Balancing Fiscal Support with Fiscal Solvency

By Carlo Cottarelli

As I noted in my last post, government deficits in many countries—particularly in advanced countries—have jumped dramatically in the wake of the global crisis, and government debt has reached levels that could jeopardize longer term macroeconomic stability and growth. These countries will need to tighten fiscal policy significantly sometime down the road, especially where demographic trends are pushing up health and pension spending.

But fiscal deficits cannot be lowered in the immediate future. For the time being, fiscal (and monetary) policies must continue to support economic activity. The economic recovery is uneven and could be threatened by any premature withdrawal of policy support. Private demand is still unable to stand on its own two feet.

 This gives rise to a policy conundrum. How can we reconcile the competing requirements of  short-term support for the economy and longer term fiscal solvency?

Fiscal solvency strategies

The challenge for policymakers is to formulate strategies for fiscal solvency—what we often call “exit strategies”—and communicate these strategies to the general public. The G-20 countries recognized this requirement in their recent communiqué. This will be important, but words may not be sufficient. Are there actions that governments can undertake today to enhance their credibility without negatively affecting aggregate demand?  Yes, there are. 

Studies say increasing retirement age in European Union by two years could save equivalent of 40 percent of GDP in net present value terms (photo: Johannes Eisele/AFP)

First, governments can reform their institutional fiscal framework to make it more likely that fiscal adjustment takes place when the time for action arrives. The precise framework will depend on country-specific circumstances. Possible reform options include fiscal responsibility laws, numerical fiscal rules (to take effect only when conditions normalize), fiscal councils tasked with monitoring fiscal developments, improvements in budgetary procedures, and increased fiscal transparency.

The example of Germany is worth noting. In June, the German parliament adopted a new constitutional fiscal rule that limits the structural deficit of the federation to 0.35 percent of GDP from 2016 onward and requires structurally balanced budgets in the states from 2020.

Health, pension reforms

Second, various reforms in health and pension entitlements, though politically not easy, can be undertaken without jeopardizing economic recovery.

These reforms will not have a large impact on the today’s deficit, but can dramatically improve long-term fiscal trends and signal commitment to fiscal sustainability. They will not undermine demand if well structured—with a focus, say, on increasing the retirement age—or if they are passed now but implemented gradually.

These reforms can have powerful effects. For example, it is estimated that increasing the retirement age in European Union countries by two years can save the equivalent of some 40 percent of GDP (in net present value terms).

In sum, postponing fiscal tightening does not mean postponing fiscal action.

3 Responses

  1. The historically low levels of short-term interest rates across the world have certainly contributed to give a non negligible impulse to the economy (and potentially fostered economic recovery). Therefore, given the current important fiscal imbalances, for instance, both in the U.S. and in Europe, cast to my mind some doubts regarding whether or not fiscal deficits cannot/should not be lowered in the immediate future. I would say that if that is not indeed the course of action in many countries, already in 2010, jittery capital markets may shortly push further up the respective financing costs. All in all, there is less of a conundrum, and rather more the need for “simple” decisive and responsible action.

    Regarding the implementation of limits for the structural deficit, as a percentage of GDP, that seems in principle a sound move. The tricky part will be when the need comes to square such rule with ever changing values for potential GDP.

  2. [...] take the place of government spending. Obviously this is not so easy to accomplish, but I feel that Carlo Cottarelli has been thinking along the right lines: The challenge for policymakers is to formulate strategies [...]

  3. [...] Carlo Cottarelli: How can we reconcile the competing requirements of short-term support for the economy and longer term fiscal solvency? The challenge for policymakers is to formulate strategies for fiscal solvency– what we often call “exit strategies”– and communicate these strategies to the general public…. [...]

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