Wednesday, June 29, 2011

The seven rules of fiscal policy

Jun 28, 2011
By Gerard Lyons

GREECE is insolvent. It could go bust at any time. To prevent this happening, it needs further financial assistance from the wealthier 'core' nations of the euro area. These core economies, such as Germany, are in good shape. The trouble is, in return for any further money to pay its debts, Greece will be forced to take tough measures to get its economy back into shape. But these measures spell recession.

Problems in Greece are focusing attention on the tensions in the euro area. But events in Greece also carry some significant lessons for countries across the globe - namely, the importance of sound, sensible fiscal policy - in good times as well as in bad.

There are some key issues - which I call 'the seven rules of fiscal policy' - which are vital. Across the emerging world these lessons need to be learnt now, in order to position economies for the future.

First and foremost, countries should run budget surpluses in good times - simple as that. This is when the economy is strong, companies are doing well and many people are in work. Tax revenues in this environment should be buoyant. Moreover, a government will be spending less on its social welfare system. The trouble is, when things are going well, governments do not always stick to this most basic of rules.

Countries more often try to change when things are going badly, and yet this is when their economies are least able to cope. The United States and Britain ran budget deficits - with annual government spending exceeding revenues - during the boom years. Greece, too, fell at this hurdle, unable to raise tax revenues from enough of its citizens.

Clearly, countries which run surpluses in good times are better able to respond to an economic downturn, financial crisis, or external shock by using fiscal policy.

The second rule is to use fiscal policy as a counter-cyclical tool
. If people and firms cut their spending, this threatens a downturn, or even recession. In this situation, governments can respond by boosting spending, or by cutting taxes. This has been used very effectively in the recent crisis.

The London Group of 20 (G-20) Summit of world leaders in 2009 was a great success. It ensured countries relaxed fiscal policy, thus preventing the global economic situation from becoming far worse and, in all probability, helping avoid a depression. But it is far better to do this from a position of strength - as China, for instance, did with its huge fiscal stimulus in the aftermath of the financial crisis. In contrast, while the US and Britain had much-needed fiscal boosts, they did so from a position of weakness, with budget deficits already running high.

The ability to use fiscal policy in a downturn can take the pressure off monetary policy to act as a policy shock absorber in a downturn. This would avoid concern - sometimes misplaced - about the unorthodox nature of monetary policy.

The third rule - applicable to many in the West today - is that when fiscal policy is tightened, there has to be a credible medium-term plan. This helps keep the financial markets on-side and borrowing costs down. A credible medium-term plan is one that makes sense in terms of the targets, and one which the markets expect to be adhered to. That, in turn, depends on how the economy will cope.

A pro-cyclical fiscal policy that tightens when an economy is already in recession, as, for example, in parts of peripheral Europe now, would not be considered credible. It might be seen as not sustain-able in either economic or political terms. Tightening fiscal policy when the private sector is weak and when there is no offsetting easing in monetary policy is pro-cyclical. It is akin to being in a hole and digging deeper.

This brings us to the fourth rule: which is that when fiscal policy is being tightened, monetary policy has to be accommodating. That is, interest rates have to be low. This is a key requirement. If monetary policy is tightened instead, then the economy will slip into, or stay in, recession.

The challenge for monetary policy becomes harder when there is a relative price shock in the form of higher commodity prices, as seen over the past year. It is important for central banks to resist the pressure to tighten, especially in an economy where wages are not rising. Hence, Europe's peripheral economies - such as Greece - where wages are falling but which are not in control of their own monetary policy, are squeezed. In contrast, the Bank of England can keep monetary policy accommodative. So, too, can the Federal Reserve, although in the US, policy has not yet been tightened.

These four rules make sense, regardless of the politics. The next few rules are also important but can sometimes offer flexibility in interpretation.

This is certainly the case with Rule Five: the speed and scale at which fiscal policy is tightened is a judgment call.

Ideally, in my opinion, it is best to wait until the private sector is strong enough before government spending is cut, or taxes are raised. In that situation, the private sector is better able to cope. However, it has to be recognised that when countries are in fiscal difficulty they do not always have this luxury. For instance, the periphery of Europe is forced to accept tough fiscal policies as a condition of receiving help from the centre. This is at a time when their economies are very weak.

Rule Six of fiscal policy is 'avoid a debt trap'. Changing slightly one word of a well-known song, 'It's a debt trap and you've been caught.'

To be caught in a debt trap, two things need to be in place. One is that debt is bigger than the size of the economy. So government debt has to be more than 100 per cent of GDP. The other is that the rate of interest on this debt needs to be higher than the rate of economic growth. This is akin to maxing out on one's credit card and then not being able to afford the monthly interest payment.

When a country is in this situation it has less flexibility on the timing, speed and scale of cutbacks. It also needs to look more closely at using monetary policy. The way out is stronger growth. However, depending on the numbers, running a primary surplus, after interest payments have been made, may help improve the fiscal numbers. A debt trap is bad news and spells economic pain.

A number of countries in the euro area are already in or are close to this debt trap. They need further help from the core, as history shows that monetary union of large sovereign nations cannot survive unless it becomes a political union. Or, as an interim step towards political union, a central treasury might work, but the principle is the same.

If countries are not in a debt trap, they may have some flexibility on the timing of cuts. The US, for instance, is not in this situation yet, despite market worries about its debt being downgraded. How-ever, its level of debt is rising, and is now at 89.4 per cent of GDP. Britain, meanwhile, is nowhere near this situation, with a lower level of debt, of 79 per cent of GDP and a long maturity, relative to other developed economies, in terms of its debt repayments. Thus, unlike Greece, which is insolvent, the US and Britain are not going to go bust.

Rule Seven is the importance of how governments close the gap. That is, where governments spend their money and, especially now, adjust the scale of spending - in other words, how and where taxes are raised. The preference for either should depend on an economy's situation and on where the problem is perceived to be.

For now, the sovereign crisis, linked to fiscal policies, is largely an advanced economy problem. The more a country runs a sound fiscal position in good times, the more it has the scope to respond with counter-cyclical measures in difficult times, and the more it takes the pressure off the need for unorthodox monetary policies, as used in the West in recent years. The effectiveness of fiscal policy is enhanced when it is coordinated with monetary policy. There are many lessons the advanced economies need to learn from this crisis.

It is important that Asia, Africa and the Middle East grasp the lessons from the problems currently facing the US and Europe. The time to get fiscal policy in shape is now - when economies are recovering - and not to leave it until things go wrong.

The writer is chief economist and group head of global research at Standard Chartered Bank.

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