Last week, Moody’s cut Greece’s credit rating to the lowest level on its scale, citing risk of default despite the recent write-off deal. Moody’s said the rating decision was “prompted by the recently announced debt exchange proposals for Greece, which imply expected losses to investors in excess of 70%.”
The sovereign debt crisis in Greece serves as a clear reminder that no country can ignore the requirement of fiscal discipline, but that discipline is slow to operate unlike the discipline of profit and loss in the market.
As Charles Wyplosz discusses in a new NBER working paper, governments can run budget deficits for years, even decades before facing the wrath of financial markets or emergency lenders. The paper is motivated by an table of OECD countries and shows the percent of years when a country has run a budget deficit since 1960 and the last year the country ran a surplus.
The table shows that deficits are more the rule than the exception, and persist in many cases for over 50 years. As Wyplosz points out, this pattern presents some unmistakable implications.
First, fiscal discipline is not a year-by-year concept. Wyplosz argues that as a “medium to long-term characteristic” it may “allow for significant temporary slippages along with eventual offsetting surpluses.” I agree that aggregate measures of debt, GDP, inflation, and the cyclical pattern of the budgetary process disguise the ways in which fiscal discipline is more of “medium to long-term characteristic”. However, the problem being disguised is one of the public choice biases of politicians to favor spending in short term. In turn, this implies that the nature of fiscal decision making is such that the budgetary process be subject to strict, inter-temporal rules—not the discretionary choices of legislators.
Second, a good track record is not sufficient to rule-out bad outcomes. Solid projections of revenue and expenditures that keep public accounts in the black is certainly a necessary condition for fiscal discipline, but not a sufficient condition. Crises create situations where private debts can quickly be assumed by the public (remember the bailouts of GM and AIG?)
Third, independent central banks are not independent. The fact that fiscal stresses and debt issues dominate policy space (especially once they get bad) means that no central back can escape political pressures. This means the relationship between deficit finance, debt, and inflationary pressures put forth by James Buchanan hold much more weight than most economists would care to admit. It’s not analytically helpful to isolate monetary policy from politics when central banking is involved, and doing so will hide the real sources of inflation.
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