Mitsuhiro Furusawa Ministry of Finance, Japan
I will start with a few comments on fiscal policy exit strategies in general and then turn to more specific comments on unwinding public interventions in the financial sector.
One of the serious challenges in an exit strategy is determining the appropriate time to begin its implementation. In Japan, the government had supported the economy with a series of fiscal stimulus measures from 1992 to 1996. It unwound those measures in 1997 through the combination of a legally binding fiscal consolidation path, tax increases, and medical benefit reforms. The international community broadly supported these moves toward exit. For instance, in June 1997, the communiqué of the Denver Summit called for appropriate structural reforms in the fiscal area as a priority for Japan, and in July 1997, Japan’s Article IV Consultation endorsed these fiscal correction measures. While it is difficult to draw a firm conclusion as to whether the 1997 measures are an example of the premature implementation of an exit strategy, I will raise three points based on this experience.
First, when assessing economic conditions, we have to be vigilant not only about macroeconomic indicators, such as growth and employment, but also about the progress made in balance sheet adjustments in the corporate or household sectors since these adjustments are a drag on economic activity.
Second, we must take into consideration the aggregate impact of various fiscal policy measures on the macroeconomy, which could affect expenditures, revenue, and social benefit reforms.
Third, we have to be mindful of the potential impact of external shocks on both the domestic economy and financial markets. We might have underestimated the degree to which the Asian financial crisis in the second half of 1997 may have undermined financial market confidence.
With regard to the challenges that are specific to fiscal policy exit strategies, I can raise a few more issues. As the IMF pointed out in its proposed principles for exit strategies, achieving fiscal sustainability will be a complex process and will take a long time. For instance, in December 1996, the Japanese government decided on the basic elements of a fiscal consolidation path, but it was not until November 1997—almost one year later—that Japan’s Parliament approved a related law. The process for the increase in Japan’s consumption tax rate was even longer, as the increases were originally called for in 1994 but did not become effective until April 1997.
These issues highlight two additional challenges. First, we have to face the reality that each major fiscal policy measure needs to go through a different domestic political process, and it is difficult to manage the timing of implementation. Second, we must be aware of a significant time lag between the decision and its implementation as well as between its implementation and effects.
On the topic of unwinding public interventions in the financial sector, I will address three points.
The first point is the importance of applying a step-by-step approach, with a clear timeline, while paying due attention to the economic environment. Japan started offering a 100 percent deposit guarantee in June 1996, in the midst of the financial sector turmoil. The government had initially set a sunset-clause to take effect for this measure at the end of March 2001. Nonetheless, due to the sluggish economic environment, it postponed its expiration and took a gradual approach. Japan lifted this 100 percent guarantee for time deposits in April 2002 but maintained the 100 percent guarantee for savings accounts until March 2005.
The second point concerns government guarantees. Their use can be effective when the government needs a large financial commitment to anchor financial market confidence, although upfront cash provisions are not necessarily required. For instance, in dealing with the financial sector problems of the late 1990s, the Japanese government set guarantees (which I will give here in dollar terms) of more than $550 billion for borrowing by the Deposit Insurance Corporation, which operates deposit insurance systems and addresses banking sector problems. At its peak in 2001, the Deposit Insurance Corporation used about $260 billion of this guarantee. Thereafter, as the economic environment improved, banks started to unwind government interventions, and use of the guarantee decreased to less than $100 billion in 2007. Capital injections from the Deposit Insurance Corporation to viable banks reached about $140 billion; to date, 75 percent of the injected capital has been returned, and the government has not yet incurred any losses.
That brings up the issue of unwinding government guarantees. Some types of guarantees, such as those for the Deposit Insurance Corporation, could continue to exist as a permanent scheme, enabling the government to deal with problems of banking sector solvency. In fact, this scheme allowed our government to promptly address the problems of several banks in the aftermath of the current financial crisis. On the other hand, it is desirable to continuously review another type of guarantee scheme aimed at addressing credit bottlenecks and promoting bank lending to specific sectors: In 1998, Japan introduced a special guarantee scheme to facilitate bank lending to small and medium-sized enterprises (SMEs). To cover the potential losses of bank lending to SMEs under this scheme, the Japanese government set a guarantee of around $340 billion. By March 2001, loans had been extended up to the guarantee amount, and the scheme was terminated as originally planned.
The third point is the importance of appropriate arrangements for institutional guarantee schemes. Due to the unprecedented problems in the banking sector, the above-mentioned special guarantee scheme for SMEs presents some extraordinary features, such as very few conditions for its application and a 100 percent guarantee. In addition, most of the lending under this scheme was made without any collateral. This institutional setting was one reason why the losses from the scheme turned out to be much larger than originally estimated by the government, with fiscal costs of more than $30 billion. This cost highlights the importance of making sure that the guarantee scheme will both prevent moral hazard and ensure an appropriate distribution of potential risks.
Simon Johnson Massachusetts Institute of Technology
I will lay out my view of the problem as it relates to the United States, the approach to a solution, and the risks posed by a failure to make real reforms.
The problem
Toward a solution
In the absence of real reform
Christian Kastrop German Federal Ministry of Finance
Exceptional support for aggregate demand and for the financial sector has been inescapable for Germany in response to the crisis: from the end of 2008 to the beginning of 2009, the German government implemented discretionary fiscal policy measures up to almost €100 billion, with the effect mostly in 2009 and 2010. The German rescue scheme for the financial sector amounts to €480 billion. Since recovery remains fragile, it is not yet time to withdraw support. Further fiscal stimulus therefore will be provided by the Growth Acceleration Law effective as of January 2010.
These measures contributed to a stabilization of the real economy: quarterly growth rates of GDP have been positive since the second quarter of 2009. A severe weakening of the budgetary position, however, is the other side of the coin. Without any consolidation measures in the near future, this leads to a large deterioration of long-term sustainability gaps. The situation, which is similar in many other countries in the European Union (EU), also creates a great challenge for the European Stability and Growth Pact. From 2011 on, therefore, fiscal consolidation must and will be the top policy priority of German fiscal policy. While withdrawing financial policy support should not put financial stability at risk, a timely exit is important to minimize fiscal risks and to avoid costs that distort competition.
The need for fiscal rules in this situation and a firm commitment to them seem to be a necessary requirement for a credible exit. Germany is committed to fiscal exit strategies at two levels. On the European level, principles developed by the Economic and Financial Affairs Council (ECOFIN) of the Council of the European Union were endorsed by the European Council with a starting date for fiscal exit in 2011 at the latest. For Germany, the deadline for the correction of the excessive deficit is in 2013, with a minimum annual improvement in the structural balance of at least 0.5 percent of GDP.
The new constitutional budget rule constitutes the framework for the fiscal exit strategy on the national level with an overall limitation of structural deficits (federation: 0.35 percent of GDP; states: zero percent of GDP) while allowing automatic stabilizers to work. This rule will come into effect in 2011 with transitional periods—where structural deficits have to be reduced to the aforementioned levels—for the federal level until 2016 and for the states until 2020. The institutional framework is also strengthened by the fact that borrowing via additional funds to cover special financing needs—which was possible according to the old budget rule—will be justified only as an exception to the new rule from 2011 on.
Exit from support to the financial sector in Germany will be realized by a bottom-up approach that allows for a gradual phasing out. A combination of procedural rules and incentives is ensuring a timely exit that responds flexibly to individual needs. By law, the German rescue scheme expires at the end of 2010. It is approved by the EU Commission on a six-month basis under state aid rules; an obligation for renotification ensures that an exit will not be inappropriately delayed.
Exit from individual stabilization measures (guarantees, recapitalization, and impaired asset relief) will be taken once viability of the individual bank is ensured. Guarantees (currently €127 billion) are limited to a maximum of five years and will phase out automatically at maturity. Banks that receive a recapitalization under the German rescue scheme (recapitalizations so far: €22 billion) have to present a restructuring plan under state aid rules. State aid rules provide for an automatic exit. They strike a balance between competitive functioning of the financial market and the need to stabilize the financial system. The possibility of creating bad banks allows the liquidation of impaired assets (to date, €6 billion), while the remaining core bank has to prove its viability and follow a restructuring plan.
The support measures to the financial sector have also increased requirements for fiscal policy analysis and management. Most of the financial market support measures have not yet had an impact on public deficits, but they increased the level of gross debt markedly. Supplementary tables published by Eurostat in the context of the Maastricht notification provisions create a certain degree of additional fiscal transparency with respect to all interventions at the EU level, though comparability across EU member states might not be perfect.
The government has to be careful in designing the exit path—not too early and not too late, differentiating between supporting the financial markets and the economy as a whole. Putting aside gross economic error or obvious political misjudgment, the risks from “too late” are, in my opinion, much more serious than those from “too early,” hampering market expectations and the structural reform agenda with a huge impact on sustainability and potential growth in the long run.
Nigel Ray Australian Treasury
This note focuses on the practical issues around the conduct of fiscal policy, particularly the Australian experience.
Although Australia is a small, open, advanced economy, it has a relatively greater share of its exports in primary commodities than would be the case for most other small, advanced economies.3 Despite a national saving rate that is around the average for OECD economies, a high investment rate means that Australia is traditionally a large net importer of capital.4
Taken together, these two facts mean that Australia’s economy is highly sensitive to developments in the world economy and in world financial markets. As a result, the global financial crisis and the associated global downturn provided one of the more severe possible tests of Australia’s economic resilience.
Explaining fiscal actions
A clearly specified, credible fiscal strategy is important to marshal and maintain public support for fiscal policy actions.
The Australian government is required to produce a fiscal strategy statement at least annually. The statement must show how fiscal policy actions taken for the purposes of moderating fluctuations in economic activity are to be reversed, and it must show that they are consistent with long-term fiscal objectives.5
The budget must also contain a statement of risks that includes contingent liabilities and publicly announced government commitments not yet included in the fiscal estimates.6 This requirement means that off—balance sheet liabilities, such as debt guarantees for other entities, must be disclosed at the same time as the balance sheet and other financial statements are updated and released.
Nontraditional fiscal measures should not be excluded from the reporting requirements. If they are excluded, then the public’s understanding of the stance of fiscal policy and of the risks that the government is facing is diminished. Contingent liabilities are not costless—financial markets will demand a premium to finance governments that have them, and ratings agencies and the IMF pay particular attention to them.
Medium-term fiscal targets
Economic theory does not give us precise guidance on appropriate fiscal targets, and each country will have different factors that need to be taken into account in formulating its fiscal objectives.7
Australia’s high reliance on foreign saving and the weighting of its export income toward primary commodities mean that adverse developments in the world economy and financial markets have significant implications for the real economy. In these circumstances, relatively conservative fiscal objectives are appropriate because they allow the government to act to minimize temporary macroeconomic disruption if necessary. Countries not subject to the same level of external exposure as Australia may be able to adopt less conservative fiscal objectives.
Long-term economic considerations are also relevant. In Australia, factors such as growth in Asia and the aging of our population have fundamental implications for the future structure of the economy. Australia’s fiscal position needs to be robust to the future demands that will be placed on public services and infrastructure. Long-term budget projections can be very useful in identifying these types of pressures.
The commitment to a fiscal target can be as important as the target itself. Just as different countries can sustain different inflation targets for monetary policy, different objectives can be sustained for fiscal policy. It is the clear statement of those objectives and the maintenance of policies consistent with those objectives that establish the credibility that can be so helpful for the conduct of macroeconomic policy.
Temporary fiscal interventions
It is important to distinguish the use of fiscal policy to boost aggregate demand temporarily from the longer-term objectives of fiscal policy.
Monetary policy is still the first choice for macroeconomic management, but it can be complemented by discretionary fiscal policy in limited circumstances, including where the downturn is likely to be deep, where it is synchronized across a number of countries, and where there is financial sector impairment that limits the potency of monetary policy.
It is important to specify which actions form part of a temporary stimulus, what their objectives are, and how and in what circumstances they will be withdrawn. It is also important to show how they are consistent with the government’s longer-term fiscal objectives. This allows the public and financial markets to judge the efficacy of the government’s measures and supports the credibility of the fiscal strategy.
Temporary fiscal stimulus needs to be clearly targeted at ameliorating temporary economic disruptions, and the budget’s automatic stabilizers must be allowed to operate. The beneficiaries of public guarantees require incentives to return to nonguaranteed financing as market conditions normalize. The timing of the withdrawal of fiscal stimulus also needs to be robust to changing economic circumstances.
Coordination of fiscal actions
In the current situation, advanced economies face the challenge of a simultaneous, large fiscal consolidation. An overly hasty effort to repair balance sheets could harm the global economic recovery.
This danger could argue for greater international coordination in the withdrawal of fiscal stimulus, although it is likely that, once a sustained economic recovery is under way, private sector activity will quickly use any resources freed up by the withdrawal of fiscal stimulus.
An area in which coordination might be a more important challenge is the involvement of different layers of government in the delivery and withdrawal of stimulus. For example, this might be a particular challenge if subnational governments have wide spending powers combined with balanced budget rules.
Conclusion
To sum up, there are some useful guiding principles for fiscal policy:
Communicating—to the public and the markets—the fiscal strategy and the fiscal position are of utmost importance, including specifying to the fullest extent possible the risks and contingent liabilities that are not shown on the government’s balance sheet.
Long-term fiscal objectives need to be set with a country’s individual circumstances in mind and should provide adequate flexibility to respond to a plausible range of economic stresses.
Monetary policy is at the front line of demand management, but discretionary fiscal policy can be useful in exceptional circumstances. When this option is exercised, the nature and role of the stimulus and its timetable for implementation and withdrawal should be clearly specified and consistent with the government’s long-term fiscal objectives.
William White, “Is Price Stability Enough?” BIS Working Papers, No. 205, 2006.
ABS Cat No. 5302.0—Balance of Payments and International Investment Position, Australia, June 2009. www.abs.gov.au/ausstats/abs@.nsf/mf/5302.0.
Organisation for Economic Co-operation and Development, 2009, Economic Outlook, No. 86 (Paris: November), www.oecd.org/document/18/0,3343,en_2649_34109_20347538_1_1_1_1,00.html; and ABS Cat No. 5206.0—Australian National Accounts: National Income, Expenditure and Product, June 2009. www.abs.gov.au/ausstats/abs@.nsf/mf/5206.0.
Section 9 of the Charter of Budget Honesty Act 1998. www.comlaw.gov.au/comlaw/Legislation/ActCompilation1.nsf/framelodgmentattachments/1AF5822889419466CA256F710051FA64.
Sub-subsection 12(1)(e) of the Charter of Budget Honesty Act 1998.
Cottarelli and Viñls offer a range of goals for returning to fiscal normalcy after the crisis, from “stabilizing public debt ratios at whatever level has been reached as a result of the crisis,” to aiming at “placing the fiscal accounts on a sustainable path, one that is indeed stronger than before the crisis, and that ensures the resilience of the fiscal accounts to the demographic shock.” (C. Cottarelli and J. Vinals, 2009, “A Strategy for Renormalizing Fiscal and Monetary Policies in Advanced Economies,” IMF Staff Position Note 09/22 [Washington: International Monetary Fund], p. 8). www.imf.org/external/pubs/ft/spn/2009/spn0922.pdf.