Can Fiscal Watchdogs Be Fiscal Rescue Dogs?

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

 

Ineffective, Inconsistent and Dangerous: The OECD-backed fiscal consolidation plans to deal with the looming sovereign debt crisis

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Today’s post is contributed by Pierre Habbard of the Trade Union Advisory Committee to the OECD (TUAC)

In 2010 in the wake of the recession, the policy consensus at the OECD – alongside the IMF, the European Commission and many G20 Finance Ministries – shifted away from support for stimulating global demand to near-term fiscal consolidation. Their priority became reducing sovereign debt through unprecedented budget austerity programmes, the costs of which will be borne almost entirely by workers and their families: cuts in public services and in social protection, regressive tax reforms, and downward wage flexibility. At the same time, the much needed re-regulation and downsizing of the financial sector, which triggered the crisis in the first place, was either scaled back or postponed until “better days”.

This policy response is ineffective, inconsistent, and ultimately dangerous.

It is ineffective because the fiscal consolidation programmes that are advocated ignore the causes of the crisis: the combination of rising inequality, excessive leveraging and de-regulation of the financial sector. To bring government debt back to pre-crisis levels, public budgets should contract by -9.5% on average in the near future, and remain in surplus afterwards.

Considering the enormity of the social crisis spreading across OECD economies, the cuts in public services and in social protection that are foreseen, as well as, concomitantly, the regressive tax reforms which the OECD is pushing for will hit households and the lower income people front on. The OECD concedes that the massive public expenditure cuts it is advocating “may have adverse consequences for equity outcomes” – but its response to this concern appears thin, to say the least, and this, in spite of its recent work in that field.

It is suggested that social protection and unemployment benefits be “revisited in terms of their effectiveness in reaching envisaged policy goals”. The OECD lives with the hope that while the inputs will effectively be cut down, the output levels (including quality of public services) could be maintained thanks to “efficiency gains”, better “targeted” services and restructuring: “doing more with less”, we are told. Trade union experience with public sector restructuring would rather point to the opposite effect: “doing much less with less”. Any restructuring involves substantial upfront costs. Importantly, the notion that social protection could be better targeted in times of social crisis appears rather illusory with unemployment at 10% and under-employment at 20%, rising poverty and social deprivation.

It is inconsistent because, as OECD experts are well aware, the most effective way to deal with the unsustainable rise in sovereign debt is to put an end to the unhealthy relationship between private sector finance and government balance sheets. If public budgets have become more vulnerable following the crisis, it certainly is not due to any badly managed or inefficient public services or social protection, or badly designed tax systems; rather, the fault lies with the unwillingness of policymakers to take decisive action on banking and broader financial regulation, which leads to growing exposure of governments to any future financial crises.

The key threat to sovereign debt sustainability in the short term lies not in fiscal policy, but in government exposure to contingent liabilities created by multiple guarantees on banks’ liabilities as a result of the crisis and by financial institutions that are too big to fail. The on-going debate on the possibility of a ‘hair cut’ or debt restructuring for the most crisis-hit countries exemplifies that dilemma. Governments must put an end to this intertwining without delay. The OECD experts know that and have been calling, as at least implicitly, for splitting the large banks to shield commercial and retail activities – that serve the real economy – from the volatile investment banking activities.

On revenue side, the obvious “under-taxation” of the financial sector barely appears in the main recommendations by the OECD. The generalisation of Financial Stability Contribution (FSC) type insurance mechanisms together with the creation of a Financial Transaction Tax and the IMF suggested Financial Activity Tax would help redress the current under-taxation of the financial sector. Here the OECD is lagging behind. On that it is no small irony to compare the OECD’s insistence on broadening VAT with its total silence on the massive VAT exemptions which benefit the financial sector across OECD countries. Together with the current G20–Financial Stability Board “action plan” (Basel III, consolidation of the supervisory framework, regulation of the derivatives markets), these measures could help reduce governments exposure to the private banking sector. But the needed speed of reform simply is not there. 

And it is dangerous because the fiscal consolidation packages currently being introduced threaten to have long-lasting consequences in terms of income and welfare distribution. Trade unions are well placed to know through their membership that social cohesion is breaking down across OECD societies; they are first-hand witnesses of rising populism within the working class. The political dimension of the crisis, the need to bring back some redistributive justice in the economy, is not factored in the OECD–IMF response. To the contrary, their response fuels the risk of weakening democratic institutions if key elements of fiscal policy are transferred away from democratically elected bodies through the constitutionalisation of fiscal rules and the empowerment of “independent” experts in the fiscal consolidation process.

Useful links

TUAC Discussion paper The International Policy Response to the Post-Crisis Rise in Sovereign Debt – A trade union critique, April 2010

OECD work on public debt management