michael c bonello : fiscal reform - an imperative for sustainable growth and development speech by mr michael c bonello, governor of the central bank of malta, at the institute of financial services annual dinner, st julians, 11 november 2004. * * * i should first of all like to thank you, mr. president, for inviting me to your annual dinner and for the opportunity to share my thoughts once again with such a distinguished audience. i must also congratulate you on your recent election as president of ifs - malta and wish you and your committee every success in your endeavours to ensure that the institute ’ s educational programmes remain relevant in today ’ s complex financial services environment. as you rightly pointed out in your first message to your members, in a situation which is rapidly evolving, “ we must be prepared to embrace change. ” i have a similar message to convey tonight. inspired by the words of george washington that “ there is no practice more dangerous than that of borrowing money ”, mine is essentially an appeal to the country to leave behind its spendthrift ways and to learn to live within its means. i shall therefore make a case for fiscal reform. now some might wonder why a central bank governor should be so concerned about the state of the country ’ s public finances. put simply, the reason is that a persistent excessive deficit situation represents a potential threat both to price and financial stability, which are key objectives of most central banks today. the central bank of malta seeks to achieve these objectives through the operation of an exchange rate peg. the bank ’ s ability to maintain the peg in an environment where capital flows freely across borders, however, depends crucially on financial market perceptions regarding the effectiveness and sustainability of macroeconomic policy, particularly fiscal policy. in this context, the present deficit scenario is not helpful and, if not corrected, could oblige the bank to raise interest rates. the role of governments how and why have fiscal deficits become a problem? in the first decades after the second world war, governments came to play a key role in promoting economic growth and social development. in today ’ s free - market economies, moreover, they provide indispensable support to the activities of the private sector and also play an important role in curbing its excesses. another function of governments concerns economic stabilisation. they can intervene to stimulate aggregate demand in periods of recession and to restrain it at times when the economy is booming. under appropriate demand and supply conditions,

such intervention can contribute to a more favourable investment environment and, in turn, to growth. perhaps the most important tool governments use to pursue these objectives is public expenditure. taxation and borrowing may be viewed as ways of financing such expenditure, but they also constitute important tools in their own right. effectiveness of government intervention government intervention in the economy has important implications not only for competitiveness and growth, but also for the promotion of the social dimension of development. it is thus essential to ensure that society obtains full value for the resources devoted to public sector activities, both in terms of the quantity and the quality of the outputs produced. now whereas in the private sector failure to deliver value for money eventually results in bankruptcy, there exists no such effective sanction in the public sector. this is partly because expenditures are typically financed through general taxation and borrowing, and the funds thus raised are not directly earmarked for specific expenditures. inadequate enforcement of accountability standards is another reason. it is also the case that industrial relations and human resource management in the public sector are often undertaken without sufficient consideration for budget constraints, while job security and tenure are taken for granted irrespective of performance or productivity levels. a further dimension of this problem is the fact that the success of government spending tends to be measured more in terms of its potential to produce electoral dividends than in a longer - term growth perspective. all of these factors reduce the incentive to use resources efficiently. similar arguments apply to the welfare system, where the size of the expenditure can easily exceed that required to maintain social cohesion and the focus be diverted away from genuine needs. this situation has materialised in a number of countries, including the more advanced economies in the eu, which are now facing hard choices regarding the future of health and pension systems. invariably, the most difficult challenge in implementing reforms in these areas is to convince people that services which were hitherto provided by government for free, or at a subsidised cost, are no longer affordable by the country. there are, therefore, a multitude of pressures to increase government expenditure over time. and as tax revenues often prove unable to keep pace with such commitments, fiscal deficits emerge leading to an accumulation of debt. in turn, this produces a growing debt - servicing burden, creating a vicious circle in which unproductive outlays effectively crowd out the scope for productive expenditure. fiscal deficits are also the result of inadequacies in the design and implementation of tax structures. in this regard