A Modern Money Perspective on Financial Crowding-out

Abstract

The withdrawal of discretionary fiscal stimulus and a renewed emphasis on institutional and ‘self-imposed’ budgetary constraints are evidence that the imperative of fiscal sustainability and sound accounting fundamentals continue to drive fiscal policymaking within many advanced economies. To buttress the urgency for fiscal sustainability, neo-liberals often draw upon financial crowding-out theory. Despite an extensive literature, empirical applications are often misspecified due to their failure to account for different institutional arrangements. However, the policy responses of national governments to the Global Financial Crisis have highlighted the institutional disparities, presenting a unique opportunity for a rigorous empirical investigation. This paper develops panel vector error correction models for both sovereign and non-sovereign economies over the period 1999 to 2010 to examine financial crowding-out. The empirical evidence reveals crowding-out effects in non-sovereign economies, but not within sovereign economies.

Acknowledgment

Special thanks to Martin Watts. I am also grateful to an anonymous referee for helpful comments on an earlier draft.

Notes

¹The 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).

²Fiscal 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.

³Crowding-out arguments opposing government intervention can be traced back to Adam Smith, John Stuart Mill and J.B. Say. The synthesis of Keynes's 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).

⁴Amid 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’.

⁵The data for all figures are drawn from OECD Economic Outlook No. 90, Annex tables, available at: http://www.oecd.org/eco/outlook/economicoutlookannextables.htm.

⁶This is often explained by noting that most Japanese government debt is held domestically. But what matters for borrowing rates is the currency in which the debt is denominated, not the nationality of the debt-holders (see the next section).

⁷Mitchell (2009, p. 11) outlines the broad charter for advancing public purpose, which includes, ‘full employment and price stability, poverty alleviation and environmental sustainability…’ Here, full employment is defined as 2 percent unemployment, no hidden unemployment, and no underemployment (see also Mitchell & Muysken, 2008).

⁸Government debt may also be desired by financial markets because it represents a risk-free interest-bearing 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.

⁹This point is often explicit in central bank documentation, in particular the Reserve Bank of Australia's account of the conduct of Open Market Operations (see RBA, 2011).

¹⁰See 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).

¹¹Recent trends in the data suggest that the implications of MMT are likely to be more pronounced for this particular subset of non-sovereign economies. The regressions commence in 1999 to coincide with the introduction of the euro.

¹²Data have been obtained from the OECD Economic Outlook Annex tables, IMF International Financial Statistics and Fiscal Monitor (IMF, 2011), Datastream, and relevant Central Bank databases. All regressions are performed in Eviews 7.

¹³Appropriate corporate bond yields were unavailable for selected non-sovereign economies. Default proxies are only applicable to non-sovereign economies. Sturzenegger (2002, p. 18) cautions against the use of credit default swaps, suggesting that markets can, at times, become ‘extremely thin’ which can create a ‘distorted view of default probabilities’. Notwithstanding this, data are limited.

¹⁴Eviews program code for these calculations was obtained from Galimberti & Cupertino (2009).

¹⁵Panel unit root results are available from the author upon request.

¹⁶Pesaran et al. (2001) asymptotic critical values may be affected by the inclusion of cross-section dummies. Period dummies are for the GFC period 2008–2010.

¹⁷Panel cointegration results are available from the author upon request.

¹⁸Fiscal 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.

¹⁹Buiter (2010) makes a similar claim, though he does not adequately distinguish between a sovereign and non-sovereign economy.

²⁰Ricardian equivalence can be dismissed on the basis of its theoretical assumptions (see Bernheim, 1989).

²¹Numerous 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).