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

 

OECD Economic Outlook: “Disconnected from real needs”?

Last week, we reported on the latest OECD Economic Outlook. Writing in the New York Times, Paul Krugman was highly critical of the Organisation’s analyses and policy recommendations. Here we summarise Krugman’s argument and the reply by OECD Deputy Secretary-General and Chief Economist Pier-Carlo Padoan.

Krugman argues that the most ominous threat to the still-fragile economic recovery is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.

He contrasts this with actions taken when the financial crisis first struck, and most of the world’s policy makers responded by cutting interest rates and allowing deficits to rise.

He goes on to say that “The extent to which inflicting economic pain has become the accepted thing was driven home to me by the latest report on the economic outlook from the Organization for Economic Cooperation and Development… what [the OECD] says at any given time virtually defines that moment’s conventional wisdom. And what the OECD is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.

What’s particularly remarkable about this recommendation is that it seems disconnected not only from the real needs of the world economy, but from the organization’s own economic projections.”

His demonstration is as follows. The OECD declares that interest rates should rise sharply over the next year and a half to head off inflation, but inflation is low and declining, and OECD forecasts show no hint of an inflationary threat.

The reason the OECD wants to raise rates is in case markets start expecting inflation, even though they shouldn’t and currently don’t.

Likewise, although the OECD predicts that high unemployment will persist for years, it asks that governments cancel any further plans for economic stimulus and that they begin fiscal consolidation next year.

Krugman insists that both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because a weaker economy depresses tax receipts, wiping out any gains from governments spending less.

Moreover, the reasons for doing this don’t hold. Investors aren’t worried about the solvency of the US government and interest rates on federal bonds are near historic lows. And “even if markets were worried about U.S. fiscal prospects, spending cuts in the face of a depressed economy would do little to improve those prospects”.

This contrasts with the OECD’s calls for cuts because inadequate consolidation efforts “would risk adverse reactions in financial markets.”

Krugman is worried that this view is spreading, citing the case of “conservative members of the House, invoking the new deficit fears, [who] scaled back a bill extending aid to the long-term unemployed… many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.

He concludes by stating that “more and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.”

In reply, Padoan starts by saying that they differ on the strength of the recovery, with the OECD more optimistic than critics of the Outlook. Unemployment will take time to fall to acceptable levels, but this will be underway by 2011. A double-dip recession cannot be ruled out, but is not very likely. The risks of running big fiscal deficits and a zero interest rate monetary policy are rising.

Recent events in Europe are a warning sign and even though the US has the world’s biggest capital market, the risks are shifting. In this unsettled financial environment, governments need to get out ahead of markets, because otherwise they will be hostage to them.

On inflation, he argues that it is not a risk today, but could be in two-years’ time. Monetary policy needs to be forward looking and this means easing up on monetary stimulus in anticipation.

“To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags.”

How quickly interest rates should rise depends on many things, especially inflation, inflation expectations and the pace of growth. It also depends on fiscal policy, which influences growth.

“All else equal, if fiscal policy turns out to be tighter than in our projection, then monetary policy should be looser to compensate.”

Useful links

OECD Economic Outlook

Capitalism and all that

A big crisis, but was it big enough? That’s the question on the mind of Larry Elliott, economics editor of The Guardian  newspaper following last week’s OECD Forum  in Paris. Elliott went along to one of the event’s most talked-about sessions, “The Future of Capitalism”, which featured contributions from – among others – economic historian Robert Skidelsky  and commentator Anatole Kaletsky  (who previewed some of the issues raised in the session in the OECD Observer).

Writing later in The Guardian, Elliott reflects on a warning from another session speaker, the OECD’s Adrian Blundell-Wignall, that the crisis may not have been severe enough to prompt much-needed reforms.

 “Speaking in a personal capacity … Blundell-Wignall warned there was likely to be a second, even bigger, meltdown unless there was radical reform of the financial sector, including splitting up banks with both retail and speculative arms,” Elliott writes.

“Although this is a sombre conclusion, it may prove accurate. The current crisis has yet to have the cathartic impact of the slump of the 1930s, when the economic cost was far higher and the links between the failure of the old laissez-faire model and the drift to political extremism were plain.”  

Geoff Gallop of The Sydney Morning Herald offers another view of the session here.

If you’d like to make up your own mind on what was said, you can see a video of the session – and all the other Forum sessions – here. Also available are text summaries  of the sessions.

Over on the OECD’s YouTube channel you can see video interviews from the Forum, including one with Lord Skidelsky, who weighs in on the debate over fiscal consolidation. Or you can just scroll down the page to catch up on the OECD Insights Blog postings from the Forum.

Useful links

OECD Insights: From Crisis to Recovery