How to Get the Balance Right: Fiscal Policy At a Time of Crisis

Last autumn was a turbulent time for Europe. The debt crisis deepened and financial markets became embroiled in turmoil, driven by fears of widespread restructuring of public debt. The crisis has harmed growth, increased unemployment, and left a large number of people less protected.

We are now seeing some signs of stabilization. Most countries are reducing their deficits and even if debt ratios are still rising, the return back to fiscal health has begun.

The International Monetary Fund and the Swedish Ministry of Finance are hosting an international conference in Stockholm on May 7-8, with the purpose of sharing knowledge and providing guidance on the best way to achieve fiscal consolidation, and on the role that effective fiscal policy frameworks and institutions can play in this endeavor.

Learning from experience

Sweden provides an interesting case study for countries’ current predicament. In the early 1990s, Sweden was rocked by an economic crisis with escalating unemployment, double digit deficits, and a sudden loss of market confidence that raised the cost of sovereign borrowing.

In response, Sweden initiated a comprehensive set of reforms. Favorable external conditions helped, but domestic policies played a critical role in the adjustment. Strong fiscal tightening was implemented to regain fiscal sustainability and market confidence. This was accompanied by the effective handling of the crisis in the financial sector, and structural reforms that raised Sweden’s competitiveness, long-term growth rates, and real wages. A new fiscal policy framework—founded on a surplus target, a medium-term expenditure ceiling and a comprehensive top-down budget process—has since helped preserve strong public finances and prepared Sweden well for the current crisis.

The experience of other countries—both those staring into the headlights of a crisis and those more gradually realigning their economies to a sustainable position—can also provide valuable lessons for those now struggling with large debt, persistent deficits, sluggish economic growth, and a lack of market confidence. While recognizing that the current crisis is unique in its scope and scale, three broad lessons can be learned.

Developing a medium-term plan

First, a comprehensive and clear plan for restoring the health of public finances needs to be developed and adopted at the outset, although consolidation measures can be spread over time depending on country circumstances (countries that are feeling more pressure from financial markets would have to frontload the adjustment; others would have more time).

Countries that have succeeded in bringing down public debt from high levels, such as Canada during the 1990s, followed this approach. It is particularly important to be clear in areas where policy decisions are hard. In the current circumstances, fiscal credibility can be significantly enhanced by clarifying how the severe long-term challenges from rising aging-related (pensions and health care) spending will be addressed.

IMF staff project this spending to increase by an average of 4 percentage points of GDP in advanced countries over the next two decades. This trend cannot be ignored. At the same time, fiscal adjustment should be done in a way that protects the poor and most vulnerable, and shares the burden across the population. If painful fiscal reforms are not perceived as fair, they never gain the support of citizens.

Having a strong institutional framework matters

Second, well-designed fiscal institutions can support the implementation of fiscal plans. The importance of strong budgetary institutions—the set of rules and procedures defining the preparation, approval and execution of the budget—cannot be underestimated. Here too a medium-term orientation is important, particularly when it comes to public spending.

In countries like the Netherlands and Finland, fiscal policy has been driven for years by well-designed medium-term expenditure frameworks. Of course, introducing fiscal frameworks on paper is not enough. An equally important aspect is transparency, which allows plans to be scrutinized and ensures that governments can be held accountable for their implementation. In this area, Australia and New Zealand have been leading with their codified transparency requirements. Independent fiscal councils can also play a role.

Reforms to support growth

Third, fiscal adjustment should go hand-in-hand with structural reforms that lay the foundation for sustained productivity and employment growth. Growth will alleviate the daunting challenges of fiscal consolidation, and the task is to find ways of encouraging it without undermining the fiscal position. Reforms in product and labor markets—several countries in Europe are stepping up their efforts in this area—may not yield immediate results, but will over time boost economic growth and lighten the burden of fiscal adjustment. IMF calculations suggest that increasing annual productivity growth by just a quarter of a percentage point could generate a virtuous circle leading to a decline in the public debt ratio of six percentage points within 10 years.

The way forward will be difficult. The fiscal challenges are daunting. It is easy to feel discouraged. But experience shows that rapid improvements are possible.

There is a way forward, but it requires immediate and resolute action on numerous fronts. The Stockholm conference is a small but important contribution to these efforts.