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Remarks by Rodrigo de Rato
Managing Director of the International Monetary Fund
to the Real Academia de Doctores
Barcelona, Spain, November 25, 2004
Mr. De Castro, thank you very much indeed for your kind words.
Before expanding on the subject at hand, may I say how very pleased I am to be given the opportunity to join the Real Academia de Doctores, as an Honorary Academician. I would also like to express my sincere gratitude to the members of the Academy for having thought of me in bestowing such a great honor.
For this induction ceremony, I would like to share some thoughts, based on theory, empirical evidence, and my own modest personal experience.
The topic I wish to address — the benefits of fiscal consolidation — is one that is dear to my heart, as it raises many issues that I had to wrestle with when I was a member of the Spanish government. One of the problems faced by any authority responsible for economic policy is that of knowing how to reconcile what modern economic principles tell us about policy design with what we learn from how these policies actually work. Having witnessed at close hand the problems confronted by those wishing to design and implement a fiscal reform, I am aware that it is a task in which theory and practice appear to clash. Nevertheless, what I would like to do today is show that this clash is more apparent than real, and to illustrate this with the macroeconomic changes that occurred in Spain in the latter half of the 1990s.
Contrary to what the title of this speech might suggest, there are no easy solutions for countries with a deteriorating fiscal position. The reality is that countries that decide to postpone fiscal reform and adjustment for fear of the political and economic price that these would entail usually end up paying a much higher price when economic necessity forces them to act. The ensuing disruptions and hardships are deplorable when we think of the many cases in which a far-reaching fiscal adjustment and a bold fiscal reform not only managed to restore a sound fiscal position, but also had the immediate benefit of spurring growth. It may be, then, that the oft-cited conflict between the long-term benefits of adjustment and its short-term costs does not always arise. In other words, it is possible to have what we call expansionary fiscal contractions.
In many advanced economies and emerging markets, the fiscal position is a pressing concern. Several euro area countries face mounting fiscal deficits and slow growth, while some of the new EU countries have ahead of them the enormous task of meeting the fiscal convergence criteria for joining the euro. The fiscal position has deteriorated significantly in the United States and is persistently weak in Japan, and it is clear that in most advanced economies medium-term fiscal challenges abound. Many of the emerging market economies, for their part, need to consolidate government finances to bolster market confidence and reduce vulnerability to financial crises. Against this backdrop, expansionary fiscal contractions may appear to offer a magic solution. Later, I will explain why I believe that, unfortunately, things do not work that way. However, I also believe that in certain circumstances fiscal reform and adjustment can produce rapid results.
The debate over fiscal consolidation
The idea that fiscal consolidation can bear fruit in the short term is controversial. Not long ago, the Financial Times described the situation very well: in one corner we have the political left, armed with a multiplier, and in the other we have the right, armed with a Laffer curve. The left insists that increased public spending boosts output via demand—the famous multiplier effect. The right asserts that tax cuts and curbs on public spending stimulate private sector effort via supply.
Obviously, the subject is much more complicated than that. It is true that the starting point should be the standard Keynesian tenet that fiscal adjustment is contractionary. However, some years ago, in a surprising departure from this orthodox stance, Giavazzi y Pagano pointed to Denmark and Ireland in the 1980s as examples of expansionary fiscal contractions, as their respective fiscal adjustments were followed immediately by an increase in growth.
The explanation of these cases was firmly rooted in the tradition of the turnaround in rational expectations. The argument is that a decisive policy for reducing both the fiscal deficit and high levels of indebtedness can shore up market confidence and create expectations among the public about future income. This in turn can have a favorable effect on growth. Clearly, this concept enjoys broad recognition in official circles and even occupies a prominent position in academic research programs. It is also reflected in the work of the winners of this year's Nobel Prize in Economics —Finn Kydland and Edward Prescott—, who demonstrated that credibility and commitment are necessary conditions for an effective policy.
Undoubtedly, the idea that expansionary fiscal contractions can be a source of economic renewal has huge implications. It immediately attracted those who doubted the efficacy of traditional Keynesian fiscal policies, arguing that many empirical studies had shown the limited magnitude of fiscal multipliers and that the response to concerted fiscal expansions was weak in any light, and above all in the case of Japan. This caused many analysts, including the IMF, to take a closer look at expansionary fiscal contractions. Numerous comparative country studies were published (mainly on Europe), as well as more detailed analyses of consolidation efforts in Denmark, Ireland, and a few other countries.
I would like to review what we have learned about the practical aspects of fiscal reform and consolidation in a wide range of countries. As we shall see, expansionary fiscal contractions are not as unusual as they might seem. A clear example is Spain in the latter half of the 1990s. We have also learned a great deal about the factors that contribute to these contractions.
Expansionary fiscal contractions in practice
How common are expansionary fiscal contractions? At first glance, the evidence is overwhelming. According to a recent empirical study by IMF experts, to be published in the next few months, large fiscal consolidations—measured as a cumulative primary fiscal adjustment of more than 6 percent of GDP—appear to be associated quite frequently with a positive macroeconomic development. The study covers more than 160 countries in the last 30 years and identifies 155 large fiscal adjustment episodes. About 40 percent of these were linked to an upturn in short-term growth. However, it is difficult to determine the causality of the relationship between growth and consolidation, and the study does not identify the probable sources of the economic expansion observed. Nevertheless, although it is not at all clear what the role of fiscal consolidation was, the total number of expansionary episodes is striking.
Other studies support this conclusion. One example is a paper published recently by the European Commission, addressing fiscal contractions in the EU-15 countries. About half of the fiscal contractions studied — 49 in all since the 1970s — were immediately followed by stronger economic growth. This effect may be partially attributable to the fact that the contractions coincided with an easing of monetary policy and with exchange rate devaluations. However, even taking this possibility into account, approximately one-fourth of the fiscal contractions were expansionary. And I am not just referring to Denmark and Ireland in the 1980s, but also to Spain and Portugal in 1986, and Italy in 1993.
Turning now to the emerging market economies, two examples demonstrate that fiscal consolidation can boost confidence, expectations, and economic activity. According to a recent IMF study on Brazil, the sharp fiscal adjustment carried out by the Cardozo government in 1999 was crucial to restoring economic stability and overcoming a financial crisis without defaulting on debt payments. The economy responded favorably in 2000, but essentially the reforms laid the foundations for more stable growth in the medium term. By the same token, fiscal adjustment played a significant role by acting as a signal to the markets during Turkey's financial crisis in 2001; combined with a sharp devaluation, it led to an economic upturn and ultimately to a sound recovery.
Channels for expansionary fiscal contractions
What makes a fiscal contraction expansionary? Even in the basic Keynesian approach, crowding-in effects may counteract the contractionary effect of fiscal contractions. These effects occur when a reduction in public spending (or an increase in taxes) leads to a drop in interest rates, which in turn boosts private consumption and investment. Nonetheless, from an empirical point of view, such effects do not appear to be strong enough to cancel out the contractionary impact on demand, although they do explain why the fiscal multiplier estimates tend to be fairly small.
Other non-Keynesian channels need to be examined to seek an explanation for expansionary fiscal contractions. The main channels identified are changes in private wealth and permanent income, and this is where credibility and commitment come into play. The quality of fiscal reforms, the speed with which they are adopted, and the conviction that they will be carried out are fundamental in convincing businesses and households that economic conditions have improved and that they can adjust their consumption and investment plans accordingly. As already mentioned, the two main factors affecting the outcome of fiscal contraction are its impact on confidence and on expectations.
The effects on confidence are visible in the favorable responses of stock market and real estate prices to fiscal contractions that increase private wealth, reduce precautionary savings, and lead to an increase in private consumption and investment. Similarly, reductions in country and exchange risk premiums may give an additional boost to demand owing to the improvement in fiscal sustainability, through a virtuous circle of a strengthening fiscal position and stimulus to economic activity. This effect can be especially pronounced if solvency is an issue or policy credibility is low. This was the case in a few European countries in the period prior to Economic and Monetary Union, including Spain and several emerging market economies such as Brazil.
Expectations affect permanent income and hence consumption through a change in regime. For example, a reduction in spending may temper expectations that taxes will rise in the future. Apparently, such effects were significant in Ireland.
The supply-side effects of fiscal adjustment can also generate stronger economic growth through expenditure composition effects, which could, for example, flow from an increase in the proportion of productive expenditure and a reduction in the proportion of distortionary taxes. Such effects have been confirmed in various studies. Private investment in particular appears to react strongly to fiscal measures that increase expected benefits, for example from the reduction of labor costs.
These effects can be more powerful if they occur in the context of a favorable and more comprehensive economic policy environment that strengthens the credibility effects of fiscal policy. Three factors are considered significant in this regard:
· First, effective coordination with monetary policy, which in turn must be based on a credible policy framework. In Denmark, a key factor contributing to the success of the fiscal reform was that it was accompanied by a monetary policy regime credibly committed to maintaining fixed parity with the German mark.
· Second, the soundness of budgetary legislation and institutions, with special emphasis on transparency and accountability. A good example of this is Brazil's use of fiscal accountability laws to bolster confidence in the government's fiscal programs.
· Third, structural reforms, such as privatization or the simplification of regulations governing business activity, are important because they can encourage expectations of sustainable noninflationary growth.
Having shown that expansionary fiscal contractions are not uncommon and having identified the channels through which they work, the next step is to examine the circumstances in which expansionary effects are most powerful.
Facilitating the occurrence of an expansionary fiscal contraction
The evidence suggests that fiscal consolidation is far more likely to succeed — in terms of positive growth effects — when countries approach a critical level of macroeconomic instability, whether as the result of a chronic tendency to increase budgetary expenditure, debt problems, or balance of payments difficulties. In these circumstances, success depends on three factors: the size of the fiscal adjustment, its composition, and the ability to signal commitment.
For a fiscal adjustment to be credible, it must be of considerable size. The evidence seems to indicate that in most advanced economies, fiscal consolidations attract the attention of the markets and the public if they signal a break with the past. In quantitative terms this means a fiscal adjustment in the vicinity of two percentage points of GDP within a period of two or three years. A change of this magnitude also leads to a substantial reduction in the ratio of public debt to GDP — of approximately three to five percentage points over the course of two or three years —, which should affect the markets' long-term expectations. This conclusion is supported by many academic studies investigating the characteristics of fiscal consolidations with non-Keynesian effects.
Spending cuts are more important than tax increases in boosting confidence. In particular, cutting programs that have survived in the past for economic policy reasons can add credibility to the fiscal adjustment and increase the probability of expansionary effects occurring. A more significant factor in this regard is the reduction in transfers to households and businesses with no specific purpose, together with reductions in public sector wages and employment. Cuts are more effective when they involve a permanent reduction in outlays — hence implying a reduction in the future tax burden — or if they increase labor participation by establishing less generous social benefits. Obviously, such cuts in spending will be problematic in countries that have urgent social needs and serious infrastructure deficiencies that can impede growth. However, better-focused expenditure targeting the sectors that need it most can be useful, as will an increase in the tax base and greater efficiency in tax collection.
Finally, an effective fiscal reform also requires public information programs to make the population aware of the basic objectives and possible ramifications of the reform, which will help win public support.
The case of Spain
Now, let me refer to the repercussions of this program by analyzing the case I know best. Spain's fiscal consolidation in the latter half of the 1990s is an example of a sound fiscal program backed by a credible monetary policy and an ambitious structural reform program.
Prior to fiscal consolidation, Spain found itself at a critical juncture in economic and fiscal terms. In the early 1990s, budget imbalances were persistent, deficits were running at an average of 5 percent of GDP, and the public debt ratio rose to 68 percent of GDP in 1996. Moreover, fiscal policy was poorly coordinated with monetary policy, which tended to be overly restrictive. The challenge of monetary policy was to maintain price stability, while at the same time keeping the peseta within the margins of the Exchange Rate Mechanism (ERM) and avoiding excessive interest rate differentials relative to other EU countries. By undermining the credibility of the inflation and exchange rate objectives, the loose fiscal stance also contributed to high risk premiums — reflecting, in large part, devaluation expectations.
Consequently, it was hoped that a decisive fiscal adjustment effort could initiate a virtuous circle leading to lower risk premiums while allowing for a less restrictive monetary policy — as the Bank of Spain could focus solely on price stability. The policy change was also designed to anchor expectations and thus improve permanent income, which in turn was likely to boost private spending. The fall in risk premiums — by more than 200 basis points between 1997 and 2000 on 10-year government bonds — and the nominal convergence process under way in anticipation of the third phase of EMU were instrumental in triggering a boom in credit to the private sector.
Both the size and the longevity of the fiscal adjustment are striking, especially when compared to the post-1997 performance of other members of the euro area. As a result of robust growth and the increase in primary surpluses, the debt ratio fell by more than 18 percentage points of GDP between 1996 and 2003, enhancing the credibility effects that emerged during the nominal convergence process of 1995-1998. While the adjustment was undertaken in a favorable international context, the overall structural balance nonetheless improved by 5 percentage points of GDP between 1995 and 2002. The primary balance improved by 4.5 percent of GDP over the same period. Recent calculations published by the IMF in the World Economic Outlook suggest that, between 1999 and 2003, the structural improvement in the overall balance, net of savings on interest payments attributable to the convergence of nominal interest rates in the euro zone, was about 3 percent of GDP, putting Spain in a league of its own among euro area member states.
The design of the adjustment strategy was aimed primarily at maximizing the credibility of the fiscal adjustment. It did so through two channels: first, by exploiting expenditure composition effects and, second, by anchoring the renewed commitment to fiscal discipline in a solid institutional framework.
Fiscal discipline was achieved mainly through a major shift in public expenditure policy, the basic principle being to contain current expenditure while protecting public investment. Between 1995 and 2002, nonfinancial public sector expenditure fell by 5.5 percentage points of GDP to 39.6 percent of GDP. Current expenditure contributed 4 percentage points of GDP, reflecting mainly reductions in interest payments, social transfers, and the wage bill, with many measures reducing outlays on a permanent basis.
On the revenue side, deep tax reforms aimed at reducing the burden of distortionary taxation and increasing incentives were implemented. These included a more favorable tax regime for small businesses, a simpler and more transparent tax code, and a more efficient tax collection system. As a result of these reforms, the elasticity of tax revenues increased significantly as a percentage of GDP.
These basic measures were supplemented with reforms of budgetary units and with structural initiatives.
· Greater fiscal discipline — such as more effective and more transparent control of budget procedures — was achieved through a new budgetary planning system. The Law on Fiscal Stability provided a solid institutional basis.
· Structural policies enhanced the response of aggregate supply to the boom in private demand, helping to anchor expectations of a durable pick-up in non-inflationary growth. In particular, competition in the goods and services markets increased — partly as a result of an ambitious privatization program — and significant progress was made in the labor market and in liberalizing the financial markets.
The comprehensiveness of the reform package marked a new era in economic policy. Its elements were coordinated and its commitment credible, which had a positive effect on people's expectations, in line with the new fiscal and monetary policy regime. As such, the recent historical developments in Spain can be considered an example of expansionary fiscal consolidation.
Finally, let me reiterate that fiscal consolidations often do have considerable political and economic costs. Clearly, the traditional effects of fiscal policy continue to be relevant and we must not lose sight of them. However, in many circumstances, the immediate costs of consolidations can be contained. The implementation of decisive, well-designed fiscal reforms can even turn these costs into short-term benefits. Of course, these benefits are not always available to the same degree; and the situations that yield confidence and credibility gains are the ones that offer the greatest opportunities.
There are no guarantees that the implementation of firm measures will produce results, and there is always the temptation to do the bare minimum. However, international experience has shown that if the circumstances are right, a fiscal consolidation that is strong in terms of its scope and coordination with other policies can even generate immediate benefits.
One of the IMF's functions is to comprehensively review and share these experiences with the member countries, in order to provide the best possible economic policy advice to governments facing the challenge of fiscal consolidation. My experience in Spain has made me aware not only of the problems but also of the opportunities that fiscal adjustment presents. These valuable lessons have convinced me that, although there is no one-size-fits-all solution, the careful formulation of policies and their proper implementation increase the chances of success.
Thank you very much.
IMF EXTERNAL RELATIONS DEPARTMENT