Zealand, the evidence is that discretionary fiscal policy tends to have only a small impact on aggregate demand, due to "leakage" to increased demand for imports, and the reaction of monetary policy (as discussed in Brook, 2013). Lags in the design and implementation of discretionary fiscal policy may also mean that the fiscal stimulus is not delivered when it is needed.

Perhaps unsurprisingly, a focus on fiscal sustainability will not ensure fiscal policy is stabilising during economic upturns. Experience has shown that there are significant challenges in managing fiscal policy through cycles. This is because of the political pressures to increase discretionary spending when the government is running large surpluses (especially when debt targets have already been met), and also because of the technical difficulties in determining whether budget surpluses are structural or cyclical. It may also be a challenge to communicate to the public that although operating surpluses may be large, owing to the revaluation of government assets, for example, cash surpluses may be a lot smaller. There are similar challenges for monetary policy, which has to distinguish supply and demand shocks and look through the cycle to estimate trend inflation. Brook (2013) considers options to make fiscal policy more stabilising during economic upturns, including revising the Public Finance Act so as to increase the importance that is placed on avoiding pro-cyclical fiscal policy; more focus on keeping to ex ante spending plans; or a stabilisation fund to safeguard revenue windfalls. The paper also touches on the potential role of an independent fiscal council.

In the New Zealand context, the government has let automatic stabilisers operate during the current economic downturn. Nevertheless, there have been periods of pro-cyclical discretionary fiscal policy. Fiscal impulse measures indicate fiscal policy was expansionary over the 2006-2008 upturn, and added to pressures on interest rate and exchange rate cycles and reduced output in the tradable sector (Brook, 2013). The 2006-2008 episode of pro-cyclical fiscal policy is one of the reasons why the PFA changes mentioned in the previous section were designed to place more emphasis on avoiding expansionary fiscal policy during economic upturns.

The preceding discussion suggests there is unlikely to be a simple rule for identifying the optimal level of government debt. This is because the impact of the level of government debt on economic growth is likely to depend on what that debt is financing, institutional arrangements for managing fiscal and monetary policy, on countries vulnerability to shocks, and the way countries and their government fiscal positions react to those shocks. While efforts have been made to identify threshold levels of government debt, some of that literature has been subject to a number of criticisms.[16] Moreover, the appropriate levels of government debt may differ depending on international financial market conditions.

Lane (2013) maintains that the appropriate target government debt ratio may be lower than was thought prior to the GFC because of lessons from the GFC about how quickly government debt can climb as the result of financial crises. Lane argues that maintaining low government debt is especially important for countries with substantial external liabilities (such as New Zealand).

Although since the GFC New Zealand government net debt has increased from less than 10% of GDP to over 30%, it is still relatively low compared to a number of other developed countries (IMF, 2012b). However, other countries, such as Australia, have lower levels of government debt than New Zealand, on both a gross and net basis. The current prudent level of government debt for New Zealand is also likely to be lower than for other developed countries because of New Zealand's relatively high levels of household and business debt (and conversely, households and businesses may be comfortable holding higher levels of debt, given the relatively low levels of government debt).