Deficit cutting - we <i>can</i> do it

It could be said that when a person realises that he has a chronic alcohol problem he has three principal options open to him: to blame the perceived causes, most probably the people close to him, the boss, wife, the business; to seek medical advice; or to join a supportive group like the AA (Alcoholic Anonymous) to learn from their proven successful experience in dealing with the problem.

Malta is realising that it has in fact a chronic deficit problem. The press is full of articles pinning the blame on one or the other. My choice is left with either providing technical and highly theoretical advice pitting Keynesian against neo-classical schools of thought on the subject; or to turn to the widely documented and proven record of successful cases of fiscal consolidation (i.e. deficit cutting). In this article I opt for the latter option.

Finance ministers worldwide have their own institution in this field. It is not AA but the IMF. Over the past three decades it has purposely documented budgetary behaviour of many industrial countries which have tried to rein in the public deficit and to draw some lessons from their successes and failures.

Fiscal deficits, no matter what their bad economic side effects are, have one thing in their favour: they push money around, creating jobs, high salaries, generous benefits and fat contracts, making people content and happy. The analogy with alcohol could not be better. Trying to wean the country or going cold turkey could be devastating to the economy, putting people out of work, drying up public contracts and creating a liquidity shortage.

If carried out successfully, it gives the public and the business sector the breath of fresh air it has been really waiting for - a large measure of confidence that the government is really in control of its own expenditure, that programmes are really sustainable and nobody should feel guilty any more that we are shoving huge unsustainable fiscal burdens on our children. Investment and economic growth would respond accordingly, creating jobs for all who seek them and afford the social benefits for those who need them. More significantly, tax burdens are lightened, leaving more discretionary consumption to the household.

Benchmarks

You cannot talk about success or failure unless you have a benchmark. The IMF is very categorical about it. A 1.5 percentage fall in the ratio of the structural primary fiscal balance to potential GDP over a two-year period is considered an episode of fiscal consolidation. This ratio takes care of the vagaries of the business cycle and interest payments. The IMF identified no fewer than 74 such episodes over the above mentioned period and group of countries.

Success is measured differently. It is a reduction of at least three percentage points in the ratio of public debt to GDP over a three-year period - no mean feat. Of the various episodes recorded, only 14 were considered unequivocally successful.

What is encouraging is that in all the countries which succeeded, economic growth, investment and job creation increased on average throughout the period. The unemployment rate declined. Among the countries proud of this accolade we find Denmark, Ireland, Australia, Norway and Sweden in the mid to late Eighties; New Zealand in the early Nineties.

For the unsuccessful cases, some with half-hearted attempts one might add, the performance was patchy but on average real GDP fell and the unemployment rate went up.

Before embarking once again on our own fiscal consolidation it is important for us to be aware of the pitfalls and the making of a successful roadmap.

The fiscal contraction over the next two years should not be less than four per cent of GDP. This was the average rate in the successful countries. It was in fact almost one percentage point higher than the unsuccessful ones. More importantly like the successful cases it has to be taken as part of a broader reform programme, which enhances the overall credibility of the government's commitment to the consolidation.

We now come to the most difficult home truths of all. Government employment, the government wage bill and government consumption were cut in the successful cases, but remained constant or increased in the unsuccessful episodes.

Social security payments and transfers were kept in check in the successful episodes, but expanded as a share of GDP in the unsuccessful cases.

Furthermore the chances of success in cutting the deficit through increasing revenue is significantly lower than by cutting public expenditure (one in six against one in two).

One encouraging note is that in the successful cases laggard growth spurred governments to take tough choices.

It is also important to clear some myths. Some may argue that this is not the right time to cut government expenditure in view of the situation regarding the world economic cycle. It has been shown from experience that while better timing does help, it will not guarantee success. Furthermore, in none of the countries could the debt to GDP ratio fall by rapid economic growth alone. Substantial fiscal consolidation was also necessary.

We are not unique

By looking at this wide experience I think we should reach a point to admit that whatever our own home- grown causes, a soaring budget deficit has been and still is a very common experience in the industrial world. More often than not a welfare state built and sustained under different economic social and demographic circumstances becomes unsustainable because it is not able to adapt to the changing local and international environment. After all, a deficit comes about simply because government expenditure grows faster than the country's ability to produce goods and services.

Likewise however we must also realise than countries with economic problems and complexity much larger than ours did something about it even though it meant unpalatable measures. Denmark brought its deficit down by 10 percentage points in four years. New Zealand turned a five per cent deficit into a three per cent surplus - both countries boosting their economies.

These are real stories with real people, not fairy tales. Closer to home is the Irish lesson. In early 1980 Ireland cut its deficit by seven per cent of GDP in two years through increased taxation but failed to sustain it and, worse, saw its economy taking a dive.

Subsequently in 1987 another fiscal adjustment of the same magnitude this time through public expenditure cuts saw to a sustained and significant reduction in the debt to GDP ratio with the economy booming for more than a decade.

There is nothing mysterious about our local conundrum. Ireland experienced it during the first half of 1980. Like them, we opted to close the deficit by increasing revenues. On paper it appeared we were going to succeed. But the increased taxation depressed the economy further. Abetted by the international slowdown, the national income was not able to cough up the required revenues to keep up with the somewhat unrestrained expenditures. We came back to square one.

We now need to go through the Irish Part II late 1980s experience. Learning from theirs and others' experiences such as the Netherlands with their Dutch Miracle is an eye-opening experience in itself. The solutions are definitely not easy for reasons that we shall analyse in the near future.

But once we are made to see the light at the end of the tunnel and the policy measures are seen by the financial markets, the investors and the public at large, to be credible and convincing, then the much desired job-creating boost to the economy will lead to the sustainable virtuous circle observed by the IMF in the successful countries. There is no reason why Malta should not be among them too.

Professor Scicluna has served as chairman of the Malta Council for Economic and Social Development for the past four years