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Can Fiscal Watchdogs Be Fiscal Rescue Dogs?

12 January 2016

Gotcha!

Bill Below, OECD Directorate for Public Governance and Territorial Development (GOV)

In The Magic Mountain, Thomas Mann wrote famously that “everything is politics”. There are some who believe that fiscal policy should be a notable exception. Those who share this viewpoint would like to see fiscal policy removed from the political arena and encapsulated in a non-partisan process, along the lines of monetary policy. But, this isn’t likely to happen anytime soon, and for reasons deeply rooted in modern democratic principles. From the First Baron’s War (1215-1217), resulting in the Magna Carta, to the French and American revolutions, the notion of taxation without representation has been roundly repudiated. What works for monetary policy and institutions such as the Fed or the ECB, cannot, it seems, work for fiscal policy.

Why is this even an issue? Because democracies have a hard time not spending more than they take in. The composite fiscal balance of all OECD countries, as well as most of its individual member countries, was in deficit throughout virtually the entire three decades prior to the crisis of 2007/2008 (OECD Economic Outlook 2009). The term for the phenomenon is ‘deficit bias,’- the tendency of democratically elected governments to veer into the fiscal red and stay there. Deficits can be manageable. But when they reach levels that are considered unsustainable, mere bias becomes ‘fiscal irresponsibility’, ‘fiscal profligacy’ or more colorfully, ‘fiscal alcoholism.’

One strategy for curbing deficits consists of fiscal rules. Fiscal rules codify deficit and debt ceilings, providing policy makers with a legal framework to guide better fiscal choices. To work, fiscal rules must navigate a tricky line between being sufficiently comprehensive to accomplish their objectives and anticipate loopholes while avoiding soul-crushing complexity and rigidity. Not an easy task, as critics of the European Union’s Stability and Growth Pact are quick to point out. Fiscal rules must also have the flexibility required to support a country’s broader macroeconomic objectives. To jumpstart growth during a downturn, governments follow countercyclical policies, increasing public spending and providing tax relief when government coffers are at their lowest (apostasy to anti-deficit hardliners). Then, when better times return, the previously avoided tax hikes and spending cuts must be instigated.

Governments consistently get the first part right.

The financial crisis was a “gotcha” moment, catching many countries off-guard and in vulnerable positions. Eight years on, countries that had the highest deficits going into the crisis still have the lion’s share of fiscal consolidation ahead of them (OECD, The State of Public Finances 2015). The public debt position of OECD countries continues to worsen.

Can watchdogs be rescue dogs? The OECD thinks so. The period since the crisis has seen the rise of a relatively new breed of fiscal watchdog-the Independent Fiscal Institution (IFI), also known as Fiscal Councils. Prior to the crisis, only six countries had IFIs in place. Today, they number twenty-five and growing. It could be that IFIs are the missing link in a form of fiscal tri-therapy already consisting of fiscal rules and budget reform. That’s the hope of the OECD and many of its members. The OECD Network of Parliamentary Budget Officers and Independent Fiscal Institutions (PBO network, for short) was created as a support organization for IFIs ranging from fledgling operations to well-established entities.

In many cases, the support is badly needed.

This has a lot to do with the precarious role IFIs play, particularly when starting out. Their job: to depoliticize fiscal policy information, intervening prior to policy but without decision-making authority. If it sounds like a challenge, it is. What IFIs can do is issue objective, non-partisan assessments of proposed fiscal policies, promises and programs. In lieu of legally binding enforcement power, the IFI plays the role of fiscal gadfly, whose job—not unlike that of Socrates—is to point out inconvenient truths that often contradict the powerful and ambitious and the institutions that they represent. We know what happened to Socrates. Needless to say, it can be a lonely job. Effectiveness depends on having good friends elsewhere, notably in the financial community, the media and of course the greater public. It also requires a solid reputation for independence, transparency, expertise and fearlessness. IFIs must be constituted to resist partisan pressure and intimidation in all forms, from the risk of defunding to being shut out from vital government data.

Consequently, every IFI that has made it has a harrowing, near-death experience to recount. For the UK’s Office of Budgetary Responsibility (OBR), it occurred in November, 2011, the day it told the government it could not afford its budget plans (the Chancellor duly revised them). For Canada’s Parliamentary Budget Office it was the publication of its first report—during an election campaign–revealing that the cost of participating in the war in Afghanistan was significantly higher than claimed. One European IFI went from a well-staffed organization with a broad remit, to a vastly reduced operation consisting of just a few people. Venezuela’s Congressional Budget Office was shuttered without further ado by President Hugo Chavez in 2000, two years after its creation.

The OECD’s PBO network offers a place where IFIs can exchange best practices and build up their staying power in a dangerous but badly needed line of work. Following the OECD Recommendation on Principles for Independent Fiscal Institutions, the PBO network offers guidance on setting up and managing effective IFIs.

So, why is deficit bias so entrenched? At least some of it boils down to politics. In campaign mode, the urge to give (funding programs, cutting taxes) is consistently stronger than the urge to take away. When it comes to cold, fiscal reality, there seems to be a strong belief that ineluctable truths make unelectable candidates. Ironically, some research suggests that if voters are made fully aware of fiscal arithmetic, they will support short-term costs for longer-term gains (Alesina et al. 1998, cited in Calmfors and Wren-Lewis, 2011). Also, fiscal processes are complex and chaotic—not a monolithic, well-coordinated activity like the Berlin Philharmonic playing Beethoven, but more like a stadium filled with oom-pah-pah bands, each seeking to be heard above the rest. With well-conceived fiscal rules and objectives, aided by strong and sufficiently supported independent fiscal institutions, policy makers may at last begin to play in the same key when it comes to fiscal responsibility. That, at least, is the outcome that the OECD’s PBO network is passionately working towards.

Useful links

OECD, The State of Public Finances 2015

OECD Recommendation on Budgetary Governance 2015

OECD Recommendation on Principles for Independent Fiscal Institutions 2014

OECD work on Budgeting and Public Expenditures

Directorate for Public Governance and Territorial Development

 

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