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A Cure For Fiscal Failure

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Should more countries create independent fiscal advisory councils to infuse greater objectivity into national budget debates? Jailed swindler Bernie Madoff recently summed up a lot of people's feelings about fiscal policy, declaring that "the whole government is a Ponzi scheme".
Perhaps this was just wishful thinking from a man who will die in prison after his own record-breaking $50-billion Pyramid scheme collapsed in 2008. Still, with many of the world's largest governments facing a lethal combination of unsustainable conventional debt, unprecedented old-age pension obligations, and a downshift in growth, one has to wonder what the fiscal plan is.

In a new paper called A Decade of Debt, Carmen M. Reinhart and I show that general government debt in the US  has now surpassed the record 120 per cent of GDP reached at the end of World War II.

Japan is in even worse shape, with government debt totalling more than 200 per cent of GDP.  The country now faces massive disaster-relief costs — and this on top of its depressing demographic trends. Many other rich countries' debt levels are also uncomfortably close to 150-year highs, despite relative peace in much of the world.

There is no easy way out. For now, low world interest rates are restraining debt-service costs, but debt levels can be reduced only very gradually over long periods, whereas real (inflation-adjusted) interest rates can rise far more quickly, even for rich countries. Debt crises tend to come out of the blue, hitting countries whose debt trajectories simply have no room for error or unplanned adversity.

An independent fiscal policy could rein in spending by producing a counterpoint to Panglossian government growth and revenue forecasts. In principle, an independent and respected advisory council could also force governments to acknowledge the hidden costs of government guarantees and off-balance sheet debts. It is high time to consider novel approaches. Of course, no one simple change will eliminate the huge bias towards deficit spending in most modern political systems. And no one simple change will preclude the risk of future debt and inflation crises. Many countries require sweeping reforms to make their tax systems more efficient and their entitlement programmes more realistic.

The advent of fiscal advisory councils is a promising institutional start. Many countries have long-standing fiscal watchdog agencies. For instance, the US Congressional Budget Office (CBO). But, while these older institutions have proven enormously useful, they are quite constrained. The CBO, for example, is free to issue long-term fiscal projections based on its own best estimates of growth, but is largely forced to accept politically implausible future ‘fixes' at face value, somewhat neutralising the potential effectiveness of any critique of deficit policies.

To enhance credibility, a number of governments are gingerly moving towards creating fiscal councils with greater independence, often with central banks as a role model. The new vanguard includes councils in Sweden, the UK, Slovenia and Canada.

The remit of Sweden's fiscal council is particularly broad, giving it a mandate not only to forecast, but also to look more deeply at the motivations and consequences of government policy. In principle, an independent fiscal council could have provided invaluable help during the financial crisis. In the US, such an agency could have weighed in on the costs and benefits of bailout plans, perhaps helping to end congressional paralysis and steeling nerves to give taxpayers more upside risk.

True, fiscal councils by themselves are not enough. It will remain tempting for each generation to say, "My grandchildren will be richer than I, so who cares if they have to pay some debt?" Moreover, the political cycle creates a strong deficit bias, as leaders seek to embellish feelings of economic health and prosperity by raising visible expenditures at the cost of hidden debts and lower long-term investment.
To resist these pressures, fiscal councils will need to have their work audited periodically by international agencies, to protect their independence and promote accountability.

Bernie Madoff may be proved right, and his may not turn out to be the biggest Ponzi scheme ever. But a more systematic independent evaluation of government policies could be a good step to solving the perpetual conundrum of outsized deficits. It is certainly one of the more innovative and promising ideas to emerge from a rather barren policy landscape.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2011

(This story was published in Businessworld Issue Dated 18-04-2011)