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THE ECONOMICS OF
THE GOVERN9MENT BUDGET
CONSTRAINT
Stanley Fischer
William Easterly

This article summarizesthe simple analytics of the macroeconomiceffects of

governmentbudget deficits.The presentationis organizedaround three key relationships:the national income accountsbudget deficit identity, the deficitfinancing identity, and the dynamic equation for the evolution of the ratio of
public debt to gross national product. The national income accounts identity
highlights the effect of the deficit on domestic saving and investment and the
current account. Examining the financing of the deficit brings to light the different kinds of macroeconomic imbalance the deficit can cause-as a first
approximation,printingmoney excessivelyshows up as inflation,excessiveuse
of foreign reservesleads to crisesin the balanceof payments, high foreign borrowing leads to a debt crisis,and too much domestic borrowingleads to high
real interest rates and crowding out of private investment. The debt dynamics
equation is used to show the long-run constraintson fiscal policy.

It

is increasinglyrecognizedthat sustained economicgrowth is possibleonly

within a sound macroeconomicframework and that in such a framework
fiscalpolicy plays a key role. In this articlewe draw on recent developments
in the analysis of the consequencesof deficit finance to show how and why
sound fiscalpolicyis so crucialto the achievementof macroeconomicstability.
We are not here concernedwith the effectsof fiscal policyon resourceallocation, important as these undoubtedlyare (see World Bank 1988for comparative data on government revenuesand expenditure and for an authoritative
modern account of the role of fiscalpolicy).Instead, this article focuseson the
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and Development/THE WORLD BANK
1990 The International Bank for Reconstruction

127

macroeconomic effects of government budget deficits-the consequences of different methods of financing the deficit and the links between the budget deficit
and inflation. The article is built around three simple relationships: the national
income accounts budget deficit identity, the budget deficit financing identity,
and the dynamic equation for the evolution of the ratio of debt to gross national product (GNP).

Macroeconomic Effects of the Deficit: Standard Analysis

The Keynesian revolution brought the budget deficit out of the closet as a
macroeconomic variable. Although governments had run budget deficits without the aid of Keynesian theories before, the pre-Keynesian presumption was
that in peacetime the budget should generally be balanced or even in surplus
to pay off the government debt generated by wartime deficits. The devotion to
balanced budgets is evident from the desire of political candidates and governments to balance the budget even during the Great Depression. Though few
succeeded in balancing the budget, some governments raised tax rates during
that period.
Keynes provided a framework-now recognized to be incomplete-in which
it is possible to analyze the question of how the deficit should behave. The earliest emphasis was on fiscal policy and the deficit as components of aggregate
demand. From that perspective, Keynesians saw no need to balance the budget
during periods of recession. Instead the notion of the cyclically balanced budget, that the budget should be in balance on average over the business cycle-in
surplus during booms and in deficit during recessions-was developed as a
norm for fiscal behavior.
There were, of course, well-known refinements to this concept. First, the balanced budget multiplier shows that the deficit is not an unambiguous measure
of the effect of fiscal policy on aggregate demand; given the deficit, an equal
increase in government spending and revenue increases aggregate demand.
Second, the budget deficit is itself endogenous, affected by the state of the economy as well as affecting it. The notion of the full-employment deficit, or highemployment deficit, or structural deficit developed from these qualifications of
the original concept. The structural deficit estimates the size of the budget deficit as it would be if output were at the full employment level (see appendix).
Once the threat of widespread postwar unemployment had receded, the emphasis shifted from the effect of fiscal policy on aggregate demand to its effect
on the components of demand. Here the saving-investment identity, or the resource constraint facing the economy as a whole, is a useful guide to analysis:
(1)

Budget deficit = (private saving - private investment)

+ (current account deficit).

Since equation (1) is an identity, there is not much arguing with it (though
it is necessary to define terms consistently: the budget deficit in (1) is that of

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the consolidated public sector). To illustrate the uses of the equation, suppose
the economy is at full employment, and take the rate of saving as given. The
saving-investment identity illustrated by the equation then implies the crowding-out problem: an increase in the budget deficit will result in either a reduction in investment or an increase in the current account deficit. Until this
decade, textbooks-at least U.S. textbooks-tended to emphasize the possibility of crowding out investment. The clear relation in this decade between the
U.S. budget deficit and its trade deficit has reminded us that there are two terms
on the right-hand side.
It would be a mistake, though, to overcompensate by assuming an automatic
one-to-one link between the budget and trade deficits. Balassa (1988), for
instance, finds a high correlation between budget deficits and trade deficits in
the industrial but not the developing countries. To take another, example, the
United Kingdom ran a large trade deficit in 1988-89 while maintaining a strong
fiscal position. The effect on the trade deficit of a reduction in the budget deficit
depends on the accompanying monetary policy and its effect on the exchange
and real interest rates. Fiscal contraction accompanied by monetary easing
would reduce the interest rate and lead to a depreciation of the exchange rate,
thus tending to increase investment while reducing the trade deficit.
Standard Keynesian analysis of the effects of fiscal policy has been modified
by two important theoretical developments. The first is the more sophisticated
model of saving behavior that emerges from the life-cycle and permanent income theories of consumption of Franco Modigliani and Milton Friedman. So
far in this article we have implicitly taken the rate of saving as determined by
the level of disposable income and have not focused on the link between the
budget deficit and saving. The life-cycle and permanent income theories both
relate current consumption to a measure of permanent or lifetime disposable
income. Accordingly, a current change in taxes that does not change the present
value of taxes should not, other things being equal, reduce current consumption. Thus a temporary tax change should have a smaller effect on consumption than a permanent tax change. This, of course, implies that the effect
on spending of changes in t]hebudget deficit is influenced by expectations about
the permanence of the deficit.
Pursuing the argument to its logical conclusion, Barro (1974) shows that under a very specific set of assumptions, lump-sum changes in taxes would have
no effect on consumer spending. What is more, a cut in taxes that increases
disposable income would automatically be accompanied by an identical
increase in saving. This is the so-called Ricardian equivalence result, which
states that deficits and taxes are equivalent in their effect on consumption.
The explanation is quite simple: the far-seeing consumer recognizes that the
government debt generated through deficit spending will eventually be paid off
by increased taxes, the present value of which is exactly equal to the present
value of the reduction in taxes. Taking the implied increase in future taxes into
account, he or she saves the amount necessary to pay them.
Stanley Fischer and William Easterly

129

The potential empirical importance of the Ricardian equivalence hypothesis

cannot be exaggerated. If the hypothesis holds, budget deficits do not affect
national saving, interest rates, or the balance of payments; nor does the method
of financing of social security affect the accumulation of capital. With regard
to equation (1), the hypothesis implies that an increase in the budget deficit
would, under certain circumstances, be accompanied by an increase in private
saving-and that both investment and the trade balance would therefore be unaffected.
Despite the sharpness of its predictions, it has not been possible to reject
Ricardian equivalence sufficiently decisively to persuade proponents of the theory to change their views. Bernheim (1987) reviews and extends the theory and
evidence, arguing strongly against Ricardian equivalence. Haque and Montiel
(1987) reject Ricardian equivalence for fifteen out of a sample of sixteen developing countries. Others regard the evidence as sufficient to rule out Ricardian
equivalence as anything more than an interesting theoretical possibility. We believe the evidence, including that from the United States in this decade, still
supports the view that tax cuts increase aggregate demand, though the effect
does depend on expectations of the permanence of the change.
The second theoretical development that has affected the Keynesian analysis
of fiscal policy takes off from the extremely short-run nature of the Keynesian
model. Because asset stocks are assumed fixed in the model, the consequences
of the method by which the budget deficit is financed are not pursued.

Financing the Budget Deficit

There are four ways of financing the public sector deficit: by printing money,
running down foreign exchange reserves, borrowing abroad, and borrowing
domestically:'
(2)
Budget deficit = money printing + (foreign reserve use
+ foreign borrowing) + domestic borrowing.
The public sector in this case is defined to exclude the central bank, whose
profits from the printing of money are treated as a source of financing. In both
equations (1) and (2), government revenue from the printing of money is treated as a source of financing. Private saving in equation (1) is defined to include
additions to money holding.
The terms on the right-hand side can be grouped in different ways. For instance, the parentheses around the foreign components emphasize the link
between the budget deficit and the current account, as in equation (1). Alternatively, parentheses could be placed around (money printing + foreign reserve
use), which is equal to creation of credit by the central bank; this emphasizes
that domestic credit creation is the alternative to borrowing.
As a useful first approximation, we can associate each of the forms of financing in equation (2) with a major macroeconomic imbalance. Money print130

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ing is associated with inflation; foreign reserve use is associated with the onset
of exchange crises; foreign lborrowing is associated with an external debt crisis;
and domestic borrowing is associated with higher real interest rates and, possibly, explosive debt dynamics as borrowing leads to higher interest charges
on the debt and a larger deficit. But the first approximation is only the beginning of the story, for there are links between these problems-for instance, between domestic borrowing and inflation (discussed in the next section) and
between foreign exchange use and external debt crises (discussed in the section
on foreign borrowing).

Money Printing
It is straightforward to relate the creation of base money to inflation in the
usual monetarist way. The printing of money at a rate that exceeds the demand
for it at the current price level creates excess cash balances in the hands of the
public. The public's attempts to reduce excess cash holdings eventually drive
up the overall price level, until equilibrium is restored. Of course, cause and
effect are not necessarily obvious or immediate: initially, for instance, an increase in the stock of real money may reduce interest rates, particularly in a
low-inflation economy.
The amount of revenue that the government can expect to obtain from the
printing of money is determined by the demand for base or high-powered
money in the economy, the real rate of growth of the economy, and the elasticity of the demand for real balances with respect to inflation and income. Assume for convenience that the income elasticity of the demand for base money
is unity. Assume also that the currency to GNP ratio is 13 percent, as it is in
Pakistan-this is high by international standards. (We have changed from highpowered money to currency, because rediscounts to the banking system of
about 6 percent of GNP effectively reduce the base on which the government
earns seignorage-its right to print money.)
Then for every one percentage point that GNP increases, the government can
obtain 0.13 percentage points of GNP in revenue through the printing of money
that just meets the increased demand for real balances. With an annual economic growth rate of 6.5 percent, the government should be able to obtain
nearly 0.9 percent of GNP lor financing the budget deficit through the noninflationary printing of money, increasing the high-powered money stock at an annual rate of 6.5 percent.
Beyond that rate of growth, and given a stable demand function for currency,
inflation will result. If the ratio of base to GNP were invariant to the inflation
rate, it would be easy to estimate the amount of revenue collected at different
inflation rates. For instance, at a 10 percent inflation rate the government
would be able to finance an extra 1.3 percent of GNP of budget deficit through
seignorage.
Stanley Fischer and William Easterly

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But the demand for high-powered money declines as the inflation rate rises.
Eventually the government's revenue from seignorage reaches a maximum (see
figure 1). Thereafter, increases in the growth rate of money lead to more inflation and less revenue. In this situation there is a true Laffer curve: beyond point
A in the figure, the government can obtain more revenue by printing money
less rapidly.
At what rate of inflation is the government's revenue from money printing
maximized? The historical record shows average (not maximum) rates of
seignorage of about 1 percent of GNP for the industrial countries and less than
2.5 percent of GNP for the developing countries (Fischer 1982). Estimates of the
inflation rate at which the maximum rate of seignorage is attained range from
30 percent to more than 100 percent. These estimates, however, are misleading,
for there are lags in the process of adaptation of money demand to inflation.
In the very short run of a few days or weeks, the government can almost always
increase its revenue by printing money more rapidly. But the longer a process
of high inflation continues, the more the demand for real balances at any given
inflation rate declines. People find other ways of doing business, especially by
transacting in foreign currencies. (For treatment of the problem of high inflation see Blejer and Liviatan 1987 and Kiguel and Liviatan 1988.)

Figure 1. Revenuefrom Seignorage

Government
revenue

132

Inflation rate

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The dynamic process associated with high inflation, in the high double digits, is inherently unstable. The government may initially obtain large amounts
of revenue, perhaps even 7 to 8 percent of GNP, by increasing the money stock
rapidly. But as the inflation proceeds and individuals find ways of reducing
their holdings of local currency, the government has to print money more rapidly to obtain the same revenue. Thus it is safe to argue that rates of seignorage
of much more than 2.5 percent of GNP would not be sustainable and that even
that rate would be possible only in a very rapidly growing economy.
In the extreme cases, reliance on seignorage revenue to finance the deficit
leads to hyperinflation. A recent example is Bolivia in 1984-85. Inflation in
Bolivia soared to over 11,000 percent in 1985, although revenue from currency
creation fell to 8 percent of gross domestic product (GDP) in 1985 from 14 percent of GDP in 1984. But Bolivia is not alone: many other governments-including Nicaragua and Peru-have suffered from the same phenomenon in recent
years as well as during the great hyperinflations. The instability of the process
is reinforced by the decline in the efficiency of the tax system as the inflation
rate rises, the so-called Keynes-Olivera-Tanzi effect (Tanzi 1977).

Using Foreign Exchange Reserves

The second means of financing the government budget deficit is to run down
foreign exchange reserves. By running down reserves instead of printing money,
the government can hope to put off the inflationary effects of a deficit. This
policy appreciates the exchange rate. The policy of slowing the rate of exchange depreciation to slow down inflation (carried out not only through
reserve use but also through increased foreign borrowing) has been tried time
and again; it cannot be maintained unless the essentials-that is, fiscal
policy-are made compatible with the lower inflation.
Use of international reserves to finance the deficit has a clear limit. The private sector's expectation that the limit is about to be reached can provoke capital flight and a balance of payments crisis, since exhaustion of reserves will be
associated with currency devaluation. The devaluation that takes place in response to a run on the currency might be blamed on speculators but is most
likely an entirely rational response by the private sector to unsustainable public
policies (see Krugman 1979).
This private sector response is a plausible explanation for the event that precipitated (though it did not, of course, by itself cause) the debt crisis-the exhaustion of reserves in Mexico in August 1982. A loss of fiscal control resulted
in deficits of 14 percent of GDP in 1981 and 18 percent in 1982. Capital flight
had been proceeding at the rate of $7 billion2 a year from 1979 to 1982. Finally,
a speculative attack on the remaining reserves in August 1982 led to the suspension of payments and the beginning of the rescheduling process.
Stanley Fischer and William Easterly

133

Foreign Borrowing
The third method of financing the public sector deficit, direct foreign borrowing, tends, like the use of reserves, to appreciate the exchange rate, damaging exports and encouraging imports. The dangers of excessive reliance on
external borrowing to finance the budget deficit, and of large budget deficits,
are convincingly illustrated by the debt crisis (see Sachs 1989 for a discussion
of the link between the external debt crisis and fiscal behavior, and Ize and
Ortiz 1987 for an analysis of the relation between fiscal deficits and capital
flight). Most, though not all, of the countries that developed debt servicing difficulties were running huge public deficits. For most highly indebted countries,
past overborrowing and the perception that they are not creditworthy have severely limited this source of finance for the present.
We have already noted that budget deficits and trade deficits are not necessarily linked. Budget deficits can be financed by printing money and by domestic borrowing. But when, as in some developing countries, domestic capital
markets are thin and domestic borrowing possibilities limited, the connection
between the budget deficit and external borrowing is more likely to be close.
For example, large fiscal deficits (between 7 and 11 percent of GDP) in
Bangladesh during the 1980s have been mirrored in sizable current account deficits. Recent fiscal adjustment through cutbacks in expenditure has substantially improved the current account. If the relation is viewed in the reverse
direction, reductions in the availability of external financing, as for some of the
debtor countries, force either fiscal contraction or inflation.

Domestic Borrowing
The final form of finance, available to some developing countries, is issuance
of domestic debt. This is usually intermediated by the banking system, although in a few cases, such as Brazil and Mexico, government bonds have been
sold directly to the private sector. To be considered nonmonetary debt, borrowing from the banking system must not be financed by central bank rediscounts.
Although government domestic borrowing is often thought of as a way to avoid
both inflation and external crises, it carries its own dangers if used to excess.
By definition, government borrowing reduces the credit that would otherwise
be available to the private sector, putting pressure on domestic interest rates.
In countries as diverse as Colombia and Turkey, reliance on domestic debt
has indeed brought high real domestic interest rates. In Turkey the real domestic lending rate reached 50 percent in 1987. More moderate domestic borrowing
in Colombia led to high real interest rates during 1983-86.
Even where interest rates are controlled, domestic borrowing leads to credit
rationing and crowding out of private sector investment. If the economy is well
integrated with international capital markets, government domestic borrowing
will tend to push the private sector into borrowing more abroad. In this case,

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the composition of public borrowing between foreign and domestic sources

does not have much macroeconomic effect. The link between fiscal and external deficits will also be especially close when the capital account is highly open.

Debt Dynamics
To examine the long-term consequences of running deficits, we use identity
(3), which shows the deterrminants of the change in government debt. It is most
useful to concentrate on the ratio of the debt to a measure of the scale of the
economy; accordingly, we focus on the ratio of government debt to GNP,which
we denote d. Debt is now defined to include both the net external and domestic
debts. In terms of equation (2), we consolidate foreign and domestic borrowing
and treat changes in foreign reserves as equivalent to net external borrowing.
The change in the debt ratio (d) is equal to the noninterest (or primary) deficit of the total public sector, minus the part that is financed by printing money,
plus the current debt ratio (d) times the average real interest rate on the debt
minus the growth rate of GNP (this is the last term in (3)):
(3)
Change in d = (primary deficit/GNP) - (seignorage/GNP)
+ (real interest rate - growth rate) x d
This equation, which is the key to understanding debt dynamics, has a simple intuitive explanation. The noninterest deficit has to be financed with new
debt to the extent that this deficit exceeds the amount of money creation by
the central bank. In addition, nominal interest expenditures have to be refinanced with new debt. But since the denominator of the debt ratio is nominal
GNP,the debt ratio will decline either with inflation or with real GNPgrowth
in the absence of new borrowing.
The dynamics of debt and the sustainability of deficits are particularly
affected by the difference between the real interest rate and the growth rate of
GNP (see Corbo, Goldstein, and Khan 1987; Anand and van Wijnbergen 1989;
Morley and Fishlow 1987; and Buiter 1985). Assume first that the real interest
rate on debt exceeds the growth rate. Then debt dynamics are unstable, and it
becomes impossible to run a permanent primary deficit that exceeds the
amount of revenue the government can obtain through seignorage. The conclusion deserves emphasis: if the government is running a primary deficit larger
than the amount of seignorage it can obtain, and if the real interest rate exceeds
the economy's growth rate, the debt to GNP ratio will continue rising without
limit. At some point it will be impossible for the government to sell its debt,
and the process will have to be brought to an end by cutting the budget deficit.
The point at which the process has to end depends on the expectations of the
public. When the public recognizes the unsustainability of the government's fiscal policy, it will cease buying government debt and thereby force a change in
policy.
StanleyFischerand William Easterly

135

The debt dynamics equation (3) has an interesting implication, first pointed
out by Sargent and Wallace (1981). Suppose that the government tightens monetary policy by reducing the rate of printing of money and increasing borrowing. The debt increases; either deficits will be higher in the future or the
government will have to print more money in the future to keep the deficit constant. If future deficits are to be held constant, the increased printing of money
in the future will mean more inflation in future. Generally, the expectation of
future inflation increases current inflation. And, as Sargent and Wallace show,
it is even possible in certain-though not all-circumstances that the effect of
the expected increase in future inflation outweighs that of the lower rate of
money printing today, so that an apparently contractionary monetary policy
today will increase current inflation.
We have already discussed maximum sustainable rates of seignorage. To
summarize: governments cannot use seignorage permanently to finance primary
deficits much in excess of one percent of GNP without producing inflation-but
in a rapidly growing and financially deep economy the government may be able
to raise as much as 2.5 percent of GNP through non-inflationary seignorage.
What happens if the real interest rate is less than the growth rate? This is a
world in which the painful tradeoffs just discussed do not exist. Debt is eroded
over time through growth, so primary deficits in excess of seignorage revenue
are sustainable. A so-called Ponzi3 scheme of borrowing to pay interest is
always possible. This certainly seemed to be so in the late 1970s, as high inflation rates produced negative ex post real interest rates. It is also true that real
interest rates are very likely to be below the growth rate in economies that are
growing rapidly, such as the newly industrialized Asian economies.
There are some who believe that the real interest rate should normally be
below the growth rate, and that this eventual return to normality will provide
an escape from the debt crisis. But an economist's instincts, rightly, are that
such a free lunch is not possible. Real interest rates can be temporarily below
the growth rate and could be below the growth rate for a long time in a rapidly
growing economy-this is part of the virtuous circle of growth. But market
forces tend to prevent the real interest rate from remaining below the real
growth rate permanently. As more debt piles up, the pressure on bond markets
drives up the interest rate and growth declines. If a rapidly growing economy
attempts to exploit the apparently favorable debt dynamics by borrowing excessively, the growth rate will eventually fall below the real interest rate. At the
level of the world economy, the normal situation should be thought of as one
in which the real interest rate exceeds the growth rate.
It might seem that the government could make a Ponzi scheme possible by
controlling domestic interest rates. But this is a tax on domestic bondholders
in the amount by which the controlled rate is below the long-run equilibrium
rate. Savers respond by taking their savings elsewhere, and the government
faces a limit on how much it can borrow. The experiences of countries such as
Argentina, Mexico, and Venezuela with interest rate controls and capital flight

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confirm this limitation (see Cuddington 1986). We are back again in the world
of tough choices and unforgiving tradeoffs.

Sustainable Deficits
Whether the deficit is sustainable depends on its size and on how fast the
economy is growing. It can be seen from equation (3) that a higher growth rate
allows the government to obtain more revenue by printing money and reduces
the last term in the equation. Rapid growth permits a larger deficit.
This argument helps explain why countries such as India, Malaysia,
Pakistan, and Thailand, where growth was at or above 5 percent over 1980-86,
have been able to run sizable domestic deficits while inflation has been in the
single digits, whereas Argentina and Brazil-with virtually no growth but with
comparable inflation-adjusted deficits-have been plagued with quadrupledigit inflation. This is not to say that public deficits do not matter in highgrowth economies, only that they can be bigger, so long as the growth continues.
Whether a given fiscal policy is sustainable can be determined by doing detailed projections of the future course of the debt to GNP ratio. Equation
(3) provides the essential analytic tool; the analysis requires subsidiary assumptions about the demand function for money, the desired inflation rate, the
real interest rate, and the growth rate of the economy. If the analysis shows
the debt to GNP ratio to be rising continually, the fiscal policy has to be
changed.
][t is sometimes argued that a deficit that results from high public investment
will be sustainable. But t!his argument can easily be overdone. In the first instance, although spending on public infrastructure often has a very high return, many low-return or no-return items may also be included in the category
of investment (the role of inefficient public investment in the economic crisis
of oil-exporting countries is trenchantly analyzed in Gelb 1988). More important, even if public investment has a high return, the government must capture
the additional returns from the investment if it is to be self-sustaining. For example, suppose that a project yields the remarkably high real return of 15 percent, that the marginal tax rate is 20 percent, and that the government
borrows at 7 percent to finance the project. The government will be receiving
only 3 percent of the cost: of the project in tax revenue, even though its social
yield is 15 percent (assuming that the entire social yield is pecuniary). (The
higher level of output generated by the project, as indicated by the social yield,
would also make possible more noninflationary money and debt finance, but
this is a relatively minor effect.) Thus the investment project still adds to future deficits, despite its high yield-though, to be sure, its effect on future deficits is smaller than that of current government spending financed through
deficits.
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Economies can proceed for long periods with large deficits, as the Italian
economy has. It helps in these cases if the domestic saving rate is high, so that
individuals are willing to absorb relatively large amounts of government debt
in their portfolios. But the relentless increase in the debt to GNP ratio means
that even in the Italian case, fiscal policy will eventually have to change.

Deficits and Inflation

Our analysis has made it clear that there is no automatic link between budget deficits and inflation. The visitor to high-deficit economies with high inflation is often told that the deficit cannot be the cause of inflation because the
correlation between them is low. In particular, it often happens that a contractionary policy that starts by raising the controlled prices of public enterprises
and subsidized goods and by devaluing will both raise the price level-and
thereby for some time the inflation rate and reduce the deficit. And, in the
United States, as in Italy, the high deficits of this decade have been accompanied by a decline in inflation.
Nonetheless, budget deficits do sooner or later tend to create inflation, and
countries with very high budget deficits are likely to find themselves at some
point confronted with extremely high rates of inflation. There have been massive budget deficits in all of the great hyperinflations, with the inflationary process and the deficit feeding on each other through the Keynes-Olivera-Tanzi
effect, as higher inflation reduces tax revenue, and through declines in seignorage revenue, as higher inflation causes a flight from money.
The correlation between the deficit and inflation is low in the early stages of
inflation partly for the reason already explained, that programs to reduce deficits are often inflationary. It is low also because the economy adjusts slowly
to inflationary pressures. And the correlation may be low for a third reason,
that the public in an economy with a high deficit may at different times have
different expectations about how the deficit will eventually be closed. For
instance, if the public believes at one point that the government will attempt
to deal with its fiscal problem through an inflation that erodes the value of
the public debt, current inflation-reflecting
the expectation of future
inflation-will rise. If, at a later time, the public believes that the government
will introduce an effective fiscal package to reduce the deficit, the expected inflation rate may be reduced and current inflation-again reflecting the expectation of future inflation-may fall (this argument is developed by Drazen and
Helpman 1986).
Milton Friedman's famous statement that inflation is always and everywhere
a monetary phenomenon is correct. However, governments do not print money
at a rapid rate out of a clear blue sky. They generally print money to cover
their budget deficit. Rapid money growth is conceivable without an underlying

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fiscalimbalance,but it is unlikely.Thus rapid inflationis almost always a fiscal

phenomenon.

Conclusion
The macroeconomicanalysisthat we haveoutlined is a useful starting point
for examiningthe economicsof budget deficits.But it takes more than a single
indicator to judge fiscal policy.The microeconomicsof fiscal deficits both is
crucial in its own right and1has an impact on the macroeconomicsof deficits.
The more efficientare taxes and spending,the higher is the public deficitthat
can be sustained, since growth will be higher.
Considerationof the macroeconomicsof the governmentbudget constraint
points to the dangers that arise from excessive budget deficits: inflation,
exchange crises, external debt crises, and high real interest rates, with implications for the real exchangerate and the trade account and for investment.None
of the links is automatic, for there are choicesin the sources of financing,and
lags in the effect of money printing and borrowing on inflation and interest
rates.
Nor are moderate budget deficits to be avoided at all costs: small deficits
can be financed without creatingexcessiveinflation, exchangecrises, or building up debt excessively.If the real interest rate exceedsthe growth rate of GNP,
any primary deficit smaller than the maximum amount of seignorage revenue
the government can obtain is sustainable. Whether any particular path of fiscal
policy is sustainable has to be checked through projections of the debt to
GNP ratio; a given deficit is more likely to be sustainable the higher the growth
rate of output.
The fact that a fiscal policy is sustainable does not mean that it is optimal.
A fiscal deficit may crowd out private investment, and it might well be desirable
to reduce the debt to GNP ratio to crowd in private investment. Similarly, it
may not be optimal to collect the maximum possible amount of revenue from
seignorage but rather a smaller amount corresponding to a lower inflation rate.
Both theory and evidence tell us-and warn us-that large budget deficits
pose real threats to macroeconomic stability and, therefore, to economic
growth and development.

Appendix: Problems of Measurement

International comparisons of fiscal data are plagued by the variations in
methodology and the lack of comprehensive coverage of the public sector. Definitions of deficit change from country to country and even over time in the
same country. One country may include aid receipts as revenue, whereas another treats them as deficit finance. Some countries have data only on the
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139

national government, whereas others cover to varying degrees local governments, state enterprises, and decentralized agencies. In some countries, activities of the central bank or other public financial intermediaries create
significant losses, but including their deficits in the overall public sector is difficult because of conceptual problems and lack of reliable data. Social security
is consolidated with the public accounts in some countries but not in others.
Many examples can be given of such accounting difficulties. (The most comprehensive collection of fiscal data is IMF various years. World Bank 1988,
p. 45, describes data sources. Blejer and Chu 1988 analyze many of the methodological issues.)
Even aside from technical accounting problems, there are broader issues of
how to define deficits in an economically meaningful way. Many different definitions (for a discussion of these, see World Bank 1988, pp. 56-57) have been
proposed to attempt to remove short-term distortions from deficit measures.
The most important single correction is to adjust the deficit for the inflation
component of interest payments, yielding the inflation-corrected, or operational, deficit. The correction removes from the deficit the product (inflation rate
times stock of debt), including in the operational deficit only the real component of interest. The correction can be substantial. For instance, estimates of
the fiscal deficit in Mexico for 1987 imply a deficit of over 15 percent of GDP,
but the operational balance shows a surplus of 3 percent.
Some economists disagree with the use of the operational deficit on the
grounds that the government has in fact to find a way of meeting the interest
payments, even if they only reflect compensation for inflation. A useful way of
thinking of the operational deficit is that it provides an approximate measure
of the size of the deficit the government would have to deal with if it succeeded
in getting rid of inflation. Thus the fact that there was an operational surplus
in Mexico in 1987 meant that there was no underlying fiscal problem that was
inconsistent with the government attaining a zero or low inflation equilibrium.
(The operational deficit ideally should be evaluated using the expected inflation
rate. The actual inflation rate may include an unexpected component that
would temporarily lower the operational deficit, but the lower deficit would not
be sustainable.)
In addition to correcting the deficit for inflation, influences from commodity
price fluctuations or domestic output above or below trend are sometimes removed to give the structural deficit.
Deficits can also be underestimated because of controls on interest rates or
key prices. For example, negative real interest rates paid on government debt
will make the deficit appear lower than if the interest bill were evaluated at the
true opportunity cost of capital. An artificially low exchange rate applied to
the government's external debt in a system of multiple exchange rates would
similarly suppress the size of the true deficit. To correct for such distortions,
public deficits can be evaluated at the long-run equilibrium values of the interest rate, exchange rate, and other key relative prices.

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Notes
Stanley Fischer is vice president, development economics, and chief economist at the World
Bank. William Easterly is on the staff of the Country Economics Department of the World Bank.
1. Buiter (1988) and Anand and van Wijnbergen (1989) provide a good summary of the macroeconomics of the financing of government deficits; Tanzi's earlier treatment (1984, 1985) is
also very useful. Empirical analysis of deficit financing is provided in Easterly (1989).
2. One billion equals 1,000 tnillion.
3. Charles Ponzi was a Boston resident who in the 1920s made a fortune through a pyramiding
scheme but who then ended up in jail and was later penniless.

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