Beyond the Austerity Debate: the Deficit Bias in the post-Bretton Woods Era

IMF Blog, May 21, 2012

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The austerity vs. growth debate has dominated recent policy discussions, but attracts excessive attention relative to broader, more actionable fiscal-institution issues.
Most economists agree fiscal consolidation is needed in advanced economies, and that the average annual pace of adjustment during 2011-12―about 1 percentage point―is neither too aggressive nor excessively slow.
Countries under market pressure need faster adjustment; those without such pressures have more time.
Institutional gaps in fiscal policymaking have produced a persistent bias in favor of deficits that deserves focused policy attention.

Since the collapse of the Bretton Woods system in the early 1970s, public debt levels have trended upward.
On average, the public debt-to-GDP ratio increased from 29 percent in 1974 of GDP to 74 percent of GDP in 2007.
Debt ratios surged in bad times but did not decline in good times.
Several advanced economies with previously low apparent debt (Iceland, Ireland, Spain and United Kingdom) had fiscal accounts exposed to large risks linked to the size of their financial sectors and transitory revenue sources.
In emerging economies:
- Many have grown rapidly for almost a decade (with the brief exception of 2009) and benefitted from high commodity prices.
- 40 percent of them (representing some 60 percent of emerging market debt) still has a debt-to-GDP ratio exceeding the 40 percent threshold that is often considered prudent for this country group.
- Financial repression is still used in many to facilitate financing of public debt.

The author identifies four main institutional gaps that exacerbate deficit bias:
- Budgetary processes that are too focused on the short term.
- A lack of transparency in fiscal accounts.
- Inadequate comparability of information across countries.
- Governance weaknesses.

Budgets are typically annual and insufficiently anchored in binding multi-year frameworks (example cited: the United States needs more progress).
Medium-term forecasts are prepared in many countries but often fail to constrain decisions.
Short-term focus encourages procyclical policies during high growth and neglect of long-term spending pressures (e.g., age-related spending).
Spending reviews assessing medium-term effectiveness and financial impact are still absent in some advanced economies; Italy is noted as only recently moving more forcefully.
Budgeting often emphasizes cash rather than accrual measures, reinforcing short-term bias.

Hidden fiscal imbalances have surfaced in several countries with negative credibility effects (examples: Greece, Portugal).
Spain announced it would miss its fiscal deficit target by over 2 percentage points at end-2011.
Public debt in China was recently revised up by 17 percentage points of GDP due to previously unrecorded local government debt.
Data coverage and frequency are inadequate:
- Less than half of the IMF’s 188 member countries publish fiscal data beyond the central government.
- Few publish comprehensive information on public enterprises.
- Monthly data are scarce; quarterly data often unreliable.
- Only seven countries publish fiscal risk assessments.
- Very few publish balance sheet data on assets and liabilities.
The author notes that no private firm would be allowed to operate or issue securities with such limited transparency.

International comparisons are hampered by idiosyncratic accounting and budgetary practices.
Public-sector accounting standards exist but are often ignored; the European Union issued a directive only recently and in general terms.
International statistical standards (including the Government Financial Statistics Manual of the IMF) are not closely adhered to.
Reported definitions of government financial assets and gross debt vary widely (example: Japan does not net out intra-governmental debt holdings in general government debt figures, as most other countries do).
The IMF has intensified efforts to publish a fully harmonized definition of government debt, with plans to broaden harmonization to other statistics over time.

Fiscal policy decisions redistribute income across groups and generations and therefore must be made by parliaments, unlike delegated monetary policy arrangements.
Independent assessment of fiscal trends, risks, and policies by fiscal councils is needed to improve governance and credibility.
Examples and developments:
- The Fiscal Policy Council in Sweden is cited as a model.
- The reform of the Stability and Growth Pact and the intergovernmental Fiscal Compact have encouraged or required fiscal councils in the euro area.
- Fiscal councils remain relatively uncommon, particularly in emerging economies, and at least one prominent emerging Europe case showed a recent step backwards.

If fiscal institutional gaps persist, the deficit bias will continue and debt may stabilize at new record-high levels instead of being reduced in good times.
That outcome would leave countries more exposed to shocks than they were in 2007.

Carlo Cottarelli — May 21, 2012