A legacy of the financial crisis and subsequent government intervention has been large fiscal deficits and soaring public debt. The UK’s position is worse than most, as it entered the recession with a significant structural deficit, but Portugal, Ireland, Greece, and Spain are also facing growing concerns over their government debt.
Governments are in real dilemma. A rapid switch to tight fiscal policy risks throttling the recovery, but continuing deficits are spooking markets. The obvious solution is to promise future fiscal rectitude, and stick with the current expansionary policies in the near term. This requires credibility that most European governments are lacking.
Plainly, a new device is needed to restore credibility to governments’ long-term public finances.
Never waste a crisis…
The global crisis’s momentous events create an opportunity for institutional change. With high levels of debt likely to persist for a long time, governments urgently need a way to commit to credible and sustainable long-run fiscal plans. Further impetus for reform is provided by growing unease in the bond markets about the public finances. Governments should not lose this opportunity for reform — and must act swiftly.
To focus on Britain, the problem is that the budgetary process is not sufficiently transparent. A related problem used to exist for monetary policy, but substantial reform – especially creation of the Bank of England Monetary Policy Committee (MPC) redressed this, but reform of the fiscal process has been limited. Plainly this problem is not unique to Britain. The solution, as with monetary policy, is to institutionalise fiscal transparency and ensure the proper long-term scrutiny of public finances.
Achieving this requires the creation of a politically neutral, expert body. To take the example we are most familiar with this could, the idea would be to create a body that would assess the UK’s fiscal position twice a year – about two months before the Budget and the Pre-Budget Report.
Designing a fiscal policy committee: The UK example
The aim of this Fiscal Policy Committee would be merely to assess and comment on the Budget, not to set policy. The MPC sets interest rates to achieve a government-set inflation target. However, the instruments of fiscal policy are more varied than for monetary policy and offer trade-offs among themselves and different social groups that require them to be chosen directly by a democratically elected government (Khemani 2006).
Instead, a key role for the new independent body would be to check the Government’s policy, budget projections, and growth assumptions for consistency. This should be more than simply auditing of assumptions, which is at present done by the National Audit Office. Instead, it requires a proper assessment of the macroeconomic projections and their credibility.
But the committee should avoid detailed commentary on the structure of taxation and spending, except where it is germane to the overall fiscal risks. It should make its reports directly available to the public and Parliament to ensure accountability and to rebuild trust in the public finances. What should be the benchmark against which fiscal plans are assessed? The present Government has focused on maintaining a debt-to-GDP ratio of 40%, which it has sensibly abandoned. There is no point in returning to this type of goal.
An alternative is to assess fiscal sustainability in terms of whether the current level of debt is sustainable given expectations of future growth, interest rates, and projected surpluses. But we do not favour this either.
Governments must be allowed to build into their fiscal plans contingencies that enable them to use public finance as a buffer in the face of unexpected shocks.
Therefore, we believe that an important role for our proposed independent committee should be to offer a frank assessment not just of the Government’s debt and deficit forecasts but the broader risks characterising fiscal policy.
This would enable the body to comment on whether changes in fiscal policy were a judicious and sustainable response to circumstances, or indicated a government whose plan was never sustainable or was not being properly implemented.
Making credible fiscal policy
The idea would be that the risk of public censure would force governments to act in a more consistent long-term manner. One of the principal problems of running a structural deficit is the heightened risk that a government will have to make economically and politically difficult adjustments to its tax and spending plans — precisely the situation that the UK now faces.
Independent fiscal assessments of a credible plan to manage the deficit should help to provide necessary reassurance to the markets. This would minimise the risk of further changes being necessitated by a downgrade in the UK’s credit rating, whether justified or not. It is important that fiscal adjustment is managed as far as possible by long-term economic factors.
Fiscal councils in Belgium, Denmark, and Sweden seem to have contributed to fiscal discipline in those countries by providing independent assessments. Their institutional configurations differ, but they have reinforced government’s commitments to fiscal responsibility by raising the political costs of deviation (Debrun, Hauner, and Kumar 2009). In the long run, other European nations may need to build similar arrangements to address debt problems by improving fiscal policy.
Institutional change ensured that the credibility of UK monetary policy was restored after Black Wednesday in 1992 with a series of reforms that culminated in Bank of England independence. The publication of the inflation report was an important first step, laying out the goals of policy clearly and the risks inherent in achieving them. The first fiscal policy report could have a similar catalytic effect.
Debrun, Xavier, David Hauner, and Manmohan Kumar (2009), “Independent Fiscal Agencies”, Journal of Economic Surveys 23(1): 44-81, February.
Khemani, Stuti (2006), “In Quest of Institutions that Promote Fiscal Discipline”, World Bank Research Brief, 14 March.