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3. Discussion
We want to analysis the effects of countercyclical fiscal policy and procyclical fiscal policy on the government default rate. But the effects are not always the same.
The different economic condition will change the effects of fiscal policies. Thus, as we set the technical shock represent the economic condition, during the boom the economy will face a positive technical shock and during the recession the economy will face a negative technical shock, we can analysis the change of the government default rate under different kinds of fiscal policies.
The organization in this section is as follows. First, we will discuss the relationship between the government default rate and the technical shock under the countercyclical and procyclical fiscal policy. Then, we will describe other effects that also influence the government default rate. Finally, we will use the results to give governments some policies implication during the boom and the recession.
3.1. The countercyclical and procyclical fiscal policy 3.1.1. The relationship between τ and g
The level of the tax rate and the fiscal response are very important factors that will be used in the next section. Thus, we use the government budget constrain under the steady state to find the limitation to
τ
andg
. The results express as below (see Appendix 6):(1 1(1 )) ( )
B δ P g τ y
−
β
− = − (29)Because the sign of government bonds can be positive or negative, this means that there is no restriction between tax rate and the fiscal response. In other words, the level of the fiscal policy can be either larger or smaller than the level of the income
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Here, we differentiate the eq.(28) by the technical shock. We express this equation as below:
As we assume
1 > >
β0
and the initial debts are positive, the sign of the differential is decided by ( )(1 )With these relationships, we can know that the government default rate will be affected by different fiscal policies. When the government uses countercyclical fiscal policy, the default rate will be negative relation with the technical shock. When the government uses procyclical fiscal policy but the government spending responded to the output is smaller than the tax rate, the default rate will still be negative relation with the technical shock. When the government uses procyclical fiscal policy but the government spending responded to the output is larger than the tax rate, the default rate will be positive relation with the technical shock. We illustrate the results on table 1 below.
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Table 1. The relationship between fiscal policy and the default rate The sign of the differential under different fiscal policies
fiscal policy type fiscal condition sign of differential
countercyclical
g < 0
,
3.2. Other factors and the policy implication
From the eq.(28) we can also see that other factors such as the initial liability, the initial technical rate and the equilibrium of the technical rate all affect the government default rate. Because the sign of the coefficient of the initial technical rate and the equilibrium technical rate are the same as the coefficient of the technical shock, the effects depend on the type of the fiscal policy and the level of the government expenditure. Thus, the results are also similar to the technical shock. Here, we briefly talk about the effect of the initial liability. Other things being equal, the increasing initial debt will company with the increasing government default rate. This situation can be found from eq.(28). This idea is important since many governments deficits are enlarged after the subprime crisis. The potential risk of sovereign credit is therefore increasing. The countries like the U.S., Greece and the Ireland are the examples which make them in difficult positions.
Fiscal policy is an important tool to the government, especially when the effect of the monetary policy diminished nowadays. There are two distinct types of fiscal policies. One is the procyclical fiscal policy, and the other is the countercyclical fiscal policy. In the paper of Caballero and Krishnamurthy (2004), they explain the crisis of
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Argentina in 2001 happened because the government of Argentina used countercyclical fiscal policy during downturns. The crowding-out effect offsets the effect of expansionary spending and finally made the country run into crash. Their paper also uses the empirical data to show that the advanced countries usually use countercyclical fiscal policy and, on the contrary, the emerged countries usually use the procyclical fiscal policy. The expansionary fiscal policy stimulates the economy, but is accompanied with the ascending deficits which may result in bankruptcy.
Therefore, we try to use our results to find the balance between the fiscal policy and the sovereign risk.
From the discussion above, we have found the relationship between the government default rate and the technical shock under different fiscal policies. With these results we can imply that when the government applies countercyclical fiscal policy, the government default rate will increase during the recession and decrease during the boom. When the government uses weak procyclical fiscal policy, which means the government expenditure responded to the output is smaller than the tax rate, the default rate will increase during the recession and decrease during the boom. But when the government uses strong procyclical fiscal policy, which means the government spending responded to the output is larger than the tax rate, the default rate will decrease during the recession and increase during the boom.
The results are intuitive. When the government applies the countercyclical fiscal policy, it will increase the government spending during the recession. At the same time, the output of the country is decreasing due to the negative technical shock. Both of the effects raise the default rate. Therefore, the government default rate will increase when the government uses countercyclical fiscal policy during the recession.
On the contrary, when the economy faces the positive technical shock, which means that the economy is in the boom and the production will grow more, the government
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with countercyclical fiscal policy will decrease its expenditure. In the equilibrium, the default rate will lessen. When the government applies the weak procyclical fiscal policy, the movement of the default rate will be similar to the countercyclical fiscal policy. Because the output will decrease during the recession, which makes the government expenditure also decrease. But with the level of the tax rate is larger than the level of the government spending, the effect of the decreasing outputs will exceed the effect of the decreasing government spending. Totally, the default rate will increase. Finally, when the government uses strong procyclical fiscal policy, the government expenditure will decrease during the recession and increase during the boom. The reason is that the output will lessen in the recession, but the level of the decreasing government expenditure is larger than the level of the decreasing tax revenue. Hence, the default rate will decrease in the recession. When the economy is in the boom, the output will increase and the government spending will also increase.
But the increasing spending counterbalance the increasing tax revenue. Thus, the government default rate will increase in the boom.
After the subprime crisis, there are some countries with high sovereign risk such as Greece and Ireland. In order to prevent from bankruptcy, they have to eliminate their deficits in a short time. Hence, by the implication we discussed above, we can know that under the condition of weak economy, the best policy for these governments are applying the strong procyclical fiscal policy. This means that they have to reduce a large number of government spending to reduce the sovereign risk.