The fiscal imperative


More about public finances

Jean-Claude Trichet, President, European Central Bank


Governments and central banks managed to avoid a global economic catastrophe, but the crisis has left a legacy of nearly bankrupt governments. A quick return to solvency is required.


As we head into 2011, economies around the world are still emerging from the worst economic crisis since the Great Depression. But, unlike then, this crisis was largely contained as a result of swift action by central banks, governments and parliaments.


These actions were extraordinary and have left challenges in their wake. The biggest of these challenges comes from a deterioration in public finances of unprecedented scale and geographical reach. The recession has depressed tax receipts and increased government outlays on unemployment benefits while the levels of many other expenditure items have not adjusted fully to the much-lower-than-foreseen output level. This places significant pressure on government budgets. At the end of 2010, government debt in the euro area is 18 percentage points above its 2007 levels according to the European Commission's autumn forecast data. In the US and Japan it has increased by more than 30 percentage points according to the OECD. There is little doubt that all countries among the advanced economies are now in urgent need of implementing a credible medium-term fiscal consolidation strategy.


Fortunately, there is an increasingly large consensus to maintain government fiscal integrity by offering credible exit strategies and embracing profound financial sector reform. There is by now also an increasing understanding in many parts of the global economy that there is no time to lose in implementing consolidation and restoring sound public finances.


Sustainable economic growth depends on sustainable public finances. Policymakers are doing everything possible to prevent another extreme malfunctioning of the financial sector. But even if the world manages to implement the most challenging of financial reforms, there may be other unpredictable triggers for a future economic and financial challenges. Unexpected and unavoidable events, such as the natural disasters that struck several countries in 2010, may require emergency government support. We can only face these if we have spare capacity in our public finances.


Fiscal buffers are essential when our economies are in a typical business cycle. They are even more necessary when our economies are coping with exceptional circumstances. During the financial crisis governments were forced to commit large funds to prevent the financial system from collapsing. Taxpayers took on great risks in this area, as calculations by the European Central Bank demonstrate. At one point, support earmarked for the financial sector, including recapitalisation, guarantees, dealing with toxic assets and other options, reached as much as a quarter of GDP in the EU and in the US. Commitments of this magnitude meant that governments need financial credibility.


Those who argue against a determined move toward fiscal consolidation are, in my view, underestimating that under extraordinary economic circumstances, established empirical relationships may no longer function in the same way as before. Today we are navigating in largely uncharted territory. Fiscal imbalances imply that it is no longer possible to trust the basic models that economists use to measure the impact of stimulus spending-or deficits for that matter-on economic growth. In these conditions, other factors, much more difficult to measure, come into play. I believe that, in the vast majority of OECD countries, orderly and resolute medium-term fiscal consolidation will boost confidence among households, enterprises, investors and savers.


This is why I do not agree with the argument that delaying the restoration of fiscal soundness would consolidate the economic recovery. In most advanced economies bolstering the current recovery and promoting job growth is precisely the reason why fiscal consolidation is needed right now.


The circumstances that the world economy faces are indeed extraordinary. And extraordinary times have called for extraordinary measures. Central banks have taken great efforts to maintain credibility of price stability against both inflationary and deflationary risks. The European Central Bank has been actively responding to the financial turmoil since the very beginning while always keeping its sense of medium to long-term direction: ensuring price stability over the medium term, which is its primary mandate.


The remarkable track record of price stability over the last 12 years and the solid anchoring of inflation expectations are key elements for confidence in the euro area and in Europe.


For the recovery to take hold, progress towards sound public finances in the euro area as well as in other advanced countries will be important.


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