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Q&A Seven Questions about Large Fiscal Consolidation Attempts in the Past and Implications for Policymakers Today

Author(s):
International Monetary Fund. Research Dept.
Published Date:
December 2011
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How can high and growing public debts in the largest advanced economies be stabilized and reduced? Although the scale of today’s challenge is unprecedented, there is much to learn from past attempts at fiscal consolidation. A recently published book, Chipping Away at Public Debt—Sources of Failure and Keys to Success in Fiscal Adjustment, analyzes the design of fiscal adjustment plans and compares them with outcomes, using individual case studies for each of the G-7 countries and cross-country statistical analysis for the European Union member countries over the past two decades. The questions and answers below illustrate how large fiscal consolidation attempts fared in the past and what can be learned from these cases to guide policymakers today.

Question 1: How serious is the need for fiscal consolidation in the advanced economies today?

The global financial crisis has caused government debt to soar in the advanced economies. Public concern is rising and debates rage on how to fix the problem. For the advanced economies, the average debt-to-GDP ratio is now approaching 100 percent—higher than at any time since World War II—and is set to increase further. In many countries the required fiscal adjustment is historically unprecedented. It will take many years of chipping away at the public debt to bring it back down to more prudent levels. Fiscal adjustment will be one of the defining economic challenges for the advanced economies over the next decade.

Question 2: Why look at fiscal consolidation attempts, rather than success stories?

Chipping Away at Public Debt examines past attempts to reestablish sustainable public finances. The book seeks to explain what worked, what did not, and why. It looks in detail at the cases of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States and performs a statistical analysis using data from three-year convergence and stability programs for the European Union (EU) countries for the 1991-2007 period. Previous empirical studies (e.g., Alesina and Perotti, 1995; Alesina and Ardagna, 1998) identified fiscal adjustment episodes on the basis of ex post outcomes. Instead, we approach fiscal adjustment plans on the basis of large envisaged reductions in debt and deficit. This approach allows us to learn not only from successes but also failures, to compare ex post outcomes with ex ante plans, and to avoid sample selection/survivorship bias.

Question 3: How were fiscal consolidation plans designed and implemented?

Initial fiscal position and “carrots” (like EMU accession) are key drivers of planned deficit adjustment. Planned adjustment was skewed toward spending cuts given the large initial size of government, especially in Europe. Interestingly, a majority of plans envisaged such large expenditure cuts that room for some tax cuts would also be created. Of 66 large adjustment plans in the EU, only one-third stipulated increases in the revenue-to-GDP ratio, and only ten plans were grounded in well-specified tax policy measures. This contrasts with ex post identification of fiscal consolidations, almost all of which featured revenue increases, albeit modest ones. The plans’ design was not flawed by overly optimistic macroeconomic assumptions (growth, interest rates, etc.) when compared with contemporary, independent forecasters. On the whole, the implementation record, although short of the plans on average, was not bad at all: with a planned average improvement of overall balance of 2.5 percent of GDP over three years in the EU, actual improvement was 2 percent of GDP. In addition, more ambitious plans produced more adjustment than less ambitious plans, on average. Although planned adjustment was stipulated mostly through cuts in expenditures, actual expenditure cuts did not materialize to the extent envisaged and revenues compensated in part.

Question 4: What was the role of macroeconomic factors in implementing the plans?

Economic growth played a key role in the extent to which the plans’ objectives were met. Deviations of economic growth from initial expectations were a major factor underlying success or failure of the fiscal consolidation plans studied. A percentage point increase in the growth surprise improved the implementation error, or a deviation of actual from planned adjustment, by ½ percent of GDP. There is also some evidence of asymmetric effects of growth surprises: when growth surprised on the downside, the implementation error worsened by more than when growth surprised on the upside. Policymakers are more likely to undertake countercyclical fiscal measures in a weaker than anticipated economy.

Question 5: How do political and institutional variables affect implementation of the plan?

Political and institutional factors proved to be important in achieving the fiscal objectives embedded in governments’ plans. The following features of fiscal institutions seem relevant for successful plan implementation: (i) monitoring of fiscal outturns with reliable and timely data and a response to data revisions (e.g., in 66 adjustment plans in the EU, the degree of adjustment was seldom increased in response to unexpected increases in estimated initial deficits); (ii) binding medium-term limits; (iii) contingency reserves; (iv) coordination across levels of government; and (v) fiscal rules. In addition, lower fractionalization in the legislative body and perceptions of greater political stability seemed to play a role, but the evidence is more tentative. Instead, public support was clearly found to be instrumental to implementation success. For example, opinion polls in Canada in the early 1990s showed that citizens saw public debt as the number one problem. This made it easier for the fiscal adjustment plan that ensued to be successful.

Question 6: What are the past pitfalls of fiscal consolidation to learn from?

First, governments overestimated their ability to cut spending. In Europe, for example, governments were unable to cut as much spending as they had initially planned. Eventually, European governments had to raise more revenues than they had originally intended. We saw this in Italy and France in the mid-1990s and in countries outside Europe too. Second, governments often mistook strong growth and booming asset prices for fiscal adjustment. In the 1990s, the United States saw revenues increase, and by the end of the decade there was widespread concern that the public debt might disappear. Nevertheless, the U.S. deficit soon started increasing again. In hindsight, we know the good times of the 1990s and 2000s should have been used more wisely.

Question 7: What are the key lessons for policymakers today?

First, have a plan. This is crucial to reassure markets and the public and to keep the cost of borrowing low. Second, be aware that outcomes will turn out differently than expected. Unexpected declines in economic growth lead to low revenues and changes in the government’s views of whether adjustment or stimulus is needed. We saw this in Germany in the 1970s, in Japan in the 2000s, and in many countries during the recent crisis. Third, when designing a plan, make sure responses to shocks, especially to economic growth, are spelled out. As President Dwight Eisenhower said, referring to a military context in which the situation often shifted abruptly, “planning is everything.” Fourth, when reducing deficits, think through the role of the state, and what expenditures ofter the best value for the money. The most successful case we review in the book, Canada, did exactly this. Germany in the mid-2000s is another good example. Fifth, since almost none of the fiscal adjustments identified by previous studies as “revenue-based consolidations” were intended as such in policymakers’ plans, it is clear that such revenue-based consolidations occurred because of temporary factors such as booms in economic activity and asset prices. Instead, it is reform-based (whether expenditure- or revenue-based) adjustment that attains its objectives in a lasting manner. Finally, fiscal adjustment objectives are more likely to be attained if they are supported by the general public. It is crucial to explain in lay terms that fiscal adjustment is ultimately needed to keep borrowing costs low, and thus ensuring that jobs are created and economic growth revives and to clearly outline plans whose burden will be shared fairly among various groups.

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