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Monday, September 26, 2011

Limiting Central Government Budget Deficits: International Experiences

James K. Jackson
Specialist in International Trade and Finance

The global financial crisis and economic recession spurred national governments to boost fiscal expenditures to stimulate economic growth and to provide capital injections to support their financial sectors. Government measures included asset purchases, direct lending through national treasuries, and government-backed guarantees for financial sector liabilities. The severity and global nature of the economic recession raised the rate of unemployment, increased the cost of stabilizing the financial sector, and limited the number of policy options that were available to national leaders. In turn, the financial crisis negatively affected economic output and contributed to the severity of the economic recession. As a result, the surge in fiscal spending, combined with a loss of revenue, has caused government deficit spending to rise sharply when measured as a share of gross domestic product (GDP) and increased the overall level of public debt. Recent forecasts indicate that budget deficits on the whole likely will stabilize, but are not expected to fall appreciably for some time.

The sharp rise in deficit spending is prompting policymakers to assess various strategies for winding down their stimulus measures and to curtail capital injections without disrupting the nascent economic recovery. The threat of sovereign defaults in Greece and Ireland, followed by potential defaults in Italy, Portugal, and Spain, have prompted a broad range of governments in Europe and elsewhere to develop plans to reduce the government’s budget deficit. This report focuses on how major developed and emerging-market country governments, particularly the G- 20 and Organization for Economic Cooperation and Development (OECD) countries, limit their fiscal deficits. Financial markets support government efforts to reduce deficit spending, because they are concerned over the long-term impact of the budget deficits. At the same time, they are concerned that the loss of spending will slow down the economic recovery and they doubt the conviction of some governments to impose austere budgets in the face of public opposition.

Some central governments are examining such measures as budget rules, or fiscal consolidation, as a way to trim spending and reduce the overall size of their central government debt. Budget rules can be applied in a number of ways, including limiting central government budget deficits to a determined percentage of GDP. To the extent that fiscal consolidation lowers the market rate of interest, such efforts could improve a government’s budget position by lowering borrowing costs and stimulating economic growth. Other strategies include authorizing independent public institutions to spearhead fiscal consolidation efforts and developing medium-term budgetary frameworks for fiscal planning. Fiscal consolidation efforts, however, generally require policymakers to weigh the effects of various policy trade-offs, including the trade-off between adopting stringent, but enforceable, rules-based programs, compared with more flexible, but less effective, principles-based programs that offer policymakers some discretion in applying punitive measures.

Date of Report: September
15, 2011
Number of Pages: 3
Order Number: R41
Price: $29.95

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