When Is Fiscal Adjustment an Illusion?

Abstract

A simple model shows that when an outside agent forces a reduction in a government's conventional deficit (debt accumulation), the government will respond by lowering its asset accumulation or by increasing hidden liabilities. That leaves net worth unchanged, so fiscal adjustment is an illusion. Fiscal adjustment is an illusion when it lowers the budget deficit or public debt but leaves the government's net worth unchanged, says Easterly. Conventional measures of the budget deficit largely measure the change in explicit public sector liabilities (debt). A more appropriate measure of the deficit would be the change in public sector net worth, but many criticize this concept as impossible to measure. Easterly takes a positive, rather than normative, approach to the net worth definition of fiscal balance. A simple model shows that when an outside agent forces a reduction in a government's conventional deficit (debt accumulation), the government will respond by lowering its asset accumulation or by increasing hidden liabilities. That leaves net worth unchanged, so fiscal adjustment is an illusion. He performs some simple empirical tests on the observational predictions of the model, examining a sample of countries with World Bank and International Monetary Fund adjustment programs and case studies of Maastricht Euro countries. The results confirm the model predictions: Fiscal adjustment in these countries was at least partly an illusion. This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to study the political economy of policymaking. The author may be contacted at weasterly@worldbank.org.