January 20, 2010

The Factors and Motivations of Fiscal Stability

A Comparative Analysis of 26 Countries
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There has been a rising academic debate on the sustainability of deficit spending and accumulated debt in governments across the globe. This correlates with a growing concern that excessive government deficits and accumulated debt will lead to unstable financial environments and a devalued quality of life for future generations. Varying economies with varying fiscal behavior have increased incentives to work toward more responsible fiscal behavior through reining in deficit spending and debt accumulation. We seek to understand the process these economies undertook, the procedures they used, and the resulting effectiveness of those procedures on achieving fiscal stability. This paper takes a broad, case-study view of 26 countries and some of the plausible factors and motivations that have led them to aim for fiscal prudence. While case studies like this cannot be definitive on causation, they are certainly suggestive. We look for policy reforms that may cause better long-run fiscal performance.

The countries were chosen based on their large economies (having $100 million GDP or greater), exclusive of any strongly unique budget characteristics, and for their availability of reliable data. As a result, all of the countries selected are democracies and relatively free economies. The time frame of 1980 to 2007 was chosen and data was gathered from three main sources: The World Bank, the International Monetary Fund, and the Organisation of Economic Cooperation and Development. The measures used include total central government debt as percent of GDP, the budget balance or general government balance as percent of GDP (total revenue minus total expenditure divided by GDP), dates when various fiscal stability rules were passed (specifically focusing on budget targets and expenditure limits and excluding general budget and reporting methods). Each country analysis includes a graph demonstrating these measures over the time period selected.

Additionally, we look at four main political factors that we believe may be of significance in achieving fiscal stability: fiscal stability legislation, political structure, public accounting methods, and transparency. Fiscal stability legislation, especially budget targets and spending limits, are often present in countries trying to achieve fiscal balance. Varying fiscal legislation, reform, and commitment can be affected by differing government systems and their political climates. Accounting and budgeting frameworks that are structured on the principles of accrual build creditability and transparency and may increase the likelihood of sustainable fiscal stability by forcing policy makers to look at and deal with future assets and liabilities.

Our comparative analysis puts countries into one of three categories ("Success!," "Not Quite," and "Not Close") based on whether they meet the commonly used measures we‘ve selected for fiscal stability in an economy‘s quest for fiscal responsibility. In order to determine the fiscal stability outcome for our countries, we have adopted guidelines established by the European Union‘s (EU) Maastricht Treaty and a time requirement of ten consecutive years of compliance.

The Stability and Growth Pact within the Maastricht Treaty establishes limits on the general government fiscal deficits to a maximum of 3 percent of GDP and on the general government debt to a maximum of 60 percent of GDP. These budget balance and debt targets were agreed and implemented by all members of the European Union as a sophisticated benchmark of fiscal stability. A target of 3 percent may be a reasonable goal if long-run real growth is expected to be around 3 percent for as long as the deficit grows at the same rate as the economy, it should not ever outgrow the economy. Therefore, "Success!" represents compliance with both the deficit and debt guidelines for a time span of ten years or greater. "Not Quite" covers countries that have achieved a ten-year run of success for their debt or budget balance but were unable to maintain both for the same period of ten years. "Not Close" categorizes countries that do not meet our criteria for either budget balance and debt level for the any consecutive ten-year time span.

Our analysis shows that the countries in the "Success!" category include the Netherlands, Ireland, and Finland from the EU, as well as Canada, South Korea, Australia, Switzerland, Hong Kong, and New Zealand. The countries within the "Not Quite" category include the United Kingdom, France, Spain, Belgium, Sweden, Austria, Denmark, Poland, and Czech Republic from the EU, and the United States, Japan, Brazil, and India. Finally, the "Not Close" countries are Italy, Greece, Portugal, and Hungary from the EU.

Our conclusions are as follows. For EU countries, there has been a general shift towards fiscally balanced budgets in light of the Stability and Growth Pact. Such results lead to the question as to whether the numerical targets implemented ultimately determine the results of fiscal stability. If the Growth and Stability Pact had focused on a target of 1 percent instead of 3 percent, would there have been a larger trend towards government budget balance? Along these lines, countries that have implemented their own rules appear to be more fiscally disciplined than others, EU member and non-member countries alike.

Additionally, the implementation of accrual accounting and budgeting is a major indicator of fiscal prudence. Finally, we conclude that countries achieving "Success!" tend to either (1) have a history of stability and transparency or (2) have faced some crisis which motivated fiscal stability and other government reform. This research has illuminated the fact that countries which are making reforms in accounting and reevaluating the roles of government (to respond to a national crisis or to earn a competitive edge) have been able to achieve and sustain fiscal stability.