Friday, August 1, 2014
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A Cure for Fiscal Failure?

CAMBRIDGE – Should more countries create independent fiscal advisory councils to infuse greater objectivity into national budget debates? Jailed swindler Bernie Madoff recently summed up a lot of people’s feelings about fiscal policy, declaring that “the whole government is a Ponzi scheme.”

Perhaps this was just wishful thinking from a man who will die in prison after his own record-breaking $50 billion pyramid scheme collapsed in 2008. Personally, I suspect Madoff’s unenviable place in the record books will be secure for quite a while. Still, with many of the world’s largest governments facing a lethal combination of unsustainable conventional debt, unprecedented old-age pension obligations, and a downshift in growth, one has to wonder what the fiscal plan is.

In a new paper, “A Decade of Debt,” Carmen M. Reinhart and I show that general government debt in the United States, including federal, state, and local debt, has now surpassed the record 120% of GDP reached at the end of World War II.

Japan, of course, is in even worse shape, with government debt totaling more than 200% of GDP. Though this is partially offset by foreign-exchange reserves, Japan now faces massive disaster-relief costs – and this on top of its depressing demographic trends. Many other rich countries’ debt levels are also uncomfortably close to 150-year highs, despite relative peace in much of the world.

There is a no easy way out. For now, low world interest rates are restraining debt-service costs, but debt levels can be reduced only very gradually over long periods, whereas real (inflation-adjusted) interest rates can rise far more quickly, even for rich countries. Debt crises tend to come out of the blue, hitting countries whose debt trajectories simply have no room for error or unplanned adversity.

The single most immediate and direct impact of having an independent fiscal policy would be to reign in spending by producing a counterpoint to Panglossian government growth and revenue forecasts. In principle, an independent and respected advisory council could also force governments to acknowledge the hidden costs of government guarantees and off-balance sheet debts.

It is high time to consider novel approaches. Of course, no one simple change will eliminate the huge bias towards deficit spending in most modern political systems. And no one simple change will preclude the risk of future debt and inflation crises. Many countries require sweeping reforms to make their tax systems more efficient and their entitlement programs – including their pension schemes – more realistic.

The recent advent of fiscal advisory councils is a promising institutional start. A number of countries, including Denmark, the Netherlands, the US, and Belgium, have long-standing fiscal watchdog agencies, such as the US Congressional Budget Office (CBO). But, while these older institutions have proven enormously useful, they are typically quite constrained. The CBO, for example, is free to issue long-term fiscal projections based on its own best estimates of growth, but is largely forced to accept politically implausible future “fixes” at face value, somewhat neutralizing the potential effectiveness of any critique of deficit policies.

To enhance credibility, a number of governments are gingerly moving towards creating fiscal councils with greater independence, often with central banks as a role model. The new vanguard includes councils in Sweden, the United Kingdom, Slovenia, and Canada.

The remit of Sweden’s fiscal council is particularly broad, giving it a mandate not only to forecast, but also to look more deeply at the motivations and consequences of government policy. In principle, an independent fiscal council could have provided invaluable help during the financial crisis. In the US, such an agency could have weighed in on the costs and benefits of bailout plans, perhaps helping to end congressional paralysis and steeling nerves to give taxpayers more upside risk.

It is too much to expect that these new fiscal institutions will become as important or powerful as central banks, at least anytime soon. There is far more consensus over monetary policy than over fiscal policy. And fiscal policy is far more complex and multi-dimensional. Still, the general principle seems like an important step towards fiscal sanity.

Of course, fiscal councils by themselves are not enough, no matter how well designed they are. It will remain very tempting for each generation to say, “My grandchildren will be two or three times richer than I, so who cares if they have to pay some debt?” Moreover, the political cycle creates a very strong deficit bias, as leaders seek to embellish feelings of economic health and prosperity by raising visible expenditures at the cost of hidden debts and lower long-term investment.

To resist these powerful pressures, fiscal councils will need to have their work audited periodically by international agencies such as the International Monetary Fund, both to protect their independence and to promote accountability.

To be sure, Bernie Madoff may yet be proved right, and his will not turn out to be the biggest Ponzi scheme ever. But greater transparency and a more systematic independent evaluation of government policies could be a very helpful step towards solving the perpetual conundrum of outsized deficits. It is certainly one of the more innovative and promising ideas to emerge from a rather barren policy landscape.

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