Abstract
This selected issues paper on Iceland reports that since mid-2009, Iceland has undergone a heavily frontloaded fiscal consolidation program to bring government finances to a sustainable level. To maintain the adjustment gains achieved during the last 2½ years, the authorities have started drafting a new organic budget law, which would codify recent reforms in the budget framework and introduce principles for fiscal policymaking. Iceland’s economy is exposed to adverse shocks. The external outlook continues to pose challenges, as key trading partners face weak growth prospects.
I. Iceland’s Policy Objectives under a New Fiscal Rule1
A. Introduction
1. Since mid-2009 Iceland has undergone a heavily frontloaded fiscal consolidation program to bring government finances to a sustainable level. To maintain the adjustment gains achieved during the last 2½ years, the authorities have started drafting a new organic budget law (OBL), which would codify recent reforms in the budget framework and introduce principles for fiscal policy making.2 Ideally, these principles would underpin the introduction of a procedural fiscal rule requiring each new government to present a statement of fiscal policy and set medium- and long-term numerical fiscal objectives. To assess performance against these objectives, clear indicators measuring government debt, the fiscal balance, and other targeted fiscal aggregates would need to be specified. It is expected that the OBL will be discussed by parliament by end-2012, implying that the first statement of fiscal policy will likely be presented immediately after the 2013 elections.
2. This note furthers the discussion of appropriate fiscal objectives for Iceland. It reviews different fiscal objectives discussed with IMF staff in the context of the October 2011 technical assistance mission and extends the analysis by exploring their countercyclical features and impact on output and inflation volatility. While fiscal objectives that allow countercyclical fiscal policy would be highly desirable, other factors also need to be taken into account:
Fiscal consolidation continues. With gross debt at about 100 percent of GDP at end-2011, Iceland’s fiscal consolidation is not complete and is likely to continue over the medium-term and beyond. The authorities have reiterated their desire to reduce gross debt to 60 percent of GDP in the long term. However, the horizon matters for the fiscal effort that Iceland would need to undertake for the foreseeable future. Reducing gross debt to the target by 2020 would require maintaining an overall surplus greater than 2 percent of GDP. A lower overall surplus would lengthen the period to reach the long-term debt target. There is therefore a trade-off between the ability of the government to employ countercyclical fiscal policy and the speed with which it can meet its long-term objectives.
Difficult financing environment and contingent liabilities pose risks. Iceland’s economy is exposed to adverse shocks. The external outlook continues to pose challenges, as key trading partners—notably in Europe—face weak growth prospects, and risk appetite is at a low in international capital markets. Contingent liabilities are still high, as the Icesave dispute awaits court resolution, and explicit government guarantees have reached 80 percent of GDP at end-2011 (primarily arising from guarantees on the debt of the Housing Finance Fund). The possibility of fiscal risks materializing would argue for selecting fiscal objectives that bring down debt as quickly as possible to free up fiscal room to respond to adverse shocks.
Iceland’s structural fiscal position is difficult to establish. Allowing automatic stabilizers to work hinges on a clear view of all cyclical and other temporary factors that affect Iceland’s fiscal position, such as the output gap, and equity and real estate prices. During the recent crisis Iceland’s potential output declined sharply due to contraction of the capital stock, decline in the labor force, and an increase in the equilibrium unemployment. These factors point to some of the difficulties in estimating the output gap, especially ex-ante and in the face of large shocks. Asset prices are also known to exhibit random walk characteristics, creating additional uncertainty to estimates of the structural fiscal position. These challenges would suggest that at the current stage of recovery from the crisis, simple and transparent numerical objectives that do not use a complex indicator such as the structural balance may be easier to communicate and more likely to earn credibility in Iceland.3 Calculating and monitoring the structural balance is nonetheless important to gauge the fiscal stance, especially if Iceland is to eventually introduce a structural balance rule, such as the one recently agreed by the European Union countries under the Treaty on Stability, Coordination and Governance.4
Enforcing fiscal discipline remains a challenge. Budget overruns still pose a problem, and efforts to rein them in place a premium on a rule that reinforces multi-year expenditure planning.
3. Simulation results suggest that no one fiscal objective addresses all challenges Iceland currently faces, with tradeoffs between countercyclicality and predictability of spending. An objective that limits real growth of spending has advantages in buffering the economy, but requires abrupt spending cuts to restore fiscal discipline after shocks. An objective that maintains a targeted overall balance on average during a 7 year horizon shows a neutral fiscal stance and keeps a relatively stable spending ratio. A third objective, both allowing flexibility to soften the impact of shocks and seeking to maintain fiscal discipline lies between the other two in its performance.
4. The fiscal policy objectives must be reviewed as the fiscal consolidation comes to an end. Some parameters or features of the fiscal objectives introduced at the launch of the OBL are likely to become obsolete over time. This will depend on the speed of debt reduction, the extent to which the economy becomes more stable in future, and the need to rein in long-term pressures, such as healthcare costs. Therefore, the analysis presented below has a limited policy horizon of about 10–15 years.
B. Modeling the Fiscal Objectives
5. Three types of fiscal objectives are explored for Iceland.5 In all three cases, there is a targeted level of overall balance (surplus or net lending) that would allow gross debt to decline from 100 percent of GDP to a targeted long-term debt ratio of 60 percent of GDP (Table 1).
Description of Fiscal Objectives
Description of Fiscal Objectives
| Fiscal Objective | Fiscal Indicator | (Implicit) Overall Surplus Target | GDP Indicator | Adjustment Mechanism |
|---|---|---|---|---|
| 7-year rolling surplus | Overall Balance | 1.5 percent of GDP | Long-term growth | 7-yr average |
| Augmented growth-based balance | Overall Balance | 1.5 percent of GDP | Long-term growth | 50% of slippage |
| Limit on real spending growth with deficit brake | Primary Expenditure | 1.5 percent of GDP | Long-term growth | 50% of slippage |
| Control: Structural surplus | Structural Balance | 1.5 percent of GDP | Output gap | None |
Description of Fiscal Objectives
| Fiscal Objective | Fiscal Indicator | (Implicit) Overall Surplus Target | GDP Indicator | Adjustment Mechanism |
|---|---|---|---|---|
| 7-year rolling surplus | Overall Balance | 1.5 percent of GDP | Long-term growth | 7-yr average |
| Augmented growth-based balance | Overall Balance | 1.5 percent of GDP | Long-term growth | 50% of slippage |
| Limit on real spending growth with deficit brake | Primary Expenditure | 1.5 percent of GDP | Long-term growth | 50% of slippage |
| Control: Structural surplus | Structural Balance | 1.5 percent of GDP | Output gap | None |
Seven-year rolling surplus: Under this objective, the overall balance must average the targeted surplus over a period of seven years. This period could be considered a proxy for a business cycle period. It provides the government with some flexibility to respond to shocks without the need to know the exact structural fiscal position. “Automatic stabilizers” are allowed to work, using the deviation of current growth from the long-term growth (e.g., an average over 30 years) as a proxy to the output gap.
Where:
dt=overall balance (surplus) in percent of GDP in period t;
d*=overall balance target, which could be set based on the government’s horizon to bring gross debt down;
l=number of lags included in the calculation of the average balance;
f= number of forward periods included in the calculation of the average balance;
gt=real growth rate of GDP in period t;
g*=long-term growth rate (2.3 percent in the case of Iceland);
α1=coefficient of the degree of accommodating automatic stabilizers.
Augmented growth-based fiscal objective: Under this objective, the overall surplus target must be met annually rather than on average over a period of time, but automatic stabilizers are accommodated. However, should the overall balance deviate from the targeted surplus in a given period, a (partial) adjustment should occur in the following period.
Where
α2=coefficient of the adjustment to fiscal slippage.
Limit on real spending growth with a deficit break:6 Under this objective, the real growth of government primary expenditures is limited to long-term real GDP growth, strengthening the fiscal position during upturns and worsening it during downturns. To avoid large and prolonged deviations from the targeted surplus (and debt level), expenditures must adjust in the following period to (partially) offset the difference between the actual and the target value for the surplus.
Where
Gt = government primary expenditures in percent of GDP in period t. Government primary expenditures include all expense categories, except interest, and acquisition of nonfinancial assets as defined in GFSM 2001.
6. The three fiscal objectives are modeled using the Global Integrated Monetary and Fiscal Model (GIMF) to assess their impact on inflation and output volatility. The model, calibrated to Iceland, assumes that the new fiscal objectives will enter into effect in 2014 seeking to reduce gross general government debt to 60 percent of GDP in seven years. The implied targeted overall surplus is 1.5 percent of GDP. Plausible shocks to the objectives are applied in 2015 and include: (i) a low-growth scenario, with real GDP declining by 4½ percentage points on impact; (ii) an interest rate increase of 300 basis points; (iii) a joint low-growth/interest rate shock scenario; and (iv) a contingent liability shock of 30 percentage points of GDP. The three objectives are also compared with a structural balance objective—should such an objective eventually be considered—with semi-elasticity of the overall balance with respect to the output gap of 0.28.7
C. Results
7. Three broad criteria are used to assess the fiscal objectives. As in Hughes et al. (2012), a preferred fiscal objective should: (i) provide stability and countercyclicality to the real economy; (ii) maintain a predictable expenditure pattern, which avoids large swings in the expenditure ratio even under extreme shocks, without undermining transparency of the fiscal objective; and (iii) instill fiscal discipline by ensuring that a slippage from the medium-term fiscal objective is restored promptly and that the long-term debt path is on track.
Volatility and Counter-cyclicality
8. Output gap volatility is broadly similar across fiscal objectives, but countercyclicality varies considerably. Under perfect policy credibility, countercyclical policies are associated with lower output gap volatility.8 As the model assumes that policies are implemented promptly, without a lag, and credibly, countercyclical fiscal policy has the desired mitigating effect on economic volatility. Differences in the output gap volatility are discerned when compared against counter-cyclicality. The more countercyclical an objective is, the more likely it will reduce volatility. In particular, an objective limiting expenditure growth, which by design introduces a countercyclical element beyond accommodating automatic stabilizers, appears to consistently lead to lower output gap volatility under all shocks. As the expenditure ratio declines (increases) when actual GDP growth is above (below) the long-run growth, the fiscal impulse (the inverse of the change in the cyclically adjusted primary balance) would tend to move in the opposite direction of the output gap. The model simulations show that the negative correlation of the fiscal impulse and the output gap exceeds 0.5 both under the baseline and under shocks (Figure 1). The other fiscal objectives show more moderate countercyclical features. An augmented growth-based objective also reduces output gap volatility under a growth and an interest rate shock, but is actually procyclical and volatility-inducing under a contingent liability shock. Finally, an objective achieving a surplus over a 7-year rolling period appears to be the least countercyclical and shows somewhat higher output gap volatility than the other objectives.
GDP Gap Volatility under Shocks
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.GDP Gap Volatility under Shocks
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.GDP Gap Volatility under Shocks
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.9. Differences among the effects of the objectives are also evident in real GDP growth volatility. Over a 10-year horizon, real growth volatility is lowest under a limit on expenditure growth given any shock scenario, although the difference is most striking for a contingent liability shock (Figure 2). Under a contingent liability shock, the 7-year rolling surplus performs as well as the structural surplus objective, while the augmented growth-based objective is the least resilient option.
GDP Growth Volatility
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.GDP Growth Volatility
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.GDP Growth Volatility
(10-year horizon, standard deviation in percentage points)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.10. The relatively small differences among the seven-year rolling surplus and the structural surplus objective suggest that they have similar long-term properties. Both under the baseline and under shocks, the two fiscal objectives result in similar volatility of GDP growth. This implies that the simpler and more transparent seven-year rolling surplus could replicate the more complex structural balance rule. While the augmented growth-based objective and the limit on expenditure growth also show some similarities under growth and interest rate shocks, they diverge significantly from a structural surplus objective in the case of a contingent liability shock.
11. The simulation results also suggest that inflation volatility is not affected by the fiscal response. Inflation volatility is driven mainly by the initial dynamics of the shock and the monetary policy response and remains largely unaffected by the choice of a fiscal policy objective.
12. Three main conclusions emerge from these simulations for macro-stabilization objectives:
The limit on expenditure growth with deficit brake has an advantage over the other fiscal objectives in reducing output gap and GDP growth volatility in shock scenarios.
The long-term stabilizing properties of a structural balance rule could be replicated successfully with a simpler and more transparent fiscal objective, such as a 7-year rolling surplus.
Inflation volatility is unaffected by the choice of fiscal objectives.
Predictability and Transparency
13. A good fiscal objective also facilitates medium-term budget planning. This implies that expenditures and revenues should be relatively stable or have a predictable path over the consolidation period. Large expenditure volatility under stress would undermine the credibility of fiscal policy making, as difficult adjustment measures may be required in order to bring the fiscal path back on track. Expenditure volatility also places strain on the budget process as new measures are frequently adopted, abandoned, or supplemented, which reduces ministerial incentive to focus on delivery planning and implementation.
14. Under the baseline, government spending remains most stable if the fiscal objective is a limit on expenditure growth. The volatility of government spending is lowest under this objective, with deviation of less than 0.5 percentage point of GDP from an average of about 31 percent of GDP in the first 10 years of introducing the fiscal rule (Figure 3). The other three fiscal objectives maintain primary spending at about 31½–32 percent of GDP with a deviation greater than 0.5 percentage point of GDP. In the long run, government expenditures gradually increase to an equilibrium level of about 35 percent of GDP, filling the fiscal space allowed by lower interest payments. Meanwhile, public debt continues to decline even after government spending is back to its equilibrium value.
Primary Expenditure Volatility
(Standard deviation in percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Primary Expenditure Volatility
(Standard deviation in percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Primary Expenditure Volatility
(Standard deviation in percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.15. However, a rolling surplus objective is best at preserving expenditure predictability under shocks. Under shocks, the expenditure ratio could deviate significantly from the baseline ratio. This is most evident under a growth shock when accommodation of the automatic stabilizers pushes expenditures above the baseline (Figure 4). Within two years, the deviation is about identical under a 7-year rolling surplus, an augmented growth-based objective, and a structural surplus. If greater countercyclicality is embedded in the objectives, it drives a larger wedge between the scenario and the baseline value of the expenditures, as discretionary easing is implemented through greater spending (revenue measures are not considered in this model). In the case of a limit on expenditure growth, this occurs automatically as expenditures grow at the rate of long-term growth, thereby accommodating the entire difference between the current and the long-term growth, rather than just the automatic stabilizers.
Deviation of Primary Expenditure from the Baseline
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Deviation of Primary Expenditure from the Baseline
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Deviation of Primary Expenditure from the Baseline
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.16. Under all fiscal objectives, fiscal adjustment offsets the effect of the automatic stabilizers and discretionary spending. The medium-term overall deficit target needed to bring the general government gross debt ratio below 60 percent of GDP triggers corrections under all fiscal objectives when the actual overall balance deviates from the baseline. As the automatic stabilizers have smaller effect than the adjustment mechanism, the expenditure ratio is lower than the baseline under an interest rate shock and a combined interest rate and growth shock. If the correction is not sufficient under a limit on expenditure growth, and should the shock be large—even a one-time shock—the expenditure ratio could remain lastingly higher than the baseline equilibrium. Such incomplete correction under the expenditure limit objective could pose severe challenges to restore fiscal discipline and sustainability in the long-run without a major reassessment of the parameters (overall surplus and fiscal adjustment coefficient). A stringent correction mechanism (a deficit or a debt brake as in Figure 4) allows to redirect expenditure toward the long-term equilibrium and restore debt sustainability.
17. A severe contingent liability shock provides a good example of the need to have a stable expenditure path. Under a 30-percent contingent liability shock, such as a write-off related to financial sector losses, losses of state-owned companies, or called guarantees, the limit on expenditure growth imposes a very severe restriction on other primary spending. Hence, if the objective seeks to ensure that the long-term consolidation remains intact, the level of primary spending may become unrealistically low. Alternatively, the objective could allow that “irregular” expenditure items are excluded from the growth limit, but this would come at the expense of a large slippage in the implicit medium-term surplus objective and prolong the adjustment to the desired debt level. A similar problem occurs with the augmented growth based objective, in which a slippage from the overall surplus does occur, but the automatic correction in the subsequent period requires a severe contraction in primary spending. In fact, the oscillation in spending caused by the correction in the target makes the augmented growth-based surplus highly procyclical under a contingent liability shock and creates greater growth volatility compared to the other fiscal objectives.
18. Transparency is also an important characteristic of fiscal objectives. Simpler objectives with fewer and more tractable assumptions are more likely to earn credibility because they are easier to monitor, and more likely to appeal to the public and the legislature.9
As mentioned above, the structural surplus objective is the most controversial and difficult to justify on grounds of transparency. It requires identifying all factors with transient effects on government revenues and expenditures, estimating the elasticities of government revenues and expenditures with respect to the output gap and such transient factors, and finding precise measures of the “normal” (long-term) values of these factors.
The objective of achieving a surplus during a 7-year period is less data intensive, but requires substantial precision in projecting macroeconomic variables to ensure that the current annual target is consistent with the average objective over the 7-year horizon. Furthermore, while selecting fewer lags in setting the objective allows greater policy flexibility to respond to shocks, it comes at the expense of lower precision, as greater uncertainty lies in the longer forecasting horizon. Because of this loss of precision, overly optimistic projections may make it politically more compelling to postpone necessary adjustment because the overall surplus must be met only on average over the 7-year period. Furthermore, the flexibility may inadvertently induce a procyclical bias.
The augmented growth-based surplus and the expenditure growth limit have the lowest data requirement and could be the simplest and most transparent objectives, provided that the measure of the overall balance and expenditures subjected to the growth limit are well defined and monitorable with publicly available information. However, calculating long-term GDP growth is also not without challenges. Overestimating long-term growth would cause fiscal outcomes to deviate permanently from the fiscal path and undermine the long-term debt target and debt sustainability. It would also present difficulties to constantly correct fiscal slippages and could undermine the implementation of fiscal consolidation.
19. In conclusion, when assessed against expenditure predictability and transparency the fiscal objectives show the following properties:
A 7-year rolling surplus provides the most stability in expenditure planning (unless a structural surplus objective is considered).
A limit on expenditure growth with deficit brake exhibits large swings under all shocks and requires expenditure adjustment well in excess of the historical standard deviation of primary spending (1½ percentage points of GDP in a single year), which could hinder implementation.
With well defined measures of overall balance, expenditure, and long-term growth, the limit on expenditure growth with deficit brake and the augmented growth-based objective are likely to enhance transparency over other fiscal objectives.
Fiscal Discipline
20. The overarching goal of all fiscal objectives should be to establish lasting fiscal discipline. This requires that the objectives set government debt on a sustainable path and deviations from that path be corrected promptly. The fiscal discipline requirements are achieved easily under the baseline under all fiscal objectives. However, overall fiscal balances deviate significantly from the targeted 1.5 percent of GDP under all shocks and all objectives (Figure 5). Under a 7-year rolling surplus, the overall balance deviates the least and corrects faster than under the other objectives. Under an expenditure growth limit, the overall balance strays the most and easily tends to exceed a deficit of 0.5 percent of GDP especially under a growth shock; yet, it correct within 2 years under all shocks. The augmented growth-based objective has the longest period of restoring a surplus in a lasting manner.
Deviation of the Overall Balance from a Surplus of 1.5 Percent of GDP
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Deviation of the Overall Balance from a Surplus of 1.5 Percent of GDP
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Deviation of the Overall Balance from a Surplus of 1.5 Percent of GDP
(Percent of GDP)
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.21. The debt path does not derail easily under any of the selected fiscal objectives. Gross debt declines to 60 percent of GDP under all fiscal objectives within 8 years under the baseline. Under a growth shock, achieving the target is delayed by a year, and under an interest rate shock it is delayed by two years. Given a contingent liability shock, additional 6 years are needed to bring debt down under the 7-year rolling surplus and the structural surplus, and 3 additional years under the augmented growth-based object. The debt path remains unchanged under an expenditure growth rule; however, longer period would be needed to bring debt down if the contingent liability expense is excluded from the expenditure limit.
22. These simulation results lead to the following conclusions:
Fiscal discipline is well maintained with a 7-year rolling surplus, which allows flexibility in reaching the overall balance target, but also contains deviations from it.
The limit on expenditure growth with deficit brake shows large overall balance amplitude, but if combined with an automatic correction mechanism, adjusts the overall balance promptly. The stringent correction mechanism also makes this objective most likely to support debt sustainability under all shock scenarios.
D. Summary Assessment
23. To assess the overall quality of the fiscal objectives, a grading scale helps summarize the simulation results. The performance of the fiscal objectives is ranked under every shock and averaged according to the criteria set in Hughes et al. (2012) (Table 2). The grading scale varies from 1–4, with greater score indicating better performance under the criteria.
Assessment Criteria
Assessment Criteria
| Objective | Criteria | Measurement | Higher Score |
|---|---|---|---|
| Adjustment to shocks | Counter-cyclical fiscal policy | Negative correlation between output gap and the fiscal impulse (change in the structural balance with a negative sign). | Lower negative correlation between output gap and fiscal impulse. |
| Volatility | Standard deviation of GDP growth | Lower GDP growth volatility | |
| Operability | Simplicity and Transparency | Compliance does not require great forecasting precision or use of output gap or structural balance measure. | Score reduced by: 3 points for use of structural balance; 1 point for use of projection horizon; 1 point for use of long-term growth. |
| Facilitates multi-year budget planning | Primary expenditure do not have to be reduced by more than 1.5% of GDP in any given year under shock | Lower expenditure volatility | |
| Fiscal Discipline | Long-term debt sustainability | Years to reduce general government debt to 60% of GDP | Fewer years |
| Prudent fiscal stance and correction for slippage | 1.5% overall surplus and deficit not exceeding 0.5%; years to restore surplus after slippage | Fewer years |
Assessment Criteria
| Objective | Criteria | Measurement | Higher Score |
|---|---|---|---|
| Adjustment to shocks | Counter-cyclical fiscal policy | Negative correlation between output gap and the fiscal impulse (change in the structural balance with a negative sign). | Lower negative correlation between output gap and fiscal impulse. |
| Volatility | Standard deviation of GDP growth | Lower GDP growth volatility | |
| Operability | Simplicity and Transparency | Compliance does not require great forecasting precision or use of output gap or structural balance measure. | Score reduced by: 3 points for use of structural balance; 1 point for use of projection horizon; 1 point for use of long-term growth. |
| Facilitates multi-year budget planning | Primary expenditure do not have to be reduced by more than 1.5% of GDP in any given year under shock | Lower expenditure volatility | |
| Fiscal Discipline | Long-term debt sustainability | Years to reduce general government debt to 60% of GDP | Fewer years |
| Prudent fiscal stance and correction for slippage | 1.5% overall surplus and deficit not exceeding 0.5%; years to restore surplus after slippage | Fewer years |
24. There is no ideal fiscal objective and trade-offs between countercyclicality, sustainability and predictability need to be weighed carefully. As the results above show cushioning the economy comes at a cost of slower debt reduction and expenditure swings that could undermine the deliverability of a chosen fiscal objective. It could also require subsequent painful adjustment in a scale that may appear unreasonable for the legislature and the public. Hence, sustainability and ease of implementation may have greater weight in choosing an objective than the appeal of a more active countercyclical fiscal policy.
25. The limit on expenditure growth with deficit brake provides by design the best countercyclical features by accommodating fully GDP growth deviations. It thus buffers the economy in downturns and reduces output volatility (Figure 6). Because it is constrained by a deficit brake, this objective allows the overall balance to correct relatively easily and supports long-term sustainability. However, it is marred by a very volatile primary expenditure pattern under all shocks, and especially should the government have to recognize contingent liabilities. Because it allows large deviation from the targeted 1.5 percent surplus, corrections could be very painful and require severe expenditure restraint. Abrupt adjustment, therefore, could become tiresome and difficult to implement.
Summary Assessment
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Summary Assessment
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Summary Assessment
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.26. The augmented growth-based surplus is more moderate in its countercyclical performance, and therefore, in its ability to soften output volatility. Under growth and interest rate shocks, it fares similarly to a limit on expenditure growth. However, it is highly procyclical and less resilient to volatility under a contingent liability shock. The expenditure oscillations could also make this rule challenging for medium-term budget planning, as projecting the expenditure path would hinge upon knowledge of the precise shock impact. This also makes the augmented growth-based surplus difficult to correct on a lasting basis once a slippage is evident.
27. The 7-year rolling surplus is generally acyclical and shows strong countercyclical features only under a contingent liability shock. Nonetheless, it provides relatively good policy guidance by maintaining the fiscal stance and quickly correcting for slippages from one year to the next. It provides for a stable expenditure path, and thereby promotes reliable multi-year budget planning. Finally, its properties resemble the properties of a structural surplus under most shocks, thus being a good alternative for a structural surplus objective, should the latter be considered.
28. In summary, given equal weights of all assessment criteria, the limit on expenditure growth with deficit brake scores better than other fiscal objectives. The limit on expenditure growth with deficit brake appears to have superior performance in providing countercyclical fiscal impulse under all standard shocks (Table 3). As long as it is combined with an automatic correction mechanism in case of slippage from the implicit overall balance target, this objective is also appropriate in maintaining debt sustainability. Its main caveat is the potential to induce significant expenditure volatility, especially under contingent liability shocks. Addressing this problem would require excluding irregular items—such as write-offs—from the expenditure growth limit, but would risk introducing a more complex, less transparent, and less comprehensive fiscal objective and lengthening the debt reduction horizon.
Summary Scores
Summary Scores
| Assessment Criteria | Seven-Year Rolling Surplus | Augmented Growth-Based Objective | Limit on Expenditure Growth | Structural Surplus |
|---|---|---|---|---|
| Counter-cyclical fiscal policy | 1.8 | 2.3 | 3.5 | 2.5 |
| Volatility | 1.5 | 2.5 | 4.0 | 2.0 |
| Simplicity and transparency | 2.0 | 3.0 | 3.0 | 1.0 |
| Multi-year budget planning | 2.5 | 2.3 | 1.8 | 3.5 |
| Long-term debt sustainability | 3.3 | 3.8 | 4.0 | 3.3 |
| Correction for slippage | 3.3 | 1.0 | 3.0 | 1.8 |
| Average Score | 2.4 | 2.5 | 3.2 | 2.3 |
Summary Scores
| Assessment Criteria | Seven-Year Rolling Surplus | Augmented Growth-Based Objective | Limit on Expenditure Growth | Structural Surplus |
|---|---|---|---|---|
| Counter-cyclical fiscal policy | 1.8 | 2.3 | 3.5 | 2.5 |
| Volatility | 1.5 | 2.5 | 4.0 | 2.0 |
| Simplicity and transparency | 2.0 | 3.0 | 3.0 | 1.0 |
| Multi-year budget planning | 2.5 | 2.3 | 1.8 | 3.5 |
| Long-term debt sustainability | 3.3 | 3.8 | 4.0 | 3.3 |
| Correction for slippage | 3.3 | 1.0 | 3.0 | 1.8 |
| Average Score | 2.4 | 2.5 | 3.2 | 2.3 |
E. Robustness
29. Simulations show that the parameters of the objectives could have an impact on the results, which may require further robustness checks. In particular, the lag period of a rolling average surplus objective changes its stabilization properties and could impair its credible implementation. On one hand, greater weight and more lags require more severe expenditure containment in the face negative shocks, which hinders the ability of the government to provide an adequately countercyclical response. On the other hand, more forward periods included in the objective could create incentives to “kick the can down the road” and ultimately undermine both the credibility of the fiscal rule and long-term fiscal sustainability.
30. Varying the degree of fiscal adjustment could augment the expenditure path and make it more stable, but not without a cost. This is evident under an augmented growth-based objective, where changing the coefficient of fiscal adjustment on slippage—a lower coefficient implies faster adjustment—reduces expenditure volatility significantly. However, this comes at the expense of longer time to bring gross debt to the 60-percent ratio (Figure 7).
Trade-off between Expenditure Predictability and Sustainability
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Trade-off between Expenditure Predictability and Sustainability
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.Trade-off between Expenditure Predictability and Sustainability
Citation: IMF Staff Country Reports 2012, 090; 10.5089/9781475503128.002.A001
Source: IMF staff estimates.F. Conclusions
31. As Iceland embarks on a new fiscal policy framework, the choice of a policy objective will have important implications for building credibility in the new OBL. A numerical fiscal rule addressing the challenges Iceland currently faces while remaining appropriate in the long run may be difficult to design. Hence, a procedural fiscal rule would allow sufficient flexibility to amend the fiscal objectives as Iceland’s circumstances evolve. Selecting an objective that breaks the relentless pressure for overspending would clear the path for faster debt reduction and instill a habit of sustainable fiscal policy making. However, Iceland’s small and open economy will remain more volatile than other advanced economies in the foreseeable future. It will therefore be important that the government select a fiscal objective that is flexible enough to provide some breathing room to the economy in the event of large growth or interest rate shocks. The government is also still facing large contingent liabilities and the chosen fiscal objective should remain feasible even if substantial fiscal risks materialize.
32. Selecting the objective will require careful consideration of the trade-offs. Iceland used to have (an informal) fiscal rule limiting expenditure growth, and there may be some interest in revamping the rule. A fiscal objective that limits real expenditure growth has clear benefits in cushioning the economy and being transparent. However, making such an objective fiscally prudent and sustainable may lose its appeal as expenditures become less predictable and adjustments more dramatic. The augmented growth-based surplus also poses a similar trade-off, especially if slippages are to be corrected promptly. The 7-year rolling surplus could be an easy to implement alternative, as it provides a smooth expenditure path and could be more fiscally prudent, but is not as transparent as the other two objectives. This could open the door for constant delay of adjustment on the grounds of overly optimistic future projections and ultimately undermine the very traits that made this objective appealing. Taken together, these findings imply that no one fiscal rule can fully meet all of the criteria for a preferred fiscal objective. Thus, careful consideration of the tradeoffs and priorities will be needed.
G. References
Badinger, H, 2008, Cyclical Fiscal Policy, Output Volatility, and Economic Growth, CESifo Working Paper No. 2268.
European Commission, 2012, Treaty on Stability, Coordination and Governance in the Economic and Monetary Union.
Fatas, A. and I. Mihov, 2003, The Case for Restricting Fiscal Policy Discretion. Quarterly Journal of Economics, 4, pp. 1419–1448.
Hughes R., T. Irwin, I. Petrova, and E.R. Karlsdottir, 2012, “Iceland: Technical Assistance Report on a New Organic Budget Law”, IMF Country Report 12/4.
IMF, 2009, “Fiscal Rules—Anchoring Expectations for Sustainable Public Finances”.
Kopits, G, and S. Symansky, 2008, Fiscal Policy Rules, IMF Occasional Paper No. 162.
Talvi, E. and C. Vegh, 2005, Tax Base Variability and Procyclical Fiscal Policy in Developing Countries. Journal of Development Economics, 78(1), pp. 156–190.
Prepared by Iva Petrova
See IMF, 2012, Fiscal Monitor.
See European Commission, 2012, “Treaty on Stability, Coordination and Governance in The Economic and Monetary Union”. The Treaty requires that countries adopt national legislation to limit annual structural deficits to 0.5 percent of GDP and commit to debt reduction to 60 percent of GDP with an annual pace of reduction no less than 1/20th of the distance between the actual and the targeted debt level.
A general discussion of fiscal rules is provided in IMF, 2009, “Fiscal Rules—Anchoring Expectations for Sustainable Public Finances”.
In 2003, the government announced in a policy declaration the intention to follow a quasi-fiscal rule limiting central government consumption to 2 percent per year and transfers to 2.5 percent per year. The fiscal objective analyzed in this paper (limit on real spending growth with a deficit brake) differs from the quasi-fiscal rule as it applies to the general government, does not set different growth rates for different expenditure categories, and introduces an automatic deficit correction mechanism.
IMF staff estimates suggest that the semi-elasticity of the overall balance with respect to the output gap—i.e., the difference between the cyclical sensitivity of the revenues and expenditures—is 0.28 in Iceland. This is somewhat lower than the elasticity estimated by Girouard and Andre (2005) of 0.37 for Iceland, and 0.44 for the OECD. Simulations using higher semi-elasticities (up to 0.5) do not show substantial differences in results.
This is not always the case. Badinger (2008) finds that (discretionary) cyclical policy, regardless whether it is procyclical or countercyclical is associated with greater volatility. He argues that countercyclical fiscal policy could actually increase volatility if there is a delay in recognizing the need for it and implementing the necessary measures. Talvi and Vegh (2005) argue that procyclical policies are correlated with greater volatility in part because lobbying creates a procyclical bias during booms..
See Kopits and Symansky, 2008, Fiscal Policy Rules.
Appendix I: The Financial Sector Elements of the Model
1. The model’s financial interactions build on four essential ingredients. First, banks are agents with their own balance sheets and their own net worth, referred to as bank capital, and they can inflate (or deflate, for that matter) their assets and liabilities on demand. In other words, the role for banks is not reduced to just intermediating funds between savers and borrowers, but also allows for demand for bank liquidity satisfied by creating additional bank credit at the same time. This dual role for financial intermediation is critical for the model to be able to produce a realistic relationship between real economic activity and bank credit. Moreover, the lending by banks is in both local currency as well as foreign currency, which allow the model to capture the extent of financial “dollarization” that have been prevalent in Iceland.
2. Second, the main factor determining the evolution of bank capital is capital regulation, and not private contracts between banks and their depositors (as is the case in a large amount of existing literature). Furthermore, capital regulation is introduced not as a hard-wired, ever binding constraint on the capital adequacy ratio, but rather as an incentive-based mechanism under uncertainty. Banks’ optimal choice is then to hold capital buffers in excess of the regulatory minimum, with the buffers endogenously varying over time depending, in part, on the size of expected credit losses. The buffers are a very important indicator of financial cycles, i.e. the cycle in the risk on bank balance sheets.
3. Third, credit risk associated with bank lending has both an idiosyncratic component and a macro (or common) component. The probabilistic foundations of the credit risk in the model are adapted from the loan portfolio value theory and bank capital at risk (BAR) methodology. While the idiosyncratic component can be diversified away in large enough portfolios, the macro component stays on the balance sheets, and leaves the banks exposed to possible unexpected losses. The macro credit risk is determined endogenously by the developments in the real sector and its interactions with bank balance sheets.
4. Fourth, we introduce a distinct role for the central bank’s balance sheet, namely its foreign exchange reserves. Monetary policy is characterized by a simple inflation-targeting rule and a flexible exchange rate, but the model does permit management of the exchange rate to meet monetary policy and macro-prudential objectives. Specifically, through an ad-hoc portfolio balance channel, we allow partially sterilized interventions (sterilized in the sense that the local currency interest rate remains under the control of the central bank to have at least short-term effects on the nominal exchange rate. Combined with the model’s non-linearities, the forex reserves can be then thought of not only as an additional monetary policy tool but also as a pre-cautionary macro-prudential measure.
5. There are two critical non-linearities in the model mechanisms. The first non-linearity is in how the bank lending supply curve reacts to the risk of lending to an individual borrower. The second one is in how the bank adjusts its leverage and capital adequacy in response to the risk of a whole loan portfolio. Moreover, these two non-linearities reinforce each other since the loan portfolio value is endogenously derived from the distribution of some of the real economic fundamentals (such as the price of capital).
6. In the baseline calibration of the model, we consider several aspects both Iceland’s economic structure as well as stylized facts of a number of small, open, emerging market economies in Europe, Latin America, and Asia to calibrate the four basic groups of parameters: steady-state, transitory, policy, and financial.
The steady-state parameters were calibrated with various long-run structural indicators such as average export and import shares of GDP, the net investment position, the net foreign asset position of the banking sector alone, employment in the exporting industries, composition of tradables and nontradables in final prices, and so on.
The transitory parameters were set to produce plausible dynamic responses, especially to match existing empirical evidence on the exchange rate pass-through into final prices and the cyclicality of demand components.
The policy parameters were chosen to guarantee realistic policy trade-offs (measured by indicators such as sacrifice ratio or the costs of temporarily inactive policy).
The calibration of the financial sector, in particular the various aspects of the distribution of risks, was largely based on a heuristic method: finding sensible thresholds at which the built-in nonlinearities become influential in the interactions between real economic activity and the bank balance sheets. However, the techniques of empirical validation for such financial characteristics in models with macroeconomic-financial linkages are in their infancy. Therefore, the model simulations should be considered more as stylized representations of the result of a shock rather than empirically accurate predictions.
F. References
Baldursson, F. M., (2009). What lessons can be drawn from economic development and policy in Iceland in the 20th century?—Economic historians answer S. Agnarsson. Saga, 47, 17–19
Buiter, W. H., (2000). Is Iceland an optimal currency area? Central Bank of Iceland, Working Paper, no. 10.
Buiter, W. H., and A. Sibert (2008). The Icelandic banking crisis and what to do about it: The lender of last resort theory of optimal currency areas. CEPR, Policy Insight, no. 26.
Central Bank of Iceland, 2010 “Monetary Policy in Iceland After Capital Controls,” Report No. 4, December (Central Bank of Iceland: Reykjavik).
Daníelsson, J., and G Zoëga (2009). The collapse of a country. London School of Economics and University of Iceland.
Jónsson, Á., (2009). Why Iceland? New York: McGraw-Hill.
OECD (2006, 2008, 2009). Iceland. OECD Economic Surveys. OECD Publishing.
Francis Breedon (2011), Thórarinn G. Pétursson and Andrew K. Rose, Exchange rate policy in small rich economies, Central Bank of Iceland, Working Paper, no. 53.
IMF Staff Discussion Note SDN/11/06; April 5, 2011. Managing Capital Inflows: What Tools to Use? by Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mahvash S. Qureshi, and Annamaria Kokenyne.
Rudebusch, Glenn, and Tao Wu, 2003, “A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy,” Federal Reserve Bank of San Francisco Working Paper 2003-17, September, (San Francisco: Federal Reserve Bank of San Francisco).
Sighvatsson, Arnór, Deputy Governor of the Central Bank of Iceland, speech delivered to the Icelandic Federation of Labour, 10 January 2012.
Stiglitz, J., Monetary and Exchange Rate Policy in Small Open Economies: the Case of Iceland, Central Bank of Iceland, Working Paper, no. 15.
Prepared by Jaromir Benes, Alexandre Chailloux, and Nathan Porter.
Arnor Sighvatsson, Deputy Governor of the Central Bank of Iceland, 10 January 2012
This country set was selected to cover emerging and industrialized countries having adopted inflation targeting or an hybrid regime including some reference to an inflation target.
As measures of the domestic and imported prices we use sub-indices of the CPI published by Statice. A caveat to this analysis is the import component of domestic goods that is not published.
Long-term bond yields are generally seen as reflecting information on inflation expectations (Rudebusch and Wu, 2001).
The long-term level of nominal yields is derived from a Nelson-Siegel model representation of Iceland’s government yield curves used by the Research Department of the Central Bank of Iceland.
The monthly proxy for GDP growth is a monthly principal component using a factor model (based on export, import and retail sales monthly data).
The null hypothesis that inflation does not cause the level factor of long-term yields can be rejected at a 10% threshold, and likewise the null hypothesis that inflation shocks do not cause the level factor of long-term inflation break-even yields can be rejected at a 10% threshold.
The survey of market participants was published by the CBI in February 2012.
The probability distribution assumes that survey responses are normally distributed.
Moreover, lending standards are (endogenously) slightly tighter under the “leaning against the wind policy” than under the macro-prudential policy, since banks respond to forced higher capital buffers by lowering their lending standards.
