posted by Richard Hughes
With budget discussions in advanced countries focused on how much and how quickly governments can stimulate their ailing economies, there has been little talk of the long (or even medium) term in fiscal circles lately. But when the dust eventually settles on this period of unprecedented economic turmoil, these countries will find themselves facing the same demographic pressures that dominated the fiscal agenda before the crisis – and many will be doing so from a much weaker fiscal position.
So the fiscal policy debate will eventually return to the subject of fiscal consolidation and how to go about returning the public finances to a position of long-term sustainability. Fortunately this time around, countries seeking guidance on how to deliver a successful and durable fiscal consolidation can look to a number of rigorous studies on the subject that came out shortly before the onset of the current crisis. Two of the more exhaustive examinations were the OECD’s 2007 Fiscal Consolidation: Lessons from Past Experience which became a chapter in their June 2007 Economic Outlook and the European Commission’s Lessons from Successful Fiscal Consolidations which formed a section of their 2007 Public Finances in EMU report. This posting provides a summary of their findings.
Success and Failure in Fiscal Consolidation
Looking at 85 and 146 incidences of fiscal consolidation respectively, the OECD and EC studies come to a similar set of (disconcerting) conclusions about advanced countries’ track record with fiscal consolidations over the past three decades:
- most episodes of fiscal consolidation were of the ‘cold shower’ variety in which the structural budget balance is abruptly tightened by between 1 and 4% of GDP in a single year;
- the median improvement in the underlying budget position was modest (around 2% of GDP) and the median duration was short (about 2 years); and
- between one-half and two-thirds of fiscal consolidations were deemed to have failed – in most cases the initial improvement in the budget balance had been substantially undone within three years.
Lessons from Successful Fiscal Consolidations
So what does the minority of successful consolidations have in common and what lessons do they hold for countries that will exit the current financial crisis looking to shrink their deficits and shed their heavy debt burdens? Well, the OECD and EC studies converge around five key "lessons":
- Get yourself in a whole heap of trouble: One small consolation to those countries facing the prospect of double digit deficit/GDP ratios or triple digit debt/GDP ratios is that tougher initial budgetary conditions are associated with larger and more successful fiscal consolidations. This is no doubt partly a function of necessity combined with greater public awareness of the problem and acceptance of the need for action.
- Be a tortoise not a hare: In the realm of fiscal consolidation, slow but steady wins the race. Gradual consolidations that spread the fiscal pain over a longer period tend to be both larger and more successful than "cold shower" consolidations which try to get it all over with in one or two years.
- Go for spending cuts rather than tax increases: Consolidation efforts that emphasize reducing expenditure (especially current expenditure) tend to result in larger and more durable consolidations than those which rely wholly or primarily on increasing revenue.
- Fiscal rules can help guide the way: The existence of well-specified and comprehensive fiscal rules is positively correlated with the size and duration of consolidation. Fiscal rules can support a government’s medium-term consolidation plans by providing a clear guide for the budget balance over time. Transparent rules can also help to sustain that consolidation by raising the political cost of deviating from those plans when the initial pro-austerity consensus begins to dissipate.
- But strong budget frameworks are what keep you on track: Slippage on the expenditure side was the main reason for the failure of fiscal consolidations. Countries whose budget systems were characterized by a multi-annual planning horizon and a centralized, top-down and prudent approach to budget preparation were more likely to deliver the tough budget cuts they committed to.
