The global financial crisis has caused government debt to soar in the advanced economies. Public concern is rising and debates rage on how to fix the problem.
- In advanced economies, the average debt-to-GDP ratio is approaching 100% – higher than at any time since World War II, and set to increase further.
- The required fiscal adjustment is historically unprecedented.
It will take many years of chipping away at public debt to bring it back to more prudent levels.
Previous empirical studies (eg Alesina and Ardagna 1999) identified fiscal-adjustment episodes on the basis of ex post outcomes. In a new book (Chipping Away at Public Debt – Sources of Failure and Keys to Success in Fiscal Adjustment; watch and share the video here), our team uses a novel approach. We analyse fiscal-adjustment plans chosen on the basis of large envisaged reductions in debts and deficits. This approach allows us to learn not only from successes but also failures:
- We compare ex post outcomes with ex ante plans to avoid sample selection/survivorship bias.
- We undertake individual case studies for each of the G7 countries and cross-country statistical analysis for all EU member countries over the past two decades.
Here are some of the key findings on what the plans envisaged, what worked, what did not, and why.
The plans’ design and overall degree of implementation
Not surprisingly, large fiscal-adjustment plans and their degree of ambition were positively associated with worse initial fiscal positions, as well as ‘carrots’ such as the prospect of EZ accession. Their design was, for the most part, reasonable, and based upon macroeconomic assumptions (growth, interest rates…) that were remarkably close to projections by contemporary, independent forecasters.
Planned adjustment focused on spending cuts, consistent with the large initial size of government, especially in Europe. Interestingly, a majority of plans envisaged that expenditure cuts would be large enough to create room for tax cuts, too, while reducing the deficit. Among large adjustment plans in the EU, only one third stipulated increases in the revenue-to-GDP ratio, and less than one sixth of the plans included well-specified tax increases.
On the whole, the implementation record, although short of the plans on average, was not bad in the EU sample:
- In the EU, planned average improvement in the overall fiscal balance by 2.5% of GDP over three years, actual improvement was 2% of GDP.
- More ambitious plans were no less likely to achieve their original objectives than less ambitious plans, on average.
- Governments were unable to cut spending as much as they had initially planned.
- To compensate (though only in part), revenues eventually had to be raised more than originally intended.
This was especially prominent in Italy and France in the mid-1990s, but applies to other countries, too, both in Europe and elsewhere.
The key role of economic growth
The most powerful determinant of whether plans met their objectives was economic growth.
- An unexpected percentage point increase in growth reduced the implementation error (the deviation of actual adjustment from planned adjustment) by 0.5% of GDP.
There is also evidence of asymmetric effects:
- When growth surprised on the downside, the implementation error worsened by more than it improved when growth surprised on the upside.
This suggests that policymakers were more likely to undertake countercyclical fiscal measures in a weaker-than-anticipated economy than they were to save any extra revenues from unanticipated growth accelerations.
Institutional and political factors
Several features of fiscal institutions were relevant for plan implementation:
- Timely and accurate data (upward revisions to initial deficits seldom led to compensating increases in targeted deficit reduction);
- Binding medium-term limits;
- Contingency reserves;
- Coordination across levels of government; and
- Fiscal rules.
Among political factors, support by the public at large for fiscal consolidation was far more important than a comfortable parliamentary majority. For example, opinion polls revealed that Canadian citizens in the early 1990s saw public debt as the number one problem; this factor facilitated the success of Canada’s fiscal-adjustment plan.
Lessons for policymakers today
Have a plan. This is crucial to reassure markets and the public and to keep the cost of borrowing low.
Spell out upfront how you will respond to shocks, especially to economic growth. Conditions may well turn out different than initially assumed. Unexpected declines in economic growth lead to low revenues and may cause a shift in the government's views on whether adjustment or stimulus is needed. Two options for plans that are resilient to surprises in growth are (i) targets in structural terms; or (ii) medium-term targets for expenditures that do not depend on the cycle.
Improve the quality, timeliness, and coverage of fiscal data. This reduces the likelihood of adverse surprises that are harder to fix in mid-course.
Think through what expenditures offer the best value for money. This is what Canada did, the most successful case we review. Germany in the mid-2000s is another good example.
Use structural reforms. Few if any of the ‘revenue-based’ consolidations identified by previous studies were actually intended as such in policymakers’ plans: rather, revenues rose because of temporary factors such as booms in economic activity and asset prices. Our results suggest that it is reform-based (whether expenditure- or revenue-based) adjustment that attains its objectives in a lasting manner.
Build public support. Adjustment objectives are more likely to be met if they are supported by the general public. To garner such support, it is crucial to explain in lay terms that fiscal adjustment is ultimately needed to keep borrowing costs low, and thus to ensure that jobs are created and economic growth revives; and to outline plans whose burden is shared fairly within the population.
Alesina, Alberto and Silvia Ardagna (1998), “Tales of Fiscal Adjustments”, Economic Policy, 27:489-545.
Mauro, Paolo (ed) (2011), Chipping Away at Public Debt – Sources of Failure and Keys to Success in Fiscal Adjustment, London: J Wiley & Sons, Inc.