An insightful paper from Norges Bank econs.
Its starts with intro from Jan Fredrik Qvigstad, Deputy Governor of the central bank. His experience tells him anything above 4 mark shows build up of instability in that indicator:
My 30 years of experience have taught me a few simple rules for selecting the quantitative variables I should look at.
• Is inflation higher than 4 per cent? If so, does this indicate that macro stabilisation is out of kilter and that price stability is not firmly anchored?
.If unemployment is higher than 4 per cent, does this indicate that the labour market is not functioning well? There are many OECD countries that have a long way to go here.
• The most important variable I check is the government budget balance. If the balance shows a deficit of 4 per cent over time, the country is not in a sustainable fiscal position. Average annual growth in the OECD area has been about 3 per cent. If the budget deficit is 3 per cent or less, a country will normally be able to grow out of its debt problems. If the deficit is higher than 3 per cent, this will not be possible. A deficit of 4 per cent is therefore a rough rule of thumb indicating that fiscal policy is on an unsustainable path.
• It may also be the case that the budget is in balance, but tax receipts flow in from a bloated domestic sector propped up by an unsustainable level of demand. Until just recently, for example, Spain was running a balanced budget. But a large portion of tax revenues came from a large construction industry. In the pre-crisis years, the construction industry accounted for 13 per cent of employment in Spain, while 6-7 per cent was the general average in other OECD countries. The figure for Spain is now closer to the average and the budget balance shows a substantial deficit. The true budget deficit was hidden by an unsustainable domestic sector. But a look at Spain’s current account deficit brought the unsustainability problem to light. More than 30 years of reading OECD documents from the “back benches” have taught me to look at whether the current account balance shows a deficit of 4 per cent or more.
Three out of four – inflation, Budget Def and Current Account Def- are way above 4%. Yes inflation has to be higher than a developed economy like Norway. RBI mentions it as around 5.5% and currently WPI at around 7.5% and CPI at 9.5-10% levels. Fiscal is expected at 5.3% (revised) for 2012-13 (unlikely to be met) and current account deficit hovering around 4% mark (In Q1 it was 3.9%). There is no unemployment rate in India. However, it is likely to be above four as well. India has all the four indicators above much beyond the comfort zone.
Anyways moving back to to the paper.
So based on his experience he asks the Norges bank econ to verify the experience with empirics:
I asked Nikka Husom Vonen if she could use the OECD database to check more systematically whether my intuitive 4 per cent rule, derived from 30 years’ experience, could identify which countries would encounter problems. Today in 2011 we know which countries these are. Could we have identified them earlier using such a rule? Her answer is provided in the first essay “Would the simple 4 per cent rule have uncovered that there was a crisis in the offing?”.
I asked Sigbjørn Atle Berg whether he could take a closer look at how large a country’s banking sector can grow before a country’s government no longer has the capacity to bail out the banking industry. The answer turned out to be – not that far from 4! His analysis is resented in the second essay “When is a banking industry too large?”.So while Nikka Husom Vonen applied a rule and verified whether the rule provided the answer that we today know is the right answer, Sigbjørn Atle Berg’s assignment was to establish a rule. They started at opposite ends. One started with the number 4. The other ended up with the number.
Power of four..Excellent read and very doable for a set of countries..
The first essay by Vonen shows the linkages between budget and current account deficits:
The current account reflects transactions by both the public and the private sector, as may be illustrated by the following basic identity: CA = Spr – Ipr + Sg – Ig: The difference between aggregate saving and investment, here divided into the private (pr) and public (g) sector components, determines the current account balance (Abbas et al., 2010). As documented in Blanchard (2007), there has been a steady increase in current account imbalances in the OECD countries during the last two decades. Focusing on the negative numbers, a current account deficit may be perfectly consistent with a long run sustainable development, e.g. as countries in an early phase of development borrow internationally to finance infrastructure and other growth-enhancing investments. However, sustained deficits may signal unsound conditions and misallocation of resources. Over-investment in property and construction, as seen in Spain in recent years, may serve as one example.
Turning to public spending, fiscal deficits may or may not show up in the current account, or rather, the direction in which the influence goes is a priori ambiguous. Whether there is a positive or negative relationship between the fiscal balance and the current account balance will in part depend on how the private sector reacts to a change in the fiscal balance (Nickel and Vansteenkiste, 2008). If the private sector’s behavior is fully Ricardian, higher public spending (or lower taxes) should be exactly offset by an increase in private saving, and thus not affect the current account. At the other extreme, a Keynesian view predicts a close and positive relationship between the two accounts: A larger fiscal deficit (say due to reduced taxes) leads to highe r private spending as households consume out of current rather than lifetime income, and an increase in the current account deficit follows. This line of reasoning also supports the possibility of twin deficits that has developed in certain countries (Barnes, Lawson and Radziwill, 2010).
The link:
Reality is probably somewhere in between the two theoretical extremes: The fiscal and current accounts are linked, but it is far from clear just how close this tie is. Nickel and Vansteenkiste (2008) find that the effect of fiscal deficits on the current account depends on the public debt level, indicating that the relationship between the fiscal and current account is not constant. Barnes, Lawson and Razdiwill (2010) claim that the two accounts are typically positively correlated, albeit much less than one-for-one. They point at Portugal and Greece as countries where public deficits have been important contributors to current account deficits.
On the other hand, different mechanisms such as excessive housing investment may explain a large part of the external imbalances recently seen in Ireland and Spain. To sum up, even though mechanisms and relationships differ, examining the current account is a useful supplement to debt and fiscal deficit surveillance. For this reason, in the empirical section we also assess the current account balance to get a more nuanced and comprehensive measure of the overall conditions. We see this as a form of structural adjustment of the budget balance, and as will be shown; it leads to somewhat different conclusions than those following from an observation of the budget balance alone.
Superb stuff..
