Since the early 1970s, fiscal deficits and rising public debt have been ubiquitous features of government budgetary positions. Indeed, in aggregate, fiscal balances of both industrial and developing economies have been negative in each of the past 30 years, with an average deficit of about 3 percent of GDP a year for both groups (Figure 1.1). In recent years, an improvement in the overall fiscal positions in the industrial economies during the economic and financial market boom in the 1990s was quickly reversed thereafter. In many developing economies, although there has been a welcome turnaround in budgetary positions over the last 4 years, this reflects in large part cyclical factors, higher commodity prices, and a benign global financial market environment. 1
As FY2010 drew to a close,1 the global economy appeared to be emerging from the worst recession in over 60 years. The recovery remained uneven, however, with some economies growing very robustly, while others were experiencing more tepid rebounds, and downside risks were increasing-and continued to do so in early FY2011. Policies are needed to address these risks and set the stage for a return to strong and sustained global growth.
The past year has been a roller coaster for the global economy.4 The severe financial crisis that followed the collapse of Lehman Brothers in September 2008 had a significant negative effect on the world economy, with global output falling by ½ percent in 2009. Advanced economies were the most significantly affected by the financial crisis, having to deal with a serious credit crunch, battered balance sheets, and rising unemployment. In these countries, output fell by 3¼ percent in 2009. The crisis was transmitted swiftly across the globe through a number of channels-including a collapse in trade, a drying up of capital flows, and a drop in remittances. When the dust had settled, it became obvious that several emerging markets and low-income countries had been severely affected by the global crisis, the worst in over 60 years.
Mr. Xavier Debrun, Mr. David Hauner, and Manmohan S. Kumar
Economic analysis has long recognized that policymakers, particularly in the fiscal domain, act quite rationally according to specific incentives, including reelection concerns, pressures from interest groups and constituencies, and the need to honor specific pledges or commitments. Growing evidence of fiscal indiscipline and procyclicality has prompted a debate on the likely distortions causing and arising from such behavior, and on effective ways to correct policymakers’ incentives in a socially beneficial way. This chapter examines how distorted incentives may undermine a judicious use of fiscal discretion, and explores how fiscal frameworks could improve fiscal behavior and outcomes.
Although some debate on the feasibility and effectiveness of fiscal policy in stabilizing output fluctuations continues, there is little disagreement that, as a rule, policy should not be procyclical. The standard Keynesian approach suggests that fiscal policy should act in a stabilizing manner, while within the neoclassical paradigm, tax-smoothing models imply that fiscal policy should remain neutral over the business cycle. Even in a Ricardian framework, where a reduction in taxes or an increase in spending leads to an equivalent rise in private sector saving, policy would not be expected to be procyclical.
The global economy went through a period of unprecedented financial instability in 2008-09, accompanied by the worst global economic downturn and collapse in trade in many decades. The IMF played a leading role in helping its member countries deal with the immediate challenges posed by the crisis and begin to shape a new, stronger global financial system.
Since political economy factors are an important determinant of procyclicality of policies, measures to contain the misuse of fiscal policy discretion can be beneficial. The scope of fiscal frameworks designed to attain this varies widely across countries. In some countries, economic, political, and legal factors will be more conducive to rules-based arrangements, putting explicit constraints on policy choices. In others, institutions may more effectively transmit public pressure to decision makers through a system of checks and balances. History may also play a role, with countries that have experienced fiscal crises possibly more inclined to opt for hard rules. Overall, there is a range of options to constrain discretion: from broadly defined good practices leaving ample room for interpretation to tighter setups, based on hard numerical rules or even delegation of policy-related mandates. 1