Conference: America and Europe: A Time For Unity, A Time For Vision 21-22 Feb. '97

Panel One: Sharing Hopes and Ambitions: The Economic Agenda (1) "Reforming The Public Sector"

Executive Summary This paper is intended to provide the panel participants with a suggested basis for discussion on the issue of reforming the private sector. It consists of a short background section and an additional section in which specific issues are offered for the participants to discuss. The proposed staging point for discussion is the IMF view that budget deficits have become too big, future liabilities too onerous, for the current trends in the United States and Europe to continue. New thinking need to be done on sustainable roles for government generally, and the specific roles governments can play in the United States and the European countries. That implies fiscal consolidation (i.e., budget reduction) to alleviate current, high public-sector deficits (an aggregate level of 3% among industrialized countries) and to prepare for the large demographic bubble that will increase retirement levels-and the "invisible costs" they represent-significantly early into the next century. The effects of these persistently high deficits transcend the United States and the European countries. They have important implications for global interest rates and economic development across the world. An IMF study suggests that over the past 15 years, the increase in public debt has translated into an increase in global interest rates of some 100-450 basis points. While both sides of the Atlantic face this common challenge of reducing public deficits, important differences exist in the size of those deficits and the extent to which and methods by which fiscal consolidation should occur. As a result, it is proposed that the panel discussion focus on the kinds of public sector reforms that can and should be taken, the methods by which governments can cushion the dislocations attendant with consolidation, the sustainability of social safety nets, and the effect of rapidly integrating financial markets on the capacity of governments to manage their public sector finances. More specifically, the panel would be enriched by a discussion of the fiscal impact of the EMU process, the range of views on the EMU process that exist in the EU member states, and political developments in the United States aimed at reducing the budget deficit. On that foundation, the participants could then discuss areas of potential cooperation, if any, in their efforts to effect fiscal consolidation. At Madrid in 1994, the International Monetary Fund's ministerial committee issued a statement on economic best practice. The ensuing "Madrid Declaration" called on governments to reduce their borrowing, adjust interest rates to forestall inflation, and introduce structural reforms that would generate higher efficiencies across their economies. The rationale for this declaration was clear. Mounting national debt and high government budget deficits serve to increase real interest rates, drag down the accumulation of private capital, constrain living standards, and impose burdens on future generations. Two years later, last September, the same Committee considered it necessary to strengthen the elements it had advanced in Madrid. It called on governments to formulate multi-year budget plans, make their finances more transparent, and reexamine the nature of their borrowing with a view to "reducing unproductive spending while ensuring adequate basic investment in infrastructure." Furthermore, the Committee argued for governments "to improve education and training, to reform public pension and health systems to ensure their long-term viability and enable the provision of effective health care, and to alleviate poverty and to provide well-targeted and affordable social safety nets." At that ministerial meeting, IMF Managing Director Michel Camdessus highlighted the view at the IMF that the public sectors in France, Sweden and Germany are too big and government spending must be cut relative to the size of those respective economies. On the United States, Camdessus restated the view at the IMF that planned tax cuts should be postponed. The IMF statements have highlighted the many fundamental questions that now exist in reforming the public sectors in both the United States and Europe. Against the background of aggregate deficit spending by industrialized countries of about 3% of their combined output, and in the face of looming uncovered obligations in the areas of pension and health care, governments on both sides of the Atlantic are facing mounting pressures on their public sector: In the United States-despite a declining government deficit that has dropped steadily since 1992 and is projected by the IMF to fall to 1.25% of GDP in 1996, the lowest debt ratio since 1979-there is considerable political pressure to reduce the budget deficit further. The current declining budget deficit is the result of federal budget reductions, on the one hand, and the by-product of the cyclical growth cycle, on the other. But imminent challenges-ranging from replacement of the tax system to favor more savings and investment to financing the ailing pension and health care systems-are generating considerable debate on how to restructure the public sector. In Europe, in the context of the launching of the European Monetary Union and the overarching budget-deficit rules that will underpin such a system, the issue of public sector reform is now at the center of political debate. At this writing, the EU governments were seeking to identify the features of a "stability pact" on taxes and spending in the lead-up to the establishment of the EMU in 1992 and the adoption of the Euro in 2002. As the EMU process unfolds, it will likely create a wider debate on public sector reform and the capacities of EU governments to maintain social welfare commitments while sustaining their eligibility for the monetary union. In particular, attention is likely to focus on the eligibility threshold of budget deficits no greater than 3% of GDP. Similarly, the eligibility criteria proscribe public debt levels greater than 60% of GDP. The IMF observes that: "Most of the largest fiscal imbalances are suffered by members of the European Union, including some of those countries that have experienced some of the highest unemployment rates and the weakest growth performance in recent years. It is generally recognized that progressive elimination of fiscal imbalances is necessary for an improvement in growth performance over the medium term. The priority that has now been given to fiscal consolidation has already begun to yield benefits in reducing risk premiums in long-term interest rates, in improving confidence, and in strengthening medium-term growth prospects, particularly in those countries where financial markets previously indicated some lack of confidence in government policies." For these reasons, in the context of substantially different economic and political circumstances, the United States and the EU member states are locked in a fundamental and vital reappraisal of the roles and capabilities of their public sector. It is now generally acknowledged that budget deficits throughout the industrial countries have become so large that they are unsustainable, and that many of those deficits are significant insofar as they are without peacetime precedent. Furthermore, it is generally acknowledged that government dissavings negatively affect national saving, thereby bringing down future living standards by reducing national investment or by imposing future obligations on servicing foreign debt. The implications, as important as they are in the national context, transcend the industrialized country economies. As the IMF notes: "Of continuing concern is the need shared by most industrialized countries to make further progress toward substantially reducing their fiscal imbalances over the medium term. Structural (i.e., cyclically adjusted) deficits have only been brought down from 3.5% of GDP to 2.5% of GDP in 1995 for the industrial countries as a group, and the financing of fiscal deficits remains a source of pressure on world real interest rates, keeping the level of private investment and potential future growth below what otherwise could be achieved." According to one IMF study, the increase in public debt over the past 15 years has translated into a corresponding increase in real global interest rates of some 100-450 basis points. The inevitable conclusion here is that across the world, the crowding-out effect of large stocks of government debt has been tremendous-with significant negative implications for economic growth and employment. The opportunity costs associated with persistently high public-sector deficits are likely to grow with the accelerating integration of global financial markets. Governments will likely find it increasing difficult (and expensive) to finance their deficits as the volumes and velocities of cross-border financial integration continue to increase. The IMF argues that in the light of this integration, "delaying corrective action usually will ensure only that adjustment will ultimately be imposed by financial markets, and the consequences may be more severe and more prolonged." For these reasons, the issue of public sector reform is urgent. Governments on both sides of the Atlantic must find new ways of cutting expenditures and expanding revenues before the costs on their citizenries become even more onerous. There is also the issue of uncovered pension and other future obligations such as health care-"invisible debt"-that governments have brought upon themselves. The outlook is troubling for the United States and EU alike. Smaller work forces will need to support large segments of retirees, leaving governments with smaller tax bases generated by labor income. By estimating the value of this invisible debt on governments on a net present value basis, the IMF has concluded that every industrialized countries except the United States and the United Kingdom has "invisible" pension liabilities above 68% of GDP. France and Germany were among the highest, with obligations over 100% of their GDPs. And while the United States had a less acute pension liability picture, its outlook diminishes significantly when health care benefits were taken into account. This, according to the IMF, implies that France and Germany face the necessity of increasing pension tax collections by 3.5% of GDP each year to avoid a continued deterioration. United States and Europe: Trends in General Government Fiscal Balances and Debt (%Gdp) 90 91 92 93 94 95 96* 97* 01* Industrialized Countries Actual Balance Output Gap Structural Balance -2.1 2.7 -3.3 -2.7 0.5 -3.0 -3.8 -0.4 -3.5 -4.3 -1.8 -3.3 -3.5 -1.2 -2.7 -3.3 -1.4 -2.5 -2.9 -1.4 -2.1 -2.3 -1.1 -1.6 -1.5 0.2 -1.5 United States Actual Balance Output Gap Structural Balance Net Debt Gross Debt -2.7 2.8 -3.8 44.8 57.5 -3.3 -0.8 -3.1 48.3 61.3 -4.4 -0.5 -4.1 52.0 64.0 -3.6 -0.5 -3.4 54.4 66.2 -2.3 0.7 -2.6 55.3 66.0 -2.0 0.5 -2.2 56.2 66.7 -1.3 0.7 -1.6 55.9 66.8 -1.4 0.7 -1.7 55.5 66.3 -0.9 0.5 -1.1 52.2 62.4 European Union Gov Balance/GDP Gross Debt/GDP -5.2 -4.5 72.2 -3.5 73.8 73.9 Germany Actual Balance Output Gap Structural Balance Net Debt Gross Debt -2.0 2.1 -3.2 21.6 43.4 -3.3 3.4 -5.2 21.4 41.1 -2.8 2.0 -3.8 27.7 44.1 -3.5 -2.0 -2.4 35.4 48.2 -2.5 -2.0 -1.2 40.4 50.2 -3.5 -2.2 -2.2 49.0 58.1 -4.0 -3.2 -2.0 52.0 60.8 -3.0 -3.1 -1.1 53.4 61.9 -1.2 ---- -1.1 51.8 58.8 France Actual Balance Output Gap Structural Balance Net Debt Gross Debt -1.4 2.4 -2.7 25.1 35.5 -2.0 0.6 -2.4 27.1 35.8 -4.0 -0.5 -3.5 30.2 39.7 -5.8 -3.8 -3.3 34.4 45.7 -5.8 -3.0 -3.7 40.2 48.6 -5.0 -2.7 -3.2 43.5 52.9 -4.0 -3.2 -1.8 46.1 56.2 -3.0 -2.6 -1.3 47.4 57.3 -1.6 -0.1 -1.5 48.4 56.5 Italy Actual Balance Output Gap Structural Balance Net Debt Gross Debt -11.0 2.9 -12.3 92.9 97.9 -10.2 1.8 -11.1 96.3 101.4 -9.5 0.0 -9.6 103.0 108.5 -9.6 -3.2 -8.0 111.8 119.3 -9.0 -2.9 -7.6 117.3 125.5 -7.1 -1.8 -6.1 116.5 124.9 -6.7 -2.6 -5.4 114.3 124.3 -5.5 -2.4 -4.4 112.0 122.8 -2.8 ----- -2.8 99.3 109.2 United Kingdom Actual Balance Output Gap Structural Balance Net Debt Gross Debt -1.2 2.0 -3.7 27.2 34.4 -2.5 -2.3 -2.7 26.7 33.6 -6.3 -4.5 -3.8 28.1 34.9 -7.8 -4.6 -4.4 32.5 40.4 -6.8 -3.0 -4.0 37.7 46.0 -5.5 -2.4 -3.6 40.9 47.2 -4.4 -2.2 -2.8 44.1 49.5 -3.3 -1.6 -2.0 44.3 50.8 -1.4 ----- -1.2 42.0 48.5 *Projected. Source: International Monetary Fund, World Economic Outlook; October 1996. Among other things, this presents the threat of social dislocation between age groups within societies and massive pressures on the public sector. Unless adjustments are made in the interim, young workers face the prospect of substantially higher tax burdens or substantially lower benefits from the public sector-or, most likely, a combination of the two. This has obvious political implications as well. If both the direct and indirect costs, the visible and invisible costs, associated with large and persistent public sector deficits are so onerous, why is it then that governments have only achieved limited progress in fiscal consolidation over recent years? Clearly, on both sides of the Atlantic, political considerations are at work. Engaging in adjustments at a level commensurate with the seriousness of the problem would amount to a fundamental shift in social conventions, expectations and attitudes. The results, at least in the short term, of a large contraction in the public sector would surely engender painful adjustments for large segments of society. In this connection, however, it is important to note that research work undertaken at the IMF suggests that fiscal consolidation does not necessarily need to result in massive or protracted disruptions. Contrary to conventional wisdom, the Fund has concluded that fiscal contraction can lead to an acceleration of economic growth following a relatively short contractionary period. It notes that of the successful instances of fiscal contraction, the policy has focused on curtailing the spending side (as opposed to increasing revenues). In many cases, the movement toward strengthening economic growth after spending-based fiscal consolidation was reinforced by financial markets, which perceived a significant and fundamental shift in public-sector policies. In the light of the foregoing considerations on the subject of fiscal policy reform, the following issue areas are suggested as a basis for discussion: What direction should structural reforms in the public sector take? What is the appropriate size of the public sector relative to the size of the economy? What kinds of social safety nets can governments finance on a sustainable basis? Clearly, the challenges faced by the United States and the EU countries with respect to public policy reform are significantly different. The United States, currently with solid economic growth rates and favorable employment conditions, has experienced a contraction in the rate of growth in its deficit-financing of government programs over recent years. Nevertheless, owing to the high stock of national debt it has accumulated and the uncertainties about its capacity to finance "invisibles" in the future, the need to balance federal spending with revenue is pronounced and represents a politically charged issue. It remains to be seen, however, if there is sufficient political will to address entitlements and other politically-charged areas of spending. There is a need to reach a consensus on the extent to which the Federal Government can and should provide a social safety net for its citizenry in the future. In Europe, which is currently encountering more anemic growth and the challenge of structural unemployment, the conditions represent even more of a challenge. Launching policies of major fiscal consolidation under such circumstances is problematic economically and politically, but there is nevertheless the pressure of the EMU and the longer-term role that the global markets will play in imposing new discipline on fiscal policies. How can governments reduce their fiscal imbalances further without generating additional unemployment pressures and related social dislocation? Clearly, they cannot. For the United States, particularly as it considers its future invisible debt obligations, such dislocation would entail changing the expectations of a wide spectrum of its citizenry. Generations of Americans need to face the reality that they will not have the same levels of entitlements as their parents and grandparents. It is not clear whether spending-based fiscal consolidations in Europe can result in renewed economic growth after a relatively short contraction, but it is clear that such a contraction, superimposed on already difficult economic conditions in Europe, will create new political and economic pressures. How "locked in" are the European economies in addressing their fiscal imbalances while seeking to fulfil the EMU eligibility criteria? What would be consequences of fiscal backsliding be? It remains to be seen. The process of formulating the "stability pact" is not yet complete, and the extent to which members will have fiscal policy "flexibility" under the EMU is not yet clear. But in light of the difficulties that many of the EU members will have in meeting the EMU criteria, some kind of "band" arrangement will be necessary within which governments can adjust their policies to respond to differing economic conditions. The costs associated with backsliding would be very high. Not only would it fail to improve current exposure, but it would also undercut financial market confidence in the capacity of governments to address longer-range invisible debt issues. In both these contexts, the views of the European participants in the panel would be extremely useful for the American counterparts. In the United States, what are the prospects for balancing the budget? Now that the elections are over, can the White House and the Congress forge new ground in addressing the U.S. fiscal imbalance? To what extent are uncovered pension obligations factored into the ongoing debate in the United States over the budget deficit? There are some signs of an effort to build a bipartisan consensus on some issues, but it is by no means clear that the Executive Branch and the Congress can agree on mutually satisfactory approaches to cutting the budget deficit. The issue of reductions in entitlements will inevitably rise in this context, and the recent record of reaching accord on the constellation of issues on invisible debt is not encouraging. The opinions of the U.S. participants, and especially those members of the U.S. Congress, would be helpful in this discussion in order for their European counterparts to assess the most current political conditions governing the budget in Washington. In the light of the economic and financial changes sweeping the world, what is the appropriate role of governments in promoting growth and employment? If nothing else, the current challenges to governments in the United States and Europe in the area of public sector reform reveal that there needs to be a fundamental reassessment of the appropriate role of government and the obligations-present and future-it assumes. Budget deficits have become too big, future liabilities too onerous, for the current trends in the United States and Europe to continue. New thinking need to be done on sustainable roles for government generally, and the specific roles governments can play in the United States and the European countries. While the staging points for reform in the United States and in the various EU member states are different by definition, it would be helpful to compare national strategies and approaches to carrying out fiscal consolidation in a manner that would engender the least dislocation for the respective populations.