The General Relativity of Fiscal Space: Theory and Applications

This paper argues that fiscal space is not given in absolute terms, but is relative to a country’s macroeconomic conditions. We first identify the relativity of fiscal space in the ideas of John Maynard Keynes, drawing an analogy to the theory of special relativity by Albert Einstein. We then present the outline of a ‘general relativity’ theory of fiscal space based on our interpretation of functional finance. Building on our theory we operationalize four macroeconomic determinants of relative fiscal space – two cyclical factors (unemployment and inflation) and two structural factors (productive capacity and monetary sovereignty) – using available data for 151 countries. Among the structural factors, we contribute a novel Monetary Sovereignty Index (MSI). We use this index, alongside UNCTAD’s Productive Capacities Index (PCI), the rate of unemployment, and the inflation rate, in a principal component analysis (PCA) to compute a Fiscal Space Index (FSI) for each country. We find that there is a wide variety of fiscal space across countries, and even within regions – with some developing economies scoring high, and some developed economies scoring low on the index. We illustrate the dynamic operation of our framework with mechanical simulations covering three scenarios for the case study of Malawi, the country with the fifth lowest fiscal space in our sample. We find that the functional finance paradigm of fiscal space outperforms the sound finance paradigm for a range of macroeconomic variables, including the FSI, and more so when government spending is targeted to easing import dependence, rather than just targeting increased productive capacity. We end by discussing key political economy and geopolitical constraints and identify various reforms that would facilitate countries to fully use or increase their fiscal space.