Session 1: comment from Larry Jones

Managing Fiscal Stress and Crisis

L. R. Jones

[revised version 9th May 2011]

We know from past experience that managing public sector fiscal stress and even crises requires more than cutting government spending. No nation can resolve fiscal stress or crisis solely through budget reduction. It is pure folly to think this is the case. History shows that workouts have to involve loan assistance, debt restructuring, and sometimes forgiveness or reduction, (i.e., defeasance as it is referred to in the private sector) along with means to increase revenue, increase government productivity and of the greatest importance stimulation of the economy so as over time to increase revenue flows to government. For example, given the way the UK has attempted to solve its debt and fiscal stress condition through drastic budget cuts it is no wonder that recent forecasts for the nation’s GDP in 2011 are only slightly positive and may end up negative. Such deep cuts have a direct negative impact on economic growth to worsen rather than resolve longer-term fiscal problems that are to some extent structural in nature.

If we look back about a decade when Argentina was nearing bankruptcy a combination of instruments was used to prevent fiscal collapse. Loans from international institutions were combined with debt restructuring and writing down some debt through defeasance using collateralized US Treasury bonds. Recent fiscal crises including those in Iceland, Greece and Ireland have been at least temporarily neutralized through loans, largely from the EU and the International Monetary Fund. None of these somewhat successful bailouts have involved debt restructuring and defeasance to the extent employed to save Argentina. Whether continuing fiscal stress management using loans, bank buy-ins and other measures combined with initiatives to cut spending and increase tax revenues will lead to financial recovery for these nations remains to be seen.

Fiscal stress management approaches may be divided into non-mutually exclusive categories according to variances in the measures applied in attempt to restore fiscal and economic stability:

1. Budget reductions in government operations accounts such as the cuts made in the UK by PM Cameron and those forced by the Republican Party in the US House of Representatives in negotiating the Fiscal Year 2011 federal budget with Democratic Party leaders in the Senate and President Obama. This approach tends to be superficial and its purpose is political, i.e., a method of posturing to persuade potential voters in the next presidential and congressional elections to elect more budget cutters. Significant and often inaccurately reported media attention to such reductions seems to have a real impact on some citizens under the misguided perception that something meaningful is being done to help resolve fiscal stress conditions. The critical question with these cuts is which programs and beneficiaries are hit hardest and what is the consequent effect on their welfare and the economy? Predictable spillover consequences also include shifts in the preferences of many private investors to perceived safe havens such as gold, silver and precious metals, contributing to drops in currency values and reduced consumer confidence.

Budget manipulations of this type come in at least three forms, (a) politically acceptable across the board reductions (e.g., 10%) that punish effective agencies the same as ineffective ones, (b) specific program reductions where some programs are cut by an additional percentage based on evidence that they are not efficient or their services are not needed as much as more important programs, (c) program termination and merger where some programs are terminated completely while others are merged functionally into other continuing programs (Jones, 2010). Some efforts to raise general and specific taxes may be attempted accompanying this approach but they are almost always politically unpopular, e.g., Greece.

2. Budget reductions in operational accounts accompanied by spending reductions and in some cases revenue increases in government trust fund accounts of the type that provide long-term income, health and other types of social security, particularly to older and low income portions of the population. In the US such measures may lead to restructuring Social Security through increasing the retirement age, limiting the annual inflation indexed cost of living increases paid to program recipients (something that has already been done for several years in the US), and increasing social security taxes paid by both employees and employers. Similar measures would have to be made to medical care trust fund programs, e.g., US Medicare and Medicaid programs, to ration benefits in some way and to increase user fees shifting more costs to consumers and away from government. These programs are far more resistant politically to rationing and cost shifting due to the size of the populations affected and the specific impact on the poor. In the US and in most developed nations much more is spent on these entitlement programs that in support of normal government operations, e.g., roughly 70% of annual spending in the US is on these programs where around 30% is spent from accounts that pay for daily government operations, including national defense.

3. Debt bailouts by international organizations that provide relatively low interest loans over long terms and, in some cases, direct infusion of capital into the receiving nations and their banks, e.g., loans to Ireland. In the case of Greece lending from the EU and IMF has been predicated on the nation’s willingness to engage in longer term budget reductions and measures to increase tax revenues. While some debt restructuring is part of this type of package it is less extensive than in the next option.

4. Debt workouts orchestrated by international organizations (e.g., the EU, IMF, G10 and others) that provide relatively low interest loans over long terms and also require and enable significant debt restructuring, spreading  and extending pay back periods and incorporating some form of defeasance, i.e., writing off some debt (forgiveness) to domestic and international lending institutions. The so called Brady Plan that pulled Argentina out of bankruptcy involved forgiveness and collateralizing (backing up) some of the long term debt using US Treasury bonds. This approach also assumes government budget reductions and some schedule for future tax increases when the economies of debtor nations begin to recover. In the case of Argentina these policies succeeded; the Argentine recovery continued until the global fiscal collapse in late 2008.

In conclusion, dialogue on how to manage fiscal stress, defined here as the condition when a nation or other entity can still get loans to support its debt and operations, and crisis when either loans are not available or are needed to prevent absolute bankruptcy and cessation of government operations, should be informed by an understanding of the various approaches to coping with long-term revenue shortfalls leading to sizable long-term debt. Further, it is essential to understand the complex relationships between government spending and the direction of overall fiscal policy in combination with monetary and other policies and the productivity of the private sector that is needed to drive the economy towards recovery.

Although monetary policy has not been the focus here, history should not be ignored. When the Japanese housing bubble burst in the 1980s, Japan’s monetary policy decision makers held interest rates relatively high for a long period. The result was a decade of virtually zero GDP growth for the nation. Recent efforts by the US Federal Reserve Bank to reassure markets that a low interest policy would be extended for the near future (with a constant vigil for signs of inflation) spurred the US stock market and sent signals to industry that investment required to contribute to sustained economic recovery would be supported. In contrast, the EU has recently raised interest rates in part due to fear of rising inflation. While such caution is understandable, economic recovery is likely to suffer as a consequence. Also, it is notable that during the past 18 months the US has taken only moderate steps to support the falling US dollar, which has made it easier to sell cheaper US products and services abroad. At the same time, a strong Euro and UK Pound have made it more difficult to sell products abroad from these markets.

Reference:

L. R. Jones. 2010. “Restructuring Public Organizations in Response to Global Economic and Financial Stress,” International Public Management Review, 11/1 2010: 1-20.

© L. R. Jones 2011

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