'Fiscal consolidation'. Who but an economist could love such a clunky, unsexy phrase? But then, I am an economist; and so is the OECD. Their latest Economic Outlook includes a special chapter on: Fiscal consolidation: lessons from past experiences (PDF). The authors argue that alhough "fiscal consolidation is required in most OECD countries", it "remains a challenge' for many of them. Translation: they're spending too much and/or not taxing enough. The chapter looks for some lessons from on a dataset covering a large number of OECD fiscal consolidation episodes starting in the late 1970s. Here are their main findings, along with my own summary titles:
1. Facing a crisis helps
Consolidations were larger when the initial situation was difficult: Large initial deficits and high interest rates have been important in prompting fiscal adjustment and boosting the overall size of consolidation. These results may reflect that public awareness of fiscal problems and needs can help in overcoming resistance to consolidation, a hypothesis which is also supported by the observation that qualification for euro area membership significantly increased the probability of starting consolidation. The policy implication would be that consolidation may be helped by the provision of transparent information and analysis of the fiscal situation.
2. Spending cuts work better than tax hikes
Expenditure based consolidations tended to be larger and last longer: An emphasis on cutting current expenditures has been associated with overall larger consolidation and a large weight on social spending cuts increased the chances of stabilising the debt-to-GDP ratio. This could be because expenditure cuts, as opposed to revenue increases, are more likely to trigger lower interest rates and a sympathetic response of private saving, helping to bolster activity. But it could also reflect that governments more determined to consolidate are more willing to cut current expenditures, including social spending, possibly thereby also demonstrating a commitment that makes substantial consolidation more feasible.
3. Fiscal rules can help...
Countries with fiscal rules achieved better results: Fiscal rules with embedded expenditure targets tended to be associated with larger and longer adjustments, and higher success rates. This could in principle reflect that well designed fiscal rules are effective or, alternatively, that governments committed to prudent fiscal management are more likely to institute a rule.
4. ...but need careful design
Designing effective rules raises several issues: Fiscal rules need to be adapted to country specific institutions and political systems, but, based on experience across countries, certain common design features seem important for their effectiveness. These include the need to combine transparency with sufficient flexibility to face cyclical (and other) shocks, a wide coverage across various budget items and effective enforcement mechanisms.
The Economist also discusses this chapter, in its post Words of warning:
With a Kantian flourish, Jean-Philippe Cotis, the OECD's chief economist, argues that sticking to tight spending plans should be governments' “categorical imperative”. In fact, the organisation expects no further reduction in cyclically adjusted deficits in the next two years. It thinks America's will rise. And the historical record, presented in a special chapter of the Outlook, is not encouraging.
The chapter looks at 85 budget-tightening efforts undertaken since 1978 and tries to identify the conditions associated with success. Deficit cuts based on reduced spending have tended to be deeper and longer-lasting than those founded—as in the past couple of years—on increased revenues. That may be because lower spending leads to lower interest rates and hence stimulates economic activity. But it may be because it demonstrates a determination to limit the budget. When tax revenues go up, demands for new spending can be hard to resist—so that when revenues go down again, a new hole in the budget opens up.
Several countries have adopted rules designed to keep themselves on the fiscal straight and narrow. These usually place bounds on budget balances. However, the OECD finds they have more effect if combined with rules to limit expenditure—so that extra revenues are not automatically spent, as they might be if the fiscal balance were all that mattered. Balanced-budget rules not linked to expenditure limits, such as America's Gramm-Rudman-Hollings act of 1985 and the European Union's Stability and Growth Pact, have been less successful. Of course, it is hard to know whether fiscal rules stiffen finance ministers' spines or whether they are adopted by governments that already have the necessary political will.
Either way, the OECD's warning is a timely one. Though state counting-houses may be full now, it is not hard to imagine how they might be drained. The demands of an ageing population look staggering, unless today's systems are reformed. In Greece the combined toll of health care, long-term care and pensions is expected to amount to 7.5% of GDP by 2025 and 16.8% by 2050. In Portugal the expected burden is 6.1% by 2025, rising to 15.5% by 2050.
The Outlook has one more gloomy finding for budget hawks. Not surprisingly, governments are more likely to tighten their belts when budget deficits and interest rates are high—at times, in other words, precisely unlike these.