Debt sustainability and Fiscal Councils - Essay Example

 Debt sustainability and Fiscal Councils Introduction The global financial crisis of 2008 has created unending ripples on the economic health of the nations. The government of different countries have heavily relied on the concept of deficit spending in handling the crisis. This is a system in which the government of countries makes more disbursements to stimulate the economy than its earnings (Wren-Lewis, 2013). Factors like inappropriate collection of revenues and large spending power of the state have created a huge deficit bias primarily for the European countries (Abbas, et al., 2013). It has been observed that there has been a recent growth in the number of fiscal institutions in order to improve the fiscal discipline. In this regard, the purpose of this essay is twofold. The first part of the essay discusses the factors for the accumulation of a large debt on the part of the government and the risks that are associated with it. The second part of the essay deals with the rapid rise of the deficit financing on the part of the OECD governments since the 1990’s. This implies that the fiscal authorities have been unable to control the drive of the government to use deficit spending in order to handle difficult economic situations. The second part of the essay also highlights the role of the fiscal institutions and the way in which they can reduce the high debts of the government. Theory The most obvious reasons of rising government debt are the failure to collect enough taxes or revenues in order to meet the expenditure of the government. Economists argue that if the level of government deficit is very high then it implies that the government will be unable to spend a similar amount in the future (Euro Economics, 2015). The following equation captures the debt to GDP ratio in a comprehensive manner. Growth rate of debt to GDP ratio= primary deficit/ B + i –growth rate of nominal GDP B= nominal quantity of government bonds i= nominal rate of interest Primary deficit= This measures the total budget deficit of the government minus the amount that has to be paid as interest on the debt. The equation above shows that there are three main factors which can cause very high level of government deficit (Abel and Bernanke, 2005). The first one is a very high deficit spending on the part of the government. The second one is an increase in the rate of nominal interest on the debt that has been collected on the part of the government and third is a sluggish economic growth. Falling rates of interest has contributed to a high level of debt as it became easier to finance the operations of the government through debt instruments. A rise in the propensity of savings in the emerging markets has been found to be a major factor which has contributed to the fall in the interest rates. Finally, preferential treatment of payment of interest on debt has been found to be a contributing factor in raising the debt to GDP ratio. In an empirical research it was found that the level of non-financial debts has been growing very fast. An important reason behind this approach was the growth in the level of borrowing by business enterprises under minimal restrictions (Reinhart and Rogoff, 2010). Under such situations if the level of economic growth slows down then the nation begins to accumulate a huge debt. Figure 1: Ratio of debt to GDP in countries (Source: Ritholtz, 2013) The graph above shows that the level of debt to GDP ratio has increased manifold times over the years. Economists have argued that insufficient collection of revenue on the part of the government is one of the strongest reasons which raise the debt to GDP ratio. The narrow tax base of the government and the high rates of marginal tax have often been cited as the main reasons which have caused the debt to rise (Cecchetti, Mohanty and Zampolli, 2011). Additionally, providing subsidies to the industries and attempt to become welfare states have actually increased the debt of the government. For instance, the research conducted by Reinhart and Rogoff (2010) on 44 countries to find the impact of high debt-to-GDP ratio on the economy. Their results had confirmed that high level of the ratio can severely undermine the rate of growth. In a research that has been conducted by the IMF it was revealed that high level of public debt makes public finance vulnerable to external shocks. Two factors are responsible for this. The first one is that the government loses its power to rectify the distressful economic situation by taking countercyclical policies. The second reason is that it constrains the ability of the ability of the government to use surplus in order to stabilize the debt ratio. Expectations of the agents also become quite self-fulfilling in such a situation exacerbating the situation of crisis (Cecchetti, Mohanty and Zampolli, 2011). High levels of sovereign debts have also been found to be impacting the capital accumulation of the economy which is highly detrimental. Additionally, the productivity of the economy also suffers if the debt is very high. Future taxation is likely to become highly adverse in face of high debt-to-GDP ratio (Dornbusch, 1997). This can also be accompanied by factors like rise in the rates of inflation and vulnerable economic situations. There are three main tools that are used by the government in order to reduce the high debt-to-GDP ratio. These tools are mainly fiscal policies that are devised by the government, stimulating economic growth of the economy and controlling the rates of interest (Galí and Perotti, 2003). Improvement in fiscal consolidation is one of the most effective ways in which the government can reduce the level of public debt. Fiscal consolidation helps in the reduction of the overall need of the government to borrow funds which in turn lowers the debt. However, the government has to be highly careful while it is implementing fiscal consolidation because it might involve activities like reduction of government spending and raising the level of tax which in turn maligns the expansionary effects of the fiscal multiplier (Schmitt-Grohe and Uribe, 2004). The research conducted by Eyraud and Weber (2013) have confirmed that if the short-run impact of the fiscal multipliers is very high then the impact on the fiscal consolidation can actually be counterproductive on the economy. An initial reduction of the public debt also reduces the overall level of interest rates of the economy. A fall in the rates of interest is also accompanied by an increase in the level of confidence of the investors and stimulates the overall spending of the consumers and business entities alike. The most credible method of reduction of public debt in the long-run is to increase the level of primary surplus of the government as it enhances the confidence of the consumers and improves the credibility of the fiscal policies of the government. However, increasing the level of public surplus can be detrimental in the short-run. If the government defaults on its payment then it faces the risk of loss of reputation which is particularly difficult. Finally, a government can also reduce the level of its overall fiscal deficit by selling its assets. However, this policy is only likely to be successful if it is accompanied by a prudent fiscal policy. Policy The experience of the OECD countries from the period of 1970’s to the 1990’s in terms of rising government debt had put a serious question mark on the effectiveness of discretionary fiscal policy. The late 90’s had witnessed the emergence of fiscal rules in order to curb the high debt burden of the government of the OECD countries and the U.K. was no exception. Fiscal councils are a relatively new concept that had materialized ever since the notion of failure of fiscal rules began to gain momentum. Ever since the inception of the concept, the number fiscal councils have grown over the years. In 1960 the first fiscal council was set up in Netherlands and by 2013 there were 30 councils established across diverse geographies. As the concept of fiscal councils are relatively new so there are very few studies which focus on the effectiveness of these bodies on the fiscal policies. One of the attempts was made by researchers Debrun and Kumar (2007) and their research had established that fiscal councils indeed improve the fiscal performance of nations by implementing a number of measures especially monitoring and providing neutral assessments of forecasts. The research of Calmfors and Wren‐Lewis (2011) is an insightful one which had comprehensively described the odyssey of fiscal councils and the role that they play in the current fiscal discipline. Their research had shown that presently there are a huge variety of fiscal councils with a diverse range of activities. They had also concluded that the growth of the fiscal councils bears a testimony to the fact that fiscal rules are not sufficient to ensure proper functioning of the government. There is a clear distinction between the role of the fiscal authorities and that of the fiscal councils as the primary function of the later is to influence the public debate (Jensen, 1997). It has been observed that fiscal policies can help the fiscal authorities in two different ways. The first one is to help a fiscal institution to implement fiscal decisions and the second one is to plan, forecast, analyze or advise the fiscal authorities. In a related research that has been conducted by the International Monetary Fund (2013) it was found that fiscal councils can help fiscal rules mainly by removing the information asymmetries that are the main reason behind the deficit bias. Fiscal council has the power to obtain information regarding the quality of the fiscal policies that are likely to be undertaken by the governments. Synthesis of the existing literature reveals that there are a number of contributions that are made by the fiscal councils. Firstly, these councils have the power to produce unconditional and unbiased macroeconomic forecasts before the preparation of the budgets. Secondly, the fiscal councils have been found to be useful in implementation of fiscal rules that are set by respective authorities. Thirdly, fiscal councils supplement the effort of the government in finding prudent measures that can be helpful in overcoming difficulties of the present system (Cangiano, Curristine and Lazare, 2013). These functions of the fiscal councils imply that these enterprises are helpful in creating sustainable public finances by thorough assessment of the plans and finances. They have been found to promote a culture of transparency and stability of the fiscal rules thereby enhancing the reputation of the government (Cangiano, Curristine and Lazare, 2013). Despite the major benefits that can be reaped from the formation of fiscal councils, their effective functioning is dependent on a number of factors like complete exclusion from the politics of the state, a very strong and effective communication strategy which enhances their value in the public debates and a relentless monitor of the existing fiscal policies of the state. These preconditions are necessary for the well functioning of the councils. Fiscal councils have been found to be particularly helpful in improving the market discipline by providing regular updates on the fiscal performance of the nation. This situation is particularly helpful because under these circumstances financial institutions do not need to develop the fiscal policy developments of the government instead they can only focus on the reports of the fiscal councils. Authors like Debrun and Kinda (2014) had also pointed out that fiscal councils can help in the improvement of democratic accountability of a country by educating the voters about the underlying situations of the fiscal conditions. Researchers are also of the opinion that fiscal councils can improve the efficiency of spending of the government (Bohn, 1998). In case of the U.K., Office for Budget Responsibility, the official fiscal council of the country was set up in 2010 and since then it has been proactively making official forecasts to the government. Calmfors and Wren-Lewis (2011) argued that as the primary function of the council is to provide advice to the government so it is rather a part of the government decision making system. This implies that the independence of the council is questionable as the government can manipulate the council in taking its decisions. Questions have also been raised on the vigilant status of the council as it has no option to evaluate the consequences of alternate fiscal policies that could have been taken by the government. Researchers have also claimed that governments of most of the countries including that of the U.K. has a strong desire to constrain the criticism that is made by the council to minimize the short-term damages that arise from such criticism (Checherita-Westphal and Rother, 2012). It is primarily because of these three factors that sometimes it has been argued that the government of the U.K. exerts a certain pressure on the Office for Budget Responsibility. In this regard the research of von Hagen (2010 cited in Gianviti, et al., 2010) had stated that fiscal policies can enhance the credibility of the medium-term fiscal goals only if the government of the country has enough commitment. It has also been stated that if the government is highly dominating in imposing its decisions on the fiscal councils then it renders the councils ineffective. Conclusion There is no denying the fact that deficit bias has become a perennial problem of the OECD countries ever since the 1970’s. The global financial crisis of 2008 has brought back the fear among developed countries that deficit financing is not a long-term cure. The rising debt-to-GDP ratio of the countries has become a primary concern for the governments in the developed countries. Three main factors has been identified for the rising debt-to-GDP ratio namely rise in the primary deficit, fall in the overall growth rate of the economies and a rise in the interest rates. The rising public debt poses a number of dangers for the governments namely a fall in the economic growth through reduction of capital accumulation and productivity. Prudent fiscal consolidation, increasing the surplus or selling of the assets coupled with an effective fiscal regime can be useful techniques used by the governments to bring down the debt to GDP ratio. Fiscal councils in the OECD countries have been found to be very popular in the contemporary era. These councils have been found to make a positive contribution to improve the effectiveness of the fiscal rules. They remove the information asymmetry, provide better and unbiased forecasts, improve efficiency of spending of the government and improve the overall functioning of the financial markets. This essay has also focused on the fiscal council of the U.K. especially. It has been found that the fiscal council of the U.K. is not entirely independent as it is often controlled by the government. Such a situation is unfortunate as effective function of fiscal councils is conditioned on their autonomy. Reference List Abbas, S. A., Akitoby, M. B., Andritzky, M. J. R., Berger, M. 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