Public finance and economic growth:An overview and certain reflections Public finance and economic growth:An overview and certain reflections

Public finance and economic growth:An overview and certain reflections

Public finance and economic growth:
An overview and certain reflections*

José Luis Ruiz Álvarez**

* This paper was submitted at the 32rd International Seminar on Public Budget that took place in Lima in April 2005.
** General Deputy Director of Analysis and Evaluation of Expense Policies. General Budget Bureau. Budget and Expenses General Secretariat. Ministry of Finance.

III. What can we say about the relationship between public finance and economic growth in Latin America?

The deterioration of the economic situation in several countries of Latin America at the beginning of this decade has led some sectors to question, on the one hand, the structural reforms oriented towards the deepening of the markets, and on the other hand, the merits of the fiscal consolidation for the proper performance of the economy.

Within this context, there is a deeper interest in reflecting on the growth profile of the emerging and developing countries, which are the underlying factors that promote such growth, and what can be done from the public sector in order to favor a better behavior of the economic activity.

The empirical evidence on the economic development shows that the countries that have grown in a sustained manner along time have been able to reduce the poverty levels ostensibly while at the same time they have enjoyed an increased democratic stability.

Therefore, accelerating the potential growth rate in the long term becomes a capital target, particularly for any leader of developing countries. But accelerating the potential growth rate is not an easy task. However, if this is attained, there shall be more possibilities to finance public programs permitting an increase in the personal revenue of the people and an improvement in the standard of living of the population.

Noman Loayza et al (2004), in a recent paper on the economic growth in Latin America, point out that in spite of the logical differences among the different countries with respect to their manner of growing, they may mention trends and similarities in the patterns of such growth that may help to draft the budgetary policy:

• First, there is a clear evidence of economic convergence among the different countries that compose the region, in the sense that the poor countries are growing faster than the rich countries;
• Second, it is also noted that the following structural factors have had a positive correlation with the economic growth:
–          Human capital –measured in terms of years of study, schooling or illiteracy rates;
–          Financial maturity –measured for the ratios of money supply or private credit as related to the GDP;
–          Public infrastructures –measured by number of telephones, kilometers of highways, electricity capacity installed.
• Third, economic growth is visibly weakened with high inflation rates and strong divergences in the exchange rates showing, no doubt, the importance of price stability in order to obtain sustained growth rates.
• And fourth, the external shocks –measured through the terms of trade or capital flows– also have a significant influence on economic growth.

In their effort to explain the recovery of the per capita growth in the 90’s for the countries of the area, the authors of the aforementioned article also point out that such recovery of the output was preceded in most cases by substantial gains in the total productivity of the factors.
Such results suggest that behind such recovery there are structural reforms and economic stability policies that have a proven influence in productivity improvement.
From the results point of view, the balance sheet of the public sectors in the Latin American countries during the last few years has been mixed. As stated by Anoop Singh et al (2005) recently, in a paper on economic stabilization in Latin America, during the 90’s, we can notice how a large group of countries from the area have shown common weaknesses such as:

• Strong growth of the public debt,
• Weakness of the financial institutions, and substantial crisis of indebtedness,
• Modest results of economic growth, where the financial imbalances of the public sectors have had no doubt an influence,

Although the indebtedness volume did not seem high following international standards -between 40% and 50% of the GDP- its strong growth highlighted downward fluctuations of the economic activity and the possible influence of the weakness of the aggregate control mechanisms of public finance.

A relaxed monetary policy, together with the imbalances of the public accounts that increased the level of public indebtedness, led way to the distrust of the local currencies to the benefit of the dollar denominated or inflation adjusted debt instruments thus accelerating the autonomous growth of such indebtedness.

This spiral in the growth of the indebtedness added to the assistance given to those affected by the bank crisis that hit several countries of the area, mainly after the second half of the 90’s that coincides with the economic slowdown at the beginning of 2000.

The drop in tax collection occurring due to the economic slowdown of the second half of the 90’s and the beginning of 2000 worsened, in certain cases, due to weaknesses in the institutional mechanisms related to the management of public finance.

Thus, the drop in the income obtained due to the narrowing of the fiscal bases and the crisis have deepened due to the existence of weak collection mechanisms and inflexible expenditure structures that did not permit the transfer of credits from excess items derived from specific income towards deficit items. In many cases such specific credits, which are recognized in the current legislation, are allocated to finance positions or institutions that do not rival for budgetary scarce resources in the allocation annual process.

Upon such situations of imbalance of public finance that require first, and render unavoidable later, fiscal consolidation processes, the above narrow conditions in the fiscal base and the inflexibility in the expense structure cause the adjustment to be made either in discretional expenses such as infrastructure investments and/or by increasing taxes with distorting effects and/or by reducing essential welfare expenses to mitigate poverty.

Fortunately, there are a substantial number of countries that have responded to the above situation with initiatives and reforms that make their fiscal position stronger and create a space to finance welfare infrastructure processes, and at the same time, finance programs necessary to mitigate poverty.

Perhaps, the most outstanding reforms have been those directed at attaining the aggregate control of the expenses and a more efficient use of resources through:

• The establishment of rules affecting balances and the indebtedness.
• The introduction of advertising rules and recording of the information that force governments to show more transparency in the management of public resources.
• Strengthening of the target budgeting that favors the rendering of accounts by the agents.
• And improvements in the management of indebtedness, extending the term of the debt instruments and limiting their need.

The countries have also taken note of the explosive character of the indebtedness stock when the same is based upon a short-term structure and dollar denominated or inflation-adjusted instruments plus an additional rate that constitutes the yield expected by the creditor. In order to lessen such dangers there have been initiatives to increase the debt terms and change towards instruments with a more predictable yield.