How to Bake a (Cr)edible Medium-term Fiscal Pie

By Olivier Blanchard and Carlo Cottarelli

(Version in عربي | 中文 | Español | Français | Русский )

How can governments have their cake and eat it too? How can fiscal policy provide sufficient support to economic activity, and reassure markets that fiscal solvency is not at risk? The poor state of fiscal accounts of most advanced countries calls for austere fiscal policies, before the confidence crisis that is now hitting a few small advanced economies spreads to the larger ones. But not right now: a frontloaded adjustment—that is a tightening that is not gradual but falls disproportionately early in the adjustment phase—could destabilize the recovery.

But can countries limit frontloading and still achieve credibility? Yes, but baking the right fiscal pie is likely to require a number of ingredients. While the exact recipe depends on country circumstances, here are our suggested ingredients.

1.  Fiscal rules

For starters, countries can adopt rules to constrain their future behavior, with strong legislative backing and appropriately tough penalties in case of misbehavior.

The truth however is that rules will help, but they are unlikely to be enough. For one thing, a fiscal rule that is appropriate for the long run—say, a structural balanced budget rule—cannot be immediately enforced when the starting point is, in many cases, a deficit close to double digits. A convergence period will be needed—as in the case of the Germany’s new fiscal rules, which targets a balanced structural balance only by 2016. And, to make that convergence credible, other ingredients are needed.

2.  Multi-year spending limits

Second, reasonable multi-year spending ceilings, endorsed not just by the government but also by parliament, will be crucial. In countries where spending ratios are high, a large part of the adjustment will have to come from spending restraint. This has been a feature of successful fiscal exits, such as in Sweden and Canada in the 1990s. It is missing in a number of countries, including the largest world economy.

Here the difficulty is to reconcile the need for hard ceilings, which can not be easily revised, with a modicum of flexibility in case the recovery falters.

  • This means that some items should be exempt from the ceilings, particularly expenditures that are cyclical like unemployment benefits, non-discretionary like interest payments, or fiscally neutral like EU-funded projects.
  • It also requires ensuring that the legislative process for revising the ceilings (often annual and likely to be unavoidable at least for some spending items) does not turn into a free-for-all fiscal party.

3.  Open and accountable budgeting

This takes us to the third ingredient, fiscal transparency. Countries need to be transparent in formulating budgets and presenting them to the public. Markets and the public must be confident that medium-term plans, or changes to them, are justified by overriding macroeconomic considerations, and not, for example, by short-term political goals. They should also be confident that revenue projections—and the underlying growth assumptions—are not the result of wishful thinking.

The best way to achieve this is to establish a politically-independent fiscal agent to monitor fiscal policy making. The United States has one, the Congressional Budget Office. Many European countries do not, although some, like Germany and the United Kingdom, have recently introduced them, following positive experiences in Nordic countries. For these newcomers, the test will be to show genuine independence. For the others (the two advanced countries with the largest debt-to-GDP ratios—Japan and Italy—do not have them yet) early action in this direction is urgently needed.

Transparency also means providing the public with comprehensive information on the state of public finances. Surely advanced countries already do this, right? Not so.

  • Of the nine advanced countries in the G-20, how many produce fiscal statistics covering the whole public sector—including the central bank, state mortgage guarantee institutions, and other publicly-owned corporations? Only three.
  • How many of them publish alternative fiscal scenarios; that is, information not only about the fiscal baseline, but also on what happens if shocks (say, higher interest rates), materialize? Only five.
  • How many publish adequate statements of tax expenditures (the revenue loss related to special tax treatment of certain sectors and activities)? Only four. (And what is the point of spending ceilings if they can be circumvented by granting tax deductions?)
  • How many countries do all of the above? Only Canada.

4.  Disciplined budget preparation and execution

Next, countries need more disciplined budget preparation and execution processes. Budget preparation should be driven by the overall medium-term deficit and spending ceilings. That is, it must be “top down.” Budget execution should be underpinned by processes that minimize the risk of slippages. Here advanced countries fare relatively well. And yet, some further progress is needed, including in some European economies.

The recipe. Just mix-and-bake?

Finally, we come to the most difficult part: countries need some frontloaded measures to give some filling to the pie. Hang on! Did we not say that front-loading is wrong (except when failure to do so would make things even worse)?

Here we need to distinguish between approval of the measures and their implementation. Frontloaded implementation would not be appropriate in most cases. But frontloading legislative decisions on measures that will take effect at a later date, or that will affect the economy gradually over time is definitely appropriate. For example, a partial or total freeze of turnover of retiring public employees falls in that category.

Simple, isn’t it? Of course not, as otherwise it would have already been done. But it is easier than dealing with the consequences of living without a credible medium-term fiscal plan.

A post-scriptum: All of the above is just to whet your appetite. What is just as interesting is to see how the medium-term fiscal adjustment plans announced over the last few months by major economies stack up against the above recipe. If you want to know more about this we suggest you savor our newly released Fiscal Monitor. The proof will be in the eating.

9 Responses

  1. Your comment very clearly summarizes that perception of the public debt problem which has been dominating over the past 25 years. It implies: In principle, the government has control over its budget (even though it has to consider cyclical factors etc.).

    However, if one takes into account the interaction of all financial balances, this proposition seems problematic. The household sector runs surpluses, if the business secor takes them over in the form of investment credits, the public sector can easily have a balanced budget (I neglect the financial sector as intermediary and –for the moment — also the ROW). If the business sector reduces its borrowing and even becomes itsself a surplus sector (e.g., because financial investments become more attractive), then there is a problem with fiscal rules. The problem is aggravated by the fact that since the early 1980s the rate of interest exceeds the rate of growth in advanced economies (both nominal) whereas before the opposite was the case (the situation is very different in countries like China). Given (i>g), any debtor sector must run primary surpluses. Consequently, the business sector turned its primary balance from a deficit to a surplus. The household sector continued to run primary surpluses (it saves more than just its net interest income – exception: the U.S. 1990 to 2007). As all primary balances sum up to zero, there is a problem.

    Of course: Single countries like Germany can “export” part of the problem by running huge (primary) surplusses with the ROW, but that’s evidently no systemic solution. Maybe, the systemic view might help to better understand the following puzzle: Over the 1950s and 1960s the ratio of public debt to GDP declined continuously although the welfare state was strongly built up (give the rules of the game, profits could only be made in the real shere of the economy). The opposite has been the case over recent decades. To put it differently: If we do not succeed in changing the overall incentive structure so that the captalistic “core energy”, i.e., striving for profits is shifted from the financial to the real shere of the economy, fiscal rules will not help. Sorry for some simplifications.

  2. Almost all the observers as well as international organizations say that what it is needed is a fiscal policy mix which must combine the support of internal demand (short run effect) and the stability of public budgets (long run effect trough the expectation), but nobody is able to be more specific about what must to be done. By themselves international organizations suggest different pies. It is my opinion that the suggestions of Ms Merkel must be followed, i.e. that the private and especially the bank system have to made their share of the job. By this I means the restruring of the higher public debt.

  3. Very nice, thanx adminn

  4. I wonder why you do not include as a prerequisite for all of the above, the elimination of those mindless (and outright communistic) banking regulations and that has created one of the most slippery slopes toward a fiscal meltdown ever invented?
    I refer of course to those regulations coming out of the Basel Committee that force a bank to have 8 percent in capital when lending to an unrated but job creating small business or entrepreneur, but allows that same bank to lend to the government of a triple-A rated sovereign with zero capital requirement.

    Do you really believe so much in governments’ capacity to self-restraint so that you feel comfortable taking away all external restrictions? If so, you are up for surprise!

    Do you know what the real interest rates on public debt would be without this type of regulatory favors?

  5. “The poor state of fiscal accounts of most advanced countries calls for austere fiscal policies”.

    This seems to be the axiom upon which the rest of Mr. Blanchard’s and Mr. Cottarelli’s post rests. Yet I sense their otherwise excellent post may have overlooked the truism that poor states of fiscal balance can be achieved both by budgetary austerity and by revenue increases. This would be an easy thing to overlook because we all tend to think of revenue increases as being only contractionary; and who needs any more of that now?

    But a very relevant specific to keep in mind in present circumstances is that there is one type of revenue increase which, because it can be designed to curb speculation but not investment, is quite unlikely to be truly contractionary.

    Unfortunately, some people in the financial sector seem to have convinced many who rely heavily on mathematical models that speculative capital flows are also investment capital flows. But is that always so? Most of us can distinguish between playing the tables at Las Vegas or Monte Carlo or an Asian or South American casino and investing in our children’s education. So there IS a difference between speculation and investment.

    But do macroeconomists strive hard enough to keep this distinction clear when making policy suggestions? In trying to satisfy myself on that question, I sense that in some countries the possibility that revenue can be generated while also helping to stabilize the excesses of speculation that brought on the crisis in financial confidence of 2007-2009 is not yet being given as much consideration as the concept merits, although Professor Schulmeister’s paper seems to shine some light on that.

    This perception is not unchallengeable, of course. The school of thought that says “populations whose adults, particularly those involved in initiating and trading financial derivatives in which the distinction between investment and speculation requires careful analysis, have been behaving like spoiled children may benefit from a bit of austerity” cannot be ignored out of hand. But those issue, of course, are political ones, not ones that are the central preoccupation of the International Monetary Fund.

    Financial sector taxes are policy tools that the IMF has, of course, begun to address in its reports to the G-20, and I feel happy to say that the IMF reports that I have read have left me with the distinct impression that the IMF is looking seriously at providing the tools for G-20 leaders and their Finance Ministries and financial sector regulators/supervisors to move ahead in this area. The economic stability benefits of financial transactions taxes and/or VATs are applicable to ALL countries, and the same can be said of their ability to focus capital flows on investment rather than speculation. Let us hope, therefore, that the IMF team in the Korean G-20 meetings is not underestimating the power of its technical contributions to facilitate the working of a co-operative miracle there.

  6. I agree with almost all your suggestions, which, on the other side, are rather methodological in nature. Difficulties will rise when passing to figures to which any country must be constrained in the medium term. To give just two examples: those suggested by IMF or those planned by the European Commission?

    Thanks

  7. Your comment very clearly summarizes that perception of the public debt problem which has been dominating over the past 25 years. It implies: In principle, the government has control over its budget (even though it has to consider cyclical factors etc.).
    However, if one takes into account the interaction of all financial balances, this proposition seems problematic. The household sector runs surpluses, if the business secor takes them over in the form of investment credits, the public sector can easily have a balanced budget (I neglect the financial sector as intermediary and – for the moment – also the ROW).
    If the business sector reduces its borrowing and even becomes itsself a surplus sector (e.g., because financial investments become more attractive), then there is a problem with fiscal rules.
    The problem is aggravated by the fact that since the early 1980s the rate of interest exceeds the rate of growth in advanced economies (both nominal) whereas before the opposite was the case (the situation is very different in countries like China). Given (i>g), any debtor sector must run primary surpluses. Consequently, the business sector turned its primary balance from a deficit to a surplus. The household sector continued to run primary surpluses (it saves more than just its net interest income – exception: US 1990 to 2007). As all primary balances sum up to zero, there is a problem.
    Of course: Single countries like Germany can “export” part of the problem by running huge (primary) surplusses with the ROW, but that’s evidently no systemic solution.
    Maybe, the systemic view might help to better understand the following puzzle: Over the 1950s and 1960s the ratio of public debt to GDP declined continuously although the welfare state was strongly built up (give the rules of the game, profits could only be made in the real shere of the economy). The opposite has been the case over recent decades.
    To put it differently: If we do not succeed in changing the overall incentive structure so that the captalistic “core energy”, i.e., striving for profits is shifted from the financial to the real shere of the economy, fiscal rules will not help.
    Sorry for some simplifications.

  8. Thank you for your great article. I love the way you explian fiscal stuff with making a pie. :)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 770 other followers

%d bloggers like this: