Eva Srejber: The power of transparency for macroeconomic discipline
Speech by Ms Eva Srejber, First Deputy Governor of the Sveriges Riksbank, at the 10th International
Financial Economic Forum, Vienna, 11 November 2004.
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The crisis encountered by the Stability and Growth Pact has put the new enlarged Europe at a
crossroads: either we get our act together and produce better checks and balances in our institutions
or we are going to move down a path of looser fiscal policy and tighter monetary policy.
Both fiscal and monetary policy need the other to be predictable: a government needs the
predictability of a transparent and consistent monetary policy to know how to conduct fiscal policy, and
of course no monetary policy will be sustainable if poor fiscal policies lead to a rapid accumulation of
debt. This is what Sweden witnessed in the 1980s and the 1990s. In the 1980s we had an
unsustainable mix of fixed exchange rates and lax fiscal policy, which led to high inflation and
eventually to a crisis that landed us with an even higher mountain of debt. When the regime collapsed
in 1992 we introduced a target for inflation of two per cent, which today is hailed as a success.
However, the real breakthrough for the new regime was in the mid 1990s when a forceful
implementation of fiscal consolidation, supported by a broad political majority in parliament, made the
whole macroeconomic set-up credible. It was then that inflation expectations among the public finally
trended down to the target of 2 per cent, and that interest rate spreads against Germany were reduced
to fractions of a percentage point. This fiscal tightening could in turn be based on the predictability of
the new monetary regime that would eventually allow less severe monetary policies.
This interaction is rather well understood, if not always acted upon, at the national level. But on the
European level there is a twist, as the single monetary policy is now matched by a multitude of fiscal
policies. The risk that is often discussed is that the ECB would in the end have to bail out a single
fiscally undisciplined country from unsustainable debt. But as the Stability Pact crisis has shown, the
more immediate problem might be more prosaic than a cataclysmic debt crisis: the problem might be a
bias towards fiscal laxity that has to be counterbalanced by tighter monetary policy - hence a bad
policy mix.
With a single monetary policy the effect of fiscal stimulus in one country will be diluted in the whole
area and will therefore by definition meet with less of a monetary policy response than it would if
monetary policy had been national. Furthermore the nature of the political set-up makes it more
difficult for the ECB to comment on individual national budgets. This means there will be a strong
temptation to "free ride" by expanding the budget at the expense of fellow European nations. But the
dilemma goes further - given that it is rational for others to expand their budgets it becomes rational for
your own country to do so too - even if your instinct is not to "free ride". Otherwise you might rationally
expect to end up among the small minority that does not expand and at the same time still have the
tighter monetary policy that results from everyone else expanding. This is the classic "prisoner's
dilemma" from game theory.
The conclusion is that it is necessary to have rules for fiscal policy that limit deficits and debt when
monetary policy is united and fiscal policy divided, and that these rules need to be followed. But the
conclusion is also that the pressure to over-expand is as strong during an upturn as during a
downturn. In fact this is what we have seen in the euro zone during the heyday of the late 1990s - a
much too expansionary fiscal stance in some euro zone countries, which led to tighter monetary policy
and thus an incentive for others to weaken fiscal discipline. The euro zone then started the downturn
with large deficits, considering the earlier boom, instead of surpluses. What the Pact then required, a
180-degree turnaround in fiscal policy to a tighter stance, reinforcing the downturn, was considered by
some as stupid. In fact it was the lack of savings during the boom that was stupid. Thus, we would
need rules not only like the Stability Pact, for a maximum deficit in a downturn, but equally some
forceful rule for fiscal rectitude in good times. Those rules are difficult to state as clearly as the 3 per
cent limit, but one way ahead could be to define annual targets for actual net lending based on the
predicted output gap.
But why didn't we see these problems from the beginning? Perhaps because we were fortunate to
have something that can work as a temporary replacement for rules: clear objectives, strong
leadership and the market as a quickly reacting judge. This existed not so long ago in Europe. The
objective was to join the euro zone and achieve the convergence criteria. The leadership was provided
by Germany both in terms of its economic size and its example of fiscal discipline. Now the objective
of joining the euro has been achieved, and, in addition, Germany has lost its leading role and the
markets react less to fiscal laxity.
Instead of leadership towards clear objectives we have recently seen the opposite - the political
exploitation of the gap between the national and European level. The requirements of the Pact are
blamed on heartless "accountants in Brussels", and when a majority puts narrow national political
interests first the agreed rules become moot - "peer pressure" becomes "peer protection". Incorrect
facts are more or less deliberately sent to the Commission ahead of sensitive elections. In fact, a
recent study by the ECB shows that the closer a country comes to an excessive deficit, the more likely
it is that the forecast the government presents officially will later turn out to be wrong. There is a strong
bias towards unrealistic optimism once a country's deficit approaches 3 per cent of GDP.
Let me say something in this respect about the new member states. It is all too apparent that the
collapse of Germany's leading role in fiscal discipline has also set a bad example for some of the
larger new member states. Given that public finances have deteriorated so much in Poland, Hungary
and the Czech Republic during the first years of this century it is fortunate both for themselves and for
the euro zone that these countries have postponed joining ERM II and the attempt to rapidly adopt the
euro. Had they tried and locked their currencies within ERM II they may well have stayed in that
position for a long time, becoming in the meantime targets for speculation - as their poor public
finances would have lent little credibility to their overall economic policy. This was Sweden's
experience with the combination of a currency peg and deteriorating public finances in 1991-1992. But
now there is another danger. Given that the target of imminent euro adoption is gone, and the large
euro zone nations do not provide real leadership on fiscal soundness, there is less incentive for some
of the new member states to stick to the consolidation of their public finances from today's deficits
above 5 per cent of GDP. The consolidation plans are already too dependent on a continued upturn.
Whether in the old or new member states, there is an additional problem, as we are entering a period
of intensifying structural changes. Old industrial patterns in Europe are being changed when
confronted with both the boost to productivity from IT, as partly realised since the late 1990s in the US,
and globalisation and enlargement, all of which supports this process. These trends will eventually
help productivity and growth in Europe to start to catch up with the US again. But in the short term the
structural changes will lead to higher frictional unemployment as old industries are more rapidly
replaced by new ones. In addition, the recent downturn never led to a dramatic increase in
unemployment or decrease in employment in the euro area; hence, the upturn is probably also less
likely to lead to rapid job creation. Both factors create new incentives for fiscal policy to focus more on
short-term job creation schemes and less on long-term fiscal soundness. So from this perspective, too,
the hope that the recovery alone will "fix" the European deficit problem might be too optimistic.
And the new member states are not much different in this respect. They have experienced a decade of
incredible structural change, and yet more is ahead. Furthermore the new member states have great
infrastructure needs and, coupled with high unemployment, there will be continued pressure for fiscal
expansion, even in a cyclical upturn.
So what is the solution? Let me first note an interesting development: since 1999 the average fiscal
deficit in the euro area has been 1.6 per cent of GDP while the average surplus of the three old
outcountries (the UK, Denmark and Sweden) has been 0.5 per cent of GDP.
Some Euro-sceptics will of course attribute this difference to monetary union itself but I think the
difference is that all three out-countries have been forced to find new ways of building a strong
national macroeconomic framework based on clearly stated goals and a transparent evaluation of how
these goals are to be met, in addition to the common EU rules. The part that has been much in focus
has been the monetary policy regime - in Sweden and the UK, inflation targeting with a specific target
for inflation and regular and transparent inflation forecasts has worked well. But inflation targeting, or
for that matter Denmark's euro peg, would never have been as successful had fiscal policy not been
reformed in parallel, with clear rules and budgetary ceilings in all three out-countries, which put the
problems squarely in the sight of the public. In fact those euro zone countries that have some sort of
national transparent targets and evaluation of fiscal policy, such as Finland, have managed to retain
some order in their public finances.
The power of targets and transparency is that the public, with the help of comments from analysts in
the media, can evaluate clearly how the government is doing in relation to a long-term norm. The idea
of being on or off target is quite easy to grasp, and if the process is transparent, experts and the public
alike will learn to trust the figures. In this area most countries still have a lot to do. It is a pity that
government accounts, which affect everyone in a compulsory way, are less transparent, less well
audited and less understood as the accounts of companies listed on the stock exchange, which only
affect very few people and at their own risk.
Sweden has a target of a 2 per cent surplus for the public sector over the business cycle, a figure that
includes pension savings and that, given an ageing population, is in fact akin to targeting a balanced
budget over the cycle. This target is present in the debate of every budget. The National Institute of
Economic Research comments on the target and helps the public to understand it. This keeps the
government accountable not only in the normal political sense but also in relation to the targets agreed
upon. The political debate is in a sense being taught to keep the long term in view. The public then
knows from the national debate that fiscal discipline is good for the country and if "accountants" or
other nations in Brussels criticise your budget policies, there is a greater chance of the criticism being
interpreted as a help towards fiscal soundness. The Swedish trade unions, for example, are among
the most vocal defenders of our budget target.
However, the framework might still not be strong enough - the 2 per cent over-the-cycle target has
been slipping somewhat out of view given that the government, as I mentioned, is focusing more on
the short term recently. Sweden would perhaps need an even more formal external fiscal evaluation.
This leads to an important conclusion for the Pact. Perhaps the solution to regain credibility is neither
to water down the Pact, nor to impose even stricter rules centrally. The solution is perhaps to build
from below - to complement the European level with national frameworks in the respective European
nations so that they come to internalise the need to balance their budget over the cycle and to ensure
that the same transparency exists on the fiscal side as on the monetary side. While pressure from
fellow finance ministers has apparently not worked well enough, the present attempts at national
processes with transparent targets have a better track record.
Why not have all EU countries commit themselves to establishing independent bodies with the
responsibility of enhancing transparency by conducting independent forecasts of the countries' deficits
and providing recommendations on a regular basis? They would have only an advisory role and their
authority would stem from impartiality and expertise. The subject of their recommendations would be
the overall fiscal stance - neither the specifics nor indeed the political orientation of fiscal policy. The
Excessive Deficit Protocol (EDP) states that member states shall ensure that national procedures in
the budgetary area enable them to meet their obligations. It would therefore be in the spirit of the EDP
to have EU countries commit themselves to establishing these kinds of bodies.
At the very least, these independent bodies would be able to make more reliable and unbiased
forecasts as a basis for EU recommendations. Such an arrangement would avoid having unreliable
deficit figures before elections, only to "discover" the real state of accounts after the vote - such as has
been the case in Portugal, France, Germany, and most spectacularly in Greece recently. By having a
similar role as the Congressional Budget Office in the US, the bodies would ensure a reliable and
unbiased "reality check" in times of fiscal profligacy.
At best the advisory bodies would create a continuous national dialogue with warnings and
recommendations to politicians that would boost transparency and put long-term fiscal goals at the
heart of the debate - a reinforced version of the process that has helped Denmark, the UK and
Sweden to improve fiscal soundness.
The experience of central banks is that transparency and goals help form expectations and behaviour,
enlisting the public in the struggle for macroeconomic soundness. After a while, the discipline that
initially seemed practically unattainable becomes almost natural.
Thank you.