The Global Financial Crisis and its Budget Impacts in OECD Nations: Fiscal Responses and Future Challenges 1784718955, 9781784718954

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The Global Financial Crisis and its Budget Impacts in OECD Nations

The Global Financial Crisis and its Budget Impacts in OECD Nations Fiscal Responses and Future Challenges

Edited by

John Wanna Research School of Social Sciences, The Australian National University, Australia

Evert A. Lindquist Professor, School of Public Administration, University of Victoria, Canada

Jouke de Vries Professor of Governance and Public Policy, University of Groningen and Dean, Campus Fryslân, Leeuwarden, the Netherlands

Cheltenham, UK • Northampton, MA, USA

© John Wanna, Evert A. Lindquist and Jouke de Vries 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2015933462 This book is available electronically in the Economics subject collection DOI 10.4337/9781784718961

ISBN 978 1 78471 895 4 (cased) ISBN 978 1 78471 896 1 (eBook)

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Contents List of contributorsvii Acknowledgementsix List of abbreviationsxi   1 Meeting the challenge of the global financial crisis in OECD nations: fiscal responses and future challenges Evert A. Lindquist, Jouke de Vries and John Wanna

1

  2 The United States’ response to the global financial crisis: from robust stimulus to fiscal gridlock Paul L. Posner and Denise M. Fantone

31

  3 Canada’s reactive budget response to the global financial crisis: from resilience and brinksmanship to agility and innovation David A. Good and Evert A. Lindquist

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  4 Australian and New Zealand responses to the ‘fiscal tsunami’ of the global financial crisis: preparation and precipitous action with the promise of consolidation John Wanna

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  5 Budgeting in Japan after the global financial crisis: postponing decisions on crucial issues Masahiro Horie

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  6 Budgetary challenges in the Netherlands: resuming business after a turbulent time Jouke de Vries and Tom Degen

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 7  The global financial crisis in Denmark and Sweden: a case of crisis management ‘lite’ Lotte Jensen and Sysser Davidsen

174

 8  Spain facing the global financial crisis: cutting public spending and struggling with structural reforms Eduardo Zapico-­Goñi

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 9  Portugal and the global financial crisis: short-­sighted politics, deteriorating public finances and the bailout imperative Paulo T. Pereira and Lara Wemans

231

10  The global financial crisis in Greece: its background causes, escalation and prospects for recovery Michael G. Arghyrou

255

11  Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ Richard Boyle and Michael Mulreany

284

12  Readiness, resilience, reform and persistence of budget systems after the GFC: conclusions and implications Evert A. Lindquist, Jouke de Vries and John Wanna

309

Index343

Contributors Michael G. Arghyrou is a Reader in Economics at Cardiff Business School, United Kingdom. Richard Boyle is Head of Research, Publishing and Corporate Relations, Institute of Public Administration, Dublin, Ireland. Sysser Davidsen is Head of Division, Secretariat of the Danish Economic Councils, Copenhagen, Denmark and formerly Head of Division in the Ministry of Finance, Denmark. Tom Degen is research assistant to Professor Jouke de Vries and junior teacher at the Institute of Public Administration of Leiden University, the Netherlands. Denise M. Fantone was Director of Strategic Issues in the US Government Accountability Office and Adjunct Professorial Lecturer in the Department of Public Administration and Policy, American University, Washington, DC, USA. Sadly Denise passed away in early 2015 before this book was published. David A. Good is Professor of Public Administration at the University of Victoria, Canada and a former Assistant Deputy Minister in the Canadian federal government. Masahiro Horie is Vice-­President and Professor of Public Administration at the National Graduate Institute for Policy Studies (GRIPS), Tokyo, Japan and formerly Vice-­Minister of Internal Affairs and Communications in Japan. Lotte Jensen is Professor of Core Executive Governance at the Department of Management, Politics and Philosophy at Copenhagen Business School, Denmark. Evert A. Lindquist is Professor at the School of Public Administration, University of Victoria, BC, Canada and editor of Canadian Public Administration. Michael Mulreany is Assistant Director General of the Institute of Public Administration, Dublin, Ireland. vii

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Paulo T. Pereira is Associate Professor of Economics at Instituto Superio de Economia e Gestão (ISEG), Technical University of Lisbon, Portugal. Paul L. Posner is Professor and Director, Center on Public Service, Department of Public and International Affairs, George Mason University, Washington, DC, USA and formerly Director, Federal Budget and Intergovernmental Relations, Government Accountability Office. Jouke de Vries is Professor of Governance and Public Policy at the University of Groningen and Dean of Campus Fryslân, University of Groningen in Leeuwarden, the Netherlands. John Wanna is the Sir John Bunting Chair of Public Administration (ANZSOG) at the Australian National University and former editor of the Australian Journal of Public Administration. Lara Wemans is an economist at the Portuguese Central Bank. She holds a Master’s degree in economics and public policy from Instituto Superio de Economia e Gestão (ISEG), Technical University of Lisbon, Portugal. Eduardo Zapico-­Goñi is Consultant Adviser with the Directorate-­General of Budget, Madrid, Spain and currently Visiting Fellow at the European Institute of Public Administration, Maastricht, the Netherlands.

Acknowledgements This book extends our previous collaborative research to analyse the significance of the global financial crisis on the budgetary systems of a selection of Organisation for Economic Co-­operation and Development (OECD) nations. It builds on two earlier volumes of work that have gained international recognition, namely, Controlling Public Expenditure, edited by John Wanna, Lotte Jensen and Jouke de Vries (Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 2003); and The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, again edited by John Wanna, Lotte Jensen and Jouke de Vries (Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 2010). These two previous projects focused on the changing roles of central budget agencies in modernising budgetary processes and delivering outcomes; whilst the second also explored the reform t­ rajectories followed by certain OECD countries in order to assess their effectiveness and contribution to overall fiscal sustainability. In this volume we examine the shocks to national budgetary systems posed by the global financial crisis to ask how well budgetary systems performed when faced with this enormous challenge to their sustainability. We have benefited again from the support of a number of collaborative academic organizations and wish to acknowledge their assistance, including: the Department of Public Administration, The Hague Campus, Leiden University (the Netherlands); the College of Arts and Social Sciences at the Australian National University (Canberra, Australia); the Australia and New Zealand School of Government; and the Department of Management, Politics and Philosophy at Copenhagen Business School (Denmark). They all assisted in making this project possible and with administrative and financial support. We wish to acknowledge the assistance of many finance and budgetary experts who assisted the project in each country, especially in Australia, Denmark, Ireland, Portugal, Sweden, the Netherlands, Spain and Greece. They were important in assisting with information, providing access, giving interviews and in some cases offering commentary and feedback. In many cases their commitment to such scholarly research meant that their involvement with this project was added to their ix

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already busy schedules. Some are specifically acknowledged in individual chapters. A two-­day workshop was held at Leiden University’s Department of Public Administration located at their campus in The Hague to bring together academics and practitioners from the 12 OECD nations. The workshop explored how the global financial crisis had manifested itself in the various countries selected for investigation, and what responses governments had contemplated and implemented when faced with the crisis. The workshop was crucial to our collective understanding and overall assessments of the national and international responses. We would like to acknowledge the hospitality of the workshop host, Professor Jouke de Vries, and his department at The Hague Campus of Leiden University, especially for the magnificent venue and assistance with accommodation costs. We wish particularly to thank David Tune, David Martine, Stein Helgeby, David Nicol and Arthur Camilleri (Australian Department of Finance), Ken Henry, David Gruen and Jim Murphy (Australian Treasury), Derek Gill (Victoria University Wellington), Andrew Podger (Australian National University), Paul ’t Hart (Utrecht University), and Jon Blondall (OECD). Tom Degen, Benedicte Dobbinga, Shellaine Godbold, Claire Dixon, Sam Vincent, Justin Pritchard and Hsu-­Ann Lee provided valuable administrative and research assistance to the project. Sadly, one of our contributors Denise Fantone passed away suddenly before the publication of this book. Denise participated in each of our three books on budgeting and budgetary politics, and made a significant contribution to their quality. We offer our condolences to her family and friends. Finally, we extend our appreciation to Edward Elgar and his staff for their support and encouragement of research endeavours in this field, in particular Laura Mann and Alan Sturmer.

Abbreviations AFM Authority for the Financial Markets (Netherlands) AIG American International Group (US) ANZSOG Australia and New Zealand School of Government AOS Annual Output Statement APRA Australian Prudential Regulation Authority (Australia) ARRA American Recovery and Reinvestment Act (US) BEA Budget Enforcement Act (US) BoP Bank of Portugal BPN Banco Português de Negócios/Portuguese Business Bank (Portugal) BRIC Brazil, Russia, India and China (emerging economic powers) CAF Community Adjustment Fund (Canada) CBO Congressional Budget Office (US) CDA Consejo de Politica Fiscal y Financiera/Christian Democrat Party (Netherlands) CFFP Council of Fiscal and Financial Policy (Spain) CEO chief executive officer CFO chief financial officer CFP Council of Fiscal Policy (Portugal) CFR Council of Financial Regulators (Australia) CGR Council for Government Revitalization (Japan) CiU Catalan Nationalist Party (Spain) COP Congressional Oversight Panel (US) CPB Bureau for Economic Policy Analysis (Netherlands) CPI Consumer Price Index CTV CTV Television Network (Canada) DAAC departmental and agency audit committee (Canada) DK Danish kroner (Denmark) DNB Die Nederlandsche Bank/Dutch Central Bank (Netherlands) DPJ Democratic Party of Japan (Japan) DPP Danish People’s Party (Denmark) EAP Economic Action Plan (Canada) xi

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The global financial crisis and its budget impacts in OECD nations

EC European Commission ECB European Central Bank ECOFIN Economic and Financial Affairs Council of the European Union EDP Excessive Deficit Procedure (EU) EERP European Economic Recovery Plan EFF Extended Fund Facility EFPC Economic and Fiscal Policy Council (Japan) EFSF European Financial Stability Facility EMU Economic and Monetary Union ESM European Stability Mechanism ESS Economic Stability Strategy EU European Union EU15 EU member countries before 1 May 2004 FROB Fondo de Restructuración y Ordenación Bancaria/Fund for Orderly Bank Restructuring (Spain) FY financial year G7 Group of 7: Canada, France, Germany, Italy, Japan, UK, US G8 Group of 8: G7 plus Russia G20 Group of 20, consisting of the 19 largest economies, plus EU GAO Government Accountability Office (US) GDP gross domestic product GFC global financial crisis GNP gross national product GSE government-­sponsored enterprise (US) GSP Generalised System of Preferences (EU) GST goods and services tax ICT information and communications technology IEI Investment and Employment Initiative (Portugal) IMF International Monetary Fund LAOS Popular Orthodox Rally (Greece) LDP Liberal Democratic Party (Japan) LEO Budget Framework Law (Portugal) LIBOR London Interbank Offered Rate (UK) MEF Ministry of Economy and Finance (Spain) MoU Memorandum of Understanding MPs Members of Parliament MTEF Medium Term Expenditure Framework NDP New Democratic Party (Canada) NGO non-­governmental organization



Abbreviations ­xiii

NZ New Zealand OECD Organisation for Economic Co-­operation and Development OSFI Office of the Superintendent of Financial Institutions (Canada) PASOK Panhellenic Socialist Movement (Greece) PAYGO pay-­as-­you-­go (taxation instrument, US) PIIGS Portugal, Ireland, Italy, Greece and Spain PBO Parliamentary Budget Officer (Canada) PCO Privy Council Office (Canada) PM Prime Minister PMO Prime Minister’s Office (Canada) PP Partido Popular/Popular Party (Spain) PPS purchasing power standard PPP purchasing power parity PPP public–private partnership PRACE Public Administration Restructuring Program (Portugal) PSI Private Sector Involvement (Greece) PSOE Spanish Socialist Workers’ Party (Spain) PvdA Labor Party (Netherlands) PVV Party for Freedom (Netherlands) RBA Reserve Bank of Australia (Australia) RInC Program Recreational Infrastructure Canada Program SDP Social Democratic Party (Japan) SGP Stability and Growth Pact (EU) SMP Security Markets Programme (Greece) SP Special Pension (Sweden and Denmark) SPBC Strategic Priorities and Budget Committee (cabinet committee, Australia) SPU Stability Programme Update (Ireland) TAGS The Atlantic Groundfish Strategy (Canada) TARP Troubled Asset Relief Program (US) TBS Treasury Board Secretariat (Canada) TI Transparency International UK United Kingdom USA United States of America VAT value-­added tax (EU) VVD Liberal Party (Netherlands) WB World Bank WWII World War II

1. Meeting the challenge of the global financial crisis in OECD nations: fiscal responses and future challenges Evert A. Lindquist, Jouke de Vries and John Wanna I confess to being continually amazed, and shocked, by the still evolving global financial crisis. If this crisis hasn’t changed at least some of your views about how the world works, then I reckon you haven’t been paying attention – or alternatively, your views are so tightly held as to be impervious to the arrival of new information. (Former Senior Treasury Official, David Gruen, 2009)

The global financial crisis of 2007–09 was the most serious crisis to rock global economies in more than 70 years. As it emerged and took shape, it confounded governments, financial institutions, markets and industries, academics and media commentators. Previous certainties and complacencies were abandoned amid a global loss of confidence and perceived regulatory failure. The speed of the crisis and its unexpected and calamitous twists and turns heightened the perception of a ‘meltdown’ scenario and excited fears of a ‘perfect storm’ (Patterson and Koller 2011). In a matter of months, the crisis swept around the globe, impacting on financial markets, economies and government budgets. The costs of this near implosion are still with us today and will affect future generations for years to come, even though the immediacy and lessons of the crisis seem to be fading, as governments deal with the ‘new normal’ of slow economic growth, constrained public budgets, persistent deficits and rising public debt. For these reasons the global financial crisis needs to be studied as a catalytic shock to our economic and financial systems, and to our government finances and the budgetary systems that ostensibly monitor changing conditions, provide order and discipline and some strategic direction in the face of competing demands and future challenges. The character of this shock to the system and the responses of policy and budget players are the main themes of this book, focusing on the impacts on public finances and 1

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consequences for the management of government budgets. In this introductory chapter we discuss the contributing causes of the pending global financial crisis, before arguing that the crisis represents a form of ‘natural experiment’ invoking an acute challenge to budgetary systems. We then outline a five-­phase framework through which to study the impacts of the crisis and the responses it provoked, and signal our main research questions and methodology, following that with a brief overview of the book.

EARLY SIGNS OF A PENDING CRISIS The earliest inkling of impending turbulence in international financial markets was first detected in the United States of America in the Northern summer of 2007 (Brunnermeier 2009; Greenlaw et al. 2008). Financial markets, prudential regulators and governments around the world began to watch with increasing trepidation as leading US financial institutions exhibited signs of acute stress and impending collapse. The initial indications of financial stress derived from the increasing provision of exotic and subprime mortgages from government-­ sponsored residential mortgage brokers stoking the urban real estate market. The mortgages provided by these firms to home-­buyers were ‘exotic’ products in that the home loans required little personal assurance or equity injection into the purchased property (the so-­called ‘no-­doc’ loans requiring little documentation or creditworthiness checks) and were issued to credit-­risk customers who borrowed amounts often greater than the collateral of the assets they were purchasing. Private firms such as Fannie Mae and Freddie Mac engaged in such risky lending practices under a ‘lend freely’ policy, and bundled them into packaged mortgage-­backed securities which were then sold on and backed by guarantees even though they ultimately held insufficient capital backing to adequately cover these loans (Shiller 2008; Konings 2010; Patterson and Koller 2011). As mortgage brokers they sourced similar packaged securities from across the housing sector and also sold on these securities to various other financial institutions (in the ‘shadow banking system’) who purchased these packaged debts as assets, thus spreading the contagion. At this point, with many developed nations running overheated economies, no one apparently appreciated the risk to established financial institutions from the trading in dubious mortgage-­backed securities; ­systemic contamination was not considered to be a likely occurrence. The United States’ residential mortgage system had functioned moderately well while property prices were escalating rapidly and investors continued to have an appetite for taking on increased levels of debt. The US, like other Organisation for Economic Co-­operation and Development



Meeting the challenge of the global financial crisis ­3

(OECD) nations, had largely been following a series of procyclical economic policies before the crisis. The rationale for individual home-­buyers entering the subprime mortgage market suggested that the proportion of equity to debt would gradually increase as the housing bubble inflated. But by late 2006 the US property bubble began to burst, house prices began falling steeply, and home-­ buyers faced negative amortization – owing much more than the houses were worth, or having ‘negative equity’ and being unable to make sufficient repayments to shrink their principal debt – ­resulting in more than 1 million property foreclosures or around 10 per cent of all mortgages. The vulnerability of the US housing market to a sudden fall in asset prices quickly manifested itself as a national housing crisis. As repossessions increased and families simply walked away from their homes, the various packaged securities (often transferred into futures or derivative instruments) appearing on or off the balance sheets of major financial institutions began to turn toxic. Crucially, the extended guarantees that had been underwritten for these loans simply meant that the financial risks were passed on, and borne by established institutions further up the highly interconnected international financial system. Hence, by mid-­2007 the phenomenon that came to be known as the ‘global financial crisis’ was well under way in the US. Once these mortgage firms and a cluster of merchant and investment banks began to feel the squeeze in late 2007 and early 2008, they began to face severe liquidity problems and require liquidity assistance (Shiller 2008; Konings 2010). In February, Freddie Mac, the Federal Home Loan Mortgage Corporation, announced that it would no longer buy the most risky subprime mortgages and mortgage-­related securities. In March rumours started circulating about big losses arising in Bear Stearns hedge funds, requiring a liquidity rescue from the US Federal Reserve. By April, the New Century Financial Corporation (the second-­largest subprime mortgage lender in the United  States) had filed for bankruptcy. In May, the global UBS private banking firm closed its major hedge fund. At the same time, Cheyenne Capital announced significant losses on its subprime investments. The volatility in the housing finance market was confirmed when Standard & Poors downgraded its credit ratings on $7.3 billion of asset-­backed securities, followed by Moody’s similarly downgrading $5 billion worth of subprime mortgage bonds. Suddenly, the house of cards characterizing integrated global financial markets began to look decidedly unstable. Countrywide Financial Corp soon flagged its own difficulties; the American Home Mortgage Investment Corporation filed for bankruptcy protection, soon followed by the Sentinel Management Group, which managed a significant hedge fund.1

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THE CRISIS DEEPENS These seemingly isolated developments led to a wider lack of confidence and huge losses in international financial markets during the latter half of 2007 (Melvin and Taylor 2009; Taylor and Clarida 2011; Blinder 2013). Developments in the US were mirrored elsewhere: Australia’s Absolute Capital froze withdrawals; Germany’s IKB bank was the first European bank to acknowledge its exposure to the US subprime mortgage crisis; and the French bank BNP Paribas Securities suspended withdrawals for three funds in August 2007. In the UK, the Northern Rock Bank (formerly a building society) suffered its own liquidity crisis after a run on funds saw it nearly collapse; the bank sought liquidity assistance from the Bank of England in mid-­September 2007 and after a few months was eventually nationalized and brought into full public ownership to ensure its very survival. In mid-­December 2007, several central banks in countries such as the US, the UK, Canada and Switzerland announced plans for coordinated interventions, such as interest-­rate reductions, along with other assistance measures (Borio 2008; Quaglia 2009). For instance, the US Federal Economic Stimulus Act was announced in February 2008 to avoid recession by providing tax rebates to lower and middle-­income Americans, tax incentives to business, and increased limits for mortgage purchases to more than $150 billion by government-­sponsored mortgage enterprises like Fannie Mae and Freddie Mac. But these initial embryonic interventions did not fully stem the tide. In February 2008, AIG and Credit Suisse announced significant write-­downs (Borio 2008). In early March 2008, the Federal Reserve of New York supported a deal with JP Morgan Chase to take over at a significant discount the assets of Bear Stearns, a well-­established mortgage bond underwriter in the US (Allen and Carletti 2010; Melvin and Taylor 2009). Fannie Mae and Freddie Mac continued to have problems into the summer of 2008, and shortly afterwards in September the US Federal Housing Finance Agency put Fannie Mae and Freddie Mac in government conservatorship. At around the same time, in July 2008, President George W. Bush signed into law the Housing and Economic Recovery Act, providing an additional $300 billion to the Federal Housing Agency to stabilize the subprime ­mortgage market. Yet worse was still to come. In September, the Federal Reserve of New  York bailed out one of the US’s largest insurance firms, AIG (Ito 2009), and later that month another Wall Street institution and the country’s fourth-­ largest investment bank, Lehman Brothers, declared bankruptcy after no buyers could be found. That same day, the Bank of America agreed to buy and absorb the investment banker and financial advising



Meeting the challenge of the global financial crisis ­5

firm Merrill Lynch, in order to rescue it after it recorded a write-­down of $8.4 billion in losses. While the Washington Mutual Bank went into receivership ten days later as a result of a massive $17 billion run of withdrawals in nine days, other banks teetered close to the brink of collapse. Many smaller banks and financial institutions suffered the same inevitable fate: being taken over by larger institutions prepared to contemplate mergers or acquisitions, or consigned to straight out bankruptcy (Ariff et al. 2012). It was not long before governments worldwide faced pressures to act (Haugh et al. 2009). The first US rescue package had been legislated in early 2008 and the first bailout plan for commercial and investment banks was conceived in mid-­2008. In October 2008 the US government passed the Emergency Economic Stabilization Act, which established the $700 billion Troubled Asset Relief Program (TARP). Soon, other big US entities, such as leading insurance and automobile companies, were seeking credit assistance (Nanto 2009; Rasmus 2010; Ito 2009), which would eventually amount to another $50 billion. European governments, such as the Belgian, French and Luxembourg governments, were forced to coordinate a €6.4 billion bailout package for the Dexia bank, while the Belgian, Dutch and Luxembourg governments were required to take equity stakes in Fortis, which also involved the BNP Paribas bank (Pauly 2009). Governments became the ultimate guarantors or ‘lenders of last resort’ as financial markets went into free-­fall. Significant financial institutions domiciled in their national economies were suddenly deemed by policy-­makers as ‘too big to fail’, and so deserving of various emergency rescue packages, the likes of which had not been seen in decades. Volatility continued in financial markets into late 2008. By now the emerging financial crisis affecting the international financial system was gradually becoming regarded as the most serious economic calamity since the Great Depression (Krugman 2009; Stiglitz 2010; Hetzel 2012; Blinder 2013). In late 2008 and early 2009 even countries in Asia and Europe, with little exposure to the US mortgage-­backed securities crisis, felt the effects in the real economy, with Japan’s gross domestic product (GDP), for example, falling by a full 4 per cent (Glick and Spiegel 2009). Still there was no consensus among the leading economies as to the best remedy to respond to the malaise, or the best route for sustainability. There continued to be widespread concerns about the effectiveness of government interventions with respect to avoiding a deeper worldwide recession and encouraging sustained economic recovery. Financial systems in most countries came under severe strain (Soros 2012). The turmoil in financial markets almost immediately infected the broader economy. Economic production fell, with some closures of firms, manufacturing plants and mines, unemployment began to rise to levels

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not seen in decades. The level of GDP fell in almost every developed nation, and only a few countries managed not to go into recession (for example, Australia, Singapore, Korea, as well as China among the developing nations) and some countries stayed in prolonged recession for years. Yet deeper cracks began to emerge in the welfare states of the European Union, especially (and ironically) in those more traditional economies of Southern Europe with internal structural problems, less-­diversified economies and lower value manufacturing. As the euro crisis intensified, nations such as Greece, Spain, Portugal and Cyprus required extraordinary assistance during 2010–11 (Beblavy et al. 2011; van Overtveldt 2011; Hall 2011; Baldwin et al. 2010). Various fiscal relief packages were devised by national governments in the developed economies, and in many developing nations such as China and Korea. In addition, a series of repeated emergency loans were provided internationally to countries unable to underwrite and sustain their financial markets of their own accord. These packages formed a concertina of initiatives, in some cases guided through coordinated efforts between sovereign nations, and in others taking the form of specific international injections to particularly badly affected economies. Many of these rescue packages required intense, high-­stakes negotiations among the member states of the European Union (EU), and between international funds providers such as the International Monetary Fund (IMF) and World Bank (WB). But overall, despite pleas for international coordination, much of the response activity was nationally focused, staccatic and piecemeal (Blinder 2013). Nevertheless, by 2010–11, most of the panic about the crisis had largely subsided with the enormous outlays of governments and international institutions were managing to stabilize financial markets. But the much-­promised economic recovery and a return to financial viability continued to remain elusive.

STUDYING THE GLOBAL FINANCIAL CRISIS What would soon become known as the global financial crisis (GFC), a phenomenon that in all truthfulness was near-­global but never totally, was initially seen as an insular local problem for US financial markets and domestic policy-­makers to handle. After all, other world economies were then performing well; international economic growth rates were high; unemployment rates were low; real estate markets were booming; China and Asian economies were coming on stream with extraordinary growth rates and becoming significant forces in the global economy (Asian Development Bank 2009). Initially, some heads of government, treasurers



Meeting the challenge of the global financial crisis ­7

and finance ministers stated publicly that the US subprime crisis affecting housing loans and unsecured credit markets would not impact on their economies, as they believed at the time that they were not themselves overly exposed. Some continental European leaders even speculated adversely that the crisis was exclusively an Anglo-­American disease caused by too much greed and neo-­liberalization of their financial sectors, especially from a misguided policy trajectory of allowing risky banking deregulation. For instance, the French President believed that the British and Americans had brought the crisis down upon their own heads; it was self-­inflicted, and served as a wake-­up call to these economies to restore confidence. However, this perception quickly changed as observers rapidly came to appreciate the integration of global financial markets, the extent of exposure of their own governments and economies around the world to these developments, and the increasing likelihood of a significant worldwide recession. This awareness led to growing alarm and heightened expectations of significant government interventions into financial markets and national economies, and the need for coordinated and concerted responses by international institutions and governments alike. Not surprisingly, the havoc wreaked by the GFC has led many observers to chronicle its origins and unpredictable course (see Shiller 2008; Fender and Gyntelberg 2008; Carmassi et al. 2009; Allen and Carletti 2010; Taylor and Clarida 2011). These accounts trace the various antecedents to the crisis, its initial impacts and victims, the priorities and timing of government responses and interventions, and the mobilization and coordination of international bodies or forums such as the G7, G20 and the European Union. Some observers have attempted to gauge the effectiveness of these ameliorative policies and rescue programmes once implemented, and then the efficacy of the subsequent austerity measures designed to produce fiscal consolidation and restore balanced budgets (OECD 2009). There remains ongoing apprehension and an appreciation of the prospect that potential further crises may follow, bringing additional shocks to the global economic system. To date, most of these contributions of an economic bent have focused on the financial and macroeconomic interventions and, somewhat in parallel, there has been a resurgent of interest in the public management literature on expenditure cutbacks, spending reviews, austerity management, alternative service delivery and technological displacement strategies, and co-­production – themes first emerging in the government debt crises of the 1970s and later the contracting-­out philosophies of the 1990s (see Hood and Wright 1981; Salamon 2002; Pollitt and Bouckaert 2011). However, there has been insufficient consideration of the overall performance of national public finance systems, including in particular the

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The global financial crisis and its budget impacts in OECD nations

robustness of government budgetary frameworks, as the global financial crisis took shape and governments ascertained the need for exceptional policy interventions. There appears to be scant attention paid to how well government budgetary systems were prepared both before and during the crisis, and whether different countries and their governments perceived that they were dealing with the same sets of challenges. In ‘public finance systems’ we include the fiscal strategies and outcomes evident at the national level but also increasingly integrated internationally the resilience of government budget systems, the core institutions and decision-­makers within the national and international context, and the exceptionality of decision-­ making in crisis situations. At the national and international level, governments relied heavily on the advice and analysis of their core budget agencies, their traditional and non-­traditional budgetary instruments and processes and, as the crisis deepened, a larger group of political and bureaucratic actors as well as financial experts outside government to make budget policy and response processes work (Schick 2009). This book emerges out of an ongoing research collaboration which has reviewed the budget systems of several OECD countries and led to two earlier Edward Elgar collections: Controlling Public Expenditure: The Changing Roles of Central Budget Agencies (Wanna et al. 2003) and The Reality of Budget Reform in OECD Nations: Trajectories and Consequences (Wanna et al. 2010). The 2010 book reviewed and contrasted the budget reform experiences in ten countries over a number of decades. Drafted in 2008, those chapters could not have dealt with the global financial crisis (which was then only just emerging, its full magnitude unknown). Nevertheless, the timing of The Reality of Budget Reform was propitious, providing interesting snapshots of several OECD countries as the crisis was taking shape and impacting on their economies and budgetary positions. Following this, a core set of contributors agreed to a further collaboration dedicated to exploring the impact of the crisis on the budgetary systems of a similar group of OECD countries: Australia and New Zealand, Canada, Denmark and Sweden, Greece, Ireland, Japan, the Netherlands, Portugal, Spain and the United States. Many of these countries had contemporaneously boasted of their prowess in public financial management, and the resilience of their budgetary frameworks. Sufficient time has since elapsed that we can venture assessments of how governments and their budget systems responded to the challenge and have been changed in the aftermath. Our present volume, thus, specifically explores the impact of the financial and economic crisis of 2007–09 on budgetary systems of a selection of OECD nations. It asks: how well prepared were these countries in the face of the emergency and how much was readiness a factor in their handling



Meeting the challenge of the global financial crisis ­9

of the crisis? How did the global financial crisis, which initially originated in the US housing sector, manifest itself in different jurisdictions? Did it appear as an essentially similar global crisis with similar characteristics, or a different set of crises each with its own peculiar characteristics and dimensions? How resilient and adaptive were the budget systems of each country? How did governments use their budgetary and financial regulatory systems, what political and bureaucratic strategies were adopted, and what were the consequences? What seemed to be the major challenges confronting the budget systems of each country, and, in hindsight, what might we consider to be the successes and/or failures of fiscal or regulatory management? What appear to be longer-­term budget trajectories and strategies for meeting targets, making tough decisions and balancing competing demands? Although the GFC did not hit each country at the same time or with the same degree of intensity, it did rock the foundations of the international financial system and inflict enormous public debt burdens onto national governments. It also provides an intriguing opportunity to examine how different OECD budgetary systems performed when confronted with such an intense magnitude of stress. We have already provided some important context to the emergence, background and timing of the global financial crisis. But chronology itself provides no straightforward explanation. More relevant to the deeper analy­sis of the crisis and its impact on government finances is the development and application of a conceptual framework that has been used to situate our studies and guide the research efforts of contributors of the country case studies. The remainder of this introductory chapter introduces this conceptual framework. We identify the questions and approach that guide this study, as well as our hypotheses, and explain why we settled on the country case studies. Our concluding chapter at the end of this volume will draw together and evaluate the findings from across the chapters, before listing the ongoing fiscal challenges for governments and then identifying a forward-­looking research agenda.

THE GLOBAL FINANCIAL CRISIS: A SERIOUS SHOCK AND NATURAL EXPERIMENT Recounting the historical origins of the 2007–09 global financial crisis reminds us of what a significant shock it was for governments, markets, investors, economies and citizens around the world. Many market analysts and policy players suddenly had to grapple with enormous uncertainties. Economies that had been performing well and growing steadily were hit with catastrophic changes in fortune. There was much confusion,

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The global financial crisis and its budget impacts in OECD nations

Table 1.1  Timeline of key events in the global financial crisis, 2007–10 Date

Event

Comment

1999

Repeal of the Glass–Steagall Act in US allowed banks to operate large investment banking businesses ‘Exotic’ subprime mortgage crisis emerges in US home loan markets

Beginning of the ‘shadow banking system’

Mid 2007

7th August 2007

September 2007

14 September 2007

October 2007 Mid-­December 2007 February 2008

15 March 2008 April–May 2008 July 2008

French bank freezes three hedge funds exposed to subprime mortgages, sparking global jump in interest rates Internationally some banks agree to easing the liquidity crisis by lending cash against bank mortgage securities Northern Rock Bank (a former building society) rescued by the Bank of England after run on deposits, nationalized in February 2008 Stock markets peaked Major international banks announce coordinated market interventions Freddie Mac announces it will no longer buy mortgage backed securities; US passes the Federal Economic Stimulus Act; the New Century Financial Corporation becomes the first major US bankruptcy of the GFC US Federal Reserve rescues Bear Stearns and allows take-­ over by JP Morgan Chase Many financing firms exit the subprime mortgage market and close hedge funds US passes Housing and Economic Recovery Act

So-­called ‘lend freely’ policies trigger first real signs of an overheated economy Beginning of the liquidity crisis in North America and Europe First real inkling that systemic problems were emerging in global financial markets Increased nervousness in financial markets, but not yet seen as systemic international crisis The tipping point in the overheated economies of the 2000s First signs of international concertation Crisis in the ‘shadow banking sector’ begins to infect financial markets more generally

First major sign the global financial crisis is becoming serious Beginning of panic as toxic debts cannot be accurately assessed Attempts to stabilise the housing market



Meeting the challenge of the global financial crisis ­11

Table 1.1  (continued) Date

Event

Comment

September 2008

Federal Reserve forced to bailout insurance firm AIG, which is taken over by the government

7 September 2008

US government seizes control over mortgage lenders Fannie Mae and Freddie Mac US investment bank Lehman Brothers files for bankruptcy after rescue negotiations fail; Bank of America agrees to buy Merrill Lynch to rescue it; collapse in stock markets and housing prices Icelandic banking collapse occurs, two banks into receivership and one nationalized, most foreign assets liquidated

Many governments become forced into nationalization of financial institutions to prop them up in the crisis Suddenly the GFC is getting very serious

15 September 2008

September–­October 2008

October 2008

Late 2008–early 2009

2009

The overnight TED spread rate reaches 4.65% for interbank lending; following Ireland, many nations provide banking guarantees; the US Congress provides $700 billion in financial underwriting to industries (TARP) and announced stimulus package of $800 billion Many nations commit to expansionary stimulus packages (China 6.9%, Spain 6.7%, US 5.5%, New Zealand 3.7% Sweden 3%, Japan 2.3% of GDP) Greece records Europe’s largest budget deficit at 15.2% of GDP

Lehman was allowed to fail; but had reverse effect on other governments and their big banks; the mantra went around the globe that the banks were ‘too big to fail’ Stark sign of the fragility of European money markets exacerbated by runs on deposits and inabilities to refinance debt The most intense phase of the financial crisis, causing governments to become guarantors of their national financial systems

G20 and finance minister summits coordinate government responses averaging around 2% of GDP in 2008–09 A number of smaller economies begin to destabilize the intended recovery phase (including Greece, Ireland, Cypress, Portugal and even Spain)

12

The global financial crisis and its budget impacts in OECD nations

Table 1.1  (continued) Date

Event

Comment

April–May 2010

Greek bond crisis – government bonds downgraded to junk status, and emergency €110 billion bailout provided by EU and IMF The 16 Eurozone countries agree to bailout funds of €440 billion for banks issued as loans to national governments; public debt in Greece and Italy reach 150% GDP with Japan 200% GDP Ireland’s budget deficit reached over 32% of GDP, and receives first EU bailout of €85 billion; US deficit still 11% GDP

Significant threat to the Euro single currency and possibility of exits from the eurozone as economies get out of kilter By mid-­2008 Europe’s combined public debt equalled 80% of the continent’s GDP

Mid-­2010

November 2010

Ireland’s bailout would be followed by similar emergency loans to Greece and Portugal in 2011

bewilderment and insecurity. Many policy-­makers believed that the imperatives sending markets into freefall were beyond their control, and perhaps for a while even beyond their comprehension. The GFC became the most serious shock since the 1930s Great Depression (Krugman 2009; Rudd 2009; Hetzel 2012; Blinder 2013). Much has been written about the role of governments in stabilizing markets and financial institutions, and in seeking to buffer economies with often massive fiscal and monetary policy interventions. However, much less attention has been focused on the performance of government budget authorities and processes in dealing with the GFC. Little has been written about the responsiveness, resilience and adaptability of government budget systems. Like all crises, the GFC effectively put institutional ‘patients’ on the table, revealing much about policy, politics, and public administrative and budgetary systems, and, increasingly, the development of budget policy in the context of international institutions. The international reach and pace of the GFC meant that it impacted upon the budget systems of the OECD and other countries almost simultaneously, so that in hindsight it can be considered a ‘natural experiment’ of sorts, recognizing that, as we note below in more detail, it manifested itself differently across jurisdictions depending on the fiscal and economic



Meeting the challenge of the global financial crisis ­13

health of different countries. This is a rare opportunity to explore how the budget systems of different countries responded to an acute challenge: the GFC in its various forms can be cast as an independent variable, with the dependent variables being the response of budget systems, which might involve different levels of government, including state, regional and local governments as well as supra-­governments such as the European Union and international institutions. Important intermediary variables include fiscal and economic health, regulatory system, bureaucratic readiness, political decisiveness and engagement, and institutional capability. The American budget analyst Allen Schick has argued that the ‘global financial crisis and the extraordinary governmental and international responses give rise to fundamental questions that go to the core of budgeting as the authoritative process for allocating public money’ (Schick 2009: 2). In analysing these developments, Schick made a useful distinction between the nature of the fiscal stimuli (and/or bailout packages) hastily arranged by governments and how the crisis affected the core machinery and conduct of budgeting. He volunteered a number of important observations about how budgetary routines can meet crisis situations: budgeting is fundamentally altered, if only temporarily, by pressures that overwhelm established policies and practices. Emergencies ‘stress test’ the entrenched routines that regulate budgeting in normal times. Business-­as-­usual budgeting is a stabilizer of government policy and a routinizer of public management that thrives when underlying political and fiscal conditions are stable. When they are not, budget makers may have difficulty managing the frenzied, largely unstructured and improvisational rush for decisions, and effective power may migrate from those who run the process to those who manage the crisis. In some circumstances, budgeting might be shunted aside, its main role confined to tallying the fiscal impacts of decisions taken elsewhere . . . A persuasive case can be made for adopting extraordinary measures to cope with immediate or long-­ term crisis. Arguably, the modulated cadences of budgeting – small adjustments made according to fixed procedures and schedules – should not be allowed to block forthright action. When crisis strikes, political leaders feel impelled to act, even if doing so temporarily bypasses or disables the budget process. (Schick 2009: 2)

With this in mind, Schick identified how ‘crisis budgeting’ differed from normal budgeting. He cited four main differences: ●● ●●

new procedures and ‘shortcuts’ were instituted to deal with the ‘maze of budget procedures’; the power to make budgetary decisions gravitated away from the normal budgetary guardians to political leaders, with decision-­ making becoming centralized and top-­down, and at the same time marginalizing ‘those who stand in the way’;

14

The global financial crisis and its budget impacts in OECD nations

●● ●●

many decisions were essentially non-­incremental, involving significant departures from previous thresholds; and, even though the potential for political and bureaucratic conflict increased dramatically in the crisis, the centralization of power and the urgent need to make decisions served to dampen bureaucratic conflict (Schick 2009: 8–9).

In a later piece, Schick (2010) offered some equally interesting conjectures about the nature of post-­crisis budgeting, arguing that in terms of process and aggregates there should be a return to pre-­crisis routines and incrementalism, but with some important caveats. Consider two of his predictions or observations concerning national governments in advanced economies. He suggested that: The crisis passes, normalcy returns, and budgeting reverts to pre-­set routines, stable roles, and predictable outcomes. This has generally been the pattern in the past; it may well prevail when the current crisis is over. Recent distress may spur some governments to strengthen or add a multiyear perspective to their budget work, or to bolster their capacity to analyze the interface between the budget and the economy. Undoubtedly, budgeting will continue to exhibit the restless tinkering with rules, procedures, informational requirements, and other features of the process that has characterized reform for the past half a century. But in most regards, there will not be overwhelming pressure to remake budgeting . . . In at least four ways, however, the current crisis may significantly impact budget practice. First, the crisis will leave many countries with elevated public debt levels, in some cases far above widely accepted norms such as the 60  percent ratio to GDP specified in EU’s Stability and Growth Pact (SGP). Second, national governments will pay greater attention to questions of fiscal sustainability, which will induce them to expand time horizons beyond the medium term to cross-­generational issues. Third, governments will seek new means to assess fiscal risk and integrate risk estimates into the budget and other financial statements. Finally, the crisis and its aftermath will spur governments to coordinate some budget rules and policies. (Schick 2010: 10)

Despite his general prediction about a return to budgetary incrementalism and rule-­tinkering in the wake of the GFC shocks, Schick had earlier acknowledged the possibility that some governments may retain the extraordinary powers gained as a result of crisis. He noted that ‘abnormal policies or instruments contrived to cope with crisis might be deployed to very different ends years later. For example, extra budgetary accounts introduced to inject money into the economy might become precedents for non-­crisis ploys when the government of the day wants to evade budget controls’ (Schick 2009: 2). Schick’s influential work presented to the OECD’s senior budgetary officials’ network was informed by the experiences of a diverse set of



Meeting the challenge of the global financial crisis ­15

OECD countries. It provided a synoptic overview of changes and identified interesting issues and possibilities for leaders and officials in all of those jurisdictions to consider. However, it does not provide a theory of how different countries might react to the same crisis, controlling for fiscal health, the quality of budget systems, and the willingness of political leaders to address rapidly evolving challenges. Moreover, it does not explicitly account for the fact that the GFC manifested itself in different ways in different countries, emerging variously as a financial crisis, budget crisis, economic crisis, regulatory crisis, political crisis – and in different combinations. Building on the seminal insights of Schick, this book seeks to take a closer look at the experience of different OECD jurisdictions.

MEETING THE GFC CHALLENGE: TRAJECTORIES AND RESPONSES OF BUDGETARY SYSTEMS The GFC was a significant and unexpected challenge to economies and governments around the world. However, not only did the GFC manifest itself differently in every jurisdiction, but also governments were in unique political, economic and governance circumstances when responding to it. Moreover, the scope of the challenge internationally meant that, in contrast to our previous volumes in this series, we needed to expand our focus from core budget institutions and the processes and the aggregates they normally seek to control and influence, to consider a larger circle of actors, instruments and processes. This section sets out the framework and definitions we utilized to facilitate gathering and analysing our data, making comparisons, and drawing lessons. Adopting a Five-Phase Framework for Analysis The concentrated and widespread nature of the GFC provides a focal point for the framework guiding this book. Initially we devised a heuristic ‘financial crisis response cycle’ or response/reaction trajectory through which many nations appeared to have progressed at varying speeds and levels. Figure 1.1 indicates the various stages of recognition and response depicted in the cycle, beginning with denial, disbelief or nervousness, and going through analysis, scenarios, responses, institutional reforms, and eventually to planned fiscal consolidation and a return to surplus. We then refined this cycle to better enable us to analyse the crisis and the budgetary responses. Accordingly, we adopted a five-­phase framework which considers both the trajectory of the crisis in terms of a chronological response sequence as well as the specific conditions affecting separate

16

The global financial crisis and its budget impacts in OECD nations Repositioning Fiscal Trajectory Planned Return to Surplus

Denial

Nervousness

Medium-Term Frameworks

Fiscal Consolidation

Reform of Institutions Lower spending Program Reviews

Analysis & Comprehension

Recognition & Undertakings

Process and Institutional Reform

Infrastructure (shovel-ready?)

Interest Rates

Scenarios and Priorities

New Budget & Regulatory Strictures

Tax Cuts

Implementation Guarantees to Firms/Citizens

Stimulus Measures

Stimulus Design & Implementation

Figure 1.1  The financial crisis response cycle countries. According to this framework, countries went into the crisis with differing degrees of readiness and potential resilience, which varied along a scale of low to high. The nature of the global crisis within each country often varied in its primary characteristics and local framing, perhaps appearing as a financial collapse, or as a budgetary crisis, or an economic downturn. The initial responses to the crisis also varied between nations (and governments), from slow and indecisive to fast and decisive. Countries went to different lengths to chart and plan for the medium-­term and longer-­term consequences of the crisis, ranging from tentative considerations to firm plans. Finally, the degree to which national budgetary systems could future-­proof their countries against subsequent significant challenges that may appear on the horizon was evidence of future resilience. We consider each of these sequential phases in further detail below. Readiness of budget institutions and governments Each government began from a different starting point when confronted with the GFC. One aspect of readiness concerned the capacity and competence of budget institutions and related processes in governments, including their ability to anticipate such challenges, to identify strategies, and to engage political masters and international colleagues. Another aspect



Meeting the challenge of the global financial crisis ­17

involved the fiscal health of governments, the extent of public debt, and whether jurisdictions were in deficit situations or had surpluses. Greater indebtedness restricted room for manoeuvre. A third aspect concerned the state of governance: whether political leaders had a majority or minority government, and a willingness to take charge in difficult circumstances and work with officials and other levels of governance. Finally, our previous research reported in The Reality of Budget Reform (Wanna et al. 2010) identified not only general directions for reform across several jurisdictions, but also the degree of variation of take-­up of reform initiatives and the extent to which they were insinuated into bureaucratic and political routines. Taken together, these factors combined to shape the overall readiness and resilience of jurisdictions to deal with a largely unanticipated shock. What crisis? Which crisis? In 1974 the rock band Supertramp released a well-­known album entitled Crisis? What Crisis? With the GFC there was no doubt about the emergence of a globalizing crisis, but what is now often not well understood was that many OECD countries experienced very different crises, sometimes reflected in different nomenclatures to describe them (Figure 1.2). Some countries had a combination of a financial crisis, with imminent or possible failure of financial institutions; a budget crisis (in the sense of not

Global Financial Crisis?

Housing and Property Bubble?

Political Crisis? Collapse of Financial Institutions? Sovereign Debt Crisis? Credit Squeeze?

Figure 1.2  Crisis? What crisis?

Slow or Negative Economic Growth? Unemployment?

18

The global financial crisis and its budget impacts in OECD nations

meeting surplus/deficit or debt targets), and rapidly declining performance in the real economy, such as declining purchasing, employment, trade, and so on. Some countries did not experience meltdowns in the financial sector, perhaps due to strong regulatory regimes or less leveraged institutions, and instead were primarily worried about budget issues and a pending recession, and thus focused on more aggressive economic stimulus programmes. In order to assess how well governments and budget officials performed in response to the GFC, it is important to understand what the nature of the crisis was in each jurisdiction, in part because the deeper and wider the crisis, the more political and bureaucratic actors may be required in developing a response. Initial response to the crisis In retrospect, the GFC might appear to have been an inevitable phenomenon, but it took most corporate and government leaders by surprise, and during the early stages of the crisis some jurisdictions remained in denial or apprehension. Some imagined it was not their problem and so little action was warranted or commissioned. Even when the crisis was recognized, political leaders and budget officials did not size it up accurately and tended to rely on patterned responses appropriate for other challenges. In some cases this was due to insufficient urgency, or perhaps ideological blinkers, about whether and how to respond, and in turn this affected whether a full set of options were considered in a timely fashion. More generally, political and budget decision-­making processes may have been under stress, requiring short-­circuiting or adaptation in order to support political and bureaucratic decision-­making, as well as the implementation and monitoring of decisions and policies. Initial responses were sometimes complicated by the governing context, with political engagement conditioned by whether the government was in a majority or minority position, prior policy positions, and the extent to which, if at all, fiscal and other responses required approval or alignment with regional governments and international organizations. All of these factors influenced how quickly governments were able to assess and respond to the crisis; a particularly important matter when many remedies for stabilization and stimulus are time-­sensitive. Setting a new course Stabilizing crisis situations is not necessarily the same as charting a medium-­to longer-­term course for restoring fiscal, economic and financial health. Stimulus and bailout programmes cannot last forever, and governments need to chart ways back to recovery. In some jurisdictions this might require re-­regulating the financial sector and rationalizing the



Meeting the challenge of the global financial crisis ­19

mix and content of government programmes, and fundamentally reforming the budget system. Countries in poor financial straits before the crisis, which may have received emergency support from other governments and international organizations once the crisis was felt, may in turn have to reschedule debt arrangements and make further structural adjustments. Although incumbent governments, regardless of their strength, may have had to deal with the crisis as it unfolded, they subsequently had to deal with the political consequences of difficult decisions made, and identify and defend the often unpalatable policies required for the longer term. In some jurisdictions governments became weakened or were removed from office in the aftermath of the GFC, while in other jurisdictions sitting governments attempted to galvanize and strengthen their position. Readiness for subsequent challenges Regardless of the strategic directions set by governments coming out of the GFC, there remained no shortage of possible challenges that might compromise recovery and a return to financial and economic health. Many countries experienced continuing economic and fiscal challenges, nursing fragile recoveries and jurisdictions with precarious finances, with non-­trivial risks for regional governments and global markets. In addition, some countries also encountered subsequent crises of entirely different kinds: natural disasters, wars and even political disintegration. These lingering factors had significant consequences for the restoration of public finances, economic stability, and trust in governments and other elites. Another way to think about this is to compare how resilient governments and budget systems were in the face of the GFC, and how resilient do we think that different jurisdictions will be in the face of subsequent and sometimes different challenges? Figure 1.3 indicates this five-­phase framework and provides illustrative examples to show possible variations between three different countries. It shows the range of different trajectories and patterns in response to the GFC. Some jurisdictions might have entered into the GFC with strong fiscal positions and budget systems, and emerged relatively strong, notwithstanding the crisis. Others might have started with weak fiscal positions and budget systems, and were severely compromised by the crisis. Still others might have used the crisis to galvanize political support and budget systems as part of a longer-­term process of change. Figure 1.3 can be used to explain how a particular country was moving into the GFC in relatively good shape, but was confronted with a crisis involving financial, budgetary and economic dimensions and, having responded with adequate political and bureaucratic decision-­ making, then emerged reasonably well prepared for handling future challenges.

20 General Readiness for GFC?

Which Crisis? Initial Response to the Crisis

Figure 1.3  Phases and variables affecting GFC country responses

Readiness of Budget Offices and Governments Before the Crisis

Fiscal and Economic Health of Countries

Stability and Strength of Governments

Capability and Readiness of Budget Offices

Budget System Maturity (across levels, regularity)

Budget, Financial System, Economic or Housing Crisis?

Quality and Speed of Initial Response to Crisis

Sufficiency of Stabilizing Measures; Initial Consequences

General Handling of GFC? Setting a New Course

Charting a Medium-Term Course: Policy and Process

Political and Governance Consequences

Readiness for Post-GFC Environment?

Readiness for New Challenges

Readiness for Subsequent Challenges



Meeting the challenge of the global financial crisis ­21

By contrast, another country could have started with poor readiness and repertoires, adopted a slow initial response followed by very tentative medium-­term planning and, as a consequence, remains poorly situated to deal with future challenges. Some of our case studies were in a middling state of readiness but, perhaps because of good political and bureaucratic leadership, acted in a decisive manner, and emerged from the crisis in ­relatively good shape with a robust plan and systems. The Focus on Fiscal Policies and Budgetary Systems Our previous book, The Reality of Reform, explicitly focused on expenditure budgets and budget institutions, and reform issues pertaining to them. The GFC, however, presented challenges to governments of considerable scope, demanding action and authorities broader than typical expenditure budgeting repertoires, involving fiscal and monetary policy interventions as well as significant stimulus and buy-­out packages and, for many jurisdictions, dealing with financial sector regulators and international institutions. Central budget agencies now found themselves on a broader field of play, engaging with a larger set of actors and pressures. Crises often reveal many of the latent and often taken-­ for-­ granted features of institutions and processes in which we are interested as ­researchers. With the GFC, a fast-­moving crisis required the compression of decision-­making and the involvement of many actors in order to achieve timely policy responses. This served to highlight the important aspects in the relationships between budgetary institutions, budgetary processes and governmental decision-­making: the role of prime ministers in working with finance ministers; the involvement of international institutions and networks; linkages between fiscal and tax policy and other parts of national expenditure budgets; and the political consequences of budgetary and economic decisions. In this context, we have chosen to focus our research at the level of budgetary systems, which goes beyond central budget agencies and expenditure management processes to include the larger set of actors, instruments and processes involved – typically on a rolling basis over the planning cycle – in ensuring a sound budget and financial management system for countries, including actors involved with financial regulation, prudential oversight and fiscal policy. This broad interpretation also includes the state of public finances and financial management, and indicators of the soundness of the financial and monetary system (including accumulated results such as the size of deficits, the amount of debt, bank failures, and so on). This volume provides an opportunity to see how well budgetary systems

22

The global financial crisis and its budget impacts in OECD nations

and their various actors advised and assisted governments in the face of a far-­reaching crisis with the pressing need to stabilize and provide resilience for larger governance systems and society. Taking this broader perspective does not mean we need to relinquish our focus on budget actors, processes and policy; rather, the nature of the GFC requires us to investigate how they performed under great stress. We need to consider how budgetary systems performed with an expanded array of actors and pressures in a highly compressed time period, and to consider the consequences from a budgetary perspective.

RESEARCH QUESTIONS AND METHODOLOGY Our study is guided by several broad research questions, many of which condition our subsequent questions. This section outlines these research questions along with some of our initial expectations, and then reviews the methodology and guidance given to the authors conducting the country case studies. Research Questions Our major research questions (and initial expectations) were as follows. Were governments ready for and even proactive about the GFC? Here we were curious about two related matters. First, we wanted to learn about how strong the economic, public finance and budget fundamentals were for each government jurisdiction. Our expectation was that countries with less debt and deficits to manage would find it easier to respond to the GFC, and that countries with tighter regulatory systems for financial institutions would have a more circumscribed crisis to address (fiscal and economic), no matter how daunting. Second, we wanted to learn about whether governments (and budget institutions in particular) possessed robust forecasting and early warning systems, and whether they had imagined the possibility of crises or shocks of the magnitude of the GFC. Again, our expectation was that, to the extent that budgetary systems were prepared to handle crisis situations, they would be better prepared to advise governments and implement their chosen policy responses. If governments were reactive, were they overwhelmed or resilient? It is not unusual for governments and their budgetary systems to encounter surprises, but we were interested in how quickly the gravity of the situation,



Meeting the challenge of the global financial crisis ­23

with its particular character in each jurisdiction, was recognized not only by the budgetary people but also by political leaders. We were interested in learning about the nature of the political decision-­making process: was there immediate consensus on what to do? If not, how did sufficient consensus emerge for action? We were also interested in learning about how budget offices, political leaders and other actors interacted. We were also very interested in how governments relied on or modified existing budget repertoires to deal with the financial crisis. Our expectations were that, to the extent that governments and their budget offices were working with good budget repertoires, were well led and had good rapport with political leadership, governments would be better able to assess the situation and develop more timely and concerted responses; particularly important when interventions in the economy and the financial sector had to be adroitly timed and delivered to maximize their effect. What was the role of international agencies and higher orders of government? For national governments with precarious debt, deficit and economic circumstances before the crisis, as well as those enmeshed in multilateral contexts (for example, the eurozone and the European Union), there were potential constraints on how quickly these governments could move to address the GFC. In some cases, international agencies, networks and higher governments could have served to stimulate and even demand action and coordinated responses. With these possibilities in mind, we were interested in whether and how international agencies and other governments influenced the strategies of national governments and their budget offices. We would expect that, to the extent that relationships and strategies were already worked out, national governments would be more responsive and better supported in addressing the crisis. We also expected that countries with less bureaucratic capacity and political will would be induced or coerced into action by international agencies and higher levels of government. What was the nature and mix of government interventions? As the crisis presented itself differently in each jurisdiction, this suggested that we had to pay close attention to the match of the policy response packages and the challenge in each country. Moreover, the key issue of the timing of the adopted packages was important, with respect not only to speed of adoption but also to how quickly different instruments promised to have an impact on the economy and financial sectors. We would expect that the policy mix would differ significantly depending on the perceived nature of the national crisis. If interventions were slow to be adopted and

24

The global financial crisis and its budget impacts in OECD nations

to take effect, then we would expect that perceptions of the quality of government performance would decline and there would be increased difficulty in charting exit strategies for rebalancing budgets over the longer term. What were the results and the exit strategy? Once governments adopted their respective stabilization, bailout and stimulus packages, they typically had increased their deficit and debt obligations, sometimes significantly so. An important question, therefore, concerned the costs and effectiveness of the interventions, and the impact they had not only on the economy and the national budget, but also on the fortunes of sitting governments. Over the medium to longer term, governments needed to address how they proposed to bring budgets into balance, continue nurturing their economies and re-­regulate financial institutions or develop better budget repertoires, if necessary. We would expect that, to the extent governments adopted earlier and more concerted responses to the GFC, they would be more likely to have a credible strategy for consolidating public finances, and to be more successful with respect to popularity and re-­election. We also expected that such governments would be better positioned to deal with subsequent economic and financial shocks, or other crises affecting their jurisdictions. In the final chapter of this book we will reflect back and consider whether the findings from the country case study chapters support our hypotheses and expectations, or whether more complicated or even counter-­intuitive dynamics were at play. Methodology Our methodology was as follows. To answer the specific research questions and still allow the research team to investigate individual country differences against the five phases of the crisis response cycle, we chose to feature individual country-­based case studies with the intention of compiling our comparative analysis by relying on a similar framework of analysis and research questions (and sharing these insights at a colloquium). While each case is written up separately, they all employ the response cycle framework and pursue the common research questions. We then return to a more traditional comparative assessment in the conclusion, tracing our main findings, and commenting on the robustness of the analytical framework. Countries were selected to cover a representative range of the advanced OECD nations: large and small, Old and New World, European and Asian, those with federal systems of government (or with regionally



Meeting the challenge of the global financial crisis ­25

devolved subnational governments) versus centralized unitary ones. In total 12 nations were selected. Ideally, we sought to select countries with different ‘going in’ positions: that is to say, we grouped potential cases into three groupings according to whether their economies, public finances and budgetary systems were strong and robust; or had reasonably strong economies but also underlying weaknesses in their government finances and budgetary systems; or had relatively weak fiscal monitoring and underperforming budgetary systems. Accordingly four countries with strong economies and budgetary frameworks were selected (Australia, Canada, New Zealand and Sweden). Four countries ‘going in’ with underlying weaknesses in their budgetary or regulatory systems were Denmark, Japan, the Netherlands and the United States. Finally, four countries with significant weaknesses in their fiscal position, budgetary frameworks, and often in their pre-­crisis economies, were Greece, Ireland, Portugal and Spain. Our various case study chapters each address the respective ‘going in’ position of the countries, and in the conclusion of this book we return again to these relative ‘going in’ positions as a crucial part of the explanation of resilience. In two chapters of the volume relatively similar cases have been coupled: Australia and New Zealand (Chapter 4), and Denmark and Sweden (Chapter 7). The rationale here was that these pairings share many common features (community values, political cultures and institutions), and had relatively strong budgetary positions and comparable economic performances. However, while their ‘going in’ situations were readily comparable, their assessments and responses sometimes varied markedly, suggesting that similar problems were dealt with in different ways due to the interaction of contextual factors in relatively similar political and economic jurisdictions. Again, as in previous comparative volumes we have been engaged in, we tried to pair academic scholars with expert practitioners; often the chapters are written by these complementary ­ teams, and, if not, practitioners were actively involved in the analysis but were unable to be named as a chapter author. We were insistent that authors should actively interrogate the analytical framework and the applicability of the research questions, and not ‘force’ their countries into the proposed framework mechanically or unquestioningly. This also provided a set of independent tests of the utility and robustness of the framework. We advised contributors that if the framework did not fit or suit their circumstances we certainly did not want the framework getting in the way of the analysis, and that they should craft a persuasive narrative of what transpired. Our fall-­back position was that a good story capturing the jurisdictional responses was preferable to a sterile imposition of the framework. Comfortingly, each author found value and merit in the

26

The global financial crisis and its budget impacts in OECD nations

structure of the analytical framework, because it was not overly prescriptive or too distortive and allowed for considerable national variability over the five phases. In many cases, contributors were conscious that there were many country-­specific variables and intricacies to cover in their chapters, and because of space limitations they were forced to be concise and condense what in many ways was a complicated journey through the crisis.

OVERVIEW OF THE VOLUME The volume proceeds with the two North American cases. In Chapter 2, Paul Posner and Denise Fantone recount how ‘crisis budgeting’ played out in the US with major fiscal injections initiated by the President and approved by Congress but little institutional post-­crisis institutional reform and an inevitable descent into fiscal gridlock at the federal level. This is followed in Chapter 3 by David Good and Evert Lindquist’s assessment of the Canadian responses, which they argue were clouded by indecision and a slowness to respond, due to the political convictions of the Harper government. John Wanna (Chapter 4) then traces Australian and New Zealand government responses, which were timely (but differed greatly in the magnitude of the fiscal stimuli used), and led both nations to promise an early return to surplus, although in Australia this was more problematic. In Chapter 5, Masahiro Horie traces the shifting sands of Japanese politics and documents the cascading Japanese fiscal injections, paid for through domestic bonds, but which proved less efficacious than expected, and left Japan with one of the world’s largest public debt ratios. Seven European countries are discussed in the next six chapters. In Chapter 6, Jouke de Vries and Tom Degen show how the Dutch government became embroiled in the crisis, and was then forced to nationalize banks and abandon its standard budgetary practices. They argue that while the Dutch government thought its economy and finances would rebound in the post-­crisis context, the subsequent European crises and euro bailouts meant that the nature of budgetary politics became less national in scope and more shaped by intense international negotiation. Lotte Jensen and Sysser Davidsen (Chapter 7) compare the responses from two Scandinavian exemplars of tight budgetary management; both adopted ‘lite’ responses and made relatively few changes to their budgetary systems as a result of the crisis. Sweden was hardly affected by the crisis, largely because the drop in GDP did not translate onto the government’s balance sheet; whereas Denmark found itself trapped in the crisis and looked to European budget rules to help recover and address its internal political problems. The Spanish, by contrast, were significantly impacted



Meeting the challenge of the global financial crisis ­27

by the GFC, creating incredible internal dislocation, unemployment and political turmoil (including exacerbating tensions between national and autonomous regional governments). But as Eduardo Zapico-­Goňi argues in Chapter 8, Spain did not maximize its opportunities to revive its economic credentials, and only slowly managed to stabilize its fiscal position through austerity measures and cutbacks. Paulo Pereira and Lara Wemans describe in Chapter 9 how Portugal became the third European power to require an international bailout, after decades of fiscal mismanagement and ballooning overseas debt. Portuguese governments were slow to react to the crisis, which flared into a full-­blown economic crisis, leading to a collapse of revenues and increased spending pressures. A similar story is presented by Michael Arghyrou in Chapter 10, who charts the ever-­ deepening economic depression that affected Greece from 2009 onwards, leading to a drop in GDP of almost 25 per cent after 2007 and eventually 25 per cent unemployment by 2012–13. The collapse of public finances and the downgrading of Greek bonds into junk status led to a series of emergency loans from European institutions and much talk of Greece exiting the eurozone. Meanwhile, Richard Boyle and Michael Mulreany (Chapter 11) account for the helter-­skelter ride that Ireland took from being the rich ‘Celtic Tiger’ to a poor, ‘basket-­case’ economy. They detail the painful austerity measures and belt-­tightening in areas of social provision that were forced on Irish society, with the gradual prospect of some return to prosperity detectable but still some way off. Finally, we return to our five-­ phase framework in the concluding Chapter 12, summarizing and commenting on how each country fared across the various stages of the crisis. Key findings that stand out from this comparative assessment of budgetary resilience include: the importance of preparedness and foresight; the determination to act and adjust policy settings quickly; the need for strategic thinking from politicians and senior economic and budgetary officials; an ability to implement domestic policy decisions; and the embrace of a viable exit strategy to restore sound finances in the medium to longer term. Fiscal consolidation has been a difficult road to follow, and not as easy to achieve as many of our country cases imagined when they first began to pull out of the crisis. We also address various significant ongoing fiscal and economic challenges that governments face today and into the future, including: lower revenue streams from their constituencies; tighter fiscal policy settings and budgetary disciplines; the difficulties of addressing continuing structural problems in domestic economies and the need for policies to avoid housing bubbles recurring; the need for achievable debt reduction strategies and the lingering problems of loan defaults and write-­offs of GFC bailout measures; and long-­term social problems in developed economies associated

28

The global financial crisis and its budget impacts in OECD nations

with ageing, demographic changes and escalating entitlement provision, as well as ways to re-­engage with the pool of long-­term unemployed created as a painful reminder of the crisis.

NOTE 1. For detailed accounts of developments, see Borio (2008: Annex 1), Federal Reserve Bank of St Louis (2011) and Hetzel (2012).

REFERENCES Allen, F. and E. Carletti (2010), ‘An Overview of the Crisis: Causes, Consequences, and Solutions’, International Review of Finance, 10 (1), 1–26. Ariff, M., J. Farrar and A. Khalid (2012), Regulatory Failure and the Global Financial Crisis, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Asian Development Bank (2009), ‘The Global Financial Crisis: Challenges for Developing Asia and ADB’s Response’, ADB, April. Baldwin, R., D. Gros and L. Laeven (2010), Completing the Eurozone Rescue: What More Needs to be Done?, London: Centre for Economic Policy Research. Beblavy, M., D. Cobham and L. Odor (2011), The Euro Area and the Financial Crisis, Cambridge: Cambridge University Press. Blinder, A.S. (2013), After the Music Stopped: The Financial Crisis, the Response and the Work Ahead, London: Penguin. Borio, C. (2008), ‘The Financial Turmoil of 2007 – a Preliminary Assessment and Some Policy Considerations’, Bank of Spain, Estabilidad Financiera, February, 23–54. Brunnermeier, M. (2009), ‘Deciphering the Liquidity and Credit Crunch 2007–08’, Journal of Economic Perspectives, 23, 77–100. Carmassi, J., D. Gros and S. Micossi (2009), ‘The Global Financial Crisis: Causes and Cures’, Journal of Common Market Studies, 47 (5), 977–96. Federal Reserve Bank of St Louis (2011), ‘The Financial Crisis: A Timeline of Events and Policy Actions’, http://timeline.stlouisfed.org/index.cfm?p5timeline. Fender, I. and J. Gyntelberg (2008), ‘Overview: Global Financial Crisis Spurs Unprecedented Policy Actions’, BIS Quarterly Review, December, 1–24. Glick, R. and M. Spiegel (eds) (2009), Asia and the Global Financial Crisis, proceedings of the Asia Economic Policy Conference, Santa Barbara, 19–20 October, San Francisco, CA: Federal Reserve Bank of San Francisco. Greenlaw, D., J. Hatzius, A. Kashyap and H. Shin (2008), ‘Leveraged Losses: Lessons from the Mortgage Market Meltdown’, US Monetary Policy Forum, Report No. 2, 7–59. Gruen, D. (2009), ‘Reflections on the Global Financial Crisis’, Address to the Sydney Institute, June, Australian Treasury. Hall, P. (2011), ‘The Economics and Politics of the Euro Crisis’, German Politics, 21 (4), 355–71. Haugh, D., P. Ollivaud and D. Turner (2009), ‘The Macroeconomic Consequences



Meeting the challenge of the global financial crisis ­29

of Banking Crises in OECD Countries’, OECD Economics Department Working Paper No. 683, March. Hetzel, R.L. (2012), The Great Recession: Market Failure or Policy Failure?, Cambridge: Cambridge University Press. Hood, C. and M. Wright (1981), Big Government in Hard Times, Oxford: Martin Robertson. Ito, T. (2009), ‘Fire, Flood, and Lifeboats: Policy Responses to the Global Crisis of 2007–09’, in R. Glick and M. Spiegel (eds), Asia and the Global Financial Crisis, San Francisco, CA: Federal Reserve Bank of San Francisco. Konings, M. (2010), The Great Credit Crash, London: Verso. Krugman, P. (2009), The Return of Depression Economics and the Crisis of 2008, London: W.W. Norton. Melvin, M. and M. Taylor (2009), ‘The Crisis in the Foreign Exchange Market’, CESIFO Working Paper No. 2707, July. Nanto, D.K. (2009), The Global Financial Crisis: Analysis and Policy Implications, Washington, DC: Congressional Research Service. OECD (2009), ‘Beyond the Crisis: Medium-­Term Challenges Relating to Potential Output, Unemployment and Fiscal Positions’, OECD Economic Outlook 85, Paris: OECD, pp. 211–41. Patterson, L. and C. Koller (2011), ‘Diffusion of Fraud through Sub-­ prime Lending: The Perfect Storm’, in M. Deflem (ed.), Economic Crisis and Crime, Bingley: Emerald Group Publishing. Pauly, L. (2009), ‘The Old and the New Politics of International Financial Stability’, Journal of Common Market Studies, 47 (5), 955–975. Pollitt, C. and G. Bouckaert (2011), Public Management Reform: A Comparative Analysis, 3rd edn, Oxford: Oxford University Press. Quaglia, L. (2009), ‘“The ‘British Plan” as a Pace-­Setter: The Europeanization of Banking Rescue Plans in the EU?’, Journal of Common Market Studies, 47 (5), 1063–83. Rasmus, J. (2010), Epic Recession: Prelude to Global Depression, London: Pluto Press. Rudd, K. (2009), ‘The Global Financial Crisis’, Monthly, February. Salamon, L.E. (2002), The Tools of Government, New York: Oxford University Press. Schick, A. (2009), ‘Crisis Budgeting’, paper prepared for Working Party of Senior Budget Officials, OECD Conference Centre, May–June, Paris: OECD. Schick, A. (2010), ‘Post-­ crisis Fiscal Rules: Stabilizing Public Finance While Responding to Economic Aftershocks’, Paper prepared for Working Party of Senior Budget Officials, Athens, June, Paris: OECD. Shiller, R.J. (2008), The Sub-­prime Solution: How Today’s Global Financial Crisis Happened, and What To Do About It, Princeton, NJ: Princeton University Press. Soros, G. (2012), Financial Turmoil in Europe and the United States, New York: Public Affairs. Stiglitz, J. (2010), Freefall: America, Free Markets and the Sinking of the World Economy, London: W.W. Norton. Taylor, M. and R. Clarida (2011), The Global Financial Crisis, London: Taylor & Francis. Van Overtveldt, J. (2011), The End of the Euro: The Uneasy Future of the European Union, Chicago, IL: B2 Books.

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Wanna, J., L. Jensen and J. de Vries (2003), Controlling Public Expenditure: The Changing Roles of Central Budget Agencies, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wanna, J., L. Jensen and J. de Vries (eds) (2010), The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.

2. The United States’ response to the global financial crisis: from robust stimulus to fiscal gridlock Paul L. Posner and Denise M. Fantone1 The global financial crisis (GFC) arrived at a most inopportune time for the United States. The budget was already burdened with substantial new fiscal imbalances, as the nation stood on the precipice of the retirement of the ‘baby boom’ generation. The chronic deficits with which the nation had struggled for the better part of 35 years were scheduled to explode to unsustainable levels through the next several decades unless serious reforms were undertaken on the spending and revenue sides of the budget. The financial crisis accelerated the day of fiscal reckoning, prompting deficits to exceed 10 percent of gross domestic product (GDP) – the highest peacetime deficits in US history. The crisis affected fiscal balances in two ways. First, the sharp fall in economic growth and jobs triggered automatic stabilizers, which caused revenues to plummet to a record postwar low accompanied by higher spending. Second, both the Bush and Obama administrations were forced to make unprecedented commitments of new federal resources to rescue large financial firms and jump-­start the economy through a stimulus initiative approaching US$1 trillion over several years. These two policy actions were estimated to have saved nearly 8 million jobs, which some felt saved the economy from toppling into a depression (Zandi and Blinder 2010). While the economy has been officially deemed to be out of the recession, growth is slow and many worry about a ‘double dip’ recession. Unlike previous recessions, the return of strong growth will not end the fiscal gaps facing the nation, but will serve as the prelude for even more difficult and wrenching choices. The US response to the financial crisis has been shaped by a profound ambivalence in both fiscal policy and the public’s views of government and budgeting. First, fiscal policy itself was caught between the continuing need in the short term to prop up a weak economy, and the longer-­term desire to reduce unsustainable deficits. Indeed, the economy was saved from the jaws of depression by actions that served to accelerate the growth 31

32

The global financial crisis and its budget impacts in OECD nations

of deficits that had already become unsustainable for the longer term. As the nation reversed course and adopted new fiscal consolidation initiatives in 2011, many economists and high-­level officials remained cross-­pressured between their desire to reduce deficits and their concern that such actions may cripple the nascent recovery. Indeed, in late 2013, the Republican Congress and Democratic President Obama agreed on legislation to suspend the across-­the-­board cuts on discretionary spending for at least several years – cuts that had been adopted just two years earlier.2 A republic founded on the principle of limited government, the nation has never reconciled itself to a strong role for government or to the financial resources that expansive public programs require. Reflecting this, the public and their political leaders typically hold contradictory views of the budget. When asked in polls, most Americans want a balanced budget, but oppose both higher taxes and cuts to major programs. Their leaders have encouraged fiscal illusions by promoting proposals that suggest the US can reach fiscal nirvana without hard choices on the tax and spending sides of the budget. A more polarized party system has prompted a more ideological view of budget choices, offering seemingly irreconcilable strategies for deficit reduction that are designed more to appease extreme wings of their respective parties than to reach the kind of cross-­partisan accommodation that will be necessary to solve these problems in the American system of separation of powers. The debt crisis of August 2011 illustrated how partisan polarization jeopardized the credit rating of the US Treasury, even as the resulting cross-­partisan agreement in the next several years ushered in spending cuts and tax increases that kept the rising debt in check, at least into the near future.

THE FISCAL AND POLITICAL BACKDROP Over the more than 200-­year life of the nation, the federal budget process has evolved through several distinct fiscal policy regimes. For much of US history, fiscal policy became the island of stability for a government that was perennially challenged by economic volatility, demographic and territorial change, and war. Challenged at the outset to overcome the fiscal impotence that hamstrung national government in the Revolutionary War and after, the balanced budget and public financing regime instituted by the founders became the foundation for fiscal policy for the next 150 years. Webber and Wildavsky (1986) characterized budgetary balance as the nation’s traditional religion. Until the New Deal period, economic depressions failed to sway the nation’s policy-­makers from the balanced budget



The United States’ response to the global financial crisis ­33

10

Surplus or deficit as a share of GDP (1797–2009) Percent of GNP/GDP

5 0 –5 –10 –15 –20 –25 –30 –35 1797

1820

1840

1860

1880

1900

1920

1940

1960

1980

2009

Note:  Data until 1929 are shown as a percentage of gross national product (GNP); data from 1930 to present are shown as a percentage of GDP. Source:  Department of Commerce, Office of Management and Budget, and Congressional Budget Office.

Figure 2.1  Fiscal history of the United States

course. Even during the New Deal, President Roosevelt sought to balance the budget in 1937, which caused renewed recession. The persistence of fiscal balance through much of the nation’s history is illustrated in Figure 2.1. With the exception of wars and severe depressions, the nation ran balanced budgets or surpluses for much of its history through to 1970. The second regime had its origins in the New Deal, but came to full flower in the late 1960s through to the present time. The federal role in balancing the economy supplanted older balanced budget rules as the watchword for fiscal policy-­makers, in keeping with Keynesian principles. However, contrary to Keynes, deficits persisted during periods of economic expansion and inflation, and were transformed from cyclical to more permanent structural imbalances between spending and revenues. Traditional policy-­making institutions and rules that anchored federal budgets to incremental norms were unseated by increasingly novel open-­ ended entitlements and tax expenditures that grew according to their own

34

The global financial crisis and its budget impacts in OECD nations

gyroscopes. As shown in Figure 2.1, the ‘civil religion’ of budget balance was defrocked after 1970, as the nation experienced nearly three decades of deficits in the absence of great wars or depressions.

EROSION OF POLITICAL CONSENSUS AND THE ONSET OF GRIDLOCK If the growth of open-­ended programs made budget and deficit control more difficult, the erosion of the political base for consensus over the budget and national priorities undid the political foundation for the old balanced budget religion. The past 30 years witnessed the collapse of the middle ground in national policy institutions, as the parties realigned regionally and became far more polarized. As the primary system has become the dominant model for nominations across the nation, members of Congress became increasingly sensitive to the positions of the more ideologically extreme factions within their parties, who dominate turnout in primary election contests. The general ‘median voter’ traditionally posited as being in the forefront of political leaders’ calculations in position-­taking in Washington policy-­making has been supplemented or even supplanted by the ‘median primary voter’, a far more polarizing force that arguably accentuates the incentives for gridlock and stalemate in policy formation and leadership in Washington. The interest group system disintegrated into a veritable Babel of newly emergent groups capitalizing on the lower costs of participation and the higher powers of the web, among other factors. The media core was replaced as well by a far more competitive system of more diverse publications, narrowcasters and web-­based outlets all searching for new stories and angles. Old Washington policy-­making processes featuring bargaining in closed sessions were replaced by a far more open and conflictual process where influence is pursued through appeals to broader publics throughout the nation. The trade-­offs and hard choices that budgeting requires are far more difficult to achieve under this new political system. The virtual fish bowl of media and interest group coverage makes forming coalitions and winning necessary concessions far more difficult and even politically hazardous for members of Congress and Presidents alike. The disappearing ‘middle’ in Washington removed the ballast that is often so essential to bring about fiscal order from the political cacophony that is Washington today. Ironically, as the political system became more conflictual, formal rules and structures became more essential for budgeting. Members needed more formal institutions to enable them to make the hard choices and



The United States’ response to the global financial crisis ­35

trade-­offs that were once embedded in more informal institutional arrangements, centrist coalitions and shared values. However, the fact that budget process had become more central to budgetary decision-­making also made the budget process more vulnerable and less sustainable. The Congressional budget process of 1974 marked a new step in the evolution of budget control by the legislature. Decades after the President acquired the executive budget, Congress established its own comprehensive budget process requiring it first to go on record supporting a broad fiscal policy. Coupled with other changes in the party system discussed above, this polarized budget debates in ways that were diffused and defused under the older disaggregated system. Both the President and Congress had incentives to reach for overly ambitious and symbolic fiscal goals that were often difficult to sustain in subsequent appropriations and authorizations to enforce those decisions. Differing fiscal goals are embraced by each party as a proxy for overarching differences in policy priorities and governance competency. Over the past decade, Congress was unable to pass a budget resolution during election years, poignantly illustrating that no budget process reform can save the political system from itself.

EPISODIC FISCAL CONSOLIDATION INITIATIVES This is not to say that fiscal balance and restraint cannot occur in the second fiscal policy regime. To the contrary, deficits have been reduced and even eliminated at times, but only on an episodic basis, not as a regular outcome driven by deeply rooted values and institutions. In the 1990s, Congress and the President were able to agree on fiscal consolidations that collectively resolved deficits and moved the nation to four years of budget surpluses in the second fiscal policy regime. Interestingly, divided government was more often responsible for prompting fiscal balance, as two of the three major deficit reduction actions during that decade occurred under a divided regime. In 1990, alarm expressed by the Federal Reserve and bond markets prompted President George H.W. Bush to reverse his campaign pledge against tax increases by reaching a major agreement with Democratic leaders in Congress to increase income and excise taxes, as well as to institute major spending cuts in entitlements and discretionary spending. Bill Clinton followed suit, breaking his own campaign promising a middle-­ income tax cut to achieve yet another major set of cuts and tax increases in 1993. These initiatives were reinforced by budget process reforms. Going beyond the Congressional Budget Act, Congress periodically instituted

36

The global financial crisis and its budget impacts in OECD nations

reforms to tie its hand to the mast of fiscal responsibility. The first effort under Gramm–Rudman–Hollings of 1985 sought to bring about budget balance by legislative fiat; an enterprise that was undermined by a deteriorating economy and the lack of congressional consensus over how to achieve audacious deficit reduction goals (Tat-­Kei Ho 2010). The budget community learned from this that budget process reforms cannot generally be expected to drive fiscal policy or to magically create the will to mete out fiscal sacrifice in the absence of underlying political consensus. Rather, process was reconceived as a way to solidify, implement and reinforce agreements reached through prior political bargaining. The Budget Enforcement Act of 1990 (BEA) followed this model by creating caps on discretionary spending and pay-­as-­you-­go (PAYGO) discipline, preventing new entitlements and tax cuts that were not deficit-­ neutral. These process reforms continued to serve as the foundation for Congressional budget rules even when they expired in 2002, as they were continued as part of Congressional budget rules since then. The budget cuts of the 1990s, along with a powerful economic tailwind, caused the nation to amass four years of budget surpluses. Building on the foundation of budget reforms and stronger than expected growth, revenues surpassed the expectations of the forecasters for several years running. Surpluses constituted the ironic fruit of divided government during this period, reflecting the inability of the two parties to agree how to allocate them between tax cuts, new spending and debt reduction.

THE FALL FROM FISCAL GRACE, 2001–11 As President George W. Bush took office, the Congressional Budget Office (CBO) projected ten-­year surpluses amounting to a total of $5.6 trillion between 2001 and 2011. These surpluses would have eliminated the federal debt over time and caused the US Treasury to invest funds in the market, in the unlikely event that surpluses were retained. The idea of saving all of the surpluses was unrealistic. Even nations such as New Zealand, Sweden and Canada, that retained surpluses for nearly a decade, nonetheless had to allocate some funds for tax cuts and additional spending (Posner and Gordon 2001). The United States, however, did not save any of the surplus beyond 2000, and instead recorded a cumulative deficit of $6.2 trillion; a swing of $11.8 trillion from the initial projections of surpluses as far as the eye could see at the outset of 2001. The profligate record of the United States obviously put to rest any fears that Federal Reserve Chairman Alan Greenspan and others may have had that the federal government might wind up owning assets once it paid off



The United States’ response to the global financial crisis ­37

2500

2000

Discretionary Net Interest Tax Cuts Econ/Tech

1500

Mandatory

1000

500

0 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source:  CBO (2011c).

Figure 2.2  Fiscal swing, 2001–11

the public debt. In fact, public debt nearly doubled from the 2001 level of 32 percent of GDP to 62 percent by 2010. Figure 2.2 shows the factors that caused the $11.8 trillion swing from projected surpluses to higher deficits, based on analysis by the Congressional Budget Office. The return of unified government with single-­ party control of President and Congress in most of the Bush years and the first two years of Obama’s presidency served to unleash a torrent of new tax cuts and spending that quickly disposed of the surpluses. As Figure 2.2 shows, policy changes in revenues and spending far overshadowed economic and technical changes. Specifically, $7.1 trillion of the swing was due to policy changes, with the remainder accounted for by higher interest and economic and technical changes. As the chart in Figure 2.2 illustrates, the largest effects of these changes were caused by the financial crisis of the past several years. Among the policy changes, tax cuts ushered in by President Bush in 2001 and 2003, along with smaller stimulus tax cuts passed during the Obama regime, were responsible for a good portion of the fiscal shift. The tax cuts were ostensibly offered as a response to the slowing economy in 2001 and again in 2003. However, unlike traditional counter-­cyclical tax cuts, the Bush tax cuts did not end when the economy emerged from the mild recession of 2000 but actually grew larger, with various phase-­ins over

38

The global financial crisis and its budget impacts in OECD nations

the decade. It was only in January 2013 that President Obama was able to gain partial reversal of the Bush tax cuts for those in the highest income categories.3 In total, spending exceeded tax cuts as a source of the higher deficit, accounting for $4.3 trillion over the ten years. Most of the additional spending fell into the discretionary category, with spending for Iraq and Afghanistan and homeland security following the September 2001 t­ errorist attacks, and the economic recovery program of the Obama administration. The remainder of the spending constituted increases in entitlements, with the Bush prescription drug program for seniors being the largest single item. Additional interest on the debt comprised nearly $1.4 trillion over the decade, reflecting higher public debt from increased deficits. Importantly, the policy changes that caused the fall from surpluses were not offset by other deficit reduction measures, as required by the budget process regime beginning with the Budget Enforcement Act 1990. In general, Congress was able to ignore these rules partly because the surplus diminished the sense of urgency about deficits in general. Also Bush, and to a lesser extent Obama, had very cohesive majorities in both Houses of Congress that were able to ignore points of order raised against proposed legislation by those concerned about deficits.

THE FINANCIAL CRISIS AND THE BUDGET Thus, the federal government carried a substantial structural deficit into the GFC when it hit with full force in 2008. The seeds of the crisis, labeled the ‘Great Recession’, were laid in the previous 25 years of innovative financing and borrowing that rested on the foundation of record consumption financed by debt and infusions of capital from abroad. What this masked was a secular drop in domestic savings from personal and governmental sources, as personal savings fell to close to zero from rates as high as 10 percent 40 years ago. Borrowing served as the shaky foundation undergirding corporate investment, government spending and personal consumption. At the personal level, for instance, incomes were stagnant and savings were insufficient to finance higher consumption, but expansive credit markets provided ever higher credit to a greater share of the income scale. Lower interest rates in general were sparked by the influx of savings from abroad, which saved the nation from the ravages of low savings that could have staunched economic investment and growth. Nowhere were these trends more evident than housing. Sophisticated financing strategies vacuumed more money into housing, thanks to the



The United States’ response to the global financial crisis ­39

securitization of mortgages, the use of credit scoring which extended housing credits to larger numbers of lower-­income families through subprime mortgages, and low interest rates which encouraged a speculative spike in housing prices. The expansive housing finance market worked as long as housing prices kept rising. However, prices for housing behaved in accord with the laws of economics: inflated prices must eventually come down. Housing loans were securitized and sold to investors throughout the world, appearing on the balance sheets of many financial institutions. As the underlying value of the loans themselves became more suspect, these instruments contaminated balance sheets and eroded the confidence of counterparties and investors. The widespread use of credit swaps to insure debt and investments further spread the risk of these bad loans worldwide. As assets and balance sheets in general became less transparent and clear, trading across financial institutions ground to a halt. As the flow of credit slowed, the housing finance vulnerabilities spread to the broader economy. Banks and other financial institutions were unable to raise funds in even short-­term debt due to concerns about the presence of toxic debts on their balance sheets. Recessions caused by crises in financial institutions are typically deeper and more persistent than other kinds of recessions. This is partly due to the prevalence of caution about new borrowing exhibited by businesses, households and their bankers. Production and consumption fail to pick up momentum accordingly. Following rapid declines in housing markets, GDP fell 4.1 percent from peak to trough, the largest decline in US postwar history. Unemployment surged to more than 10 percent.

COUNTER-­CYCLICAL POLICY It is ideal when monetary and fiscal policy operate in coordination to blunt the impacts of spikes in business cycles on the economy; an ideal which often does not materialize in the real world. However, the Great Recession was one occasion where there was close collaboration between monetary policy stimulus and fiscal policy. From 2008 through to the present time, both levers worked together to significantly mitigate the consequences for GDP and unemployment. Moreover, unlike previous recessions, federal counter-­cyclical help came relatively quickly after the onset of the recession. Estimates by Marc Zandi and Allan Blinder show that together, the federal stimulus and bailout programs averted a broader depression. Real GDP remained 15 percent higher, there are almost 10 million more jobs and unemployment is about 6 percentage points lower than if none of these policies had been put in place (Zandi and Blinder 2010).

40

The global financial crisis and its budget impacts in OECD nations

The federal response had three major components: ●●

●●

●●

Traditional and non-­traditional monetary policy, including nearly zero short-­ term interest rates and novel Federal Reserve Board credit-­easing strategies. Treasury acquisition of and assistance to financial institutions and selected major industries such as the automobile industry, which helped to avert a financial and economic collapse (the Troubled Asset Relief Program 2008 – TARP). Federal fiscal stimulus provided both by automatic stabilizers on the revenue and spending sides of the budget, and the Obama administration’s American Recovery and Reinvestment Act (ARRA), which provided more than $800 billion in grants, direct spending and tax cuts.

The monetary and fiscal policy responses came first, as federal officials scrambled to prevent the meltdown of the US and global financial credit markets. As markets were unable and unwilling to provide financing and credit for firms to satisfy their obligations, both the Federal Reserve and the Treasury became lenders and financiers of last resort. Breaking with long-­standing traditions of limited government, the federal government took action to keep firms alive that were perceived to be ‘too big to fail’, such as Bear Stearns and American International Group (AIG). Monetary policy was an essential part of the response, as interest rates were lowered to near zero by the Federal Reserve. However, recognizing the need for additional credit, monetary officials created new tools to restore the credit markets by providing additional lending to financial institutions, enhancing liquidity to credit markets, and purchasing longer-­term financial assets in the form of government-­sponsored enterprise (GSE) obligations and federal Treasuries (Carlson et al. 2009). The chart in Figure 2.3 shows how the Federal Reserve ramped up credit-­easing instruments to jump-­start lending in the critical months following the collapse of the financial system.

IMPACT ON THE FEDERAL BUDGET A recession with the financial implications of this one obviously had great consequences for the budget. CBO deficit estimates in Figure 2.4 illustrate the major impact that the financial crisis had on budget deficits as a share of GDP. While deficits ranged from 2 percent to 3 percent of GDP in the years preceding 2008, the crisis quickly deepened deficits to levels



The United States’ response to the global financial crisis ­41

Billions of dollars 2600 2400

Longer-Term Security Purchases

2200 2000

Providing Liquidity to Key Credit Markets

1800 1600 1400 1200 1000 800 600 400 200

Lendings to Financial Institutions

Traditional Security Holdings Net of Securities Lent

0 6/07

9/07

12/07

3/08

6/08

9/08

12/08

Source:  Federal Reserve Board.

Figure 2.3  Federal Reserve strategies (Percentage of gross domestic product) 4

Actual

2

4

Projected

2 0

0 –2

CBO’s Baseline

–4

Continuation of Certain Policies

–6 –8

–4 –6 –8 –10

–10 –12 1971

–2

1976

1981

1986

1991

1996

2001

2006

2011

2016

–12 2021

Note:  The projected deficit with the continuation of certain policies is based on several assumptions: first, that most of the provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111–312) that originally were enacted in 2001, 2003, 2009, and 2010 do not expire on 31 December 2012, but instead continue; second, that the alternative minimum tax is indexed for inflation after 2011; and, third, that Medicare’s payment rates for physicians are held constant at their 2011 level. Source:  Congressional Budget Office.

Figure 2.4  Deficit trends

42

The global financial crisis and its budget impacts in OECD nations

(Percentage of gross domestic product) 120

Actual

Projected

Continuation of Certain Policies

100 80 60 40

CBO’s Baseline

20 0 1940

1950

1960

1970

1980

1990

2000

2010

2020

Note:  The projected deficit with the continuation of certain policies is based on several assumptions: first, that most of the provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111–312) that originally were enacted in 2001, 2003, 2009, and 2010 do not expire on 31 December 2012, but instead continue; second, that the alternative minimum tax is indexed for inflation after 2011; and, third, that Medicare’s payment rates for physicians are held constant at their 2011 level. Source:  Congressional Budget Office.

Figure 2.5  Trends in federal debt exceeding 10 percent. The graph also shows that deficits are returning to their pre-­crisis path, and are expected to be below 3 percent of GDP for much of the next decade (Congressional Budget Office 2014a). Much of this is attributable to a growing economy, but some can be chalked up to agreement by President Obama and the Republican Congress to cut discretionary spending and raise taxes on high-­income groups. Debt held by the public jumped from 40 percent of GDP in FY2008 to 67 percent just three years later. As shown in Figure 2.5, debt levels are projected to come close to 80 percent of GDP in ten years. The effects of the Great Recession were particularly acute on the revenue side of the budget. Revenues crashed from 18.5 percent of GDP in 2007 to 14.9 percent of GDP in 2010, a level not seen since 1950. This reflects both the significant effects of the financial crisis as well as the tax cuts of the period, which had grown over the decade as they were phased in. For the Organisation for Economic Co-­operation and Development (OECD) as a whole, the automatic stabilizers accounted for about 50 percent of the cumulative deterioration of fiscal balances, while fiscal stimulus accounted for about 20 percent of the increased deficits. In the United States, the magnitude of the counter-­cyclical financial bailouts and the economic stimulus programs was higher as a share of the fiscal response. From 2009 through 2011, the two major stimulus measures that



The United States’ response to the global financial crisis ­43

were passed, one in 2009 and the other in 2010, spent over $1.1 trillion during those three years alone, slightly more than the $1 trillion fiscal effects of the automatic stabilizers. Indeed, the United States and Korea had the largest fiscal stimulus packages as a share of GDP of any of the OECD nations (Posner and Blondal 2012). The federal budget was not the only public budget that was affected by the recession. State and local governments experienced the brunt of fiscal pain far earlier than the federal government. Although state and local government spending is only half of the federal government’s size, their cuts constitute a drag on recovery. Unlike the federal government, states and localities face pressures to balance the general fund portion of their budgets, about 50 percent of total spending. Pressures come not only from constitutional balanced budget provisions, but more importantly also from bond markets, which can hike interest costs for those governments which are viewed as fiscally profligate. Given the depth of the recession and their accountability for growth and jobs, the Obama administration channeled significant federal aid to states and localities to reduce the full force of state and local fiscal pressures on the recovery. While the ARRA program helped to prop up state and local budgets by providing nearly $300 billion in federal grants, states nonetheless experienced nearly $425 billion in deficits since the recession began (Johnson et al. 2011).

A TALE OF TWO INTERVENTIONS: TARP AND ARRA TARP and ARRA illustrate how a national economic crisis can compel concerted action by leaders of both parties to staunch losses and bring about recovery. This was not the first time the US federal government had intervened to rescue financial institutions and prevent bank runs, and ARRA was not even the first fiscal stimulus of this recession. But TARP, enacted in 2008 in the waning days of the George W. Bush administration, and ARRA, the first major legislation of the new Obama administration, were bookend emergency actions that in size and scope simply eclipsed all previous economic and fiscal stimulus measures. Accordingly, it is important to explore more in depth how these two measures came about and what challenges they faced in achieving their economic and policy goals. Two years after the US recession was officially declared ended, most of TARP and ARRA’s direct budgetary impacts are known, with their greatest effects occurring between fiscal years 2009 and 2011. Beyond their direct impacts on the federal budget, most economists and budget experts

44

The global financial crisis and its budget impacts in OECD nations

credit TARP with helping to stabilize financial institutions and calm markets, and ARRA with shoring up state and local governments and increasing employment. Yet a majority of Americans believe that TARP and ARRA have been ineffectual, or worse, that they represent Wall Street or Big Government interests over Main Street concerns. Critics prophesy that TARP has made it more likely that financial institutions will take questionable risks in the future, while ARRA detractors point to continuing high unemployment and compounding deficits and debt as the true legacy of the fiscal stimulus measures.

LET’S NOT CALL IT A BAILOUT, LET’S CALL IT A RESCUE In September 2008 the housing bubble, the liquidity crunch and the financial crisis culminated in a string of unprecedented events that convinced Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke, and the Secretary of the Treasury, Henry Paulson, that actions within their authority would be insufficient to unfreeze the drastically reduced flow of credit caused by illiquid mortgage-­related assets. In testimony on 24 September, before the Senate Committee on Banking, Housing, and Urban Affairs, Secretary Paulson described the need for a program to remove troubled assets from the system quickly, that would be significant enough to restore market confidence. Additionally, it should protect taxpayers to the maximum extent possible and provide transparency and oversight. What followed on 20 September was a mere three-­ page legislative proposal requesting authority to purchase the troubled assets of financial institutions, particularly residential and commercial mortgage-­related assets. This was the beginning of TARP’s troubles. No one proposes anything in Washington in three pages, let alone a program that would make the federal government a private sector shareholder and create unknown, but potentially huge, financial risks for taxpayers without benefit of oversight or review. And the size of the budget request was eye-­ popping. As the New York Times reported: A $700 billion expenditure on distressed mortgage-­related assets would roughly be what the country has spent so far in direct costs on the Iraq war and more than the Pentagon’s total yearly budget appropriation. Divided across the population, it would amount to more than $2,000 for every man, woman and child in the United States. (Herszenhorn 2008)

Over the next two weeks the proposal was revised, expanded and signed into law on 3 October 2008 with bi-­partisan support. However just days



The United States’ response to the global financial crisis ­45

after enactment, Treasury officials changed course and provided capital and guarantees to eight of the largest US financial institutions. While appealing in theory, the Treasury realized that it would be very difficult to establish a market for toxic assets with unknown risks and prospects. Given the emergency facing worldwide credit markets, the Treasury adapted quickly by providing capital injections to major financial institutions to restore their balance sheets and restore the confidence of markets in the financial solvency of these institutions. Nevertheless, this tactical shift raised questions about the direction of the program and the transparency of the Treasury’s actions. That Secretary Paulson was a former Chairman of Goldman Sachs added fuel to concerns that the legislation had given unfettered economic authority to a single unelected official. Reassurances from presidential candidate John McCain and others that this was not a bailout but a rescue of Main Street America did not dampen public skepticism. One of the continuing controversies regarding TARP has been its focus on assisting financial institutions over providing relief to homeowners facing foreclosure. Although the Treasury created several programs to help homeowners directly or indirectly through state housing authorities or mortgage servicers, these programs have been slow to gear up (Department of the Treasury 2011). Neil Barofsky, the Special Inspector General for TARP, made clear in his last report that these programs were not mere window-­dressing, but crucial to getting the votes of reluctant legislators; a vote that for some proved to be political suicide. The Congressional Oversight Panel (COP), one of several entities charged with monitoring TARP’s implementation, echoed the following sentiment: The program’s potential was oversold as a means to ‘protect home values, college funds, retirement accounts, and life savings’ and ‘preserve homeownership and promote jobs and economic growth’ when TARP was always intended by Congress and Treasury to primarily recapitalize banks rather than buy assets. (Congressional Oversight Panel 2011)

On 21 July 2010, President Obama signed into law the Dodd–Frank Wall Street Reform and Consumer Protection Act, legislation intended among other things to correct the systemic regulatory problems identified as contributors to the US financial crisis of 2007–09. While the legislation broadened the scope of market transactions to be overseen by federal agencies, implementation requires new structures and additional staffing that have been jeopardized by the resurgence of deficit reduction initiatives. Moreover, several years after passage of the reform, the new regulatory authority has led to a counter-­mobilization of regulated firms and ideological allies concerned about the centralization of federal power.

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The global financial crisis and its budget impacts in OECD nations

A MODEST PROFIT TARP in its final form provided: ●● ●● ●● ●●

capital and other support to financial institutions; funds and guaranteed assets for certain credit markets; financial assistance to the automotive industry; and business and consumer loans, as well as compensation to some mortgage servicers for homeowner loan modification.

As Figure 2.6 shows, most TARP expenditures were authorized to recapitalize financial institutions, followed by support to the automotive

TARP EXPENDITURES BY SUPPORT CATEGORY $ Billions, % of $454.3 Asset Support Programs $26.7

Homeowner Support Program $27.1

Automotive Industry Support Programs $81.1

Financial Institution Support Programs $319.5

Note:  Shows gross disbursements and not net present value as of September 2009. Source:  US Department of Treasury (2009).

Figure 2.6  TARP expenditures by program



The United States’ response to the global financial crisis ­47

industry. Purchase of assets and assistance to prevent foreclosures make up the remaining support programs. Initially, the significant uncertainty over TARP’s implementation and significant delegation of authority to the Treasury and Federal Reserve Board left the CBO unable to estimate the budgetary effects of the legislation. The agency concluded that the ultimate cost would be lower than the upper limit of $700 billion authorized for asset purchases, because of the high likelihood that the federal government would sell those assets at some point in the future (CBO 2008). So as not to overstate TARP’s budgetary impact, the CBO was directed to use net present value scoring for calculating the net costs to the government from TARP transactions. Accordingly, the cost to the government was recorded not as the face value of a TARP purchase, but rather as the estimated net present value basis for all future cash flows, adjusted for market risk (CBO 2009). Rather quickly, the Treasury determined that it would not need the full amount authorized, and CBO’s March 2009 re-­estimate showed that TARP would ultimately cost about $350 billion and not $700 billion. Since then the costs have been re-­estimated numerous times and the budgetary impacts have changed significantly, so that the net cost to taxpayers will be $28 billion according to the CBO’s most recent ten-­year projection (CBO 2015b). The CBO report concludes that the federal government net costs stem from the assistance to the American International Group (AIG), aid to the automobile industry and the continuing grants to forestall home mortgage foreclosures. While both the AIG and American automobile companies prevented impending bankruptcies, those institutions have now emerged from the federal program, although the federal costs of those companies’ assets have exceeded the receipts the government reaped from their sales. The bulk of TARP purchases of assets of financial institutions, however, realized net gains for the federal budget, as federal receipts from sales outweighed the initial purchase costs. TARP accomplished its primary purpose of increasing liquidity and stabilizing the financial markets at a much lower cost than anticipated. Yet when asked in a Bloomberg poll in December 2010 how TARP had affected the economy, only 24 percent of the public said it had helped. Forty-­three percent said that it had weakened the economy, and another 21 percent that it had made no difference (Samuelson 2011). When asked whether the money extended to banks would be repaid, 60 percent thought that the funds would be lost and only 33 percent believed that most would be recovered (Congressional Oversight Panel 2011). Given the amount of attention paid to the initial $700 billion estimate for TARP, the public would most likely be amazed to learn that the current estimate has ­dwindled to $23 billion.

48

The global financial crisis and its budget impacts in OECD nations

THE RECOVERY ACT: CONVERTING CRISIS INTO OPPORTUNITY The case for a significant fiscal stimulus had been building as the economic situation worsened and government actions, including the Bush administration’s Economic Stimulus Act of 2008, fell short. As the merits of a second stimulus package were debated, the description by former Clinton Treasury Secretary Summers of an ideal stimulus as timely, targeted and temporary caught on. By the November 2008 presidential election the main question was not whether a fiscal stimulus was needed, but how large it should be. Some of President-­Elect Obama’s advisors wanted a fiscal stimulus in excess of $1 trillion, but this was thought to be politically unattainable. Facing a House and Senate controlled by his own party, President Obama was able to secure passage of the stimulus bill quickly, but political differences emerged even among Democrats. While there was general agreement among House Democrats that the stimulus bill should focus on protecting the most economically vulnerable, the Democratic-­led Senate included a provision to keep many in the higher middle class from paying the alternative minimum tax – a measure originally intended to reach upper-­income Americans who could shelter their wealth, but which through years of inflation had increasingly hit persons of more modest income. Providing fiscal relief to state and local governments was a priority for most, but Congressional Democrats disagreed on how much should go towards infrastructure investments and so-­called ‘shovel-­ready’ projects (ready for construction) versus general fiscal relief to make up for lost state and local revenue. Then there were initiatives important to the new administration, such as green energy technology and high-­speed rail, which were programs that represented the reinvestment commitment of the Act. In contrast to the bipartisan support received for the initial TARP bailout, Republicans presented a nearly united front, opposing the stimulus in both House and Senate, except for three Republican Senators who voted for the bill. In the end, ARRA was a compromise. Or as one political pundit wrote: ‘the resulting package is part temporary and part permanent, part timely and part untimely, part targeted and part untargeted’ (Brooks 2009). Split into three roughly equal parts, $285 billion of ARRA funding went to states and localities as grants, and another $227 billion to support future-­oriented reinvestment initiatives, such as health care information ­technology and green energy projects. The final third provided $275 billion in tax relief for corporations and individuals. With the crucial votes of three Republic senators that allowed him to claim bi-­partisan support, President Obama signed ARRA into law on 17 February 2009.



The United States’ response to the global financial crisis ­49

A TIME TO BUILD DEFICITS UP AND A TIME TO TEAR THEM DOWN Figure 2.7 groups ARRA by areas of focus and the relative share of funding authority provided for each. Over time, ARRA spending shifted from recovery to reinvestment activities, which affected the composition and timing of spending. In the first year most of the funds went towards temporary increases for Medicaid and other safety net programs, such as unemployment benefits. Education funds were also made available because education is primarily a state and local government responsibility. A new program, the State Fiscal Stabilization Fund, was designed to have varying degrees of flexibility that enabled states to maintain levels of support to the school system, or to free up state resources for other purposes. In

$81 B $53 B Protecting the Vulnerable

Education and Training $144 B

$288 B

* State and Local Fiscal Relief

$43 B Energy

$59 B $8 B Health Care

Other

$111 B

* Tax Relief

Infrastructure and Science Note:  The original estimate of $787 billion for ARRA was revised to $830 billion as of May 2011. Additional disbursements have been made for protecting the vulnerable and for tax relief. Source:  Recovery Accountability and Transparency Board (Recovery.gov).

Figure 2.7  ARRA expenditures

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The global financial crisis and its budget impacts in OECD nations

subsequent years, ARRA spending shifted increasingly to funding for highway and transit programs, followed by energy, environment and community development. These later expenditures in particular are intended to create long-­term economic growth opportunities. The CBO’s current estimate is that ARRA will add $840 billion to the US federal debt between fiscal years 2009 and 2019 (CBO 2015a). This is the latest revision of several re-­estimates since the CBO first priced the cost of the legislation in February 2009. Overall, ARRA is winding down as it was designed to do. For example, ARRA’s largest tax payouts have come and gone, and decisions to increase unemployment and nutrition benefits are now attributable to other legislative actions. More than 50 percent of the costs were incurred one year after the program was enacted, and 95 percent of the budget impact was realized by December 2014. As with TARP, ARRA has not done well in opinion polls. When Americans were asked whether they approved of the economic stimulus package, only 43 percent said yes. On the question of whether the stimulus had helped state and local governments avoid lay-­offs and budget cuts, 60 percent said it had not, while only 29 percent thought the stimulus had helped. CBO estimates that ARRA at the peak of its impact in 2010 increased the number of full-­time equivalent jobs by between 1.9 million to 4.8 million compared to what would have occurred otherwise (CBO 2011b). Since much of the actual impact was to save existing jobs rather than create new ones, it is difficult for even those whose jobs have been saved to appreciate the difference ARRA made. Proponents believe that ARRA came at the right time, and credit it with slowing if not stabilizing deteriorating state fiscal conditions. By 2015, unemployment had fallen to a level of 5.5 percent from its recession high of 9.3 percent. However, unemployment remained stubbornly high for several years after passage of the ARRA, staying at an unacceptable level of 8.1 percent by 2012, a full three years after passage of the Act. Defenders of the stimulus laid the blame at the feet of Republicans for holding down the total spending on ARRA, while conservatives pointed to the long-­term impact of the higher debt which the CBO estimates to reduce long-­term output by up to 0.2 percent of GDP after 2016 (CBO 2015a). Although few dispute that the President inherited a deteriorating economy, responsibility for the largest fiscal stimulus in US history and the economic recovery since continue to define his economic leadership through 2015.



The United States’ response to the global financial crisis ­51

FISCAL REMORSE: DEFICIT ANXIETY REDUX While the nation rallied to support both the bailout and the stimulus programs at the height of the crisis, concerns about both the rising deficits and the growth of the federal role in the economy caused a counter-­ mobilization of the electorate. In public opinion polls, the deficit overtook the economy as the most important concern on the public’s mind. To some extent, the public has never lost its preference for balanced budgets, notwithstanding the latest advances in economic analysis and thinking. While temporary crises stemming from war or economic crisis have perennially been supported, the nation generally snapped back to budget balance very quickly after these one-­time events. It is no surprise that the large federal stimulus and accompanying deficits also stimulated the growth of a major grassroots initiative – the Tea Party – which mobilized conservative voters within the Republican Party to pursue fiscal consolidation as the first priority. As a party that had moved to the right over the past 20 years, the Republican Party was eager to capitalize on these grassroots stirrings. The party rode back to control of the House of Representatives in the elections of 2010, largely on the strength of this fiscal argument. The renewed sense of urgency on deficits partly reflected the looming problem of long-­term deficits facing the nation in the next several decades. While this has been known at least since 1992 when the Government Accountability Office (GAO) first published a long-­term budget outlook, the Great Recession accelerated the onset of these truly wrenching fiscal challenges. The chart in Figure 2.8 illustrates the nature of the long-­term challenges. An aging population and rising health care costs will, in the absence of policy changes, send the budget into deeper deficits by 2039, according to the CBO. Deficits would grow to over 6 percent of the economy and debt would exceed 100 percent of GDP. At these levels, deficits would become economically unsustainable, as rising government debt crowds out nearly all private investment and growth (CBO 2014b). Figure 2.9 reveals that federal spending priorities will undergo a profound shift that is already happening. Federal discretionary spending for costs funded by annual appropriations by Congress will decline to post-­ war lows, while federal health care spending will very soon become the largest single element of the budget. The growth of health care spending reflects both the excessive growth of health care overall and the aging of the population. While recent years have seen a slowdown in the growth of health care costs, there is still a debate about how much of this was due to temporary effects of the recession and how much to sustainable reforms

52

The global financial crisis and its budget impacts in OECD nations

Potential Fiscal Outcomes

Revenues and Composition of Spending under Alternative Simulation Percentage of GDP 50 40 30

Revenue

20 10 0

2010

2020

2030

2040

Fiscal year Net interest

Social Security

Medicare and Medicaida

All other spending

Note:  Data are from GAO’s January 2011 simulations based on the Trustees’ assumption for Social Security and CMS Actuary’s alternative assumption for Medicare. a This also includes spending for insurance exchange subsidies and CHIP. Source: GAO.

Figure 2.8 Long-­term budget outlook (based on GAO’s alternative policy path) Percentage of Gross Domestic Product Social Security

Spending

Average, 1974–2013

4.3

2014

4.9

2039

6.3

Major Health Care Programs

Other Noninterest Spending Net Interest Total

2.8

11.2

4.8 8.0

9.3 6.8

2.2 1.3 4.7

Source:  Congressional Budget Office (2014b).

Figure 2.9  Changing composition of federal spending through 2039

20.5 20.4 25.9



The United States’ response to the global financial crisis ­53

ushered by President Obama’s health care reform and other changes in the health care market. The forces promoting fiscal consolidation in 2010 got a new boost from the release of reports by a series of high-­level commissions of experts and political centrists, providing menus of policy options for both reducing the deficit and institutionalizing more fiscal discipline in the budget process. While not forcing action, these reports nonetheless served to legitimize the need to take action by illustrating how the long-­term gap could be addressed through options that garnered a surprising level of support among moderates in both parties (National Academy of Sciences, National Commission on Fiscal Responsibility, Peterson–Pew Commission, 2010).4 Following a thorough drubbing in the mid-­year 2010 elections, which saw the Republicans regain control of the House, the Obama administration was forced to work with Republicans in Congress to enact significant spending cuts as well as a new process that could well lead to further deficit reduction on both the revenue and spending sides of the budget. The Republicans’ first victory was gaining agreement by President Obama and Democratic leaders in Congress for substantial cuts in discretionary spending in future years as the price for passing appropriations bills to avoid a government shutdown in March of 2011 and to extend the debt ceiling. The threatened shutdown of the government was followed by the high-­ stakes battle over extending the nation’s debt ceiling. In what many fiscal experts view as an anachronism, Congress must periodically increase the nation’s debt ceiling to authorize the Treasury to issue additional borrowing arising from spending already approved by Congress itself in prior legislation. While never an ‘easy vote’, Congress has never failed to extend this ceiling, fearing the consequences of what would amount to a default on the nation’s outstanding debt. Republicans in Congress, particularly those aligned with the ‘Tea Party’, raised the political stakes in the summer of 2011 by threatening to withhold approval for raising the debt ceiling. The resulting debt-­ceiling crisis preoccupied the nation’s politics and policy-­ making agenda for much of the summer of 2011. The stakes could not have been higher, both for the nation’s standing in global credit markets and for the political standing of the Obama administration. Following protracted negotiations between President Obama and the Republican leadership in Congress, an agreement was ultimately reached to stave off default by increasing the debt ceiling. In return, the President agreed to a new round of spending cuts and a new set of spending caps for the next ten years.5 While the spending caps in the new agreement would reduce the deficit to some extent, hopes for achieving broader reforms and more significant deficit reduction rested with a new joint Congressional committee charged

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The global financial crisis and its budget impacts in OECD nations

with developing a package of reforms achieving over $2 trillion in savings over ten years from the end of 2011. The super-­committee’s actions could range over the entire budget, including further discretionary spending cuts, entitlement reforms and tax increases or reforms. In November 2011, the super-­committee proved unable to reach agreement to achieve the additional savings. Under the new law, this failure precipitates a series of a­ utomatic cuts – known in American parlance as ‘sequesters’ – to fall equally on defense and domestic programs. The US’s fiscal ambivalence reared its head once again as the nation deliberated about whether and how to comply with these new ambitious spending targets. With a stubborn and lingering recession, many mainstream economists warned that cuts in federal spending might jeopardize an emerging recovery. Others were concerned about the impacts of the cuts on a wide range of policy areas, ranging from defense to infrastructure to education. A Republican Congress sympathetic to national defense nonetheless let the sequesters be imposed in 2013, resulting in cuts of $55 billion from approximately $1 trillion of discretionary appropriations, or a 5 percent cut. However, the cuts went into effect during the fiscal year, causing much dislocation in the agencies and among their clientele. Following this one-­year experiment with austerity, Republicans and Democrats in Congress reached agreement to suspend sequestration over the next two years, raising discretionary spending above what the 2011 agreement had prescribed. As we enter into the fiscal year 2016, this temporary agreement expires, along with the relief from sequestration. While Republicans defined fiscal consolidation in spending terms, President Obama and the Democrats in Congress achieved a measure of success in increasing revenues. With the looming expiration of the Bush tax cuts finally at hand, both Obama and the Republicans were loathe to see major tax increases imposed by default on families and businesses alike across the income spectrum. In a ‘lame duck’ session after the 2012 Presidential elections, both parties were able to reach an agreement to continue the tax cuts for the vast majority of Americans, while raising rates and eliminating special preferences for the highest-­income ­taxpayers. Whether this was a victory for fiscal hawks or tax cutters depends on arcane budget accounting. When compared to a budget projection assuming that the Bush cuts expired on schedule, this reduced revenues by nearly $4 trillion. However, when compared to a ‘current services’ baseline presuming that the past is a prologue for the budget, then the adoption of income tax increases for the first time in 20 years has to be considered at least a modest victory for both Democrats and fiscal hawks.



The United States’ response to the global financial crisis ­55

CONCLUDING OBSERVATIONS: INSTITUTIONAL ADAPTATION AND RESPONSE Many have lost faith in the capacity of a nation with increasingly polarized parties to make the hard choices necessary to steer the economy both for the short and the longer term. In previous recessions, counter-­cyclical aid was either bottled up in a gridlocked Congress or provided too late to make a real difference. When the economy demanded fiscal restraint, the nation’s leaders have often not seemed up to the task. The well-­founded skepticism about the American system was reaffirmed when the joint super-­committee proved unable to reach agreement and surmount substantial conflicts between the two parties, even with a sequester in the offing as a penalty for inaction. The disillusionment with the American system of government was the basis for the downgrade of US Treasuries by Standard & Poor’s; a downbeat report card on the political and fiscal resolve of the nation’s leaders (Standard & Poor’s 2011). Against this backdrop of low expectations, national leaders in fact did rise to the challenges prompted by the Great Recession. The passage of both TARP and ARRA constituted the most sweeping federal response to economic crisis since the New Deal. A nation traditionally loathe to have government intervene in private markets suddenly abandoned these constraints, launching unprecedented government investments designed to stabilize the private financial system. It was notable that the response to unprecedented policy challenges entailed significant institutional innovation and adaptation. While the advent of the financial crisis initially prompted ad hoc approaches by the Treasury and the Federal Reserve, a more systemic institutional approach was ultimately adopted through the passage of TARP. The ambitious purchase of financial assets and injection of capital was carried out by executive-­based experts who were given extraordinary leeway by a Congress traditionally jealous and protective of its prerogatives. However, Congress also provided for multiple oversight bodies and commissions to oversee the decisions made by these agencies. The stimulus also entailed singular federal investments and institutional responses. Recognizing the high stakes for the economy, Congress and the administration established a series of networks to coordinate, oversee and report on the implementation of this wide-­ranging initiative across numerous federal agencies and state and local governments. Reflecting the high stakes politically for the President himself, the federal management of the stimulus programs was led by the Office of the Vice President and entailed extraordinary levels of management guidance provided by the Office of Management and Budget. New partnerships were forged with

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The global financial crisis and its budget impacts in OECD nations

state and local leaders, reflecting their significant roles in implementing the stimulus programs. The large investment of federal dollars prompted the creation of extraordinary new accountability institutions: a new board of inspectors general was established which was charged with tracking and publicly reporting the expenditure of every last stimulus dollar by all levels of government. Pivoting from fiscal stimulus to consolidation entails a wrenching challenge for an increasingly polarized political system. While many economists rightly took leaders to task for starting consolidation in the throes of a recovery, national leaders nonetheless were able to achieve significant progress in reducing short-­term deficits. It is notable how often polarized divided leaders were, in fact, able to come together to reach agreement on overarching fiscal agreements. Agreements in 2011, 2012 and 2013 achieved modest cuts in deficits through both spending and revenue actions. Yet, while these actions were notable, they resembled a drowning man fighting just to keep his head above water. While defying predictions of total gridlock, the agreements were modest indeed, featuring discretionary spending cuts that most feel would prove to be politically unsustainable, and revenue actions that, while increasing taxes on the highest incomes, failed to reach to the deeper sources of economic and fiscal dysfunction stemming from the tax code. One comes away from this recent fiscal history disappointed in the political capacity of the US to address its simmering economic and fiscal challenges. The stimulus, while appropriate and impactful, ended too soon, extending unemployment at higher levels than it needed to be. Deficit reduction measures were focused largely on reducing operating funding for defense and non-­defense programs that, ultimately, were not politically sustainable. Enacting declining budget caps is the easiest symbolic vote a member can take on deficits, confident that someone will be clever enough to sidestep the cuts in the nick of time before they arouse a public that has become increasingly dependent on the federal government for economic well-­being and social support. At the same time, national leaders largely have failed to address the major drivers of current and future deficits: the entitlements for an aging population in social security and health care. A nation with among the lowest tax share of the economy of any OECD nation can and should address tax reform as a way to both raise revenues for an aging nation and assure a more growth-­friendly economy. However, the first tax increase in 20 years placed increases only on the wealthiest. While these measures help to mitigate yawning disparities among incomes in this country, the real revenue resides with the vast middle class that Congresses and Presidents alike are loathe to touch with tax increases. Tax expenditures for over 160 income tax credits and deductions constitute



The United States’ response to the global financial crisis ­57

over $1.4 trillion in revenues lost to the government, with untold inefficiencies imposed on markets. Yet, like spending entitlements, these largely escaped the budget ax. As if this were not enough, the debt limit crisis of the summer of 2011 raised concerns among the public and rating agencies alike about the political capacity of a divided nation even to pay its bills, let alone to make the tough choices necessary to resolve long-­term fiscal challenges. Difficult choices await the nation’s leaders and public. The political divisions over budget choices reflect deeply rooted conflicts about the role of government in the nation’s economic and social life. The choices involve nothing less than renegotiating the social contact between government and its citizens on both the spending and the revenue sides of the budget. Ultimately, a fiscally ambivalent but aging nation will have to resolve its tension between the need for government to mitigate economic risk and its long-­standing attachment to private solutions to common problems.

NOTES 1. The views expressed are those of the authors and not the US government or the Government Accountability Office. 2. Bipartisan Budget Act of 2013 (Public Law 113–67). 3. The American Taxpayer Relief Act of 2012 (Public Law 112–240). 4. National Commission on Fiscal Responsibility and Reform, Moment of Truth, December 2010; Debt Reduction Task Force (2010); National Academy of Sciences and National Academy of Public Administration, Choosing the Nation’s Fiscal Future, January 2010; Peterson–­Pew Commission on Budget Reform, Getting Back to Black, November 2010. 5. Budget Control Act of 2011 (Public Law 112–25).

REFERENCES Brooks, D. (2009), ‘Cleaner and Faster’, New York Times, 30 January. Carlson, J., J.G. Haubrich, C. Kent and S. Wakefield (2009), Credit Easing: a Policy for a Time of Financial Crisis, Cleveland, OH: Cleveland Federal Reserve Bank. Congressional Budget Office (CBO) (2008), ‘Letter to Honorable Christopher J. Dodd, Chairman, Committee on Banking, Housing, and Urban Affairs, United States Senate, Emergency Economic Stabilization Act of 2008’, October, Washington, DC: CBO. Congressional Budget Office (CBO) (2009), ‘Methodology to Calculate Estimated TARP Costs’, January, Washington, DC: CBO. Congressional Budget Office (CBO) (2010), Letter to Nancy Pelosi, 20 March, Washington, DC: CBO. Congressional Budget Office (CBO) (2011a), Report on the Troubled Asset Relief Program, House of Representatives, March, Washington, DC: CBO. Congressional Budget Office (CBO) (2011b), ‘Estimated Impact of the American

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Recovery and Reinvestment Act on Employment and Economic Output from April 2011 Through June 2011’, August, Washington, DC: CBO. Congressional Budget Office (2011c), ‘Changes in CBO’s Baseline Projections Since January 2001’, May 12. Congressional Budget Office (CBO) (2014a), The Budget and Economic Outlook: An Update, August, Washington, DC: CBO. Congressional Budget Office (2014b), The 2014 Long Term Budget Outlook, July, Washington, DC: CBO. Congressional Budget Office (2015a), Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output in 2014, February, Washington, DC: CBO. Congressional Budget Office (2015b), Report on the Troubled Asset Relief Program – March, 2015, Washington, DC: CBO. Congressional Oversight Panel (2011), March Oversight Report: The Final Report of the Congressional Oversight Panel, Washington, DC: House of Representatives, pp. 155–6, http://cop.senate.gov/about/. Debt Reduction Task Force (2010), Restoring America’s Future, November, Washington, DC: House of Representatives. Department of the Treasury (2011), ‘Daily TARP Update’, 7 September, web log post, http://www.treasury.gov/initiatives/financial-­stability/briefing-­room/ reports/tarp-­daily-­summary-­report/Pages/default.aspx. Herszenhorn, D.M. (2008), ‘Administration is Seeking $700 Billion for Wall Street’, New York Times, 20 September, http://www.nytimes.com/2008/09/21/ business/21cong.html. Johnson, N., P. Oliff and E. Williams (2011), ‘An Update on State Budget Cuts’, Center for Budget and Policy Priorities, February. National Academy of Sciences and National Academy of Public Administration (2010), ‘Choosing the Nation’s Fiscal Future’. National Commission on Fiscal Responsibility and Reform (2010), ‘Moment of Truth’, December. Peterson–Pew Commission on Budget Reform (2010), ‘Getting Back to Black’, November. Posner, P. and J. Blondal (2012), ‘Deficits and Democracy: Prospects for Fiscal Responsibility in Democratic Nations’, Governance, 25 (1), 11–34. Posner, P. and B. Gordon (2001), ‘Can Democratic Nations Save?’, Public Budgeting & Finance, 21 (2), 1–28. Samuelson, R.J. (2011), ‘TARP’s Success Story’, Washington Post, 28 March. Standard and Poor’s (2011), ‘AAA/A-­11 Rating on United States of America Affirmed: Outlook Revised to Negative’, 18 April. Tat-­Kei Ho, A. (2010), ‘Budget Reforms in the United States: A “Perfect Storm” for a New Wave of Deficit-­Reduction Reforms’, in J. Wanna, L. Jensen and J. de Vries (eds), The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. US Department of Treasury (2009), ‘Transactions Report’, 2 October. Webber, C. and A. Wildavsky (1986), A History of Taxation and Expenditure in the Western World, New York: Simon and Schuster. Zandi, M. and A. Blinder (2010), ‘How the Great Recession Was Brought to an End’, 27 July, http://www.economy.com/mark-­zandi/documents/End-­of-­Great-­ Recession.pdf.

3. Canada’s reactive budget response to the global financial crisis: from resilience and brinksmanship to agility and innovation David A. Good and Evert A. Lindquist As the early shocks of the global financial crisis moved to Canada in 2008, its budget system was on autopilot, largely concerned with domestic issues. It had been nearly 15 years since the budgetary system had been tested by major pressures. In the mid-­1990s it was internal fiscal ­pressures – ­accelerating deficits and ballooning debt levels – that threatened to undermine the government’s fiscal framework and its financial credibility. The inability of the two Mulroney Conservative governments (1984 to 1993) to address the fiscal challenges had weakened the credibility of the Department of Finance whose regular annual five-­year fiscal plans invariably forecast ­balanced budgets in the fifth year which were never achieved. Elected in 1993, the Chrétien Liberal government failed miserably in its first budget to address the increasingly worsening fiscal situation. By summer 1994, with its credit rating falling and international pressure mounting, the Wall Street Journal labeled Canada ‘a third world country’ amid widespread rumors it was about to ‘hit the wall’ with the International Monetary Fund coming in to take over its fiscal policy. Canadian public attitudes coalesced around the need to reduce government deficits and debts. This, along with fears about how the Mexican peso crisis would affect the Canadian economy, led the government to introduce its unprecedented 1995 ‘Program Review’ budget. It restructured and eliminated programs, and significantly cut expenditures; program spending was reduced to 13.1  percent of gross domestic product (GDP), the lowest level since 1951. That budget, with its prudent economic and fiscal forecasting, restored fiscal balance in 1997 and established the ongoing basis for ‘a balanced budget or better’ (Good and Lindquist 2010: 106). For the next 12 years, whether in majority or minority government, Canada achieved fiscal balance and gradually reduced its public debt 59

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relative to the size of the economy, assisted by a buoyant economy with expanding revenue streams from corporate and personal income taxes and an efficient Goods and Services Tax (GST). The revenues were sufficiently robust to also underwrite the costs of significantly increasing expenditures. The government reached agreement with provinces and territories on a multi-­year health care accord, allowing federal expenditures to increase by 6 percent annually. Direct federal program spending more than doubled since its low-­water mark in the late 1990s and the size of the public service increased. Under the political rhetoric of ‘ensuring truth in budgeting’, a new Parliamentary Budget Officer (PBO) role was established by the 2006 Federal Accountability Act to provide independent budget analysis to parliament. The PBO immediately became embroiled in a visible political struggle with the government over its independence from the Library of Parliament. A ‘new’ expenditure management system was to link programs to results, regularly review programs and operations, and reallocate expenditures from old programs to fund new ones. With an emphasis on reallocation, few significant expenditure savings were achieved, however. Although the flexibility in the fiscal framework was considerable, it was expended on personal and corporate tax cuts, a proliferation of new tax expenditures targeted to specific political interests, and a significant two percentage point reduction to the GST to a level of 5 percent. When the global financial crisis (GFC) began crashing on Canada’s shores, the balanced budget was entrenched in the public’s consciousness, but the prudence and flexibility in the budget had substantially narrowed. In early 2008, just prior to the GFC, the Canadian budget system was not an integrated whole and had to be ‘discerned from individual pieces operating at several levels . . . a combination of remnants, current practices, recent central reforms, and future promises and challenges’ (Good and Lindquist 2010: 118–19). The central elements were: a strong commitment to a balanced budget; prudent economic and fiscal forecasting; extensive year-­ end budgeting; major budget allocations controlled by the Prime Minister and Minister of Finance; limited administrative and operational reviews and reallocation; strengthened financial watchdogs; and a proliferation of performance reporting. There was coherence in the system’s adaptation and resilience ‘in the face of changing economic and fiscal pressures on the global and domestic fronts’. Indeed, ‘the anchor holding the system together’ was ‘the balanced budget commitment’ and when it loosened, as it surely would, ‘the government will need to be prepared with a package of budget reforms and incentives . . . fully integrated with its central decision-­making processes’. This chapter analyzes the state of Canada’s preparedness for the GFC, how the government perceived and reacted to the impending crisis against



Canada’s reactive budget response to the global financial crisis ­61

the backdrop of its existing budgetary situation, how it went about developing and implementing its budget response in light of the constraints and opportunities it faced, and the implications of its response for its ongoing budgetary system. The government’s response to the GFC unstuck the fiscal anchor of a balanced budget, and the adaptability and resilience of the government’s budget systems has been put sharply to the test. The chapter provides a chronicle divided into five ‘acts’, each with various associated ‘scenes’: an initial reluctance going into the crisis (Act 1); an immediate and near-­catastrophic false start (Act 2); a rapid-­fire restart as the government was forced to turn on a dime (Act 3); a determined effort to fight the recession with skillful implementation of a stimulus spending program (Act 4); and coming out of the recession with an uncertain and challenging fiscal future (Act 5). It concludes with an assessment of how Canada was able to respond the way it did, before considering the challenges for a majority Conservative government seeking to restore fiscal balance while achieving government priorities.

ACT I: INITIAL RELUCTANCE TO RESPOND In early 2008 prior to the GFC, several factors combined to support a ‘steady as you go’ attitude by the incumbent Conservative government: the strength of the Canadian economy, the solid fiscal position of the government, a deeply held belief in a balanced budget, and a fragmented political situation of minority government. The inertia of the budgetary system, coupled with the government’s belief that economic and fiscal fundamentals were in place, reinforced a reluctance to change. Scene 1: Sound Fiscal, Monetary and Financial Policy Going into the GFC, Canada was in a remarkably healthy economic situation compared to other countries. It had a solid fiscal position with a balanced budget or better, enjoyed the benefits of low inflation through effective monetary policy, and had a sound financial system based on a history of prudent regulation of financial institutions. Canada was in a strong fiscal position compared to other Organisation for Economic Co-­operation and Development (OECD) countries. Since 1996–97 it had achieved a dozen consecutive budget surpluses. Prior to the crisis, Canada recorded a total government surplus of 1.4 percent of GDP in 2007, and the OECD estimated Canada would be the only G7 country in surplus in 2008.1 However, by 2008 a small budgetary deficit was forecast for 2009 on a total government basis, due to the impact of

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The global financial crisis and its budget impacts in OECD nations

Per cent of GDP 2

0

–2

–4 2007 2008 (estimate) 2009 (projection)

–6

–8

G7 average Germany

Japan

Italy

France

United Kingdom

United States

Canada

Note:  The OECD uses the term ‘financial balance’ to mean ‘budgetary balance’. Source:  Department of Finance (2008a).

Figure 3.1  Total government financial balances (National Accounts basis) slower economic growth on government revenues and expenditures (see Figure 3.1). In addition, Canada posted the strongest record of debt reduction in the G7, with the total government net debt to GDP ratio falling almost 50 percentage points from 71 percent in 1995 to 22.3 percent in 2008, which was less than half the average for all G7 countries. Since 2004, Canada had the lowest ratio of total government net debt to GDP in the G7 (see Figure 3.2). The Canadian banking and financial sector was particularly well placed. Canada largely escaped the financial carnage of the US, and in the aftermath of the GFC was seen as a model for financial regulation by other countries. Most securities firms were owned by the chartered banks,2 benefiting from their ‘prudent’ culture and conservative regulation by the Office of the Superintendent of Financial Institutions (OSFI). Scene 2: The Fragility of Minority Government While Canada’s fiscal, monetary and financial systems were strong, its political position was fragile. Since 2004, it had three successive m ­ inority governments: the Martin Liberal government in 2004–06; the Harper



Canada’s reactive budget response to the global financial crisis ­63

Per cent of GDP 100

Per cent of GDP 100

Japan

Italy

United States1

Germany

France

0

United Kingdom

0

Italy

20

Canada

20

United States1

40

United Kingdom

40

France

60

Germany

60

Japan

80

G7 average

80

Canada

2008 (estimate)

G7 average

1995

Note:  1 Adjusted to exclude certain government employee pension liabilities to enhance comparability with other countries’ debt measures. Source:  Department of Finance (2008b).

Figure 3.2  Total government net debt (National Accounts basis) Conservative government in 2006–08; and a second Harper government elected in October 2008 lasting to May 2011. Canadian minority governments are widely seen as temporary and exceptional; the expectation is that governing and opposition parties will seek to return to a majority government as soon as political fortunes permit. They are typically viewed as ‘fragile constructs, providing a short bridge between majorities but otherwise untrustworthy as governing instruments’ (Globe and Mail 2007). Canada’s minority governments are unique, reflecting a particularized political and parliamentary culture and, in contrast to other countries, there is no coalition or formal agreement between the governing parties (Leduc 2009; Russell and Sossin 2009; Russell 2009). Governing is by ad hoc arrangements, with governments finding the support they need on each issue from different sections of the opposition benches. In this context, budgets take on even more political significance: they are matters of the confidence convention – for the government to continue, it must enjoy the support of a majority in the House of Commons. As a result budgeting in minority government involves higher stakes, with budget preparation being even more centralized and tightly controlled by

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the Minister of Finance and the Prime Minister to allow for quick strategic adjustment to secure necessary political support from opposition parties (Good 2011a).

ACT II: A FALSE START AND A NEAR BLUNDER In October 2008, Canadians were increasingly concerned about the economy. The newly elected Harper government, though disposed towards smaller government, had a recent record of significant spending and was anxious to show that it was a prudent manager of the government’s finances. With a minority government, the Prime Minister also recognized the increasing need for some level of cooperation among parliamentarians. On 19 November, the government outlined five broad objectives to protect Canada’s economic security in a short Speech from the Throne. To show that it would be fiscally responsible, the government committed to ‘sound budgeting so that Canada does not return to ongoing, unsustainable structural deficits while putting all federal expenditures under the microscope of responsible spending’ (Government of Canada 2008: 1). The next day in the House of Commons the Prime Minister challenged all Members of Parliament (MPs) to ‘put aside clearly partisan considerations and try, wherever possible, to work co-­operatively for the benefit of Canada’ (Prime Minister 2008). One week later all this resolve was sharply tested. Scene 1: The Economic Mis-­Statement The annual Economic and Fiscal Statement normally takes place each November, providing the Minister of Finance with a significant opportunity to update the country on the economic situation before the regularly scheduled budget in February. Normally, it is the February budget and not the November economic statement that is reserved for making major fiscal announcements. However, Finance Minister Flaherty’s 27 November 2008 statement went well beyond providing an economic update: it ignited political upheaval. With the deteriorating and uncertain economy the minority government was more anxious than ever to demonstrate to Canadians that it was fiscally responsible, which, against the backdrop of ballooning deficits and expanding debts up to the mid-­1990s, had come to be defined as ‘a balanced budget or better’. Given the economic uncertainty, the November statement was prepared as the usual update, with subsequent fiscal action to be delivered three months later in the budget. With little to announce, the Minister of Finance simply extolled the comparative virtues of Canada’s financial system:



Canada’s reactive budget response to the global financial crisis ­65 we had a head start over other nations. Our financial system is considered to be the world’s soundest by the World Economic Forum. The International Monetary Fund concluded Canada’s financial system is mature, sophisticated, well managed and able to withstand sizeable shocks. (Department of Finance 2008a: 6)

Late on Thursday afternoon, the Finance Minister rose in the House of Commons and began by announcing that the government would keep the budget ‘balanced for now’, but noted that ‘in the weeks ahead we will determine the extent to which we will inject additional stimulus to our economy’. However, without a clear plan he remained firmly tied to the security of the fiscal anchor: a balanced budget. He was reluctant to consider a deficit, cautioning that ‘the thought of a long-­term structural deficit would be even more serious – one that the Government is unable to climb out of, even when the economy improves’ (Department of Finance 2008a: 8). The minister boasted about keeping the government in surplus until 2013–14, based on optimistic fiscal projections combined with unspecified modest savings in operational and administrative expenditures from periodic strategic reviews of selected departments and agencies. This assumed surplus was in contrast to the findings a week earlier in one of the first reports of the PBO, which assessed the increasing risk to the economic outlook. It concluded that a deficit for 2008–09 was ‘a distinct possibility’ and the government’s fiscal targets would be compromised over the next two years (Parliamentary Budget Officer 2008). The minister then dropped the surprise bombshell inserted by the Prime Minister into the economic statement the day before, eliminating the $1.95 per vote taxpayer subsidy for politicians and their parties. ‘There will be no free ride for political parties. There never was. The freight was being paid by the taxpayer. This is the last stop on the route’, declared a self-­ satisfied Finance Minister (Department of Finance 2008a). As if to add insult to injury, the minister announced that pay equity for public servants would no longer be considered by the courts but as a part of collective bargaining and that the right to strike for public servants would be suspended through 2010–11. One observer noted, ‘it was hard to overstate the rage that swept through the opposition ranks that afternoon’ (Sears 2009: 42). The GFC had not yet fully arrived in Ottawa; and it was presaged by a near political blunder and a parliamentary crisis. Scene 2: Political Crisis and the Unorthodox Prorogation In response, MPs and political staffers from the Liberal Party and the  New  Democrat Party (NDP) burnt up the phone lines negotiating the shape of a deal to form a new coalition government, hastily agreed

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the following day (Friday evening). The speed of the negotiations caught everyone by surprise. Over the weekend news percolated across political circles that a new coalition government could be formed by the opposition parties. On Saturday the government withdrew its political party funding decision and by Sunday evening the Finance Minister announced that he would present his budget on 27 January, weeks earlier than his initial plans. By Monday morning the government cast aside its earlier economic statement. Having jettisoned the elimination of political funding, it then eliminated the ban on public service strikes, and finally abandoned its pay equity fight. Just before Question Period the government pulled the confidence vote on the Economic and Fiscal Statement scheduled for that day in the House of Commons. Late that afternoon the coalition leaders held a press conference with the formal signing of a coalition accord by the two opposition leaders – Liberal Dion and NDP Layton – accompanied by the Bloc Québécois Duceppe who also offered support (Topp 2010). By Tuesday the government went on the attack, with Prime Minister Harper denouncing the coalition as ‘the separatist coalition’ and expressing outrage at the treachery of ‘undemocratic coup-­plotters’. On Wednesday night the Prime Minister addressed the nation, and by Thursday morning, to avoid certain defeat, he visited the Governor-­General to seek a prorogation of the House of Commons two weeks after it had opened, which would suspend the sitting of parliament, allowing for a new Speech from the Throne and time to conceive of a new budget. After a two-­and-­a-­ half hour marathon meeting, the Governor-­General granted the Prime Minister’s request. Prorogation gave the government a second window of opportunity. However, the signing of a coalition accord between the Liberals and the NDP with the support of the separatist Bloc Québécois, and Mr Dion’s inept videotaped response to the Prime Minister’s national address,3 precipitated an immediate change in leadership of the Liberal Party. Michael Ignatieff, skeptical about the coalition arrangement, became leader of the Liberal Party.

ACT III: REVISE AND RESUBMIT – THE NEED FOR A RAPID RESTART The budgetary restart was both a political and an economic event. Proroguing parliament provided a cooling-­off period during which the Prime Minister and the opposition leaders could attempt to work out their differences away from the combative glare of parliament. If differences could not be dealt with and a satisfactory new budget strategy worked out, there was an alternative government-­in-­waiting. The giant wave of the



Canada’s reactive budget response to the global financial crisis ­67

GFC which was destroying the financial systems and economies of other countries was crashing onto Canadian shores. The vehicle for dealing with the economic difficulties and the political differences was the upcoming budget. Scene 1: Turning on a Dime – Agility Being the Imperative With a budget now only weeks away the Department of Finance was scrambling, and rapidly accelerated its budget preparation. The first step was to redo its economic and fiscal forecasts which, despite continuous monitoring, were last completed on 14 November for the 27 November statement.4 Over that short period and before, several significant and interrelated economic developments were taking place. Global economic conditions continued to weaken. The US economic outlook worsened, with a consensus forecast calling for a contraction of 1.1 percent in 2009. Commodity prices (especially crude oil, which in one month dropped from US$72 to $56 per barrel) declined sharply. The recession which began ten months previously in the US was now hitting Canada, with most private sector forecasters now expecting that Canada had already entered a recession in October 2008. A survey of private sector forecasters indicated that Canada’s real GDP would contract in 2009 by 0.4 percent; a month earlier the average forecast predicted an increase of 0.3 percent. Nominal GDP was expected to drop by $20 billion in each of the next two years, further decreasing government revenues. On 9 December the Bank of Canada confirmed what everyone already knew: the economy was ‘now entering a recession as a result of the weakness in global economic activity’, and the bank reduced its interest rate by 75 basis points to 1.5 percent, the lowest rate since 1958 (Bank of Canada 2008). When the Department of Finance released its revised economic and fiscal forecast on 17 December it concluded that there was ‘a risk that nominal GDP could be weaker than suggested by the most recent private sector survey and that the corresponding fiscal outcome would be more in line with the low scenario’ (Department of Finance 2008b). What this meant could only be discerned by interpreting a graph contained in the updated forecast: the previous non-­existent deficits would now become real deficits – about $8 billion in 2009–10 and $11 billion in 2010–11. In the Department of Finance there was considerable uncertainty and worry about the risks associated with the rapidly deteriorating economic and fiscal situation. At the political level there was no question of the necessity to secure broad public support for the upcoming budget, and, given the need for stimulus spending, little risk in consulting as many ­interests as possible.

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The global financial crisis and its budget impacts in OECD nations

Scene 2: Something for Everyone – ‘No Consultee Would Be Left Behind’5 The pre-­budget consultation with stakeholders and outside interests was extensive especially given the short time period – six weeks – for budget preparation. The traditionally quiet and low-­keyed approach led by the Department of Finance, involving its regular cadre of economic and private sector experts, was superseded by a highly visible process of discussions and consultations with businesses, provincial leaders, municipalities, industry associations, social groups and Aboriginal leaders, as well as online consultations and a string of roundtable meetings with selected stakeholders in cities across the country. Nothing like this had been seen since the machinations involved in the cutbacks associated with ‘Program Review’ (Lindquist 1994). The calculus was clear and decidedly political: to secure sufficient public support for the upcoming stimulus budget to ensure that at least one of the opposition parties would support it. The Minister of Finance launched his national consultations on 11 December. The issue was less about what to do and more about how much to do. The background documents were decidedly action-­oriented, with a focus on creating fiscal stimulus. They set out proposals for stimulating the economy, including investing in housing, expediting infrastructure spending, building sustainable labor markets and training incentives, supporting traditional and emerging industrial sectors, and improving access to credit. They emphasized that any stimulus must be timely, have maximum impact by focusing on domestic activities like construction, and not lead to a structural deficit. But in sharp contrast to the earlier economic statement, it was clear that ‘if the recession is longer or deeper than anticipated, the stimulus will need to be larger and longer in duration’ (Department of Finance 2008c). A widely reported meeting, held on 17 December with federal, provincial and territorial finance ministers, set the tone for cooperative action across governments. There emerged a political commitment ‘to work together in common purpose to support our economy against the unprecedented financial turbulence sweeping the globe’. Commitments included putting items in the budget such as ‘accelerated investments in strategic infrastructure, measures to safeguard the financial sector, and targeted ways to help negatively affected communities, as well as struggling sectors like the manufacturing, forestry and automotive sectors’ (Department of Finance 2008d). In the context of the government’s commitment to G20 countries, the Minister of Finance referenced stimulus in the order of 2 percent of GDP. The next day a high-­profile, blue-­ribbon Economic Advisory Council was formed to advise the Minister before Christmas. It was chaired by



Canada’s reactive budget response to the global financial crisis ­69

Carole Taylor, the former British Columbia Minister of Finance, and consisted of 11 prominent business leaders who agreed to a salary of $1.6 These similar-­minded individuals could be counted on to agree on the broad outlines of a stimulus package to keep the economy moving, provide public credibility to the beleaguered government and, perhaps most important, influence key members of the business community and the media to support the upcoming budget. By 16 January, the Prime Minister met with provincial premiers and territorial leaders and, in a show of unprecedented intergovernmental unity, agreed to an array of initiatives for the budget. These were not mere themes and intentions, but concrete actions about what would be done and how. They were captured in a host of widely circulated and reported video clips, press releases, backgrounders and photo sessions. They included taking immediate steps to get ‘shovels in the ground’ to flow the money faster for infrastructure projects, cutting red tape, streamlining regulatory and environmental approval processes to avoid unnecessary overlap and duplication, accelerating projects on which provinces and territories were in agreement, identifying ways Aboriginal people could benefit from infrastructure projects, ensuring continued availability of credit, and enhancing existing programs to support workers and the unemployed (Prime Minister 2009). To ensure that no consultee would be left behind in the days before the budget, the government departed from conventions of pre-­budget secrecy and unleashed a series of announcements and orchestrated leaks. On the weekend before the budget, the Minister of Human Resources and Skills Development Canada announced on CTV Television Network’s Question Period $1.5 billion in new training funds for laid-­off workers, and $2 billion to build new public housing and renovate existing units, with $600 million to build more on-­reserve Aboriginal homes. The Prime Minister signaled that the budget would include ‘permanent’ but ‘modest’ tax cuts for individuals and businesses. The pre-­ budget announcements were rounded out by a statement that the government would stimulate the economy by running deficits totaling $64 billion over two years. The (revised) Speech from the Throne was delivered by the Governor-­ General in a record minimum time of five minutes, the day before the budget. It emphasized that the government had ‘consulted widely . . . with everyone whose input might help chart a course through the present storm’ (Government of Canada 2009: 2). It presaged the key elements of its forthcoming economic action plan, which included: new investment in infrastructure; protecting the stability of the financial system; ensuring access to credit for businesses and consumers; supporting industries in difficulty, including forestry, manufacturing, automotive, tourism and agriculture;

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The global financial crisis and its budget impacts in OECD nations

and protecting the unemployed, lower-­income Canadians, seniors and Aboriginals. The actions would be targeted, injecting immediate stimulus, promoting long-­term growth, while avoiding a return to permanent ­deficits. Indeed, no one was to be left behind. Scene 3: ‘Doing What it Takes to Keep our Economy Moving’ With these words the Minister of Finance delivered his budget on 27  January, two months to the day after the November Economic and Fiscal Statement triggered a constitutional crisis that shook Ottawa to its core. His budget speech confirmed the government’s commitment to G20 leaders to inject a fiscal stimulus of 2 percent of GDP; an amount that the government thought necessary to keep the economy going. Cynically, it was what was also necessary to keep the Conservative minority government going. The fiscal stance of the budget – a large and intended deficit – was a dramatic shift from the assumed surplus in the November 2008 Economic and Fiscal Statement. The Minister, then still operating in the mindset of ‘a balanced budget or better’, had assumed a status quo fiscal projection for a deficit of $5.9 billion for 2009–10 and set out new measures to reduce program spending, which allowed him to forecast budget surpluses for 2009–10 and the following three fiscal years. His 27 January budget came in sharp contrast, updating the economic forecast and projecting a deficit for 2009–10 of $15.7 billion (including $4.5 billion for risk), and providing an additional $18 billion for stimulus. This resulted in a forecast deficit of $33.7 billion, along with the accumulation of deficits to 2012–13 of more than $84 billion. The extent of the measures contained in the Economic Action Plan (EAP) makes the budget difficult to summarize. With the participation of provincial governments the stimulus represented 1.9 percent of GDP in 2009 and 1.4 percent in 2010, fulfilling the government’s commitment at the G20 leaders’ summit in November and exceeding targets recommended by the International Monetary Fund. The EAP was cast as a ‘deliberate choice to run a substantial short term deficit’ (Department of Finance 2009a) and encompassed: ●●

Stimulating consumer spending through income tax relief by: raising the basic personal amount and increasing the upper limit of the two lowest personal income tax brackets; raising the income at which the National Child Benefit begins to be phased out; doubling the tax relief under the Working Income Tax Benefit; and increasing the age credit for seniors.



Canada’s reactive budget response to the global financial crisis ­71 ●●

●●

●●

●●

●●

Stimulating home construction and renovation by providing tax relief for a broad array of home renovation costs, saving families up to $1350 on their 2009 taxes. Extending maximum Employment Insurance benefits and work-­ sharing arrangements, targeting skills training for youth and Aboriginals, and freezing Employment Insurance payroll taxes for two years. Protecting jobs and supporting businesses by creating a two-­year $1 billion Community Adjustment Fund; allocating $1 billion over five years to create a Southern Ontario Economic Development Agency (all regions now had regional development agencies); providing tax relief to businesses in the form of extending the temporary accelerated capital cost allowance for manufacturing and processing machinery; and increasing the amount of income eligible for the small-­business tax rate. Increasing the liquidity in the Canadian financial system by providing an additional $50 billion to the Insured Mortgage Purchase Program, and giving greater flexibility to the Canadian Deposit Insurance Corporation to enhance its role of safeguarding the stability of the financial system. Providing substantial new investment over two years for infrastructure including everything from roads, bridges, harbors, public transit and border crossings to schools and universities, social housing, recreation centers, hockey arenas and curling rinks. This included $4 billion for local and regional projects, $2 billion for universities and community colleges, $1 billion for a Green Infrastructure Fund, and $2 billion for social housing including homes for low-­income seniors, persons with disabilities and Aboriginals. The projects required the financial cooperation of provinces and municipalities with the federal government taking action to move quickly on ‘shovel-­ready’ projects and to reduce red tape and needless duplication.

Overall, the EAP was described as providing ‘$60 billion over two years to help protect and create jobs and invest in future prosperity’ (Government of Canada 2011). Scene 4: Passing the Stimulatory Budget but with Quarterly Reporting The NDP party leader, Layton, strived to persuade Liberal leader Ignatieff to defeat the budget. However, the Harper government had moved quickly into crisis management mode and raised its strategic game, producing a budget seemingly acceptable to many Canadians. The Liberals supported

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the budget but put the government on probation by demanding a quarterly report card on its budget roll-­out. The government immediately agreed to what it perceived as a gift from the opposition since, without a prescribed format for the reports, it had a free hand to determine their content. Unlike the significant additional costs for penitentiaries resulting from the government’s efforts to ‘get tough on crime’, stimulus spending was not something to hide but something to announce and to reannounce.7 Over the next few years the government used these opposition-­sanctioned quarterly reports as a regularized political communications opportunity to remind Canadians what it was doing for them by way of spending initiatives and tax cuts.

ACT IV: SKILL AND DETERMINATION IN GETTING THROUGH The public service, hitherto viewed skeptically by Prime Minister Harper, played a particularly important role in supporting the government to design the EAP and implement its many programs in a timely and effective way. This was achieved by a combination of singular political focus, skillful bureaucratic coordination across departments and agencies, and the rapid introduction of several budget implementation innovations. For an often risk-­adverse public service, innovation was made a bit easier after the Minister of Finance, early on, acknowledged publicly that ‘some mistakes will be made’. Scene 1: Dealing with Delivery Dilemmas – The Public Service Innovates and Delivers The public service faced an enormous challenge in delivering the EAP because of its inherent contradictions. The action plan was based upon three principles: the ‘3-­T’s’. The stimulus must be timely, with the measures to begin within 120 days. It must be targeted to businesses and families most in need to trigger the largest increase in jobs and economic output. And it must be temporary, so that it can be phased down when the economy recovered in order to avoid long-­term structural deficits. However, the EAP was sharply criticized by many (Courchene 2009), including the former Governor of the Bank of Canada and former Deputy Minister of Finance, for failing to include a fourth ‘T’: ‘transformative investments’ – which could provide long-­term and more lasting benefits for the country.8 Instead, it focused almost exclusively on job-­creating infrastructure investments of the traditional ‘shovel-­in-­the-­ground’ kind. Finally,



Canada’s reactive budget response to the global financial crisis ­73

public service managers were sensitive to the need for prudent and responsible delivery of the stimulus programs; they were still stung by the recent legacy of the Gomery Inquiry into the ill-­fated Sponsorship Program and the over-­reaction by the Harper minority government with the Federal Accountability Act and its promises to clean up the procurement of government contracts and strengthen the power of the Auditor-­General. It is unlikely that the public service, on its own, could have ensured both speedy and responsible program delivery. The Minister of Finance and his Deputy Minister, assisted by the Treasury Board President and Treasury Board Secretariat (TBS), would normally have been responsible for overseeing budget implementation. But these were not normal times. The deepest recession since the Great Depression, combined with the need for political survival, led the government to focus singularly on its new EAP. The Prime Minister plainly indicated that this was not simply the government’s highest priority but its sole priority: the public service was to focus exclusively on its successful implementation. Under the firm direction of the Prime Minister, the Clerk of the Privy Council made it clear to deputy ministers that their collective and individual performance depended on successfully implementing the EAP. The Privy Council Office (PCO) ensured that budget implementation was ‘clearly the number one priority with departments’ and met regularly with deputy ministers (Kennedy 2009). There was also unprecedented coordination among the three central agencies – PCO, Finance and TBS – often criticized by departments for creating confusion. Such concerted central coordination did not mean complete collaboration, cooperation and agreement (Good 2007). However, it led to exclusive focus on establishing and implementing coordinated, consistent and integrated direction to guide more than 35 departments and agencies in implementing the EAP. Several smart budget implementation practices were undertaken. To ensure timeliness the central agencies concerted to accelerate the policy and program design and financial approval processes. This normally required sequential approval at the individual program level, first from Cabinet for policy approval, and then from the Treasury Board for financial approval, with the overall process taking six months. An accelerated parallel process was instituted, with the reviews and approvals by the PCO and Cabinet undertaken simultaneously with those of the TBS and the Treasury Board. The total time taken to design, review and approve the EAP was a mere two months. With Budget 2009 tabled in late January, there was insufficient time to incorporate EAP initiatives into the Main Estimates of each department. Funds would have to be secured through supplementary estimates approved by parliament, and the earliest opportunity for that would only

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be in late June. To expedite the funding so that allocations could be made between 1 April and 30 June 2009, the Treasury Board established a new central vote in the Main Estimates of $3 billion. The Treasury Board delegated to its President the authority to allocate funds to departments from this new vote for their EAP initiatives ($2.1 billion was allocated). To expedite project start-­up, the Treasury Board allowed departments to design programs which allowed non-­governmental applicants to incur costs at their own risk once the project was announced by the Minister. The Treasury Board increased delegations for spending authority for ministers so that they could sign agreements without having to return to the Treasury Board for additional approvals. Environmental assessment processes were streamlined significantly. They were viewed as complex, time-­consuming and sometimes redundant with those of other jurisdictions, often delaying projects in the past. Congruent with its long-­standing desire to harmonize environmental reviews, the government introduced additional exclusions for environmental assessments for certain EAP projects by amending the exclusions list regulations in the Canadian Environmental Assessment Act. Of the project proposals reviewed for the Infrastructure Stimulus Fund, 93 percent were excluded from environmental assessment.9 Furthermore, the budget legislation made exemptions permanent for certain infrastructure programs. Departments and agencies accelerated their internal processes. Some stimulus programs were modeled on well-­ established program frameworks, while others built on regional development programs using existing networks of regional staff. The instinct was to rely on things that had worked, use existing repertoires and find ways to make it happen sooner, rather than to innovate in new directions. For example, Western Economic Diversification, which delivered the Community Adjustment Fund (CAF) and the Recreational Infrastructure Canada (RInC) Program, used their existing model for infrastructure programs. Application processes were accelerated, allowing applicants to apply, secure approval and report on progress through online systems. To speed up the application process for the Knowledge Infrastructure Program, most provinces and territories agreed that the federal government through Industry Canada could deal directly with post-­secondary institutions. Various projects had different eligibility requirements, but there was one single and overriding eligibility criterion: they had to be substantially or fully completed before 31 March 2011, with signed attestation by the applicant and reviewed by departmental officials. For example, for the $4 billion Infrastructure Stimulus Fund, applicants had to attest that proposed projects were ‘construction ready’ and would not otherwise have been constructed by 31 March 2011 without federal funding. Despite considerable



Canada’s reactive budget response to the global financial crisis ­75

pressure from provinces, municipalities and project proponents, the Prime Minister and the Minister of Finance remained adamant that funding would not extend beyond the deadline. The unambiguous and oft-­repeated message from the Prime Minister to ‘spend it or lose it’ put pressure on proponents and departments to complete projects on time. It was not until December 2010 that the government announced that certain projects under four delayed infrastructure programs could receive limited funding until 31 October 2011.With this announcement, Quebec, which had not allowed the federal government to deal directly with its municipalities and post-­secondary institutions, was accommodated. Departments and agencies focused on assessing and responding to risks. For example, the capacity to deliver programs quickly was immediately recognized as a major risk. Many departments established oversight committees of senior officials to assess and manage EAP ­responsibilities and, particularly in the area of infrastructure, to coordinate with other ­departments. Most departments reassigned experienced employees and hired legions of temporary staff to manage dramatically increased w ­ orkloads (one department added a separate shift). Another major risk was program management and financial control. Most deputy ministers relied extensively upon their internal audit function, particularly their recently created departmental and agency audit committees (DAACs) which included experienced and external advisors such as former senior public servants, private sector executives and nationally recognized auditors. Their independent advice was important for deputy ministers, anxious to receive objective assurance that adequate controls and reporting on department programs and operations were in place (Larson and Zussman 2010). While public servants worked hard to implement the action plan in the face of the contractions among its three underlying principles, there was also a fourth, largely unstated, but universally understood objective: no screw-­ups. That takes us to the unique role played by the Auditor-­General. Scene 2: The Auditor-­General Sets Down Her Marker The ink had hardly dried on the 27 January 2009 budget when the Secretary of the Treasury Board received an unprecedented letter from the Auditor-­General, Sheila Fraser. She outlined the elements that the government should take into account when ‘designing and implementing its Economic Action Plan . . . as well as the types of audit objectives and criteria that [she] would consider’ in her audit (Auditor-­General 2009). It is customary for the Office of the Auditor-­General, as an agent of parliament, to consult with departmental managers on audit criteria prior to undertaking an audit, but never before had an Auditor-­General so clearly

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and definitively set out criteria in advance of the design and implementation of the programs. As if to fashion herself as the government’s own chief operating officer, she asserted that ‘the government’s chief financial officers will no doubt play a critical role in managing risks and assuring compliance’ and that the ‘internal audit community and the departmental audit committees [would] play a key role in providing assurance that the governance, risk management, and control frameworks established by federal departments and agencies are adequate’. This reinforced the role of the DAACs and the status of the newly designated chief financial officers (CFOs), previously known as assistant deputy ministers for finance, and occasionally ignored by program managers when designing programs.10 Ms Fraser detailed the 14 audit criteria she would use to audit the 90  programs in the 35 departments and agencies contained in the $40 billion Economic Action Plan.11 These criteria ranged from ‘appropriately planned and monitored programs’, ‘decision-­making . . . supported by sound, documented, risk-­assessment processes’, to ‘clear and well-­ defined eligibility and selection criteria . . . documented, commonly understood, and applied consistently’. The letter and annex were immediately circulated to all deputy ministers. They quickly became the government-­ wide standard for departmental managers when designing their stimulus-­ related programs, and for chief audit executives (internal auditors) who, with their respective DAACs, were undertaking independent risk assessments and producing timely reports and advice for program managers to incorporate into their program designs and implementation plans. Eighteen months later, the EAP received a clean audit when the Auditor-­ General delivered her highly anticipated audit report of selected programs on 26 October 2010 (Auditor-­General 2010a).12 Her report and press release noted that ‘the government took adequate measures to speed the design and roll-­out of the Economic Action Plan’, and found that ‘departments and central agencies paid considerable attention to risk and put in place suitable controls and mitigation strategies’. With a nearly unprecedented compliment, and echoing the expectations set out in her letter, the Auditor-­General stated that ‘Departments and central agencies worked hard to accelerate their selection and approval processes and put in place the appropriate controls. We are pleased to see the important role that internal audit played’ (Auditor-­General 2010b). While some newspapers acknowledged this accomplishment (Chase 2010; Globe and Mail 2010), the opposition parties hardly mentioned the audit report and it became a non-­event.



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Scene 3: ‘Never Waste a Crisis’ – The Politics of Signs and Announcements This often-­quoted comment from Rahm Emanuel, former Chief-­of-­Staff to President Obama, became the communications watchword for Prime Minister Harper’s political staff (Boin et al. 2005). The EAP roll-­out was the major political activity for the minority Conservative government. It involved more than 26 000 projects ranging from provincial and municipal infrastructure, social and aboriginal housing units, buildings for colleges and universities, upgrading parks and national monuments, modernizing federal laboratories, improving small craft harbors, to repairing federal buildings. From the unveiling of the EAP in January 2009 until early 2011, ministers and government MPs made almost 2500 announcements – more than three every day – complete with press releases, advertisements, signs, photo opportunities and ribbon-­cutting. Traditionally, the Department of Finance played the lead role in overseeing the roll-­out of budget announcements. That was not the case with the EAP which, like other budget announcements under the Harper government, was increasingly orchestrated by the Prime Minister’s Office (PMO) with support from the PCO. A PMO–PCO working group was formed immediately to oversee the marketing of the action plan, with the key element being a flashy website designed to enforce ‘a single, consistent brand . . . across all departments and agencies’. The PMO determined the content: it was initially filled with many pictures of the Prime Minister, subsequently removed as part of ‘routine maintenance’ after the opposition criticized the site’s self-­aggrandizing appearance (Cheadle 2011). The website also had a section on ‘What they’re saying’, containing extensive and selective endorsements from prominent leaders, heads of associations, international organizations, the Auditor-­General, university presidents, media, banks and Aboriginals. For example, the International Monetary Fund (IMF) is quoted as describing the economic action plan as ‘large, timely, well diversified and structured for maximum effectiveness’, and an association head declared that the budget ‘has played a significant role in assisting Canadian manufacturers weather [sic] the recession’ (Government of Canada 2011). Of course, there was no mention of studies such as the one by the conservatively oriented think tank the Fraser Institute, which concluded that the contributions from the EAP to the improvement in GDP growth were ‘negligible’ (Karabegovic et al. 2010). The motivation underpinning the EAP political communications strategy was to carry the minority government to the next election. In January 2011, as the EAP began to wind down, and in anticipation of the next budget that would test the confidence of the minority government, citizens

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were bombarded with a fresh round of EAP advertising (television, radio and newspaper) under the enticing theme: ‘Find out what’s in it for you’. The advertisements uniformly directed viewers to the EAP website. At the same time 80 government MPs, ministers and senators were dispatched across the country to extol the virtues of the action plan. In addition, the government kept track of every job site sign related to the federal stimulus package. Each of the 8500-­plus signs included the ‘actionplan.gc.ca’ web address. Scene 4: The Beginning of Divergence about Consolidation Even as the EAP was being implemented, the Minister of Finance released new economic and fiscal projections in September 2009, boasting that Canada was: much better off than most of its G7 colleagues. Our deficit and debt levels are manageable and small relative to other countries. Our banks and financial system are the strongest in the world. The unemployment rate in Canada is 1 percentage point lower than in the US. We will weather the storm.

While acknowledging a downward revision in the economic forecast, the Minister expected a weaker fiscal position for the government than projected in the 2009 budget. The deficit was forecast to climb to $56 billion in 2009–10 and to $45 billion in 2010–11, and then to fall to $5 billion in 2014–15. Relative to the size of the economy the budget deficit in 2009–10 was 3.7 percent of GDP, below the most recent peak of 5.6 percent after the recession in 1992–93. By 2014–15 the deficit was forecast to be a ­‘manageable’ 0.3 percent of GDP and the government would be ‘staying the course . . . with a sound plan for the economy and for bringing the budget back to balance’ (Department of Finance 2009b). On 15 September the PBO indicated that his July economic and fiscal update was ‘very much in line’ with the Minister of Finance’s update. However, the PBO flagged that in the coming weeks he would release updated projections based upon risk assessments and analysis of potential output and structural budget balances13 (Parliamentary Budget Officer 2009a). Over the summer and fall of 2009, the PBO worked on estimates of the government’s structural budget balance based on a forecasting methodology that improved upon the approach used by the OECD and IMF in their official estimates.14



Canada’s reactive budget response to the global financial crisis ­79

ACT V: COMING OUT WITH CHALLENGES AHEAD As Canada came out of the GFC, the government had the new budget challenge of transitioning from stimulus to restraint. The first step was turning off the stimulus tap, which it did with the March 2011 budget. The more difficult task of addressing the emerging structural deficit is yet to be fully achieved. Scene 1: The Structural Deficit and Disputes with the Parliamentary Budget Officer On 2 November, the Parliamentary Budget Officer released his fiscal and economic assessment update, which differed from the government’s forecast. The PBO focused squarely on the structural deficit, indicating that ‘the budget was not structurally balanced over the medium term’. He predicted that the structural balance would deteriorate from a zero position in 2007–08 to an $18.9 billion structural deficit in 2013–14. While the structural deficits projected over the medium term were significantly smaller than those in the 1980s and early 1990s, the PBO foreshadowed his next report, indicating that a more in-­depth assessment of the sustainability of the current fiscal structure would require a longer-­term perspective, especially in light of fiscal pressures from population aging (Parliamentary Budget Officer 2009b). In January 2010, with political and media attention squarely focused on the government’s preparations for its upcoming budget, the PBO released a more detailed estimate of potential GDP and the government’s structural deficit. He confirmed his projection that the government’s ­ structural balance would deteriorate from a balanced position in 2007–08 to a s­ tructural deficit of $18.9 billion in 2013–14. He noted that despite different methodologies used by the Department of Finance and the PBO, the two estimates of the structural budgetary balance tracked each other closely until 2006 and subsequently diverged. This reflected different views on the economy’s potential GDP and the impact on structural revenues of the run-­up in commodity prices (Parliamentary Budget Officer 2010). The idea of a $20 billion structural deficit was not appealing to a minority government, since it implied that the government could not ­ ‘grow’ its way out of deficit but had to make significant expenditure reductions. It also harkened back to the controversial decision by Prime Minister Harper in 2007 to reduce the GST by two percentage points, resulting in a significant reduction in revenues. Both the Prime Minister and the Minister of Finance attacked the structural deficit concept and personally criticized the Parliamentary Budget Officer. The Prime Minister indicated that while

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spending reductions would be made in the budget, the government would not be cutting transfer programs to individuals, not cutting transfer payments to provincial and territorial governments, and not raising taxes. The case for dealing with a $20 billion structural deficit (and the inherent difficulties in doing so) was made public by two retired top officials of the Department of Finance (Clark and DeVries 2009). Their analysis, prepared for the upcoming budget, set out the simple arithmetic in light of the significant constraints imposed by the Prime Minister. With program spending of $208 billion and $108 billion transferred to provinces and individuals, this left only $100 billion to be sliced by a fifth. However, $20 billion of this was tied to long-­term obligations under offshore energy agreements and expenditures by Canada Mortgage & Housing Corporation, which left only $80 billion. Another $35 billion was subtracted for sensitive programs such as defense, Aboriginal nations and student assistance. Then there were more sensitive areas such as post-­Haitian earthquake relief and commitments to Afghanistan. This left less than $40 billion, largely consisting of personnel and other operating costs, and at best only likely to yield $2.5 billion in cuts (a 5 percent reduction) not the $20 billion required to address the structural deficit (Geddes 2010). In January 2010 the Prime Minister appointed Stockwell Day as President of the Treasury Board with a mandate to secure expenditure reductions by focusing on government operations. The Minister of Finance, in his 4 March 2010 budget, announced a three-­point plan to achieve a rapid decline in the deficit from $53.8 billion in 2010–11 to a position of fiscal balance after 2014–15. The plan advocated winding down the stimulus spending as initially planned; restraining future year growth in defense and foreign aid spending; and freezing operating budgets and reviewing government administration, service delivery and overhead costs. The practice of strategic reviews, where departments assess their programs and identify 5 percent of the lowest-­priority and lowest-­performing ones, would continue; however, any such savings would no longer be available for reallocation but go towards reducing the deficit. Program spending as a share of GDP was expected to decline from 15.6 percent in 2009–10 to 13.2 percent in 2014–15. Against the backdrop of the Prime Minister chairing the G20 Economic Summit in Toronto in June 2010, the federal government bragged in its fall Economic Statement that it had recouped virtually all of the output lost during the recession – the best performance of the G7 countries. However, with declining economic growth since the budget, subsequent fiscal projections had worsened. The deficit was now expected to be $55.6 billion in 2009–10 and with the wind-­down of the economic action plan the government forecast returning to a balanced budget in 2015–16. It was assumed



Canada’s reactive budget response to the global financial crisis ­81

that economic growth and unspecified expenditure restraint in the operations of government would be sufficient. Scene 2: Winding Down the EAP and Heading for a Pre-­Election Budget The much-­anticipated 22 March 2011 budget was a pre-­election document. It sprinkled an array of minor expenditures and ‘boutique’ tax credits targeted to selected voters: seniors, parents, small business owners, voluntary fire-­fighters, temporary workers, new family doctors and nurses, returning veterans and family care-­givers. It contained no ‘big-­ticket’ items. True to its commitment the government confirmed that the EAP, supporting more than 28 500 projects, would wind down as planned on 31 March 2011. While not revealing details of its expenditure reductions, the government indicated that it expected to save $4 billion annually in program spending through departmental streamlining and efficiency reviews, and to eliminate its 2010–11 deficit of $40 billion, leading to a forecasted surplus of $4.2 billion by 2015–16.15 NDP leader Layton, who had set out five major spending priorities as a condition of his support, immediately signaled that his party would not support the budget. Liberal leader Ignatieff introduced a no-­confidence motion, agreeing with a parliamentary committee report that the government was in contempt of parliament for its failure to provide sufficient information on the costs of its crime legislation. With that, the government fell and a general election was under way. On 2 May 2011, the Conservatives were rewarded with a majority government; the NDP became the official opposition as support for the Liberal Party and the Bloc Québécois collapsed. On 6 June the majority Conservative government reintroduced its budget, which was almost identical to the one presented in March with the fiscal projections forecasting a return to balanced budgets in 2015–16. This new budget was so similar to the previous one that the slight changes in the text were simply ‘highlighted in blue’. The most significant change was the government’s commitment, announced by the Prime Minister in the election campaign, to balance the budget ‘one year earlier, by 2014–15’. It was noted that this would be achieved ‘by reducing expenses through the Strategic and Operating Review’ with these savings to be ‘reflected in the Government’s fiscal projections once these actions are determined and implemented in Budget 2012’ (Department of Finance 2011: 19). In sharp contrast, the June 2011 Economic and Fiscal Outlook from the PBO still projected deficits of $13.3 billion in 2014–15 and $7.3 billion in 2015–16 (Parliamentary Budget Officer 2011). Nearly a year later, the March 2012 budget forecast a balanced budget by 2015–16 with a commitment to

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secure ongoing saving of $5.2 billion through a 6.9 percent reduction to the $75 billion of direct program spending, including reduction of 19 200 public service jobs. The actual plans for achieving these savings across all departments, agencies and Crown corporations – from environmental assessments to the Canadian Broadcasting Corporation – were developed, announced and implemented over the course of the next two fiscal years.

ASSESSING THE CANADIAN RESPONSE Canada’s budgetary response to the GFC becomes a narrative of resilience complemented by some agility in the midst of the crisis. Traditional incremental budgeting and its associated drift had been the long-­term norm in Canada (Good 2011b). Yet, when the crisis hit the budgetary system, as it did in 2008–09, the response was not guided by gradual adjustment, internal feedback and adaptation; rather, the response trajectory was sharply punctured by external circumstances. Significant budgetary change in Canada is episodic and the ability of the system to change depends on its resilience to respond periodically in a significant way to major external shocks and crises. Canada’s response was also initially a story of political denial, controversy and brinksmanship. Political will is ultimately the trigger that changes the budgetary system, but such will does not crystallize immediately; rather it coalesces gradually, under increasingly focused political and public pressure, often preceded by a ragged and disjointed process of denials, threats, false starts, and subsequent actions and reactions. Behind the scenes, Canada’s response was also a story of bureaucratic skill, coordination and latent capacity. While the public service cannot by itself significantly change the budgetary system and its central processes, procedures and strategies, it can and does contribute significantly to periodic redesign features and the implementation of budgetary reform initiatives, especially during periods of significant change. The implementation of the EAP is an illustration of how the public service can, with political support and clear direction, put in place budget innovations to ensure coordinated, timely and effective design and delivery of a massive set of initiatives. Going into the GFC, Canada had some distinct advantages compared to many other countries. It was in a strong fiscal position, had a prudent and effectively regulated financial system, and a sound monetary policy of low inflation targets. The recession hit Canada later than most countries. It was not as deep and far-­reaching; nor was it as long. However, coming out of the recession, the economy did not immediately become stronger, as the Prime Minister had boasted it would in 2009. Real income for families has



Canada’s reactive budget response to the global financial crisis ­83

not increased; income distribution continues to be more unequal (Frenette et al. 2009); poverty remains substantial; and no significant improvements have been made in dealing with long-­standing low levels of productivity and private sector innovation. The fiscal situation is weaker, with increased structural deficits of $20 billion and increasing debt to GDP ratios, although not nearly as severe as for other countries. At the political level, the Harper government stepped away from the brink, reassessed and adapted its position, and designed and implemented a broad strategy in a focused way, levering considerable political benefit for adopting a fiscal strategy it originally sought to avoid. Despite a weakened minority government which was ideologically opposed to increasing deficits and was brought to the brink of dissolution, Canada’s budget system responded reasonably well to the crisis. It proved sufficiently resilient and responsive to put together a timely, targeted and temporary stimulus package. Once the politicians gave the go-­ahead, the public service showed that it had the capacity to deal with the crisis and deliver stimuli projects in an expeditious manner, instituting several ‘smart budget design’ and implementation practices along the way. For Canadian governments, spending public money has proved to be considerably easier than curtailing and reducing public expenditure. Arguably, Canada had the right type of government – minority – to force the second Harper government to adopt stimulus spending (Good 2011a). The hard reality of imminent political defeat galvanized the government’s will to act, and the prospect of gaining political support for increased spending in a minority government situation led to the EAP. Conversely, Harper’s third government, a majority, is better positioned to address the fiscal issues now facing the country. That said, Canada has achieved short-­ term gains but has yet to implement credible plans to address the resulting long-­term pain. While the $5.2 billion in stealth-­like cutbacks to direct government spending announced in the most recent budget may appear relatively small when compared to the total budget, they will inflict significant and long-­lasting reductions in government services and programs, touching all Canadians. Great skill, determination and sensitivity will be required to successfully implement these reductions. Past experience indicates that Canada’s budget system as employed by its political leaders and public servants has not been particularly adept at gradually curtailing and controlling public expenditures. Instead, the approach has been a reactive one. The tendency has been to let expenditures pile up, allow the pressures of a pending crisis and public demands for action to build, and then, by galvanizing political will and animating a pliable budget system, respond with significant one-­time expenditure reductions.

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CONCLUSION: PROSPECTS AND STRATEGIES TO CONSIDER It is doubtful that the Canadian government can continue to rely simply on a reliable budgetary system that reacts to extreme pressure and exogenous crises. The ability to adapt and adjust during more regular times, and to plan ahead and prepare for future expenditure decisions, will be increasingly important for ensuring an effective and resilient budgetary system. In this regard there are several changes to the budgetary system that should be instituted, some informed by Canada’s budgetary response to the global financial crisis: ●●

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Broaden expenditure guardianship. Even with a majority government, there will continue to be great pressure on the fiscal framework and increased risk of unsustainable structural deficits. Effective guardianship requires moving beyond the ambit of the Department of Finance and the Treasury Board, with parliamentarians playing a more significant role. To assist parliamentarians, the mandate of the recently created role of the PBO should be clarified and strengthened, by making the office legislatively separate and independent from the Library of Parliament, operating as a full agent of parliament (like the Auditor-­General of Canada). A confused mandate means that PBO reports and statements only serve to increase partisan jibes, rather than stimulating more meaningful debate on significant economic and budgetary issues. A strong and independent PBO could force the government to substantially defend its economic and fiscal forecasts, promote accountability in government costing and analysis, and provide economic and fiscal analysis for use by all parliamentarians and committees. Institute recent budget procedural innovations. The procedural innovations used in designing and implementing the 2009 budget should become established practice. Continuing to strengthen central agency coordination and cooperation, streamline Cabinet and Treasury Board budget approval processes, and support departments and agencies will do much to ensure effective design and timely implementation of budget initiatives. The increased use of internal audit and DAACs by deputy heads should continue to ensure that adequate financial and administrative controls are in place. Over a two-­year period following the announcement of the EAP in January 2009 budget, seven performance reports were released setting out expenditures and outcomes. The government should ­institutionalize the practice of providing quarterly performance reports on its



Canada’s reactive budget response to the global financial crisis ­85

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budgets, with the format established professionally in consultation with the PBO. It should also support the PBO in its development of a ‘real-­time’ expenditure database which, in contrast to the recently published quarterly financial statements, would track departmental spending on a quarterly basis and, most important, make that data available to parliamentarians in a timely and understandable manner. Recognize the limits of strategic reviews. To eliminate its deficit by 2015–16, the government adopted a strategy of undertaking strategic and operating reviews by focusing on a myriad of so-­called ‘small p’ programs of government ranging from such activities as the weather service, through cultural programs, veterans’ support and fisheries management, to public service salaries and government operations. This array of expenditures amounting to some $80 billion represents only 30 percent of the government’s $260 billion in total expenditures. These annual reviews, first introduced in 2007 and designed to reallocate expenditures, have had no impact in controlling overall expenditures and limited success in curtailing the growth of operational expenditures. At best they provided for small reallocations of minor expenditures and facilitated some administrative streamlining and service delivery improvements. Four annual reviews (2007–10) have achieved ongoing annual savings of about $1 billion in 2010–11, with savings forecast to increase to $2.8 billion in 2014–15, largely as a result of anticipated savings in defense. The new strategic and operating reviews, which were part of Budget 2012, only reviewed the same limited base of expenditure.   Bringing greater political weight to these reviews in the form of the newly established Treasury Board Sub-­Committee on the Strategic and Operating Review has been encouraging, since implementing cuts of this magnitude from such a small but politically sensitive expenditure base is particularly challenging. Furthermore, some areas of expenditure remain largely untouchable either because they are dramatically rising, as with new prisons and increased incarceration, or because of special programming for rapidly growing populations such as for Aboriginal nations. Others are major government priorities such as border services and security; and still others, such as shared corporate services, are likely to require some upfront investment or temporary redundancy in order to yield any downstream savings. As a consequence, more of the cuts are being found from a diminishing expenditure base, and securing a modicum of public support is dependent more on the ability to sell and achieve smaller government than on the actual expenditure reductions themselves.

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Putting all the restraint eggs into the Strategic and Operating Review basket carries a particular risk to government. These reviews are costly, complicated and time-­consuming, and implementing the cuts and achieving the savings will require determination, skill and perseverance. Increased uncertainty over the global economic recovery may require the preparation of fiscal action in areas beyond the limited scope of strategic and operating reviews. Institutionalize long-­term expenditure planning. One way to assess how well the government responded to the GFC is to consider where it finds itself today in light of the challenges ahead. There are several significant challenges looming on the horizon – uncertainty over the economic outlook, demographic change, financing increasing health care costs, fostering innovation and productivity, addressing climate change, renewing fiscal transfer programs, and maintaining national unity – each carrying major budgetary implications. These are tough challenges, but taken together, and with a sizeable structural deficit, they will be especially difficult to address. To tackle them requires the federal government taking a long-­term view. For example, the health care spending to GDP ratio is projected to increase from nearly 12 percent in 2009 to 18.7 percent in 2031, and even with incredible success in productivity, efficiency and effectiveness in the health care system the spending to GDP ratio is expected to rise to 15.4 percent by 2031 (Dodge and Dion 2011). In December 2011, the Harper government announced to the provinces and territories a ‘take it or leave it’ deal which sees health care spending continuing to increase by 6 percent a year until 2017, after which it will be tied to nominal GDP with a guaranteed minimal increase of 3 percent. Credible reporting and forecasting on long-­term trends and scenarios will be essential; the government should institutionalize publishing long-­ term analysis and projections for major statutory expenditure areas such as health care, education, federal–provincial transfers, major transfers to individuals, and defense and security outlays. Moreover, the quality of the Department of Finance’s work can be furthered through open contestability from the PBO and non-­governmental forecasters. Engage citizens about pressures and choices. The government must not only undertake longer-­term analysis, but also engage parliamentarians, think tanks and citizens about current and emerging pressures, trade-­offs and possibilities. This requires finding ways to convey the information in an accessible manner, allowing them, and external analysts, to come to their own conclusions about trends and options. This suggests a possible role for Horizons Canada (formerly



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the Policy Research Secretariat) in highlighting medium-­to longer-­ term issues and trends, beyond informing the work of deputy ministers and the government. Finally, making decisions that return the country to fiscal health in the longer term may be too divisive in the shorter term; this suggests the need to identify strategic policies and their effects over a transitional period, thereby giving citizens, other governments and the private sector sufficient time to assess, adjust and invest over time. Such an approach would allow the government to adjust and recalibrate, depending on the economic situation and how long fiscal pressures remain, as well as learning about how well the policies appear to be working and what Canadians value and need. These suggestions to continue improving Canada’s budgetary processes could be viewed as largely administrative and informational in nature. However, improving budgeting in substantive and process terms has always been a blend of politics, policy and administration. In this context, the importance of political will cannot be underestimated: budgetary systems need political resolution to enable them to realize their future potential. Even the best budget systems will not have much traction if political leaders are not acknowledging trends and uncertainties, engaging citizens, making difficult decisions and seeing them through. More generally, budgeting is an ongoing dialectic among political values, policy feasibility and administrative capability. This chapter has provided an account of this interplay under stressful conditions, and how the budget system was animated by a government that became more clear-­eyed about political risks and economic challenges. While the fiscal pressures and risks remain very real for Canada, and despite three minority governments, it is important to acknowledge that the country’s finances are in relatively good shape by international standards. Indeed, it was minority government politics that drove the Harper government towards reassessing a dogmatic stance and adopting a successful budget strategy. A majority government, however, is more likely to adopt some of the suggestions we have outlined above for improving budgeting and positioning the budget system and the government to address longer-­term challenges. The paradox is that for a majority government to succeed in these circumstances requires not only maintaining focus and discipline, but also openness and creativity, as if it were still a minority government seeking to earn the trust of citizens.

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NOTES   1. These data, published by the Organisation for Economic Co-­operation and Development (OECD) are on a National Accounts basis for the total government sector. For Canada, the figures included the federal, provincial-­territorial and local government sectors, as well as the Canada Pension Plan and the Québec Pension Plan (Department of Finance 2008a).   2. As explained by Courchene, this happy circumstance occurred in the mid-­1980s. When Quebec indicated that it intended to relax ownership rules, allowing financial institutions to own Quebec-­based securities firms, Ontario countered with a proposal to allow both domestic and foreign ownership of securities. Ottawa objected, as US access to the Canadian securities industry was an important bargaining chip in its Free Trade Agreement negotiations with Washington. Ontario then allowed Canadian financial institutions one year to purchase these firms or open their own firms before foreigners could apply for entry. The Canadian chartered banks purchased most of the securities firms. This had the salutary result that most of the securities industry remained within the prudent culture of the banks, and was conservatively regulated by the Office of the Superintendent of Financial Institutions.  3. A veteran parliamentary observer explains: ‘Stephane Dion has always had a hard time with English, with television and with scripts. To add to these handicaps his staff had decided to employ a homemade porn video look for his response [to the Prime Minister], using a cheap camera with a broken auto-­focus. They sealed his fate by delivering his tape to the broadcasters late and to the wrong address. His face was framed peering over a shelf. He looked like a squirrel peering nervously out of a birdcage . . . As one Liberal wag observed the next day, “It was fabulous radio if you closed your eyes.” It was the dagger in the heart of Dion’s leadership the moment it aired’ (Sears 2009: 47–8).   4. The Department of Finance bases its fiscal projections on the average private sector economic forecasts, a practice that started in 1994 following an independent review by Tim O’Neill of the department’s forecasting practices (Good 2007: Chapter 6: ‘Fiscal Aggregates: Controlling Totals’).   5. See Courchene and Allan (2009).   6. This was a throwback to infamous ‘Dollar a Year Men’ who selflessly served the government during World War II, with the Harper government attempting to invoke a similar spirit and symbolism in an effort to mobilize public support for its preferred budget strategy.   7. On 9 March 2011 the Speaker of the House of Commons ruled that the government breached parliamentary privilege by refusing a committee’s request for detailed information on the costs of federal law-­and-­order legislation. A parliamentary committee found subsequently that the government was in contempt of parliament, and on 25 March 2011 the Conservative government was defeated by the opposition parties on a no-­confidence vote.   8. This was in sharp contrast to the Australian budget of 3 February 2009 which did not provide funding to state governments but focused on providing one-­time cash bonuses directly to individuals and families.   9. The Auditor-­General reported that from its sample of 52 approved projects (all of which were excluded from environmental assessment), 35 ‘lacked sufficient information to make a determination about whether an exclusion was warranted’ (Auditor-­General of Canada 2010a). 10. The most visible and high profile was The Atlantic Groundfish Strategy (TAGS), which was poorly designed and excessively costly. 11. An additional $12 billion was to be funded by the provinces and the territories. The overall amounts were increased subsequently to $47 billion in federal stimulus and $14 billion from the provinces and territories, representing about 2.9 percent of GDP. 12. The audit examined the delivery of infrastructure spending by 12 departments and



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agencies responsible for 11 programs, as well as the guidance and direction provided by central agencies. 13. The structural budget balance (or cyclically adjusted budget balance) is the budgetary balance that would occur if the economy were operating at its potential GDP. It is a calculation that removes the cyclical components from the observed or projected balance. As the IMF notes, failure to distinguish between the cyclical and the structural components of the budget ‘poses the risk that the fiscal levers may be over-­or under-­adjusted in response to budgetary developments that might be reversed automatically over the course of the business cycle’ (International Monetary Fund 1999). 14. The improved methodology included: (a) estimates of potential GDP by taking into account trends in labor input and labor productivity reflecting the slower growth of the working-­age population; (b) adjustments in budgetary balance to account for terms of trade; and (c) an estimate of tax elasticities which better estimates changes to the tax structure over time. 15. In the 2011 election campaign the Prime Minister committed to eliminate the deficit one year earlier, 2014–15. This $4 billion annual reduction in program spending assumes that program spending would be frozen at its current level of $80 billion for the next two years and increase by 2 percent thereafter. This presented a major challenge since this level of sustained reduction in program spending had never been achieved before.

BIBLIOGRAPHY Auditor-­General of Canada (2009), Letter to Secretary to the Treasury Board, March 5. Auditor-­General of Canada (2010a), Chapter 1: Canada’s Economic Action Plan, Ottawa: Public Works and Government Services Canada. Auditor-­General of Canada (2010b), Press Release, ‘Launch of Program was Well Managed’, 26 October, Ottawa. Bank of Canada (2008), ‘Bank of Canada Lowers Overnight Rate Target by ¾ Percentage Points to 1½ Per Cent’, Press Release, 9 December, Ottawa. Boin, A., P. ’t Hart, E. Stern and B. Sundelius (2005), ‘Learning from Crises and the Politics of Reform’, The Politics of Crisis Management: Public Leadership Under Pressure, Cambridge: Cambridge University Press. Chase, S. (2010), ‘Sheila Fraser Gives Tories Thumbs up on Stimulus’, Globe and Mail, 26 October. Cheadle, B. (2011), ‘Documents Show Economic Action Plan Marketing Blitz a PMO Production from the Get-­go’, Canadian Press, 24 February. Clark, S.C. and P. DeVries (2009), ‘A Credible Budget will have to Include Tax Increases’, Globe and Mail, 14 December. Courchene, T.J. (2009), ‘Murphy’s Law Running Rampant? Gump and Gretzky to the Rescue’, notes from a presentation to the MPA Policy Forum, School of Policy Studies, Queen’s University, 24–25 April. Courchene, T.J. and J.R. Allen (2009), ‘Finding a Balance: Assessing Budget 2009’, Policy Options, March, 12–18. Department of Finance (2008a), Economic and Fiscal Statement, 27 November, Ottawa: Public Works and Government Services Canada. Department of Finance (2008b), Economic and Fiscal Update, December, Ottawa. Department of Finance (2008c), Fiscal Stimulus: Budget 2009 Consultations December, Ottawa.

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Department of Finance (2008d), Canada’s Finance Ministers Discuss Budget Priorities, 17 December, Ottawa. Department of Finance (2009a), ‘Canada’s Economic Action Plan’, Budget speech, 27 January, Ottawa: Public Works and Government Services Canada. Department of Finance (2009b), Update of Economic and Fiscal Projections, September, Ottawa. Department of Finance (2011), The Next Phase of Canada’s Economic Action Plan, 6 June, Ottawa: Public Works and Government Services Canada. Dodge, D.A. and R. Dion (2011), ‘Chronic Healthcare: A Spending Disease’, C.D. Howe Institute Commentary, No. 327, April. Frenette, M., D. Green and K. Milligan (2009), ‘Taxes, Transfers, and Canadian Income Inequality’, Canadian Public Policy, 35 (4), 389–411. Geddes, J. (2010), ‘Note to Stephen Harper: It’s not so Easy Cutting Federal Spending’, MacLean’s, 22 January. Globe and Mail (2007), ‘There’s No Reason for a Federal Election Now’, 16 April, A12 (editorial). Globe and Mail (2010), ‘Sheila Fraser Offers a Rare, Fragrant Bouquet’, 26 October (editorial). Good, D.A. (2007), The Politics of Public Money: Spenders, Guardians, Priority Setters, and Financial Watchdogs Inside the Canadian Government, Toronto: University of Toronto Press. Good, D.A. (2011a), ‘Minority Government and the Public Service: Some Impacts on Governing’, Optimum Online, 41 (1), 31–46. Good, D.A. (2011b), ‘Still Budgeting by Muddling Through: Why Disjointed Incrementalism Lasts’, Policy and Society, 30 (1), 41–51. Good, D.A. and E.A. Lindquist (2010), ‘Discerning the Consequences and Integrity of Canada’s Budget Reforms: A Story of Remnants and Resilience’, in J. Wanna, L. Jensen and J. de Vries (eds), The Reality of Budget Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Government of Canada (2008), Speech from the Throne, 19 November, Ottawa. Government of Canada (2009), Speech from the Throne, 26 January, Ottawa. Government of Canada (2011), Canada’s Economic Action Plan, http://www. actionplan.gc.ca/eng/index.asp. International Monetary Fund (1999), ‘The Structural Budget Balance: The IMF’s Methodology’, Working Paper 99/95, http://www.imf.org/external/pubs/ft/ wp/1999/wp9995.pdf. Karabegovic, A., C. Lammam and N. Veldhuis (2010), Did Government Stimulus Fuel Economic Growth in Canada?, Vancouver: Fraser Institute. Kennedy, S. (2009), Deputy Secretary, Privy Council Office, ‘Testimony before the Standing Committee on Government Operations and Estimates’, Parliament of Canada, 12 March. Larson, P. and D. Zussman (2010), ‘Departmental Audit Committees: An Evaluation’, Optimum Online, 40 (4), 29–51. Leduc, L. (2009), ‘Coalition Government: When It Happens, How It Works’, in P.H. Russell and L. Sossin (eds), Parliamentary Democracy in Crisis, Toronto: University of Toronto Press. Lindquist, E.A. (1994), ‘Citizens, Experts and Budgets: Evaluating Ottawa’s Emerging Budget Process’, in S.D. Phillips (ed.), How Ottawa Spends 1994–95: Making Change, Ottawa: Carleton University Press.



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Lindquist, E.A. (2002), ‘How Ottawa Plans: The Evolution of Strategic Planning’, in L.A. Pal (ed.), How Ottawa Spends, 2001–2002: Power in Transition, Don Mills, ON: Oxford University Press. Martin, L. (2010), Harperland: The Politics of Control, Toronto: Penguin Books. Parliamentary Budget Officer (2008), Economic and Fiscal Assessment, Ottawa, 20 November. Parliamentary Budget Officer (2009a), Economic and Fiscal Assessment Update, Ottawa, 15 September. Parliamentary Budget Officer (2009b), Economic and Fiscal Assessment Update, November. Parliamentary Budget Officer (2010), Estimating Potential GDP and the Government’s Structural Budget Balance, 13 January. Parliamentary Budget Officer (2011), PBO Economic and Fiscal Outlook, 1 June. Prime Minister of Canada (2008), Official Reply to the Speech from the Throne, 20 November, Ottawa. Prime Minister of Canada (2009), ‘Prime Minister and Premiers Agree on Action for the Economy’, Press Release, 16 January, Ottawa. Russell, P.H. (2009), ‘Learning to Live with Minority Governments’, in P.H. Russell and L. Sossin (eds), Parliamentary Democracy in Crisis, Toronto: University of Toronto Press. Russell, P.H. and L. Sossin (eds) (2009), Parliamentary Democracy in Crisis, Toronto: University of Toronto Press. Sears, R.V. (2009), ‘Anatomy of a Crisis: Seven Days that Shook Ottawa’, Policy Options, March, 41–52. Topp, B. (2010), How We Almost Gave the Tories the Boot, Toronto: James Lorimer & Company.

4. Australian and New Zealand responses to the ‘fiscal tsunami’ of the global financial crisis: preparation and precipitous action with the promise of consolidation John Wanna1 Australia and New Zealand initially confronted the global financial crisis (GFC) of 2007–12 from positions of economic and fiscal strength. Their national governments took precipitous remedial action as the crisis swept through domestic markets, and then moved gradually and tentatively to reconsolidate their financial position in the wake of the crisis. The crisis tested both the system of financial regulation and the budgetary system in both countries. It caused some months of great turmoil at the macroeconomic level, resulting in just one quarter of negative growth for Australia and negative growth of five quarters for New Zealand. Both governments guaranteed financial deposits in banks and underwrote lines of credit for financial institutions and other at-­ risk commercial sectors. They stimulated their economies in classic Keynesian mode, massaging effective demand and sustaining business and consumer confidence (although direct cash injections to citizens were much more evident in Australia than New Zealand). Both believed the crisis could be weathered by allowing short-­term cyclical deficit spending to occur, but also found that structural deficits eventuated. Once the nadir of the crisis had passed, governments on both sides of the Tasman Sea then went on a relentless exercise to rebalance their budgets and return them to surpluses in a most expeditious manner. Suddenly, ‘fiscal consolidation’ became the new political mantra: attempting to hold spending flat while awaiting a recovery in revenue income as economic output and inflation recovered. While some critics accused them of unnecessary paranoia over successive post-­crisis deficits and of being beguiled by a fetish for surpluses, their consolidation strategies for a time elevated fiscal rectitude as these governments’ main priority. It was 92



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evidence of a return to prudent fiscal management and a reversion to a neo-­liberal medium-­term economic and fiscal framework, even though revenues were slow to recover. Indeed, the Australian Treasurer, Wayne Swan, stated the government’s strategy succinctly as: ‘if we are going to be Keynesians in the downturn, we have to be Keynesians on the way up’, implying the withdrawal of fiscal stimuli, exploring additional sources of revenue and aiming to balance budgets.2 The inherent fiscal strength of the Australian and New Zealand economies immediately prior to the crisis cannot be overemphasized. This strength was partly the result of a healthy fiscal position (budgetary reserves), a strong financial position (low inflation and scope for effective monetary policy), and partly to the economic policy settings and financial regulation pursued by these governments. In April 2007 the Australian Treasurer, Peter Costello, in launching the government’s second intergenerational report, claimed that: We have better policy settings in place today. Our monetary policy is set by an independent Bank with an explicit inflation target, our Budget is in surplus and we have eliminated Government debt . . . Soon after election in 1996, the Government committed to maintain a budget balance, on average, over the course of the economic cycle. Budget surpluses in eight of the past nine years have allowed the Australian Government to eliminate its net debt. This compares to net debt averaging around 24 per cent of GDP [gross domestic product] in other OECD [Organisation for Economic Co-­operation and Development] economies. We pursued an energetic and wide-­ ranging structural reform agenda, including important initiatives on corporate law, prudential regulation of financial markets, the ownership and regulation of infrastructure, and reductions in trade barriers. And we put in place landmark, generational changes to Australia’s tax and workplace relations systems. (Costello 2007)

His tone was triumphal but the message was clear: prudent fiscal management combined with economic reform and sustained economic growth placed Australia in an enviable position to combat the GFC. With substantial growth in revenues over the period 2000–2007 both the Australian and New Zealand governments had been accumulating embarrassingly large annual budgetary surpluses. The Australian government had delivered a fiscal balance of $17.2 billion (1.6 percent of GDP) and a headline cash balance of $26.7 billion, and a further $43.6 billion in its net asset position on the balance sheet. On the eve of the crisis in 2007–08 Australia still managed to record a fiscal surplus of $21 billion (or 1.8 percent of GDP) and a cash surplus of $28.2 billion. New Zealand, with a slightly different reporting basis, enjoyed similarly large surpluses with recorded surpluses of around NZ$8 billion in 2007, or approximately 4 percent of GDP, and projected surpluses well into the future. Australia’s last real deficit was

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recorded in 1997, while New Zealand had not experienced an operating deficit since 1993. New Zealand, moreover, had significantly reduced its public sector workforce (down from more than 60 000 in the late 1980s to 30 000 by 2000 but then increasing slightly to 38 000 by 2010). Such reductions were far greater than occurred in Australia, where the federal public workforce had increased in size following a decrease in the late 1990s while the larger state public workforces had continued to grow (APSC 2011; Laurie and McDonald 2008). This chapter analyzes the impacts, responses and consequences of the GFC on Australia’s budgetary position, and then briefly explores the related story in New Zealand. It focuses initially on the Australian case, analyzed in four chronological sections, followed by a shorter section on New Zealand. For a short while when the crisis first hit, New Zealand was playing catch-­up to Australia and to some degree was buffered by its economic neighbor, but it also implemented its own response and recovery path differently to Australia’s, and exerted greater political will behind the imperative to rebalance budgets.

AUSTRALIA: CONTINGENCY PLANNING AND THE ONSET OF THE GFC The early signs of a looming financial crisis were greeted by mixed messages and contradictory assessments from Australian politicians, but also with a certain degree of preparedness and readiness from senior economic, financial and budgetary officials. The immediate catalyst for the GFC appeared to Australian budgetary officials to be an exogenous event unrelated to its own domestic circumstances, as it did to officials in many other OECD nations. It largely emanated from the US subprime mortgage meltdown and the toxic assets held by some US and European financial institutions. Initially, this external real estate ‘correction’ appeared to Australian policy-­makers to be contained purely within the US financial lending markets that had overextended their loans. One commentator had argued that Australia seemed a ‘passive rather than active participant in the opening stages of the GFC’ (Wettenhall 2011), and it did not seem that, even if a wider crisis occurred, it would affect Australia or Asian markets greatly. There was a sense that it was a peculiarly North American crisis, perhaps infecting Northern Europe, but not the rest of the developed or developing economies. Throughout 2007, as the US subprime mortgage crisis intensified, Australia was preoccupied with a federal election. Politicians were out campaigning on the hustings, trying to outbid each other over substantial



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tax cuts, with some $43 billion in cuts promised over three years by both sides of politics, and yet maintaining bi-­partisan commitments to fiscal conservatism and sound economic management. It had been 15 years since the last recession, and no one seriously wanted to countenance the prospect of a return to those days. Politicians on both sides preferred to talk of sound economic management, with export-­led growth and high commodity process continuing unabated. Yet, economic anxieties remained. In October 2007, shortly before the federal election, the Liberal federal Treasurer, Peter Costello, obliquely hinted that a repeat of the 1997 Asian financial crisis could conceivably occur in 2008. Costello argued that a sudden downturn in China’s demand for resources and a readjustment in its financial systems would ‘set off a huge tsunami that will go through world financial markets’. He was not predicting a worldwide financial crisis but warning that a downturn in commodity prices or in China’s demand for commodities would impact in the region. Immediately after the election, the new Treasurer in the incoming Labor government, Wayne Swan, publicly refused to accept that the US subprime financial crisis would affect Australia. He suggested that Australia had a proud record of strong regulation over its financial institutions which had sufficient collateral (reserves) and no exposure to the toxic assets beginning to unravel in the US. While he was simply trying to shore-­up confidence in the markets, his departmental officials were less sanguine. They sensed that all was not well with international finance markets, and that gathering clouds of a global recession were imminent. The Treasurer was told that Australia faced a credit squeeze and other contingent risks to its financial and economic wellbeing if the US loans fiasco spread to other systems. Meanwhile, the new Prime Minister, Kevin Rudd, was anxious to know of the depth and magnitude of risks Australia faced. He had given a speech in January 2008 mentioning that global financial uncertainties were posing a threat to the Australian economy. On 29 February 2008 he asked for a briefing from the Treasury to discuss what might go wrong and how an international financial crisis might affect Australia in the immediate term. At that stage, the Treasury thought there was only a slight chance that a serious financial meltdown might occur, but it seemed unlikely. The Treasury was uncertain what would be the magnitude of any looming crisis, and decided it would need to undertake specific research and modeling to investigate the strength of the financial markets. The Treasury advised that there were a number of possible policy responses: from using the balance sheet to inject fiscal stimuli, to finding ways to ensure credit and wholesale lending in financial markets, to the use of a planned financial insurance (claims) scheme which could mop up particular financial

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institutions if they were to collapse. From then on, the Prime Minister and his senior economic ministers met continuously with senior Treasury and Finance officials, sometimes on a twice-­daily basis, to explore how global markets were tracking and what Australia could do to stave off the worst aspects of the crisis.3 The Treasury had been preparing for a fiscal or economic crisis for some time. From around 2003–04, departmental officials had been secretly modeling the projected effects of scenarios involving a sudden economic downturn or significant recession. Long before the GFC appeared on the horizon, senior Treasury officials had run a few internal contingency exercises to undertake some ‘war-­gaming’ of economic shocks, including a repeat of the Asian financial crisis of 1997. These anticipatory and preparatory exercises were highly confidential, undertaken off-­site and involved no one other than the senior echelons of the Treasury (even the Treasurer may not have known about them). By the early 2000s some executives in the department had become worried that there were only a few veterans left in the department who had experienced the 1991–92 recession and the debacle that followed, and as a consequence institutional corporate memory was deficient. They were not confident that the new echelon of senior officials would react appropriately without some dedicated contingency planning and scenario modeling. So special ‘retreats’ were organized to run mock economic crises as a way of preparing for the worst, reacting to a sudden economic deterioration, and at the same time sensitizing senior officials to the contingent nature of advisory work in the context of massive uncertainty. Most of these abstract exercises modeled a severe sudden recession in the real economy that increased unemployment dramatically; other tests were then run on the effects on various sectors and on the medium-­term fiscal position of the government’s budget. These simulations also tried to test the degree to which a major macroeconomic downturn would affect the profitability of the Australian banks; but apparently no conceivable scenario could be found in which the banks would become unprofitable. In these contingency exercises, the main concerns of the officials were a sudden lay-­off of large numbers of employees, a surge in unemployment, the immediate cost to the budget of cash benefits, and the long-­term effects of getting (or not getting) those thrown out of work back into the workforce. These contingency planning exercises proved useful in assisting with the Treasury’s analytical preparedness when the GFC unfolded, but unfortunately the wrong kinds of scenarios were modeled: economic slowdowns in the real economy rather than financial collapses and credit freezes.



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AUSTRALIA’S INITIAL UNCERTAINTY AS THE IMPACT OF THE GFC BECAME APPARENT The full impact of the GFC was not apparent or felt in Australia until late August and early September 2008 with the collapse of Lehman Brothers in the US, not long after the bailouts of US mortgage lenders Fannie Mae and Freddie Mac, but almost a year after the enforced nationalization of the Northern Rock bank by the UK government and some five months after the US bailout of Bear Stearns in March 2008. Australia even produced a ‘normal’ mildly expansionary budget on the cusp of the GFC in May 2008. Two immediate problems faced Australia as the impact of the GFC became apparent. First, there was a diverse group of domestic regulatory and policy institutions that had compartmentalized responsibilities for monetary and fiscal policy and the robustness of the financial system. These fragmented institutional actors included the Reserve Bank of Australia (RBA), the Australian Prudential Regulation Authority (APRA), the Australian Securities and Investment Authority, and the separate departments of Treasury and Finance. In addition to these authorities were the economic and fiscal advisory units in the Prime Minister’s department. The first four actors were all members of the Council of Financial Regulators (CFR) where coordinated regulation and a broader strategy of monetary and fiscal policy could be orchestrated. Second, Australia was not really part of an effective international economic coordinating network at the start of the GFC. While the US, UK, Germany and France tended to see the G7 as the main international coordination body, Australia stressed the need to incorporate the ‘new world’ and include developing economies such as Brazil, Russia, India, China (the so-­called BRIC countries), as well as the European Union (EU) generally and Australia itself. As a severe credit squeeze (and sometimes a total freeze of credit) began to grip international markets, Australia argued along with others that concerted efforts from the major global economies were needed to unlock the system. In Australia, one of the main policy problems of 2007 and early 2008 was that the Reserve Bank and the departments of Treasury and Finance were often working against each other in adjusting the economic settings. Some elements of the government’s expansionary fiscal policy (for example, increased spending and tax cuts) were undermining the inflation-­fighting goal of monetary policy, but such policy discrepancies were the result of the 2007 election outcome. The RBA remained worried about inflationary pressures and excessive government spending (or tax cuts) which would serve to stimulate higher inflation. The bank had been consistently tightening interest rates to put a brake on economic activity. Yet, in its Financial

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Stability Report (March 2008), it made explicit reference to the deteriorating global financial environment (not yet termed a crisis), created by ‘asset re-­pricing’ and ‘bank liquidity’ problems. It noted in passing that other central banks were easing monetary policy, citing the USA and UK as examples. Meanwhile, the Australian government, after enjoying a strong fiscal position for years, had been rapidly increasing public spending (by 58 percent over seven years from 2000–2001; see Laurie and McDonald 2008) while dispensing annual tax cuts and yet still accumulating embarrassingly high budgetary surpluses. Labor’s 2008–09 budget of May 2008 continued this trend even though signs of the crisis were imminent. By mid-­2008, the policy preferences of these financial-­regulatory institutions remained divergent. The RBA was still tightening monetary policy in March 2008, while the government was overseeing the expansionary May 2008 budget, which served as a powerful countervailing stimulus.4 APRA was confident that it had a robust prudential regulatory framework covering the banks, non-­banking institutions and the superannuation  funds, but as a risk management precaution was preparing a Financial Insurance (Claims) Scheme in the event of an institutional collapse. Monitoring the growing crisis in the winter of 2008 saw the Council of Financial Regulators take a more coordinated stance. Its members were meeting regularly and emailing each other about what concerted action to take. Despite media reports in October 2008 that the RBA Governor Glenn Stevens and the head of Treasury Ken Henry were at loggerheads over the size of the banking guarantee (both wanting an upper cap on the savings deposit guarantee, but each preferring a different amount – see below), the regulatory and policy institutions gradually began to define the financial problem in the same way and to agree substantially on the most apposite solutions. Maintaining confidence was now the number one priority. Tentatively, the RBA announced a 0.25 percent (25 points) cut in interest rates on 3 September 2008 but then, after some criticism of its judgment, announced a further tranche of major cuts to the interest rate. In October 2008, a full percent cut was made, followed by a further 75-­point cut in November, followed by a full percent cut of 100 points in early December 2008, and again in February 2009 (a combined total of 400 percentage points, or 4 percent in interest rates). Before the large cut in October 2008, the Treasury had known that the RBA was going to make a substantial cut as the crisis deepened, but thought that it would be of the order of 50 points (0.5 percent). However, Stevens decided almost overnight to increase the cut to twice this size to underscore the point. Together, the RBA’s series of substantial cuts finally indicated that the bank was taking the downturn seriously; it sent a clear message to the local markets, and became a huge symbolic message worldwide. Acting precipitously,



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Australia was the first country in the international arena to make such a massive central bank cut in interest rates, principally because it had the latitude to do so with domestic interest sitting then at 7.25 percent (high by world standards). Other central banks in other countries followed suit in a concerted effort to provide a circuit-­breaker, but they had considerably less room to maneuver. In addition, other coordinated measures were taken to ease market nervousness (see Taylor and Uren 2010). The government announced on 19 September that short-­selling of shares would not be permitted on local money markets as this was exacerbating the crisis (offloading superannuation stocks until the price drops and then buying back in at the cheaper price). Following the Irish government’s bank guarantee unilaterally announced in late September 2008, the Australian government issued a similar guarantee on 12 October 2008 on savings deposits (up to a total of $1 million) and a guarantee applying to wholesale funds for the banking and non-­banking sectors. This in effect guaranteed the funds for both customers and the financial institutions by providing them with insurance backing on their deposits. While the Treasury had been considering a smaller guarantee on retail deposits of around $50 000, a political auction developed when the then Opposition leader claimed it should be $100 000, to which the government responded by going all the way up to $1 million to cover around 99 percent of cash deposits (probably because the Prime Minister did not want to have to publicly defend the rationale for a lower cap and explain why some investors would be excluded, and in the early negotiations had favored a free limitless guarantee). The government also announced that it would purchase $8 billion in residential mortgage-­ backed securities (in two $4 billion tranches) between late September and early October. However, the Australian government did not have to contemplate subsidizing the banks or extending taxpayers’ cash to them to remain liquid. But there were real concerns over the survivability of some of the smaller non-­banking institutions that were facing credit and liquidity problems, which led to the government allowing some consolidation takeovers in the local banking industry, enabling some big players to mop up smaller competitors (for example, the St George Bank and Bankwest). On the international scene, the G7 club was proving extremely difficult to mobilize and formulate an agreement on the need to endorse a strategy of coordinated action. France was reluctant to act in the face of what it termed the ‘Anglo-­American disease’. Germany did not want to be left with a bill for the total financial losses across the Economic and Monetary Union (EMU) if Northern European banks defaulted or countries in the eurozone got into substantial deficit. The US was debating (or p ­ revaricating) in its usual partisan manner the merits of any stimulus measures, while

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beginning to purposely deflate its own currency (collateral easing), while Britain had already nationalized one building society (Northern Rock) and was reeling at the magnitude of the pending crisis. Importantly, from the global periphery, in late September and early October 2008 the Australian Prime Minister, Kevin Rudd, convinced the outgoing US President George W. Bush and UK Prime Minister Gordon Brown to employ the G20 as the principal driver of the global strategy, given that it involved a much wider array of economies and in particular the developing economies of Brazil, Argentina, India, China, Saudi Arabia and Indonesia (but also Australia and the combined EU). The finance ministers of the G20 and the central bank governors of these countries met on six occasions between October and November 2008, such was the uncertainty about the health of the global financial system. Rudd’s persuasion of international leaders quickly led to the G20 Washington summit of 14–15 November at which concerted effort among the G20 was announced, including that improved financial and fiduciary regulation regimes would be implemented across these nations. The Washington Declaration that emerged from this meeting was soon labeled the Bretton Woods II accord.

AUSTRALIA’S FISCAL RESPONSES – FOUR SUCCESSIVE STIMULUS PACKAGES – TIMELY, TARGETED AND TEMPORARY Australia responded to the GFC proactively, announcing four massive stimulus measures in short succession, and all outside its standard budget cycle of annual statements, followed by some additional spending in the 2009–10 budget. The orchestrated stimulus measures were ‘mini-­budgets’ designed to ‘bucket money out of the door’ in four tranches of spending aimed at different spenders that were timely, targeted and temporary in their effect (including infrastructure spending which had to be ‘shovel ready’ – a faddish term of international coinage, meaning that they were ready to be constructed, not merely planned or designed). The spenders targeted were those with a high propensity to consume and spend their income (lower-­income taxpayers, first-­home buyers, then pensioners, seniors and self-­funded retirees). It was by far the largest fiscal injection into the economy in the OECD as a percentage of GDP. The four major fiscal stimulus packages were integrated cash injections crafted at short notice and amid much confusion about the economic fundamentals (especially how much would be required to have the desired impact). They were all contingency measures, each planned in some haste and with the government aiming to adjust the main stimuli as the crisis



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evolved (see Schick 2009). The government’s main strategy of injecting a concerted fiscal stimulus was not altered, but it was able to tweak the balance of ‘cash and construction’ from one package to the next (Saunders 2009). The four initial packages were: 1. Package I – the Economic Security Strategy announced on 24 October 2008, committing $10.4 billion (or 0.9 percent of GDP). 2. Package II – an infrastructural package of $15.8 billion distributed to the states through the Council of Australian Governments on 29 November 2008, to be devoted to housing, hospitals and education. 3. Package III – the Nation Building Package announced on 12 December 2008, investing $4.7 billion in infrastructure projects. 4. Package IV – the third fiscal injection called the Nation Building and Jobs Plan injecting $42 billion in cash, energy packages, school buildings and community infrastructure, announced on 3 February 2009 and amounting to 4 percent of GDP. These packages of new funding totaling some $73 billion (or more than 6 percent of GDP), and all committed outside the annual budget process, were then added to the 2009–10 budget, which included a further $22.5 billion in new infrastructure measures. In total the various stimulus packages came to a staggering $95.4 billion over five years. The rationale behind the design of the fiscal spending measures was almost entirely down to senior ministers (the so-­called ‘Gang of Four’, namely: Kevin Rudd, Wayne Swan, Deputy PM Julia Gillard and Finance Minister Lindsay Tanner) and their departmental advisers. The Treasury had been assessing the efficacy of various stimulus instruments (­ comparing the economic benefits of tax cuts, direct payments, infrastructure s­ pending; calculating which worked best, which worked quickest, which mix might work better than other mixes). By late 2008 the government was interested in the ‘biggest bang for the buck’, or to use technical jargon, they were assessing the efficacy of the various fiscal multipliers to keep domestic demand buoyant and unemployment low. There had been much theoretical discussion about tax cuts versus cash injections (especially as the neo-­liberal US had long favored tax breaks for households, as these interventions could be closely monitored to assess their relative contributions to changes in spending patterns). By contrast, the Australian government came to the conclusion that a cash stimulus would maximize spending in the short-­term, providing a direct windfall bonus to consumers. So, further tax cuts were rejected as a policy response and instead cash-­in-­hand spending was prioritized (around 17 percent or $23 billion spent in the initial four packages was in direct cash payments of some form). As one Treasury

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official said (Hart and Wanna 2010): ‘we simply wanted money out of the door; we wanted speed not necessarily “solidity” of spending’ (meaning that less importance was attached to the substance on which the money was spent or the nitty-­gritty of implementation, so long as dollars got into people’s pockets quickly). The rationale which was sold to the PM and his senior ministers in the ‘kitchen cabinet’ (the Strategic Priorities and Budget Committee, SPBC) was ‘Go hard, go early and go households’, a slogan attributed to Ken Henry, the Treasury Secretary (Taylor and Uren 2010: 78). Stimulus package I was intended to augment the pre-­Christmas retail splurge, pump-­priming the economy to maximize consumer spending and maintain levels of business confidence. The 24 October package expended some $10.4 billion (of which $4.8 billion was in pensioner cash payments, $3.9 in low-­income cash payments, $1.5 billion in grants to extend the first-­home buyers scheme, and $187 million in new training places). The package was hastily put together over a weekend of intense negotiations in early October for implementation in November 2008. Over these days, wildly fluctuating proposals and counter-­proposals were countenanced, with the ‘Gang of Four’ ministers of SPBC bunkered down with their key advisers and closest senior officials. The size of the package rested largely on intuition, best-­guessing, following hunches and an auctioning-­up of the figures by politicians. Kevin Rudd, Wayne Swan and Julia Gillard favored a sizeable cash package; the Finance Minister Lindsay Tanner did not (Taylor and Uren 2010). Convinced of the imperative of ‘going hard, going early and going households’, the Treasury had considerable enthusiasm for a ‘cash splash’, but remained unsure over how much cash to inject. At the weekend meeting with the ‘Gang of Four’ senior ministers, the Treasury initially favored a $2 billion injection, then later that same day it ran to $5 billion, before being politically upped to $10 billion. Interestingly, the Treasury’s earlier analysis suggested that up to $10 billion could be needed, but the department still argued for smaller amounts, as there were some intense internal debates about the efficacy of fiscal stimuli, with some officials still preferring to allow markets to run their course (see Taylor and Uren 2010). The second package of $15.8 billion was targeted at major infrastructural projects being planned and brought forward by the states and territories. The funds were allocated through an emergency meeting of the Council of Australian Governments after consultation with these jurisdictions and with local mayors. The infrastructural injection was intended to prop up business investment in the medium term to avoid a metaphoric ‘sugar hit’ from the initial cash injections. A much smaller third package of interventions was announced just



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before Christmas 2008. The Nation Building Package committed a further $4.7 billion to infrastructural projects, which would maintain employment levels in the construction and supply industries. Importantly, these projects had to be ‘shovel ready’. The projects or types of infrastructure identified included $1.2 billion for rail, $1.6 billion for universities, $0.7 billion for road accident ‘black spots’ (accident-­prone stretches of roads) and an amount set aside for a temporary capital investment allowance. The fourth stimulus was assembled in early 2009 as the economy remained relatively buoyant after the initial ‘sugar hits’. The government threw caution to the wind with the amounts involved because it wanted to inject so much with this package that it would not have to consider a subsequent package. The $42 billion Nation Building and Jobs Plan consisted of various measures designed to inject direct cash payments to lower-­income earners, plus a ‘tail’ of medium-­term stimulus projects that would help to maintain semi-­skilled and unskilled jobs. The six measures making up the package included: 1. A second wave of cash injections to households of $12.7 billion, with cheques of $900 per person to those who qualified – employees on lower income, self-­funded superannuants – posted out to taxpayers. 2. $14.7 billion (later increased to $16.2 billion) for schools ­infrastructure – Building the Education Revolution. 3. The Home Insulation Program costing $3.8 billion (later reduced to $3  billion) providing for the retrofitting of insulation into some 2 million existing homes, together with a Green Loans program for the promotion of environmental programs. 4. Funding for the construction of 20 000 new homes, for social and defense housing, costing $6.6 billion. 5. $2.7 billion in taxation relief for small business and concessions to general business taxes. 6. A further $0.9 billion for roads and community infrastructure. The four stimulus packages, injecting some $73 billion in four months, were precipitous measures, examples of crisis budgeting outside normal budgetary rules and procedures. These ‘on-­ budget’ expenses did not include the estimated contingent liabilities to which the government was potentially exposed through the generous bank guarantees (which began devastating the economies of Iceland, Ireland, Greece and Portugal). The 2009–10 budget, delivered in May 2009, continued some of the big spending initiatives, investing in a medium-­term injection to shore up growth. The budget committed a further $22.5 billion to various infrastructure projects in the sectors of transportation ($8.4 billion), the

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broadband network ($4.7 billion), another $3.6 billion for clean energy initiatives, $3.2 billion for hospitals, and a further injection to universities of $2.6 billion.

AUSTRALIA’S REPEATED MANTRA: ‘NOT YET OUT OF THE WOODS’ While the government waited for the massive fiscal stimuli to work, there was real uncertainty over how Australia would fare and whether the various sectors of the economy (such as finance, retail, construction and manufacturing) would remain solvent or rebound after the crisis. Australia faced just one quarter’s negative growth in the last quarter of 2008 (not experiencing a technical recession requiring two consecutive quarters of negative growth, it subsequently experienced another negative quarter in the first quarter of 2011 largely due to the result of severe flooding in Queensland). But forecasts for overall GDP growth were reduced from 3.7 per annum in 2007–08 to just 2 percent by November 2008. The Treasury estimated that unemployment would increase from 4.3 percent to 5 percent in 2008, and then peak at 8.5 percent by 2010–11; but this higher-­level projection never materialized, and in fact unemployment increased only from around 4 percent to 5.9 percent by June 2009, raising the question of whether this good fortune was primarily due to the stimuli measures, or to the better underlying economic conditions as well as the rebounding of commodity markets spurred by Chinese demand. But some industries or sectors of the economy had taken a hit as the crisis materialized: the mining sector (briefly), the upper end of the real estate market, retail sales, the car industry (both manufacturing and sales), and some regional manufacturers. Senior government ministers were keen to repeat the mantra that ‘we are not yet out of the woods’, at one press conference after another. The government’s budget of 2008–09 delivered the electorally committed tax cuts and promised a surplus, but contained no new initiatives that were not fully offset from existing expenses. There were no ‘new money’ items in the budget. The following year, the 2009–10 budget contained almost no new spending outside the generous infrastructural amounts indicated above ($22.5 billion). It was anticipated in this budget that some $210 billion had been stripped from expected tax receipts over a five-­year period (2008–09 to 2012–13) as revenues fell dramatically (the so-­called write-­down of revenues), although this estimate may have been exaggerated given that the 2012–13 Budget reported that some $150 billion was reportedly foregone over the previous five years. In the 2009–10 budget, the government committed to deliver the budget into surplus by the end of



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the 2015–16 budget year (that is, by June 2016), and that general government expenses would not increase by more than 2 percent per annum in real terms for the next five years or until the budget surplus had reached 1  percent of GDP – a very tight fiscal straitjacket. It also managed to extract a further $22.6 billion in savings measures against the budget bottom line.5 For instance, over $0.5 billion was cut from ‘under the radar’ health programs, and a much-­ anticipated funding increase for mental health programs was delayed in 2010 and only moderately funded in 2011. The government’s message was all about ‘putting the Budget on a sustainable footing’, but in May 2009 the Treasurer steadfastly refused to even mention the word ‘deficit’ either in his budget speech or in subsequent interviews – an evasion copied by the Prime Minister Kevin Rudd in subsequent interviews. Both the 2010–11 and 2011–12 budgets continued the strategy of holding the line on expenses, but significantly committed the government to generating a surplus by 2012–13, or two years ahead of its timetable announced the previous year; a commitment the government argued was occurring before any major advanced economy. This commitment to deliver a surplus by 2013 on time, as promised, was about the only ‘good news’ announcement the Treasurer could muster from the 2010–11 budget at various presentational events. In terms of net debt, predictions that debt could rise to 13 percent of GDP ($200 billion) proved to be unfounded at the time, with net debt calculated in 2011 to peak at just 7.2 percent of GDP by the middle of the decade (at $106 billion), later then increased to11.4 percent in 2014 at $192 billion. Thereafter, net debt was expected to gradually fall from 2015, although interest payments would continue to increase until 2016.

THE PRIORITY TO REBALANCE THE AUSTRALIAN BUDGET, WITH THE PROMISE OF THE FASTEST FISCAL CONSOLIDATION No sooner were the four integrated stimulus packages rolled-­out than the government began the process of a rapid fiscal consolidation and a return to a general fiscal stringency across the board. This even began occurring in 2008 with some tightening of saving measures (reducing some program spending and increasing the ‘efficiency dividend’ or administrative clawback to 2 percent per annum; see the Treasurer’s Budget Speech 2009). Such trimming together with optimistic estimates of a rebound in revenues led the government to predict in May 2010 that it would achieve a budgetary surplus of $3.5 billion by June 2013, claiming it was making the ‘fastest

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fiscal consolidation’ in the developed world. This strategy was confirmed by the next budget of 2011–12, by which time the Labor government now led by Julia Gillard was reduced to a minority government relying on the support of the cross-­benches. The Treasurer Wayne Swan predicted in May 2011 (despite continued sluggishness in revenues) that the budget was still on track to produce a surplus final budget outcome of $4 billion (fiscal balance) by the end of 2012–13, saying the surplus was ‘on time, as promised’. This was then further reduced to a slim surplus of $1.5 billion in the 2012–13 budget, before the government reluctantly conceded in late 2012 that the promised surplus would not eventuate, and that a surplus might not be achievable until after 2017. Fiscal consolidation was suddenly the main game. Treasurer Swan (2011) argued: With private demand strengthening, unemployment falling and our economy pushing towards capacity, we now face new challenges. We need to restrain public spending, and stay the course back to budget surpluses. Just as it was the right thing to step in and support demand during the financial crisis, the right thing to do is to take a step back as private activity recovers. That’s why, since we first put together the stimulus package, I have adopted the motto: if we are going to be Keynesians in the downturn, we have to be Keynesians on the way up again. That means a speedy return to surplus.

His policy from the May 2010–11 budget was one of moderate fiscal consolidation, holding down expenditures while hunting for every conceivable source of taxation revenue from existing sources (increasing charges and announcing some new taxes on the mining industry and on carbon emissions). It was a policy of retrospective austerity, or belated prudence. The 2011–12 budget announced that the government had succeeded in holding its increase in spending below the 2 percent real cap, and indeed that spending was only growing at 1 percent per annum in real terms over the next five budget years (the lowest growth increase since the 1980s). Many measures to tighten budgetary policy were announced and a great many others were undertaken behind the scenes in the adjustments to the forward estimates (lapsing program expenses that were not renewed, additional cost-­cutting measures). These were essentially selective tweaking measures to existing programs, using classic budgetary rationing procedures, offsetting costs, delaying introduction, tightening criteria or eligibility, closing smaller programs and imposing additional administrative clawbacks. Almost all these savings came from the Commonwealth’s ‘own use’ expenses (around one-­third of its total expenses) and not from intergovernmental transfers or benefits. Pensions and family benefits were politically hard to cut or ration (and in Australia are paid entirely from



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general taxation, with no individual contributions). The main indirect tax on goods and services (levied at 10 percent) continued to be paid directly to the states and territories, but while the Commonwealth had an agreement in place to compensate the subnational jurisdictions (through specific-­ purpose payments) in the event of a decline in Goods and Services Tax (GST) revenue due to depressed post-­GFC economic circumstances (an estimated fall of around $11 billion), it later reneged on this commitment and forced the states and territories to accept lower revenues than had previously been projected in budget papers. Savings measures were announced in four successive budgets (2009–10, 2010–11, 2011–12 and again in 2012–13), supposedly trimming up to $33  billion from the forward estimates out to 2016 (later upped to $43 billion over five years). These savings measures came from two sources and tended to impact most on medium-­term commitments; they included reducing spending in the current and out-­years, especially cuts to intended spending; and augmenting taxation receipts or reducing tax concessions. Reductions in expenses came from departmental or agency operating costs (travel, property and information technology costs, staff redundancies, and imposed cuts), and from across a wide range of programs, some small and relatively insignificant but others larger and representing real cuts. In 2011 it was announced that the government would amend the eligibility criteria for the aged pension, delaying the age at which older Australians qualified for the benefit. However, attempts to limit access to aged pensions (the largest single social welfare expenditure), by equalizing the age at which women were entitled to aged pensions (raising the age from 60 to 65 years) and then increasing the age at which all Australians would qualify from 65 to 67 years of age starting from 2017, were not very successful in assisting the consolidation phase, as the time frames involved were long term and many women approaching their sixties simply opted to claim the disability support pension rather than wait for the aged pension or remain in the workforce. Some benefit or entitlement provisions were rationed in minor ways. For instance, the eligibility criteria for disability pensions were tightened; single parents on care-­provider pensions were pushed back to the less generous unemployment benefit when their youngest child turned eight years old; while family payments to middle-­income earners were limited by imposing a two-­year freeze on the indexation of the upper rates at which these payments were made, saving $1.2 billion. The ‘efficiency dividend’ (the annual administrative clawback on departmental expenses) had been increased from 1.25 percent in 2008–09 through to 2010–11 (although a one-­ year additional impost of 2 percent was imposed in 2008–09). Then in the 2011–12 budget the savings measure was increased to 1.5 percent supposedly for two years (2011–12 and 2012–13),

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before being scaled back to 1.25 percent for 2013–15 and reverting back to 1 percent in 2015–16. Then, to impose further austerity, the Finance Minister, Penny Wong, announced in November 2011 that the efficiency dividend would be increased by an additional 2.5 percent to 4 percent for the 2012–13 financial year, saving $1.5 billion over the four-­year forward estimates. This administrative tightening was a modest budgetary cut but as an annual levy it put strain on some departments and agencies, especially smaller ones. A raft of other frugality measures was introduced, including: ●●

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welfare entitlements were tightened and tougher mandatory work rules for the unemployed were introduced, as well as up-­front payments to longer-­term unemployed to stay off welfare; some intended additional increments were deferred or cancelled; the Baby Bonus grant scheme was abolished. Spending cuts were made to Defense of around $3 billion, including shedding 1000 Defense jobs. Fringe benefits tax rules were tightened to raise $954 million over five years. The dependent spouse tax rebate was partially abolished. Access to some health services was capped, such as pathology testing services, and other Medicare safety net reimbursement items were capped to prevent excessive fees being paid out. Solar subsidy programs were redesigned to reduce outlays by $156 million. Increased road charges for heavy vehicles were levied, raising an additional $700 million. The up-­front discount for prepaying higher education student fees was reduced from 20 percent to 10 percent. Cuts were made to universities ($900 million), research centers ($54 million), to illicit drugs in sports programs ($5.6 million), and to reading programs for schools ($1.6 million). Departments were instructed to observe the strict legal requirement to impose ‘economical’ criteria on the proper use of any public money, meaning that they would have to consider the lowest cost in any purchases or commitments. Departments were instructed to reduce their use of consultants, minimize media and advertising expenditure, reduce printing and publishing expenses, cut hospitality and entertainment activities, and reduce travel to only the most essential by using information and communication technology (ICT) and virtual meeting and ­‘telepresence’ facilities.



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A new government-­wide procurement arrangement was announced for office and stationery supplies, saving $6 million per annum. New taxation levies were introduced to force higher-­income earners to take out private health insurance, and the government imposed a one-­off flood levy to partly offset the Flood Package of assistance measures announced in January 2011, raising some $1.8 billion in additional revenues, and with other flood relief spending coming from savings.

In short, while many of these measures represented small-­scale adjustments, their combined size was considerable, with the Treasurer claiming some $180 billion had been culled from spending over six budgets since 2008–09 (a misleading figure as much of these savings would have been recommitted, often to similar purposes). From 2011 onwards it was apparent, however, that the government’s fiscal consolidation was aimed purely at eliminating the deficit, with approximately half the amount met by various program savings and half from additional revenues. Despite this intent, the deficit proved much more sticky than anticipated, with the 2011–12 final budget outcome reporting a persistent deficit of $43.7 billion, or 3 percent of GDP (twice as high as the projected deficit of $22.6 billion in the original budget papers). The main reason for this continued shortfall was a significantly less than expected growth in tax receipts, especially due to lower company taxes, capital gains taxes and excise taxes, along with depressed GST collections. The government labeled this as the ‘slower than expected recovery in revenue’ in its 2012–13 budget. However, the government also continued to make considerable additional spending commitments (mainly to families and households), with the total expenses growing from $324  billion in 2008–09 to $381 billion in 2012–13 (an increase of 17.6 percent over four years). The 2012–13 budget continued the pattern of increasing spending, with increased family payments, carbon tax compensation payments to low-­income households, school children’s bonuses, dental and disability funding as well as increased program costs for health and immigration and asylum processing. Hence, the immediate imperative of fiscal consolidation was allowed to drift over the next three budgets introduced after 2010 due to the perceived need to cushion the economy and maintain consumer demand, as well as the repetitive propensity of the Labor government to make new program funding commitments. Although the Australian government formally committed itself to the fastest fiscal consolidation in the developed world, the achievement of such a target proved much more difficult in practice (see Appendix). The target of producing a surplus by mid-­2013 was jettisoned in December 2012, with a new target in the next budget aiming to produce a balanced budget in

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2015–16 with a surplus finally in 2016–17. Even so, there was much speculation that the government would not be able to meet this revised budget balance unless spending was contained or revenues markedly improved. The Treasury forecast a more optimistic recovery for the underlying cash balance for four years straight from 2009–10 to 2012–13 inclusive, getting its projections wrong by some $50 billion over the last three years.

THE GFC HITS NEW ZEALAND: NO CHOICE BUT TO FOLLOW WHILE OPTING FOR A FASTER RECOVERY The policy trajectory and timelines followed by New Zealand (NZ) in the GFC were substantially the same as those followed in Australia, except that NZ’s fiscal stimulus focused far more on tax cuts to individuals and businesses; provided far more modest spending injections, mostly geared to infrastructural projects; and officials had seemingly undertaken far less preparatory analysis before the event, and as a consequence NZ was far less prepared than Australia for the downturn (the GFC seemed to catch the NZ government by surprise even beyond the election period of late 2008). The NZ Treasury had misread its previous strong fiscal position, believing the country had a sizeable structural year-­on-­year budgetary surplus, only to be left surprised when it disappeared in 2008 as economic growth declined by almost 4 percent and revenues fell by 2.3 percent of GDP from 34.5 to 32.2 percent. The other big difference in response was that while Australia tended to address the crisis outside the normal budget cycle through ‘extraordinary’ mini-­budget statements, in New Zealand the responses were introduced almost entirely as part of the normal annual budgetary process and half-­yearly updates. Like Australia, New Zealand entered the GFC from a fiscal position of incredible strength, with 15 years of consistent and increasing operating surpluses and a strong budgetary system underpinning years of economic growth. New Zealand, however, is a relatively small economy (with a GDP of NZ$180 billion and 4 million people) with limited natural resources, and with the exception of Australia located a vast distance from global markets. Despite its size, New Zealand boasted a high rate of economic growth over the six years prior to 2005, with a compounded rate of growth of 25 percent compared to the OECD average of 16 percent (New Zealand 2005: 2). Unemployment was low at just 3.4 percent, and its net debt position was stationary at around 20 percent of GDP. Its general government operating surplus, averaging 4 percent of GDP between 2003 and 2007, peaked at a massive 7.3 percent of GDP in 2006 (or $11.47 billion,



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with core Crown revenues of NZ$59.2 billion and expenses of NZ$49.9 billion). The 2006 budget looked forward to a resurgence of growth, with the biggest risk being identified as the robustness of global trading markets and the fear of the imposition of ‘food mile taxes’ by European governments, levied as a climate change mitigation measure on the distance goods imported to Europe had travelled. Like Canada, New Zealand was lulled into thinking that a strong balance sheet and substantial surpluses would insulate it from any economic downturn. In 2007 the government again predicted a healthy annual operating balance of between 3.8 to 2.7 percent of GDP over each of the next five years (or between NZ$6.3 billion and $5.3 billion annually). Total Crown expenses were a relatively modest 41 percent of GDP compared to revenues equaling 43.9 percent of GDP (while core Crown revenues were 37.8 percent of GDP compared to expenses of 31.9 percent, which were projected to rise to 33.1 percent by 2010–11). The 2008 Budget Economic and Fiscal Update highlighted the downside risks arising from a lack of stability in global markets, with worries about depressed trade prospects (New Zealand 2008: 67). Recognizing that economic conditions were tightening worldwide, the budget update projected that the operating balance would fall from 2.9 percent of GDP to just 0.7 percent in the year to June 2009 (but still in surplus). Revenue was particularly hit, and fell from 34.3 percent in June 2008 to an estimated 32.6 percent by 2012 (2008: 68). The economy recorded five quarters of negative growth from March 2008 to March 2009 inclusive, wiping off 3.7  percent from GDP (although the 2009 budget had predicted up to seven quarters of recession). Interest rates were cut from 8.25 percent in July 2008 to just 2.5 percent in April 2009. New Zealand’s policy responses followed a similar though less generous pattern than those of Australia (and included no direct cash payments to households, although entitlement benefits were maintained). As the New Zealand economy went into recession (losing some NZ$50 billion in nominal output over three years), a banking deposit guarantee was issued once the Australian government unilaterally announced its guarantee, with some complaints that the larger polity had not informed or consulted the New Zealand government about such a move. The Finance Minister Michael Cullen said NZ had ‘no choice but to follow’. New Zealand’s three-­pronged objectives were: to help New Zealanders through the recession by supporting jobs and maintaining front-­line public services; to lift productivity and the country’s international competitiveness; and to take steps to keep government debt under control (New Zealand 2009). The government’s strategy, informed by orthodox Treasury advice, was to absorb the shock of the GFC on the government’s balance sheet, rather

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than to run up higher debt unnecessarily with higher stimulus spending. In its advice to the incoming National government, the Treasury argued in 2008 that ‘our advice is that the Government should not undertake a further expansionary fiscal stimulus package’ (New Zealand Treasury 2008: 9). Accordingly, the government maintained citizen entitlements while boosting spending on public services by some NZ$5.8 billion over five years (around 1.5 percent of the budget per annum in additional spending or 0.5 percent of GDP) and $7.45 billion in new capital spending over the next seven years (most of these projects were, in the Treasury’s terms, bringing forward projects that were going to happen anyway). Overall the government estimated in 2009 that some NZ$16.4 billion in additional funding had been committed over six years to 2013 (or around NZ$2.5 billion per annum, representing some 1.3 percent of GDP). The net effect was that expenses increased markedly while revenue income fell sharply from around NZ$63 billion down to NZ$57 billion by 2010. Despite its sizeable annual surpluses, New Zealand public finances quickly fell into deficit and debt increased. In 2009, the deficit for 2010 was expected to be NZ$7 billion, with a further run of deficits of the order of NZ$9 billion per annum for 2011, 2012 and 2013. Initially, the budget was not expected to get back into the black until 2018. This was a staggering turnaround of fortunes. With public debt projected to increase from below 20 percent of GDP in 2008 to 50 percent in 2014, and with some Treasury calculations going as high as 70 percent by 2023 (perhaps a ‘scare chart’ prepared by the budget agency to convince ministers to behave economically responsibly), the government announced a series of policy responses, many with deferred timing. Initial responses included modest tax cuts for business (NZ$480 million) and individuals (NZ$2.3 billion or 1.2 percent of GDP), introduced in October 2008 but spread over four and three years, respectively. In the 2009 budget the second and third tranches of these individual tax cuts (over 2010 and 2011) were deferred, due to the perilous fiscal position (saving NZ$900 million). Hence, there was little confidence tax cuts per se would reverse the malaise. A limited range of job creation and employment protection measures were hastily announced (including a 90-­day trial employment program for new workers in small businesses, a restart program to get those made redundant back into work, and a job support program that assisted workers who would voluntarily go onto a nine-­day fortnight). In the longer term, the new National-­ led government appointed from 19 November 2008 chose to invest in infrastructure (roads, rail), job skills such as better literacy and numeracy, and regulatory improvements. In late 2008 some NZ$1.5 billion in infrastructure spending was committed over three years. The 2009 Budget provided grim reading. It predicted deficits of NZ$7.7  billion in 2009 and NZ$9.3 billion in 2010, both more than



Australian and New Zealand responses to the ‘fiscal tsunami’ ­113

5 percent of GDP, and suggested that gross debt would rise to $43 billion by 2016–17 (approximately 40 percent of GDP) and only return to the mid-­ 30s percent by the early 2020s. The 2009 budget announced a 2 percent cap on new spending (the ‘operating spending allowance’, a similar measure to the Australian cap) yet conceded that present growth in new spending was only around 1.4 percent (or $1.1 billion). The budget predicted that unemployment would rise to 8 percent by 2010. It also suspended the government’s automatic payments into the NZ superannuation fund, normally contributing around $1.5 billion, growing to $2 billion by the early 2020s (but the government still made a contribution of NZ$250 million). However, by 2010 with a return to slightly better economic indicators (and as a result of some policy adjustments) the government was able to claim the budget would be back in surplus by 2015–16 (meaning June 2016). Debt was expected to peak at only 27.4 percent of GDP by 2014–15 because of the lower than expected future deficits (and adopting a narrower definition of net debt). The 2010 budget introduced income tax cuts (worth some NZ$15 billion over four years) to the four rates of income taxation, with the highest rate of 33 percent in the dollar applying only to those on incomes over $70 000. However, as an offsetting measure the GST was increased from 12.5 percent to 15 percent to maintain budget neutrality while increasing prices by 2 percent. In November 2011, the Treasury adopted a firm commitment to return the budget to surplus a year earlier, by 2014–15 and successfully convinced the National government to accept this new target (NZ Treasury 2011). However, in 2012 the deficit remained sluggish at NZ$10.1 or 6 percent of GDP. In short, New Zealand had less room to maneuver than Australia and less prospects of immediate recovery. It chose to maintain a low debt policy above all else while eschewing cash handouts to households. The National government preferred income tax cuts as a preferable strategy (but was forced to suspend these for two years in 2009), but later increased indirect taxation with some compensation for lower-­income households. Over the period 2010–12 the government remained committed to debt reduction and eliminating deficits. It also commenced a program of reprioritization, freeing up some $1.8 billion from existing baseline agency budgets over four years for reallocation to new priorities.

CONCLUSIONS In both countries, policy decisions were the main contributors of increased spending after 2008; governments of differing political complexions

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continued to increase their budgetary commitments mainly in areas of social expenditures. This made fiscal consolidation difficult on both sides of the Tasman Sea. However, while New Zealand initially expected to deliver its next surplus budget only by 2018 and Australia promised to produce one by 2013, in reality the New Zealanders exercised their own fiscal consolidation far more effectively than the Australian federation. New Zealand revised its commitments forward and now promised to deliver a surplus by mid-­2015, whereas Australia’s projected surplus did not materialize and was subsequently extended out to 2017, which was a target year that was still widely regarded as somewhat optimistic. Perhaps the main difference in the policy responses to the GFC was that Australia took the opportunity to make a substantial but temporary fiscal stimulus that was heavily cash-­ weighted (extraordinary measures taken outside the normal budgetary cycle and with an emphasis on consumption over investment); whereas New Zealand chose to use tax relief to individuals and businesses to stimulate growth and not to make additional financial injections. Australia’s measures were counter-­cyclical and were supported by increased overseas demand for commodities, while New Zealand opted for structural adjustments that were more ongoing and difficult to remove and, importantly, less costly to the budget. However, New Zealand showed greater preparedness to restrain spending in the post-­crisis phase (despite the capital rebuilding required after the Christchurch earthquakes). Australian ministers frequently boasted of their intention to undertake the fastest fiscal consolidation in the world, but lacked the wherewithal to achieve this goal in the face of political expediency and the experience of minority government after 2010. Hence, the main lessons from the experiences of these two countries in the GFC and its aftermath are: fiscal stimuli (and some tax cuts) were effective preventing a major recession but were expensive in the longer term; governments preferred amelioration and fiscal tinkering rather than substantial structural economic reform; governments continued to spend on new initiatives in the post-­crisis environment; governments announced (inflated) cuts to spending and talked of austerity measures but failed to impose serious cuts in the short term; fiscal consolidation proved much more difficult to achieve than the government had contemplated during and after the crisis; and governments largely abandoned all interest in further reform to their budgetary systems.

NOTES 1. The author would like to acknowledge the assistance of the Department of Finance and Deregulation, Canberra, and in particular two senior budgetary officials, David Nicol



Australian and New Zealand responses to the ‘fiscal tsunami’ ­115

and Arthur Camilleri. Andrew Podger and Evert Lindquist also read earlier drafts. All opinions or commentary are the responsibility of the author alone. 2. Labor’s Wayne Swan, who was Treasurer throughout the crisis and its aftermath, emphasized the mantra of balancing the books speedily in a well-­cited Fabian essay, reproduced in the Treasurer’s Economic Notes, 2011/12 (April 2011), available at www.treasurer.gov.au/dis​ playdocs.aspx?pageID5001&doc5../content/economicnotes/2001/012.htm&min5wms. 3. The behind-­ the-­ scenes contingency planning is captured in two Australia and New Zealand School of Government (ANZSOG) case studies, by Paul ’t Hart and John Wanna (2010), and John Wanna (2012). 4. The RBA increased interest rates four times between August 2007 and March 2008, bringing the case rate from 6.25 percent to 7.25 percent, after which it held interest rates steady until September 2008. 5. Savings measures included not only spending cuts and deferred spending and other reductions in forward estimates of expenses (that is, from lapsed programs), but also any revenue measures that increased revenues to the government. In other words, ‘savings’ measures were any adjustment (1/−) that improved the budget bottom line. But as the government began to boast about its tough annual savings strategies (implying that it was reducing expenses drastically when it was not), then criticism was often levelled against the government because much of the savings total was an artificial construct and comprised of increased revenue measures and the tightening of some existing tax concessions.

REFERENCES Australian Public Service Commission (APSC) (2011), State of the Service Report – 2010–11, November, Canberra: Australian Government. Costello, P. (2007), ‘Ensuring Australia’s Economic Prosperity: The Intergenerational Report’, Address to Australian Business, London, 10 April. Hart, P. ’t and J. Wanna (2010), Treasury and the Global Financial Crisis, ANZSOG Case Study, Melbourne. Laurie, K. and J. McDonald (2008), ‘A Perspective on Trends in Australian Government Spending’, Canberra: Commonwealth Treasury. New Zealand Treasury (2008), Briefing to the Incoming Minister of Finance, November, Wellington: Treasury. Saunders, P. (2009), ‘A Review of Australia’s Economic Stimulus Packages: Timely, Targeted, Temporary’, Address to the 6th Annual Meeting of OECD Senior Budget Officials, OECD, Paris, 1–2 December. Schick, A. (2009), ‘Crisis Budgeting’, OECD Conference Centre, Paris, May; reproduced as OECD Discussion Paper. Swan, W. (2011), ‘Budget Speech 2011–12’, Hansard, May, Canberra: Australian Parliament. Taylor, L. and D. Uren (2010), Shitstorm: Inside Labor’s Darkest Days, Melbourne: Melbourne University Press. Wanna, John (2012), Break on Through to the Other Side: Australia and the Global Financial Crisis of 2008–09, ANZSOG Case Study, Melbourne. Wettenhall, R. (2011), ‘Global Financial Crisis: The Australian Experience in International Perspective’, Public Organization Review, 11 (1), 77–91.

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APPENDIX Table 4A.1  Australia’s projected surplus of deficit at three points in the budget year, main budget estimates, mid-­year update and final budget outcome (2006–07 to 2012–13) Year

Fiscal Budget Budget MYEFO MYEFO or cash ($ billion) (% GDP) ($ billion) (% GDP) balance

2006–07 Fiscal balance Cash balance 2007–08 Fiscal balance Cash balance 2008–09 Fiscal balance Cash balance 2009–10 Fiscal balance Cash balance 2010–11 Fiscal balance Cash balance 2011–12 Fiscal balance Cash balance 2012–13 Fiscal balance Cash balance

Final budget ($ billion)

Final budget (% GDP)

110.3

11.0

110.4

11.0

116.9

11.6

110.8

11.1

111.8

11.1

117.2

11.6

110.0

10.9

114.9

11.3

121.0

11.8

110.6

11.0

114.8

11.3

119.7

11.7

123.1

1.9

15.8

0.5

−29.7

−2.4

121.7

1.8

15.4

0.4

−27.1 (−35.9)

−2.2

−53.1

−4.5

−54.4

−4.5

−53.7

−4.2

−57.6

−4.9

−57.7

−4.7

−54.8

−4.2

−39.6

−2.8

−41.9

−3.0

−51.5

−3.7

−40.8

−2.9

−41.5

−3.0

−47.7

−3.4

−22.6

−1.5

−32.5

−2.2

−44.4

−3.0

−20.3

−1.4

−37.1

−2.5

−43.7

−3.0

12.5

0.2

11.2

0.1

−19.4

−1.3

11.5

0.1

11.1

0.1

−20.3

−1.3



Australian and New Zealand responses to the ‘fiscal tsunami’ ­117

Table 4A.2  Australia’s budget expenses (spending), estimated at budget versus actual outcome Budget year

2005–06 2006–07 2007–08 2008–09 2009–10 2010–11 2011–12 2012–13

Budget estimate of expenses ($ billion)

Final budget outcome (actual expenses) ($ billion)

Fiscal balance (accrual) ($ billion)

246.0 259.7 264.7 292.5 338.2 354.6 365.8 376.3

242.2 259.2 280.1 324.6 340.0 356.1 378.0 381.4

116.6 116.9 121.0 −29.7 −52.9 −51.5 −44.7 −20.2

Table 4A.3  Australia’s budget revenues (income), estimated at budget versus actual outcome Budget year 2005–06 2006–07 2007–08 2008–09 2009–10 2010–11 2011–12 2012–13

Budget estimate of revenue ($ billion)

Final budget outcome (actual revenue) ($ billion)

Difference

262.9 271.7 289.9 319.5 290.6 321.8 356.4 368.8

261.2 278.4 303.7 298.9 292.8 309.9 338.1 359.9

116.6 116.9 121.0 −29.7 −52.9 −51.5 −44.7 −20.2

Sources:  Commonwealth Budget Papers, MEYFO and Final Budget Outcome.

5. Budgeting in Japan after the global financial crisis: postponing decisions on crucial issues Masahiro Horie THE 2008 LEHMAN SHOCK IN JAPAN The American subprime loan crisis that emerged in 2007–08 was seen by most Japanese people as a ‘fire on the opposite shore’. It was only after the collapse of Lehman Brothers on 15 September 2008 that Japan began to take the matter seriously as something that affected daily life. The situation in Japan after the Lehman bank collapse was suddenly quite different from the period before. This is why the 2008 global financial crisis (GFC) became known in Japan as the ‘Lehman Shock’. Japan experienced an earlier housing bubble collapse in the 1990s. The problem of non-­performing loans in the financial institutions was solved by the infusion of a huge amount of public money. Experiencing the collapse in housing prices and being under the regulation and guidance of the government, Japanese financial institutions became cautious about exposure to high-­risk lending. Hence, Japan largely assumed that the subprime fiasco occurring in the United States of America could not trigger a repeated banking crisis in Japan. Soon after the collapse of Lehman Brothers was reported, the Economic and Fiscal Policy Minister said: ‘It is just like a bee sting. Japanese financial institutions will never be harmed. A calm and decent response is expected.’ His remark was intended to prevent panicked behavior. Yet, he was subsequently criticized for having misled the people and delaying the economic and employment measures taken in response to the Lehman Shock. A false sense of immunity meant that the response of the Japanese government to the crisis was later and slower than other countries. The effect of the Lehman Shock was wide and deep. Even though the immediate damage to Japanese financial institutions was not as great as in the US or Europe, the financial market was confused and business enterprises had difficulties in financing their operations. The Lehman Shock 118



Budgeting in Japan after the global financial crisis ­119

worsened the real economy of Japan: industrial production declined; domestic employment became unstable; the export of motor vehicles, information and communication (ICT) devices and other domestic appliances dropped sharply; and domestic consumption declined. Between October and December 2008, real GDP dropped 3.3 percent (equivalent to 12.7 percent annually) from the previous period. In the next quarter (January to March 2009) GDP again dropped a further 4.0 percent (15.2 percent annually). This was the largest fall since the first oil crisis of the early 1970s, and an even bigger decline than had occurred in the US where the GFC began. Gradually, as Figure 5.1 shows, from the second quarter of 2009 GDP began to recover because of improvements in the economic situation overseas and due to the favorable effects of the government’s stimulus measures. Yet the long-­term effects of the Lehman Shock lingered on. Indeed, Japan’s level of exports and its overall GDP remained lower than in the pre-­shock days, in contrast to the cases of the US, Germany and France.

THE RESPONSES OF THE LIBERAL DEMOCRATIC PARTY GOVERNMENT TO THE LEHMAN SHOCK The Unprecedented Scale of the Rolling Stimulus Packages In response to the contagious GFC and economic recession after the Lehman Shock, the Japanese government designed a series of major stimulus measures. The Japanese government had in the past introduced economic stimulus packages in response to economic recessions or crises, but the stimulus packages in response to the GFC were the largest ever. In all, a total of four packages were made by the ruling Liberal Democratic Party (LDP) government. Instrumental in all this was Prime Minister Taro Aso, who took over as leader on 24 September 2008, soon after the Lehman Shock. In these initial months, there was a possibility he would dissolve the House of Representatives to strengthen the basis of his government, yet he chose to postpone the dissolution and to devote his time and energy purely to addressing the Lehman Shock. As an experienced politician, as well as a former chief executive of an industrial consortium, he was particularly confident and enthusiastic about the task of dealing with the crisis. As Table 5.1 indicates, the four stimulus packages combined amounted to ¥130 trillion (or US$1750 billion), of which about ¥30 trillion was to be funded by direct government budgetary expenditure. The rest of the measures were funded through the loan programs, including the Fiscal

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The global financial crisis and its budget impacts in OECD nations

(Year-on-year change; quarter-on-quarter change; %) 4

Real GDP growth rate

Imports

Exports

Public demand 2

Consumption

0

Residential investment

–2

–4

Non-resi. investment

Inventory

–6

–8

01 02 03 04 05 06 07 08 09

I

(FY)

II III IV 08

I

II III IV 09

I 10

Source:  Cabinet Office of Japan (2010).

Figure 5.1  Changes in real GDP growth rate Investment and Loan Programs. Introducing a series of stimulus packages of this scale in less than eight months was an unprecedented action for the government. And each sequential package increased the size of the fiscal stimulus, beginning with an initial ¥11.5 trillion (US$153 billion) in the first measure decided in August 2008, rising to ¥56.8 trillion (US$757 billion) in the fourth stimulus package called the Economic Crisis Measures decided in April 2009. The government used supplementary budgets to introduce



Budgeting in Japan after the global financial crisis ­121

Table 5.1  The four rolling stimulus packages Fiscal stimulus package

Date of government decision

Title of the package

Package I

29 August 2008

Urgent Comprehensive Measures for Realizing Safety Measures for Lives Urgent Measures for Defending Lives Economic Crisis Measures

Package II 30 October 2008 Package III 19 December 2008 Package IV 10 April 2009

Amount Government budgetary committed (trillions) expenditure (trillions) ¥11.5

¥1.8 of ¥11.5

¥26.9 ¥37.0

¥4.8 of ¥26.9 ¥10 of ¥37.0

¥56.8

¥15.4 of ¥56.8

the rolling stimulus packages, giving each a symbolic title, and financing them mostly through government bonds. These fiscal stimulus measures were omnibus packages combining a wide range of support instruments, including: measures for employment promotion; social security assistance; medical services and child care; assistance and financing to private enterprises, especially to small and medium-­sized enterprises; assistance to individuals and households; policies promoting economic growth and regional vitalization; measures for agriculture, forestry and fisheries; programs promoting a low-­carbon society; and measures for housing and against natural disasters. Many measures were included that did not appear to have much to do with the Lehman Shock or with the viability of financial markets. The omnibus nature of these packages was politically inevitable given that a general election was expected to be held sooner or later. The Implementation of the Stimulus Packages Among the various measures included in the stimulus packages of the LDP Aso government, three are chosen here for further discussion. These are: (1) stimulus measures for financing private enterprises; (2) measures to promote a low-­carbon society; and (3) the provision of fixed cash grants to every resident in Japan. The largest portion of the stimulus packages was devoted to financing private enterprises. Instead of committing government money through budgetary expenditure, the government requested (or rather demanded) that government-­ affiliated financial institutions, such as the Policy Investment Bank of Japan, provide loans to private enterprises under

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The global financial crisis and its budget impacts in OECD nations

favorable conditions. Specific policy objectives and eligibility criteria were detailed in the stimulus packages and in other official documents and guidelines. Where necessary, the government agreed to provide guarantees to these financial institutions offering such loans. Private enterprises which were at the time finding it difficult to obtain loans from private financial institutions considered this scheme very useful. The government also considered the financing provisions to be very successful in effectively addressing the Lehman Shock. Measures to promote a low-­carbon society, entitled the Low-­Carbon Revolution, pursued at least two competing objectives: first, to promote mitigation measures against greenhouse gases and global warming and to prevent the excessive use of precious energy and resources; and second, to use these environmental initiatives to promote domestic consumption to stimulate the economy. Hence, the government promoted the use of eco-­friendly vehicles and so-­called eco-­friendly home electric appliances or ‘green’ home electric appliances. The government subsidized the installation of solar panels to houses, office blocks and school buildings. As an incentive to promote these measures, the government introduced an ­ ‘eco-­ car’ subsidy for the purchase of eco-­ friendly vehicles and an ­‘eco-­point system’ for the purchase of green home electric appliances. The government also allowed for an exemption or reduction of tax for anyone who installed such energy-­saving facilities, or facilities using new kinds of energy. These measures were successfully implemented. Indeed, the succeeding government led by the Democratic Party of Japan (DPJ) continued and extended these eco-­friendly measures to include subsidies for the construction or renovation of ‘eco-­houses’ in the second supplementary budget of FY2009. The most controversial aspect of stimulus packages of the LDP government was the provision of cash directly to Japanese residents. This measure was designed to help households and revitalize the economy by encouraging greater consumption. A standardized amount of cash was provided to those with a residential address in Japan and foreigners who were legal residents (except for short-­stayers), and the amount was paid irrespective of the recipient’s income. A one-­off payment of ¥12 000 (US$160) was made to individual residents, with ¥20 000 (US$270) given to those 65  years and above or under 18 years. More than ¥2 trillion in cash-­payments was included in the second supplementary budget of FY2008 classified as expenditure for the ‘urgent aid to households’. Intense debates occurred on important points such as whether it was really effective to stimulate consumption and whether it was appropriate to give handouts to richer people. Some criticized it as a nonsensical scattering of money. It was, however, regarded as a better option than a tax reduction, which would



Budgeting in Japan after the global financial crisis ­123

have applied only to those who actually paid taxes. According to a survey of 15 000 households by the Cabinet Office, some 32.8 percent of the money received by each household was spent on increased consumption. Problems Associated with the Large-­Scale Stimulus Packages The rolling stimulus packages were not implemented without problems, even though it appeared that the Japanese economy would recover from its critical condition relatively early, and ahead of other countries. It is worthwhile reflecting on the problems resulting from the roll-­out of the large-­scale packages aimed at addressing the Lehman Shock. First, it was believed at the onset of the GFC or Lehman Shock that it would be of such magnitude that it would be a once or twice in a hundred years event. Accordingly, many peripheral items were included in the stimulus packages without sufficient scrutiny over the relevancy and effectiveness of each measure. It would appear that every possible measure was shoe-­horned into the stimulus packages. Second, the government resorted to the convenience of introducing supplementary budgets, which really should be regarded only as exception devices in the budgetary setting. Japan’s proclivity to rely on multiple, sequential, supplementary budgets has made it more likely that looser fiscal discipline will result in the future. The long-­term implications were generally neglected. Moreover, the supplementary budget packages meant that the government had to issue additional government bonds, thereby worsening the fiscal position of the government. Third, given that Japan’s aggregate annual expenditure fluctuated markedly (as a consequence of the supplementary budgets), the criterion for setting and controlling the appropriate magnitude of annual expenditure has become more ambiguous. And fourth, by focusing on the immediate pressing issues, Japan risks postponing the addressing of long-­term crucial issues; namely, how to repair Japan’s fiscal condition which is heavily burdened with the huge amount of outstanding government bond debt.

POLITICAL CHANGE: OUT WITH THE OLD, IN WITH THE NEW The Declining Credibility of the LDP Government Since 1955, when two large conservative parties in Japan were merged into the new Liberal Democratic Party (LDP), the LDP or a LDP-­led coalition has dominated politics in Japan, except for a short period from 1993 to

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The global financial crisis and its budget impacts in OECD nations

1994 when a short-­lived non-­LDP coalition of eight political parties and groups organized to form the government. However, the credibility and popularity of the LDP gradually declined due to a growing public repugnance at the LDP’s politics. People were especially concerned about the dominance of dynastical political families ruling the party; the self-­seeking vested interests affiliated with the LDP that were opposed to change or structural reform; the recurrence of corruption and scandals involving LDP politicians and government officials; and the persistent failure of government policies and administrative modes. The LDP’s Junichiro Koizumi became Prime Minister in 2001 and tried to reverse this decline by appealing to the general public as a politician enthusiastic about reform and change. He was determined to pursue his objectives and even announced that he would destroy the old LDP in the process. In 2005 he dissolved the Lower House when his postal privatization bills were voted down in the Upper House. He turned the election into a single-­issue contest and asked the public to support his reform agenda, winning a landslide victory with a two-­thirds majority as a ruling coalition. After these legislative bills were passed and the implementation phase of postal privatization began, he voluntarily stepped down in 2006 with his popularity remaining extremely high. Nevertheless, the long-­term trend of declining credibility for the LDP continued. The ‘Twisted Parliament’ and a Succession of Short-­Term Prime Ministers after Koizumi Koizumi chose Shinzo Abe as his successor in 2006, the grandson of a former Prime Minister, Nobusuke Kishi, and son of the former Foreign Affairs Minister, Shintaro Abe. Initially, the Abe government’s p ­ opularity was high. However, as ministerial scandals were exposed and blunders in government administration disclosed (such as the mismanagement of pension records), the credibility and popularity of his administration declined sharply. The LDP was defeated in the Upper House election in 2006, losing its majority in the chamber. This produced a situation rarely experienced in Japanese politics, where the ruling coalition enjoyed a healthy majority in the Lower House but commanded only minority status in the Upper House. This situation was called the ‘twisted parliament’ and it began to cause serious problems for the ruling party and government. For instance, important government bills were voted down in the Upper House, and the LDP faced great difficulties in ensuring that its budgets won support and its policies were authorized. The twisted parliament effectively crippled the government. After suffering the defeat in the Upper House and losing face over



Budgeting in Japan after the global financial crisis ­125

the difficulties negotiating the twisted parliament, Prime Minister Abe stepped down in September 2007, one year after he succeeded Koizumi. Yasuo Fukuda, also the son of a former Prime Minister, Takeo Fukuda, succeeded Abe. To overcome the difficulty of the twisted parliament, he tried in vain to organize a grand coalition together with the biggest opposition party, the Democratic Party of Japan (DPJ). Although the LDP remained in government, Fukuda struggled to overcome the difficulties of his abortive gesture and stepped down in September 2008, again one year after he succeeded Abe. The next head of government was Taro Aso, also a grandson of a former Prime Minister, Shigeru Yoshida, who assumed the prime ministership immediately upon the Lehman Shock. Although he commenced a series of initial stimulus packages, the government was criticized for being too slow to address the fiscal problems, and his particular measures were not necessarily applauded. For example, the cash payments handed out to rich Japanese residents caused incensed criticism. Within months, the credibility of the Aso government declined spectacularly. The media began to find faults, big and small, with Aso and his ministers which accelerated the decline into a vicious circle. In August 2009 the ruling LDP lost its majority in the Lower House election, a victim of its own hubris and the crisis. Hence, after Koizumi, three different LDP prime ministers held office, each for about one year. These short-­lived prime ministers found it impossible to tackle the big issues. Being suddenly thrust into office, they were not well prepared. Once they took office, they were preoccupied with pressing problems and immediate issues. Their power bases were not yet well established even in their own party. So, important long-­term or complex issues, or time-­consuming reforms such as fiscal consolidation, debt reduction and structural reform were all inevitably pushed aside. The Landslide Victory of the DPJ in the 2009 General Election The DPJ was propelled into office with a landslide victory in the general election of August 2009, just one year after the Lehman Shock. The electorate wanted change. The DPJ won 308 of 480 seats in the Lower House and formed a coalition with two other parties to command a narrow Upper House majority. However, the DPJ had no experience in running government; people were unaware how it would perform or what it was going to do. But people welcomed the fact that the DPJ had relatively younger politicians and fewer from political dynasties. People thought that the DPJ was not as bound by vested interests, and was a relatively clean party, less troubled with corruption and scandals, and it seemed initially a

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The global financial crisis and its budget impacts in OECD nations

refreshing change from the continuation of LDP politics with a succession of short-­lived prime ministers. The Pattern of Short-­Lived Prime Ministers Continued Under the DPJ The DPJ-­led coalition government was formed in September 2009 with Yukio Hatoyama as Prime Minister. Although the DPJ had publicly released its manifesto of policy promises during the general election, many were slogans and the specifics were not discussed in detail. The new Prime Minister Hatoyama was personally committed to achieving these promised policies, yet he faced many difficulties in compiling the FY (financial year) 2010 budget to meet the manifesto’s commitments. However, the really controversial issues, which delivered the fatal blows to his leadership, were the issues of the US Marine Corps bases on Okinawa, and a ‘politics and money’ scandal involving himself and the Secretary-­General of the DPJ. He could not find any acceptable solution to the issue of the US bases on Okinawa, as he could not satisfy both the US government and his coalition partner, the Social Democratic Party (SDP). The SDP then quit the coalition, resulting in the DPJ losing its majority in the Upper House. Prime Minister Hatoyama resigned from office on 8 June 2010. Although he had been expected to remain in the office for longer than the preceding LDP prime ministers, he occupied the highest office for an even shorter period. Naoto Kan became the next DPJ Prime Minister. He had served briefly as the Minister for National Strategies and then Finance Minister in the Hatoyama government. Enjoying high popularity, the new Prime Minister opportunistically called an early election of the Upper House without extending the session of the Diet, hoping thereby to pass important legislation including the manifesto promises. During the campaign he referred to the possibility of raising the consumption tax rate from 5 to 10 percent. He was faced with questions and criticisms, and his credibility declined as his explanations changed every day. In the election for the second chamber, the DPJ again did not secure a majority and a further twisted parliament appeared. But this time, unlike the previous LDP government that lost control of the chamber, the DPJ-­led coalition did not control a two-­thirds majority in the Lower House to overcome the obstruction of the Upper House. Remaining as Prime Minister even after the election defeat, Kan then had to face an election as head of the DPJ, since the leader’s term of office expired in September of 2010. He won the race for the leadership of the DPJ by the narrowest of margins against Ichiro Ozawa. The DPJ was thus seriously split and the party found it difficult to decide on many policies and issues, and many remained unresolved. Opposition criticism increased



Budgeting in Japan after the global financial crisis ­127

and the Prime Minister’s distrust of bureaucrats and officials further deteriorated the smooth running of government. The popularity of the DPJ government continued to decline and Kan was forced into a difficult predicament. For a while, around the time of the massive earthquake, tsunami and Fukushima nuclear power plant accident in March 2011 that affected eastern Honshū, accusations and criticisms against Prime Minister Kan were inhibited at least temporarily. But the apparent mismanagement of post-­disaster recovery attempts and the lingering stalemate in the parliament in dealing with the budget (including a supplementary budget related to the disaster) finally forced him to resign. Prime Minister Kan first flagged the possibility of a resignation on 2 June 2011, then announced unequivocally his intention to resign on 26 August, effective from 2  September. Although he survived for almost 15 months (longer than his predecessor Hatoyama and each of the last three LDP prime ministers), his last three months in office were days of inaction and seemed only to worsen the economic situation in Japan. Yoshihiko Noda of the DPJ succeeded Kan on 8 September 2011. Noda had served as the Deputy Finance Minister in the Hatoyama government and Finance Minister in the Kan government. He was familiar with the problems of fiscal management and budgetary issues and prioritized these in his administration. But, although his leadership was confirmed by a party vote of the DPJ, he soon faced and survived a no-­confidence motion in parliament over raising the consumption tax by 5 percent. He made commitments to introduce reforms, but did not manage to stay in office for long or produce any meaningful results; as a consequence the DPJ became a one-­term government incapable of dealing with the crisis, succeeded by the LDP’s Shinzo Abe.

BUDGETING AND PROGRAM REVIEW UNDER THE DEMOCRATIC PARTY OF JAPAN The DPJ’s Manifesto for the 2009 General Election In recent years it has become common for political parties to release their policies and opinions in the form of a manifesto. There is no law or regulation concerning the manifesto and no established format. The detailed extent of a manifesto differs from party to party. But those who have promoted the so-­called ‘manifesto movement’ generally encourage specific promises even if the precise details are not included. The DPJ’s manifesto for the 2009 election covered a wide-­ranging set

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of commitments and policy proposals. It included the basic principles of government to which the DPJ subscribed, and measures to implement those principles, including reorganizations and proposed changes to the way government would be run. Specific promises made to appeal to the electorate were oriented towards social goals rather than infrastructural ambitions (‘policies for human beings, not for concrete’ was the guiding concept). On fiscal policy, the DPJ’s manifesto indicated the necessary expenditure to fund its major commitments, including the ways it intended to finance those promises. For example, the DPJ’s manifesto proposed the introduction of a child allowance payment, free high school education, pension reform, medical service reform, income guarantees to farming households, the abolition of the temporary additional tax on gasoline, and the removal of road tolls to allow the free use of highways. The manifesto claimed that it was necessary to appropriate ¥16.8 trillion to implement these policies fully by FY2013. In the 2010 budget some ¥7.1 trillion was considered necessary to implement these programs. To fund this amount of expenditure, the manifesto proposed to impose four measures: to cut ¥9.1  trillion from existing expenditure programs; to commandeer ¥4.3 trillion from the reserve fund (‘buried treasure’); to sell ¥0.7 trillion of government property; and to produce ¥2.7 trillion by reviewing existing tax expenditures. Thus, the 2010 budget became the first test of the DPJ’s ability to govern. Concerns were raised when it was recognized that it would become necessary to appropriate ¥16.8 trillion every year from FY2013 for the continuation of the above-­mentioned policies, yet the manifesto commitments included mainly one-­off revenues such as the use of the reserve fund and selling of government property. The DPJ felt it had no option but to deliver these policies, because the manifesto had become the criterion by which to judge its credibility as a government. Organizations for Policy-­Making and Budgeting by the DPJ Government Under the LDP government, the Economic and Fiscal Policy Council (EFPC) and the Minister for Economic and Fiscal Policy played important roles as the ‘control tower’ in the making of economic and fiscal policy, annual government budgeting and policy coordination. By contrast, the DPJ did not use the EFPC despite its statutory role to deliberate and advise the Prime Minister. The party’s 2009 manifesto promised that the DPJ government would establish a National Strategy Bureau directly under the Prime Minister to strengthen the functioning of the Prime Minister’s Office. This bureau, to be composed of experts from the public and private sectors, was to frame a national vision for the new era and advise on its resourcing in the budget framework. The DPJ’s manifesto also committed



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the government to establish a Council for Government Revitalization to review public administration as a whole from the citizen’s viewpoint. The council’s role was to scrutinize the whole of the budget, review systems and remove waste and unfairness in public administration. The DPJ government considered it necessary to establish these organizations by legislation, simultaneously abolishing the EFPC. On assuming office, as a temporary alternative until the legislation could be enacted, the DPJ government decided to establish the two organizations by Cabinet decision on 18 September 2009. In the following year, the government then submitted the legislative bill to the regular session of the Diet to establish these organizations as statutory organizations. However, the bill was not enacted, and not even considered by the relevant committee of the Diet, allegedly because there was not enough time. The legislative bill was to be resubmitted to the regular session of 2011 but was tentatively withdrawn in May 2011. After that the DPJ government never tried to submit the bill again. Yet the two organizations established by the cabinet decision continued to exist and played important roles, as described below. The National Strategy Office: A Staff Organization Not a Coordinating Controller The National Strategy Office was established within the Cabinet Secretariat to plan and coordinate the fiscal framework (expenditures and taxation) and oversee economic policy and other important policies of the Cabinet. Before this office was created, the first Minister for National Strategy, Naoto Kan, was appointed in the first DPJ government under Hatoyama. One of the deputy ministers of the Cabinet Office was appointed as the head of the National Strategy Office. But the National Strategy Office was not sufficiently organized to work on the supplementary budget of FY2009 and could not contribute much for the annual FY2010 budget. Minister Kan did not play a major role in budget-­making. Whereas the EFPC was created by LDP as a high-­level deliberative body composed of the Prime Minister, influential ministers and members invited from outside of the government, the National Strategy Office was not established as a deliberative body but as a staff organization. It was difficult for the new entity to play the role of a ‘control tower’ once exercised by the EFPC. Whether or not the office gained much influence depended on what the Prime Minister of the day thought of the office, who was appointed as the minister in charge of the unit, and how that minister activated or used the office. Initially, when the office was established the Minister for National Strategy (Deputy Prime Minister Kan) was appointed simultaneously as the Minister for Economic and Fiscal Policy. When Naoto Kan

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became the Prime Minister in June 2010, he appointed the same person to the roles of the Minister for Economic and Fiscal Policy as well as for National Strategy. Then, three months after that, Prime Minister Kan appointed different persons to these critical positions. However, when making these changes he appointed the Minister for National Strategy as the chairman of the DPJ’s Policy Committee as well. By doing so he tried to integrate the policy-­making in the government and in the ruling party. Prime Minister Noda, who succeeded Kan in September 2011, appointed one Minister for National Strategy who was simultaneously Minister for Economic and Fiscal Policy. Noda tried to integrate the top-­level positions in the government responsible for national strategy and budget-­making. So, even among DPJ leaders there appeared differences of opinion as to the roles of the National Strategy Office. The National Strategy Office is composed of both the officials seconded from ministries and employees dispatched from private organizations. The office has performed considerable review work over a wide range of policy areas, including economic policy, tax and fiscal policy, mid-­term fiscal management and others. But its work is not widely known or debated, and being composed of civil service staff it cannot act as a ‘control tower’ by itself. Such controls over the budget were lacking in the DPJ government. Hence, it appeared that a high-­level political deliberative organization was still necessary for control and coordination, such as a council composed of the Prime Minister, major ministers, influential business leaders, highly respected scholars and others from the private sector. The Council for Government Revitalization: Preparing for Program Reviews The Council for Government Revitalization (CGR) attracted most attention in the DPJ’s budgetary processes. According to a Cabinet decision, this council was established in the Cabinet Office to review the national budget and investigate public administration as a whole. It was composed of the Prime Minister and some of his most senior ministers (for example, the Minister for Government Revitalization, Chief Cabinet Secretary, Finance Minister, National Strategy Minister, Internal Affairs and Communications Minister) together with some influential business executives, scholars and other experts. The composition of this council appears somewhat similar to that of the EFPC under the LDP governments. Interestingly, from outside the DPJ, the head of a private think-­tank which had promoted the review activities, Hideki Kato, was appointed as the Secretary-­General of the council. Previously under LDP



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governments it was rare that the executive head of such a powerful council was appointed from outside the government. Under the stringent fiscal conditions of the GFC and in view of the manifesto of the DPJ, the council was urgently required to undertake wide-­ranging expert reviews of expenditures and other programs as early as possible. It was not practical or feasible that the council undertook such voluminous review work entirely by itself. Hence, working groups were organized under the council. Outside experts and scholars were requested to participate in the review works. Secretary-­ General Kato played an important role in recruiting experienced reviewers. Members of the ruling coalition parties in the Diet were also requested to participate in the work of working groups. Even though there was a view that it was not permitted or appropriate for members of the Diet to work for such working groups in the Cabinet Office without statutory authorization or a specific resolution of the Diet, the DPJ government ignored such opinion. Reviewing Expenditure Programs: Conducting the ‘Sorting Out’ Process in Public Gradually, in the CGR a method of ‘sorting out’ programs and projects (a rationing or cost-­containment methodology) was adopted in conducting expenditure reviews. Hearings with those directly engaged in targeted programs were conducted by the working groups, and made open to the public or even televised. This new method of holding public hearings attracted considerable attention across government and the general public. The Minister for Government Revitalization and chairpersons of the working groups became TV stars for a time. Secretary-­General Kato played the role of producer of the show. The results of reviews were reported to the council. But in the absence of a binding Cabinet decision, the results of reviews were not necessarily fully accepted or implemented. The total amount of savings created by the reviews was smaller than expected, yet the activities of the council were applauded and well accepted by the general public. The sorting out methodology was pioneered by Hideki Kato as the head of the private think-­tank and was applied to local government programs. Then, as the Secretary-­General of the National Council, he applied the same methods to the expenditures and programs of the national government. Kato argued that the rationale for sorting out programs and projects was to test whether the budget of the program was used effectively and efficiently to achieve the objectives of the program in question; it was not intended to question the policy itself. Yukio Edano, the Minister for Government Revitalization, added that reviewers could examine whether

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the objectives of the program were appropriate or not when there was an obvious gap found between the objectives and the results of the program. The sorting out method of reviewing government programs involved open scrutiny and debate involving outside reviewers. Debates were conducted face to face in front of public audiences and they were usually broadcast through the internet. Reviewers were selected by the CGR. Most of them were either familiar with the targeted programs or had experience in sorting out other activities, and were selected from outside government, with some from the ruling parties in the Diet. Targeted programs were selected by the executive office of the council in consultation with the Budget Bureau of the Finance Ministry. Reviewers were given information and data on targeted programs before the public hearings were held. At the beginning of each debate on a targeted program, a brief explanation of the program was made by an official of the ministry in charge of that program. Then, a budget examiner from the Budget Bureau would explain the key points of each program and provide opinions from the Budget Bureau. The chairperson of the working group then usually explained the rationale for choosing the targeted program and issues for debate. Then, around 40 minutes were assigned for a question-­and-­answer session between reviewers and officials in charge of the program. Reviewers made public judgments about the program and backed these with reasons. The chairperson brought together a final composite judgment of the working group based on the individual judgments. Reviewers could recommend the abolition of the program, a reduction of budget, postponing budget requests, returning the funds to the National Treasury, or devolving implementation to improve performance. The main finding was then communicated publicly at the conclusion of the hearing. Altogether about one hour was consumed for each review of targeted programs. One by one, the targeted programs were examined in this way, all day for several days. There were various arguments for and against publicly sorting out. On one hand, the spectacle of the sorting out inquiries was generally well accepted. It attracted the attention and interests of the general public to the world of government, as well as government employees. People enjoyed watching arrogant and privileged government officials being accused of neglect or harshly criticized at the hearings, and in front of a large television audience. They enjoyed the show. On the other hand, there were other concerns and criticisms of the process. Strong reactions came from programmers about negative judgments of programs. There were also criticisms of the way reviewers and targeted programs were selected. Time for real debate was often very short, especially for defenders of the targeted program who thought the process was unfair to them. The debate could appear one-­sided with the judgments arrived at before the debate. It was



Budgeting in Japan after the global financial crisis ­133

also criticized for being interested in providing a showcase for performing politicians rather than eliciting information. The first round of the sorting out reviews produced ¥1.7 trillion through cutting budgets and returning unused money to the Treasury. The council then expanded the targets for further sorting out. The second round was conducted on programs within government-­affiliated independent administrative agencies and public-­interest corporations subsidized or contracted to deliver government programs. The third round was conducted into the special account budgets.

THE RETURN TO SUPPLEMENTARY BUDGETING AND THE STRUGGLE TO IMPLEMENT THE 2009 ELECTION MANIFESTO Upon assuming office in September 2009, the DPJ government ordered its ministries and agencies to review the execution of the FY2009 budget. Considering the serious economic and fiscal conditions in the aftermath of the Lehman Shock, it was soon deemed necessary to make a second supplementary budget for 2009. Hence, in response to Prime Minister Hatoyama’s directive of 18 September, the execution of the first supplementary budget of FY2009 (made in May 2009 by the LDP g­ overnment) was reviewed to explore whether expenditure programs and projects could be suspended and whether any unused funds included in the first supplementary budget for future use could be recovered to the National Treasury. Of the ¥15.4 trillion of budgetary expenditure included in the first supplementary budget, the review managed to claw back some ¥2.7 trillion which was endorsed by the DPJ cabinet on 16 October 2009. In its place the DPJ government prioritized its own economic measures entitled Urgent Economic Measures for the Security and Growth of Tomorrow. Thus, the second supplementary budget of FY2009 was the first budgetary instrument formulated by the DPJ government but submitted to the Diet in January 2010. The total amount committed in this urgent economic budgetary measure was ¥24.4 trillion with some ¥7.2 trillion provided directly from budget expenditure. However, because of the decline in tax revenue due to the deteriorating economic conditions, the government was forced to rely mostly on the issuing of new government bonds totaling ¥9.3 trillion. Further borrowing was contrary to the expressed intention of the Urgent Economic Measures for the Security and Growth of Tomorrow, which attempted to keep new borrowing down as much as possible by reprioritizing the funds produced by the review of the first supplementary budget.

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However, when this second tranche of issued bonds was added to the borrowing in the first supplementary budget, the total amount of bonds issued in FY2009 was predicted to be ¥53.5 trillion, with the predicted bond dependency ratio hovering at 52.1 percent (the proportion of borrowing sought to provide annual budget expenditures). Making of the Initial Budget of FY2010: Struggle with Manifesto and Bond Issue In formulating the FY2010 budget, agencies were directed on 29 September 2009 to review and resubmit their budget requests by 15 October according to the DPJ government’s budget priorities. In order to fund new policies and programs, the DPJ government’s manifesto required ministries and agencies to examine their budgets and produce new revenue sources. The revised requests added to the overall budget totaled some ¥95 trillion, the largest budget request ever made from the general account. This was because ministries and agencies sought to include in their requests any manifesto-­related items, while reductions to their existing budgets were not made, allegedly due to the limited time. Compared with the previous year’s annual budget spending of ¥88.5 trillion, the request for ¥95 trillion in 2010 was considered too high, and so the government’s immediate challenge was how to deal with this huge budget request aligned to its manifesto. On receiving the budget requests, the Finance Minister announced his intention of containing the size of the total expenditure for FY2010 from the general account to below ¥92 trillion, and that the total amount of new bonds issued would be kept to below ¥44 trillion, an amount equal to the bond issue planned by the preceding LDP government of Aso after the first supplementary budget. As it is usual in Japan to compare the initial budget of the coming year with that of the initial budget of the preceding year, in 2010 comparing the size of the annual budget after the supplementary budgets was tricky. However, at the time the attention of the mass media and public shifted to the results of the sorting out reviews of the CGR. Because the sorting out process produced far smaller rewards than expected, the government considered that some of the promises in the manifesto had to be ­‘victimized’, at least for the FY2010 initial budget. But then the issue was which items were to be victimized. The government’s targets soon became its promises to abolish the temporary additional rate of gasoline tax and increase the children’s allowance. The proposal to abolish the additional tax on gasoline would necessitate a budget reduction for public works (road-­building). As to the children’s allowance, the relevant issues became whether or not local governments should share the burden and whether an



Budgeting in Japan after the global financial crisis ­135

upper limit of family income should be stipulated. Negotiations within the DPJ government reached a stalemate, until finally it was decided that the surcharge on gasoline would be kept but that no upper limit on the family income for the child allowance would be introduced. After this trimming exercise, the total expenditure from the general account in the initial budget of FY2010 became ¥92.3 trillion. Yet again, considerable decreases in tax revenues were expected. Tax estimates were expected to drop from ¥46.1 trillion in the initial budget of FY2009 to ¥37.4 trillion in the FY2010 initial budget, and accordingly the projected bond issue would need to be increased from ¥33.3 trillion in FY2009 to ¥44.3 trillion in the FY2010 initial budget. The scale of this bond issue was far larger than the contribution expected from taxation. Hence, the bond dependency ratio for the FY2010 initial budget was 48 percent compared with the estimated 37.6 percent in the previous year’s initial budget. The DPJ’s Initial Budget of FY2011: Genuine Start or Anticlimax? Allowing for the fact that the DPJ was inexperienced in government and time was limited, its budget-­making in late 2009 (for the 2010 budget) was unsatisfactory even to DPJ members. It was considered necessary for the government to reformulate its medium-­term economic and fiscal framework to allow the preparation of more genuine DPJ-­like budgets in the coming years. The government hurriedly announced the Basic Outline of the New Growth Strategy on 30 December 2009, after it had endorsed the FY2010 budget on 24 December. In his speech to the Diet on the government’s fiscal policy made at the time of the submission of the FY2010 budget on 29 January 2010, the Finance Minister said that the government would formulate a new fiscal management strategy and achieve its mid-­ term fiscal targets by the middle of the year. In line with the Basic Outline, a new economic growth strategy and fiscal management framework was announced in June 2010, subtitled ‘The Scenario for the Restoration of a Robust Japan’. The mid-­term fiscal framework was outlined in the Fiscal Management Strategy which set limits on the total size of the general account budget expenditures, excluding the payments related to the management of government bonds. The FY2011 budget was to be made in line with the Fiscal Management Strategy as well as the New Growth Strategy and the DPJ’s manifesto. As required by the Fiscal Management Strategy, the size of planned expenditures, excluding the bond-­ related expenditure, was maintained under the level of the previous year’s budget, coming in at ¥70.9 trillion. Bond-­related expenditure still increased, but relatively modestly. The total size of the general account budget for FY2011 increased to ¥92.4 trillion,

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with a new government bond issue of ¥44.298 trillion, a little less than the ¥44.303 trillion contained in the initial budget in 2010. The bond dependency ratio sat at 47.9 percent, virtually identical to the 48.0 percent of the initial budget in the previous year. The government may be said to have largely met the requirements of the Fiscal Management Strategy. But the size of the total budget remained extraordinarily large and even for Japan it is highly unusual that tax revenues do not meet half the total expenditure budget, implying that borrowings exceeded revenues for two consecutive years. Matching the overspending of the previous year was unwise, given that the Finance Minister had said in his budget speech to the Diet in January 2010 that the economic crisis following the Lehman Shock was over. The Lehman Shock, he said, was a once or twice in a hundred years event. If so, then the level of total expenditure and the bond dependency ratio should have returned to the level of that before the Lehman Shock. Clearly, such profligacy was unsustainable and an exit policy had now become imperative. The second and third rounds of the sorting out reviews were targeted towards government-­affiliated organizations and special account budgets. But again the resulting trimming was disappointing: a reduction of just ¥0.3 trillion in expenditure and ¥1.4 trillion in savings from government-­ affiliated independent agencies. Expected revenue, other than from taxes and bonds, decreased this time by more than ¥3 trillion from ¥10.6 trillion in 2010 to ¥7.2 trillion in the 2011 budget. Indeed, the DPJ government found it could not claw back enough funds by reviewing existing programs to make up for the additional funds necessary to satisfy the commitments of its manifesto. It became clear to the government that it could not implement its manifesto to a satisfactory extent. So, after trying to produce a genuine ‘DPJ budget’ for 2011, the government produced an anticlimax and was forced to contemplate abandoning many of the commitments in its 2009 manifesto.

DPJ’S WAYS AND MEANS TO ASSIST FISCAL CONSOLIDATION: INCREMENTS BY MUDDLING THROUGH The GFC brought to an end the hegemony of the LDP and ushered in an inexperienced DPJ government that had appealed to the electorate with catchy slogans but underestimated the difficulties in implementing such promises. Not only did the DPJ have no experience in working with bureaucrats, but it also fundamentally distrusted the loyalty of the bureaucracy. Although in opposition the DPJ had advocated stronger political



Budgeting in Japan after the global financial crisis ­137

leadership over policy-­setting and transparent budget-­making, it proved difficult to achieve this when in government. The DPJ government chose not to use the organizations and methods devised over decades by its LDP predecessors, but instead established its own bodies and procedures. By rejecting accumulated knowledge and experience, it was inevitable that ‘muddling through’ would prevail. Under the DPJ, Japan not only had to adjust to the financial crisis but also had to do so with new and untried institutional entities. The National Strategy Office could not play the disciplinary role of the LDP’s EFPC. On taking office in September 2011, Prime Minister Yoshihiko Noda (the DPJ’s third Prime Minister in two years) began to reconsider the role of the National Strategy Office and created the National Strategy Council, which unlike the Office was roughly similar to the EFPC in its composition but not necessarily its intended role. In his 15 months in office the new Prime Minister hoped the Council would provide greater strategic advice inside government rather than perform a more open budgetary control function. In program review, the CGR attracted the attention of the general public, but could not produce the expected savings results. The sorting out process did not apply to all expenditure programs as only selected programs were targeted. And even in these selected programs, proposed reductions were not necessarily fully accepted and implemented by the ministries and agencies concerned. Although the review process was conducted with much fanfare in public, the rebalancing process within agencies was not made open to the public. Disillusionment spread among the public, and the sorting out hearings were increasingly criticized as a ‘performance’. Few people expected any major savings to emerge from the reviews. Tax policy-­making became another case of trial and error. To reconsider its tax policy the DPJ government reorganized the Tax System Council, comprising its advisory body entirely of politicians chaired by the Finance Minister and two other ministers as vice-­chairpersons. Previously, under the LDP government, this council had consisted of scholars and knowledgeable persons familiar with and influential in various revenue fields, but operating in tandem with a party-­based tax council inside the LDP. The DPJ at first did not adopt this tandem approach, instead favoring a solely executive-­oriented body disconnected from its own internal organs. This was intended to strengthen political leadership within the government and improve policy integration, but it is questionable whether the new arrangements actually strengthened the government’s resolve to make the tough decisions needed to augment revenues. Backbench politicians were excluded from participating in deliberations over tax reform and complained about this way of decision-­making. Yet without their support, legislative bills to drastically change the existing tax system or to introduce

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new taxes could not be enacted. Prime Minister Noda revised these arrangements, and established a parallel deliberative council on tax inside the DPJ, chaired by the former Finance Minister. Then, during the election for the head of the DPJ in September 2011, Noda expressed his strong determination to address tax issues, including raising the consumption tax rate eventually up to 10 percent. The Tax System Council of the DPJ became the forum to involve party members allowing them to examine and discuss such proposed tax changes, and after intensive discussions, a tax bill to raise the consumption tax was submitted to the Diet in early 2012 and passed later that year. But reflecting the fact that Japanese politicians are usually reluctant to raise taxes, the 3 percent increase from 5 to 8 percent was scheduled for April 2014 and a further increase to 10 percent was postponed. Another reform adopted to assist with fiscal consolidation required all budget requests for new funds to be prioritized and ranked according to a transparent and competitive process. The DPJ established a new fund (the Special Quota for Restoring a Robust Japan), with more than ¥1 trillion. Requests from this special quota had to be put to a ‘policy contest’, where each requesting ministry had to explain the necessity and likely effects of the budget request to the public (often putting up some of their existing budgets to support initiatives – ‘offsets’). Policy bids were to be prioritized according to the opinions of the people outside government. The final allocation of budget would be decided by the Prime Minister. This reform was intended to stimulate the reallocation of budgets among ministries and also to increase the transparency of budget-­making. The public hearings on the budget requests for this special quota were held by the evaluation committee headed by the Minister for National Strategy, but the rating each budget request was given was not conveyed to the public. The DPJ government never managed to replicate the fiscal discipline imposed by the former EFPC of the LDP. This LDP council, chaired by the Prime Minister (PM) and steered by the Minister for Economic and Fiscal Policies, would deliberate all the basic budgetary issues and frameworks, and all the materials used for the deliberation were fully disclosed. The Minister for Economic and Fiscal Policy held a press conference soon after the conclusion of its deliberations; and a record of the press conference was put on its home page with a summary of its deliberations and full text of the minutes of the meeting about a week later. This meant that everyone had access to the council’s deliberations, and it could coordinate and control budget requests in a comprehensive and transparent way. While in office, the DPJ discarded the previous budgetary controls for political reasons but put nothing as effective in their place, and so was fated to continue along its trial and error way of muddling through.



Budgeting in Japan after the global financial crisis ­139

The greatest threat to fiscal consolidation is the continued escalation in the size of expenditures in the general account budget requiring high levels of continued borrowing to meet recurrent costs. Medium-­term fiscal frameworks have been determined behind closed doors, with aggregate expenditure limits set at relatively safe levels; ‘safe’ in the sense of enabling smoother budget-­ making. The size of Japan’s budget (and borrowing requirement) in the aftermath of the Lehman Shock remains extraordinary high and structural rebalancing remains an imperative. Political pronouncements of the need to undertake drastic rationalizations and cutting of existing programs have not been enough by themselves to bring about change. Even the rationalization measures indicated in the DPJ’s manifesto of 2009 had not yet been implemented, and short-­sighted measures or one-­ off windfall revenues such as raiding the reserved funds or ‘buried treasure’ in government-­affiliated organizations and special account budgets cannot be used repeatedly.

ASSESSMENT OF JAPAN’S LONG-­TERM FISCAL SUSTAINABILITY The nominal growth rate of the Japanese economy had been low since the late 1990s and often recorded minus values since 2007. It was the worst record among the major Organisation for Economic Co-­operation and Development (OECD) countries. Yet, after the Lehman Shock, the size of government expenditure expanded considerably. The fiscal condition of the Japanese government continued to worsen. The bond dependency ratio as shown in the annual budget worsened considerably after 2007 and continued to remain high well after the crisis. The accumulated outstanding government bond issue (public debt) continues to increase and is among the highest of the developed countries. As Figure 5.2 shows, the general account budget expenditure of the Japanese national government increased considerably after the GFC. Total expenditure in the general account budget of FY2009, including the supplementary budget, jumped to ¥101.0 trillion from ¥84.7 trillion in FY2008. Under the DPJ government this high level of expenditure continued: ¥96.7 trillion for FY2010, including the supplementary budget; and ¥92.4 trillion for FY2011, excluding the supplementary budget. As the Finance Minister has said, now that the Lehman Shock is over, this high level of expenditure should be lowered. As total expenditure increased, the amount of bonds issued increased from ¥25.4 trillion in FY2007 to ¥33.2 trillion in FY2008 and ¥52.0 ­trillion in FY2009. Under the DPJ government, this high level of bond issue

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3.7

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Specific Deficit-Financing Bond Issues

Tax Revenues

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Construction Bond Issues

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23.7

38.8

46.9 47.2

53.0

61.5

70.5 69.3 70.5

75.1

78.8 78.5

17.0

17.0

34.0

49.4

84.4

11.1

33.0

50.7

9.1

82.4

45.6

6.7

8.7 7.8

31.3

21.1

6.4

27.5

33.2

44.3

84.7

19.3

6.0

26.2

25.4 7.0

51.0

81.4 81.8

49.1 49.1

84.9 85.5

35.0 35.3 35.5

43.8 43.3

83.7

30.0 9.1

47.9

84.8

24.3 21.9 25.8 28.7 26.8 20.9 23.5

13.2

37.5

47.2

89.0 89.3

96.7 92.4

36.9 38.7 38.2

38.7 39.6 40.9 6.1 7.6

15.0 44.3 44.3

52.0

101.0

Total Expenditures

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 (FY)

3.2 2.1

5.3

13.8

20.9

24.5

50.6 51.5

892 (184%)

57.7

668 (138%)

Long-Term Debt Outstanding of Central and Local Governments

As of end FY2011 (Percentage of GDP)

(Unit: trillion year)

Government Bonds Outstanding (General Bonds Outstanding)

[Stock]

47.9% –22,748.9

General Account Primary Balance

Figure 5.2 Trends in general account tax revenues, total expenditures and government bond issues

Notes: 1.  FY1975–2009: Settlement, FY2010: Revised budget, FY2011: Budget. 2. Ad-­hoc deficit-­financing bonds (approx. 1 trillion yen) were issued in FY1990 as a source of funds to support peace and reconstruction efforts in the Persian Gulf Region. 3. General Account Primary Balance is calculated based on the easy-­to-­use method of National Debt Service minus Government Bond Issues, and is different from the Central Government Primary Balance on an SNA basis.

0

20

40

60

80

100

(Unit: billion year) FY2011

Bond Dependency Ratio

[Flow]

(Trillion year) 120



Budgeting in Japan after the global financial crisis ­141

continued unabated; with ¥44.3 trillion in bonds required in FY2010 including the supplementary budget and ¥44.3 trillion in FY2011 excluding the supplementary budget. As the tax revenue has decreased since the early 1990s and since the crisis was the lowest in 25 years (see Figure 5.2), the bond dependency ratio climbed considerably from 31.0 percent in 2007, to 39.2 percent in 2008, to 51.5 percent in 2009, then down slightly to 45.8 percent in 2010 and to 47.9 percent in 2011, excluding the supplementary budget. The estimated bond dependency ratio in the initial budget for 2009 was 37.6 percent. But as a result of a large volume of bonds issued in the supplementary budget, the bond dependency ratio increased to 51.5 percent that year. Each year the government tended to set the next year’s bond level against the previous year’s total (usually aiming at achieving the same level or slightly less). But there were two major problems with this during and after the GFC: firstly, the level of bonds required for the initial budget tended to be exceeded by the additional supplementary spending funded by further bonds; and secondly, the high and increasing bond levels used as benchmarks for subsequent years constituted an unsustainable way of managing public finances. Setting the ceiling for the annual bond issue in comparison with the excessive levels of the preceding year is not a rigorous policy based on the long-­term perspective of fiscal sustainability. In Japan today, governments seem to prefer to issue bonds directly to compensate for declining revenue streams, and in preference to increasing the tax burden. Such practices raise serious issues of intergenerational equity. The size of the accumulated outstanding government bond issue (as  shown in Figure 5.3) continued to grow. The national government’s accumulated outstanding long-­term debt comprised of decades of government borrowing, and at the end of FY2011 was estimated to be ¥668 trillion, which was 138 percent of expected GDP. Together with that of local governments, the total public sector debt was estimated to have risen to ¥892 trillion or 184 percent of GDP at the end of 2011. In December 2010, the OECD’s Economic Outlook estimated that Japan’s accumulated outstanding bonds would increase to 204.2 percent of GDP by the end of 2011, which is by far the highest among the developed countries (and this estimate did not include the higher levels contributed in the FY2011 budget). The next highest debtor nation was Italy with 132.7 percent of GDP. The Budget Bureau of the Japanese Ministry of Finance warned that the ¥668 trillion of accumulated outstanding bonds issues by the national government is equal to 16 times the annual tax revenues of the general account budget in 2011. Servicing the debt created by this pattern of bond issuing (interest payments and debt repayments) constituted the second-­highest component

142

For reference

Construction Bonds

Special DeficitFinancing Bonds

65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 (As of the end of the FY)

(Note) Disposable income and family size are based on the ‘FY2009 Survey of Household Economy’ by the Ministry of Internal Affairs and Communications

(Average family size: 3.43)

Approx. ¥5.13 million

Average disposable income of a working family

Approx. ¥20.94 million per family of 4

Approx. ¥5.24 million per person

Approx. ¥668 trillion (projection)

FY2011 Government Bonds Outstanding

Figure 5.3  Accumulated government bonds outstanding

Notes: 1. FY1965–2009: Actual, FY2010: Estimates, FY2011: Budget. 2. Specific deficit-­financing bonds outstanding include refunding bonds for long-­term debts transferred from JNR Settlement Corporation, the National Forest Service, etc. 3.  The estimate of FY2011 excluding front-­loading issuance of refunding bonds is approximately 656 trillion yen.

0

50

100

150

200

250

300

350

400

450

500

550

600

Equivalent to approx. 16 years of General Account Tax Revenues Tax Revenues in FY2011 General Account Budget: Approx. ¥41 trillion

356

650

231 258 280 288 305 321

700

0 1 2 2 2 3 4 6 8 10 15 213 22 5 17 32 10 22 43 15 28 56 21 35 71 28 42 82 33 49 96 40 56 110 47 63 122 53 69 134 59 75 145 64 81 152 65 87 157 65 91 161 64 97 166 65 102 172 64 108 178 63 116 193 61 131 207 64 142 225 67 158 245 77 168 258 83 175 295 108 187 332 134 197 368 158 209 392 176 216 222 421 199 547 226 241 499 247 527 243 532 287 541 225 546 238

(Trillion Yen) 642 668 594 242 247 394 421



Budgeting in Japan after the global financial crisis ­143

of the general account annual budget – some 23.3 percent in 2011, next to the expenditure for social security at 31.1 percent. When analyzing Japan’s national debt servicing expenditure, the amount of interest payment attracts the most domestic attention. Even though interest rates have been at historically low levels (1.4 percent or lower since 2005), the quantum of expenditure consumed in interest payments increased from ¥7.0 trillion in 2005 to ¥9.9 trillion in 2011. This increase was generated by increased borrowing; however, should interest rates rise by even small margins, the effect on Japan’s fiscal position would be very serious indeed.

CONCLUSION: NO MORE POSTPONING CRITICAL DECISIONS Around 50 days after the Finance Minister said in his 2011 budget speech given to the Diet that the economic crisis was over and that his budget would restore a ‘robust Japan’, the Japanese archipelago was hit by the Great Eastern Earthquake accompanied by the monstrous tsunami and the nuclear power plant accident. Many people in Japan reflected that one calamity follows closely on the heels of another. The Japanese government now has to address various sequential and complicated crises of the finance sector, the economy, the environment and the well-­being of society. There are many things that the government is now committing to undertake in rebuilding. But unless rigorous fiscal discipline is maintained, government expenditures are expected to increase sharply, contributing to even further indebtedness. Japan has become a country with a huge public debt burden, and determined efforts will have to be made for many years into the future to overcome these present-­day difficulties. The DPJ came to power claiming it understood the fiscal difficulties, and two of its most recent prime ministers had some experience as finance ministers; yet as short-­term prime ministers they could not address the most challenging issues facing the nation. What was required was for them to impose a strenuous fiscal discipline and set the direction ahead for the Japanese economy. We have seen merely slogans and muddling through without much real achievement. The DPJ government was replaced by the LDP Abe government in December 2012. Yet, there is still a long way to go and it is not clear in which direction and with what speed the new ­government intends to go.

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REFERENCES Asahi Shinbun News Report Center (2010), Minsyutou Seiken: 100 Nichi no Shinsou (The Truth of 100 Days of the DPJ Government), Tokyo: Asahi Shinbun Shuppan. Cabinet Office of Japan (2008, 2009, 2010, 2011), Keizai Zaisei Hakusho (White Paper) (Annual Report on the Japanese Economy and Public Finance), Tokyo: Japanese Government. Democratic Party of Japan (2009), Seiken Koutai – Manifesto (Change of Government – Manifesto), Tokyo: Democratic Party of Japan. Japan Reconstruction Initiative (2013), Minsyutou Seiken: Shippai no Kenshou (The DPJ Government: Verification of the Failure), Tokyo: Chuou Kouron Shinsha. Kaizuka, Keimei (ed.) (2005), Zaizei Akaji to Nihon Keizai (Fiscal Deficit and Japanese Economy), Tokyo: Yuhikaku. Komine, Takao (2010), ‘Ri-­man Shokku go no Nihon Keizai to Keizai Seisaku’ (‘Japanese Economy and Economic Policy after the Lehman Shock’), Keizai Shirin (Hosei University Economic Review), 77 (3), 5–24. Ministry of Finance (2009, 2010, 2011, 2013), Japan’s Fiscal Condition, Tokyo: Ministry of Finance of Japan. Ministry of Finance (2009, 2010, 2011, 2012), Japan’s Public Finance Fact Sheet, Tokyo: Ministry of Finance of Japan. Ohta, Hiroko (2010), Kaikaku Gyakusou (Running Against Reform), Tokyo: Nihon Keizai Shinbun Shuppansha. Organisation for Economic Co-­ operation and Development (OECD) (2010), Economic Outlook, Paris: OECD. Sugimoto, Kazuyuki (2010), ‘A Study on Fiscal Policy Challenges in Japan’, Public Policy Review, 6 (4), 625–44. Tanaka, Hideaki (2011), Zaisei Kiritsu to Yosan Seido Kaikaku (Fiscal Discipline and Reform of the Budget System), Tokyo: Nihon Hyoronsha. Yamaguchi, Jirou (2012), Seiken Koutai toha Nandatta noka? (What was the Change of Power?), Tokyo: Iwanami Shoten. Yumoto, Masashi (2010), Sabupuraimu Kiki go no Kinkyu Zaisei Seisaku (Urgent Financial and Fiscal Policy after the Sub-­prime Crisis), Tokyo: Iwanami Shoten.

6. Budgetary challenges in the Netherlands: resuming business after a turbulent time Jouke de Vries and Tom Degen In mid-­2008 financial markets around the world were hit by a global financial crisis (GFC) that rapidly impacted on the real economy of many nations. In the Netherlands the financial crisis caused a recession heralding a period of negative economic growth not seen in many decades. Rather than exploring the origins of the downturn, this chapter analyzes the responses to the crisis through the lenses of public budgeting and the resilience of the Dutch budgetary system. Almost overnight the Dutch government was forced to move into crisis mode and take swift decisions to stabilize domestic financial markets. In a short period of time, budget decisions of enormous consequence were made by the Ministry of Finance, directly affecting the public budget and levels of state debt. Besides the government’s expedient interventions in the financial sector, other significant budget challenges were also on the horizon as a result of the changing demographic structures and increased imperatives to fund well-­being. With an ageing population, the Dutch government was already confronting a ‘sustainability gap’ in its public finances, driven by increasing expenditures on old-­age pensions and healthcare. The financial crisis served to intensify calls for substantial budgetary reforms to ensure future financial sustainability. When studying the financial crisis through the lens of public budgeting, a public administration perspective can assist since it is a multidisciplinary field, encompassing politics, policy, economics, organizational theories and management studies. A public administrative view gives us the opportunity to analyze government responses to the financial crisis not simply as financial actions, but also as policy or political actions. In turn, it is necessary to question and analyze the decision-­making processes adopted by the government, as well as the role of various actors during and after the crisis, and the character of the long-­term decisions that were taken to overcome the consequences of the dramatic public interventions. 145

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The global financial crisis and its budget impacts in OECD nations

Preparedness

Conditions Response

Resilience Restoration

Reforms Budgetary Trajectory

Figure 6.1  Three phases of the Dutch budgetary responses to the crisis This chapter analyzes the budgetary challenges and policy responses of the Netherlands, divided into three key phases. Figure 6.1 attempts to capture these three phases and the budget trajectory followed by the Dutch government. The first phase reviews the preliminary conditions and degree of preparedness of the Dutch budgetary system ahead of the financial crisis. The second phase concerns the policy responses and resilience of the budgetary system throughout the crisis. And the third phase traces the trajectory of restoration and the reform of public finances in the aftermath of the crisis. Using these three phases it is possible to explore the significant budgetary (and other policy) responses before, during and after the GFC. The sequencing also allows the analysis to focus on the critical institutional junctures and decision-­making trajectories shaping the policy responses. The first phase provides a snapshot of the financial and economic state of the Netherlands before the crisis crossed the Atlantic. Presenting an overview of the Dutch economy, concentrating on the state of the public finances, provides a point of departure to assess the later responses. It is important here to explore the fundamental principles of public budgeting as they have evolved in the Netherlands and to explain why the Dutch government was primarily focused on the reduction of the state debt and



Budgetary challenges in the Netherlands ­147

the control of public deficits by striving for balanced budgets through a model of a ‘trend-­based budgetary policy’. This phase is accompanied by an institutional overview of the prominent actors in the budgetary process and the financial sector. The analysis of the second phase focuses on the policy responses and budgetary resilience in the midst of the crisis. It describes how the GFC first hit the financial institutions and afterwards dragged the national economy into recession. From an international comparative perspective, the Netherlands has a relatively large financial sector with some of the world’s leading banks and financial institutions, and stabilizing this sector had an enormous impact on the national economy. The combined stabilization and stimulatory responses of the government created long-­term budget deficits and escalating levels of public debt. It also showed the resilience of the Dutch budgetary system and its ability to withstand these severe hits, not merely through budgetary responses but also within the context of the overall resilience of the Dutch economy to such exogenous shocks. After analyzing the immediate responses of the Dutch government, this section then discusses the institutional junctions at which crucial decisions were taken, especially by the Finance Ministry. Logically there would appear to be a central, directive role for the Ministry of Finance in combating the crisis and preparing the appropriate responses. After all, the Finance Ministry had already acquired a ‘unique and u ­ nprecedentedly dominant role in reshaping the country’s financial system’ (de Vries and Bestebreur 2010: 235). While senior officials in Finance were keen to adopt a proactive leadership role to enable quick and responsive actions, nevertheless the existing institutional checks and balances could not be forgotten. How then were the actual decisions taken? Did the formal decision-­making procedures remain important or were they replaced or supplemented with more ad hoc informal decision-­making procedures? One of the consequences of the crisis was that the core budgetary executive was opened to new institutional actors, who fought to have influence alongside the prominent role of the Ministry of Finance. The third phase focuses on the restoration and post-­crisis reform initiatives. After the financial crisis had passed and financial markets began to stabilize, the Ministry of Finance urged the government to prioritize the consolidation and recovery of public finances as soon as possible. Consolidation required hard political decisions be taken to bring the public deficit back into balance and curtail the explosive growth of public debt, restoring it to the level it was before the global crisis. This section describes the likely longer-­term impact of the financial crisis on public finances and charts the attempts the government has made to rebalance the budget over

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The global financial crisis and its budget impacts in OECD nations

the medium term. The post-­crisis decision-­making process again crucially involved the Ministry of Finance using its influence to force the government to embrace the goal of fiscal consolidation in the immediate term, but, as will be shown, the process inevitably became highly political. While the domestic budget system was still grappling with the process of reform and restoration, another overarching crisis arose. The GFC shifted in magnitude from a credit crisis affecting unstable domestic banks to a crisis of unstable European countries. Subsequent waves of further financial instability led to serious crises in the eurozone and involving the European Central Bank (ECB). Hence in this section of the chapter the focus returns to the international context, reviewing the ongoing responses of international institutions, such as the European Union (EU), the G20 and individual European governments. The instability in the so-­called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) led to the establishment of the European Financial Stability Facility (EFSF) in July 2011 to support these troubled nations. Finally, the chapter concludes by speculating whether the ongoing negotiations designed to manage the post-­crisis consequences for these eurozone nations reflects a concern with the sustainability of European public finances in general, or a concern to protect the domestic finances of those European countries not so affected. The constant interplay between national policies and European and international imperatives across the post-­crisis period raises the question whether budgetary systems should be analyzed on a national level or at an integrated international dimension. The overall argument of this chapter is that the GFC forced the Dutch government to abandon its standard budgetary practices and prudent policy settings almost overnight. It was forced to address the unique circumstances of the crisis in an endeavor to produce solutions to the crisis, initially within its own national confines and subsequently within the entire eurozone community. As subsequent crises reverberated through the European financial systems, it is argued that budgeting in the post-­crisis world is not simply a process of designing the most appropriate national financial measures in isolation, but one involving highly charged political decision-­making and negotiation in an interconnected international context.

PHASE ONE: THE ECONOMIC PRECONDITIONS AND BUDGETARY PREPAREDNESS PRIOR TO THE GFC To understand the budgetary trajectory prior to the financial crisis it is necessary to describe some important relations between the budgetary system



Budgetary challenges in the Netherlands ­149

and the financial sector. An important institution in the Dutch budgetary system is the Bureau for Economic Policy Analysis (CPB), which analyses the effects of current and future government policies. Besides in-­depth scientific research, its role is most apparent in its quarterly economic forecasts of the Dutch economy. These forecasts form the basis for parameter-­ setting in budgetary decision-­making in the Finance Ministry. The CPB also plays a role during elections by publishing a four-­year period forecast prior to the elections to assist political parties develop their policy plans; it also analyzes the economic effects of the policy proposals in the election manifestos of almost all parties at the outset of the election campaign. As an independent advisor and arbitrator the CPB has clearly contributed to budgetary discipline. There are other important institutional interdependencies between government and the financial sector, where two supervisory bodies ensure that close relations exist between the Ministry of Finance and the banking world. First, the Dutch central bank (De Nederlandsche Bank or DNB) is responsible for supervision of the ‘solidity’ of the other financial institutions (banks) and pension funds and generally monitors financial stability in the Netherlands. Its working relationship has been enhanced in a new agreement made in 2006 by the Minister of Finance and the DNB on the exchange of information, consultation on financial stability and crisis management (Ministerie van Financiën 2007). While responsibility for monetary policy has been transferred to the ECB, the Finance Minister is still politically responsible for the effective functioning of the financial system and can resort to a range of public policy and regulatory means when facing a possible crisis. Should the financial stability of the entire financial market or an individual institutional player come under pressure, the Ministry is represented on the ‘crisis team’ of the DNB. The DNB, however, is tasked with acting as the primary crisis manager. The second supervisory body is the Authority for the Financial Markets (AFM) which is the financial services regulator for savings, borrowing, investment, pension and insurance markets. The AFM and DNB usually work closely together in providing regulatory advice. Just before the financial crisis, the Dutch financial sector had already faced a traumatic episode. This was due to speculation that the international mega-­bank ABN-­AMRO was in financial trouble and would either be broken up or undergo a possible merger (perhaps with another Dutch bank such as ING) or even be acquired by foreign investors. When ABN-­AMRO decided to merge with another bank, initially the British Barclays Bank emerged as the favorite prospective buyer, but a rival consortium of banks (consisting of the Royal Bank of Scotland, the Belgian Fortis and the Spanish Banco Santander) finally outbid Barclays. The successful bid by the consortium proposed the

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The global financial crisis and its budget impacts in OECD nations

disestablishment of the ABN-­AMRO bank. Before ABN-­AMRO could be legally acquired, both the DNB and the Ministry of Finance had to give their approval for the takeover, which they ultimately gave. But afterwards a parliamentary investigation committee criticized the Minister and the DNB, stating that neither should have given approval since the financial stability of the Netherlands had now been placed at risk (Commissie de Wit 2010). The new risk was created by the fact that the Dutch bank would be owned by the smaller Belgian Fortis group, which was itself financially unstable even before the GFC hit (and Fortis only managed the takeover by issuing extra shares in itself). Before the Crisis: Striving for Annual Budget Surpluses Before investigating the impact of the financial crisis on the public budget and budgetary system, it is necessary to survey the pre-­existing economic circumstances, the state of public finances prior to the crisis, and the political situation. This provides a benchmark against which to judge the subsequent preparedness of the budgetary system to respond to the global financial crisis. The Dutch economy was clearly gaining strength in the years before the GFC, and, after a slow rate of economic growth over 2002 and 2003, the economy improved to a growth of 3.4 percent of GDP in 2006 and even to 3.9 percent in 2007. The flourishing economy served the government well in keeping the budget in balance, since revenues from company and income taxes increased while expenditures on unemployment benefits decreased, due to a very low unemployment rate of just 3.8 percent in 2008. In the first half of 2008, economic growth began slowing down principally because of uncertainty in world financial markets and a faltering of international trade. At the beginning of 2008, when the crisis was looming but not yet apparent in Europe, the state of the Dutch public finances was relatively satisfying from an international comparative perspective. The national debt had dropped over past decades, from 77 percent of GDP in 1990 to 45 percent in 2007. Since 1983 Dutch cabinets have placed more emphasis on reducing the budget deficit and bringing the ever-­increasing state debt down to manageable proportions. During this period, the huge budget deficits of around 9.5 percent of gross domestic product (GDP) in 1995 gradually diminished, and by 2000 a couple of budget surpluses were achieved. The euphoric sentiment soon passed when the budget again fell into deficit, caused by the dot-­com collapse (or ‘Internet bubble’) together with societal unrest post the September 11 terrorist attack in the US. To re-­establish control over public finances, the first three Balkenende cabinets (2002–06)



Budgetary challenges in the Netherlands ­151

had to impose severe budget cuts. The fourth Balkenende cabinet, installed in 2007, benefitted automatically from the high levels of economic growth and recorded budget surpluses, although it did not manage to achieve the much-­heralded budget surplus of 1 percent of GDP. So, immediately prior to the point at which the main impact of the crisis hit the Netherlands, the situation was that government was in the process of making public finances sustainable for the future; national debt was continuing to decrease and reached its lowest point in 2007; and the public budget was gradually being fortified to enable it to meet the expected future expenditures on old-­age pensions and healthcare driven by demographic factors. In absolute terms, the level of the national debt had become relatively constant over the decades since 1990, fluctuating between €200 billion and €250 billion per annum. Consequently, with a growing GDP, the national debt expressed as percentage of GDP dropped markedly over a 20-­year period. Fiscal Discipline Using ‘Trend-­Based Budgetary Rules’ The aim of the Dutch government to realize a structurally balanced budget was driven by high annual deficits at the outset of the 1980s and seemingly ever-­increasing public debt. Because the increasing debt level was accompanied by increasing interest expenses, the pressure on the annual budget was persistently rising. In 1994 the new Finance Minister from the Liberal Party, Gerrit Zalm (1994–2002 and 2003–07), introduced his ‘trend-­based budgetary policy’. Previous budget estimates had been based on overly optimistic predictions that were susceptible to the economic cycle. The new budgetary policy was henceforth based on cautious (or prudential) economic and fiscal predictions, whereby the chance of unexpected deficits was severely reduced. Trend-­based budgetary rules were intended to produce budgetary balances in the medium term, with room for fluctuations within defined parameters. Furthermore, the Ministry of Finance began to treat revenues and expenditures as if they were strictly separate. Windfalls to the government’s revenues could not be used automatically for additional expenditures, and had to be used to repay public debt. On the other hand, expenditures were limited by fixed annual expenditure ceilings, which were agreed and stipulated for four years out at the start of a new coalition cabinet. When a ministry faced setbacks (or overspending) in one set of budget expenditures, it had to economize in other policy areas within the same budget. Another aspect of the new policy was the creation of one principal moment of decision-­making to calm budgetary processes. The new budgetary trend-­based rules reduced the influence of economic cycles on the public budget and enabled a more balanced and stable budget to be

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The global financial crisis and its budget impacts in OECD nations

created, with only the possibility of slight annual variations. It proved to be successful in limiting expenditure growth for most of the first decade of the 2000s. Although the government complies strictly with its budgetary rules, these rules are not enacted in law. Compliance with budgetary rules is based on a widespread budgetary discipline among actors at the political and the civil servant level. Since the main budgetary rules are devised at the start of a cabinet, simultaneously with the creation of a coalition agreement, governments have a strong commitment to adhere to their own budgetary rules. The fiscal discipline imposed by the Ministry corresponds to the standards set in the Stability and Growth Pact (SGP) of the Economic and Monetary Union (EMU) created in 1997, which focused on medium-­term sustainability and insisted member states maintained budget discipline by allowing them to have a maximum deficit of no more than 3 percent of GDP. The budget discipline was imposed to limit the possibility that member governments could (accidentally or deliberately) exert inflationary pressures on the economy of the eurozone. The EMU framework has become a new tool for the Minister of Finance in the Netherlands to achieve and enforce fiscal discipline domestically (de Vries and Bestebreur 2010). In Box 6.1 the main budgetary rules of the Balkenende government are shown, before changes were made due to the financial crisis. Although most budgetary rules have already been explained, the ‘signal value of 2 percent’ has not yet been introduced. This rule of the Balkenende government was created as a signal that would be triggered in the event that the deficit was approaching the 3 percent limit under the SGP, requiring immediate reparation measures to be undertaken. It would appear, therefore, that the Dutch government had been strengthening its budgetary system during the years of high economic BOX 6.1 BUDGETARY RULES BEFORE THE FINANCIAL CRISIS ● ● ● ● ● ● ● ●

One annual principal moment for budgetary decision-­making; a strict separation between revenues and expenditures for control purposes; expenditure framework with ceilings; cautious economic predictions and projections; fixed revenue framework; automatic stabilization policies; a ‘signal value’ in the event of a projected deficit reaching 2 percent of GDP; and compliance with Stability and Growth Pact.



Budgetary challenges in the Netherlands ­153

90 80 70 60 50 40 30 20 10 0 1960

1970

1980

1990

2000

Source:  Centraal Bureau voor de Statistiek (CBS).

Figure 6.2 Public debt as a percentage of GDP, 1961–2010 (with projected debt levels prior to the GFC) growth primarily to put its public finances on a sound footing. In the years before the financial crisis, governments realized budget surpluses and the level of state debt was decreasing (see Figure 6.2). The use of trend-­based budgetary rules provided the capacity for government to loosen the budget strings during economic cycles, while still remaining constrained by the standards of the SGP. Although public finances were in order, the Dutch budgetary system was constructed to achieve stability and continuity in the government’s fiscal policy; arguably, it was not designed or prepared to absorb the consequences of the global financial crisis. The Political Context: Stable but Tense Politics The Netherlands has a multiparty democracy based on proportional representation, with governments formed by coalitions. The position of the central government in relation to local governments is relatively strong, although many tasks are decentralized to provinces and municipalities. Politics and governments have been dominated by three major parties competing around the center: the Labor Party (PvdA), the Christian Democrats (CDA) and the conservative Liberal Party (VVD). Decision-­making was created by consensus, often in close cooperation

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The global financial crisis and its budget impacts in OECD nations

with employers’ organizations and labor unions. But in the last decade politics has become polarized with the emergence of populist parties at the left and right. After the elections in late-­2006, the fourth Balkenende cabinet was formed between the Christian Democrat Party (CDA), the Labor Party (PvdA) and a small Christian party (Christen Unie) in early 2007. A continuously tense relationship existed between the two major coalition parties, who had opposed each other fiercely during the election campaign. During their period of office they experienced great difficulty in making decisions on economic and budget issues. This center-­left coalition was in government at the start of the financial crisis. Nevertheless, among most political parties – within and outside government – there existed agreement on fiscal discipline, a balanced budget and the aim for a reduction of state debt.

PHASE TWO: RESPONSE AND RESILIENCE IN THE FACE OF THE GFC The Arrival of the Crisis The GFC hit the Netherlands and Europe relatively late. The initial reaction within the Ministry of Finance and the Dutch Central Bank was that the financial crisis was mostly a US problem contained to US mortgage lenders. When the real estate bubble burst, the financial sector in the United States was left holding toxic assets and had to depreciate much of its capital. But the US banks were soon followed by their European counterparts. The Dutch financial sector, which had grown rapidly during the last decades, had become the ninth-­ largest financial sector in the world, mostly because of internationalization of its activities. Before the GFC, the financial sector had been expanding at a rate far higher than the average growth of GDP, to a size where the collective balance sheets reported a value of 400 percent of GDP. Not only had the financial sector grown but it had also become more complex, with the traditional Dutch retail banks becoming transformed into international investment banks. When the US-­induced crisis appeared, it soon transpired that Dutch banks and insurance companies were heavily involved in American mortgages. The worst problem of exposure existed at the Belgium bank Fortis, which incorporated the Dutch branch of the ABN-­AMRO bank. Fortis was suddenly short of capital, caused largely by the earlier acquisition of the Dutch bank. As the financial stability of Fortis/ABN-­AMRO became a cause of real concern (followed by other major financial institutions), the only solution was an intervention by the state.



Budgetary challenges in the Netherlands ­155

Decline of World Trade and the Dutch Open Economy In addition to the financial crisis, an economic crisis was ensuing. Although the size of the financial sector is large and has influenced the economic growth negatively, the recession was mostly caused by a decline in world trade. The Netherlands has a strong open economy, depending on international trade volumes. It is strongly dependent on exports, and a third of Dutch GDP is directly or indirectly influenced by developments abroad (CPB 2009). The Dutch economy is particularly reliant on developments in the economy of Germany. The expected economic growth in 2008 changed from a projected increase to a decline of 3.9 percent of GDP, the largest decline since World War II. The economic downturn led to declining tax revenues and to higher expenditures on unemployment payments. These automatic stabilizers remain relatively strong in the Netherlands (Studiegroep Begrotingsruimte 2010a). Furthermore, revenues from gas extraction decreased sharply, caused by a decline in the oil price. The Dutch government faced these initial consequences in 2008 and still had to intervene in the financial sector, with enormous budgetary consequences. Decisive Intervention in the Financial Sector The response of the government to counter the consequences of the financial crisis was plural and distinctive. It tackled three sequential priorities: (1) restoring the stability of the Dutch financial system in the short term; followed by (2) policies to support the real economy; and ending with (3) policies to rebalance the public budget and stabilize the abrupt growth of the state debt. The US housing bubble created a situation where mutual distrust occurred among the banks that precipitated the global financial crisis. The fall of Lehman Brothers in September 2008 then accelerated the crisis and severely lowered the already wavering confidence across the financial sector. When the Dutch Minister of Finance, Wouter Bos of the Labor Party (PvdA), presented the Budget Memorandum in September 2008, there was still confidence that the financial crisis would remain predominately an American problem. When the Belgium bank Fortis became one of the first European banks to hit financial insolvency, it was realized that the credit crisis was global, and the governments of the Netherlands, Belgium and Luxembourg decide to intervene by a partial nationalization of Fortis to the tune of 49 percent. This intervention was praised by the market, since it seemed that the government’s action would restore the stability of Fortis. Yet despite the concerted intervention of the Benelux

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governments, the value of Fortis further declined and major customers withdrew their savings from the bank. The Ministry of Finance was again forced to intervene. The Dutch government decided to nationalize the entire Dutch banking and insurance divisions of Fortis. The plan was to renegotiate with the Belgium government over its share of the purchase. After negotiations on an official level did not succeed, the prime ministers of both countries finally agreed on the sum of €16.8 billion in a one-­for-­ one negotiation. The Dutch government accepted liability for €34 billion worth of short-­term loans and €16 billion of long-­term loans. Although the Dutch government acted quickly over the domestic market, the international market was still in meltdown. Further problems occurred in Iceland, where the government was not able to intervene in the fall of the bank Landsbanki, which owned the brand Icesave. At relatively short notice, Iceland and the Netherlands agreed on a loan by the Dutch government to prefund Icesave’s deposit guarantee payments. The Dutch government further extended the amount which would be covered by the deposit guarantee scheme to €100 000. The extension of the scheme was a result of a joint strategy at a European level to restore confidence in the financial sector. Two days later, the Dutch government created a facility providing capital injections to financial institutions. Three banks and insurance companies made use of this facility for a total amount of €13.75 billion. These injections were used to strengthen the capital position of these institutions. Furthermore, the government created a guarantee facility, consisting of €200 billion for bank loans. The last intervention was the creation of a back-­up facility for the ING bank, which owned a portfolio of securitized mortgage loans. The arrangement was aimed at lessening the risks for ING. Table 6.1 summarizes the interventions and financial injections by the Dutch government. Together, these government interventions came to €80 billion (€30 billion for shares in the capital of banks, and €50 billion for the acceptance of liability for Fortis’s debts). These expenditures were not at the expense of Table 6.1 Interventions and financial injections by the Dutch government Interventions

Financial injections (€)

Acquisition of Fortis/ABN-­AMRO Acceptance of liability of Fortis’s debts Capital injection facility Prefunding of bank deposit guarantee payments Iceland Bank loan guarantee facility Backup facility for the ING bank Source:  Algemene Rekenkamer (National Court of Audit) (2009).

16.8 billion 50 billion 13.75 billion 1.236 billion 200 billion 27 billion



Budgetary challenges in the Netherlands ­157

the public budget, but were counted directly against state debt. This consequently led to an increase in outstanding liabilities but also to the acquisition of more assets. The direct financial interventions, therefore, did not impact on the immediate budgetary position, but the additional interest to be paid on the enlarged debt would have longer-­term implications. Initially, these costs were not included in the aggregate expenditure ceiling (which also applied to the dividend the government hoped to earn from its holdings in the financial institutions). In the event, the backup facilities offered by the government were not used, but the guarantees explicitly created risks for the government. The final price tag of the nationalization of Fortis/ABN-­ AMRO still remains unknown, since the government intends to privatize the bank as soon as the market will allow. Hence, whether the government will finally make a profit or a loss on the nationalization is still unclear. The contractual terms for the capital injections into the financial institutions were aimed to terminate state investment as soon as possible and to create a positive financial outcome for the government. To finance the capital injections into the banks, the Finance Ministry had to attract capital from the market at very short notice. This sudden demand for capital led to an increase in the interest rate on Dutch loans, which consequently increased budgetary expenses. The interventions and guarantees of the Dutch government, expressed in GDP, are the highest in the EU, caused by its relatively big financial sector. A Small and Late Stimulus Package The government’s second response was fiscal and was aimed to mitigate the effects of the widespread onset of economic recession. The immediate effects domestically were manifest: a decline in private spending, a decrease in investments and a sharp decline in world trade. So, after sustaining the staggering financial sector with emergency interventions, the government decided to support the real economy with the implementation of economic stimulus packages. The resurgence of these Keynesian policies began in many of the English-­speaking nations, followed by the larger European countries, with agreement on the need for stimulus packages orchestrated by the G20. While other countries supported their economies with billions of euros, the Dutch government was relatively parsimonious in devising a rescue plan for its own economy. In view of the fact that the Netherlands remained an open economy with a great dependence on world trade, the Dutch economy stood to gain substantial benefits from the stimulus packages in other countries. This free-­rider behavior was criticized by other EU members and the European Commission (EC). Yet the government faced continuous difficulties in deciding on the appropriate action because of the

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different preferences of the coalition parties. One of the coalition partners was hesitant to increase public spending, since it argued that this would serve to increase the deficit. Furthermore, there was reluctance within the Finance Ministry to implement stimulation policies, since these were considered to be ineffective even when targeted, timely and temporary. It believed that a domestic economic stimulus package would only provide limited support to the Dutch economy, since for each euro the government expended, 60 cents would leak abroad. These considerations influenced the timing of the Dutch stimulus package, presented in early 2009. Since the trend-­based budgetary policy was based on hard estimates and is fixed in the coalition agreement, a supplementary policy agreement had to be created by the coalition partners. The stimulus package focused on temporary and targeted policies, and was mostly directed at maintaining employment. The cabinet decided to support the economy with €6 billion over 2009 and 2010. It included the following measures: ●● ●● ●● ●●

restoring and maintaining employment by facilitating part-­ time unemployment benefits and providing retraining; fiscal measures to support companies; supplementary and speedy investments in housing and infrastructure projects; and stimulation of the transition towards a sustainable economy (see Ministry of General Affairs 2009).

The stimulus package was too small to make a substantial contribution to supporting the economy, and it was felt that a more substantial stimulus package would only lead to a further deterioration of the public budget without actually boosting the economy. Nevertheless, the stimulus package was seen as a positive contribution to maintaining employment, although it was not subjected to fierce political debate due to its relatively small size. In addition, the automatic stabilizers of increased spending on unemployment benefits and declining revenues also produced a stimulus of €60  billion, at a cost to the public deficit. Figure 6.3 shows the debt generated by the fiscal stimulus. Hence, the expenditures on the stimulus package and the extra expenditures caused by the automatic stabilizers both influenced the public budget negatively. The government decided to temporarily exclude expenditures on unemployment benefits and interest from the pre-­ agreed ­expenditure  ceiling, principally because it could not contain these rising expenditures and maintain the ceiling. The government did not wish to apply the brakes too severely, since any recovery would otherwise be



Budgetary challenges in the Netherlands ­159

% of GDP 70

Other debt

Debt by interventions in the financial sector

60 50 40 30 20 10 0

2007

2008

2009

2010

Source:  Ministerie van Financiën (Ministry of Finance) (2007).

Figure 6.3  Level of public debt in GDP augmented by the fiscal stimulus

BOX 6.2 BUDGETARY RULES ADOPTED DURING THE FINANCIAL CRISIS ● ● ● ● ●

Expenditures and revenues associated with the interventions in the financial sector remained ‘off-­budget’; a loosening of the expenditure and revenue framework was permitted; expenditures on interest payments, unemployment benefits and the stimulus package were excluded from the previously approved expenditure ceiling; the ‘signal value’ applying when the deficit hit 2 percent of GDP was temporarily suspended; and the government recommitted itself to comply with the Stability and Growth Pact.

impaired. The budget surpluses of 2007 and 2008 declined dramatically to a deficit of minus 5.5 percent of GDP in 2009 and minus 5.4 percent in 2010. The dramatic increase of state debt in 2008 (see Figure 6.3) was almost completely caused by the interventions in the financial sector, while the growth in debt in the following years was primarily a consequence of the accumulated public deficits. The new budget rules adopted by the government during the crisis are indicated in Box 6.2.

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The global financial crisis and its budget impacts in OECD nations

THE EFFECTS OF THE CRISIS ON THE INSTITUTIONAL FRAMEWORK OF BUDGETING Decision-­Making in the ‘Budgetary Village’ The budgetary institutional framework in the Netherlands is characterized by Heclo and Wildavsky’s (1974) ‘village life’ metaphor, which depicts the relationships among the various budget actors. A small, influential and close-­knit network was responsible for the budget-­making process, which was technocratic in nature and focused on internal organization. This insular ‘village’ of the budgeting network has been gradually transformed into a global or ‘international cosmopolitan city’ (de Vries and Bestebreur 2010), where new actors influence budgeting processes as the old ‘village’ was gradually opened up to influences from outside. The behavior of these budgeting actors became increasingly influenced by global developments, and predominantly by the behavior of significant external players, such as the EU, the ECB and the International Monetary Fund (IMF). During the global financial crisis it could be observed that a close reciprocity developed between the internal and external actors in the village. Alongside the gradual transformation of the financial ‘village’, there emerged a predisposition to insist on fiscal discipline among actors in the budget-­making process. The traditional struggle between the spending departments and the Ministry of Finance gradually swung to the advantage of the latter. The Limitations of Politics Under normal conditions, the budgetary process is standardized through the trend-­based budgetary rules where annual budget decisions are taken in spring and the budget is presented in September. Since the Netherlands is a parliamentary democracy, the right to authorize and scrutinize the budget is at the heart of parliamentary power. However, during the crisis when the government decided to intervene in the financial sector and spend billions overnight on capital injections, the usual formal decision-­making procedures were abandoned. This meant that parliament did not give its approval to these expenditures. Furthermore, cabinet ignored the long-­ standing rule stating that it must inform parliament if and when the government acquires shares in private concerns. For reasons of confidentiality, sentiments concerning the financial markets and the urgency of action, the cabinet did not have the opportunity to respect the budget right of parliament (Ministry of Finance 2008). When the government was forced to nationalize Fortis and accept liability for its bad loans, the parliament took the view that ‘necessity knows no law’ in such extraordinary circumstances.



Budgetary challenges in the Netherlands ­161

It gave the government a free rein because it did not want to hamper ‘a fireman fighting a fire’. Although parliament provided scope to the Finance Minister, Wouter Bos, to manage the crisis, it was suspicious about the origins of the financial crisis. Parliament decided to establish a parliamentary committee to investigate the origins of the crisis and the government’s handling of the crisis. The so-­called Temporary Committee Investigation Financial System, or the ‘Committee De Wit’, named after its chair, was installed in 2009. The first report on the origins of the crisis in the Netherlands found that the crisis started in the real estate sector. The committee also came to the opinion that the inspection and compliance monitoring of the Dutch government and the Dutch central bank had both failed. The second inquiry report in particular focused on the actions taken by the Minister of Finance and the Finance Ministry during the crisis and was critical of both. The National Court of Audit was also critical of the cabinet ignoring the budgetary rules, and since that time the court has taken on itself the legal task of controlling government expenditures. ’War Rooms’ in the Ministry Parliament played only a marginal role during the heat of the crisis, while the Ministry of Finance had a decisive role. During the crisis the traditional hierarchical organization of the ministry became more organic. First, cross-­ sectional crisis teams were formed across the department because flexibility was seen as a main priority to counter the unpredictable market. In these ‘war rooms’, teams of civil servants worked to manage the crisis. The staid routines of the Ministry had to cope with an unpredictable financial crisis and, almost overnight, the department was obliged to function as a crisis manager. Second, the relations between politicians and civil servants were blurred and the budget process became more informal. Traditionally, there existed a clear hierarchical relationship between the Minister and the civil service. On these cross-­sectional teams the civil servants became preoccupied with techniques, while the politicians focused on solutions. In addition to these teams, there already existed an informal cross-­sectional consultative body within the Ministry of Finance. This informal body of senior civil servants met occasionally to discuss public finances. During the crisis, this consultative body met far more often to discuss government actions and the consequences for public finances. This informal but organized consultation served as a platform for coordination and consideration.

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The global financial crisis and its budget impacts in OECD nations

The Prime Minister as a Significant Budget Actor The GFC also enhanced cooperation between the Ministry of Finance, the Ministry of General Affairs and the Prime Minister’s office. Traditionally there exists a close cooperation between the Prime Minister and the Minister of Finance. To achieve fiscal discipline, the Minister of Finance needs the backing of the Prime Minister to keep expenditures of spending departments of other ministers under control. During the crisis coordination took place on a European level, within the EU and the eurozone, and on a global level within institutions such as the G8, G20 and the IMF. Within these institutions there is a prominent role for first ministers, which strengthened the position of the Dutch Prime Minister on financial issues. Although the relationship of the Dutch Prime Minister (PM) and Minister of Finance was known to be tense, during the crisis they nevertheless worked well together. With the crisis at its height and governments around the globe fighting it, many government leaders received considerable support for their actions from their electorates, reflected in favorable polls. In the Netherlands it was the Finance Minister who earned the credit for handling the crisis, which created further tensions with the PM. Nevertheless, cooperation at the civil service level remained strong, with senior civil servants of the Ministry of Finance seconded to the Prime Minister’s office. Because a large measure of budgetary decision-­making took place at the international level, the ‘village’ too became i­nternationalized, providing more scope for the Prime Minister to act in this network.

PHASE III: POST-­CRISIS RESTORATION AND REFORM Tackling the Consequential Budgetary Challenges The previous section discussed the government’s actions when the crisis was at its height. How severely the crisis impacted on public finances can be seen in Figures 6.4 and 6.5. The dotted line indicates the trajectory of public debt (Figure 6.4) and public deficit (Figure 6.5) as predicted in the economic outlooks of the CPB before the crisis emerged (cf. Figure 6.2, previously). As a result of the GFC, public debt increased sharply from 45.3 percent of GDP to a predicted 65.5 percent in 2011, transgressing the European budgetary rules. The budgetary surplus evaporated, leaving an unusual annual deficit of minus 5.4 percent of GDP, again exceeding the allowed 3 percent set by the Stability and Growth Pact.



Budgetary challenges in the Netherlands ­163

80

70

60

50

40

30

1990

1994

1998

2002

2006

2010

Note:  Predicted debt is indicated by the dotted line. Sources:  Centraal Planbureau (2007–11).

Figure 6.4 Public debt as percentage of GDP, 1990–2011, actual and predicted When the storm passed, the Dutch government realized that the budget had to be repaired, deficit rates had to be reduced and further growth of the public debt had to be brought to an end, since the sustainability of public finances, and even the welfare state, was under threat. It was the Ministry of Finance which directly urged repairing the budget in order to regain sustainable public finances. The primary objective of government during the crisis was to stabilize the financial markets, to support the economy and to keep people working. The emphasis soon shifted to the reduction of the deficit, which required severe budget reforms. To realize a healthy budget, sustainable for the future, fundamental political choices had to be made. In the long-­term recovery plan, ‘The Netherlands 2020’, the following seven ambitions were announced (Ministry of Finance 2010a): ●● ●● ●●

putting the financial sector in order; implementing a sustainable energy and climate policy; fighting unemployment and increasing labor market participation;

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The global financial crisis and its budget impacts in OECD nations

3 2 1 0

1996

2000

2004

2008

2012

–1 –2 –3 –4 –5 –6 Sources:  Centraal Planbureau (2007–11).

Figure 6.5 The public deficit as a percentage of GDP, 1996–2011: actual and predicted annual change ●● ●● ●● ●●

revitalizing civil society; stimulating growth, knowledge innovation and enterprise; conducting broad-­based reviews; and reforming the tax system.

To enable fundamental policy reform, more insight was needed into the potential policy options and their budgetary and other consequences. Twenty teams of civil servants were asked to independently investigate possible budget cuts in various policy areas. These professional teams delivered a veritable shopping cart of policy choices aimed at reducing spending. Since the general elections were brought forward, due to the collapse of the Balkenende cabinet in February 2010, the expenditure reviews by the Ministry of Finance were also published earlier. Another  report published by the Ministry of Finance was made by the Budgeting Framework Commission (Studiegroep Begrotingsruimte). The commission consisted of high-­ranking officials from the Ministry of Finance, the CPB, the DNB and other involved ministries. Traditionally, this group draws up an advisory report on fiscal principles and budgetary targets



Budgetary challenges in the Netherlands ­165

before a new government is installed. While its studies are advisory, its findings and recommendations have proven influential. In its  thirteenth report (Studiegroep Begrotingsruimte 2010b), which advised  the Cabinet on the budgetary restructuring, budgetary targets and the budgeting framework, it advised that the cabinet could save €18 billion in the ­following cabinet period to improve the budget and prevent debt levels rising further. It also advised the new cabinet on public reforms  for the long term which should structurally save €29 billion to secure a ­sustainable budget. The commission argued that savings measures were not enough to produce a sustainable budget, since ‘structural challenges ask for structural solutions’ (Studiegroep Begrotingsruimte 2010b: 14). The outgoing fourth Balkenende cabinet did not have the ability after February 2010 to restore the public budget since they only acted as care­ takers until they were succeeded. The parliamentary elections of 2010 mainly focused on solving the economic crisis and restructuring the public budget. The election campaign mostly discussed the policy directions and severity of budget cuts. The Ministry of Finance’s expenditure reviews served as an important source of information, both for political parties during the campaign and in the process of forming a coalition. The Ministry of Finance in this way framed the budgetary challenge, while the CPB also contributed to the contextualization of the budget trajectory. New Budgetary Challenges and Rules In October 2010 the new minority government of the Liberal Party (VVD) and the Christian Democrat Party (CDA) was installed. This coalition enjoys a parliamentary support agreement with the right-­wing Party for Freedom (PVV). The primary agreement between the coalition parties and the PVV is on fiscal consolidation, while there is no agreement on other economic, European or foreign policies. Budgetary policy has been quite constant since the introduction of the trend-­based budgetary policy in 1994. To gain more certainty regarding the realization of a balanced budget, the new government prioritized healthy public finances above stabilization policies (Ministry of Finance 2010b). The government decided to tighten budgetary rules concerning spending. It announced an ambitious budgetary target to economize €18 billion over the period 2011–15. The targets will be difficult to achieve and the intended expenditure reduction is quite sizeable in GDP terms compared with other countries driven by financial circumstances to cut budgets (OECD 2011). Under new budgetary rules (see Box 6.3), the expenditures on unemployment benefits and interest have now been placed under the expenditure ceiling. Moreover, the commercial activities associated with the financial

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The global financial crisis and its budget impacts in OECD nations

BOX 6.3 BUDGETARY RULES ADOPTED AFTER THE CRISIS ● ● ● ● ● ● ● ●

One principal moment for budgetary decision-­making; strict separation between revenues and expenditures; tougher expenditure framework with ceilings; cautious economic predictions; fixed revenue framework; introduction of a signal margin of 1 percent; expenditures and revenues from the commercial interventions in the financial sector and EFSF remain off-­budget; and compliance with Stability and Growth Pact and a budget surplus of 1 percent from 2015.

sector interventions remain off-­budget and outside the expenditure ceilings (Ministry of Finance 2010b). Hence, any future revenues will contribute to the repayment of public debt and cannot be used for additional expenditures. To achieve a balanced budget, government will continuously work at public deficit reduction according to the ambitions and the standards of the SGP. Were the reduction plan to fall behind, additional readjustments will be made. Therefore, the government introduced a signal margin of 1 percent compared with the economic outlook prescribed at the start of the government’s term. When the economic outlook indicates that a deficit of 1 percent is likely (the signal margin), additional reduction measures will be taken to accomplish the projected budget balance (Ministry of Finance 2010b). This new signal margin, thus, aims to strengthen the budgetary discipline. As the deepening crisis in the eurozone began to impact significantly on the domestic economy, ministry forecasts indicated the budget would soon be further challenged by a deteriorating economy. If the signal margin is breached, government will be forced to create a new package of budget cuts. Furthermore, the succession of financial crises has revealed significant collateral risks for government, for example, through the issuing of relatively open-­ ended guarantees given by governments to capital markets. To absorb these risks in the future, the Budgeting Framework Commission has advised the government to aim for a budget surplus of 1 percent after 2015.



Budgetary challenges in the Netherlands ­167

THE INTERNATIONAL INSTITUTIONAL DIMENSION It would be remiss to present the Dutch responses to the crisis in purely domestic terms. International obligations, multilateral treaties and other global coordinating influences each affected the internal fiscal responses and budgetary system. Indeed, the budgetary process was further internationalized by the financial crisis. As world trade and confidence in the international financial system fell dramatically, international coordination of the global financial crisis and the economic consequences was required. Many financial institutions and governments were surprised by the nexus of the international financial markets and realized that a common international approach was vital. The Dutch government has always been a strong advocate of international cooperation and was a founding member of most international organizations, both at the European and global level. International Forums While the Netherlands is the sixteenth-­largest economy in the world, it is not a part of the G20 and its participation in this forum depends on invitations by host countries. During the financial crisis, the Netherlands participated in most G20 meetings through intensive government lobbying. Initially as the GFC arose, coordinated European action proved difficult, fragmenting the individual policy actions by member states. The solution of the Netherlands to strengthen the capital position of its financial institutions in order to stabilize the market and strengthen confidence in these institutions was seen as a well-­founded solution internationally. British and French governments both adopted similar initiatives. Dutch participation in international forums tried to speed up decision-­making and harmonize international policies. Within the eurozone the primary focus of cooperation was not based on economic coordination but on budgetary coordination through the Stability and Growth Pact. The European Ministers of Finance declared that the Dutch government must reduce its budget deficit to below the ceiling of 3 percent by 2013 (CPB 2010). In 2010 the European Council decided sanctions for breaking the rules of the Pact needed to be increased, and that compliance of member states would be monitored more strictly by the Council. European Problems Require European Solutions Greater European cooperation became imperative when the GFC became a protracted sovereign debt crisis together with a crisis in the euro currency.

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The global financial crisis and its budget impacts in OECD nations

Rising government deficits and increasing state debts led to a loss of confidence in financial markets. The announcement of the misreporting of Greece’s financial statistics led to a downgrading of debt by various rating agencies. The crisis spread to other countries with high public deficits and structural economic challenges. Portugal, Ireland, Italy, Greece and Spain were all considered at risk. A subsequent increase in interest rates created problems for these countries in financing their debts. To prevent Greece from falling into the debt trap, the countries in the eurozone and the IMF created a fund facility for Greece, backed by guarantees by the eurozone states, the European Commission and the IMF. While the decision-­making was relatively expeditious, the structure of the facility was the object of fierce discussion. The Dutch government was an advocate of close collaboration with the IMF, since its participation obliged countries to make severe budget cuts and reform their economies. When Germany supported the Dutch proposal, the role of the IMF became explicit, largely because of the important role Germany has in this crisis as Europe’s largest economy. After Greece, both Ireland and Portugal followed with a request for financial support. Although the European governments created a facility to prevent a new crisis and stabilize the position of their currency, it became apparent that economic cooperation and harmonization of economic policies had to be strengthened. These actions were taken in a period when people were becoming more skeptical about further transfer of powers to the EU, such as the creation of an economic government. Although member governments realized that support to other eurozone countries was necessary to maintain confidence in the euro and to prevent a possible second financial crisis (and support for remaining in the EU remained high), there was serious criticism among the population and especially among the left-­and right-­wing populist parties. However, closer coordination continued to occur among member states, with many accepting that a form of economic governance will probably emerge. The euro crisis grievously revealed the economic imbalances between member states, whether in current account imbalances, differentiation in fiscal policies or the lack of any budgetary discipline. The Dutch government emphasized that at the European level member states should aim to comply with the Economic and Monetary Union (EMU) standards. Tough sanctions ought to be enforced, unlike the  episode in 2003 when Germany and France ignored and stretched the budgetary rules. Along with the ‘Pact for the Euro’, the rules of the Stability and Growth Pact were accordingly strengthened, by enforcing compliance with the automatic introduction of fines. The fiscal principles of domestic budget-­making were clearly reflected at the European level, by stressing the necessity for fiscal discipline, balanced budgets and a



Budgetary challenges in the Netherlands ­169

restraint on the annual growth of the European Commission budget. Each nation’s budgetary position is monitored by the European Commission and the Council of Ministers sets out the targets for the austerity plan. The Dutch government wants to strengthen the role of the Commission, by proposing a Commissioner responsible for the independent supervision of member states’ budgets, who sets requirements for the budgetary policy of countries which keep running excessive deficits. This Commissioner for Budgetary Discipline should have the ability to enforce compliance through a ladder of intervention, thereby superseding the guardianship by the European Commission. At the EU level, eurozone governments have created a ‘Pact for the Euro’ to strengthen the economic policy coordination for competitiveness and convergence. Those countries receiving loans through the EFSF have been inundated with unprecedented interference from the supra-­national EU impacting on their domestic public finances. Although European governments claimed they were overtaken by extraordinary events, the speed at which powers and controls were transferred to the European level was momentous. Although prognoses of further remedial actions remain speculative, all signs point towards greater economic political integration, such as with the establishment of a European Budget Authority or a European Monetary Fund. The GFC ratcheted up the level of European interference in national budgetary processes of the member states, leaving this as the main legacy of the GFC in Europe.

CONCLUSIONS Prior to the GFC hitting the Netherlands, its public finances were under control and looked sustainable for the future. Budgetary discipline over some 20 years had led to a decrease in public debt, and the introduction of the trend-­based budgetary policy further enhanced the improvements. This starting position of the Dutch government naturally influenced the response of government when confronting the crisis. It gave room to the government to intervene in the financial sector and to support the staggering economy. To the Dutch, the GFC emerged like a bolt from the blue, and the impact was severe. The size of the Dutch financial sector and the vulnerability of certain domestic banks forced the government to mobilize and act in an unprecedented manner. This explains why the government’s primary aim was to stabilize the financial market. Although the financial consequences of the bailouts were significant, the subsequent economic crisis pressed the budgets even more. As a consequence of the financial crisis and economic

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downturn, budgetary rules came under pressure. The Dutch government opted to relax the budgetary rules and give the economy room to recover. By excluding cyclical expenditures from the expenditure ceiling, automatic stabilization was intensified. The interventions in the financial sector and the relaxation of budgetary rules were in contrast with Dutch budgetary tradition as it had been developed. In contrast to most Organisation for Economic Co-­ operation and Development (OECD) countries, the government was reluctant to adopt stimulus policies, and the final stimulus package was relatively late and small. This was framed within the context of the openness of the Dutch economy. It was felt that the openness of the economy constrained any response, since Holland’s reliance on world trade impacted on the severity of economic downturn while on the other side it discouraged the government from making sizeable stimulus policies. Among the key actors in the budgeting process there existed skepticism towards Keynesian policies. Furthermore, the Dutch government focused on international cooperation to coordinate government actions and harmonize new budgetary regulations. The Netherlands has always been an advocate of regulatory frameworks to enforce international agreements, as evidenced in the strengthening of the Stability and Growth Pact of the eurozone. The budgetary challenge after the storm passed was sizeable and added to existing budgetary challenges in the long term caused by the ageing of the population. After the peak of the crisis passed, there was a sudden change of emphasis to reorder the financial markets and regain control of public finances. The emphasis on fiscal consolidation was further enhanced by elections in 2010 and the installation of a center-­right government. Remarkably soon after the crisis, the former pre-­crisis budgetary framework was re-­established. The rules of the trend-­based budgetary policy again became central, reinforcing the priority of fiscal discipline. This demonstrates a dedication towards the trend-­based budgetary rules, but also emphasizes that the financial crisis was handled as an extraordinary event. The impact of the financial crisis also put pressure on the institutional framework of the budgetary system. The crisis demanded flexible and decisive action, and in crisis mode the Ministry of Finance was given free rein. The ministry quickly re-­engineered itself into a more organic organization, with the emergence of informal and cross-­sectional structures. A pragmatic approach towards the budgetary rules clearly contributed towards an effective crisis response. Since the extant budgetary rules were not fixed in law, there was scope for the government to relax those rules during extraordinary circumstances. Rigid compliance with those rules would have limited the possibilities for the government to act. The relaxation of the budgetary



Budgetary challenges in the Netherlands ­171

rules was only temporary, and after the crisis the emphasis on budgetary discipline and fiscal consolidation was quickly reintroduced. Arguably, the state of the budget and the effectiveness of budgetary processes have become central in Dutch society and often constitute the heart of political debate. There has emerged a broad consensus supporting the necessity of budgetary discipline among politicians, administrative officials and the population generally. The health of the budget can be regarded as a core value within Dutch politics. Furthermore, the crisis gave the Ministry of Finance a unique role in reshaping the country’s financial system and budgeting system. In the restoration phase we can clearly observe an important leading role for civil servants of the Ministry of Finance and independent agencies such as the Bureau for Policy Analysis (CPB). After the crisis passed and governments were once again imposing restraints on government finances, a new crisis has appeared. The ­‘eurocrisis’ requires European governments both to cooperate in guaranteeing solvency and harmonizing economic policies. At the outset sovereign debt crisis was managed very cautiously (almost muddling through), although mounting concerns over the escalating size of the debt forced eurozone governments to offer increased guarantees through the EFSF up to €1 trillion to avert a new crisis. Accordingly, when analyzing the Dutch budget trajectory it is not sufficient to focus on the internal budget system and decision-­making. The GFC and the eurocrisis clearly demonstrate that the budget trajectory is in a continuous interaction with European and ­international rules, decisions and developments. In 2012 economic developments again changed the budgetary l­ andscape, especially in the political realm where the fear of economic slowdown and deterioration of public finances became reality and begged renewed action from government. Over these months the Dutch government faced several setbacks in its initial ambitious expenditure reduction plans. The expected budget deficit for 2013 would remain at 4.6 percent, despite having planned a much smaller one of 1.8 percent (CPB 2012: 79). The eurocrisis continued to affect the real economy, resulting in faltering economic growth and a decline in output caused by the shocks of the eurocrisis. Since the government tightened its budgetary rules after the GFC, the further deterioration of public finances should automatically compel them to take additional reduction measures when the signal margin of 1 percent is breached. Another development stimulated by the eurocrisis has been the increased understanding among European countries that fiscal discipline should be safeguarded more strictly. The EC, with the approval of the Dutch government, has used this momentum to sharpen its ability to control domestic finances and compliance to the rules of the SGP. In the Netherlands,

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the government’s own rules, together with the external pressure from the European level, pushed the government to find additional expenditure reductions above the agreed €18 billion. The government had to abandon its original plan of budget reduction, and was forced to follow the trajectory as set out by the EC, which obliged it to reach the 3 percent budget deficit target by 2013. With an expected deficit now of 4.6 percent, additional austerity measures need to be taken to reach this norm. The financial and economic instability across Europe, wherein the Dutch government operates, differs significantly from the fiscal conditions at the commencement of the GFC. The Dutch budgetary system proved to be resilient after the GFC forced the government to intervene in the financial sector and provide a breathing space to the economy. Now with a second setback in such a short space of time and the fiscal and economic challenges ahead, government should be vigilant, since the eurocrisis has greatly slowed down the pace of restoration and reform. Restoring control over public finances in the midst of a storm is a difficult job, but succeeding would again prove the resilience of the Dutch budgetary system.

BIBLIOGRAPHY Algemene Rekenkamer (National Court of Audit) (2009), The Financial Crisis, 2008–2009, Den Haag: Algemene Rekenkamer. Centraal Planbureau (CPB) (2007–11), Centraal Economisch Plan (Central Economic Outlook), Den Haag: Centraal Planbureau. Centraal Planbureau (CPB) (2011), Nederland en de Europese Schuldencrisis (The  Netherlands and the European Debt Crisis), Den Haag: Centraal Planbureau. Centraal Planbureau (CPB) (2012), Centraal Economisch Plan, CPB. European Central Bank (2009), ‘The Impact of Government Support to the Banking Sector on Euro Area Public Finances’, ECB Monthly Bulletin, July. European Central Bank (2010), Reinforcing Economic Governance in the Euro Area, 10 June, ECB. European Commission (2009), Public Finances in the EMU, European Economy, No. 5, Luxembourg: European Communities. Ewijk, van C. and C. Teulings (2009), De Grote Recessie. Het Centraal Planbureau over de Kredietcrisis, Amsterdam: Uitgeverij Balans. Giebels, R. and L. Nicolasen (2008), ‘Nog is het Einde Niet in Zicht: Reconstructie Dertig Dagen Kredietcrisis’ (‘The End is Still Not in Sight: Reconstruction of Thirty Days Financial Crisis’), De Volkskrant, 18 October. Heclo, H. and A. Wildavsky (1974), The Private Government of Public Money: Community and Policy Inside British Politics, Berkeley, CA: University of California Press. Kam, de C.A. and A.P. Ros (2003–08), Jaarboeken Overheidsuitgaven (Public Finance Yearbooks), Den Haag: SDU. Ljungman, G. (2008), ‘IMF Working Paper: Expenditure Ceilings’, WP/08/282.



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Ministerie van Algemene Zaken (Ministry of General Affairs) (2009), Aanvullend Beleidsakkoord (Supplementary Policy Agreement), Den Haag: Ministerie van Algemene Zaken. Ministerie van Financiën (Ministry of Finance) (2007), Afspraken over de Informatie-­ Uitwisseling en Overleg Inzake Financiële Instabiliteit en Crisismanagement (Memorandum of Understanding on the Exchange of Information and Consultation Concerning Financial Stability and Crisis Management), 13 February. Ministerie van Financiën (Ministry of Finance) (2008), Informatieverstrekking Kredietcrisis (Provision of Information), BZ/2008/764 M, 19 December. Ministerie van Financiën (Ministry of Finance) (2010a), Rapporten Brede Heroverwegingen (Reports Expenditure Reviews), 1 April. Ministerie van Financiën (Ministry of Finance) (2010b), Nederlandse Begrotingsregels 2011–2015 Kabinet Rutte (Dutch Budgetary Framework Cabinet Rutte 2011–2015), 8 December. OECD (2010), ‘Fiscal Consolidation: Requirements, Timing, Instruments and Institutional Arrangements’, OECD Economic Outlook 2010, Paris: OECD. OECD (2011), Restoring Public Finances, Special Issue of the OECD Journal on Budgeting, Volume 2011/2. Price, R. (2010), ‘The Political Economy of Fiscal Consolidation’, OECD Economics Department Working Papers, No. 776, OECD Publishing, http:// dx.doi.org/10.1787/5kmddq798lls-­en. Studiegroep Begrotingsruimte (Budgetary Framework Commission) (2010a), Budget Practices in The Netherlands, July, Den Haag. Studiegroep Begrotingsruimte (Budgetary Framework Commission) (2010b), Dertiende Rapport: ‘Risicio’s en Zekerheden’ (Thirteenth Report: ‘Risks and Securities’), 1 April, Den Haag. Tijdelijke Parlementaire Onderzoekscommissie Financieel Stelsel (Commissie de Wit) (Temporary Parliamentary Investigation Committee Financial System) (2010), Verloren Krediet (Lost Credit), Den Haag: SDU Uitgevers. de Vries, J. and T. Bestebreur (2010), ‘Budget Reform in the Netherlands’, in J.  Wanna, L. Jensen and J. de Vries (eds), The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.

7. The global financial crisis in Denmark and Sweden: a case of crisis management ‘lite’ Lotte Jensen and Sysser Davidsen From a comparative global perspective, the two neighboring Scandinavian countries, Denmark and Sweden, share the fate of being among the countries least affected by the global financial crisis (GFC) (Finansministeriet 2011b). Gifted by sound public finances prior to the crisis, both countries were in a position to stimulate their economies after the outbreak in the autumn of 2008. However, partly due to diverging histories and institutional features, differences remain on two key dimensions. Firstly, with regard to fiscal performance, Swedish public finances were hardly affected by the crisis and soon re-­bounded, whereas in Denmark the deficit eventually exceeded the 3 percent limit set by the European Monetary Union (EMU) and so activated the excessive deficit procedure over 2011–13. Whilst the Swedish debt to gross domestic product (GDP) ratio began to decline after peaking in 2009, the Danish debt continued to increase. Secondly, considering institutional preparedness, the cornerstones of the Danish budgetary framework have remained untouched since the 1980s; whilst Sweden enshrined in law a rather textbook-­oriented top-­down budgetary and fiscal framework in midst of a previously severe economic crisis in the mid-­1990s. The GFC was not used as a window of opportunity for institutional reform in the Swedish case; whereas in Denmark it did provide an opportunity for launching not only structural labor market reforms that had stalled amid party politicking for years, but also institutional reforms of the budgetary framework – with heavy reference to Sweden. The chapter opens by exploring the similarities and differences in the respective budget histories of these countries to provide an understanding of the differences in crisis exposure, experience and action. Following this, for each country we examine the position prior to the crisis; the impact of the crisis, the response to the crisis, the impact of international institutions and, finally, the consequences of the crisis and the crisis management for the budget institution and the future fiscal and political challenges. 174



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The chapter covers the period through to autumn 2011 when the effects of the US credit rating downgrade and the Southern European debt acceleration significantly affected all European nations to varying degrees. In Sweden, the international financial situation resulted in weaker growth expectations for 2012 and a projected fiscal balance instead of an anticipated surplus of 1.8 percent. However, the impact of this latter crisis was still considered temporary, and the economy forecasted to recover gradually from 2013. In Denmark, the aggravated international situation heightened the pre-­election posturing between the government and opposition. Competing stimulus packages were presented, with the prospective effect of a weakened structural balance in 2012 and postponed fiscal consolidation. This jockeying became the trigger for a long anticipated election called for 15 September 2011, at which a change of government from right to left occurred. The chapter ends with a brief postscript covering the effects of the election and the situation in the two countries in spring 2012.

CONSTITUTIONAL BACKGROUNDS, INSTITUTIONAL FEATURES AND POLITICAL CONTEXTS The two Scandinavian countries share a number of institutional features relevant in shaping their responses to the crisis. Both have multi-­party systems and especially Denmark has a long-­standing experience with coalition and minority governments. Both countries have extensive welfare states with a strong element of decentralization, although approaches to subnational finances vary. Local governments in both countries remain responsible for around half of public expenditure. In Denmark, local government tax and expenditure levels are negotiated collectively between the Finance Minister and the peak organization, Local Government Denmark. Danish local government finances are shielded from the impact of the business cycle as the forecasted effects are regulated within the annual agreements. Swedish local governments are required to maintain balanced budgets with fixed nominal ceilings and no automatic regulation across the business cycle (Finansministeriet 2010: 235f; Statistiska Centralbyrån 2004). State traditions vary markedly across Scandinavia, with Sweden and Finland having a relatively strong tradition for formal regulation and central coordination, and Norway and Denmark displaying a less formalized approach, which is also mirrored in the budget institutions (Grønnegård Christensen and Jensen 2009; Knudsen 2000). Swedish

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election periods are fixed four-­ year terms, whereas the Danish Prime Minister (PM) can call an election at their discretion within a four-­year period. Success in crisis management was considered a strength for the Swedish government at the 2010 elections, with the Finance Minister personifying that success (Jochem 2010: 28; Business 2010). In the lead-­up to Denmark’s election of 2011, the fiscal crisis and its management was a potent issue that resulted in the development of a medium-­term framework, Reformpackage 2020, in spring 2011. In both countries, the Social Democrats played a significant role in the introduction of rather different fiscal frameworks. In Sweden, after the economic crisis of 1992–94, the Social Democrat Prime Minister Göran  Persson gained a significant reputation for his fiscal crisis management and defense of robust budgetary institutions after Sweden came under severe pressure from the international financial markets. This paved the way for a reformed fiscal framework in 1997 (Persson 1997; Hallerberg 2004: 164; Henriksson 2008). The same year in Denmark a medium-­ term fiscal framework, Denmark 2005, was introduced by the Social Democratic Finance Minister Mogens Lykketoft to further budgetary discipline (Finansministeriet 1997: 3; Finansministeriet 2010a). The plan was subsequently followed by plans for 2010, 2015 and 2020 announced by the party’s political opponents in government. In accordance with Danish norms, the plans were not legal documents but flexible political commitments to fiscal sustainability issued at the convenience of government, rather than on a fixed schedule and employing a wide range of informal indicators (Andersen 2008; Dreyer Lassen 2010b). The fiscal framework remained rather detached from the annual budget procedure, which was installed in the mid-­1980s by the then Conservative–Liberal government (Jensen and Fjord Nielsen 2010). Both countries were governed by center-­right coalitions during the financial crisis. The Danish Liberal–Conservative minority coalition took office in 2001, following eight years of dwindling minority governments headed by the Social Democrats. In Sweden, the left-­wing PM Göran Persson held office for ten years from 1996 to 2006, before a four-­ party center-­right coalition, Alliance for Sweden, headed by Frederik Reinfeldt took over but lost its majority in 2010. Both center-­ right governments adopted a ‘third way’ strategy aimed at outmaneuvering the Social Democrats on their own turf and assuming policy ownership to the welfare issue (Independent 2006; Hellmann 2011). In Denmark a leading minister coined the neologism ‘Scandi-­liberalism’ to denote the new identity (Cordua 2008). Hence, political paradoxes operate both ways, allowing left-­wing politicians to strengthen budgetary governance and right-­wing politicians to increase public spending with lower risk of blame



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than their counterparts. Accordingly, governments in both countries have been under significant pressure to affirm their new political identity as welfare proponents at the same time as their original constituencies have continued to argue for tax cuts and smaller government. In order to straddle these opposing demands, both governments have operated within a discourse in which contradictions between increasing welfare expenditure and tax cuts were dismissed or ignored (Nielsen 2007; Finanspolitiska Rådet 2011a: 8). Both countries have independent fiscal watchdogs, but the institutional arrangements differ. The Danish Economic Council, headed by three economic ‘wise men’ (independent university economists, nominated by the Minister of Business Affairs) dates back to 1962. It is primarily concerned with fiscal policy, structural policy and, in later years, environmental sustainability. The Swedish Council of Fiscal Policy was introduced in 2007 after its predecessor, founded in 1981, was discontinued by the Finance Minister in 2003 because its analyses were considered politically inconvenient (Lemne 2010). Contrary to the Danish Economic Council, the mandate for the Swedish Fiscal Policy Council explicitly encompasses the annual budget proposal as well as the functioning of the fiscal framework, on which it comments in detail (Andersen 2008; Calmfors 2010; Finanspolitiska Rådet 2010a). No such independent function has existed in Denmark and, although the Economic Council could undertake such tasks, this is not the tradition. In Sweden, several units play the watchdog role alongside the Fiscal Policy Council, namely the Swedish National Financial Management Authority, the Institute of Labor Market Policy and the National Institute of Economic Research. In Denmark, the Economic Council is the only organization with the formal role of overseeing fiscal policy. However, the National Bank, interest organizations, university economists, think-­tanks and commercial banks regularly comment on fiscal policy. Further, Statistics Denmark plays a significant role, providing commentators with annual national accounts against which government finance, particularly the extent of public consumption, has been evaluated since 1997. During the recent crisis, sharp controversies occurred between the Swedish Council and the Finance Minister, who threatened to cut its budget as pay-­back for criticism of the government. The conflict received massive media coverage (Dagens Nyheter 2010; Finanspolitiska Rådet 2010b; Calmfors and Wren-­Lewis 2011). Conversely, in Denmark, the Economic Council has been under some criticism for going too soft on the government’s expansive fiscal policy during the boom in 2006. These allegations were vehemently rebutted by the council’s ‘wise men’ (Birch Sørensen 2007a, 2007b; Andersen 2009; Samfundsøkonomen 2010). Hence, the fiscal trajectories and crisis histories of the two countries

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were of a different nature and somewhat out of synch, but these legacies were employed by reform stakeholders to influence responses to the GFC, to shape fiscal policy settings and tighten the institutional rules of the budgetary game.

LEARNING FROM PREVIOUS FISCAL CRISES IN THE BUDGETARY MANAGEMENT OF DENMARK In the 1970s Denmark gained a reputation for serial deficit budgets, rising debt levels and increased debt repayment requirements (Andersen and Christiansen 1991). In 1979 the Social Democratic Finance Minister stepped down in protest against the lack of budgetary discipline. Three years later the government resigned, unable to deal with a deficit of DK70  billion (Danish kroner) for the following year, and allowed the Conservative– Liberal opposition to deal with the looming crisis. The change of guard and the preoccupation with the public deficit allowed the Finance Ministry to implement sweeping budget reform (Budgetreformudvalget 1983). The reform centralized the budget process significantly, trading line-­item controls for ceilings and top-­down processes but retaining the Danish tradition of pragmatism and informality. Initially, the government pursued a rather restrictive line in expenditure politics, which led to a fiscal recovery in the mid-­1980s fuelling private consumption and later deteriorating the balance of payments (Nielsen 1988). In the late 1980s unemployment became the most important social problem, which again paved the way for a return to power of the Social Democrats in 1993. The new government immediately launched a ‘kick-­start’ infusion of DK12 billion together with reforms to the tax system and labor market (Albrekt Larsen and Andersen 2004; Gaard and Kieler 2005). Despite the fact that further budgetary reform was largely eschewed (Jensen 2008), the government achieved surpluses from 1999 onwards. In 2001 a Liberal–Conservative minority coalition took office, basing their parliamentary majority on the Danish People’s Party, a nationalist welfare party which supported a freeze on taxes, in return for a more restrictive immigration policy, a ‘tough on crime’ stance and visible welfare entrenchment, especially for the vulnerable and elderly. Good economic times made this combination perfectly politically feasible until the outbreak of the crisis. When the Prime Minister, Anders Fogh Rasmussen, resigned to pursue an international career, his successor – the former Finance Minister, Løkke Rasmussen – was keen to re-­establish the government’s original liberalist stance on economic responsibility and public sector retrenchment, whilst carefully not inciting welfare-­conscious voters (Weekendavisen 2010, 2011b). The change of leader and political



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orientation within government coincided with the onset of the financial crisis. Compounding this, a new permanent secretary was appointed to the Finance Ministry in 2010, stressing the need for a closer focus on expenditure politics through legislative budget ceilings at central, regional and local levels, and close monitoring of budgetary management in ministries and agencies (Hellemann 2011; Personalestyrelsen 2011). These coinciding events provided the opportunity for institutional reforms of the budget game rules not seen since the 1980s. A reform proposal on multi-­ year expenditure ceilings inspired by Sweden, Holland and Austria was launched early in 2011 with the expectation that the new parliament would be inclined to support such an institutional change (Regeringen 2011b, 2011d; Berlingske Tidende 2011c).

LEARNING FROM PREVIOUS CRISES IN SWEDEN’S BUDGETARY MANAGEMENT Like Denmark, Sweden was hit by the 1970s oil shocks and the economy tanked in 1976–77, leading to a marked deterioration in the budgetary position and rapidly rising debt repayments. GDP shrank significantly and successive depreciations of the Swedish krona were made to enhance competitiveness; a successful strategy which improved public finances by the beginning of the 1980s, but also planted the seeds for an ensuing overheating of the economy in general (wage rises, expansion in private credit, speculation in currency markets and the overheating of real estate markets) (Dahlström et al. 2009; Jonung 2009). The internationally induced sharp upturn in the real interest rates pressured aggregate demand sharply and unemployment increased rapidly from 2 to 8 percent, bankruptcies skyrocketed and inflation rose significantly. The public deficit rose to 15 percent of GDP in 1993, and debt to GDP ratio reached the highest level since World War II (Hallerberg 2004: 160). Successive attempts to defend the pegged krona broke down under speculative attacks and the currency floated from late 1992 (Molander 1999; Jonung 2009). During 1992–94, the center-­right government introduced significant cutback measures to turn around the economy; a policy continued by the Social Democrats taking office in 1994, but with enhanced weight on increasing revenues (Berggren 1997; Dahlström 2008; Lindvall 2004). The combination of these factors, together with the fact that the Swedish crisis of the 1990s was out of synch with important export markets, opened a window for intense focus on the budgetary institutions in the early 1990s. The old bottom-­ up ‘fiefdom’ model (Hallerberg 2004), in which ‘the Finance Minister knew the size of the budget only on the day all budget

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bills had been passed in Parliament’, was considered a source of crisis in its own right inside the government machinery (quoted in Hallerberg 2004: 157f; Paulsson 2003). During the mid-­1990s key bureaucratic players launched ideas for institutional reform based on comparative studies of budgetary systems. Swedish public finances were suddenly ranked among the ‘spaghetti league’ of Europe along with Italy and Greece (Molander 1992; Molander et al. 1995; Hallerberg 2004: 161). As in Denmark earlier, the crisis produced a strong public political commitment to ‘economic responsibility’ (Persson 1997) which enabled bureaucratic reformers not only to impose stringency measures but also to redefine institutional game rules (Dahlström 2009). Reformist stakeholders managed to sell a budget reform as attractive to both current and future incumbents of power (Molander 1999; Blöndal 2001; Regeringskansliet 2010a). The reform process evolved step by step. In parliament, the voting procedures were divided between an initial vote on the desired aggregates that then subsequently bound the votes on the particular expenditure areas. Further, a procedure was introduced, according to which the opposition must present a complete alternative to the government’s budget proposal, rather than merely pulling out elements to support or oppose. Also, the reform aligned the fiscal year and extended the fixed electoral terms from three to four years. The concept of an all-­encompassing ‘gross budget’ was adopted, limiting off-­budget expenditures and discontinuing open-­ended appropriations (for example, social benefits). Further adjustments were made to tighten the aggregate ceilings (Regeringskansliet 2010a). By 2000 the parliament had passed a budget law insisting on a surplus target for the general government sector, which was then upped to a 1 percent surplus over the business cycle. These aggregate parameters that extend over three years then condition the central government expenditure ceilings, including block grants to localities. In practice, the government budgets for a minimum surplus of 1 percent in the budget year, a surplus of 1.5 percent in the second year, and a 2 percent surplus in year three. The final reform insisted that any grants from central to local be included in the aggregate ceilings and that these jurisdictions produce balanced budgets (Dahlström 2009; Molander 1999; Paulsson 2003; Hallerberg 2004; Wehner 2010; Bergman 2011). These budgetary reforms were widely heralded as a major cause of the strong fiscal position Sweden enjoyed at the outset of the GFC, influencing the ability to stimulate the economy after 2008 without creating excessive debt (Nationalbanken 2010; Dreyer Lassen 2010a; Boije and Kainelainen 2011; Bergman 2011).



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DENMARK ON THE CUSP OF THE CRISIS Prior to the GFC, Denmark’s growth level was lower than in most of Scandinavia, including Sweden (Andersen 2011). Consumption was steadily growing, due significantly to rising real estate prices and high ­employment rates. Private and commercial loans grew steadily, increasing annually to a peak of 25 percent in 2007 (Rangvid 2011: 73). Denmark had enjoyed a sustained period of budgetary surpluses in its general government sector since 1999, and structural budget surpluses since 2000. By 2007, gross government debt was down to 27.3 percent of GDP, the structural surplus was above 2 percent and the nominal surplus was just below 5 percent (Finansministeriet 2010c: 95; Finansministeriet 2010d: 171). In the years preceding the crisis, the nominal budget surplus, to which the politicians and media pay closest attention, deviated significantly from the structural balance due to a cyclical decline in unemployment expenditures, oil and gas income (high oil prices) and pension yield taxes. The impressive run of surpluses spurred a public and political impression of infinite fiscal invulnerability. This sentiment lured politicians into a false sense of security. The run-­up to the 2007 election turned into a bidding race between government and opposition (the ‘third way’ strategy) ending not only in considerable public consumption and investment packages (for example, the so-­called Quality Reform) but also further spurring welfare expectations among voters, a confident union campaign on public pay negotiations, as well as rising pressure from the government’s electoral base for tax cuts (Jensen 2011). All this occurred in combination with an expanding housing market bubble and an increasing volume of private borrowing. Expert economists across the various research institutions (the Economic Council, banks, commissions, and so on) began to warn about overheating and replicating the ‘Dutch disease’ of the 1990s, calling for further reforms. But these warnings gained no momentum (e.g. Birch Sørensen et al. 2006a, 2006b, 2007a, 2007b). On the contrary, the Prime Minister scolded them and urged them to rewrite their textbooks (TV2 2007). So, by 2007 the political cleavages had shifted from distributional conflicts to value politics, concerning immigration, crime, value institutions such as media, university autonomy and the national heritage in school syllabi and cultural products and institutions. Until the outbreak of the crisis in 2008, public consumption generally exceeded politically agreed targets (Finansministeriet 2010a: 33) but this was counterbalanced simultaneously by higher structural employment, higher tax revenue levels and other types of income unanticipated in the medium-­term plan. This buffered attention to the systemic or problematic

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nature of overspending that has later become the rationale for launching new budget legislation (Regeringen 2011b). The Economic Review of August 2007 produced a large quantity of evidence testifying to the strong position. It showed a sustainable economy, higher employment than ever before, expanding public sector quality, increasing liabilities, declining debt and declining tax (Finansministeriet 2007: 3); and in his 2008 New Year address, the PM declared that Denmark was ‘doing better than ever before  – actually the largest risk is that we will be doing too well in the coming year!’ (Larsen 2008). At the time, governance discourse was primarily devoted to the sustainability of the medium-­term plans within the fiscal framework. The general view was that government finances were under control, even though the plans did not impose any tough constraints on the individual annual budgets, allowing decision-­makers to front-­load the spending of projected savings assuming some later corrections could be made, when in fact they would be extremely difficult to make once the GFC hit (Finansministeriet 2011a: 22). The financial crisis, thus, hit a rather self-­confident country in which the public and political debate had long evaded a robust scrutiny of current public expenditures, with corrections put off into the distant future (Birch Sørensen et al. 2007a). As late as February 2009, the Prime Minister diagnosed the Danish economy as ‘profoundly strong and healthy’, but little did he anticipate the avalanche to follow (Andersen 2011: 98).

SWEDEN ON THE VERGE OF THE CRISIS Sweden enjoyed even better levels of growth, investment and exports than Denmark in the years before the crisis. House prices were following a rising trend. Unemployment was about 6 percent and declining in 2007, although a little above the Danish level of 4 percent. Consumer confidence peaked around 20 percent in 2007. Public consumption grew less rapidly than in Denmark, whilst the level of public employment was growing faster until 2006 (Statististiska Centralbyrån 2011c, Annex 1). Governments regarded their aggregate expenditure ceilings as the fulcrum of sound fiscal policy, and surplus targets had been met since their initiation in 1997; although debate recurred about their rationale, calculation and monitoring (Hallerberg 2004: 165; Finansdepartementet 2007; Bergman 2011). Public net savings were increasing and peaking at 3.6 percent prior to the crisis (Konjunkturinstituttet 2011: 80); public debt decreased from 70 percent of GDP in the mid-­1990s to slightly below 38 percent in 2008 (European Commission 2010b). Also, net financial assets had grown well above the



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Organisation for Economic Co-­ operation and Development (OECD) average (Jochem 2010: 3). Besides a general public acceptance of the need for firm fiscal policy, Hassler (2010: 5–6, 21) draws attention to the effect of structural labor market reforms, introduced by the change of government in 2006, as an important explanation of the pre-­crisis economic fitness. The joint factors evoked confidence on financial markets and allowed low-­risk premiums on borrowing, as lenders trusted government to be well capable of repayment (Boije and Kainelainen 2011: 5). Like his Danish colleagues, Prime Minister Frederik Reinfeldt redefined his old school Conservative party to become the ‘New Moderates’ to accommodate the broad voter support behind the Swedish welfare state and eliminate the perception that the party was only interested in tax cuts at any price. The party was defined as the ‘Labor Party of modern times’ (www.nyamoderaterne.se). Also, earlier positions were softened on subsidy cuts for local and regional welfare to a point where the party was criticized for resembling the Social Democrats and the PM was regarded as a ‘softie’ (Lindbom 2010: 146–7). The government still maintained a distinction between earned income and welfare subsidies, manifested in labor market reforms and an ‘in-­work tax credit’ introduced in 2007, then expanded twice in the spring and autumn of 2008, and again in 2010 as part of the crisis stimulus (European Commission 2009; Finanspolitiska Rådet 2011a). But the main cleavage issues were not over citizen rights to welfare support but around the degree of privatization of procurement, deregulation and adjustment of taxation systems (Jochem 2010: 4). Since 2006, the Swedish government had privatized significantly (Børsen 2006; OECD 2008). So the fact that the Swedish economy was in a sound position when entering the crisis in 2008, along with its banking sector, was widely attributed to the political lessons learnt from the recent historical experiences of the 1990s that embedded the symbolic significance of a sound fiscal policy. Evaluations of the domestic economy at the outbreak of the crisis were generally appreciative (OECD 2008).

THE GFC HITS DENMARK: IMPACT ON KEY INDICATORS The financial crisis in 2008 hit Denmark relatively hard in several ways. First, several banks began to suffer from their boom-­time aggressive lending policy, much of which was financed by international loans against real estate values, which rapidly decreased (Rangvid 2011: 72).

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Second, the Danish krone came under pressure, meaning that domestic demand and exports declined. Consumer confidence fell from 110 in 2007 to −17 percent in 2008 and, in contrast to Sweden, only recovered to a relatively low rate of 15 percent by June 2010 (Statistikbanken dk). GDP declined  in the last quarter of 2008 and the first quarter of 2009 by an estimated 3–4 percent, which was in line with comparable European neighbors (for example, the UK, France, Spain and Sweden (Finansministeriet 2009: 29)). The crisis turned a structural government surplus of 2 percent into an almost similar deficit of −1.7 percent in 2010. The public account deteriorated from a surplus of DK60 billion in 2008 to an estimated DK80 billion deficit in 2010, amounting to 4.6 percent of GDP and initiating the European Union (EU) Commission’s excessive deficit procedure in July 2010 (Finansministeriet 2010b: 176). EMU debt was estimated to climb from 34.2 percent of GDP in 2008 to an expected 44.6 percent in 2011 (still within the EMU limits) (Finansministeriet 2011b). Subsequent budgetary corrections to volatile revenues from the pension yield contributions and taxation from oil and gas activities eventually revealed a significantly lower deficit of 2.7 percent in 2010. However, in light of an almost unchanged structural budget deficit, the government awaited budget calculations from the EU before it jumped to conclusions about the strength of budget consolidation demands. Consequently, EU demands continued to set the premise of the public debate and the budgetary politics in 2010. The abrupt budget deterioration, which was about twice the size of the EU average in 2009–10, was first and foremost due to fiscal stimulation compounded by the significance of automatic stabilizers. Denmark recorded the steepest deterioration in the actual and structural balance between 2008 and 2010 from among the OECD nations. No formal distinction indicating the structural imbalance is available from official sources. However, by adding the impact of automatic stabilizers and the discretionary crisis stimulus together with other sources of stimulus (for example, coverage of overspending within the police budget) the government spent an additional DK605 million with an additional DK615 million spent on the Copenhagen climate summit in 2009 (Finansministeriet 2009: 84; Finansudvalget 2009). The significance of the expansionary fiscal policy initiatives for 2009 and 2010 strained the budget and required an EU-­induced exit strategy over the short term. It also served to compound the effects of already existing underlying challenges in the public budget, primarily the demographic development and decreasing future revenue from North Sea activities. Future rebalancing of the expansionary measures relied significantly on income tax reliefs in 2009–10, compensated later by a series of



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indirect energy and health taxes increasing out to 2019 (Finansministeriet 2010a: 21). The crisis and the ensuing stimulation responses twisted the political and epistemic debate about expenditure politics. Whereas, prior to the crisis, the government was scolded for its propensity to allow budgetary slippage in the short term both by the ideological critics of the ‘third way’ strategy and by independent economists (Birch Sørensen et al. 2007b; Samfundsøkonomen 2010), the urgency of the crisis stimulus in 2009 served to divert attention from this prior governance performance (Andersen 2011: 104). Further, the crisis eased the pressure on local government to keep within agreed budgets (Finansministeriet 2010d: 67). Instead of being a problem, spending suddenly became a solution and substantial public investment was planned over 2009 and 2010. However, the growth in public consumption in 2009 remained greater than the spending on planned investments. By 2010, the EU procedure availed a political opportunity for addressing welfare reforms long-­protracted by governments in spite of the recommendations of consecutive commissions, due to fear of electoral punishment and opposition point-­scoring. As will be seen below, the crisis opened a window for politicians to parade their economic responsibility and market it to the electorate in a fashion not seen since the early 1980s, and expressed in such colloquialisms as ‘picking up bills’ and ‘paying in cash’.

THE GFC HITS SWEDEN: IMPACT ON KEY INDICATORS Like Denmark, Sweden is a small, open economy and its exports dropped by 10 percent in 2007–08. Real GDP declined by 6 percent 2008–09 (twice the size of the OECD average and faster than in the 1990s) (Hassler 2010). Large banks reported losses on their loan portfolios, inflation rose and the currency came under pressure (OECD 2011a: 5; Jochem 2010: 9–11). Unemployment increased from 5.6 percent in April 2008, peaking at 9 percent in December 2009, and youth unemployment became a particular problem, even though unemployment rose by less than expected and less than the previous crisis (Statistiska Centralbyrån 2011a). Export industries, particularly in the northern part of the country, were severely hit. Newspapers reported grown workers ‘crying like little girls’ at Volvo factories. The Minister of Labor acknowledged that ‘some shit years are ahead’ (Silberstein 2008). Compared to the OECD average, however, the fiscal balance deteriorated much more modestly, from a surplus of about 3 percent in

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2007 and 2 percent in 2008 to less than −1 percent in 2009 (Statistiska Centralbyrån 2011c), which served to stress public finances less than expected as tax revenue suffered less. Gross debt increased only marginally (OECD 2011a: 183). Compared to Denmark, a brief dip in housing prices occurred, followed by modest increases (Englund 2011: 52). Consumer confidence fell abruptly from 120 in 2007 to −25 in 2008, but picked up rather spectacularly to 130 by mid-­2010 (Statistiska Centralbyrån 2011b). At the same time reforms to unemployment benefits and health insurance systems dating back to 2006 from the centre-­right government decreased public spending (Finanspolitiska Rådet 2011a: 2). As well, the indexation profile of sub-­state block grants, business grants and national government appropriations implied a considerable surplus bias within the Swedish fiscal regime, given the absence of discretionary policy measures (Finanspolitiska Rådet 2011a: 78–9; Calmfors 2011).

THE DANISH RESPONSE: PROCESS, SUBSTANCE AND TIME FRAME Given the fact that the Danish economy was operating at full capacity and somewhat overstimulated due to costly public pay bargains in early 2008 (Danmarks Radio 2008), the government responded hesitantly. The Finance Ministry and Economic Council diagnosed the GFC as a problem of risk to structural unemployment and the future problem of lagging labor supply, rather than general unemployment (Andersen 2011: 97, 100f). The first response came in October 2008 to January 2009 and related to the financial sector. Two consecutive packages were announced: one based on mandatory self-­financing within the banking sector, with public money forthcoming when losses exceeded DK35 billion, and a subsequent credit package in which public monies were lent to private banks as hybrid capital accompanied by a strengthening regulation of transparency, solvency, monitoring and executive pay policy (Finansministeriet 2009: 33–5). It was debatable whether the second package was best interpreted as a credit package, allowing banks to support healthy investment projects, or a bank package, primarily saving the banks, as the former was regarded nobler than the latter and served to disguise the risk of moral hazard made worse by golden handshakes to commercial bank chief executive officers (CEOs) (Rangvid 2011: 78). In terms of public finances, the Danish response to the GFC fell into three phases: (1) a fiscal stimulus (the Spring Package 2.0) of February 2009; (2) local government agreements of June 2009 and a further central government budget bill of December 2009; and (3) an exit strategy of May



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2010 (Picking up the Bill) together with a medium-­term consolidation plan of May 2011 (Reform Package 2020 – Securing Danish Welfare in Cash). Pressure for a fiscal stimulus mounted during late 2008 (Arbejderbevægelsens Erhvervsråd 2008), and in February 2009 the government agreed on a stimulus package, the Spring Package 2.0. It consisted of a fully financed tax reform lowering income taxes in 2010 and increasing energy taxes through to 2019; a release of private savings from a mandatory Special Pension (SP) scheme; subsidies for housing refurbishment; increased local government investment allowances above the agreed budget in 2009; and an expansion of infrastructure investments (Finansministeriet 2009: 35; Regeringen 2009). The Spring Package was publicly debated on the grounds that it drew government out of its ideological comfort zone as it represented a visible break with the heretofore untouchable principle of the tax freeze, to which the government had repeatedly attached its credibility. Government insisted the tax freeze remained credible, as the tax system would return to the status quo after the reform. This unorthodox move was dubiously dubbed the ‘Thai window’, implying a husband going solo on holiday, professing monogamous faithfulness before and after the trip (Information 2009). In June 2009 an expansion of public investment was included in the local government agreements and the central government budget bill for 2010. In May 2010, a consolidation exit package, Picking up the Bill (Regeringen 2010b), was formulated to comply with EU recommendations and later integrated in the autumn budget covering the period 2011–13. It sought to improve the structural account by 1.5 percent over three years, bringing the deficit below 3 percent. The main elements of the package were a reduction of growth in public consumption; postponing of previously agreed tax cuts and a freeze on the indexation of the thresholds for income taxes over 2011–13; a shortening of unemployment benefit ­eligibility; and ceilings on deductions for trade union membership fees (European Commission 2011: 2). Whilst the immediate focus was the period 2011–13, the reduction in eligibility for unemployment benefits from four to two years reached further into the future, potentially increasing labor supply. This part of the agreement was politically controversial, as it came as a result of an about-­face by the Danish People’s Party (DPP). It came as somewhat of a surprise to the government and was interpreted as an attempt by the DPP to appear economically responsible, whilst avoiding cutbacks to the elderly (Politiken 2010). The agreement was also carefully drafted to reallocate funds directly to benefit municipal welfare and health at the expense of other government expenditure items. The May agreement was formulated to meet EU requirements over

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2011–13, and projected a structural balance in 2015 in accordance with the 2015 plan (Regeringen 2010a: 17). The agreement had strong symbolic significance for the government’s attempt to reassert its credentials in terms of economic responsibility, which had been largely underplayed in the preceding years. The related annual budget for 2011, launched in August 2010, was thus titled ‘Responsibility and Lasting Welfare’. In April 2011 the government launched its medium-­term plan for 2020 in the shape of a reform plan Reform Package 2020 – Securing Danish Welfare in Cash (Finansministeriet 2011a). The title signaled a departure from the opacity of previous medium-­term plans in two ways. First, none of the previous plans were launched as ‘reform’ packages (that is, specifying concrete action steps to fulfill the requirements embedded in the ­objectives). Second, the wording ‘in cash’ denoted a commitment to finance the requirements up-­front rather than pinning them against future projections and frontloading the spending. The 2020 plan addressed structural and medium-­term issues made apparent by the financial crisis. It also extended the deadline for a structural balance from 2015, announced in May 2010, by five years to 2020. A coherent narrative was released in 2011 to justify the government’s economic and fiscal policies, including unplanned overspending, entitled Before, During and After the Crisis (Finansministeriet 2011a: 13). This narrative warned that the previous growth pattern of ever-­increasing expenditures would have to cease, and that declining growth in public expenditure was the inevitable premise of future politics if persistent deficits were to be avoided. Concern over long-­term sustainability was no longer regarded as sufficient to ensure credibility in international markets, and tougher expenditure limits were now imperative (Finansministeriet 2011a: 10; Kieler 2011). Hence, the 2011 plan carried a double agenda: a policy reform agenda and an institutional reform agenda, to which we return below. The main elements of the policy reform agenda were an early retirement reform launched under the heading of You Can’t Borrow for Welfare (Regeringen 2011a). Intense political and media scrutiny and debate ensued. It was seen by some as courageous statesmanship, by others as a high-­risk maneuver by the Liberal Prime Minister Løkke Rasmussen preparing for an early election. However, the polls did not improve, no election was called and the initiative began to stall (Weekendavisen 2011b). Then an unexpected political agreement was reached in late May 2011, when the small Social Liberal party broke the political deadlock and proclaimed its support for the proposed reform, subject to a clause stating that it would be implemented only after the next election. Intense press coverage, high political drama and daily election rumors followed. Once again, nothing happened.



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This reform agenda tried to create the conditions for a structural balance in 2020. Tacked on were some ‘further ambitions’ where the government looked to find new ways of saving money before launching new initiatives (offsets). The further ambitions took the form of a catalogue of measures aimed at saving money through efficiency measures or strengthened incentives, and inviting politicians to find savings before planning new initiatives (Regeringen 2011d). By late 2011, crisis fiscal management was enmeshed in the politics of a looming election with fierce competition between the government and opposition, creating continual politicking over which party would gain from playing the economic responsibility card.

THE SWEDISH RESPONSE: PROCESS, SUBSTANCE AND TIME-­FRAME An external OECD report to the Swedish government (Gurría 2011) summarized Sweden’s response to the GFC in the following way: Sweden is recovering quickly and robustly from the crisis. As highlighted in our survey, this is in large part thanks to the sound macro-­economic and structural policies Sweden has pursued over the past couple of decades. Sweden is an island of prosperity in the middle of very uncertain waters, which makes your achievement even more remarkable. Sweden’s enviable situation is not a stroke of luck. The very severe crisis in the early 1990s triggered major reforms. Some of them have been painful but they helped to put Sweden on a path of sustained and sustainable growth. And they served Sweden well to weather the recent global financial and economic crisis.

Other commentators have similarly stressed the learning and institutional effects of the mid-­1990s crisis as the core explanation as to why Sweden, although hit hard in 2008, recovered fast and robustly to a degree where ‘the deficit is likely to vanish more or less by itself as growth picks up’ (Hassler 2010: 4). The first response was made in October 2008 when the ‘repo rate’ charged by the central bank to other banks was rapidly and drastically cut to stimulate liquidity (a maneuver repeated in December 2008 and June 2009), resulting in a decline from 4.75 percent in September 2008 to just 0.25 percent in June 2009 (OECD 2011: 3). Floating the Swedish krona led to significant depreciation (Jochem 2010: 12). Other initiatives towards the financial sector commenced in the winter of 2008–09. They were decided swiftly without much public debate, which was seen as rather controversial, but the measures were considered comprehensive and clearly formulated (Jochem 2010: 35). New loan facilities were set up to enable access to

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long-­term funds and new collateral arrangements were installed to secure temporary credit facilities; foreign exchange liquidity was assisted and the national bank intervened to increase stability and trust in the financial system by doubling its deposit guarantee; troubled banks were able to access hybrid capital in return for restrictions on remuneration for senior management (Business 2009). The government was more hesitant over a stimulus policy, but came under strong pressure from various interest groups to stimulate domestic demand. In October 2008, the budget bill for 2009 contained several expansionary measures, two-­ thirds of which were related to tax cuts: reductions of corporate income tax rate and of employers’ contributions; an increase in the income tax threshold and enlargement of income tax credit. In December 2008 a special extra-­budgetary crisis packet targeted to the automotive industry contained funds for research and development, green-­tech loans and short-­term loans (but no subsidies), with an expiration date of March 2010. Then in January 2009 increased spending on infrastructure, education and social security was made via discretionary enlarged local government grants through an extra-­budget bill. All in all the expansionary measures amounted to 2.7 percent of GDP. The trajectory was extended in the 2010 budget bill where, again, grants to local government were enlarged above agreed levels and the income tax credit was expanded, as were investments in education and active labor market policy. On top of that, the Swedish system rests on substantial automatic stabilizers. The OECD reported that the Swedish response was the largest fiscal stimulus among countries included in their survey, with one-­third of the stimulus explicitly temporary (Jochem 2010: 18–19). It should be kept in mind, however, when making the comparative assessments that the Swedish fiscal framework does not include cyclical adjustments of general local government grants. Hence, additional grants to local governments in Sweden appear as discretionary stimuli, whereas in Denmark they are automatically regulated in the annual budget round. The stimulus policy became the subject of much debate. The Council of Fiscal Policy criticized the quality of analysis behind the infrastructure investments and its Chairman also queried the two-­thirds proportion of non-­temporary stimuli. Politically, the expansion of welfare and education was interpreted as outside the ideological comfort zone of the center-­right government, although the government also pursued a strategy of deregulation and privatization. In general, crisis management strengthened the position of the governing party among voters; and the 2010 budget was seen as an election campaign budget as well as a crisis management budget (Jochem 2010: 28, 35). No explicit exit strategy program was ever announced, since it is



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assumed that the budget deficit created by the stimulus policy will more or less disappear automatically as the economy picks up. Forecasts in 2011 announced a surplus no later than 2012 (Konjunkturinstituttet 2011: 108). However, growth expectations were dampened significantly in late 2011 as problems with the international economy appeared (Borg 2011). Sweden’s relatively fortunate fiscal stance, however, did not mean that the consequences of the stimulus measures were not debated. In comments on the 2010 budget bill, the Council of Fiscal Policy drew attention to the risk of permanent budget weakening, to the extent that stimuli were not explicitly temporary (Finanspolitiska Rådet 2009: 8). In further commentary on the 2011 budget bill, the council warned of a softening of fiscal policy discipline if expenditure ceilings were not adjusted downwards when tax cuts were promised (Finanspolitiska Rådet 2011a; Bergman 2011).

INSTITUTIONAL FITNESS AND FUTURE INSTITUTIONAL CHALLENGES IN DENMARK The EU’s excessive deficit procedure, and the requirements to improve budgets by 1.5 percent of GDP over three years, came to play a significant role in Danish crisis management and fiscal consolidation. On the one hand, the external requirement shifted the blame for the decision to cut budgets from the national to the supranational arena. The government repeatedly referred to the EU requirements during the policy process and its specific targets defined success criteria to which the government could claim credit. The tactical opportunity availed by the EU requirements did not go unnoticed in the public debate, particularly as revised calculations indicated a lower deficit for 2010 than expected (Finansministeriet 2011d; Arbejderbevægelsens Erhvervsråd 2011; Børsen 2011). This led to allegations that the government had exploited supranational regulations to press through politically costly, but necessary, retrenchment (Politiken 2011). The Economic Council, moreover, refused to lend support to an interpretation that the consolidation package was surplus to requirements. Rather, the Council was of the opinion that consolidation was necessary, even with a deficit level below EU requirements. It further argued that the government estimates of 2010 were close to the calculations of the Council (Det Økonomiske Råd 2011). On the other hand, the reference to the EU also entailed significant risk, as the government was depending on the Danish People’s Party (EU ­skeptics), which felt uncomfortable with the EU requirements and already had to defend cuts to unemployment benefits in their hinterland. Once the consolidation plan was politically accepted, political communication

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changed from blame-­shifting onto the EU, to credit-­claiming by a ‘responsible government’. Also, the frame of reference in fiscal policy setting shifted from EU requirements to the pressure from international financial markets to demonstrate trustworthy crisis management (Kieler 2011). Whereas the EU imposed specific demands on fiscal policy for 2011–13, no such requirements were presented in terms of Denmark’s institutional set-­up. Bodies such as the OECD and International Monetary Fund (IMF) have already recommended preferred institutional arrangements of fiscal frameworks: clear fiscal rules, independent fiscal watchdogs and effective top-­down procedures of budgeting. No criticism was made of the Danish fiscal framework. However, it was repeatedly stressed that targets were not being met in spite of the fiscal framework, resulting in expenditure drift. It was suggested that an annual expenditure target be derived from the medium-­term consolidation objectives, which would then be the ceiling for the annual budget including local government agreements. Better monitoring of the annual targets was recommended, as well as closer involvement of the fiscal watchdog in the budget calculation process which, in contrast to Sweden, is out of its remit (Finansministeriet 2011c). The Danish government’s assessment of its own institutional capacities was somewhat ambiguous. On the one hand, the economy remained under control, and according to the Reform Package 2020 this was always the case ‘before, during and after the crisis’. Further, the government considers that it was able to master fiscal responsibility and pay off debt during ‘the good times’, without any formal legal framework. On the other hand, severe future challenges have been mentioned as the motivation for strengthening the fiscal framework through a dedicated budget law, formulated according to the proposal Better Expenditure Governance – Expenditure Ceilings for State, Regions and Municipalities (Regeringen 2011b). The proposed budget law would introduce a number of formal rules premised on the imperative of a structural balance by 2020: parliament will vote annual ceilings four years ahead; ceilings will encompass both mandatory and running expenditure; and for regions and local government nominal ceilings will contain all service expenditure (that is, primarily public consumption). Any overspends by central or subnational governments will be sanctioned through consequential reductions of appropriations and grants (Regeringen 2011b: 9). Public debate on the suitability of the proposed budget law has been mixed. As technical matters and implications remain obscure for most commentators, media coverage has focused on strategy and process. In some quarters, the budget law was seen primarily as a political tactic ­vis-­à-­vis the opposition. With the 2011 election approaching and the opposition leading the polls, fixed budget ceilings were seen as a way of limiting



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the room to maneuver for the next government, while exposing any budgetary underperformance through recurring annual procedures involving the fiscal watchdog, whose formal remit would be extended. Yet, the EU-­skeptical Danish People’s Party refused to support such a law on the grounds that its only real function, given the already agreed consolidation measures and sanctions, would be subservience to the EU pact (Berlingske Tidende 2011a, 2011b). Subsequently, the Social Democratic opposition (soon to become the new government) declared partial support for a budget law. This situation removed the tactical advantage for government and led it to postpone the decision until after the election (Information 2011a). Commentators expected either side of parliament to support the proposed budget legislation after the 2011 election (Berlingske Tidende 2011c).

INSTITUTIONAL FITNESS AND FUTURE INSTITUTIONAL CHALLENGES IN SWEDEN Rather than urging institutional change on Sweden, international organizations have generally lauded Sweden as a country of success (Gurría 2011). Sweden has shown no qualms in displaying its keen adherence to EU principles, and in many instances overperforms in its institutional fitness. Indeed, Sweden chaired the EU in 2009 with the intention of providing good governance, and in early 2011 the Finance Minister noted that when designing EU directives on national fiscal frameworks Sweden was often ‘considered an exemplar’ to follow (Finansdepartementet 2011b). In combatting the GFC Sweden was never subjected to EU demands over its fiscal stimulation and no exit strategy was required over the need for consolidation to satisfy EU rules. While endorsing Sweden’s crisis management, the EU and OECD have expressed concern about the country’s long-­term fiscal sustainability in the face of demographic changes and labor market structures (European Commission 2010b; OECD 2011b). Youth unemployment has been flagged primarily through advice on incentives (OECD 2011a). Sweden firmed up its fiscal framework in 2010 (Finansdepartementet 2011b), but such institutional adaptation was not coupled directly to the crisis, although the crisis offered an opportunity to reinforce the consensus around firm fiscal governance as the way to future fiscal sustainability (Regeringskansliet 2010; correspondence with Ministry of Finance). The changes to the fiscal framework were intended to brand Sweden as fiscally responsible par excellence. In 2010, the many regulations governing the budget process were collected into an exhaustive publication which, apart

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from being a regulatory manual, functions as a government narrative of fiscal control, and provides a history of a nation going from budgetary distress into a model of virtue to be followed (Regeringskansliet 2010; Finansdepartementet 2011a). As the protracted international sovereign debt crisis took hold, the Finance Minister, Anders Borg, reiterated that, ‘order and control of public finances is the cornerstone of government’s economic policy. The strong public finances of Sweden have played a decisive role in fiscal crisis management’ (Borg 2011). Nevertheless, while the Swedish fiscal framework was widely praised abroad, and has inspired other countries such as Denmark to introduce budget legislation and budget ceilings, the concept continues to be debated in the epistemic community. Boije and Kainelainen (2011: 17) ask in their appraisal of the Swedish framework: ‘is it the framework or is it the Swedes?’ and conclude that whereas well-­designed rules and procedures were important, what matters most is political commitment. They further conclude that the general Swedish adherence to budget discipline after the 1990s crisis ‘has made deviations from the framework politically costly’. The other side of this political cost is the incentive to engage in creative accounting (Meyers 1994). In 2005 an EU assessment made the point that while nominal ceilings enforce transparency and legitimacy, they also invite creativity to stay below them. For example, contingency margins can be used to cover additional spending, and payments have been shifted across years (Fischer 2005; Clayes 2008; Finanspolitiska Rådet 2009: 13). The balanced budget requirement for local government has been continually debated. According to the requirement, local government must budget for a balance between revenues and costs, or compensate any deficit within three years. Surpluses cannot be carried forward, so in economic downturns local government must either raise taxes or cut expenditures (Dagens Nyheter 2011). The GFC forced the central government to introduce consecutive discretionary support packages, which then raised the questions of both political blackmail and lock-­in effects where initiatives were impossible to phase out later (Finanspolitiska Rådet 2009: 13). Accordingly, a commission has been established to investigate the sensitivity of local budgets to the business cycle and the problem of procyclicality (Finansutskottet 2010). The surplus target has been criticized for its opacity, in terms of both its raison d être and the indicators used when measuring government performance against it (Bergman 2011). It has further been alleged that government has hidden behind neutral and scientific language for value-­based political choices, such as defining tax cuts as ‘structurally justified’ rather than a consequence of legitimate political preferences (Finanspolitiska Rådet 2011a). The Council of Fiscal Policy has warned against the loss of



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credibility of government budget discipline through simultaneous promises of tax cuts and entrenched expenditures. The surplus bias built into a system whereby taxes follow GDP, but most social transfers, block grants and subsidies do not, has created political pressure to restore replacement rates, particularly given that previous surpluses have been used instead for tax cuts (Finanspolitiska Rådet 2011b: 6; Finanspolitiska Rådet 2011c: 78–9). Finally, contrary to the Danish case, whereas Sweden is celebrated for its expenditure governance, it is criticized for the absence of analytically based fiscal sustainability measures and specification of any intergenerational effects (Finanspolitiska Rådet 2011b: 11). The Swedish fiscal framework may have been praised for its virtues, but the financial crisis and its stimulus requirements also illustrated and highlighted, if not its weaknesses, then the inevitable trade-­offs embedded in budget rules between firmness and flexibility, as well as simplicity and comprehensiveness (Fischer 2005; Milesi-­ Feretti 2003; Clayes 2008). The downside of local government budget balance requirements has proven to be procyclical. And where the definition of rules is subject to interpretation, they can and will be tinkered with at the edges by, for instance, creative bookkeeping, flexible definitions and discretionary choices of performance indicators when adherence to surplus targets were being measured.

CONCLUSION AND POSTSCRIPT Both of these Scandinavian countries engaged in ‘crisis management lite’ to weather the GFC from 2008 onwards. It is worth summarizing their efforts here from three perspectives: the economy, the institutional framework and the politics. By any international comparison, the Scandinavian responses and consolidation efforts appear both slight and fairly similar. At first glance, both countries were in a similar situation when the crisis hit: politically self-­confident and with sound public surpluses and declining debt to GDP ratios. Consequently, both countries were able to inject small, targeted fiscal stimuli into the economy in 2009–10 without severely impacting their budget balance. Sweden never subscribed to the EU excessive deficit procedure, whereas Denmark received a light treatment and later proved better off than anticipated. However, interesting differences remain. From an economic perspective, whilst economic growth in Denmark declined and surpluses turned into deficits and debt increased, Sweden’s public finances and debt levels were hardly affected by the brief dip. Accordingly, budget policy in Denmark has remained trapped within the discourse of ‘crisis’,

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whilst this did not gain significance in Sweden until August 2011, and even then only as a temporary, and internationally induced, phenomenon. There are several explanations for this. Sweden’s GDP was hard hit, but the impact on employment and private consumption was less severe. Whilst Swedish house prices had increased prior to the crisis, they had not ballooned like the Danish prices and therefore did not drop as abruptly, which extended the trend of domestic consumption based on private borrowing. Tax credits on low-­paid work served to enhance employment; reforms to the magnitude and eligibility of unemployment benefits decreased their fiscal impact, as did the reduced indexation of social transfer schemes; and subsidies and local government grants under the budget ceiling sustained Sweden’s surplus bias. The surplus bias is not central to the Danish case. In Denmark after the deflation of the house price bubble, domestic demand did not recover, which exhausted the revenue side in combination with a decline in North Sea oil income. The automatic stabilizers kicked in massively and were not moderated by reforms capping size and eligibility. The negotiated nature of subnational finances made conversion from public investments to public consumption a feasible strategy for municipalities. So the GFC evoked different political dynamics. Whereas the Swedish government benefitted from past experiences and reforms to its fiscal framework, the Danish government was in a position of having to use the GFC as a lever for expenditure-­limiting mechanisms that in Sweden were already in place and widely accepted. Denmark’s adjustments took place within the context of a ‘third way’ political confluence, where government maintained a compassionate, voter-­sensitive, welfare line (particularly prior to the 2011 election) and was in the process of reviving a more liberalistic identity. Whereas in Sweden stringent fiscal control had long been accepted as the evidence of government prowess, in Denmark its adoption evoked fierce and potentially politically costly conflict. Conflicts occurred not only between the major political parties preparing to fight the next election but also, importantly, between central and local governments. However, Danish reform entrepreneurs managed to use the crisis as a reform window and embraced a long-­awaited opportunity to launch both substantive reforms in the labor market and institutional reforms of the fiscal framework, both with close attention to the political and electoral costs. The differences in institutional lineage shine through the two GFC responses. In Sweden the formalized budget law remains congruent with its politico-­administrative traditions. In Denmark, proposals to formalize its heretofore informal and pragmatic budgetary processes (balancing power between parliament and government, between ministers and their apparatuses, and between national and local government) has evoked



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considerable resistance. It remains unclear exactly how far the caliber of formal institutional change will eventually be pushed through the reform window in Denmark. What became clear, though, was that ‘economic responsibility’ became the new token of government capacity, and ongoing political struggles will be over its interpretation and institutionalization. What remains in both countries is the challenge of greater central steering of local government finances without doing away with local government autonomy and responsibility. Here, the countries looked to one another for inspiration. Denmark wanted the firmness of Sweden’s fixed and all-­ encompassing ‘out-­year’ expenditure ceilings, whilst Sweden looked to soften its balanced budget requirement and allow municipalities to carry forward surpluses in good times for future rainy days. The political ‘third way’ projects of the two center-­right governments in office during the GFC both employed the crisis to strengthen their particular ideological preferences: for less tax in Sweden, and a brake on public spending in Denmark. But in both countries, the inherent conflict between lower taxes and expanding public consumption embedded in the strategy came under pressure. In Denmark, the expansionary welfare policy prior to the financial crisis was possible under a tax-­freeze regime because of temporary compensating revenues from pension yield taxes and oil income. In Sweden, consecutive tax relief measures were launched simultaneously with expansionary measures during the extended economic boom. Given that the fiscal framework focused principally on expenditure caps rather than declining revenues, critics soon pointed to a possible hollowing-­out effect, if expenditure ceilings were not lowered as promises of tax relief were announced. Finally, the GFC has invigorated the role of independent fiscal ­watchdogs. The Danish Economic Council is old and well established with 20-plus staff working to the ‘three wise men’, but with no mandate and limited capacity to monitor expenditure politics and budgetary performance and frameworks. The future role and organizational capacity of the council has recurred as an institutional reform issue. In Sweden, the Council of Fiscal Policy is less well consolidated with only four staff and eight academic members. In contrast to Denmark, the work of the Council is entirely focused on fiscal policy and budgeting, which has been subject to continual critical scrutiny, not always to the taste of government. In both countries, the focus on alternative views and voices is likely to continue to grow. A final postscript completes the chapter. The Danish election in September 2011 became a close race between the government and opposition, and the result turned out slightly unexpectedly. A winning coalition was formed between the Social Democrats, the Socialist Party and the Social Liberal Party. In terms of economic and budgetary policy, the

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government changed but policy did not. The Socialist Party paid a significant price for its ambitions to become part of government, joining the green and leftist ‘unity list’. The Social Liberal Party, whose party leader had personified the ‘reform agenda’, gained spectacular support and as a former Prime Minister came out of the election with more support than he ever had in the polls when in office. So the new government, headed by the first female Prime Minister in history, Social Democratic Helle Thorning Schmidt, came under significant pressure both internally and externally to display ‘economic responsibility’ by continuing and even strengthening the reform route laid out by the former center-­right government. This provided space for reform entrepreneurs to include into the written government program the budget legislation that had been stalling in the system since the spring. When in December the Southern European situation escalated and brought an EU financial pact on the agenda, the budget reform was relaunched, going from being primarily a disciplining tool towards local government to an ‘international guarantee’, designed to comply with international standards of good economic governance (Danske Kommuner 2012). Hence, the budget law was expected to be presented to parliament in spring 2012, gaining the support of the government and opposition. The political reaction to and the technical challenges of actual implementation are both yet to be encountered. Whilst Denmark is in the process of introducing firm measures on annual local government spending, the Swedish government has drafted a coping strategy for avoiding the unintended consequences of the balanced budget regime. The Council of Fiscal Policy has endorsed the initiative, but criticized the core idea of a fund system remaining outside the budget ceiling (Finanspolitiska Rådet 2012). In sum, the two initiatives illustrate the fluctuating nature of institutional design in which reformers seek to straddle the dilemmas that exist between epistemic and technical decrees on the one hand, and political and historical contingencies on the other.

BIBLIOGRAPHY Albrekt Larsen, C. and J. Andersen (2004), Magten på Borgen: en analyse af beslutningsprocesser i større politiske reformer, Århus: Århus Universitetsforlag. Amundsen, E.S., C.T. Kreiner, M. Rosholm and H.J. Whitta-­Jacobsen (2010), ‘Vedtag Reformer nu og Undgå Uheldig Stramning’, Børsen, 21 January. Andersen, A.L and L.H. Nielsen (2010), ‘Fiscal Transparency and Pro-­cyclical Fiscal Policy’, EPRU Working Paper 2010–01, Copenhagen: University of Copenhagen. Andersen, J.G. (2009), ‘Dansk Økonomi på Katastrofekurs’, Indblik Nu, 4 March. Andersen, J.G. (2011), ‘Økonomiske Kriser. Danmark fra økonomisk mirakel til



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8. Spain facing the global financial crisis: cutting public spending and struggling with structural reforms Eduardo Zapico-­Goñi The impact of the global financial crisis (GFC) in Spain was far stronger and more prolonged than ever anticipated. The risk of public debt default still imposes immense pressures for fiscal consolidation on the national budget and for the immediate adoption of structural reforms to Spain’s economic, financial and fiscal systems. As with the reaction of most European Union (EU) countries to the crisis, the then Spanish Socialist government first applied an expansive fiscal intervention to avoid financial and economic collapse, and then undertook a series of medium-­term fiscal consolidation plans to tackle the quick deterioration of public finances. By 2010 Spain had imposed one of the largest austerity packages in absolute terms of any Organisation for Economic Co-­operation and Development (OECD) country. Yet, recovery remained slow and highly uncertain. Since 20 November 2011, the new Popular Party (PP) right-­wing government has declared its full commitment to comply with EU fiscal stability targets. And indeed it has started to take further austerity measures and to prepare fiscal legislative reforms as required by the recently amended Article 135 of the Spanish Constitution. The issues at stake here are: What types of fiscal measures were undertaken? Were they sufficient as a response to the GFC and, if not, why not? What were the longer-­term effects? What relevant knowledge can be gained and recommended from Spanish mistakes and achievements? What adaptations have taken place in budget systems? This chapter first provides an overview of the main effects of the GFC on the Spanish economy and its public finances, and on the government reactions to these impacts. Then, particular attention is turned to the fiscal consequences and budgetary adaptations made as a result of the GFC. The final section presents an overall assessment of the impact of the GFC on Spain and offers some further suggestions for improvements. But before starting, it is important to review some relevant background and contextual information. 205

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THE ‘GOOD EUROPEAN’: BOOM TIMES BEFORE THE CRISIS Prior to the 1980s Spain had a relatively small public sector by international standards (around 25 percent of gross domestic product, GDP). Public budgeting was largely revenue-­driven (Gunther 1980), but revenues were dependent on a weak tax system based on income sources rather than an integral tax on personal and company incomes. However, during the second half of the 1980s through to the beginning of the 1990s the volume of resources managed by the public sector almost doubled from 25 to 45 percent of GDP. These profound changes in public finances were brought about by exponential social and demographic demands, the consequences of political decentralization, and a particular sanction in the Spanish Constitution (1978). The combined effect of these forces created budgetary stress even before the GFC appeared. The economic crisis of 1993 hit the Spanish public sector hard. Previous assumptions about the levels of economic growth prior to this crisis soon proved overly optimistic. Decentralized new regional governments faced problems in meeting the increasing community demands for public services in areas under their responsibility, such as education and health. The inevitable result was increasing deficits and a growing burden of public debt at both regional and local levels. After 1994, following pressures from the Economic and Monetary Union (EMU) setting clear conditions for membership, successive Spanish governments made serious efforts toward achieving and maintaining fiscal stability (Ballart and Zapico 2010). Partially due to EU funds for structural development and to the economic policies that followed from the mid-­1990s to 2007, the Spanish economy enjoyed a prolonged period of growth similar to many other EMU countries (Cuerpo and Kessler 2011). Hence, the domestic economic situation before the crisis was buoyant. The Spanish economy grew at an annual average of 3.6 percent of GDP between 1997 and 2007, creating more employment and producing a sound fiscal position. Up to 2007 Spain was considered to be a ‘good European’. The integration into the eurozone (EMU) brought with it beneficial short to medium-­term advantages for Spain (such as improved fiscal discipline), but it also had long-­ term undesired effects. A rapid increase in internal demand (especially with real estate, tourism, cars and noticeable consumption) was fuelled by an EMU low interest rate policy causing high levels of private sector indebtedness for apparently endless profitable undertakings. Extended greediness provoked market bubbles, particularly in the real estate sector. Moreover, revenue increases, along with disciplinary rules over expenditure, made it possible to achieve an almost balanced budget in the year 2000 and annual



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budgetary surpluses from 2005 to 2007. European pressure at the time reinforced a top-­down discipline over the aggregate budget. Initially, the rightist government of the Popular Party under President José M. Aznar (1996–2004) and then the Socialist Party under José L. Rodriguez Zapatero (2004–2011) prepared tough fiscal legislation enshrining the main requirements of the European Stability and Growth Pact of 2005. Both the Popular and Socialist governments became convinced that establishing fiscal rules in statutory law approved by the parliament was the best way of imposing budget discipline across the system and avoiding the tendency of present or future political authorities to resort to uncontrolled public spending. However, at the onset of the financial crisis in 2008 and its immediate impact, the efficacy of this tough and detailed fiscal legislation was rather limited. As with other countries, the Spanish government responded urgently to these external shocks with budgetary injections, discarding (temporarily) the previous policy of stringency budgeting. Most European countries applied expansionary measures followed by the implementation of fiscal consolidation plans. After the amendment of the Stability and Growth Pact in 2005, exceptional cases of a severe reduction in economic activity could be accepted as a justification for amassing public deficits beyond the limits established by the EU (Ballart and Zapico 2010). Hence, budgetary discipline was not guaranteed simply by reinforcing the strictness of legislative regulation over the budget, or by intentions to comply with EU limits on spending. Rules and norms can control budget figures but not necessarily socio-­economic behavior.

POSTPONEMENT OF LONG-­STANDING AND CONFLICTIVE STRUCTURAL REFORMS The good times were not used for tackling and coping with ever-­present structural problems. Solutions were postponed again and again by successive governments of different affiliations. Examples of these structural problems were: low competitiveness and productivity (labor market rigidity, high fiscal and social burdens); an external trade deficit; high dependence on external energy; huge private indebtedness of households and corporations; a real estate sector with a bubble of about 700 000 unsold houses, most of them owned by banks; an informal economy estimated by experts as representing in 2008 between 20 and 23.7 percent of GDP and involving 2 million hidden jobs (Arrazola et al. 2011); weak and inefficient public services; a public sector structural deficit in 2007 of around 3 percent of GDP; ill-­defined intergovernmental fiscal coordination; and

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low awareness or consciousness of co-­responsibility among sub-­central governments. Most of these problems required sizeable structural reforms affecting powerful and privileged groups and, thus, requiring considerable political strength. Yet Spain’s governments have been anything but strong. The GFC and its fiscal consequences further disclosed the political weaknesses of Spanish governments to manage conflict and change. The post-­fascist democratic regime with a bicameral legislature has thus far produced a rotation of government between two parties: the Spanish Socialist Workers’ Party (PSOE) and the right-­ wing Popular Party (PP). Both parties have ruled from a relatively weak de facto position, dependent on parliamentary agreements with Nationalist parties, leaving them unable to address complex and conflictive problems. After eight years in power, more than three of which have been under the GFC, the image and capacity of the then Socialist President Zapatero became greatly undermined. The political situation became bipolar and dysfunctional with a weak central government and a persistent non-­collaborative attitude from the opposition (including over response to the economic crisis). Furthermore, Spain has a quasi-­federal system in which all levels of government contribute substantially to public spending. The central government accounts for 50 percent of total public spending (including social security), while regional governments commit a further 36 percent, and municipalities another 14 percent (Lopez-­ Laborda 2011). During the crisis the Socialist central government was forced to share power with many regional and local governments ruled by the right-­wing party. After the local and regional elections of May 2011, almost all sub-­central governments were governed by right-­wing authorities. The general election of November 2011 evicted the Socialists and installed the right-­wing PP under President Mariano Rajoy with sufficient overall majority in the legislature. Going forward, this might facilitate better intergovernmental coordination, and eventually fiscal discipline at the regional level. The budget for 2012 was presented by the new government by March. However, fiscal uncertainty still remains.

THE INITIAL IMPACT OF THE GFC AND EMERGENCY REACTIONS, 2008–09 The immediate effects of the GFC created a credit freeze leading to serious difficulties for refinancing private debt. Following pressures on the banking sector, the Spanish government undertook rescue measures designed to avoid the collapse of the financial system, for example, bank guarantees



Spain facing the global financial crisis ­209

for refinancing debt, raising the limit of individual accounts and deposit guarantees, the creation of a special fund, the Fondo de Restructuración y Ordenación Bancaria (Fund for Orderly Bank Restructuring, FROB) to assist banks with their restructuring processes such as internal restructuring, mergers, and so on. However, this was merely the start of a long road to recovery. Government financial support to the banking system did not flow towards businesses and families, since the measures adopted provided insufficient guarantees for banks to lend money. The problem was more than financial. Uncertainty over the scope and dimensions of the GFC along with a collapse in confidence in the economy caused a sharp fall in demand (a  drop of 5 percent of GDP in 2007–08) similar to the experience of other members of the EU (MEF 2011). In Spain the decline in economic activity was particularly drastic in the previously booming housing sector. Unemployment increased by an additional 2 million from 2007 to 2009, bringing the total jobless figure to 20 percent of the active population, the highest percentage in the EU. Moreover, one of the immediate consequences of the GFC was a sharp deterioration in public finances, leading to a fall of 13 points of GDP in the budget balance between 2007 and 2009. Spain had appeared fiscally sound in 2007, with a nominal budget surplus of 1.9 percent of GDP (even though some estimates put the budget in structural deficit to the tune of 3 percent GDP) and a moderate public debt level of 37.5 percent of GDP. However, not surprisingly for experts in the field, these advantages quickly vanished as the crisis took hold and emergency measures were required. The deterioration of public sector finances was quick and sharp: the budget went from a nominal surplus of 1.9 percent in 2007 to a surprising 11.1 percent deficit in 2009. The level of public debt increased from about 37 percent in 2007 to 63 percent in 2010 and was further expected to reach 69 percent at the end of 2011 (MEF 2011) (see Figure 8.1). The Government’s First Reaction: Emergency Fiscal Expansion Growing pressures from financial markets and suggestions from the G20 and international oversight organizations – the EU and International Monetary Fund (IMF) – were essential drivers influencing the timing, shape and composition of the government’s reactions. An urgent series of top-­down packages were undertaken sequentially and reactively. Spain responded, without much time for analysis, to the emergency EU coordinated Plan for Economic Recovery (2008). New measures were added or previous ones adjusted as these proved inadequate or were perceived as

210

The global financial crisis and its budget impacts in OECD nations Total public sector deficit (–) and surplus (+) (% of GDP)

4 2

1.0

2.0

1.9

0 2

–0.3 –3.0

4 –4.1

6

–4.4 –16.0

8 10 12

–11.1 2004

2005

Source:  MEF (2011).

2006

2007

2008

2009

–9.3 2010 2011 2012 2013 percent percent percent percent

Figure 8.1 The direct fiscal impact on the budget balance and public debt of the GFC insufficient for tackling the successive waves of disturbing news, such as further deteriorations in the economy, financial market pressure across Europe, geopolitical conflicts and energy crises. Participation from domestic stakeholders in these packages took place through formal channels – for example, parliament, the Council of Fiscal and Financial Policy (Consejo de Politica Fiscal y Financiera, CFFP), the Spanish Federation of Municipalities and Provinces, and other social partners – and via informal meetings with the government, for example, special meetings between the President and bankers, the largest entrepreneurs and leaders of the trade unions. The initial effort of government was relatively large compared to other EU initiatives. In 2009, the stimulus measures amounted to 2.3 percent of GDP, more than double the EU average of 1.1 percent (Vallés-­Liberal and Monzó-­Torrecillas 2011). The estimated stimulus spending for 2010 was expected to fall back to 0.6 percent of GDP but these estimates were made before important additional measures were announced subsequently by government (see Figure 8.2). As with other countries in the region, Spain’s initial response was to implement some quick expansionary fiscal measures amounting to

2.5%

Spain facing the global financial crisis ­211 2.3%

2009 2010

2.0%

1.9% 1.4%

1.5%

1.4% 1.0%

1.0% 0.6%

Average EU 2009 Average EU 2010

0.5% 0.0%

0.1%

0.0% Spain

Germany

UK

France

0.0% Italy

Source:  Vallés-­Liberal and Monzó-­Torrecillas (2011: 21).

Figure 8.2 The magnitude of the fiscal stimulus in the main European Union member states (% GDP) €25  billion. On the expenditure side, the Plan Español para el Estímulo de la Economía y el Empleo (Spanish Plan for Stimulating the Economy and Employment or ‘Plan E’) was launched and financed by the central government, but implemented through local governments. It included a long list of small or medium-­sized investment projects, easy to initiate and manage, and oriented toward the employment of the jobless rather than large investments and equipment acquisition. The initiatives were essentially a long list of low-­productivity projects with high overall cost. On the revenue side, the main response measures saw the introduction of a €400 deduction in personal income tax delivered in conjunction with several other small bonuses and subsidies (for example, the ‘baby check’, a car renovation plan). These measures were small and generally oriented to all citizens, but not necessarily to those prone to consuming or groups especially affected by the crisis, meaning that the multiplier effect of the initiatives was not optimized (Uxó et al. 2010).

INITIATING A LONG AND PAINFUL PROCESS TOWARD FISCAL CONSOLIDATION FROM 2010 Following recommendations from the Council of the EU given on 30 November 2009, the Spanish government approved in January 2010 a strict Stability and Growth Program 2009–13 aimed at achieving

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The global financial crisis and its budget impacts in OECD nations

fiscal consolidation by the end of the period projected. However, later in the year, after the first Greek crisis of May 2010, further extraordinary austerity measures were taken to respond to financial market pressures. Additional economic recovery overall measures contained in the Economic Stability Strategy (ESS) were designed in 2010, and legislated in March 2011 in the Sustainable Economic Law (see below). This section provides an overview of these three initiatives and related instruments. Updating the Stability and Growth Program 2009–13 The announced targets of the Stability and Growth Program 2009–13 included reducing the public deficit from 9.2 percent of GDP in 2010 to 3  percent in 2013, and containing the size of public debt to below 70 percent of GDP, thereby anticipating an increase of about 15 percent in debt from 53.4 percent of GDP in 2010 to 69 percent in 2013. The consolidation effort from the spending side (reductions) was estimated to total some €65 billion and from the revenue side (increases) around €6 billion. This program was presented along with national plans for reforms which provide information on sector policy initiatives envisaged as necessary to achieve the objectives (see Table 8.1). The main instruments supporting figures of the Stability and Growth Program were the Plan of Immediate Action, the Austerity Plan for Central Government Spending 2010–13 and the Framework Agreements between Central and Regional Governments. The Immediate Action Plan imposed budgetary cuts of €5 billion. It cut the operating costs of ministries (totaling €3.5 billion) and reduced the Budget Contingency Fund by €1.5 billion. Furthermore, this plan included the elimination or postponement (without further date) of a selected number of non-­priority capital investment projects. It also proposed to reduce the level of public employment by imposing a replacement rate of only 10 percent of staff retiring and preventing any recruitment of Table 8.1  Stability and Growth Program 2010–13 % GDP

2009

2010

2011

2012

2013

Estimated GDP growth −3.7 Public deficit (excluding interest) −11.1 Public debt 53.3 Public debt % change on previous year 13.4

−0.1 −9.2 60.1 6.9

1.3 −6.6 67.3 7.1

2.3 −4.4 68.5 1.2

2.4 −3.0 69.3 0.8

Source:  MEF (2010).



Spain facing the global financial crisis ­213

‘interim’ personnel (temporary personnel who are neither civil servants nor labor contract staff). The Austerity Plan for Central Government Spending 2010–13 proposed a further general cut of €50 billion over four years. Annual austerity cuts were to be specified in each of the forthcoming budgets to 2013. The implementation of the first round of this austerity plan resulted in a tough spending review and severe cuts to all budget items amounting to €23 billion, with only selected priorities exempted. The plan included new budget rules for achieving fiscal consolidation, including that new spending initiatives would only be financed if targets were already achieved (that is, applying the ‘pay-­as-­you-­go’ rule), any unexpected revenue gains had to be allocated to deficit reduction, and if necessary further cuts would be applied to achieve the objectives. The effort on the revenue side was more limited. The fiscal stimulus measures adopted in 2008 and worth collectively around €4.1 billion were withdrawn (that is, the €400 fixed personal income tax concession, €2500 ‘baby check’ and house acquisition financial aid); tax increases were imposed on high-­income taxpayers and on the saving tax rate raising €400 million; a cut of five points in the corporate tax rate was made for small and medium-­sized enterprises meeting certain minimum criteria; an increase of two points in the VAT tax rate was made, and one point for basic goods, raising an estimated €1.9 billion; and an increase in oil and tobacco taxes was announced. The Framework Agreements between Central and Regional Governments were used to implement the principle of co-­responsibility vis-­à-­vis public sector fiscal discipline. These agreements were discussed and approved by the CFFP, which stipulated both regional government financial arrangements and budget discipline scenarios. Framework Agreements were aimed at achieving budget consolidation at the regional level consistent with the projections presented in the Spanish Stability and Growth Pact presented to the EU. The deficits and debt levels of regional and local governments had already been worrying in 2008–09. Yet, the fiscal scenarios for budget discipline approved by the council were not, as a rule, very credible. This was due to several reasons: the lack of effective monitoring systems, the lack of rewards or sanctions, and little control over debt burdens (Arellano et al. 2011). In June 2010, the main Framework Agreement was strengthened with additional deficit and debt reductions for regional governments and new budget procedures (see below). Extraordinary Cutting Measures A further deterioration in the economic situation in the first half of 2010 (alongside the first Greek crisis) saw reinforced pressures emerge from

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The global financial crisis and its budget impacts in OECD nations

the EU on member states, especially the Southern peripheral countries. Continued uncertainty in the financial markets and volatility in the cost of servicing Spanish public debt forced the Spanish government to propose additional austerity measures. A new wave of extraordinary budget cuts totaling €15 billion were imposed across all levels of government: civil servants’ wages were reduced by 5 percent, pensions were frozen for the year 2011, and pharmaceutical spending was reduced. Many of these subsequent measures affected social rights, but some compensatory fiscal supports were allowed to preserve or improve the rights of specific groups (for example, the long-­term unemployed). Again, these additional austerity measures in 2010 were top-­ down urgent decisions presented sequentially and reacting to a range of market pressures, emergency EU agreements and recovery plans. Little time was available for systematic analysis of the expected results. Measures were augmented as they proved or were perceived to be insufficient for tackling successive disturbing news in the deteriorating economy. Experts considered that the Stability and Growth Pact 2010–13 was based on optimistic economic growth estimations for this period. One assumption was that the deficit would be reduced to just 6.6 percent of GDP in 2011. Furthermore, the announced cuts or tax increases were not based on substantial reforms to reduce the structural deficit. Fiscal adjustments were mainly based on the spending side of the budget with a generic proposal of €50 billion in reduced spending. Tools and methods were not sufficiently explained. Some measures were contrary to the left-­wing government’s ideology and electoral program, although specific measures were taken to compensate specially affected groups. It was not easy to quantify the specific impacts of the austerity measures announced in 2010. The diversity of measures and the annual cumulative effects made precise calculations difficult. But overall the achievement of the 2010 fiscal objective (reducing the deficit to 9.4 percent GDP or just 0.2 percent higher than the declared target) was a positive signal and tended to validate the government’s strategy. However, approximately 7.8  points of the deficit remained structural (Valle 2010). The Socialist government had reduced the speculative pressure on financial markets and announced its fiscal commitments through to 2014, with annual spending increases of 6 percent in 2011, 4.4 percent in 2012, 3 percent in 2013, and 2.3 percent in 2014. Efforts Toward Fiscal Consolidation During 2011 the government continued its fiscal consolidation efforts. A new Stability and Growth Program 2011–14 was approved, extending and



Spain facing the global financial crisis ­215

Table 8.2  Budget balance as percentage of GDP (excluded debt interest) Budget entity

2010

2011

2012

2013

2014

Central government Regional governments Local governments Social security Total

−5.7 −2.8 −0.5 −0.2 −9.2

−4.8 −1.3 −0.3 10.4 −6.0

−3.2 −1.3 −0.3 10.4 −4.4

−2.1 −1.1 −0.2 10.4 −3.0

−1.5 −1.0 0.0 10.4 −2.1

Source:  Council of Ministers Agreement of 24 June 2011.

adapting fiscal discipline figures of the previous plan. To date, this is one of the most ambitious consolidation plans in the eurozone. In June 2011 the public sector deficit target for 2011 was 6 percent of GDP falling to 2.1 percent by 2014. The country aimed to get its deficit below the EMU three percent level by 2013, meaning it would begin debt reduction in earnest from 2014, gradually reducing debt from estimated 69 percent GDP in that year (see Table 8.2). Hence, the main effect of the fiscal measures undertaken in 2010 was expected to cumulate during the period 2011–14. Further spending cuts introduced in the central government budget for 2011 and the projected cyclical effect were expected to allow the achievement of public deficit targets set up to 2014. Following the 2011 elections, the Minister of Economy and Competitiveness of the new Spanish government has recently ratified the government’s commitment to reduce the deficit to 4.4 percent in 2012 (El Pais 24 January 2012). In the second year of the Austerity Plan for Central Government Spending 2010–13, the government imposed cuts that were selected so as not to damage productivity and social welfare. It cut administrative personnel costs by 2.1 percent; introduced efficiency measures saving 6.7 percent, including reduced orders for goods and services; cut current transfers by 8 percent; reduced investment capital transfers by 38 percent; and reduced infrastructure investment by 22.4 percent. Nevertheless, the budget share of education, and research and development, were maintained. This revised plan was based on two optimistic assumptions: that increases in economic growth rates would occur, and that regional governments would comply in achieving their fiscal targets. Official projections of GDP were based on an average annual rate increase of 2.4 percent, which was overestimated by about 0.6 percent compared with other international and domestic calculations, putting GDP at 1.8 percent. The IMF predicted a deficit for 2014 of nearly 4 percent of GDP, which implied that to achieve the desired fiscal targets further cuts to wages and investments, and increases in the VAT and excise rates, would be necessary (IMF 2011).

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The global financial crisis and its budget impacts in OECD nations

More austerity measures could still be necessary if financial costs, running at around 20 percent of GDP, keep growing due to financial market pressures or if the economic situation further deteriorated. Both the President and the Ministry of Economy and Finance (MEF) agreed that the government would take such steps if these risks materialized. But the solution of further austerity remains complex in the current situation. Speculative pressures from financial markets in Spain, Italy and Greece threatened a much worse scenario for the eurozone. Serious concerns about a second recession have also risen. And in Spain some experts started arguing that future economic growth would be inhibited if the economy was further burdened by excessive, overly concentrated and short-­term austerity measures (Ontiveros 2011; Casais 2011). Spain’s troubles during 2011 were not helped by the long duration of the pre-­electoral political blockages, in which a weakened Socialist government led by a ‘lame duck’ president was incapable of taking drastic actions to address the structural problems of the economy. Furthermore, fiscal indiscipline by the regional governments became apparent after the May 2011 local elections. The MEF warned regional governments falling into fiscal difficulties that there would be no further approvals of increased debt levels until they presented a credible fiscal recovery plan to reduce their own deficits from 2.8 percent in 2010 to 1.3  percent in 2011. Most regional governments have recovery plans approved by the CFFP. Yet, in 2011, total regional government spending increased by 5.4 percent while revenues decreased by 2.23 percent over the year. The most recent Framework Agreements introduced new debt authorization procedures requiring improved information and reposting systems. Transfers of revenues to regional and local governments were now conditional on proper budget reporting. Moreover, due to the change of regional governments at the May 2011 elections, there was serious pressure from incoming right-­wing governments for full accounting disclosures.

BEYOND FISCAL CONSOLIDATION: SEARCHING FOR ECONOMIC SUSTAINABILITY The related Economic Stability Strategy (ESS) of 2010 identified an ambitious, long-­term set of structural reforms prepared in the context of the Europe 2020 Strategy. Many of them had been claimed for years. The ESS included a long list of legal and administrative measures oriented towards counter-­cyclical economic recovery and structural reforms to produce a more sustainable economic future. It prescribed reforms needed in order to advance towards a more productive and competitive economy. The



Spain facing the global financial crisis ­217

main reform agenda included: restructuring the financial system; fighting the informal economy; the promotion of innovation and competitiveness; devising a sustainable energy model; reform of the labor market and pensions; and the modernization of administration. These objectives were supported by declared targets and selected performance indicators through to 2020; and as the ESS evolves its ambitions can be updated and enhanced as the situation becomes clearer or the context changes. Its objectives and indicators coincided with the EU’s overall Stability and Growth Pact ­(committing to deficits of less than 3 percent of GDP) and were able to be updated in Spain’s Stability and Growth Programmes. It also established the overarching aim of reducing the relative size of regional government debt to that of the central government (MEF 2009). Most of the ESS initiatives were reflected in the Sustainable Economy Law, drafted in 2010 and approved after some delay in March 2011. The law was equally ambitious, covering multiple domains: the need for better regulation and transparency; for better evaluation and greater independence of regulators; financial sector reform; and new rules, measures and incentives for fiscal sustainability and austerity plans at all levels of government. The law also mandated follow-­up and reporting conditions, and participatory and evaluation arrangements of the implementation of the ESS. Some initial negative opinions criticized the Sustainable Economic Law for being an incomplete disarray of casuistic measures (Valle 2010). However, a macroeconomic analysis (the Rational Expectation Models for Spain using a dynamic general equilibrium approach) claimed that the main measures of the law had potential impact in terms of their influence on productivity factors. These authors argued: The orientation of the set of policy changes . . . (envisaged by the Sustainable Economic Law), creates the right incentives to move towards a more intensive knowledge and innovation economy, to raise potential GDP of the economy through mainly increases in productivity . . . The impulses of productivity related to the fulfillment of the objectives are relevant and would be compatible with progress, although moderate in employment. (Cuerpo and Kessler 2011)

However, they also added that this estimated impact would only materialize if the law’s objectives were attained expeditiously. Supporting legislation and reform agreements were supposed to be ready before the dissolution of parliament in late 2011, but several of these reforms were not produced. Progress was also delayed by the change of government at the general elections of November 2011. Hence, parts of the reform agenda have been initiated, but advances in the difficult structural reform areas (for example, labor market reform or financial reform) have so far produced only limited

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The global financial crisis and its budget impacts in OECD nations

and diffused results (Pimentel 2011). One reason for this is that some of the law’s objectives affect some highly conflictive policy arenas and the prerogatives of powerful vested interests in society; many of these structural issues appeared to be characterized by lasting unresolved conflicts.

ADAPTATION OF BUDGET NORMS, INSTITUTIONS AND PROCEDURES The Budget Normative Framework There was no substantial change in the central government’s budget norms and procedures as a result of its response to the crisis. The current legal-­ budgetary framework was configured early in the previous decade, through the General Stability Budget Law (2001) and its complementary Organic Budget Law (2001). National fiscal legislation already enshrined the main conditions required under EU agreements such as the preparation of fiscal scenarios, setting stability targets and non-­financial spending limits for government. However, at the end of the previous parliament (September 2011), the Socialist government and the opposition agreed to reform the Spanish Constitution to incorporate explicit reference to budget discipline measures (see below). Following the EU’s Stability and Growth Pact (2005), Spain’s legal framework was adapted in 2006 and 2007, seeking more flexibility in the application of the EU’s deficit rule, considering that the original definition of ‘stability’ was excessively rigid and framed on the year rather than the economic cycle. New stability legislation stipulated the obligation for governments to budget for a surplus when economic circumstances were favorable, while allowing the possibility of incurring a deficit during the low points of the economic cycle with the aim of achieving an average position of equilibrium (Gil-­Ruiz and Iglesias 2007). Moreover, it was also felt necessary that regional governments had to participate in the discussion of the general budget framework as they were also responsible for the final budgetary results of the whole country. The conformation of this legal framework of fiscal legislation was followed by a period of fiscal discipline between 2001 and 2007, although this was mainly due to the economic expansion during the same period (Fernández and Monasterio 2010). After the GFC there were no changes to this legal framework. Instead, internal efforts were made to enhance the application of fiscal discipline and reinforce the application of budget norms and principles. For instance, government plans and declarations have insisted on the need for evaluation



Spain facing the global financial crisis ­219

of all new spending proposals and apply a ‘pay-­as-­you-­go’ condition (that is, any proposal that implies increased ongoing spending or decreased tax collection must be compensated through offsetting spending or tax measures). Furthermore, the latest Stability and Growth Program 2011–14 announced acceptance of new spending rules as requested by the EU. So, throughout the crisis, Spain’s legal-­budgetary framework was considered to be appropriate for central government, even though it proved to be less effective for fiscal discipline in the regions. New Budget Rules for Regional Governments New norms and conditions have been introduced to encourage sub-­central governments to discipline their fiscal policy. These have been debated and approved jointly by central and regional governments in the CFFP. Various reasons might be given for the cause of the fiscal difficulties of regional governments. An important one is the vicious circle initiated with the GFC, leading to the deterioration of their revenues, forcing them to search for financial credit and escalating their financial costs. A good illustration of this is Catalonia, where the Regional Government of Catalonia issued two ‘patriotic’ bonds (similar to war bonds) in 2010, at 4.75 percent rate (plus 3 percent bank commission). Thus, although the government managed a 10 percent spending cut in 2011 its debt service became 35 percent more expensive. For more than three decades regional governments have required central authorization for their debt levels, further debt issuance and any financial dealings abroad (LOFCA 1980). With the crisis, debt procedures became tougher and a new authorization system was established. Regional government information systems were improved through increased publicity and frequency of reporting on budget execution and debt issuing. They were compelled to use standardized accounting and budgetary formats covering execution, scope and reporting, with budget data presented to the CFFP not later than 60 days after each trimester. Furthermore, the central government required that if regional governments did not comply with their stability targets, they had to produce rationalization plans for budgetary correction (structural reorganization, efficiency, spending reduction, and so on) and get central approval for long-­term budgetary operations. If a region did not achieve its targets and did not present a recovery plan of sufficient quality accepted by the CFFP, then all short-­term debt required central authorization. Debt limits would gradually be applied, together with additional conditions and risk assessments (for example, an approved recovery plan, first-­semester budget execution, recovery accomplishment). Furthermore, policy sector agreements for transfers from central to

220

The global financial crisis and its budget impacts in OECD nations

regional governments would be adjusted to comply with fiscal targets. Finally, the principle of co-­responsibility in the event of any EU sanctions was also applied. Fiscal misbehavior by regional governments was also addressed on a ‘name and shame’ basis (IMF 2011). Generally, these containment measures did not work, and even stricter measures were being considered over spending and deficit rules. A constitutional reform was considered necessary. The new content of Article 135 of the Spanish Constitution of 1978 was approved in September 2011, incorporating the principle of fiscal stability in the constitution and requiring government to present a new organic budget law with concrete references to a deficit limit for each level of government, before 30 June 2012 (see below). No Major Changes in Budget Institutions and Processes, but Reinforced Top-­Down Decision-­Making From a formal perspective, the preparation of the annual draft budget is a well-­regulated inter-­institutional political process, involving the legislative and executive branches of government, and technical interactions between the MEF, sector ministries and their counterparts in regional governments. In fact, multiple informal interactions normally take place throughout the budget process. The government maintains direct contact with other political parties and negotiates to build a coalition of support to guarantee final budget approval in parliament. Continuous lobbying pressures are exercised by relevant stakeholders (for example, regions, trade unions, entrepreneurs associations, non-­governmental organizations – NGOs, and so on) during the preparation of the draft budget and throughout the parliamentary debates. Prior to the change of government on 20 November 2011, relations between the government and opposition were highly contentious, so that the former needed support from some regional Nationalist parties at the price of compensating benefits. At the beginning of the fiscal year, according to the Stability and Growth Pact, the MEF would prepare an economic and fiscal outlook based on a one-­plus-­three-­year scenario. This projected scenario did not really create a fully fledged medium-­term economic framework (see IMF 2011). Although the outlook presented economic growth forecasts and fiscal targets for the central, regional and local governments, the regional targets remained to be debated and agreed in the CFFP, while local government targets were set in consultation with the Spanish Federation of Municipalities and Provinces. Prior to the crisis, the process of setting fiscal objectives for each region was mainly bilateral, between each region and the central government (Ruiz-­Almendral, quoted in Fernández



Spain facing the global financial crisis ­221

and Monasterio 2010). Since the crisis, the process has become more multilateral. In 2011 at the central government level, the Secretary-­ General for Budget and Public Spending drafted budget estimates and ceilings for the following year (to include in the economic and fiscal outlook) in line with stability targets and government priorities. Once approved by the parliament, the budget scenario was presented by the MEF to spending ministries in the Spending Policy Analysis Commission. Then, ministries prepared their budget requests within the scenario. The preliminary draft budget is normally discussed and approved by the Council of Ministers in September and a draft budget is then submitted to the parliament by 1 October for debate and approval. However, preparation of the draft budget for 2012 was stopped in September 2011 and postponed until after the general elections in late November 2011. The new central government began by functioning on the basis of a prorogated 2011 budget, although it announced that it intended to present its draft budget by March 2012. After the crisis, no major changes have been taken to adapt or improve the institutional capacity of the budget system. The creation of the Parliamentary Budget Office took place but so far its effective functioning has been delayed. Fiscal and expenditure management control institutions (for example, Court of Auditors, internal control and evaluation ­organizations) have not been specifically or sufficiently adapted and used to combat the fiscal consequences of the crisis. In general, the level of budget management and control transparency is low (OECD 2009), but the preparation of transparency legislation has been delayed for several years. The strengthening of the budget system is a pending issue. However, additional emphasis was placed on top-­down decision-­making, ensuring that budget requests were within the limits set in the Stability and Growth Pacts, applying the so-­called ‘pay-­as-­you-­go’ criteria and checking that cutting decisions taken by government were applied. As in previous years, several specialist executive commissions continued to play a key role as forums for communicating government fiscal priorities, imposing aggregate budget ceilings and distributing the main spending aggregates among ministries. These commissions are: the Spending Policies Analysis Commission, which analyzes and debates spending programs; the bilateral Program Analysis Commissions and Ministerial Budget Commissions; and the Revenue Commission, which presents revenue forecasts according to the MEF’s GDP growth assumptions (Ballart and Zapico 2010). The MEF’s current assumptions about growth running at 1.4 percent of GDP for 2011 were considered too optimistic compared to other forecasts of around 0.8 percent, but nevertheless its estimates for 2010 proved to be more accurate than others. In the aftermath of the crisis, the authority

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The global financial crisis and its budget impacts in OECD nations

of both the Finance Minister and the President has been enhanced for imposing fiscal priorities and budget cuts. Budget commissions have restrained portfolio budgets to fit within strict restrictions from the MEF, while Program Analysis Commissions at the program level have ensured that reduction decisions respect spending limits and government priorities (education, research and innovation, and the social welfare guarantee for citizens suffering the worst effects of the crisis). In short, throughout the crisis, the MEF has adopted a pragmatic and flexible role. Budget adjustments were prepared either within or outside the formal budget procedure. Budget preparation became a much more top-­down, restrictive exercise. Once the crisis was recognized, the MEF has enjoyed the full support of the President to impose with the strictest discipline the priority of consolidating public finances as committed in the sequential Stability and Growth Programs. The power of the MEF has been reinforced to consolidate fiscal stability at the central government level, but it has been less successful with regional spending, and insufficient efforts have been made to improve the institutional capacity of the overall budget system. Postponement of Efficiency Initiatives in the Face of Cutbacks Prior to the crisis, new legislation was passed aimed at improving ­‘budgeting for results’ (General Budget Law 2003) and initiating a decentralized public management model (Agencies Law 2006), including the creation of the State Agency of Evaluation. Both were aimed at achieving greater efficiencies. ‘Budgeting for results’ had been used for some decades for presentational purposes, but the actual use of performance information for budgeting remained rather low (OECD 2009). The Agencies Law enabled the government to create new public entities (called Agencias Estatales) with greater autonomy in the management of personnel and spending resources. However, the crisis together with bureaucratic politics appears to have frozen this initiative. As Valero (2010) argued, a ‘lack of concordance between the Ministry of Public Administration and the Ministry of Economy and Finance, ended up limiting the . . . degree of autonomy’ of agencies, while ‘the creation of new agencies in standby has been paralyzed as a result of the measures taken to reduce the public deficit’. Accordingly, the impact of these reforms on public spending management performance has so far not matched expectations. With the crisis there seems to be an indeterminate postponement of these efficiency-­ related initiatives. Spain’s stability plans and austerity measures do not include relevant efforts to improve public management efficiency (Valle 2010). Yet, once recovery commences, perhaps some ongoing initiatives may have positive



Spain facing the global financial crisis ­223

implications for promoting efficiency gains by enhancing evaluation, auditing for performance, and through strategic-­analytic advisory units in sector ministries (Feinstein and Zapico 2010). Recent measures including the creation of the Parliamentary Budget Office may lead to a qualitative jump in the budgetary transparency but so far there have been delays in its functioning.

INITIATIVES AND MEASURES TAKEN BY THE NEW POPULAR PARTY GOVERNMENT Faced with increased international concerns about a second global recession, the new PP government approved additional measures to correct the deficit. Its first fiscal-­ related decision on 30 December 2011 was to announce a further deficit reduction of about €15 billion net. This included an estimated amount of €6 billion on the revenue side including a temporary and progressive increase in the rates of several direct taxes (for example, personal income tax, savings income tax), combined with other revenue concessions to stimulate growth (for example, 4 percent reduction of VAT on home acquisition, extra tax benefits for home acquisition). From the expenditure side, an amount of about €9 billion included some spending reductions similar to the previous government (for example, current and capital spending cuts, reducing transfers to political parties and social partners, cutting the budget of public corporations, freezing personnel costs, reduction in the number of top public managers, zero personnel replacement in agencies except in education, health and police which maintained a 10 percent replacement limit), plus some spending increases (for example, a 1 percent increase to the pension, and the discontinuance of a special benefit for long-­term jobless people while ending the time limits of the benefit). Between January and March 2012 other measures were announced such as combating fraud by limiting cash payments, and reinforcing inspections in high-­risk sectors such as labor and social security, expected to raise an amount of €8 billion; reducing or disinvesting of public corporations at all levels of government; and a new transparency law. On 30  March 2012, the Council of Ministers approved the Budget Bill of Central Government for the year with more than €27 300 million total estimated adjustment both on the expenditure side (including an average cut of 16.9 percent in the accounts of the ministries) and on the revenue side (for example, eliminating income tax allowances to big corporations, and a tax amnesty whereby undeclared incomes will be regularized by paying of a tax rate of 10 percent). The effects of several measures were not

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sufficiently explained. Overall, these measures did not create much credibility in the financial markets or the international press. A few days after the approval of the Budget for 2012, the Spanish government prepared the Stability Programme for 2012–15 and the corresponding National Reform Programme, including a savings plan to reduce spending in health and education policies. This plan focused on service reduction, rationalization and efficiency savings aiming for a reduction of €10 billion (in addition to the cuts already made in the budget for 2012). In the legal domain, one of the priorities of the PP government was the implementation of the new Article 135 of the Constitution that obliges central government to prepare an Organic Law. The new Organic Law of Budget Stability and Financial Sustainability (April 2012) reinforced budget principles already considered in current legislation (fiscal stability, multi-­annual projections, transparency and efficiency) and incorporated new principles (financial sustainability, responsibility and institutional loyalty). All levels of government are now obliged to present and achieve a surplus or budget balance. No structural deficit will be accepted from 2020. However, when undertaking structural reforms with long-­term budgetary effects, a structural deficit of 0.4 percent of GDP will be accepted. The maximum rate of debt for the public sector will be 60 percent of GDP. These limits will gradually be implemented until full compliance is reached in 2020. During the transitional period, the public sector structural deficit should be annually reduced by an average of 0.8 percent. Public debt will be reduced if the economy is growing in real terms. The public debt has to be reduced by at least 2 percent of GDP when the GDP growth rate is 2 percent or above, or when there is an annual net increase in employment. Fiscal targets will be reviewed in 2015 and 2018. Fiscal objectives have to be fixed, taking into consideration EU recommendations on the Spanish Stability Programme. In general, the methodology for setting the limits and arrangements for ensuring compliance are similar to and coherent with EU budget stability framework and deficit deviation procedures. All levels of government (central, regional and local) have to approve a spending level that cannot be higher than the rate of GDP growth. Deviations oblige the responsible government to present an annual correction plan. If this plan is not accomplished the responsible government will see automatically blocked budget estimates for an amount sufficient to guarantee the achievement of fiscal targets. This penalty is not applied if the deviation is due to exceptional circumstances (structural reforms and cases of hardship). EU penalties under the framework of budget stability will be paid by the government (central, regional or local) responsible for the deviation. According to the principle of transparency, regional governments are obliged to: provide main budget figures before approval; provide



Spain facing the global financial crisis ­225

national accounting information corresponding to budget information; and provide information on extra-­budgetary data every three months. The law also establishes incentives to encourage compliance. For instance, debt issue, policy grant concessions and intergovernmental agreements will be conditional upon achieving fiscal objectives. Furthermore, it guarantees the continuous and automatic adaptation of Spanish norms to future changes in the European economic governance. The extraordinary market pressures focused on Spain and other EU southern member states is accelerating the implementation of this legislation. Furthermore the new government restructured the MEF, splitting the economic and finance sections of the portfolio (with the former now the Ministry of Economy and Competitiveness, and the latter the Ministry of Finance and Public Administration), thus providing an opportunity for better understanding and coherence between the budgetary and civil service functions.

PRELIMINARY ASSESSMENTS AND EMERGING CHALLENGES It is still too soon and too difficult to evaluate the actual effects of the fiscal measures Spain undertook throughout the GFC. Achievements to date can only be estimated with reference to the first of the four years of the SGP 2011–14. It is obvious that the first year’s stability efforts were not successful at all. There was a public deficit of 8.3 percent of GDP; a 2.3 percent deviation from the 6 percent planned. The Spanish economy was entering a new recession period (−1.7 percent of GDP) and new stability targets were reduced, in agreement with the EU, for next three years. However external factors, such as the Greek crisis, the increased international market pressures and the slow economic recovery in the US and Europe influenced and diluted the intended results of any measure or plan. Furthermore, the economic and fiscal effects of some measures will not be visible and relevant for several budgetary years. Important structural reforms (for example, labor markets, financial system, public finances) were approved and are slowly being implemented, but others, at the time of writing this chapter in 2012, remain on standby or have been neglected (for example, the electoral system and public management). On the other hand, there is evidence of some positive international recognition for Spain’s initiatives. A comprehensive pension reform plan has been agreed with social partners (IMF 2011). At mid-­2011, economic growth rates remained positive, and there were signs of ‘green shoots’ in economic recovery. Although GDP growth was below that of other EU

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countries, it was approaching a 1 percent increase. Higher increases were expected if crucial sectors continued improving (a 10 percent increase in exports, 8 percent in tourism, and so on). However, at the beginning of 2012 the debt crisis was worsening and economic projections for 2012 were lowered. The IMF and the EU predicted a fall in the Spanish GDP of between 1.5 and 1.7 percent in 2012. Up to 2012, budget cuts had been substantial, and are still ongoing, but were insufficient in dimension or inadequate to calm financial market pressures. The budget for 2012, approved in March 2012, was based on optimistic assumptions on the evolution of revenues (direct and indirect taxes) and of spending (for example, pensions and unemployment). The budget behavior has followed a sort of ‘repetitive budget’ pattern (Wildavsky 1975), in which taxes and spending adjustments are announced as soon as new information (macroeconomic data, market pressures, and so on) appears. For instance, just a week after the approval of the Central Government Budget for 2012, and as a reaction to a specific attack by financial markets on Spain and Italy, the Spanish government announced further adjustments, cuts and reforms to health and education amounting to €10 000 million (without giving much information on concrete measures), on this occasion affecting regional governments. Up to 2012, central government stringency efforts were more than offset by lower fiscal performance by the regional governments. Although transparency and prompt disclosure of fiscal data at the regional level have been enhanced, some important regions have missed their fiscal targets (for example, Andalucía, Catalonia and Valencia). Most regional governments have presented fiscal recovery plans and are enforcing austerity measures. But so far there is still uncertainty as to whether this will be sufficient to achieve the fiscal targets. Formal limits on deficits and budget cutbacks, while being highly necessary to calm market pressures, might not be sufficient to guarantee economic growth. There are still high risks and challenges floating on the Spanish horizon. From a range of perspectives (fiscal, economic and political) the following challenges affect the capacity for budget resilience. One of the main challenges in Spain has been the questioned credibility of budget projections, normally based on optimistic projections of GDP growth (IMF 2011) and quick budget cuts. Actual fiscal sustainability requires institutional measures such as the creation and effective functioning of an independent body or council of experts or similar mechanism that would enhance the credibility of growth estimates. Another challenge is to avoid poorly targeted public spending cuts in order to reduce the public deficit without postponing the recovery, or even provoking another recession. The way to diminish fiscal uncertainty is by reducing the high



Spain facing the global financial crisis ­227

budget structural deficit that has been estimated at more than 60 percent of the total deficit (Valle 2010). Time and effort expended on budget program analysis and evaluation have been much reduced. These mechanisms need to be embedded into robust and systematic public expenditure reviews, so far neglected in Spanish government. In principle, the new Organic Law of Budget Stability and Financial Sustainability (2012) enforced the reduction of the size of debt. But actual results will take some time to be effective, due to the long period allowed for full application of the new deficit limit (up to 2020). So far, public debt in Spain is quickly rising towards 100 percent of GDP. High fiscal risk continues at the regional level. This level of government is constitutionally autonomous for decision-­making in two high and growing spending areas: health and education. In fact, this autonomy is being restrained by new constitutional reform. Traditionally, regions have a low commitment to co-­responsibility, having suffered for several decades an asymmetry between their spending responsibilities versus insufficient taxation ability. This asymmetry was officially balanced with the 2009 Agreement between Central and Regional Governments. The latter have made substantial use of their tax autonomy. But the former is still interested in enhancing the use of tax autonomy in order to promote accountability and budgetary discipline (Utande 2012). Up to 2011, there was little clear evidence that public deficits or debt levels were greater than officially recognized by regional or local governments, but there remain many suspicions (for example, creation of foundations with unclear public/private identities, retention of invoices and/or spending information, and so on). Measures announced in 2012 by the government were properly oriented to solve these problems (for example, reduction of the number of regional public corporations, financial aid conditional upon the presentation of recovery plans, obligation to report monthly on budget execution, and disciplinary measures in cases of deviation from approved fiscal targets). There is also room for much-­needed structural fiscal reforms for solving problems, for example: local government finances are not consolidated and suffer chronic shortages of resources; the tax system is highly sensitive to the economic cycle; the hidden economy is widespread with serious implications for fraud and tax evasion; there is feeble capacity for customary review of spending programs, tax expenditures and deductions, and program evaluation including selective in-­depth analysis and evaluation of selected strategic policy initiatives; in general, the institutional capacity of the budget and control system is weak. From an economic point of view the challenge is huge and urgent. In 2012, unemployment was about 22 percent and increasing. Despite uncompleted financial reform, the financial system is still in trouble and

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does not provide a funding or credit for the normal functioning of the economy. There is high dependence on the evolution of external demand, oil prices and comparable cost pressures. Structural economic reforms remain fragile. An ageing population places a huge burden on public spending policies (for example, over healthcare, social services and dependence care). The changes to the pension system have been consolidated but their effects will materialize only over the long term. Most of these reforms have lain dormant for years and are now being confronted within an urgent and uncertain framework. From a political point of view, structural reforms need a strong government with the capacity to manage a series of conflicts and build support from society precisely when the country is under high social distress. The inclination of the PP is in line with neo-­liberal ideas, preferring less government and more business (for example, downsizing the public sector and cutting public spending, externalizing activities, and searching for private capital for public investment). However, it is arguable whether this strategy will prove sufficient to sustain recovery without paying attention to growing demands for greater openness in policy-­making and strengthened governance. A new law on transparency is close to being approved, including measures to penalize undisciplined budget behavior. But there seems to be insufficient awareness of the relevance of this law for open and participatory policy-­making, effective learning-­oriented control systems and long-­term fiscal sustainability. The political alignment of most regional governments with central government has created a clear opportunity for ameliorating the situation from all perspectives. As the new President Rajoy said in 2011, still from the opposition: ‘never before has a political party had in its hands the possibility of coordinating territorial governments for an ambitious reform, and never before has it been so urgent and necessary’ (PP 2011). But the materialization of this advantage depends on many ongoing political factors, such as cooperation from the regions governed by nationalists and other regions in which left-­wing government can still be formed; the traditional lack of a consensus decision-­making style in majority governments; and a growing distance between politics and society.

CONCLUSION Fiscal consolidation efforts made by Spain have already been considerable, but there remain severe fiscal cautions ahead. A sequence of top-­down decisions and measures has been taken in response to the evolving effects of the GFC and financial market pressures, and these were still growing in 2012. Public spending has been reduced and taxes increased, but further



Spain facing the global financial crisis ­229

fiscal measures are necessary to comply with targets. Budget austerity has been imposed with increasing determination, and regional spending has been put under focus with tighter monitoring and increased transparency. Yet, they seem to be insufficient or perhaps contradictory to initiate recovery. New rules about the limit of the deficit and debt have been incorporated into the Constitution and Organic legislation. However, the strengthening of the institutional capacity of the public expenditure and control system is a pending issue. Consolidating fiscal sustainability in the longer term and paving the way for a return to higher growth will require serious economic reform efforts that have proved too difficult to achieve in the past. So, four years after the beginning of the GFC in 2008, the Spanish situation was still highly uncertain and risky. Recovery was being postponed more than expected and, considering an emerging second recession, even recovery remained under question. A stronger right-­wing government declared its full commitment to comply with the EU’s fiscal targets, firmly corrected central government finances and was given a historic opportunity to convince regional government (most of them fellow party members) to discipline their finances. This is precisely the current challenge, the solution to which is being strongly requested by financial markets and the EU. At the moment of editing these lines, some signals show initial improvements in the Spanish economy and fiscal situation (for example, expected GDP growth and public deficit curbing). There is emerging evidence of public spending discipline and deficit control. But these signals are shadowed by other data (for example, soaring public debt, and huge segments of the population without employment or on low salary schemes). The debate over the austerity model keeps growing.

REFERENCES Arellano, P., R. Pajares and I. Rodríguez (2011), ‘El Nuevo Sistema de Financiación en un Entorno de Estabilidad Presupuestaria’, Presupuesto y gasto publico, Madrid: Instituto de Estudios Fiscales, 62 (1), 159–78. Arrazola, M., J. de Hevia, I. Mauleón and R. Sánchez (2011), ‘Estimación del volumen de economía sumergida en España’, Cuadernos de Información Económica, 220 (January–February), Madrid: FUNCAS. Ballart, X. and E. Zapico (2010), ‘Budget Reforms in Spain: Anything Else Beyond Budget Discipline?’, in J. Wanna, L. Jensen and J. de Vries (eds), The  Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 240–59. Casais, E. (2011), ‘La respuesta a la crisis en la UE: España camino de su década perdida’, Revista Problemas del Desarrollo, 166 (42), 37–62.

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Cuerpo, C. and A. Kessler (2011), ‘Impacto Macroeconómico de la Ley de Economía Sostenible’, MEF, Documentos de Trabajo 2011/3, Madrid. Feinstein, O. and E. Zapico (2010), ‘Evaluation of Government Performance and Public Policies in Spain’, ECD Working Paper Series No 22/May 2010, IEG, Washington, DC: World Bank. Fernández, R. and C. Monasterio (2010), ‘Entre dos o entre todos? Examen y propuestas para la coordinación presupuestaria en España’, Hacienda Pública Española/Revista de Economía Pública, 195 (4), 139–63. Gil-­Ruiz, M.L. and J. Iglesias (2007), ‘El gasto publico en España en un contexto descentralizado’, Presupuesto y gasto publico, Madrid: Instituto de Estudios Fiscales, 59 (2), 185–97. Gunther, R. (1980), Public Policy in a No-­ Party State: Spanish Planning and Budgeting in the Twilight of the Franquist Era, Berkeley, CA: University of California Press. International Monetary Fund (IMF) (2011), Spain – Staff Report for the 2011 Article IV Consultation, Country Report No. 11/215, July, http://www.imf.org/ external/pubs/ft/scr/2011/cr11215.pdf. López-­ Laborda, J. (2011), ‘Comparación del Sistema español de financiación regional con el de otros países de estructura federal: Bélgica e Italia’, Presupuesto y Gasto Publico, Madrid: Instituto de Estudios Fiscales, 62 (1), 159–88. Ministerio de Economía y Hacienda (MEF) (2009), ‘Estrategia de Economía Sostenible’, at http://www.economiasostenible.gob.es/wp-­content/uploads/ 2009/12/1_2_indicadores_2020.pdf. Ministerio de Economía y Hacienda (MEF) (2010), Stability and Growth Program – SGP: 2010–13, Madrid: MEF. Ministerio de Economía y Hacienda (MEF) (2011), Presentación del Proyecto de Presupuestos Generales del Estado 2011, Madrid: MEF. OECD (2009), ‘Government at a Glance’, http://www.oecd.org/document/3/0,3746 ,en_2649_33735_43714657_1_1_1_1,00.html. Ontiveros, E. (2011), ‘La crisis del Euro: al borde del colapso El País’, 29 June. Pimentel, M. (2011), ‘Reformas a medias, reformas pendientes’, Cinco Días, 17 June, Madrid. Popular Party (PP) (2011), Press Release, 1 June. Utande, J.M. (2012), ‘Spanish Tax System: State, Autonomous and Local Taxes’, presentation at the Seminar organised by the Institute of Fiscal Studies for Officials of the Ministry of Finance of the Netherlands, Madrid, IEF, 23 January. Uxó, J., J. Paúl and J. Salinas (2010), ‘Análisis y valoración de las medidas discrecionales de estimulo fiscal aplicadas a España en 2009’, in Presupuesto y Gasto Publico, Madrid: IEF, 59 (2), 55–83. Valero, J. (2010), ‘Elementos para una reflexión en la Administración General del  Estado’, Documentación Administrativa, Madrid: INAP, No. 286–287 (January–August), 25–59. Valle, V. (2010), ‘Las reformas de nunca empezar’, in Cuadernos de Información Económica, Madrid: FUNCAS, 215 (March–April), 1–13. Vallés-­ Liberal, J. and J. Monzó-­ Torrecillas (2011), ‘El Refuerzo del Gobierno Económico Europeo’, in Presupuesto y gasto publico, Madrid: Instituto de Estudios Fiscales, 63 (2), 63–77.

9. Portugal and the global financial crisis: short-­sighted politics, deteriorating public finances and the bailout imperative Paulo T. Pereira and Lara Wemans In April 2011 Portugal became the third country in a row, after Greece and Ireland, to receive a bailout from the ‘Troika’ of the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF). Financial markets began to become suspicious about the ability of the country to fulfill its sovereign debt liabilities, risk premiums increased up to a point where access to capital markets was no longer an option, and a debt default soon became imminent. At this point the Portuguese minority Socialist government of José Sócrates had no option other than to negotiate a bailout in the form of a memorandum of understanding with the Troika lending consortium.1 The natural question is: Why did Portugal suffer this fate? This chapter aims to explain the political and institutional foundations that led to this bailout by exploring two key dimensions: the democratic features of Portuguese governments, and their fiscal policy settings shaped within the context of the European Union’s (EU) budgetary framework. Firstly, the chapter examines the long-­run trends in the management of Portugal’s public finances. Secondly, it explores the economic and fiscal situation before the crisis emerged. Thirdly, it analyzes the impacts of the global financial crisis (GFC) on the Portuguese economy and how the government first reacted to the crisis in line with the European Commission’s proposals. Thereafter, it explores how the government, in the emergence of the escalating sovereign debt crisis, weighed its preferred policy priorities against competing claims (the need for economic stimulus, avoiding excessive deficits and stabilizing the financial markets). It asks which measures were taken and why, when were they implemented and what was their impact. Finally, it will present the main measures included in the memorandum with the Troika, and conclude with the main shortcomings of 231

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the supposed surveillance of public finance among EU member countries under the Stability and Growth Pact (SGP).

DEMOCRATIC POLITICS AND PUBLIC FINANCE IN PORTUGAL: AN OVERVIEW Throughout the entire democratic period following the 1974 revolution, a particular peculiarity of Portugal was that the country never managed a surplus in the state budget. Deficits were the rule without exception, and were considered normal in Portuguese political discourse even before this last crisis. Hence, it came as no surprise that once the crisis hit, Portugal’s poor record in European public finances was exceeded only by Greece. Recall, too, that Portugal became the first country in 2000 to be subjected to the EU’s Excessive Deficit Procedure (EDP), a process commenced by the European Commission under the Stability and Growth Pact (although one year later France and Germany were also placed under the EDP arrangements). Another peculiarity is the structure of fiscal federalism across the jurisdiction. The archipelagos of Madeira and the Azores have a special autonomous status, including the constitutional right to all tax revenues generated in their territories, plus they receive generous transfers from Lisbon as regional and local governments. This fiscal arrangement was embedded in the Constitution in 1976 and remains to this day despite several important amendments to other parts of the Constitution. Hence, Portugal is a unitary state but paradoxically has two ‘mini-­states’ ­(autonomous regions) within its borders with more tax powers and tax revenues than real states within federations. Since the country is formally a unitary state, Eurostat does not provide any separate statistics for these regions; they are mixed up with fiscal statistics of local governments, which contributes to a lack of transparency in public accounts. Since the restoration of democracy in Portugal in 1976, the IMF has been involved on three different occasions in an enforced fiscal consolidation program in the country. The nation’s pattern of public finances was usually imprudent: firstly, a significant increase in public spending compared to GDP would occur, leading to permanent deficits; secondly, higher deficits led to an increase of the debt to GDP ratio; thirdly, with the level of debt soaring, a privatization program was imposed on the government together with a restrictive fiscal policy (see Pereira 2012). The recent bailout of Portugal by the EC, IMF and ECB is, therefore, not a completely new story. Portugal was definitely not prepared for the GFC from the public finance point of view. However, as clarified below, the banking

Portugal and the global financial crisis ­233

Revenue

Expenditure

% GDP (Balance)

2015

2014

2013

2012

2011

2010

2009

2008

2005

2007

2006

2004

2003

2002

2001

2000

1999

1998

1995

1997

1996

1994

1986

1984

1976

1974

Budget balance

1993

12.0 1992

11.0

0

1991

10.0

10 1990

9.0

20

1989

8.0

30

1988

7.0

40

1985

6.0

50

1987

5.0

60

1983

4.0

70

1982

3.0

80

1981

2.0

90

1980

1.0

100

1979

0.0

110

1978

1.0

120

1975

2.0

130

1977

140

1973

% GDP (Revenue, Expenditure, Debt)



Public debt

Source:  Pereira et al. (2012), updated to 2015 (estimate AMECO).

Figure 9.1  Portugal’s revenues, expenditures, deficits and debt, 1973–2015 and financial sector was relatively robust and the housing bubble did not play as important a role as in other countries. Figure 9.1 gives an overview of the long-­run evolution of public finances in Portugal. The reasons why Portugal was not prepared and could not respond adequately to the GFC were not only fiscal, but also economic and ­political. A brief overview of economic and political constraints is necessary here. When the Maastricht Treaty and the Stability and Growth Pact established the reference values for the ratio of debt to gross domestic product (GDP) (60 percent) and deficit to GDP (3 percent), economists and politicians looked to the past growth record and considered it reasonable to assume a 5 percent annual nominal GDP growth rate in European countries. If economic growth was maintained at that level, public finances would be sustainable. Portugal had a reasonable growth record in the 1990s but then an appalling one in the first decade of this century, particularly in the years immediately preceding the crisis. Low growth was associated with low productivity and a significant loss of competitiveness related to several factors. Firstly, low educational levels, which have been widely acknowledged (OECD 2010), do not promote productivity increases. Secondly, a higher than expected exchange rate established for the conversion of the former Portuguese currency (the escudo) to the euro brought further damage to

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external competitiveness. Thirdly, an allocation of European Structural Funds, spent mainly on infrastructure and other non-­tradable goods and services, which contributed to increase productivity in the former years after joining the EU (1986), became a partial waste of resources in the last decade. Finally, rigidities in the labor and housing markets were also considerably damaging to economic growth, contributing to low mobility in the labor market and, along with low interest rates, promoted a high household indebtedness. On the political front, there are problems in Portugal that are not common in other European countries. Portugal, like most European countries, has a proportional representation system, which favors a fragmentation of parties in parliament when compared with majoritarian systems. However, two specific characteristics of Portuguese democracy are the lack of political competition associated with the closeness of the ballot,2 and the difficulty in making coalitions, particularly with the center-­left Socialist Party which has never formed a coalition with other left-­wing parties. Only once did the Socialists achieve an absolute majority in parliament (2005–09). In all the other years they were in power, they formed minority governments or formed weird and unstable coalitions with the more extreme right-­wing party, the conservative Social Democrats. This succession of minority governments were more prone to lobbying from interest groups and other special interests, pushing for increased expenditure and tax benefits, and less able to implement necessary reforms.

THE SITUATION IN PORTUGAL BEFORE THE CRISIS EMERGED From 2000 to 2007 the size of general government increased by 3.3 ­percentage points to an aggregate of 44.4 percent of GDP, and all of this increase was explained by growing social expenditures. Low growth and persistent deficits implied soaring public debt (as was shown in Figure 9.1) and higher debt serving charges. In just seven years the ratio of debt to GDP increased by one-­fifth from 48 percent to 68.3 percent of GDP. The Political Situation The political situation did not help governments in their fiscal management of the economy. As Box 9.1 shows, the decade started with a Socialist government with exactly half of the seats in parliament (115 out 230 Members of Parliament). This coincidence was not helpful, because, on



Portugal and the global financial crisis ­235

BOX 9.1 ELECTIONS AND GOVERNMENTS IN PORTUGAL, 2000–2011 1999–2002: XIV Government – Socialist (Prime Minister A. Guterres, a split parliament 115/230 seats) 16 December 2001: Municipal and local elections 17 March 2002: Parliamentary elections XV Government – Center-­Right (Prime   Minister José Barroso; Majority Coalition) XVI Government – Center-­Right (without elections) then P.S. Lopes became Prime Minister due to resignation of José Barroso 22 February 2005: Parliamentary elections XVII Government – Socialist (Prime    Minister J. Sócrates – Majority) 9 October 2005: Municipal and local elections (for a four-­year term) 22 January 2006: Presidential elections (for a five-­year term) 7 July 2009: Parliamentary elections XVIII Government – Socialist (Prime Minister J. Sócrates – Minority)     27 September 2009: Elections for the European Parliament (for a four-­year term) 11 October 2009: Municipal and local elections (for a four-­year term) 23 January 2011: Presidential elections (for a five-­year term) 5 June 2011: Parliamentary elections XIX Government – Center-­Right (Prime   Minister P.P. Coelho – Majority Coalition)

the one hand, no-­confidence motions could not be carried to dismiss the cabinet, and, on the other hand, the government could not pass its proposed bills through the legislature. This eventually led to the resignation of the Prime Minister Antonio Guterres in April 2002, and a right-­wing coalition led by the center-­right Prime Minister José Barroso took power. His government ended abruptly two years later in July 2004, when Barroso resigned to become the President of the European Commission. He was replaced without elections by P.S. Lopes and supported by the same coalition of Social Democrats (center-­right) and Christian Democrats. However, political instability and erratic governance led the President of the Republic to dissolve the parliament and call an early election which was won by the Socialists. A new government was formed led by socialist José Sócrates with an absolute majority in parliament. In short, in the period 2000–2007 Portugal had four different and usually unstable governments. This had important implications in the mismanagement of the economy and public finances.

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The global financial crisis and its budget impacts in OECD nations

Fiscal Policy The first implication of political instability – in particular the rotation from a center-­left-­wing government to a right-­wing government (2002) and vice-­versa (2005) – is that governments always like to present their inherited fiscal position in the worst light they can to provide a rationale for austerity measures. In 2002 Prime Minister José Barroso implemented a restrictive fiscal policy, freezing public employees’ wages and admissions into government service, which had a procyclical effect in 2003 when the country entered into recession. His successor from the same party, on the other hand, developed a slight expansionary fiscal policy (see Figure 9.2). When the Socialist Prime Minister José Sócrates came to power in March 2005, he asked the Bank of Portugal to conduct an audit of the public deficit. The Central Bank predicted that if no further measures were taken, net borrowing for that year alone would amount to 6.56 percent of GDP. This auditing of the deficit partly explained the sharp increase in net borrowing in 2005 which reached 5.9 percent of GDP (up by 2.5 percent). Sócrates retained the policy of freezing wages and new recruitment in the public sector started by Barroso’s government in 2002. Just before the GFC hit (the years 2005–07) some fiscal consolidation was shown, leading to an improvement in the structural primary balance and a reduction in net annual borrowing. The government also implemented an important reform to social security which significantly improved the long-­run sustainability of the pension system. However, the short-­run impact of 6 4 2 0 2 4 6 8 10

GDP (real var.)

Interests (% GDP)

Struct. Prim. Balance (% GDP)

Cyclical Component (% GDP)

Net Lending (% GDP)

12

Source:  AMECO database.

Figure 9.2  Portuguese main fiscal policy indicators, 2000–2011



Portugal and the global financial crisis ­237

this reform was very small. Additionally, there was a large scale reform program to central government (the Public Administration Restructuring Program, PRACE), changing the structure of all ministries. The aims were to make central government more efficient, to reduce its expenditure and at the same time to increase its efficacy. However, since targets for expenditure cuts were not tightly quantified this particular objective was not achieved. Data from Figure 9.2 does not indicate what happened in the state-­ owned enterprises and public–private partnerships (PPPs) outside the general government, which have obvious implications both on deficit and debt. From the beginning of the decade, governments became increasingly involved in PPPs. Initially most PPPs had an immediate positive impact on the budget balance, since the government initially received a lump sum payment when it signed the contract. But later such projects had a negative impact once the infrastructure had been built and government began paying for its availability, and possibly also for its use if provided free of charge to users, particularly if the investments were inefficient. That happened with many PPPs in the road transport sector. The excessive use of PPPs led to an overcapacity, especially of highways, and put a burden on the government’s budget. Also in the health sector, several hospitals were transferred out of the general government sector to become public enterprises (off-­budget). The impact on the public accounts of this externalization of hospitals was that public expenditures decreased only slightly, because these hospitals were still funded mostly from recurrent transfers from general government.3 However, the structure of public expenditure changed with these moves because hospital salaries no longer appeared as civil servants’ wages. Finally, with these institutions off-­budget the level of public debt appeared to decrease because their borrowings were not taken into account. One of the main problems for Portugal on the verge of the economic crisis was that the creation of public enterprises at central, regional and local government levels was effectively a deception and an escape from the rigid deficit and debt targets from the Maastricht Treaty and the Stability and Growth Pact (SGP). Economic Situation The Portuguese economy, after enjoying a period of high growth rates and a rapid catch-­up to the EU average in the 1990s, faced a mild recession in 2003 and recovered only gradually in the following years. GDP contracted by 0.9 percent in 2003 and grew at rates lower than 2 percent each year from 2004 until 2006. As a result of this period of lower growth, there came a halt to the

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The global financial crisis and its budget impacts in OECD nations

economic convergence to Economic and Monetary Union (EMU) standards. Between 1995 and 2000 the Portuguese per capita GDP was clearly getting closer to the EMU average (it rose quickly from a low 47.6 percent of the EMU average to 55.4 percent). However, in the following five-­year period (2000 to 2005) this convergence continued at a much slower rate, rising only to 57 percent by 2005; a level at which it has largely remained ever since. Taking into account this low-­growth environment, the year 2007 was a particularly good one, as GDP growth was 2.4 percent that year. Moreover, exports indicated signs of improvement, posting growth rates of 11.5 percent and 7.6 percent in 2006 and 2007, respectively. Yet, even with an improvement in the trade balance, the country still presented a current account deficit of 10.1 percent of GDP in 2007.

THE GLOBAL FINANCIAL CRISIS: THE EUROPEAN RESPONSE AND NATIONAL POLITICS Framework of Action at the European Level As the US subprime crisis struck in the summer of 2007, few predicted that its effects would be felt so deeply and would spread as widely as they eventually did. In fact, financial markets faced important disturbances as early as August 2007, but it took several months before the cascading effects turned the subprime crisis into a global financial crisis of initially unthinkable proportions. One credit risk indicator widely used to measure stress levels in financial markets (the TED spread;4 see Figure 9.3), spiked significantly at the beginning of the subprime crisis in August 2007 and when Bear Stearns was rescued in March 2008. These events were clearly severe disturbances in financial markets. But the major increase in this indicator was related to the aftermath of the Lehman Brothers breakdown in late 2008. The last event clearly marked the tipping point into a full GFC, triggering government financial sector rescues in the developed and developing world. Box 9.2 indicates a chronology of the main European and Portuguese responses to the disruptive effects of the GFC. It was only after these disruptive events that EU leaders, faced with the imminent collapse of several important financial institutions, decided to act decisively to foster financial stability in Europe. In October 2008, consecutive meetings of several EU and euro area governing institutions led to a set of decisions designed to increase confidence in the banking sector by raising the threshold of guaranteed deposits, and to provide



Portugal and the global financial crisis ­239 TED spread – a measure of financial market stress

b.p. 500

Subprime crisis outbreak

Rescue of Bear Stearns

Takeover of Fannie Mae and Freddy Mac and Lehman collapse

400 300 200 100 0 Jan-07

Jun-07

Nov-07

Apr-08

Sep-08

Feb-09

Jul-09

Dec-09

Source: Bloomberg.

Figure 9.3  The level of stress in financial markets, 2007–09 guidance to deal with the problems of the financial institutions in a way which would lessen financial instability. Moreover, euro area governments started anticipating the likely impacts of the financial sector rescue packages in public accounts and so began to invoke the provisions for flexibility due to ‘exceptional circumstances’ in the Generalised System of Preferences (GSP). At the end of 2008, it was increasingly acknowledged that financial market disturbances would wreak significantly damaging effects on economic growth and that the problems would not be solved simply by flooding the financial system with liquidity. It was then that it became clear to political leaders in Europe that both monetary and fiscal policy would have to be loosened promptly in order to avoid a deep and protracted recession. Therefore, in December 2008, the European Council approved the European Economic Recovery Plan (EERP), designed to push national governments to increase public expenditure in a coordinated move. A communication from the European Commission at the time stated gravely that: ‘We sink or swim together’ (ECB 2010: 2). This clearly captured the urgency of European institutions in the implementation of a significant fiscal stimulus in order to support economic growth. The euro-­wide fiscal stimulus was first planned at €200 billion (or around 1.5 percent of GDP), and some months later in March 2009 this amount was revised upwards to around €400 billion (or 3 percent of GDP).5

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BOX 9.2 A SIMPLIFIED CHRONOLOGY OF THE MAIN DISRUPTIVE EVENTS OF THE GLOBAL FINANCIAL CRISIS TOGETHER WITH THE MAIN EU AND PORTUGUESE RESPONSES July 2007 (GFC): First clear signs of disruptions in the subprime market February 2008 (GFC): Rescue of Northern Rock (UK) March 2008 (GFC): Rescue of Bear Stearns (US) September 2008 (GFC): US government intervention in two major real estate    agencies known as Fannie Mae and Freddie Mac (US)    Investment bank Lehman Brothers (US) collapsed    The takeover of AIG, a worldwide insurance corporation (US)    Several important banks and financial institutions have to be rescued in the  aftermath of the Lehman Brothers collapse: in the US (Wachovia and Washington Mutual); in Europe (Fortis, Dexia and ABN-­ AMRO in Benelux; Bradford & Bingley in the UK; Hypo Real Estate in Germany; Glitnir, Landsbanki and Kaupthing in Iceland). October 2008 (EU): ECB begins to loosen monetary policy in an unprecedented   coordinated move with central banks from the US, UK, Sweden, Switzerland and Canada.    Consecutive meetings of the Heads of State or Government of the EMU;  ECOFIN and the Council of Europe agree to: raise guarantees on deposits to a minimum of €50 000; provide guidance to deal with financial institutions’ problems; and stress the flexibility of the GSP in exceptional circumstances. October 2008 (PT): Portuguese Government increases the guarantees on   deposits from €25 000 to €100 000 and sets a €20 billion facility to be used in guarantees to banks. November 2008 (EU): EU approves financial assistance to Hungary. November 2008 (PT): Nationalization of BPN and provision of a €4 billion   facility to buy preferential shares in order to reinforce the financial system’s capital ratios. December 2008 (EU): European Council approves the European Economic   Recovery Plan (EERP) containing a fiscal stimulus of €200 billion (1.5% of GDP). December 2008 (PT): Portuguese Government announces a fiscal stimulus   package, the Investment and Employment Initiative, amounting to 0.8% of GDP (around €1.3 billion). January 2009 (GFC): Nationalization of Anglo Irish Bank (Ireland). February 2009 (EU): EU approves financial assistance to Latvia. March 2009 (EU): European Council re-­evaluates the amount of the fiscal stimulus   being pumped into the European economy to around €400 billion (3% of GDP).    EU approves financial assistance to Romania. Source:  Based mainly on information from the concise calendar of EU policy actions, European Commission (2009a: 57).



Portugal and the global financial crisis ­241

Factors Contributing to the Initial Resilience of the Portuguese Economy After recording the best performance in seven years in 2007, the Portuguese economy continued to grow positively during most of calendar year 2008. Indeed, it was only in the last quarter of 2008 that GDP declined, but even then the major drag to growth came from exports, as internal demand remained bullish. Accordingly, it is important to identify the main sources of this initial resilience. One factor was the more risk-­averse stance of the major Portuguese banks, leading to a more conservative investment profile overall. This meant that they had relatively low exposure to the highly complex financial products that were affected in the original subprime crisis. Furthermore, the spillover effects to the economy from the instability of world financial markets were at this stage less severe in Portugal than in other European countries. The Portuguese real estate market had also already faced major adjustments at the beginning of the decade and properties were considerably less overvalued than in other European countries. As a result residential property prices, which had been growing at a slower pace after 2002, faced no more than a slight deterioration in 2009 (see Figure 9.4). The resilience of the real estate sector was an important factor behind a better-­than-­expected performance of the Portuguese economy in 2008 for a number of reasons. Firstly, negative spillover effects from this particular sector to other sectors, such as construction, were smaller than in Residential property price index: new and existing dwellings 10.0%

Annual growth (%)

8.0% 6.0% 4.0% 2.0% 0.0% –2.0%

1995

1997

1999

2001

2003

2005

2007

2009

–4.0% Eurozone (16)

Portugal

Source: ECB.

Figure 9.4 Residential property price index, Portugal versus eurozone, 1995–2010

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The global financial crisis and its budget impacts in OECD nations

Table 9.1  The evolution of forecasts for the Portuguese economy Growth forecasts

For the years 2008–10 2008

IMF Oct 2007 BoP Winter 2007 IMF Apr 2008 BoP Summer 2008 IMF Oct 2008 BoP Winter 2008 IMF Apr 2009 BoP Summer 2009 IMF Oct 2009 BoP Winter 2009

2.0 2.0 1.3 1.2 1.6 0.3 −0.5 – 0.5 –

2009 2.2 2.3 1.4 1.3 0.1 −0.8 −4.1 −3.5 −3.0 −2.7

2010 2.2 – 2.2 – 1.0 0.3 −0.5 −0.6 0.4 0.7

Sources:  IMF WEO database; Bank of Portugal BoP.

other countries. Secondly, the banking sector did not have to deal with major downward revisions of the asset value of properties under mortgage contracts, as happened in other countries. Finally, confidence among Portuguese households was not shaken by a sudden loss of value of their major assets. In order to understand how the Portuguese economy evolved during the first two years of the GFC and how its prospects rapidly declined, Table 9.1 shows the consecutive revisions of both the IMF and the Bank of Portugal (BoP) growth forecasts for the Portuguese economy undertaken from October 2007 until the end of 2009, and related to the 2008–10 period. In October 2007, two months after the subprime crisis manifested itself, the IMF forecast that the Portuguese economy would grow at around 2 percent over the forecasting period (2008–10), and the revised outlook published in April 2008 presented only a slight downward revision of these projections. It was only in the last quarter of 2008 (October) that the IMF acknowledged that the Portuguese economy could face a standstill in 2009, and it took until April 2009 for a significant economic recession to be reported in the forecasts. By comparison, in October 2008 the IMF had already anticipated recessions in a number of advanced economies, namely in Iceland, Ireland, Italy, Spain and the United Kingdom. In a nutshell, the Portuguese economy was slower than other economies to show clear signs of economic deterioration, as two of the most important sources of the global contagion in this initial period (disruptions in the



Portugal and the global financial crisis ­243

banking system and collapses in real estate sector) were less pronounced domestically. Consequently, the domestic recognition of the real impacts of the crisis on the national economy lagged significantly behind other vulnerable nations such as Spain or Ireland. Financial Sector Aid, Budgetary Reform and Discretionary Fiscal Stimulus The Portuguese government was swift in responding to EU requests and took decisive action in an extraordinary meeting held on 12 and 13 October, only four days after the EU’s Economic and Financial Affairs Council (ECOFIN) meeting of the 7 October, at which European leaders established a course of action to deal with financial turbulences. Decisions by the Portuguese government included an increase of government guarantees on bank deposits from €25 000 to €100 000,6 and a €20 billion facility to be used in guarantees to Portuguese banks. In November 2008, in an environment of increasing surveillance of the banking sector’s performance, the government decided to nationalize BPN (the Banco Português de Negócios, or Portuguese Business Bank), a medium-­ sized bank that was facing significant liquidity constraints and in which the Bank of Portugal had found a number of irregularities. Simultaneously, the government opened a €4 billion facility to buy preferential shares of financial institutions, in order to ensure that they would achieve minimum capital requirements. Moreover, in the context of the European Economic Recovery Plan, the Portuguese government in December 2008 presented its own Investment and Employment Initiative (IEI), which consisted of a plan to modernize secondary school buildings, boost economic activity and exports, raise social protection and employment, and promote renewable energies and energy efficiency. The combined impact of these stimulatory measures on the public accounts was first estimated at €1.3 billion (or around 0.8 percent of GDP). As the European Commission had recommended, these measures were designed to boost economic growth temporarily in order to avoid a deeper and more protracted recession in the country. Although meant to be temporary, some of these measures were maintained into 2010 and an important part of the fiscal stimulus was effectively deferred into that year. In addition to the discretionary fiscal stimulus prompted by the EU, there was an important fiscal impulse contained in the 2009 budget presented in parliament in October 2008. And this was where politics entered the scene. Anticipating elections by the end of 2009, the government agreed to a wage increase for civil servants of 2.9 percent at a time it was already aware the economy was stagnating. It was the first pay rise for

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The global financial crisis and its budget impacts in OECD nations

public employees after several years of a salary freeze. The government also reduced the standard value-­added tax (VAT) rate by one percentage point in July 2009. The combination of the EU-­driven fiscal stimulus together with other discretionary policies led to a significant increase in the public deficit. Apparently, the cyclical component of the budget balance in 2009, measuring the automatic stabilizing effect of the recession, accounted for only −1 percent of GDP, while the structural component accounted for −9.1 percent of GDP (see Figure 9.2). However, a more detailed a­ nalysis indicates that the state (mainly responsible for the general government deficit) had a revenue decline of 15 percent in 2009 and an expenditure rise of 6 percent, suggesting that the cyclical (or non-­discretionary) ­component of the budget balance should have been greater than one-­tenth. Nevertheless, a significant general government deficit of −10.1 percent may have contributed to a less severe recession, but it also escalated public debt in 2009. At the end of 2009 the Socialist Party again won the elections, but only with minority support in parliament. Although there was a political majority of left-­wing parties in parliament, the fact that the Socialists refused to form a coalition with these parties because they were far too distant on the ideological spectrum led to a minority government with the same Socialist Prime Minister José Sócrates. A further political failure at this time was the inability or unwillingness of the Portuguese President of the Republic to insist on a coalition government with majority support in parliament. Although Portugal is a parliamentary system the President retains some relevant powers, including the ability to dissolve the parliament in extraordinary circumstances. However, the President himself was running for re-­election in about one year (January 2011) and did not want to create a political crisis by precipitating new general elections.

THE INEVITABILITY OF THE BAILOUT Fiscal Developments up to the 2011 Budget After the November 2009 elections, the Minister of Finance announced the need for a supplementary budget in order to allow for an increase in net borrowing associated with an upward revision of the public deficit for 2009. The annual budget for 2010, usually approved by December of the previous year, was promulgated in April 2010 because of the late elections. This implied that for the first four months of the financial year, the budget was implemented with the same appropriations as the 2009 budget. This



Portugal and the global financial crisis ­245

delayed the possibility of fiscal consolidation. Furthermore, with a minority government in office various active lobbies were pressing for expenditure increases, and becoming more successful in gaining concessions and favorable legislation. For instance, schoolteachers, the largest group of civil servants, opposed their model of performance assessment as too bureaucratic. They managed not only to change that model but also amend the career path of teachers in a way that will see the wage bill increase. The autonomous regions of Azores and Madeira lobbied for a more favorable Regional Finance Act and were able to pass the bill in parliament, even against the will of the government and under threat from the Minister of Finance to resign. Means testing procedures intended to target social benefits better were relaxed, and the opposition was successful in limiting the type of allowances subject to means testing, therefore reducing the selective impact of the rationing measures. During 2010 the government presented successive tightening measures, trying to cope with the large deficit. In the middle of the year, the freeze on public sector salaries was continued and a new reduction in public ­managers’ salaries of 5 percent was imposed; the government increased all VAT rates by a further 1 percent and created an additional top bracket applying to high earners in the personal income tax scales. Financial Markets Disturbances The risk premium that investors required to invest in ten-­year maturity Portuguese Treasury bonds (compared to German ones) had been falling steadily since the EMU formation and was stable at very low levels before the crisis emerged. This risk premium, or ‘spread’, began to widen as the global financial crisis deepened. This was a clear ‘flight to quality’ move by financial institutions, which was expected to be reversed once risk-­aversion returned to normal levels; and indeed, from April 2009 to the beginning of 2010 there was a significant correction to the risk premium, as financial markets regained some confidence. However, during 2010 the spread to the German bund started to rise again and by the end of that year the premium was more than seven times higher than at the end of the previous year, as shown in Figure 9.5. This widening of the risk premium on government debt markets was not exclusively Portuguese, as a similar movement happened in several other eurozone countries and triggered the sovereign debt crisis that followed the GFC. Arguably, the main events triggering these severe increases in the Portuguese spread were related to the Greece and Ireland bailouts in May 2010 and November 2010, as Figure 9.5 indicates. So, clearly, while the full impacts of the eurozone debt crisis are yet

246

The global financial crisis and its budget impacts in OECD nations Risk premium from Portuguese, Irish and Spanish 10-year OT to equivalent German Bund

12 10 8 6 4 2

-1

-1

1

1

pt Se

11 n-

ay M

0 -1 pt

Ja

0 -1

Se

ay

9

10 M

n-

-0

-0 Spain

Ja

9

pt Se

09

ay

n-

8 -0

Portugal

M

Ja

8

pt

-0 ay

Se

08 M

7 -0

-0

nJa

pt Se

ay M

Ja

n-

07

7

0

Ireland

Figure 9.5  Risk premium for Portuguese, Irish and Spanish ten-­year bonds to be revealed, its causes go well beyond the Portuguese situation. Here, however, the focus is solely on the impacts of this sovereign debt crisis to the Portuguese economy and in the fiscal response it ultimately triggered. One important point to bear in mind is that contrary to Portugal’s relative resilience to the first shocks coming from the GFC, the sovereign debt crisis had an overwhelming effect on the Portuguese economy. At the commencement of 2010, the Portuguese economy was starting to recover from the previous difficult year, with exports recovering at a faster pace than expected and public spending supporting investment and household incomes. Yet, high public and external debts and low growth prospects soon placed the country on the radar of the financial markets which pressured a steep deleveraging process. Soon Portuguese debt was spiraling out of control. The downward spiral was triggered by high risk premiums being charged for borrowings, which in turn significantly increased the costs to service public debt, that then amplified the doubts about the country’s ability to keep up with its repayments (risk of default), which further increased the risk premium. It was a vicious circle amplified by constant downward reviews of the country’s sovereign rating, as Table 9.2 indicates. Moreover, the erosion of market confidence was not confined to sovereign debt markets. It also affected the ability of Portuguese banks to secure finance in the marketplace, which immediately led to a shutdown in capital markets to Portuguese banks, making them ever more dependent on ECB funding as they were unable to restore their credibility in order to return to normal interbank market activity. These financial developments triggered a complete somersault in Portugal’s fiscal policy stance, as the government was pressed to remove the fiscal stimulus swiftly and present a credible path of fiscal consolidation.



Portugal and the global financial crisis ­247

Table 9.2  Calendar of sovereign debt negative reviews Fitch

Moody’s

Standard & Poor’s

2010 24-­Mar 27-­Apr 5-­May 13-­Jul 30-­Nov 23-­Dec

AA− – – – – A1

– – Aa2 A1 – –

– A− – – A− –

2011 15-­Mar 24-­Mar 29-­Mar 1-­Apr 5-­Apr 5-­Jul

– AA− – BBB− – –

A3 – – – Baa1 Ba2

– BBB BBB− – – –

Source: Bloomberg.

The main events of this turmoil with effects on fiscal policy are described in Box 9.3. From the 2011 Budget to the Resignation of the Prime Minister The 2011 budget, presented in October 2010, was the first budget with a clear fiscal consolidation objective. The new target for the 2011 deficit was reduced down from 7.3 percent of GDP to 4.6 percent (a fall of 2.7 percent on previous projections). The main consolidation measures included on the expenditure side were a progressive wage cut for civil servants with monthly salaries above €1500 (their first ever salary cut in 37 years of democracy), and a reduction in social protection expenditures. On the revenue side, a reduction in tax benefits and an increase in the VAT normal rate from 21 to 23 percent were proposed. Since the Socialists were in minority government there were long budget negotiations with the major opposition party, which eventually led to a formal agreement. It included the need to create an independent committee to analyze public–private partnerships, a commitment to reduce public expenditure, and a lower reduction of tax benefits than that requested by the government. March was the decisive month. On 2 March, the Prime Minister and the

248

The global financial crisis and its budget impacts in OECD nations

BOX 9.3 SIMPLIFIED CHRONOLOGY OF THE PORTUGUESE WAY INTO THE BAILOUT December 2009: EU council opened excessive deficit procedures on a list of eight    countries, including Portugal. March 2010: Approval of the 2010 budget. May 2010: €110 billion bailout to Greece and the establishment of the European    Financial Stabilization Mechanism (EFSM); and the European Financial Stability Facility (EFSF). May 2010: Deficit target for 2010 revised upwards to 7.3%.    A wide set of consolidation measures were announced. November 2010: €85 billion bailout to Ireland. November 2010: Approval of the 2011 budget, including further consolidation    measures. March 2011: Additional consolidation measures presented in the informal meeting   of Heads of State or Government of the EMU. These were then rejected in the Portuguese parliament and the Sócrates government resigned.    2010 deficit was revised upwards from 7.3% to 8.6% due to the inclusion of   three state-­owned enterprises in the consolidation perimeter. Apr 2011: Portugal requests a bailout – through the negotiation of an Economic    Adjustment Program with the IMF/EC/ECB within the framework of the European Financial Stabilization Mechanism (EFSM).    2010 deficit was revised upwards from 8.6% to 9.1% due to the reclassification   of several PPP contracts. May 2011: The Portuguese government and the ‘Troika’ sign the Memorandum of   Understanding that includes a financial package of €78 billion. July 2012: OECD predicts recessions in 2012 and 2013 of −3.2% and −0.9%   respectively, although later figures indicated the true figures for the recessions in these years were −4.0% and −1.6%, increasing the ratio of debt to GDP to 129.7%. Source:  Based mainly on information from European Commission (2011: 15).

Minister of Finance went to Berlin for a private meeting with the German Chancellor Angela Merkel. The objective was to calm down capital markets and perhaps to talk about the austerity measures to include in the Stability and Growth Program (SGP) in exchange for broad support from the European Stability Mechanism (ESM). The Prime Minister and the Minister of Finance decided to anticipate some strong austerity measures, which would later be included in the Portuguese SGP. The objectives were twofold. The government sought, on the one hand, to send signals to the markets that the country intended to succeed in fiscal consolidation; and, on the other hand, to gain some bargaining influence at important EU meetings ahead. On 11 March the government called a press conference and announced



Portugal and the global financial crisis ­249

a large set of austerity measures. On the same day, without even consulting the President, the Prime Minister presented these measures at the Eurogroup meeting in Brussels. On the following day the leader of the main opposition party announced that he would not support the so-­ called ‘SGP-­IV’. On 15 March, Moody’s downgraded the sovereign debt rating of Portugal from A1 to A3. The government formally submitted the SGP to parliament on 21 March, where it was opposed by all other non-­ government parties from the left and right. These parties moved a series of amendment motions against the SGP which were all approved with the combined votes of the opposition parties on the 23 March, leading to the Prime Minister’s resignation on the same day.

THE NEW FISCAL FRAMEWORK AND THE BAILOUT MEMORANDUM Following the resignation of the Prime Minister, the President declared fresh general elections for 5 June 2011. But two months was too much time for Portugal to languish with a caretaker government. There was a need to borrow in capital markets, and Portuguese bond yields were rising against German bonds. On 8 April the Eurogroup and ECOFIN ministers issued a statement, extending financial support to Portugal under a conditionality agreement (Memorandum of Understanding on Specific Economic Policy Conditionality). A €78 billion loan was agreed with an equal tripartite division between the IMF, the European Financial Stability Facility (EFSF) and the ESM. Although the main negotiations for the bailout were conducted between the Portuguese minority government and the Troika of the IMF, EC and ECB, the main opposition right-­wing parties gave their formal agreement to the Memorandum of Understanding (MoU). Remarkably, before the Socialist Prime Minister stepped down the rightist parties were vehemently against any further austerity measures (for example, tax increases), but once he had resigned, and even before general elections, they accepted everything they had opposed and even accepted further austerity measures. Such is politics. The Introduction of a New Fiscal Framework The lack of political cooperation was clear in that interim caretaker period (April–May) when a new and important change to the Budget Framework Law (LEO) was approved on 6 April 2011, supported only by the votes of the minority Socialist party. Nevertheless, it introduced an array of important changes. It established a relatively independent

250

The global financial crisis and its budget impacts in OECD nations

Council of Fiscal Policy (CFP), whose main functions were to develop its own macroeconomic forecasts, to analyze the sustainability of public finances (including pensions), to verify whether the fiscal rules set by law were being violated or not, and to check whether the limits to indebtedness of regional and local governments were being surpassed or not. The LEO set fiscal rules not only for general government (including the structural balance) but also for central government and social security. With regional and local governments, since they have autonomy from the state budget limits, the LEO imposed limits only on indebtedness. It also stipulated that multi-­year limits would apply to central government expenditure funded by general revenues with cascading limits to expenditure programs and groups of programs. The more ambitious task proposed by the LEO was the progressive implementation of zero-­based budgeting not only across public administration, but also applying to public enterprises. Priority must be given, said the law, to those programs which have deficits. It predicted that the target of a balanced budget (adjusted for the cycle) should be achievable by 2015, while the annual SGP should update the progress to reach that objective. The LEO also laid out the general chronology of the budget process, starting precisely with the presentation of the multi-­annual SGP. Memorandum, Consolidation Path and Main Measures to Reduce the Deficit The bailout of May 2011 (MoU) has been mostly implemented by the new center-­right government led by Passos Coelho that emerged from the legislative elections of 5 June with majority support in parliament. As an overarching consolidation document, it has a detailed, quantified and time-­specified set of measures to be taken by the Portuguese government. Objectives are set by quarter, and after each quarter there is an assessment of the progress done. The measures included in the initial memorandum were very broad, including: (1) fiscal policy and fiscal structural measures; (2) financial sector regulation and supervision; (3) labor market and education; (4) markets for goods and services (energy, telecommunications, transport); (5) the housing market; and (6) the judicial system. Focusing on the first type of measures, the MoU set a consolidation path until 2013 where the deficit should be no more than 5.9 percent of GDP in 2011, 4.5 percent in 2012, and 3 percent in 2013. The main measures directed to fiscal consolidation were the following: 1. Privatization of public sector enterprises: energy producers, flight companies, the post office, and so on.



Portugal and the global financial crisis ­251

2. Targeted expenditure rationing: a decrease in higher monthly pensions above €1500 plus savings on health expenditures, for example. In 2012 and 2013 a freeze was imposed on recruitment, promotions and wages for the public sector. Transfers to local and regional governments were reduced and controls over the expenditures of state-­owned enterprises tightened. Capital expenditures were trimmed and are to be funded mainly by own-­revenue sources or from increased European funding. 3. Targeted revenue measures include a revision of the list of goods and services subject to reduced VAT rates; and increased revenues from personal income tax (increased marginal tax rates and reduced tax benefits) and corporate income tax (ending the reduced rate for small enterprises). The idea behind the Memorandum was also to introduce measures that would increase competitiveness in the long run. Among these more structural measures, mainly targeted at reducing rigidities in housing and labor markets, was a significant decrease in the employers’ contribution to social security. Although the austerity program was designed to curb some of the most important structural problems over the long run (to improve internal efficiencies and liberalize sectors), there were some one-­off measures (for example, privatization) that will have a short-­run impact on reducing debt, but, on the other hand, reduce the assets of the public sector that in some cases generated dividends (a public revenue). Other measures which the government adopted in 2011 to help achieve the deficit target of 5.9 percent of GDP had an immediate impact on the deficit, such as the incorporation of pension funds in the banking sector into social security accounts, but at the same time this created an implicit debt. In fact this incorporation of these pension funds served as an important one-­off revenue boost in 2011 but will increase government liabilities in the future.

CONCLUSIONS Portugal’s problems with its public finances are closely connected with the level of external debt and the lack of competitiveness of the economy. In some part, the present difficulties arose from Portugal’s past structural mismanagement of public finances, in particular in phases two and three of the EMU. The tolerance of a poor commitment to fiscal discipline and an overvalued currency (the euro) posed big challenges both to the Portuguese economy and to fiscal policy.

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The global financial crisis and its budget impacts in OECD nations

The analysis of this chapter has emphasized the shortcomings of the proximate institutional framework (at the international, European and domestic levels) that served to impinge on the nature, design and speed of fiscal policy as a response to the GFC. Insofar as European institutions are concerned, the Portuguese case is illustrative of how monitoring from the European Commission and European Council appears to have been flawed. They were slow in anticipating the scope of the GFC and its impact on Portugal, perhaps initially partly due to the smaller impact of the crisis on the banking system and the real estate sector compared to other countries. The initial targets of the SGP were limited because they essentially focused on the public deficit and largely neglected the public debt. These institutions failed to take account of the debt of public corporations which, at some stage, may be outside general government (off-­budget), but later can be included and therefore deteriorate the public finances of particular countries.7 It also seems that the Bank of Portugal and the European Monetary Institute (a predecessor of the European Central Bank) were overly optimistic about the ability of the Portuguese economy to withstand a high conversion rate of the former escudo. These monitoring and informational failures are not an excuse for not criticizing the Portuguese government’s mismanagement of public finances. Political instability and inherent weaknesses of the domestic political system helped to paralyze responses and reforms. Portugal’s poor record in its economic and fiscal policy settings was related to the specific characteristics of the political system, in particular the lack of political competition, difficulty in making coalitions (and majority ­governments) and absence of independent institutions to scrutinize fiscal policy. Moreover, a constant turnover of governments, many in minority status, did not help the nation’s plight. So, before the crisis hit, instead of benefitting from decreasing interest rates in order to have increasing primary surpluses and decreased levels of public debt, governments used these savings to deteriorate their primary balances. They formally abided with the Maastricht budget deficit criteria by counting windfall or extraordinary revenues (for example, third-­ generation mobile phone licenses) rather than taking structural consolidation measures. Political failure and policy timidity exacerbated the eventual impact of the GFC and sovereign debt crisis. What lies ahead is unknown. Currently, the viability of the euro project is under scrutiny; it may break up, divide or slowly muddle through. The future of Portugal is integrally connected with the future of the EU, and of the euro in particular. A second bailout may be necessary if the debt crisis does not abate in the near future. And yet, there are some signs of positive news. In Portugal, like Ireland and unlike Greece, the government has enjoyed a wide consensus around the necessity to carefully implement the



Portugal and the global financial crisis ­253

austerity program. The parties that signed the agreement consist of about 80 percent of the members of parliament, although the actual majority supporting the government is smaller. This shows that there is wide political support for the program. The government presented the budget for 2012 announcing severe cuts in bonuses for both civil servants and pensioners, to which the main opposition party has abstained in parliamentary voting. These cuts go beyond the agreement with the Troika, and some sectors in Portuguese society consider that they are unconstitutional. There are also some ongoing worrying concerns which are related mainly to the inability of nations such as Portugal to undertake a fiscal devaluation within the eurozone. At present such a policy does not appear a viable option and this could retard the nation’s ability to increase its competitiveness and build economic growth after enduring the present period of fiscal austerity and recession which will be, for sure, deeper than the government predicted in the 2012 budget.

NOTES 1. The opinions expressed herein are those of the authors and do not reflect those of the institutions to which they are affiliated. 2. To understand why the Portuguese ballot structure is closed and gives little freedom for voters to choose candidates, see Pereira and Silva (2009). 3. See Eurostat (2010) to understand when hospitals may be considered public corporations outside general government, and also the meaning of several financial operations between hospitals and general government. 4. The TED spread measures the difference between what the market asks for lending to the banking sector and to the government for three-­month loans. 5. The practical impact of the fiscal stimulus was apparently small (see Afonso et al. 2010; ECB 2010). 6. EU leaders had set the minimum guaranteed threshold at €50 000. 7. This happened in 2011 when Eurostat and the INE (the European and Portuguese statistical authorities, respectively) reclassified several public corporations and included them in general government.

BIBLIOGRAPHY Afonso, A., Checherita, C., Trabandt, M. and Warmedinger, T. (2010), ‘Euro Area Fiscal Policies: Response to the Economic Crisis’, in Ad van Riet (ed.), Euro Area Fiscal Policy and the Crisis, Frankfurt am Main: European Central Bank, pp. 22–34. Bank of Portugal (2007), Economic Bulletin, Winter. Bank of Portugal (2008a), Economic Bulletin, Summer. Bank of Portugal (2008b), Economic Bulletin, Winter. Bank of Portugal (2009a), Economic Bulletin, Summer. Bank of Portugal (2009b), Economic Bulletin, Winter.

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European Central Bank (ECB) (2010), Euro Area Fiscal Policy and the Crisis, A. van Riet (ed.), Frankfurt am Main: European Central Bank. European Commission (2009a), Economic Crisis in Europe: Causes, Consequences and Responses, DGEFA European Economy, No. 7/2009. European Commission (2009b), Communication on a European Economic Recovery Plan, COM (2009/800). European Commission (2011), The Economic Adjustment Program of Portugal, DGEFA Occasional Paper No. 79, June. European Commission (2012), Public Finances in EMU, European Economy No. 4. Eurostat (2010), Manual on Government Deficit and Debt: Implementation of ESA 95, Luxembourg. IMF (2007), World Economic Outlook, October. IMF (2008a), World Economic Outlook, April. IMF (2008b), World Economic Outlook, October. IMF (2009a), World Economic Outlook, April. IMF (2009b), World Economic Outlook, October. OECD (2010), PISA 2009 Results, OECD: Paris. Pereira, P. (2012), Portugal: Dívida Pública e Défice Democrático, Lisbon: Fundação Francisco Manuel dos Santos. Pereira, P.T. and Silva, J.A. (2009), ‘Citizens’ Freedom to Choose Representatives: Ballot Structure, Proportionality and Fragmented Parliaments’, Electoral Studies, 28, 101–10. Pereira, P.T., Afonso, A., Arcanjo, M. and Santos, J.C. (2012), Economia e Finanças Públicas, 4th edn, Lisbon: Escolar Editora.

10. The global financial crisis in Greece: its background causes, escalation and prospects for recovery Michael G. Arghyrou Greece is a country in deep crisis – fiscal, economic, political and social. Between 2008 and 2013 its economy recorded six consecutive years of recession before registering a slightly positive growth rate in 2014. This prolonged economic contraction has resulted in record rates of unemployment (increasing from 7.8 percent in 2008 to a peak of 27.5 percent in 2013 before declining to 26.5 percent in 2014). Greece faces fiscal derailment, with its public debt to gross domestic product (GDP) ratio surging from 109 percent in 2008 to 177 percent in 2014. As a result, since early 2010 Greece has been effectively excluded from international bond markets, relying on external rescue schemes, provided by the European Union and the International Monetary Fund (IMF), to fund the servicing of its public debt and basic state services. Finally, the country’s position in the European Economic and Monetary Union (EMU) is in considerable doubt, with many inside and outside the country calling for a Greek exit from the euro, the so-­called ‘Grexit’. The acute fiscal and economic crisis has caused a sea-­change in Greek politics: since October 2009 Greece has held four general elections, changed six governments (including one acting government) and has seen one of its traditional mainstream parties (the centre-­left Panhellenic Socialist Movement, PASOK) all but wiped out from the country’s political map, while the second mainstream party (the centre-­right New Democracy) has suffered critical electoral setbacks. At the same time, parties holding, either in their entirety or in substantial proportions, highly populist and extremist views have emerged both from the left and the right of the political spectrum, prompting the ex-­Greek Prime Minister, Antonis Samaras, to repeatedly warn against the risk of Greece becoming a new Weimar Republic.1 This growing political radicalization culminated in the subsequent rise and electoral victory of the far-­left Syriza party. Finally, the fiscal and economic crisis has imposed rising social costs, 255

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The global financial crisis and its budget impacts in OECD nations

reflected in increased poverty and increasing criminality including violent xenophobia. This chapter explains what led to the Greek crisis, how it unfolded, and the prospects for resolution. It begins by reviewing the antecedents to the Greek crisis during the period 2001–09. Next, it discusses the immediate events that triggered the Greek crisis and explains how the Greek and European authorities attempted to handle the crisis. The chapter then assesses the various potential resolutions to the crisis, including the Grexit scenario, while paying particular emphasis to the internal and external risks currently faced by Greece. The argument of this chapter is that the Greek government misread the crisis and did not take appropriate precipitous action in time. The financial crisis quickly morphed into an enduring political crisis, leaving governments increasingly less able to act to rectify or remedy the economic pain. As a result Greece has drifted through a succession of crises applying half-­hearted austerity measures in the face of European and international pressure. Greece will confront a stark choice going forward: staying within the eurozone or departing from it. I suggest in the concluding section that the option of Greece remaining in the eurozone is preferable to one where Greece departs from the Monetary Union to resurrect its own currency, with the intention of implementing a major devaluation.

BACKGROUND CONTEXT TO THE GREEK CRISIS: 2001–09 The Greek crisis is widely acknowledged to have commenced in autumn 2009, after a prolonged period of high economic growth. From 1996, and especially since Greece’s accession to the EMU in 2001, the country registered increasing growth rates consistently higher than those achieved by the EMU average (see Figure 10.1). This resulted in a rapid increase in income levels which, at first sight, seemed to have put Greece on track for full convergence with its EMU partners: measured in purchasing power standards (PPS), Greek per capita GDP increased from 84 percent of the EMU’s average in 1995 to 94 percent in 2009. Yet, a closer look at the data reveals that this optimistic picture was deceptive. The first clear indication that Greece was not doing as well as implied by the headline growth figures is provided by the ‘output gap’ statistics (that is, the difference between recorded GDP and potential output, or the level of GDP justified by a country’s production capacity). From 2003 the Greek output gap entered a sharply increasing path, registering a cumulative positive value of 39 percentage points over the years 2003–10



The global financial crisis in Greece ­257 8 6 4 2 0

–2 –4 –6 2008

2009

2010

2011

2009

2010

2011

2007

2006

2005

2008

Greece

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

–8

EMU average

Source:  IMF – International Financial Statistics.

Figure 10.1  GDP growth rate (%) 11 6 1

Greece

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

–4

EMU

Source:  IMF – International Financial Statistics.

Figure 10.2  Output gap (% in GDP) (see Figure 10.2). By comparison, over the same period the cumulative sum of the eurozone’s output gap was nearly zero (−1.5 points). In other words, for almost a decade the Greek economy maintained a level of economic activity one-­third higher than the level justified by the country’s

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The global financial crisis and its budget impacts in OECD nations

production means. From that point of view, and to foreshadow what follows, there is nothing surprising about the deep and prolonged character of the current recession. To a large extent, this can be seen as an equilibrium phenomenon restoring Greek economic activity to its equilibrium value. The recession has been prolonged and severe because the bubble preceding it was equally prolonged and significant. Four main factors fuelled the pre-­crisis Greek economic bubble; three increasing demand and the other constraining supply. The first factor was a fiscal deterioration caused by an expansionary fiscal policy. Between Greece’s accession to the euro in 2001 and the onset of the global financial crisis (GFC) in 2007, this was mainly manifested in reduced public revenue as a percentage in GDP. Given the high-­growth conditions of this period, this reduction is paradoxical and reflects the inability of the Greek authorities to tackle significant tax evasion or avoidance effectively (Artavanis et al. 2012). At the same time, expenditure remained stable as a percentage of GDP but in absolute terms it increased by approximately 60 percent. The bulk of this increase was directed to increased employment in the public sector, as well as increases in public sector wages, pensions and other social benefits. Public finances spiraled out of control with the onset of the global credit crunch, culminating in 2009 when the government’s headline deficit reached the unprecedented level of 15.5 percent of GDP (see Figure 10.3) putting public debt on a rapidly accelerating path (see Figure 10.4), mainly due to increased government expenditure, although revenue also fell. While 5 0 –5 –10 –15

Net lending/borrowing Structural balance Source:  IMF – International Financial Statistics.

Figure 10.3  Fiscal balance (% of GDP)

Primary net lending/borrowing

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

–20



The global financial crisis in Greece ­259

180 160 140 120 100 80 60

Greece

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

40

EMU

Source:  IMF – International Financial Statistics.

Figure 10.4  General government gross debt (% in GDP) public deficits and debt increased substantially in all European countries in 2008–09, Greece’s fiscal deterioration was different: unlike other countries, such as Ireland, it did not originate from any significant banking rescue programme, and was primarily the result of discretionary expenditure increases and revenue reductions, directly linked to the Greek political cycle ahead of the general election of 2009. The second factor was excessive wage growth, primarily driven by the increased wage increases granted to the public sector of the economy. A useful benchmark determining the size of wage increases compatible with the economy’s production capacity is the sum of growth in labour productivity and consumer prices (Tobin 1995). Table 10.1 reveals that over the period 2001–09 Greek wages (compensation per employee in current values) registered a cumulative increase of 50 percent, the highest wage growth among the 12 EMU countries. Although partly justified by increases in productivity, it was significantly higher than the latter. By contrast, German workers over the same period were underpaid relative to the previously explained benchmark by a cumulative total of 8 percentage points. Table 10.1 indicates that Greek workers were granted purchasing power well beyond the capabilities of the Greek economy from 2001–09. Therefore, the reduction in wages over 2010–11 was bringing labour

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The global financial crisis and its budget impacts in OECD nations

Table 10.1 Cumulative growth in nominal compensation per employee, consumer price inflation and labour productivity, 2001–11 (a) (b) (c) (d) (e) Nominal Consumer Labour Sum of labour Excess compensation Price Index productivity productivity compensation per employee (CPI) growth and CPI growth, growth, growth growth (b) 1 (c) (a) − (d) 2001–09 Greece Ireland Spain Portugal Finland Luxembourg Netherlands France Belgium Austria Italy Germany Average EMU12

50.3 44.1 33.8 28.5 27.9 26.2 25.4 25.3 22.7 20.1 19.3 7.3 27.5

28.0 22.8 24.9 20.3 12.2 19.0 15.7 14.8 17.3 15.8 18.7 13.2 18.6

8.2 13.0 3.8 5.2 5.1 −2.1 5.4 4.6 4.3 5.4 −5.8 1.9 4.1

36.2 35.9 28.7 25.6 17.3 16.9 21.2 19.4 21.6 21.2 13.0 15.1 22.7

14.1 8.2 5.1 2.9 10.6 9.3 4.2 5.8 1.1 −1.2 6.4 −7.8 4.9

2001–11 Greece Ireland Spain Finland Luxembourg France Portugal Netherlands Belgium Austria Italy Germany Average EMU12

40.7 39.9 34.7 34.5 32.5 31.8 29.2 28.9 28.2 23.8 22.9 13.1 30.0

38.4 24.8 31.2 17.4 25.8 19.1 26.5 20.0 24.1 21.8 23.9 17.1 24.2

6.2 21.3 8.2 10.4 −2.0 7.7 8.2 7.9 6.5 7.7 −3.3 7.3 7.2

44.7 46.1 39.4 27.8 23.8 26.7 34.7 27.9 30.6 29.5 20.6 24.4 31.3

−4.0 −6.2 −4.7 6.7 8.7 5.1 −5.5 1.0 −2.4 −5.7 2.3 −11.2 −1.3

Note:  Countries are ranked by order of nominal compensation per employee growth. Source:  Based on European Central Bank data.

income in Greece into line with its income-­generating capacity. Indeed, the data reported in Table 10.1 suggests that a slight overshooting in the wage correction may have taken place over the last two years. The third factor causing excess demand was the significant reduction in Greek interest rates following the elimination of exchange rate



The global financial crisis in Greece ­261

25.0 20.0 15.0 10.0 5.0

12-month treasury bill rate

Real interest rate

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

–5.0

1991

0.0

CPI inflation

Source:  IMF – International Financial Statistics.

Figure 10.5  Inflation and interest rates risk accompanying Greece’s accession to the euro in 2001 (Arghyrou et al. 2009). Combined with relatively high inflation, this resulted in negative real interest rates (see Figure 10.5). Within an environment of abundant international credit and positive output gap values (that is, at a time when mainstream monetary policy would imply increasing interest rates to control inflation pressures), the reduction in real interest rates fuelled demand further, making the Greek economy vulnerable to a sharp correction in the event of a negative external shock. Finally, there was insufficient progress in addressing long-­ standing structural and institutional weaknesses. This constrained the supply side of the Greek economy, preventing it from expanding to meet the increase in demand discussed above. Structural and institutional weaknesses have long been a salient feature of the Greek economy, with the convergence programmes implemented in the 1990s aiming towards EMU participation achieving only limited progress in terms of addressing them (Mourmouras and Arghyrou 2000). These weaknesses causing distortions in the markets for goods, labour and services can be summarized as excessive regulation and market-­entry barriers, extensive bureaucracy, extensive corruption, and institutional hostility towards business. Of particular importance is the degree of corruption. Evidence of Greece’s performance in the fields of transparency and corruption is reflected in the country’s score in the Corruption Perception Index compiled by Transparency International (TI). Higher index values (up to 10) denote a higher degree of transparency, implying less corruption; lower

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The global financial crisis and its budget impacts in OECD nations

values, vice versa. Greece started the previous decade from a relatively low base (4.2 out of 10 in 2001), ranking it forty-­second in the list of all countries surveyed by TI. Since then, Greece deteriorated even further on both accounts, particularly since the onset of the Greek debt crisis. By 2009 Greece’s transparency score slipped to 3.2 out of 10, taking the country’s ranking down to 80. Table 10.2 presents Greece’s performance in providing a business-­ friendly environment. The data comes from the 2012 Doing Business Database compiled by the World Bank. It ranks 183 countries in terms of their overall business-­friendly performance. Greece is ranked 100 out of 183 countries, and when ranked against its peer-­group average, the high-­income Organisation for Economic Co-­operation and Development (OECD) countries, Greece is outranked in nine out of ten business areas, with its ranking being particularly low in starting a business (135), registering property (150) and protecting investors (155). Greece is ranked lower than its peer average in 13 out of 17 sub-­area indicators measuring the number of procedures, days and documents necessary to perform a business task, reflecting a high level of bureaucracy. The lack of progress in promoting structural reforms combined with excess wage growth resulted in a substantial reduction in Greek external competitiveness, as suggested by the significant overvaluation of the Greek real exchange rate (see Figure 10.6). A degree of real appreciation is justified, and in that respect is benign, as long as it reflects productivity gains, as suggested by the well-­known Balassa–Samuelson hypothesis (Taylor and Sarno 2002). However, in the case of Greece, real exchange rate overvaluation took values well beyond the degree justified by productivity gains, and is almost certainly related to the excessive increase in unit labour cost and other prices caused by the positive demand shock described above. With a stagnating supply side hindering exports and increasing disposable incomes boosting imports, the result of real exchange rate overvaluation was record high current account deficits (see Figure 10.6) giving rise to a large stock of external debt (Arghyrou and Chortareas 2009). To summarize, following accession to the euro in 2001, Greece recorded substantial growth rates which, however, were purely demand-­ driven. On the eve of the GFC, Greece had accumulated unsustainable macro-­ imbalances in the form of large public and external debt, with a supply side weak in terms of production capacity and lacking flexibility to adjust successfully in the event of a major external shock. Given this background, and as predicted in due course (Arghyrou 2006), the Greek debt crisis was one waiting to happen.



The global financial crisis in Greece ­263

Table 10.2 Ease of Doing Business Index, 2012 (ranking out 183 countries) High-­income Greece OECD average Ease of Doing   Business rank Starting a business

Dealing with  construction permits Getting electricity

Registering property

Getting credit

Protecting investors

Rank Procedures (no.) Time (days) Cost (% of income per capita) Paid-­in min. capital (% of income per capita) Rank Procedures (no.) Time (days) Cost (% of income per capita) Rank Procedures (no.) Time (days) Cost (% of income per capita) Rank Procedures (no.) Time (days) Cost (% of property value) Rank Strength of legal rights index  (0–10) Depth of credit information   index (0–6) Public registry coverage (% of  adults) Private bureau coverage (% of  adults) Rank Extent of disclosure index  (0–10) Extent of director liability   index (0–10) Ease of shareholder suits index  (0–10) Strength of investor protection   index (0–10)

29.7

100

57.4 5.3 12.5 4.7 14.1

135 10 10 20.1 22.8

53.5 13.8 151.9 45.7 53.8 4.7 103.1 92.8 58.6 4.8 30.6 4.4 41 7.2

41 14 169 3.4 77 6 77 59.2 150 11 18 12 78 4

4.7

5

9.5

0

63.9

82.4

62.5 6.1

155 1

5.1

4

6.7

5

6

3.3

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The global financial crisis and its budget impacts in OECD nations

Table 10.2 (continued) High-­income Greece OECD average Paying taxes

Rank Payments (number per year) Time (hours per year) Profit tax (%) Labour tax and contributions  (%) Other taxes (%) Total tax rate (% profit) Trading across borders Rank Documents to export (no.) Time to export (days) Cost to export (US$ per  container) Documents to import (no.) Time to import (days) Cost to import (US$ per  container) Enforcing contracts Rank Time (days) Cost (% of claim) Procedures (no.) Resolving insolvency Rank Time (years) Cost (% of estate) Recovery rate (cents on the  dollar)

62 13.4 185.7 15.4 24

83 10 224 13.4 31.7

3.2 42.7 33.6 4.4 10.5 1031.7

1.4 46.4 84 5 20 1153

4.8 10.7 1084.6

6 25 1265

37.2 518 19.7 31.4 27.3 1.7 9.1 68.2

90 819 14.4 39 57 2 9 41.8

Source:  Ease of Doing Business Index, 2012, http://www.doingbusiness.org/rankings.

THE LAUNCH OF THE GREEK CRISIS AND THE MEMORANDUM OF UNDERSTANDING The Immediate Crisis: November 2009–April 2010 The Greek debt crisis erupted in autumn 2009, immediately after the general election that took place on 4 October of that year, resulting in a change in government from the centre-­right New Democracy to the centre-­ left PASOK. The crisis was experienced in two discrete steps. The first took



The global financial crisis in Greece ­265

110

20

100

15

90

10

80

5 0

70 1991

1993

1995

1997

1999

2001

REER ULC-BASED

2003

2005

2007

2009

2011

Current account deficit

Note:  An increase in the real effective exchange rate denotes a real appreciation. Source:  IMF – International Financial Statistics.

Figure 10.6 Real effective exchange rate (2005 5 100) and current account balance (% in GDP) place in November 2009, when the borrowing costs for the Greek government, as reflected in the ten-­year government bond yield spread against Germany, increased from 136 basis points in October 2009 to 235 points in December 2009. The second took place in January–February 2010, by the end of which the spread had reached 329 points (see Figure 10.7). This author has argued earlier that between 1999 and July 2007, a period characterized by abundant global liquidity and low interest rates, markets were pricing EMU sovereign bonds disregarding any macro-­ imbalances such as those observed in Greece (Arghyrou and Tsoukalas 2011; Arghyrou and Kontonikas 2012). They did so expecting that imbalances would voluntarily be corrected in due course, and, if they were not, no country would be allowed to default within the eurozone. Effectively, markets were pricing sovereign bonds assuming an implicit guarantee from the financially sound core EMU member states to the financially fragile periphery EMU countries. This rendered investing into periphery bonds a one-­way bet in which all likely gains would benefit private investors, while any losses would be transferred to EMU governments. This led to ‘­convergence trading’ (see The Economist 2010), a self-­fulfilling state of affairs in which periphery bonds experienced significant increase in demand, increasing their prices and lowering their yields, removing market-­based incentives from countries such as Greece to undertake corrective action to limit increasing mounting macro-­imbalances.

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The global financial crisis and its budget impacts in OECD nations

28 24 20 16 12 8 4 0 I

II III IV 2007

I

II III IV 2008

I

II III IV 2009

I

II III IV 2010

I

II III IV 2011

I

II III 2012

Notes:  Vertical lines – First: Lehman Brothers’ collape (October 2008); Second: Greece submits 2010 proposed budget for EU approval (November 2009); Third: EU countries fail to agree on Greek rescue package (February 2010); Fourth: Greece requests financial assistance (April 2010); Fifth: First memorandum of understanding signed (May 2010); Sixth: Second memorandum of understanding signed (June 2011); Seventh: Papandreou announces then calls off referendum on PSI. Papandreou resigns, Papademos’s government formed (November 2011); Eight: PSI negotiations successfully concluded (March 2012); Ninth: Elections (May 2012); Tenth: Elections (June 2012). Source:  European Central Bank.

Figure 10.7  Ten-­year government bond yield spread versus Germany Following the onset of the global credit crunch in July 2007, particularly following the collapse of Lehman Brothers in October 2008, international investors, motivated by losses on their private equity and bonds portfolio, switched from this convergence bond pricing model to one placing emphasis on macro-­fundamentals. In the case of Greece, however, market signals went unnoticed by the New Democracy government, which throughout 2008–09 did not undertake any corrective policy initiative. Hence, a very substantial increase occurred in Greek budget deficits over 2008–09. By mid-­2009 it had become obvious that the New Democracy government was either unwilling or unable to reverse the unsustainable debt dynamics. International investors, fully anticipating a change in government, maintained a wait-­ and-­ see stance. During the two-­ month-­ long election campaign of summer 2009 they kept Greek spreads in the area of 120–130 basis points, expecting political developments. When the new PASOK government took office on 5 October 2009 the Greek spread



The global financial crisis in Greece ­267

did not react either. It still did not react even after the new government announced a revision of the projected 2009 public deficit from 6 percent of GDP to 13.7 percent of GDP on 13 October 2009. The markets gave the new government a window of opportunity to signal its policy intentions. Up to this point Greece was facing a crisis of macro-­fundamentals, which was obvious and openly discussed in international policy circles,2 but not yet a full-­blown public debt crisis. But like its predecessor, the new PASOK government interpreted the market signals incorrectly. During a few crucial initial weeks in office it appeared divided over its policy priorities and sent mixed signals regarding its policy intensions. The new government was split between those who realized the imminent danger of a market backlash if drastic steps were not taken immediately, and those who were advocating that Greece was only facing speculative pressures that could easily be brushed aside. The new Prime Minister, George Papandreou, who had come to power promising that austerity was not necessary, was reluctant to go back on his pre-­ electoral commitments. He thus attempted a balancing act, culminating on 9 November 2009 when the new government submitted to the European Commission its draft budget for 2010. This was widely seen as a collection of half-­measures inadequate to effectively address the mounting fiscal and external imbalances. The proposed budget attracted public criticism by senior European officials, including the President of the European Central Bank (ECB) Jean-­Claude Trichet, and markets quickly deemed the plan as insufficient to achieve its stated objectives (Lynn 2011). This event was the catalyst for the launch of the Greek debt crisis. For the first time since the creation of the euro, markets seriously questioned the willingness or the ability of Greece, as expressed by two successive governments from the mainstream parties, to take measures necessary for maintaining Greece’s participation in the euro. Credit rating agencies issued repeated downgrades of Greek bonds, and markets introduced into Greek spreads a previously non-­existent or very limited default and exchange rate premium (Lynn 2011: 133).3 They then proceeded into a massive sale of Greek bonds, doubling Greek spreads from 130 points in October to 235 points in December 2009, and 276 points in January 2010. Belatedly, on 2 February 2010, Greece announced spending cuts and new taxes aiming to reduce the budget deficit to 3 percent of GDP by 2012. Spreads, however, continued to increase. Following credit downgrades of four major Greek banks, on 23 February 2010 Greece announced further austerity measures, including for the first time cuts in civil service salaries and a value-­added tax (VAT) increase by two percentage points. With confidence deteriorating fast in Greece’s ability to service its debts, investors looked at Greece’s EMU partners to provide a solution in their

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The global financial crisis and its budget impacts in OECD nations

perceived capacity as guarantors of Greek fiscal liabilities. This was not forthcoming, as there was a significant rift between France, which advocated putting in place a financial rescue package for Greece, and other North European countries (Bohn and de Jong 2011). Led by Germany, these Northern European countries refused to bail out Greece. Their initial response was a policy officially described as ‘constructive ambiguity’. Then, to the markets’ great surprise, in February–March 2010 Germany made it publicly clear that it was not prepared to help Greece unconditionally. Germany’s hard line was interpreted by markets as a withdrawal of the previously perceived fiscal guarantee for Greece. The price of Greek bonds plummeted further, causing spreads to increase to 636 points in March. With confidence in Greece’s EMU participation fast disappearing, Greek banks experienced significant deposit withdrawals, with cash withdrawn either hoarded or sent abroad. The Greek sovereign debt crisis was fast becoming a banking crisis. Overall, the Greek debt crisis was caused by the significant deterioration of economic fundamentals over the period 2001–09. Yet, the crisis could have been at least partially contained if the PASOK government had not made major policy mistakes during the crucial period October–November 2009, and the rest of the EU countries had not been so fragmented and reluctant to agree to the first Greek financial rescue package. These two events transferred Greece from a regime of credible EMU commitment under guaranteed fiscal liabilities, to a non-­credible EMU regime with no guarantees. Hitherto, the handling of the Greek crisis would proceed in an environment of negative expectations and extreme risk-­aversion, making its management much more difficult than it could otherwise have been. The First Memorandum of Understanding: May 2010–June 2011 On 9 April 2010 Greek bonds were downgraded to the last investment category above junk-­status. In response, and with yields on Greek bonds rising to 715 basis points, EMU Finance Ministers agreed to provide loans up to 30 million euros at an interest rate close to 5 percent. On 23 April 2010, Prime Minister Papandreou publicly announced that Greece would request aid from the eurozone and IMF. The announcement was followed by further downgrades of Greek bonds on 27 April, placing them for the first time in junk-­status territory. Greek bond yields reached 1016 basis points. On 2 May 2010 Greece signed the first memorandum with the so-­called ‘Troika’, consisting of the IMF, the European Commission and the ECB. The agreement put in place a three-­year financial rescue package for Greece with loans totaling €110 billion; with €80 billion coming from EU



The global financial crisis in Greece ­269

countries and €30 billion provided by the IMF at an interest rate close to 5.5 percent. At the same time the ECB announced that it was changing its rules so that it would continue to accept Greek bonds as collateral, regardless of Greece’s credit rating, to provide liquidity to Greek banks. Greece undertook to reduce expenditure and increase revenue, aiming to reduce its budget deficit to 3 percent of GDP by 2014. Greece also agreed to introduce a series of structural reforms, aiming towards higher labour market flexibility, privatizations, abolishing entry barriers for a number of goods and services, and reforming the country’s pension and social security system. The first Memorandum of Understanding was ratified by the Greek parliament on 6 May 2010, with a majority of 172 members of parliament (MPs), consisting of the bulk of PASOK MPs and those of the small right-­ wing Popular Orthodox Rally (LAOS) party. All other opposition parties, including the centre-­right New Democracy headed by Antonis Samaras, voted against it. The signing of the memorandum was met with strong protests from segments of the population, including general strikes and riots, culminating in the killing of three bank workers on May 5 in a bank arson deliberately committed by extremist protesters. At the same time, PASOK itself faced serious internal divisions, with many ministers and MPs opposing the austerity measures imposed by the memorandum. Over the next 16  months several PASOK MPs defected from the party, reducing the government’s parliamentary majority from 160 MPs to 153 out of 300, and weakening its ability to implement the memorandum’s terms. The growing civil unrest and political uncertainty led markets to continue to sell Greek bonds, and credit rating agencies to downgrade them further, renewing pessimism regarding Greece’s ability to service its outstanding debt. In September 2010, the Finance Minister, George Papakonstantinou, denied publicly that Greece was considering debt restructuring. This reassurance and the submission of the 2011 budget with further expenditure cuts, and the significant purchases of Greek bonds on behalf of the ECB’s Security Markets Programme (SMP) launched in May 2010, brought a temporary lull to the crisis. This lasted until the end of 2010, taking the Greek spread to 900 basis points. Events in the real economy, however, did not go according to plan: the Greek government did not implement most of the reforms it had approved; the recession gathered pace; unemployment increased further; and government revenue stalled, making the meeting of the fiscal targets set by the memorandum unlikely. Citing these economic factors, in 2011 credit rating agencies downgraded Greek bonds further. In response, on 12 March 2011 the European Council decided to increase the maturity of the loans provided to Greece from three years to seven and a half, and lower the interest

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rates by 1 percent, to approximately 4.5 percent. This, however, did little to stop bond selling. By June 2011 it had become obvious that Greece would need further financial support. Amid growing fears of restructuring, the Greek spread reached 1400 basis points. Greece entered new discussions with the Troika, raising for the first time publicly the issue of debt restructuring. The Troika made the continuation of financial support to Greece openly conditional upon parliament passing new austerity measures, intending to compensate for the time lost in fulfilling the terms of the memorandum. With the bond downgrades and under significant pressure from his own MPs and the country’s powerful civil service unions, Papandreou reshuffled his government on 17 June, replacing his Finance Minister Papakonstantinou with Evangelos Venizelos, a high-­profile PASOK politician widely regarded as Papandreou’s most likely successor in PASOK’s leadership. On 29–30 June 2011, amid mass protests and strikes, the Greek parliament narrowly passed the set of austerity measures demanded by the Troika. More PASOK MPs defected, reducing the government’s parliamentary majority even further. Citing increased economic and political uncertainty, credit rating agencies again downgraded Greek bonds in July 2011. The Second Memorandum of Understanding: July 2011–December 2014 With the targets of the first memorandum clearly unattainable, confidence in Greece’s ability to service its debt collapsing, and government bond yields reaching 1770 basis points, eurozone leaders agreed in principle to a second financial rescue package for Greece in July 2011, totaling €109 billion. A key feature of this package was that private bondholders would for the first time be called upon to participate in Greece’s financial rescue, under the Private Sector Involvement (PSI) scheme, by writing €37 billion (21 percent) off the present value of the Greek bonds they held. Following this announcement, Greek bond yields temporarily dropped by approximately 300 points. The proposed deal, however, was widely interpreted as an imminent Greek default, prompting credit rating agencies to downgrade Greek bonds further into junk territory. Worse was to come. The Greek authorities and private bond-­holders failed to reach agreement on the latter’s participation in the PSI. Data was published showing that Greece was way off meeting its fiscal targets. Civil unrest continued to cause political uncertainty. In this context, Greek government bonds yields increased again. Eurozone leaders put pressure on Greece to improve its performance in implementing the agreed fiscal and structural reforms, threatening publicly to discontinue financial support. By 23 September 2011 the Greek bond yield reached a staggering record



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of 2427 points. On 21 October 2011, Greek lawmakers narrowly passed another set of austerity measures. In return, on 27 October 2011, eurozone leaders confirmed a new €130 billion financial rescue package for Greece and agreed in principle with Greece’s private debt-­holders to increase their PSI participation from 21 percent to a 50 percent face-­value haircut. With Papandreou coming under pressure from a significant portion of his party who opposed the strict austerity measures, the Prime Minister unexpectedly and without consultation with other eurozone leaders announced a referendum on the revised PSI agreement on 31 October 2011. EMU leaders unanimously expressed their strong opposition to the referendum plan. On 2 November 2011, German Chancellor Angela Merkel and French President Nicolas Sarkozy stated that Greece would not receive further financial support until the Greek position was clarified, and indicated that the referendum would effectively be on Greece’s continuation in the euro. Papandreou faced a revolt within his own party led by his Chancellor Venizelos, as well as strong opposition from New Democracy. On 4 November 2011, Papandreou called off the referendum, and with his position becoming untenable he agreed to resign, enabling PASOK to share power with New Democracy. On 11 November 2011, PASOK, New Democracy and the small right-­wing LAOS party, agreed to form a national unity government headed by the ex-­Vice President of the ECB, Lucas Papademos. The three parties supporting the Papademos government agreed that its mandate would be to: conclude the revised PSI plan; negotiate with the Troika the details of the second financial rescue package and bring it to Greek parliament for ratification; and lead the country to elections within a period of six months. During its short time in office, the Papademos government faced extremely challenging conditions, involving a deepening recession, further civil unrest, and continued market pressure increasing Greek spreads to the all-­time high of 2739 points in February 2012. Nevertheless, it made progress on all the issues included in its mandate. First, it negotiated the particulars of the second memorandum with the Troika, bringing the deal for ratification to the Greek parliament on 12 February 2012. This set a target for a primary surplus of 4.5 percent of GDP by 2014 and a public debt-­to-­GDP ratio of 120 percent by 2020. The parliament passed the bill by a majority of 199 to 74. A significant development in this vote was that, unlike the first memorandum, the second memorandum was supported by the mainstream centre-­right New Democracy party. This support came at a high political price, as a number of the party’s MPs revolted, forming a breakaway right-­wing party under the title ‘Independent Greeks’. By contrast, the small LAOS party, which had voted in favor of the first memorandum, voted against the second, resulting in a number of its prominent

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members joining New Democracy. Second, the Papademos government successfully concluded the PSI negotiations, proposing on 25 February 2012 to private bond-­holders to exchange their holdings for new securities involving a 53.5 percent face-­value haircut, rising to 73 percent in net present value terms. By April 2012, 96.9 percent of private investors had accepted the proposed deal. The bonds included in the agreement had a total face value of €206 billion, producing an unprecedented debt relief of €106.5 million. Greek spread fell in the wake of the PSI’s successful conclusion by 1000 basis points to 1724. Finally, the government called national elections for 6 May 2012. The election produced a political earthquake. In a massive show-­of-­ protest vote, PASOK and New Democracy suffered major losses while parties in the far left and far right extremes registered significant gains. Although New Democracy came first, its vote fell to an all-­time low of 18.9 percent, with the strongly anti-­ memorandum radical-­ left Syriza party taking second place at 16.9 percent. PASOK finished third with just 13.2 percent, while Independent Greeks got 10.9 percent. One of the election’s great shocks was the 7 percent share obtained by the ultra-­nationalist Golden Dawn. Finally, the moderate Democratic Left polled 6.1 percent. Overall, the anti-­bailout parties gathered a 48.7 percent share of the vote, while the pro-­bailout parties polled 44.7 percent. With no party capable of forming a single-­party government, political leaders entered a series of meetings hoping to form a coalition government. These, however, were unsuccessful. The strong showing of the anti-­memorandum parties combined with the political uncertainty caused by the fragmentation of the vote resulted into new market panic as the Grexit was openly discussed as a very likely scenario. In May 2012 the Greek spread increased again to 2556 points, while the capital flight, present since the beginning of the Greek crisis back in October 2009, ­intensified.4 Failing to form a government, new elections were proclaimed for 17 June 2012. These effectively became a single-­issue election, with the dilemma facing voters presented both internally and externally in a very clear manner. Greeks had to choose between the memorandum, possibly in a slightly modified version, preserving Greece’s euro participation; or rejection of the memorandum, most likely leading to euro exit and official bankruptcy. In a hard-­fought election, pro-­memorandum parties achieved a significant swing in their favor, polling 49.8 percent against 44.7 percent gained by the anti-­memorandum parties. Despite Syriza’s strong showing of 26.9 percent, New Democracy again finished first, polling 29.7 percent. With PASOK maintaining its electoral share at 12.3 percent and the moderate Democratic Left at 6.3 percent, the way was now open for the formation of a three-­party pro-­memorandum coalition government under New



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Democracy’s leader Antonis Samaras. This was duly formed on 21 June 2012. During its first months in office the coalition government under Samaras made a promising start. The appointment of a pro-­reform technocrat Finance Minister, Yiannis Stournaras, along with public commitments for reform by Mr Samaras, went well with European leaders, particularly with the German Chancellor Angela Merkel. In a show of support for the new government’s efforts to promote reforms, Merkel visited Athens in October 2012 for the first time since the crisis began. Markets reacted positively, reducing the Greek spread from 2652 points in June 2012 to 1527 points at the end of October 2012. The flight of capital was stemmed, with a small recovery of Greek deposits in the order of €4 billion taking place. The new government officially asked for a two-­year extension of the Greek financial support package, aiming to achieve the fiscal targets set by the second memorandum in 2016 rather than 2014. This was granted in the Eurogroup meeting of November 2012 in which EMU countries decided to extend the maturity of loans to Greece and reduce interest rates on them. It also decided to consider further debt assistance if certain fiscal targets were met and structural reforms including privatizations, the opening of closed professions and the introduction of new labour legislation aiming at higher labour market flexibility were concluded in 2013–14. During its time in office the coalition government headed by Samaras achieved notable progress in stabilizing the Greek economy and putting in place the conditions necessary for economic recovery (for a detailed discussion, see Arghyrou 2014). Between June 2012 and September 2014 Greece achieved significant progress in improving private expectations (reflected, among others, in a substantial fall in government bond yield spreads which in April 2014 fell to 400 basis points), improved fiscal performance, banking/ credit conditions and external competitiveness. This progress culminated in the recording of a positive growth rate in 2014, the first year of positive growth after five years of continued recession, and a reduction in the unemployment rate following five years of unemployment increases. Notwithstanding this, the coalition’s time in office was anything but smooth. On the political front, it had to cope with considerable disagreements among its constituent parties on the appropriate policy mix and the speed of fiscal and structural adjustment. These disagreements eventually caused the withdrawal from government of its junior partners, the Democratic Left party. On the economics side, fiscal adjustment relied too heavily on taxation while progress in rationalizing expenditure and reducing tax evasion was limited. At the same time, gains in external competitiveness came mainly through necessary but disproportional reductions in nominal wages while excessive monopolistic mark-­ups declined

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too modestly. Finally, despite significant achievements in restructuring the Greek banking sector, credit conditions remained too tight, an element which in the case of Greece appears to be very strongly correlated with the maintenance of unemployment at high levels. All in all, despite the substantial progress achieved by the coalition, by spring 2014 the improvement in macro-­fundamentals had not yet been felt by the majority of the Greek population. This, combined with a widely spread sense of unfair distribution of the costs of adjustment, resulted in a victory for the far-­left Syriza party in the European Parliament elections held in May 2014 and the general election held in January 2015.

THE WAY FORWARD: PROSPECTS AND RISKS The Feasibility of a Grexit Scenario Despite the progress achieved by the coalition government headed by Samaras, Greece remains at a crucial juncture. The country effectively has only two options: pursue continued euro participation by meeting the commitments under the second memorandum of understanding; or unilaterally renege on these commitments and leave the eurozone. There are those, including a substantial part of the far-­left party Syriza that eventually won government, who argue it is possible for Greece to abandon its memorandum commitments and remain part of the eurozone. How this could be achieved, however, has not been convincingly explained, as all EMU countries have directly linked continued financial support, without which Greece cannot avoid default and exit from the euro, to the honoring of its memorandum commitments. Several observers believe an exit from the euro would be in Greece’s best interests (Lapavitsas 2012). Their argument, in a nutshell, is that the significant devaluation that would follow the introduction of a new drachma will boost Greek competitiveness, providing a platform for economic recovery by improved exporting performance. They also believe that the austerity imposed via the strict fiscal targets contained in the memorandum will end, because readopting the drachma will increase internal demand, creating conditions for higher economic growth. This oversimplified approach is naïve Keynesianism, outside modern mainstream economic thinking. It ignores the role of key factors in a country’s economic performance, including private expectations, the credibility of monetary policy, and distortions in the economy’s supply side. First, it fails to explain why, if subdued demand is the cause of Greece’s current economic woes, the ten-­year boom in demand that preceded the Greek



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crisis did not create sustainable high growth rates. Second, if an independent monetary policy was the answer to Greece’s problems, it fails to explain why its macroeconomic performance was so fragile before Greece joined the euro, plagued by spiraling high inflation, frequent devaluations, rising public debt and persistently high unemployment rates. If the answer was weak institutional performance, as it was indeed the case, those in favor of returning to the drachma must explain what makes them believe that Greek institutions are now able to manage an independent currency, especially in view of the disappointing developments in institutional performance discussed above. In reality, the causes of the Greek crisis have very little to do with subdued demand and the nature of the country’s currency. They are to be found in the background factors preceding the Greek crisis: the propensity of Greek politics towards over-­expansive, populism-­driven fiscal policies; Greece’s weak supply side; and its below-­par institutional performance. The major recession affecting Greece as well as the significant reduction in incomes during 2010–14 were to a large extent unavoidable equilibrium phenomena, restoring Greek production and income levels consistent with Greece’s production capacity. A return to the drachma would not solve these problems, and almost certainly would make the situation far worse. Simple calculations, based on purchasing power parity (PPP), imply that a reintroduced drachma would be devalued against the euro by at least 50 percent. This would cause hyperinflation, ending up in double-­digit values, cancelling out any competitiveness gains Greece would enjoy from a nominal devaluation; gains whose significance would be very doubtful, given Greece’s narrow exporting base. Second, a euro-­exit would almost certainly be accompanied by a Greek default, after which international markets would extend very little credit to Greek firms, banks or the government. This would result in more business closures and restrict even more the pool of savings available to finance investment projects internally. Indeed, as the proponents of the return to the drachma acknowledge (Lapavitsas 2012), the lack of external credit and access to international financial markets would mean that Greece faced shortages of basic commodities such as oil, medicine or even foodstuffs in the short run. How these authors claim that Greek society cannot sustain the implementation of further austerity measures in the context of the memorandum, whose loans make these basic provisions available, but expect that somehow the same society can sustain shortages of basic commodities following the memorandum’s abolition and a return to the drachma, is very puzzling. Furthermore, the credibility of an independent Bank of Greece running the monetary policy of a country that has defaulted on its debt will be

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very low. The bank will have no access to international financial markets and possess only one channel to finance continuing public deficits, namely money creation. As a result, inflation expectations will increase markedly, as would interest rates, making business and personal loans prohibitively expensive. Greek firms relying on foreign imports, or those with loans in foreign currency, will see their costs soar, leading to even more business closures and unemployment. Finally, and importantly, leaving the euro would deprive Greece of its only reference point of stability: EMU status. An isolated Greece will lack policy and institutional credibility, putting off foreign investment. Still in deficit and with international money markets inaccessible, Greece would become an increasingly closed economy having to print money to pay for its internal debts, resulting in stagflation and a dramatic fall in living standards. If an economic and social breakdown follows, one may not completely discount the probability of an authoritarian, or even t­otalitarian, regime emerging. Risks to a Successful Implementation of Structural Reforms Exiting the euro will have major negative consequences for the Greek economy and society. It is therefore in Greece’s best interest to maintain the commitment it has undertaken within the memorandum and remain in the eurozone. There are, however, significant internal and external risks jeopardizing this prospect. Internal political risks First, there is political risk. As explained above, the pro-­reform government under Samaras was supported by an inherently fragile coalition whose constituent parts faced difficulties in maintaining their internal cohesion in the face of the tough austerity measures the government was committed to implement. This challenge was demonstrated in the disagreements observed among the coalition’s members regarding fiscal consolidation, privatizations and other measures aimed at higher labour market flexibility, and was particularly acute for the junior coalition members, PASOK and Democratic Left, whose support for austerity was not consistent with their ideological background. These parties were vulnerable to defections of their MPs to the far-­left opposition party Syriza, whose political rhetoric and promised policies were much more consistent with the traditional PASOK expansionary mindset and heavy regulation. Eventually, in June 2012 the Democratic Left withdrew its support from the Samaras government and subsequently played a crucial role in its fall when it sided with Syriza’s refusal to vote for a consensus President of



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the Hellenic Republic in the parliamentary vote held in December 2014. According to the Greek constitution, the failure of the Greek parliament to elect a president triggered the general election of January 2015, which resulted in the formation of a coalition government between the far-­left Syriza and the right-­wing Independent Greeks party. As large sections of both parties are highly Eurosceptic and advocate economic policies that are inconsistent with Greece’s participation in the EMU (including the reversal of fiscal consolidation and structural reforms carried out during the implementation of the memorandum programmes) the continuation of the reforms that are necessary for Greece to remain in the EMU is in question. In addition, reforms face stiff opposition from two influential sections of Greek society. First, the public sector trade unions and the unions of professionals working in the so-­called ‘closed professions’, ranging from lawyers and doctors, to pharmacy owners and taxi drivers. These interest groups are highly organized and influential across the whole of the Greek political spectrum; indeed, they are the same professions from which the bulk of Greek politicians have traditionally emerged. As far as the public sector is concerned, the reforms under way will reduce employment and salaries and will limit rent-­extracting opportunities through a crackdown on bureaucracy and outright corruption. On the other hand, they will open up the markets of many services to free competition, thus reducing the monopolistic mark-­ups enjoyed by closed professions. Therefore, these two groups have an incentive to prefer Greece’s exit from the euro rather than its continued participation at the expense of their privileges. They have become the standard-­bearers of the so-­called ‘lobby for drachma’. Their influence among Greek politicians, their control of services vital for the smooth functioning of the country, their willingness to employ extreme tactics disrupting these services, and the political support they received from the parties constituting the present Syriza government, render them a serious threat to Greece’s efforts to stay in the eurozone. Second, an increasing pool of citizens has been hit hard by the recession alienating by mainstream politics. The Greek private sector has lost approximately 1.2 million jobs over the period 2009–13, comprising mainly newly unemployed private employees or small-­scale retailers who went out of business, many of whom have to service mortgages and other personal loans. With the economic hardship continuing to hit them hard, this middle-­class bastion of the political middle ground, which normally would be natural allies of pro-­reform initiatives, have been moved, more in desperation rather than self-­interest, to the two extremes of the political spectrum, lured by the oversimplified, easy solutions promised by the far left and the far right.

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Overall, the pro-­reform Samaras coalition government faced the challenge of pushing on with necessary reforms with a fragile coalition including many fair-­weather supporters of reform and within highly fragile social conditions characterized by an explosive cocktail, including, on the one hand, die-­hard, highly organized, highly influential, anti-­reform vested interests operating in a highly radicalized political landscape, and, on the other, a hard-­pressed Greek middle class which eventually withdrew its support from the adjustment programme and supported the anti-­austerity block in 2014–15. Given the lack of realism evident in the latter’s pre-­ election promises and the necessity of structural reforms discussed above, it is rather clear that without a major shift in Syriza’s economic positions Greece will find it difficult to maintain its euro participation and avoid the economic and social collapse described in my discussion on Grexit above. External risks In recent years a number of observers in countries of the European core have argued that given Greece’s limited progress in implementing structural reforms, a Greek exit from the euro would strengthen the single currency by reducing the moral hazard accompanying the financial rescue programmes of other periphery EMU countries. This would facilitate the creation of a new European economic architecture necessary to sustain the euro. More specifically, the external arguments for a Grexit are as follows: ●●

●●

●●

The euro’s long-­ term sustainability pre-­ supposes: (1) a banking union, eventually including a European bank deposit guarantee scheme; (2) official delegation to the ECB of the role of the lender of last resort; and (3) introduction of some form of European fiscal union, accompanied by common debt issuance (Arghyrou 2015). These measures cannot be introduced as long as they face strong popular opposition from the core EMU member states. This is primarily based on surveys of antagonistic public opinion towards the Greek financial rescue package (Reuters 2012). This opposition, in turn, is based on the perception that Greece is deliberately procrastinating in implementing the reforms it has promised in return for financial assistance it has received from its eurozone partners. As a result, taking the Grexit will eliminate public antagonism in the core EMU countries, obviate the need for an EU rescue package, and allow them to accept the new economic architecture necessary for the euro’s sustainability. It will reduce the moral hazard associated with financial rescue packages in other periphery countries; given the  enormous economic and social cost Greece will face by leaving the euro, the remaining periphery countries will then embrace



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reforms rather than rejecting them and finding themselves outside the euro. As a consequence, market expectations will improve regarding the euro’s sustainability, which will contribute towards a favorable resolution of the European debt crisis through a virtuous circle of improved expectations and improved economic performance. External supporters of the Grexit have become increasingly influential among European policy-­makers, as evident by a number of statements by high-­ranking officials.5 However, Grexit carries significant risks for the European and global economy. The first is the domino effect, which may reignite and intensify the sovereign debt crisis in other euro-­periphery countries. Although this risk is not as high as during the initial stages of the Greek debt crisis it continues to exist, as one cannot exclude the possibility that Grexit may trigger precautionary capital flight from periphery countries to the European core, additional to the significant capital flight that has already taken place (see Bloomberg 2012). Such developments may cause a major European recession through two channels: a new credit crunch and a collapse of trade. Because the international banking system remains exposed to European bonds, a collapse of the EMU periphery bond market could result in significant balance sheet losses, leading to a financial crisis similar to the one of 2008–09. Second, with the world’s largest economy (the eurozone) in recession, international trade will be suppressed, affecting growth in developed as well as emerging countries. The supporters of the Grexit acknowledge the domino risks described above. They believe, however, that they are manageable by bringing forward the completion of the new European economic architecture discussed above, along with steps already taken, such as the ECB’s announcement in September 2012 to buy without restrictions the bonds of debt-­stricken EMU countries requesting financial aid from the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). Yet, even if the domino is avoided, the Grexit can still cause significant costs to the core EMU countries in three ways. First, the unavoidable costs of fiscal union will be more expensive for core EMU countries if it takes place in the near future, immediately after a Grexit, rather than later. If periphery countries are given further breathing space to implement adjustment measures resulting in a visible reduction in their fiscal imbalances, enough to consolidate confidence in their debt-­ servicing ability improving market expectations, core EMU countries will be called to guarantee a contingent debt stock for the periphery lower than the current one, in whose repayment markets will have a higher degree of confidence. By contrast, a Greek exit from the euro will oblige them,

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to avoid the domino effect, to introduce the fiscal union immediately. In that case, they will have to commit a larger than otherwise necessary volume of funds to the union’s common fund pool, enough to guarantee the creditworthiness of other debt-­ stricken, still recovering periphery economies. This implies that they may be obliged to introduce Eurobonds immediately, involving interest rates higher than the interest rates which core countries are currently paying on their own public debt. In short, it is in the interest of core EMU countries to pay less and later without a Grexit, rather than more and immediately because of it (as long as, of course, Greece reaffirms its commitment to economic policies consistent with sustainable euro participation). Second, it is not clear that a Grexit will reduce the moral hazard problem; and it may increase it. A Grexit, together with any new European architecture that will almost certainly accompany it, will be presented to the markets as the permanent systemic solution to the European debt crisis. The credibility of this solution will be irrevocably damaged in the event of an exit of any other member state from the eurozone. Therefore, a Grexit will increase the strategic importance of all other periphery countries, an element which they may use to water down reforms and achieve a higher level of support from core EMU countries. To achieve the necessary reforms in the EMU periphery, it might be preferable to avoid Grexit, thereby increasing the sense of security of periphery member states of larger size. Third, and very importantly, a Grexit will establish that the euro is not irrevocable. If a precedent of a country leaving the eurozone is established, markets will abolish any irreversibility discount that they still incorporate in European periphery bonds. In due course, the cost other EMU states will bear, either directly through higher interest rates on their borrowing requirements or indirectly through guaranteeing countries under market pressure, will be higher than by providing some limited further financial assistance to Greece provided, as mentioned above, that Greece reaffirms its commitment to the necessary reforms and implements them. All in all, Greece possesses powerful arguments to convince its European partners that as long as it delivers on reforms, even with occasional delays and setbacks, it is in their interest to avoid a Grexit. By reducing uncertainty and improving expectations, the elimination of a Grexit scenario will go a long way to putting Greece back on a track of sustainable growth and contribute towards the consolidation of economic recovery at the EMU level.



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CONCLUSION Greece currently faces a deep economic, political and social crisis ranking among the country’s most challenging times in modern history. The crisis was the unavoidable outcome of a distorted, weak supply side and an outdated, ineffective system of political and institutional governance whose roots go back at least three decades. The crisis has put Greece at a crucial junction. It can either take the painful road of the necessary and beneficial structural and institutional reforms; or can opt for the present status quo which will almost certainly result in Greece’s exit from the eurozone. This latter scenario would be catastrophic for Greece and highly damaging for the remaining eurozone members. As such, it would be in Europe’s interest to avert it. A Grexit, however, will remain likely as long as the public opinion in the countries of the European core oppose the Greek rescue programmes, and as long as Greece provides the basis for this opposition by not promoting the necessary reforms actively enough. To avoid a Grexit, Greece must offer solid proof of its determination to reform its economy and institutions, convincing its European partners that it is also in their interest to help Greece stay in the eurozone. EMU partners should offer Greece a more flexible, less rigid environment to implement the necessary reforms and commit credibly that, as long as these take place, Greece will remain in the single currency. This commitment is a necessary prerequisite for abolishing the present uncertainty regarding Greece’s position within the single currency, which constitutes the number one obstacle for the restarting of the Greek economy. The internal and external risks threatening to derail the necessary adjustment policies are many and real. If Greek pro-­reform politicians and above all Greek society stand this test, the crisis has the capacity to prove a turning point in Greece’s modern history. It could usher in changes establishing the conditions for long-­term economic growth, sustainable public finances and a much-­improved system of political governance. Observers of Greece’s plight very much hope that this positive outcome will materialize, so that in future years Greece will be an example of a country that used a time of severe crisis to successfully reform itself.

NOTES 1. See Mr Samaras’s interview with the German newspaper Handelsblatt on 5 October 2012. 2. See, for example, the public statements of the EU Economics Commissioner Joaquin Almunia during a press conference on 14 September 2009, when he stated, ‘All Greek political leaders and all parties know very well what is the situation [of the Greek economy] and what has to be done’.

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3. See, for example, the articles titled ‘Confidence in the Euro still Low’, published by the Financial Times Advisor on 20 September 2010, and ‘Economists’ Survey of the UK: Will the Euro Survive with its Current Membership for the Next Five Years?’ published in the Telegraph on 9 June 2010. 4. According to ECB data, Greek household bank deposits fell from a peak of €244 billion in December 2009 to €156 in June 2012. They partly recovered to €173 billion in August 2014 before collapsing to €145 billion in March 2015 in the immediate aftermath of the general election held in January 2015. 5. See, for example, the statements of Germany’s Interior Minister Hans-­Peter Friedrich on 24 February 2012 to Der Spiegel magazine; as well as Sweden’s Finance Minister, Anders Borg, on 13 October 2012 in Tokyo, at the annual meeting of the International Monetary Fund.

REFERENCES Arghyrou, M.G. (2006), The Effects of the Accession of Greece to the EMU: Initial Estimates, Study No. 64, Centre of Planning and Economic Research, Athens: KEPE. Arghyrou, M.G. (2014), ‘Is Greece Turning the Corner? A Theory-­ Based Assessment of Greek Macro-­Policy’, CESIfo Working Paper No. 4995. Arghyrou, M.G. (2015), ‘Towards a New European Economic Architecture: Challenges and Likely Solutions’, in D.D. Thomakos, P. Monokrousos and K. Nikolopoulos (eds), A Crisis Manual: A Retrospect of the Crisis and the Road to Recovery, Basingstoke: Palgrave Macmillan. Arghyrou, M.G. and G. Chortareas (2009), ‘Current Account Imbalances and Real Exchange Rates in the Euro Area’, Review of International Economics, 16, 747–64. Arghyrou, M.G. and A. Kontonikas (2012), ‘The EMU Sovereign Debt Crisis: Fundamentals, Expectations and Contagion’, Journal of International Financial Markets, Institutions and Money, 22, 658–77. Arghyrou, M.G., A. Kontonikas and A. Gregoriou (2009), ‘Do Real Interest Rates Converge? Evidence from the European Union’, Journal of International Financial Markets, Institutions and Money, 19, 447–60. Arghyrou, M.G. and I. Tsoukalas (2011), ‘The Greek Debt Crisis: Likely Causes, Mechanics and Outcomes’, World Economy, 34, 173–91. Artavanis, N.T., A. Morse and M. Tsoutsoura (2012), ‘Tax Evasion Across Industries: Soft Credit Evidence from Greece’, Chicago Booth Research Paper 12–25, Fama-­Miller Working Paper Series. Bloomberg (2012), ‘Deposit Flight from Europe Banks Eroding Common Currency’, Bloomberg.com, 19 September. Bohn, F. and E. de Jong (2011), ‘The 2010 Euro Crisis Stand-­off Between France and Germany: Leadership Styles and Political Culture’, International Economics and Economic Policy, 8, 7–14. The Economist (2010), ‘When Markets go Wrong’, Buttonwood column, 12 June. Lapavitsas, C. (2012), ‘It is in Greece’s Interest to Leave the Euro’, Financial Times, 23 May. Lynn, M. (2011), Bust: Greece, the Euro and the Sovereign Debt Crisis, London: John Wiley. Mourmouras, A.A. and M.G. Arghyrou (2000), Monetary Policy at the European



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Periphery: Greek Experience and Lessons for EU Candidates, Berlin, Germany and New York, USA: Springer-­Verlag. Reuters (2012), ‘Germans Overwhelmingly Oppose Greek Bailout: Poll’, Reuters. com, 26 February. Taylor, M.P. and L. Sarno (2002), The Economics of the Exchange Rates, Cambridge: Cambridge University Press. Tobin, J. (1995), ‘Inflation and Unemployment’, in S. Estrin and A. Marin (eds), Essential Readings in Economics, London: Macmillan, Chapter 11.

11. Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ Richard Boyle and Michael Mulreany The rise and decline of the Irish economy in the 1990s and 2000s has been a dramatic roller-­coaster ride. General government debt as a percentage of gross domestic product (GDP) exceeded 100 percent in the late 1980s. The government addressed this problem through economic policies to stimulate growth and by establishing the National Treasury Management Agency to manage the national debt and borrow on behalf of the Exchequer. The so-­called ‘Celtic Tiger’ boom started in the late 1980s to early 1990s. From 1987 to 1993 there was a period of stabilization and recovery after the recession of the 1980s. Then there was a period of very strong economic growth from 1993 to 2000, with the average growth of GDP being 9.3 percent per year. Employment also increased rapidly, with unemployment falling from 16 percent to 4 percent, effectively full employment. Irish incomes converged rapidly with the European Union (EU) average. Support from structural funds from the EU, amounting to roughly 3 percent of GDP per annum in the early 1990s, also helped finance an expanded public infrastructural program. Ireland was seen as an exemplar nation in the EU, a model to follow for peripheral and accession countries, its virtues extolled by those promoting the benefits of economic and monetary union. The management of government budgets played an important role in the recovery from the earlier crisis in the 1980s. Then, the strategy was to cut capital expenditure significantly while largely protecting current expenditure. On the revenue side, there was a successful tax amnesty. Importantly for a small open economy, there was an effective devaluation of the currency in 1986 and the subsequent growth engendered in the traded sector helped to generate increased tax revenues. The surge of growth in the 1990s, based on productivity and competitiveness, stands in contrast to the growth from 2001 to 2007 when the construction sector and the banking system become too big for the economy. In the latter period economic growth averaged more than 5.5 percent per year. As a consequence current receipts, predominantly 284



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from taxation, grew strongly. At the extremes, current receipts grew by 19 percent in 2001 and by 17 percent in 2007 and the average growth in current receipts from 2001 to 2007 was approximately 10 percent per annum. Hence, the Celtic Tiger generated a growth in current expenditure of more than 10.5 percent per annum over the same period, reduced the national debt to amongst the lowest in the EU and financed a sovereign wealth fund. Since 2008, however, the global financial crisis (GFC), combined with domestic challenges and mistakes, had a profoundly negative impact on Ireland. GDP fell by some 11 percent between 2007 and 2010; the unemployment rate increased to nearly 14 percent in 2010; tax receipts in 2010 were about a third lower than in 2007; yet expenditure has continued to rise. The National Recovery Plan 2011–2014 (Government of Ireland 2010:  14) stated that, ‘A downturn of this size is without precedent in Ireland’s recorded economic history and has few modern parallels at an international level’. At the end of 2010, in response to the crisis, the government signed a Memorandum of Understanding for the provision of €85 billion of financial support to Ireland by member states of the EU through the European Financial Stability Fund (EFSF) and the European Financial Stability Mechanism; bilateral loans from the UK, Sweden and Denmark; and funding from the International Monetary Fund’s (IMF) Extended Fund Facility (EFF). In essence this program set out the overall fiscal limits and framework within which the Irish government had to operate up to 2014. This chapter examines the role of, and implications for, budgeting systems and the budgetary process in Ireland arising from the financial crisis of the late 2000s. In order to do this, it is first necessary to examine economic and financial developments from 2000 onwards, to set the scene for understanding how the crisis arose, and the implications for the budgetary process. Subsequently, the reassessment and rebuilding of Ireland’s budget systems is examined. The chapter draws heavily on four independent reports commissioned by the Irish government to examine aspects of the crisis and make recommendations as to what should happen in the future: ●●

●●

A report into the Irish banking crisis and the role of regulatory and financial stability policy drawn up by the Governor of the Central Bank of Ireland (Honahan 2010). A preliminary report on the sources of Ireland’s banking crisis drawn up by a German economist who was a former Director General in the German Ministry of Finance and a former IMF Deputy Director (Regling and Watson 2010).

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A report on strengthening the capacity of the Department of Finance carried out by an independent review panel chaired by a former Deputy Finance Minister from Canada (Wright 2010). A report by a commission of investigation into the banking sector in Ireland overseen by a former Director General for Financial Services in Finland’s Ministry of Finance (Nyberg 2011).

COMPONENTS OF THE EMERGING CRISIS, 2000–2008 With hindsight, it is possible to identify three key components over the period from 2000 to 2008 which helped magnify the impact of the GFC on Ireland from mid-­2008: an inflated property bubble, the emergence of a banking crisis, and evolving fiscal challenges of expenditure growth and revenue reductions. The Inflated Property Bubble A sharp fall in nominal and real interest rates in the months running up to Economic and Monetary Union (EMU) entry in 1999 triggered the housing price surge (Honahan 2010: 22). A combination of population growth, higher income and lower mortgage interest rates provided an upward shift in the willingness and ability to pay for housing. Whelan (2010: 233) notes: The result was an extraordinary construction boom. The total stock of dwellings – which had stood at 1.2 million homes in 1991 and had gradually increased to 1.4 million homes in 2000 – exploded to 1.9 million homes in 2008. As house completions went from 19 000 in 1990 to 50 000 in 2000 to a whopping 93 000 in 2006, construction became a dominant factor in the Irish economy. With the economy already at full employment, much of the labour employed in the construction boom came from the new EU member states in Eastern Europe, and the inward migration further fuelled demand for housing. By 2007, construction accounted for 13.3 percent of all employment, the highest share in the OECD.

This extreme and increasing reliance on the construction sector for the Irish economy was noted by many commentators at the time, but suggestions of a ‘soft landing’ in the housing market were common when scenarios for slowdown or decline were put forward. The prevailing view was that a gradual managed decline would be possible rather than a crash.



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The Beginnings of the Banking Crisis Linked to the property bubble, Irish bank loans to property developers increased massively over the 2000s. Honahan (2010: 26) notes that while at the end of 2003 net indebtedness of Irish banks to the rest of the world was just 10 percent of GDP, ‘by early 2008 borrowing, mainly for property, had jumped to over 60 percent of GDP. Moreover, the share of bank assets in property-­related lending grew from less than 40 percent before 2002 to over 60 percent by 2006’. In practice, Irish banks were allowed to build up huge exposures to the property sector. In particular, there was the rapid expansion of one bank, Anglo Irish Bank, whose property lending was allowed to grow from assets of €26 billion in 2003 to assets of €97 billion in 2007 (Whelan 2010: 244). This expansion put pressure on other banks to follow suit, with Allied Irish Bank and the Irish Nationwide Building Society rapidly increasing their exposure to the property sector. Evolving Fiscal Challenges: Spiking Expenditures, Collapsing Revenues For a long time, Ireland’s overall fiscal policy was considered to be exemplary, producing fiscal surpluses every year from the mid-­1990s to 2006. A National Pension Reserve Fund was created in 2001 to meet as much as possible of the costs of Ireland’s social welfare and public service pensions from 2025 onwards and make effective use of the budget surpluses being generated. However, these positive budget figures masked an underlying deterioration in the fiscal situation from 1999. A procyclical fiscal policy was pursued for much of the 2000s: statistical tools to capture the full impact of asset bubbles on tax revenue are not well developed, otherwise it would have become clearer much earlier that the structural, underlying fiscal balance was much less favorable than assumed at the time. The IMF estimates now that in 2007, when the headline budget was approximately in balance, the underlying, structural deficit (taking into account the large positive output gap and the effects of the asset price bubble) had deteriorated to 8¾ percent of potential GDP and amounted to 4 to 6 percent in the run-­up to the crisis. The conclusion is that overall fiscal policies were pro-­ cyclical during most years up to, and including particularly, 2007 thus adding markedly to the overheating of the economy. (Regling and Watson 2010: 25)

Fiscal challenges were discernible on both the expenditure and the revenue sides of the government’s ledger arising from this procyclical stance. So, from 2001 to 2007, annual expenditure growth averaged around 10 percent, which was higher than the annual rate of economic

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growth. Also, ex post growth in current expenditure was higher than budgeted in every one of these years bar one. Public expenditure per person increased: up to 2006, Ireland’s public expenditure per person was below the EU15 average; from 2007 onwards it was above the EU average. Expenditure increases were particularly marked in 2006, 2007 and 2008, which Honahan (2010: 30) described as ‘an unfortunate late burst of spending which boosted the underlying deficit’. Public sector pay and the growing size of the public service contributed strongly to the growth in current expenditure. The total number of public sector employees grew from around 295 000 in 2000 to 347 000 in 2010, an increase of 18 percent. Yet the growth in total employment in the economy led to a relative fall in the proportion working in the public sector between 2003 and 2007. However, the downturn in the economy and the relative security of public sector jobs saw an increase in the public sector share of the work force from 2008 to 2010, with 19 percent of the workforce in the public sector by 2010. The costs to the Exchequer of meeting public sector pay and pensions more than doubled from €8.632 billion in 2000 to €18.753 billion in 2008. Combined with increases in expenditure was a narrowing of the revenue stream and real reductions in revenue. The main reason for the sharp increase in the fiscal deficit in 2008–09 was the collapse in tax revenue. As Regling and Watson (2010: 26) state: This was possible because the structure of tax revenue had changed dramatically from the 1990s. The composition of tax revenue had shifted gradually from stable sources of taxation, like personal income tax and VAT [value-­added tax]/ excise taxes, to cyclical taxes, such as corporation tax, stamp duty and capital gains tax. The share of these cyclical taxes reached 30 percent of tax revenue in 2006; in the late 1980s it had amounted to only 8 percent.

Regling and Watson (2010: 27) noted that this shift in the composition of the tax base created two problems: (1) it was more difficult to assess the underlying, structural situation of the budget and the fiscal stance because the cyclical taxes grew rapidly in the run-­up to the crisis; and (2) the budget became more vulnerable to a recession, beyond the normal working of automatic stabilizers, because yields from the cyclical taxes reversed rapidly in the downturn. Thus, we can see the impact of a combination of effects working together to create the conditions for the 2008 crisis. In particular, excessive and careless lending by the Irish banks to the commercial real estate sector was a major contributor to the problems subsequently faced. The scale of debt built up here was beyond anything previously imaginable. When combined with domestic government expenditure and revenue problems, the cumulative



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impact was massive. The seeds were thus set for Ireland’s response to the GFC of 2008. Honahan (2010: 20) summarized the issues well: Domestic policies did not act as a sufficient counterweight to the forces driving this unsustainable property bubble. Bank regulation and financial stability policy clearly failed to achieve their goals. Neither did fiscal policy constrain the boom. Indeed, the increased reliance on taxes that could only generate sufficient revenue in a boom, made public finances highly vulnerable to a downturn. Specific tax incentives also boosted rather than restrained the overheated construction sector. And, with surging labour demand, wage rates in both the public and private sectors moved well ahead of what could protect international competitiveness.

THE 2008 CRISIS: THE GOVERNMENT’S REACTION AND THE EU–IMF INTERVENTION The economic consequences of the crash were severe and surprising in the scale and scope of the impact. As The National Recovery Plan 2011–2014 concluded: The level of GDP in 2010 will be some 11% below and the level of GNP [gross national product] some 15% below their respective levels of 2007 in real terms. Employment has fallen by about 13% from its peak of 2007 while the unemployment rate has risen from 4.6% to 13.5%. A downturn of this size is without precedent in Ireland’s recorded economic history and has few modern parallels at an international level. (Government of Ireland 2010: 14)

The collapse in construction, the fall in property prices and the severe knock-­on effects on the banking system all led to major increases in unemployment and deterioration of the public finances. Indeed, the economy would have faced serious difficulties even without the impact of the GFC. One estimate of the relative impact of domestic and international forces suggests that as much as three-­quarters of the reduction in GDP from 2007 to 2010 was attributable to domestic factors (Honahan 2010: 31–2). This led to rapid and sustained government intervention, as well as a significant bailout from the EU and IMF. In September 2008, in response to the banking crisis, the government introduced a blanket bank guarantee scheme to guarantee assets, and protect creditors and bondholders. This was a controversial decision even at the time it was done, as Ireland was the only country in the eurozone to provide such a sovereign guarantee covering bank creditors. It subsequently emerged that the scale of the exposure of the state was significantly underestimated and unclear at the time of the guarantee.

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Table 11.1  Budgetary adjustments since 2008 Adjustment July 2008 expenditure adjustments Budget 2009 (October 2008) revenue raising measures February 2009 expenditure adjustments Supplementary budget (April 2009) revenue-­raising and expenditure-­   reducing measures Budget 2010 (December 2009) expenditure-­reducing and minor   revenue-­raising measures Budget 2011 (December 2010) expenditure-­reducing and revenue-­   raising measures Budget 2012 (December 2011) expenditure-­reducing and revenue-­   raising measures Total

€ billion 1.0 2.0 2.1 5.4 4.1 6.0 3.8 24.4

Source:  Adapted from The National Recovery Plan 2011–2014 (Government of Ireland 2010: 16, Table 1.1).

With regard to budgetary adjustments, the Irish government reacted to these domestic and international financial challenges with interventions totalling €20.6 billion. Table 11.1 shows the budgetary adjustments made since 2008. In terms of measures designed to assist the budget bottom line, the brake was first applied in mid-­2008 with the announcement of €1 billion in spending cuts. Budget 2009 was brought forward from its December date to October 2008. A further adjustment followed with an emergency budget introduced in April 2009 which, combined with Budget 2010 (introduced in December 2009), led to adjustments of €9.5 billion. In December 2010, the Budget 2011 announced further budgetary adjustments of €6 billion. And in December 2011, Budget 2012 announced budgetary adjustments of €3.8 billion. The level of Irish budgetary adjustments has been enormous by international standards. To give an idea of the scale of these adjustments, one noted economic commentator has stated that: In 2009 and 2010, the Irish public experienced the two biggest years of fiscal adjustment anywhere in the advanced economic world over the past thirty years. And this left Ireland with a budget deficit of nearly 12 percent of GDP . . . By the time the stabilisation programme is supposed to be finished, the cumulative fiscal adjustment will have been close to 20 percent of GDP. Previous academic studies of large adjustments reported cumulative adjustments of 10 percent of GDP as the outer limits of what had been achieved. (Whelan 2011)



Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ ­291

From 2008 to 2011, as the cutbacks in employee numbers and pay introduced by the government have taken effect, the Exchequer pay and pensions bill decreased from its high of €18.753 billion to €17.127 billion – a decline of about 8.7 percent. Debate ensued about the extent to which gaps should be closed through expenditure reductions or tax increases. Broadly speaking, those on the left favored more emphasis on taxation increases, arguing that the main problems had arisen from a shortfall in revenue and the need to protect public services. Those in the center and on the right favored a balance more towards expenditure cuts as being more conducive to the long-­term development of the economy. Public opinion was more supportive of expenditure cuts than tax increases. The prevailing view is captured in The National Recovery Plan 2011–2014 which stated that: the adjustments to be made must comprise a mix of revenue-­ raising and expenditure-­ reducing measures. In determining the appropriate balance between the two, the Government has been guided by the lessons of our past as well as the experience of other countries that have found themselves in similar circumstances. (Government of Ireland 2010: 18)

This analysis drew on evidence provided by the IMF, the EU Commission and the Organisation for Economic Co-­ operation and Development (OECD), which indicated that expenditure reductions would be superior to tax increases in reducing deficits and stabilizing debt ratios. Of the €24.4 billion of budgetary adjustments undertaken between 2008 and 2011, roughly two-­thirds have fallen on the expenditure side, with the remainder comprising revenue-­raising measures. Similar proportions are built into the National Recovery Plan. Broadening the tax base is seen as an important component of the adjustments on the revenue raising side. Domestic government interventions were not the only means of stabilizing the Irish free-­fall. At the end of 2010, in response to the crisis, the government signed a Memorandum of Understanding (bailout) for the provision of €85 billion of financial support to Ireland by member states of the EU through the European Financial Stability Fund (EFSF) and the European Financial Stability Mechanism; bilateral loans from the UK, Sweden and Denmark; and funding from the IMF’s Extended Fund Facility (EFF), on the basis of an agreed support program. This support program included a commitment to meet the fiscal and budgetary targets set out in The National Recovery Plan 2011–2014 and was, therefore, very influential in determining Ireland’s budgetary stance during the period of the program.

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WHY DID THE CRISIS COME ABOUT AS IT DID? EXAMINING THE ROLE AND FITNESS OF THE BUDGETARY PROCESS IN THE CRISIS Before examining the role and fitness of the budgetary process, it is worth mentioning more general causes of the crisis, to put the budgetary limitations and subsequent responses in context. First, not many people in positions of authority, both national and international, saw the extent to which the crisis would turn out at the time. It is only with the benefit of hindsight that many of the issues have become clear. For example, various OECD reports on Ireland, while recognizing the possibility of a hard landing arising from the property boom, predicted a soft landing as the most likely scenario. Failures in the banking system were the predominant catalyst for the extent and scale of the crisis that hit Ireland. As Honahan (2010: 15) stated: ‘there is prima facie evidence of a comprehensive failure of bank management and direction to maintain safe and sound banking practices, instead incurring huge external liabilities in order to support a creditfuelled property market and construction frenzy’. The government’s commitment to the bank guarantee scheme was a high-­risk approach to attempting to ensure that no institution failed. However, fiscal policy failure also contributed to the development and scale of the financial crisis. Macroeconomic and budgetary ­policies contributed significantly to economic overheating. The continued growth in expenditure, use of tax incentives to fuel the property boom, o ­ ver-­reliance on the construction sector and other cyclical sources for revenue at the same time as narrowing the tax base all contributed to a procyclical policy response, even if it was not necessarily done by design. An independent review of the Department of Finance (Wright 2010) identified three key reasons for this failure of fiscal policy: ●● ●● ●●

the expectations on the government to create spending and tax initiatives; the overwhelming of the budgetary process by programs for government and social partnership; and a failure of the Department of Finance to do more to avert the crisis.

The analysis below expands upon each reason in further detail to identify what went wrong and why.



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Extraordinary Community Expectations The Wright Report noted that there were extraordinary expectations on the government in Ireland to create spending and tax initiatives, to share the fruits of recent economic gains (Wright 2010: 5). Growth during the Celtic Tiger years created a climate of expectation that it was possible for expenditure to grow and revenues increase while income taxes were cut. This put great pressure on government and opposition political parties to meet rising expectations and try to ensure all parts of society benefited from the boom. People with contrary views, warning of potential dangers, were sidelined or marginalized as establishment figures such as politicians, bank leaders and the like dismissed their opinions, pointing to the growth in the economy as justification (Lewis 2011). The Irish economy was also regarded by most as an exemplary model. The Wright Report found that EU fiscal rules as outlined in the Stability and Growth Pact were respected, debt fell and spending was below EU average levels. As a consequence, ‘the underlying dangers were either missed or ignored’ (Wright 2010:5). Social Programs Overwhelming the Budgetary Process As revenues increased it proved impossible for government to control demands for increased expenditure. The government’s Action Programme for the Millennium (Government of Ireland 1999) contained a target of restricting current expenditure growth to 4 percent per annum. Although this was achieved in 2000, by 2001 and again in 2002 current expenditure was growing by four times the target rate. Put simply, the growth in revenues, fuelled by unsustainable tax revenues from a property boom, led to a series of procyclical budgets contrary to the stabilization needs of the economy. In the absence of critical public debate and of a consensus of economic analysis about the unsustainability of the boom, budgetary policy failed in significant ways. A particularly interesting element of the Wright Report’s analysis was its conclusion that the government’s budget process was completely overwhelmed by two dominant processes: the social partnership process and additional general program spending under coalition government arrangements (Wright 2010: 23). Social partnerships had been widely praised as a pre-­eminent reason for Ireland’s recovery from the recession of the 1980s and the creation of the Celtic Tiger. These partnerships were formal, multi-­annual agreements between the social partners of government, the main employer groups, the trade unions and representatives of the voluntary and community sector on pay and key social policy issues.

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New government spending programs were seen as important in providing stability. These were agreements reached by the parties in government following their election and necessitated by the continued presence of coalition governments in Ireland since the late 1980s. How did the perception of these institutional processes turn from that of hero to zero? The social partnership agreements began primarily as a means of determining pay settlements in the private and public sectors in the late 1980s, and a series of multi-­year social partnership agreements reached between 1987 and 2009. Over time, the social partnership process increasingly covered a wider range of issues than pay, incorporating broad social and economic policy across most sectors, and impacting significantly on expenditure and taxation decisions. Tax cuts and tax expenditures (tax allowances, reliefs and so on) were a part of the mix, aimed at securing wage restraint in the years of the boom. Inclusion of these non-­pay elements was generally seen as a helpful contribution to the policy process. As Hardiman (2006: 344) claimed: The non-­ pay elements of the agreements have not replaced conventional methods of developing policy, but they have generated new networks of linkages through which issues can emerge into the political process. Although these networks are open to some criticism on grounds of both effectiveness and legitimacy, the claim here is that they extend rather than undermine democratic deliberative capacity.

However, as the economic situation deteriorated, the process of social partnership accelerated the momentum for spending and contributed to the consequent deterioration of competitiveness of the Irish economy. With regard to general government programs, these policies formed by agreements among coalition partners at the start of a new government were typically detailed agreements with specific policy commitments and associated spending and taxation implications. The agreements set the framework for subsequent policy decisions. Some economic commentators saw this as promoting upward pressure on government spending as key electoral commitments of each party are promoted and downward pressure on government revenue as taxation options were closed off (McCarthy 2011). The Wright Report concluded that the budgetary process became subservient to social partnership and programs for government: Over the ten year period of review, the Programme for Government and Social Partnership Processes helped overwhelm the Budget process. Instead of providing an appropriate fiscal framework for prioritisation of competing demands on the Government’s overall agenda, the Budget essentially paid the bills for these dominant processes. Relatively clear advice to Cabinet in June on the risks



Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ ­295 of excessive spending and tax reductions was lost by the time of December Budgets. (Wright 2010: 25)

It has also been argued that the predominance of these various programs limited, and to some extent marginalized, the impact of parliament in its scrutiny role (O’Cinneide 1999). The contention here is that all the major policy decisions were made outside of parliament, with the role of parliament reduced to that of commenting on commitments made elsewhere, and that this limited the engagement of parliamentarians in the process. A Closer Look: The Performance of the Department of Finance The Wright Report found that the Department of Finance had provided warnings about the risks of the procyclical fiscal policy. The department’s advice was also found to be more direct and comprehensive than concerns expressed by other Irish analysts, or by international agencies. But the Department of Finance was not seen as entirely, or even substantially, without fault in the process. It was found that the department: should have adapted its advice in tone and urgency after a number of years of fiscal complacency. It should have been more sensitive to and provided specific advice on broader macroeconomic risks. And it should have shown more initiative in making these points and in its advice on the construction sector, and tax policy generally. (Wright 2010: 6)

In other words, the department was insufficiently proactive or forceful in its promotion of sound budgetary policy. Particular weaknesses were found with regard to the availability of specialist skills in the Department of Finance and in multi-­annual expenditure planning. With regard to skills, the Wright Report found that the department: ●● ●● ●● ●● ●● ●● ●●

does not have critical mass in areas where technical economic skills are required; has too many generalists in positions requiring technical economic and other skills; is more numbers-­driven, than strategic; does not have sufficient engagement with the broader economic community in Ireland; often operates in silos, with limited information-­sharing; is poorly structured in a number of areas, including at the senior management level; and is poor on human resources management (Wright 2010: 35).

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Many of these limitations had been identified in an internal capacity analysis carried out in 2009 (Department of Finance 2009), and were consistent with the generalist and career-­based nature of the civil service in Ireland. Compared to many OECD countries, the Irish civil service has remained at the more conservative end of the spectrum with regard to human resources reform (O’Riordan 2008: 49). The development of specialists, such as those in the Government Economic Service in the UK, has not yet featured in the department or across the civil service (though in early 2012 the government announced the establishment of a new Government Economic and Evaluation Service to be based in the Department of Public Expenditure and Reform). The Department of Finance was also not immune to the challenge facing many countries of the projection of tax receipts as part of expenditure planning. This has: proved to be an Achilles Heel of policy analysis . . . and the related challenge of estimating the degree of slack in the economy in real time is also much harder than previously acknowledged. The economic analysis resources of the Department of Finance deserve to be strengthened for these reasons. (Regling and Watson 2010: 28)

Such criticisms represented not so much a fault in the department as a weakness in the overall budgetary system and multi-­annual expenditure planning. The Department of Finance itself clearly highlighted the problems associated with multi-­annual planning: the shortcomings lay in the almost complete focus being placed on the first year’s spending plans, with the multi-­annual dimension of expenditure planning often seen as indicative, non-­binding and subject to future budgetary processes. This point is borne out by [Figure 11.1] . . . which is taken from the July 2009 Report of the Special Group on Public Service Numbers and Expenditure Programmes (Government of Ireland 2009). The chart shows the three-­year 30 Year 1

% Deviation

25

Year 2

Year 3

20 15 10 5 0 –5

2000

2001

2002

2003

2004

2005

2006

Average

Budget Year

Figure 11.1 Deviation of actual gross current expenditure from budget projections



Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ ­297 expenditure projections as published each year in the annual Budget volumes for 2000 to 2006, compared against the actual outturns for expenditure in each of the three projection years. It shows that while the first-­year outturns – those voted in the Dáil – typically came within 1% of the projection, the second-­ year outturns came in ahead of projection by 6% on average (equivalent to €3.2 billion in 2011 terms), while the third-­year outturn overran by around 12% on average (equivalent to €6.3 billion). In short, the existing budgetary process focuses attention on the year ahead, whereas expenditure trends and pressures that fall outside this annual frame of reference do not receive the same attention or control; and by the time these future years are reached, earlier projections will invariably have been superseded. (Department of Finance 2011: 3)

The analysis carried out in the Wright Report clearly identified problems with the budgetary process in Ireland. In particular, the absence of a sufficiently robust challenge to the consensus brought about through the social partnership process and building government coalitions and programs meant that the budget was in many ways predetermined by agreements reached previously. The ability to adapt to changed circumstances was constrained. When combined with an absence of forceful advice on the dangers of procyclical fiscal policy, this meant that the budgetary process was not strong enough or nimble enough to foresee or even to respond to the crisis as it unfolded in a sufficiently timely manner. Parliament was not a major player in the process; nor was independent advice given sufficient prominence. Skills and capacity gaps in the Department of Finance further contributed to the budgetary challenges.

MOVING FORWARD: THE QUEST FOR FISCAL SUSTAINABILITY There have now been enough thorough reviews explaining why Ireland suffered so badly in the crisis. The next challenge is to adapt the budgetary process in light of the identified deficiencies. The four governmentcommissioned reports mentioned in the introduction to this chapter (Honahan 2010; Nyberg 2011; Regling and Watson 2010; Wright 2010), taken together, provide a comprehensive analysis of what happened and why in the banking, regulatory and administrative arenas since the early 2000s. They have significant implications for fiscal and budgetary policy development, as they highlight weaknesses in systems and procedures as major contributory factors in the development of the crisis. They also set out a broad agenda for change which is examined below.

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Institutional Change and Stronger Leadership There have been significant changes of personnel in senior positions in both the public service and the banking sector, and some significant institutional change. In 2009 a new Governor of the Central Bank of Ireland was appointed, a well-­respected professor of international financial economics with World Bank and IMF experience (the post had previously been filled by former secretaries-­general of the Department of Finance), as well as a new Head of Financial Supervision in the Central Bank, a former Chief Executive of the Bermuda Monetary Authority. These appointments coincided with developing new regulatory structures for financial regulation and a new Central Bank of Ireland, chaired by the Governor, with responsibility for both the supervision of individual firms and the stability of the financial system generally. The Head of Financial Supervision has responsibility for the regulatory and supervisory functions and objectives of the Central Bank of Ireland. Following the election of a new government with an overwhelming majority in February 2011, a Fine Gael and Labour Party coalition, the Department of Finance was restructured. The department was split in two, with a new Department of Public Expenditure and Reform responsible for public expenditure and the modernization and reform of the public service, and a Department of Finance with responsibility for overall budget, tax and spending matters. New secretaries-­ general, each with public and private sector experience, were appointed to lead the Department of Finance and the Department of Public Expenditure and Reform. An Economic Management Council was also created, with the status of a cabinet committee, and membership of the Taoiseach (Prime Minister), Tánaiste (Deputy Prime Minister), Minister for Finance and Minister for Public Expenditure and Reform. The council oversees economic policy. It is intended to give a strong political lead to the required budgetary adjustments and reforms. The creation of this Economic Management Council is a significant departure in Irish economic policy. As it proceeds with its work, it is critically important that significant economic issues do not become seen as somehow apart from the full cabinet, and that there are appropriate two-­way channels of communication. Bringing in people with outside experience was seen as sending a message that the traditional complacent ways of doing things needed to be changed, providing an opportunity to develop a new approach and culture. These personnel and institutional changes were aimed to create a new dynamic at top levels at the center of government regulatory and fiscal administration. They were intended in part to enhance the challenge function and strengthen independent advice.



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However, there are challenges associated with capacity and capability constraints in the system that could impact on the level of budgetary expertise available in the coming years. The skills and capacities gaps in the Department of Finance noted above are likely to be exacerbated by labor market developments within the public service unless specific actions are taken to address the challenges. In particular, there has been an embargo on recruitment of all new staff in the public service in operation from early 2009. This embargo, taken together with an early retirement scheme incentivizing those over 50 to leave before March 2012, is likely to lead to a loss of capacity at senior levels, a lack of fresh talent developing through the public service in the medium term, and a loss of institutional memory that will be hard to replace. A New Integrated Fiscal Framework: Enshrining New Disciplines Specifically with regard to the budgetary process, plans have been under way for major changes in fiscal policy. In particular, in line with international trends, and in part arising from the independent reviews undertaken, there has been a move to develop a much stronger fiscal framework: A fiscal framework is characterized by some combination of four elements: (a) reform to the budget process; (b) a medium-­term budgetary framework; (c) numerical fiscal rules; and (d) a formal policy role for independent fiscal institutions. By setting fiscal policy within the constraints imposed by a formal fiscal framework, the hope is that fiscal decisions will take into account a longer horizon and will be more insulated from the behavioral traps and political distortions that threaten long-­term fiscal sustainability and induce destabilizing pro-­cyclicality in fiscal policy. (Lane 2010:17)

These four elements of a strong fiscal framework have each been the subject of examination in Ireland to see how they can be strengthened. Proposals with regard to each of the four elements are now examined. Budgetary Process Reform: Hardening the Estimates The National Recovery Plan 2011–2014 (Government of Ireland 2010: 59) stated that the ‘budget system will be comprehensively reformed and updated to bring greater sustainability to the management of public finances; to achieve maximum value for money in public expenditure; and guard against the emergence of structural budgetary imbalances’. In planning for this reform, account has been taken of a review of budgetary practice and recommendations for reform produced by the Houses of the Oireachtas Joint Committee on Finance and the Public Service (2010)

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(hereafter referred to as the Joint Committee Report). The Joint Committee Report recommended that the traditional budgetary process of votes, subheads and sub-­subheads should be changed and that a new budgetary process should be introduced. The report also recommended that the method for presenting departmental estimates must be changed and that ‘the new system must clearly link all expenditure, no matter how disparate, to all projects so that all activity including costs, current, capital, administrative etc. are fully captured and recorded against a project’ (Houses of the Oireachtas Joint Committee on Finance and the Public Service 2010: 8). The Joint Committee Report was particularly critical of the estimates process and associated Annual Output Statements (AOSs) which were introduced in 2007 to improve prior consideration by parliament of budgetary and expenditure options and to enhance parliamentary scrutiny of outputs for resources provided. The Joint Committee Report stated: The Estimates process with its tabular format and the Annual Output Statement are incompatible as the information supplied is not expressed in a cohesive common understandable format and does not highlight any deficiencies, lack of oversight or value for money issues; the current system of Estimates and Annual Output Statements is akin to comparing apples with coal. (Houses of the Oireachtas Joint Committee on Finance and the Public Service 2010: 28)

In response to these criticisms, The National Recovery Plan 2011–2014 set out proposals for a reformed budget formation process, which also took into account agreed EU-­wide coordination and surveillance mechanisms. A budgetary timetable along the following lines was being considered: ●● ●●

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December: Annual Budget presented to Dáil Éireann, with detailed estimates for the coming year (year t 1 1). Draft Stability Programme Update (SPU) projections prepared, together with proposed multi-­year Ministerial Current Expenditure Envelopes, for the later years t 1 2 to t 1 4. January–April: refinement of the draft SPU projections and multi-­ year budgetary policy objectives, taking account of the updated global and domestic economic outlook, and in light of commentary from the Fiscal Advisory Council and the relevant Dáil committee. In addition, the EU policy coordination processes culminate with the Annual Economic Summit (European Council) and its Conclusions. April: the final Stability Programme Update for the years t 1 2 and beyond is prepared in light of the perspectives received from the above policy inputs. July: EU-­wide budgetary surveillance, on the basis of SPU documents, would be completed.



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September–December: preparation of the December budget and detailed estimates for the following year, t 1 2, is ongoing, in line with the overall parameters set out in April’s SPU document (Government of Ireland 2010: 60).

To replace the annual output statement, it was proposed that a new system of performance budgeting be introduced. Already in place in a number of OECD countries, performance budgeting is typically concerned with bringing performance information into the estimates and the wider budgetary process so that budgetary decisions are informed by performance as well as by input data. Annual departmental output statements had been meant to fulfill a similar role and address some of the deficiencies in the budgetary process, but limitations in the type and quality of data produced by output statements was evident (Boyle 2009). A pilot project was put in place for the 2011 estimates in two government departments to trial performance budgeting and integrate high-­level performance information as part of the annual estimate process, rather than present the information in a separate document. This approach to performance budgeting involved: ●● ●● ●●

full alignment between the subhead structure of the estimate and the program structure used in the AOS and Statement of Strategy; integration of administration subheads alongside the corresponding program subheads, to show the full costs of delivering each program; inclusion of concise, high-­level performance information – as regards both outputs and impacts – as part of the annual estimate document (Department of Finance 2011: 30).

Another important related initiative introduced by the new government in 2011 was the announcement of a comprehensive spending review to be undertaken prior to Budget 2012. In its design, this review drew on  both domestic and international experience. Domestically, a review undertaken and published as the Report of the Special Group on Public Service Numbers and Expenditure Programmes (Government of Ireland 2009), and a value-­ for-­money and policy review initiative (essentially a rolling three-­year evaluation of selected government expenditure programs) provide relevant models. Internationally, Canada’s ‘program review’ experience and the UK’s ‘comprehensive spending reviews’ were referenced by politicians and the Department of Finance as relevant reviews whose experience can be drawn upon. Medium-­Term Fiscal Planning: Discipline, Plans and Ceilings As noted earlier, a substantial weakness in medium-­term fiscal planning was presented as an important limitation in the Irish budgetary process.

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Particularly when compared to many other countries in the EU and OECD, where Medium Term Expenditure Frameworks (MTEFs) have long been a normal part of the budgetary process, Ireland’s system was seen as deficient. The National Recovery Plan 2011–2014 outlined proposals for a new MTEF for Ireland, based on best practice in other EU countries. The Department of Finance subsequently stated that its intended approach was to develop the annually updated Stability Program (a document required under the EU’s Stability and Growth Pact) into a medium-­term fiscal plan, based around the following elements: ●●

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Publication of an initial draft of the Stability Program in the early part of each year; this will allow for the draft document to be considered by the relevant Oireachtas committee, and be assessed by the independent Budget Advisory Council (re-­established in 2011 as the Fiscal Advisory Council). Having taken account of the outcome of the discussion and debate, the Stability Program will be finalized and submitted to the EU in April, in line with the requirements of the Stability and Growth Pact. The Stability Program will specify the medium-­ term budgetary objective, towards which the government is steering the public finances, and will show the annual plans and projections for revenues and expenditure for each of the next three years, in line with this objective. The budgetary projections must continue to take full account of the costs arising from all government decisions and policies in place over the period of the program. The program will include a detailed analysis and forecast of the economy, with an assessment of risks including any potential imbalances or bubbles within the economy. The program will also show how the budgetary plans for each year conform to the fiscal rules. The proposed Budget Advisory Council will also have a role in assessing whether the rules are complied with, and in providing an independent assessment of the budgetary plans and forecasts. The Stability Program will include limits or ceilings on expenditure that will apply over each of the next three years. Taking account of the latest information to hand and also the various policy orientations received both domestically and internationally, the December Budget will be prepared on the basis of the tax and expenditure aggregates set out in the April Stability Programme Update (Department of Finance 2011: 21).



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Fiscal Rules: Tougher Corrective Measures Fiscal rules are intended to encourage governments to behave responsibly in relation to budgetary decisions, and not be overly influenced by short-­ term political priorities. They are seen as a way of helping to reduce deficits and debt, with strong rules, enshrined in legislation and with effective enforcement mechanisms, seeming to have a larger influence on budgetary outcomes (European Commission 2006). In Ireland it has now been proposed that a public finances correction rule should be introduced which would have the following elements: ●●

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Whenever the state is in breach of the EU’s 3 percent deficit and 60 percent debt ceilings, the primary budget balance should be improved by at least 1.5 percent of GDP each year. If the state has brought the deficit to below 3 percent of GDP, but the debt level is still above 90 percent of GDP, then this minimum pace of consolidation should be maintained until the debt level falls below this level. Progressive savings in debt-­interest costs should allow for a speedy adjustment to below the 90 percent figure; a figure viewed by many market participants as a key benchmark of ongoing sustainability. If the deficit level is below the 3 percent ceiling, and the debt figure has been brought back below the 90 percent threshold, then debt dynamics become more favorable, and a less onerous annual consolidation of 0.75 percent of GDP (at minimum) in the primary balance should be targeted, until the debt figure is also back within its ceiling of 60 percent of GDP. Once the primary balance has moved into surplus, then it may be sufficient to maintain it at a certain level rather than increase it further. Accordingly, the fiscal rule might specify that further improvements in the primary balance are not automatically required beyond a surplus level of 4 percent of GDP. Of course, it would be open to a government to target a higher primary surplus if it considered this appropriate; however, a fiscal rule should not, it is suggested, seek to curtail government discretion beyond this point (Department of Finance 2011: 12).

However, recognizing that exceptional circumstances may arise, and that it is not possible or desirable to remove all discretion from national government, the Department of Finance (2011: 17) proposed that the fiscal rules should be balanced with what it terms an ‘exceptional provisions clause’: ‘whereby the Government of the day may deviate from the rules when preparing its medium-­term fiscal plans, provided that it sets out its reasons in

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writing when it lays its plans before the Dáil. The Dáil would then consider and debate the fiscal plans’. Of course, there is a significant question as to the actual impact of fiscal rules and whether or not they will have the desired effect. Rules alone are obviously not replacements for sound fiscal policy. The consensus of the literature is that fiscal rules can be helpful in supporting positive budgetary outcomes, though issues of causality remain a methodological challenge in interpreting the findings (Krogstrup and Wälti 2007). But the exact design and implementation of the rules is less clear-­cut. Schick (2010) suggests that unduly rigid rules tend to be unworkable, and that paradoxically more flexible rules built into budgetary frameworks such as medium-­term expenditure frameworks may have more chance of ensuring governments achieve sound fiscal policy outcomes. Independent Fiscal (Budget Advisory) Council: Improved Transparency As with other elements of the fiscal framework, an independent fiscal council is seen as good practice in an increasing number of EU and OECD countries, and something lacking in the Irish framework. Consequently, Ireland committed under the IMF–EU program of assistance to the establishment of an independent council, which was established in July 2011 as the Irish Fiscal Advisory Council. Its role is to provide an assessment of, and comment publicly on, whether the government is meeting its budgetary targets and objectives. It is also charged with assessing the appropriateness and soundness of the government’s fiscal stance and macroeconomic projections, and assessing the extent of compliance with the government’s fiscal rules. The council’s existence is underpinned by the Fiscal Responsibility Act 2012. As with fiscal rules, there is a question as to the benefits arising from the introduction of a fiscal council; and, in particular, how independent it can be of government. There is a temptation for governments to constrain the actions of councils so as to avoid criticism. This was illustrated by Calmfors and Wren-­Lewis (2011: 676) who noted the fate of the Canadian and Hungarian fiscal councils: Examples of the fragility of newly established councils are provided by the PBO [Office of the Parliamentary Budget Officer] in Canada and the Fiscal Council in Hungary. The PBO’s budget was reduced in 2009–10 after the office released controversial reports on the costs of Canada’s engagement in Afghanistan and the economic and fiscal outlook . . . After only two years in existence, the [Hungarian] council had its secretariat taken away and was transformed into a more toothless body . . . This occurred after the council had criticized the government’s budget for over-­optimistic assumptions and lack of transparency.



Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ ­305

The response of the government to the reports of the Fiscal Advisory Council is that the advice of the council is only one of the factors taken into account in determining the scale of the required budgetary adjustment.

CONCLUSIONS AND CONSEQUENCES There is a long established formal fiscal framework in Ireland which stretches back at least as far as the Exchequer and Audit Departments Act in 1866. It includes provisions from the Irish Constitution of 1937 and is complemented by the EU framework ranging from the Maastricht Treaty of 1992 to the Stability and Growth Pact of 1997 to recent developments such as the Fiscal Compact. Reforms, such as a multi-­annual approach to capital expenditure initiated in 2004 and the introduction of departmental annual output statements in 2007, were already under way prior to the global financial crisis. The crisis has accelerated the nature and pace of reform under which Ireland has moved significantly toward independent fiscal advice, performance budgeting and more comprehensive multi-­annual budgeting. This recent period of reform has been accompanied by significant institutional change. At the center of the Irish budgetary process there are now two government departments instead of one, and a specialized Economic Management Council with the status of cabinet committee. The advisory function has been bolstered by the creation of a Fiscal Advisory Council and the evaluation function by the creation of a Government Economic and Evaluation Service. There already exist other institutions such as the National Treasury Management Agency with specialist responsibility for managing the national debt and for borrowing on behalf of the Exchequer. The inevitable question is whether these reforms will be effective. There are challenges in ensuring coordination and coherence in this suddenly more crowded budgetary landscape. There are challenges also in ensuring both that there are proper resources allocated to the generation of reliable advice and that the independence of this advice is protected in order to enhance public discussion and analysis of policy objectives, assumptions, decisions and outcomes and to improve the long-­term conduct of fiscal policy. The problems facing Ireland since 2008 are the result of a confluence of factors. There is no single cause, but rather a number of issues coming together at one point. In many ways, Ireland has been a victim of its own success. The factors that contributed to the huge growth rates also contributed to the massive decline post-­GFC. And the overwhelming effect of the bank guarantee and its contribution to generational debt reflects not just a

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budgetary problem but also a policy problem, with the transfer of private debt to the public sector. The policies that helped resolve the 1980s crisis are now either unavailable as in the case of devaluation, or already exhausted; for example, the capital budget has been cut considerably since 2008. As a result of the EU–IMF deal, governments are however expected to continue to cut large sums of the order of €3 billion per year out of an economy with a GDP of around €160 billion. After a prolonged period of growth Ireland has adjusted relatively quickly to a period of continuing austerity budgets and is now managing the economy within severely binding budget constraints. The period of achieving ‘more with more’, whereby increased government expenditure was expected to achieve better outcomes (Hood 2010), is over. There has been an element of ‘spend to save’, such as an incentivized early retirement scheme for public servants, whereby frontloaded expenditures are designed to save even greater expenditure in future. With reductions in public sector numbers, and greater demands in certain areas of state provision, there have as a consequence been some notable achievements of ‘more with less’. Inevitably, however, as austerity budgeting proceeds there is a growing pressure to make strategic decisions about spending priorities, and as a result to terminate programs; in other words, to achieve ‘less with less’. The Minister for Finance introducing the 2010 Budget summed up the position as follows: In simple terms, the gap between Government receipts and spending is almost €19 billion this year. The gap must be closed. We got into this position by seeking, with the full support of those opposite, to spread the benefits of the boom across every section of the population. Between 2000 and 2008, public spending increased by over 140%, while the consumer price index increased by just 35%. Working-­age social welfare rates are now more than twice their rate in 2000. Over the same period, the State Pension almost doubled. These increases were well ahead of the cost of living. At the same time, taxation was reduced and the proportion of income earners exempt from income tax increased from 34% in 2004 to an estimated 45% this year. All of this was made possible by the very large property-­related tax intake during the boom years. In our dramatically changed budgetary circumstances, it is clear the State can no longer afford this level of social provision.

As balance is gradually restored to the public finances, the reductions in deficits will create deflationary effects on the economy. It is necessary, therefore, that tax and expenditure measures must, from a strategic economic decision-­making point of view, be growth-­promoting. Inevitably there have been a number of innovations. For example, the tax system has been significantly redesigned over a relatively short period of



Managing Ireland’s budgets during the rise and fall of the ‘Celtic Tiger’ ­307

two budgets. At the institutional level, as noted previously, there has been a separation of the tax part of the budget, which remains in the Department of Finance, from the expenditure part which is now the responsibility of the newly created Department of Public Expenditure and Reform. These departments are headed by senior politicians, one from each of the two coalition parties in government. There are considerable challenges for the management of budgets in coming years. Clearly there is the overriding problem of trying to generate job-­rich growth at a time when cutbacks are required by the EU and IMF. Within this there are fresh management problems, such as how effectively the two budgetary departments will be able to coordinate: imperative to the formulation and management of budgets. Heretofore, when an expenditure proposal emerged it was assessed by the ‘vote’ section responsible for that area of expenditure within a unified Finance Department. This section brought together the views of the tax and expenditure sides of the department before finalizing its position. There is a challenge ahead in coordinating a unified view from, or in resolving disagreements between, the two departments about expenditure, not least tax expenditure, proposals. This challenge is compounded by the loss of senior personnel due in part to the aforementioned early retirement scheme, which is part of government policy to reduce public service numbers and hence pay. Finally, a further key challenge is to combine objective economic analysis with effective communication on economic policy between the senior civil servants and ministers so as to transmit difficult economic choices to the political system so that action can be taken before crises occur.

BIBLIOGRAPHY Boyle, R. (2009), Performance Reporting: Insights from International Practice, Washington, DC: IBM Center for the Business of Government. Calmfors, L. and S. Wren-­ Lewis (2011), ‘What Should Fiscal Councils Do?’, Economic Policy, October, 649–95. Department of Finance (2009), Capacity Review, Dublin: Department of Finance. Department of Finance (2011), Reforming Ireland’s Budgetary Framework: A Discussion Document, Dublin: Department of Finance. European Commission (2006), ‘Public Finances in the EMU’, European Economy, No. 3, Brussels: Directorate General for Economic and Financial Affairs. European Commission (2010), Enhancing Economic Policy Coordination for Stability, Growth and Jobs – Tools for Stronger EU Economic Governance, Communication from the Commission to the European Parliament, the European Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, Brussels: European Commission.

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Government of Ireland (1999), Action Programme for the Millennium, Dublin: Government of Ireland. Government of Ireland (2009), ‘Report of the Special Group on Public Service Numbers and Expenditure Programmes’, Dublin: Stationery Office. Government of Ireland (2010), The National Recovery Plan 2011–2014, Dublin: Stationery Office. Hardiman, N. (2006), ‘Politics and Social Partnership: Flexible Network Governance’, Economic and Social Review, 37 (3), 343–74. Honahan, P. (2010), ‘The Irish Banking Crisis: Regulatory and Financial Stability Policy 2003–2008’, Report to the Minister for Finance by the Governor of the Central Bank, Dublin: Department of Finance. Hood, C. (2010), Reflections on Public Sector Reform in a Cold Fiscal Climate, London: 2020 Public Service Trust Houses of the Oireachtas, Joint Committee on Finance and the Public Service (2010), ‘Report on Macroeconomic Policy and Effective Fiscal and Economic Governance’, Dublin: Houses of the Oireachtas. Krogstrup, S. and S. Wälti (2007), ‘Do Fiscal Rules Cause Budgetary Outcomes?’, HEI Working Paper No. 15/2007, Geneva: Graduate Institute of International Studies. Lane, P. (2010), ‘Report on Macroeconomic Policy and Effective Fiscal and Economic Governance’, Appendix 3 in Houses of the Oireachtas, Joint Committee on Finance and the Public Service, ‘Report on Macroeconomic Policy and Effective Fiscal and Economic Governance’, Dublin: Houses of the Oireachtas. Lewis, M. (2011), ‘When Irish Eyes are Crying’, Vanity Fair, March. McCarthy, C. (2011), ‘Programmes for Government allow Issues to be Ducked’, Sunday Independent, 27 February. Nyberg, P. (2011), ‘Misjudging Risk: Causes of the Systemic Banking Crisis in Ireland: Report of the Commission of Investigation into the Banking Sector in Ireland’, Dublin: Department of Finance. O’Cinneide, S. (1999), ‘Democracy and the Constitution’, Administration, 46 (4), 41–58. O’Riordan, J. (2008), ‘A Review of the Civil Service Grading and Pay System’, Committee for Public Management Research Discussion Paper No. 38, Dublin: Institute of Public Administration. Regling, K. and M. Watson (2010), ‘A Preliminary Report on the Sources of Ireland’s Banking Crisis’, Dublin: Stationery Office. Schick, A. (2010), ‘Post-­ Crisis Fiscal Rules: Stabilizing Public Finance while Responding to Economic Aftershocks’, OECD Journal on Budgeting, 10 (2), 1–17. Scott, C. and C. Brown (2010), ‘Regulatory Capacity and Networked Governance’, UCD Centre for Regulation and Governance, UCD Geary Institute Discussion Paper Series, Dublin: UCD Geary Institute. Whelan, K. (2010), ‘Policy Lessons from Ireland’s Latest Depression’, Economic and Social Review, 41 (2), 225–54. Whelan, K. (2011), ‘Behaving Like Teenagers’, blog post on The Irish Economy blog, 22 March, http://www.irisheconomy.ie/index.php/2011/03/page/2 (accessed 26 April 2011). Wright, R. (2010), ‘Strengthening the Capacity of the Department of Finance: Report of the Independent Review Panel’, Dublin: Department of Finance.

12. Readiness, resilience, reform and persistence of budget systems after the GFC: conclusions and implications Evert A. Lindquist, Jouke de Vries and John Wanna Our previous book, The Reality of Budget Reform in OECD Nations: Trajectories and Consequences (Wanna et al. 2010), explored the trajectory of budget systems and reform in several Organisation for Economic Co-­operation and Development (OECD) countries during the early to mid-­2000s. The study was in progress just before the global financial crisis (GFC) hit most governments and markets of the developed economies. In the conclusion to that book, John Wanna ventured these observations about how the 2007–09 global financial crisis might affect government budgeting, their ability to respond to challenges, and reform trajectories. He suggested: the onset of the global financial crisis – with its associated fiscal implications for governments – does not imply budgetary mismanagement or that the reform trajectories of the previous decades have been undermined. Arguably, most OECD nations were in a much better position to withstand the financial crisis precisely because they had put their budgetary houses in order over the preceding period. The changes in fiscal conditions brought on by the crisis, and the political imperatives to spend as a means of stimulating their economies, will undoubtedly see all OECD nations incur greater levels of debt than they enjoyed in the mid-­2000s. This will place additional constraints on annual budgets into the foreseeable future, especially as interest repayments grow as a proportion of annual expenditures. (Wanna 2010: 296–7)

Wanna went on to argue that: Many of the reforms introduced were explicitly to assist with fiscal discipline and produce surplus balances. How well they are able to achieve this in the future will be a measure of their robustness and salience in times of economic 309

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recession. If they are up to the job they will be retained and consolidated; if they are not then the history of these countries suggests that further experimentation will occur, and that they will be replaced with reform measures more effective in a different context. (Wanna 2010: 297)

The GFC certainly was a catalyst for rapid and expedient government intervention, consisting in the main of concerted economic, budgetary, financial and regulatory responses. The GFC, despite variations in how it manifested in different jurisdictions, was also close to a natural experiment, testing not only the resilience and the mettle of central budget agencies, but also the larger integrated financial systems in which international authorities, national governments, prudential regulators, finance ministries and other public agencies, and a myriad of private financial institutions and credit agencies operated in the broader financial and economic system. It was a systemic shock that rocked the institutional foundations of financial systems, while challenging the prudential frameworks of financial regulators and the analytical assumptions of market and government actors. The austerity and immense difficulties many nations have had in repairing their systems after the GFC (the so-­called ‘long tail’ fiscal deterioration and eventual consolidation) bears witness to the magnitude of this systemic shock. In this concluding chapter, we reflect on several questions using our ‘readiness–response–resilience’ framework animating this volume, recognizing that many jurisdictions experienced unique challenges: ●●

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Readiness before the crisis. How did government budgeting systems anticipate and respond to the challenges presented by the GFC? Were countries with healthy surpluses and less public debt more resilient and better able to respond to the GFC? Did countries with robust budget agencies and budgeting repertoires find themselves in better positions to respond to the GFC? If governments were overwhelmed and reactive in their responses did they find their footing in due course? What was the timing and mix of interventions in each jurisdiction? Unique crisis combinations. How did the GFC manifest itself in different jurisdictions? Did it manifest itself to policy-­makers as a housing affordability crisis, a severe credit freeze, a banking crisis and a loss of confidence in financial institutions, or a macroeconomic crisis with attendant fiscal meltdowns and steep increases in unemployment? Did countries with superior regulatory systems for their financial institutions have a more circumscribed crisis to address (fiscal and economic), no matter how daunting it appeared



Conclusions and implications ­311

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at its nadir? How did the various governments of the OECD and G20 define the crisis and characterize the main impacts of the crisis on their domestic constituencies? Responses to the crises. How good were political and administrative leaders at recognizing and understanding the challenge, and framing responses? What was the interaction and coordination between political leaders, central budget agencies, regulators and other important actors? What was the extent of influence of international institutions, and how effective with national governments and European Union (EU) members were calls for integrated international responses? Did countries with engaged and proactive political leadership have more concerted and timely stimulus and bailout strategies? Did countries with less resilient capacity feel politically coerced into action by international institutions? Were stabilization or exit strategies devised and apparent to markets and voting constituencies? Looking beyond the crisis. To what extent were jurisdictions well prepared for fiscal consolidation and re-­regulation, politically and administratively? Did countries with earlier, concerted responses to the GFC find themselves in a better position for addressing the subsequent challenges of consolidation and additional shocks? Were elected governments able to make tough decisions (show resolve) and balance competing demands, or did they make concessions and accede to populist demands (show a lack of resolve)? What fiscal targets did jurisdictions set themselves (or have set for them by international authorities)? What appear to be the longer-­term budget trajectories and strategies for meeting declared targets? Readiness for subsequent challenges. Did the GFC help to generate greater long-­term resilience in public finances and budgetary systems? Were new budgetary rules or further budgetary reforms introduced? Was a reform trajectory accelerated or undone because of the global financial crisis? Were budgetary systems sufficiently robust and recalibrating or were systems damaged, forcing key decision-­makers to revert to older and cruder forms of control of expenditure? Do jurisdictions seem better prepared and ready for the next shock or do they remain precarious?

With this analytical framework and these questions in mind, we provide an overview that explores the implications of the empirical findings from the country cases; our intention here is to diagnose the state of contemporary budgeting, including the dialectic between the quality of political leadership and the performance of budget systems, and how we ought to

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theorize this relationship. We conclude with some reflections of imminent and future challenges confronting budget systems across the OECD.

HOW READY WERE BUDGETARY AND GOVERNANCE SYSTEMS TO COMBAT THE CRISIS? Before the onslaught of the GFC, each country we surveyed had different degrees of economic prosperity and fiscal health; different constellations of government leadership, with majority or minority government arrangements representing different parts of the political ideological spectrum; and budget systems with varying degrees of robustness and ability to anticipate, recognize and adapt to new circumstances (see Figure 12.1). The international financial crisis would test the full range of these ­capabilities in every country. The countries most ready in terms of fiscal posture and budgetary resilience were clearly Australia, New Zealand and Canada (with perhaps Denmark, Sweden and the Netherlands approaching their readiness). Each of these ‘New World’ jurisdictions had strong executive government with legislative authority, strong central budget agencies, good regulation of financial institutions, and had been running large annual budgetary surpluses before the international financial crisis. Australia and New Zealand had accumulated substantial surpluses from around 2000, and neither government had experienced deficits for a long time. Both had kept spending patterns below revenue expectations, although spending had grown both in aggregate terms and very slightly as a proportion of gross domestic product (GDP). All three countries had siphoned off surplus funds into off-­ budget foundation funds1 or sovereign funds; sometimes with specific purposes formally stated (for example, superannuation, pension funds, infrastructure) but occasionally Strong economy, government finances, and budget system

Underlying weakness in budget system, regulation or economy

Weak fiscal monitoring, budget and regulatory frameworks

Australia

Denmark

Ireland

New Zealand

Netherlands

Portugal

Canada

United States

Spain

Sweden

Japan

Greece

Figure 12.1  The ‘going-­in’ positions of countries



Conclusions and implications ­313

as unspecified ‘hollow logs’. The Department of Treasury in Australia was a stand-­out in terms of its pre-­GFC preparation; in particular, it had run some realistic scenario exercises well in advance of the crisis which alerted staff to divergent possibilities and to look more closely at potential early warning signals. Canada also had strong regulation of its financial sector, which meant that Canadian markets were less exposed than those of the US or Mediterranean Europe; and a strong record of balanced budgets and debt reduction, practicing a conservative ‘prudential budgeting’. However, at the GFC’s onset the Conservative minority government led by Stephen Harper was uninterested in fiscal stimuli measures, a pattern largely replicated in New Zealand and Sweden. Other nations – Sweden, the Netherlands, Denmark and perhaps for a time even Spain – had implemented reasonably strong budgetary controls to restrain spending and produce surpluses. However, their governance systems did not readily position them to respond to the crisis: ●●

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Sweden’s fiscal problems in the early 1990s (where it had been consigned to the same category as Italy and Greece), led to fiscal institutional reforms, fixed fiscal targets, functional expenditure ceilings and the inclusion of local government outlay limits including requirements to balance spending. From 2007 an independent Swedish Council of Fiscal Policy alongside other watchdogs could review the budget and fiscal policy framework. Denmark had also experienced strong economic growth and had sound public finances with sustained budgetary surpluses during the early 2000s, but local government outlays were somewhat independent and shielded from the economic cycles, and the Danish Economic Council had become less influential and proactive. Moreover, the Danes had chosen not to implement much budgetary reform, relying instead on spending limits. The Netherlands, with its open economy, had developed a strong institutional framework involving many fiscal players, and invested in hard medium-­term fiscal frameworks aligned with EU fiscal limits. The GFC had hit the Dutch economy suddenly and hard,  resulting in negative growth in 2008 (3.9 per cent), and immediately exposing the susceptibility of its main banks to the crisis.

These nations each had multi-­party governments as the crisis hit (often center-­right coalitions naturally cautious about responding to the sudden deterioration of their financial systems), and tended to have extensive welfare states, fragmented budgetary systems, and large proportions of

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local expenditure (devolved spending to regions). They had also enjoyed high economic growth prior to the GFC. Several other OECD nations were in a fiscally weakened position or had less robust national budgetary or financial regulatory systems going into the crisis, namely: the United States, Japan, Spain, Portugal, Ireland and Greece. The reasons for their respective structural weaknesses varied considerably. The critical question was how broadly these weaknesses were understood and anticipated: ●●

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In the US, a polarized party system and public dissonance about lower taxes and not cutting programs led to policy and budgetary gridlock at the national level. Projected surpluses over the period 2001–11 were squandered and replaced with equally significant federal deficits, exacerbated by the Bush tax cuts instituted in the early 2000s and increased discretionary spending (for example, on the Iraq and Afghanistan wars and homeland security) which continued through the GFC. The vulnerabilities were magnified by a speculative boom in property and lax regulation of financial institutions. Japan had wrestled with chronic overspending and lack of fiscal discipline over many decades, with 18 consecutive deficits since 1993, resorting to public borrowing campaigns largely consisting of government bonds issued to raise funds from its own citizens. Such practices led to the accumulation of an enormous debt burden even before the GFC, amounting to some 160–170 per cent of GDP, way beyond what an EU country would consider the upper limit (60  per  cent). Arguably, although with a relatively smaller size of government, Japan has had the largest and longest-­lasting structural deficit of any comparable developed economy. Spain had emerged from the 1990s ‘golden decade’ with increased public spending on essential services and infrastructure, and budgetary surpluses arising from high rates of economic growth. The growth was fostered by a real estate bubble pushing up inflation and private borrowings, low productivity in many sectors, and high levels of conspicuous consumption. It had a large informal economy operating outside the tax system, similar to Greece and many other Southern European nations. Portugal had also recorded steady growth and avoided a property boom, but also suffered from several problematic economic issues: an uncompetitive economy, productivity gaps and rising labour costs. Excessive government spending (with no surplus since the 1974 revolution) led it to become the first country subjected to the EU’s Excessive Deficit Procedure.



Conclusions and implications ­315

The financial and fiscal positions of the last four countries certainly did not precipitate the GFC, but their highly vulnerable economies were spectacularly dragged into the mire once it appeared, resulting in huge macroeconomic dislocation, negative growth over many years and high structural unemployment as a consequence. Ireland and Greece, as small, constrained economies, were arguably the worst-­performing of the nations surveyed in this book. Both had inflated property booms and cost-­of-­living increases as a result of joining the European Union from a low-­wage basis; both hid behind false indicators of their economic performance and underlying fiscal position; both embarked upon irresponsible sprees of unsustainable public spending followed by huge collapses in state revenues and then difficulties in reining in expenditures. And both also were subjected to massive exposure in their banking sector, which when transferred onto their public balance sheets resulted in fiscal impacts not seen in peacetime Europe since the ill-­fated Weimar Republic. Greece’s situation was further exacerbated by a fiscal– productivity imbalance, widespread tax evasion and corruption.

WHAT KIND OF A CRISIS? DIVERSITY, RECOGNITION, METAMORPHOSIS, INTERPRETATION Despite the common tendency to refer to ‘the global financial crisis’ as if it manifested itself as a universal phenomenon, there was no single crisis with similar characteristics impacting on nations uniformly. Rather, the country cases in this book suggest that there were several distinct crises, driven by different mixes of factors, which materialized in different countries in short succession. The initial subprime mortgage crisis emanating from the US Mid-­West was largely a ‘panic crisis’ affecting non-­standard financial institutions in a national setting where real estate markets had overheated and housing affordability was a significant problem, inviting residential mortage brokers to take unsecured risks with marginal home-buyers (non-­collateral loans). The integration of financial markets in the US greatly exacerbated the magnitude of this mortgage crisis as major banks around the world became embroiled in the crisis (largely due to the on-­selling of mortgage risk). The resulting severe credit freeze spilled into global markets despite the initial prognostications of the leaders of European and Asian governments who thought their jurisdictions largely immune from such contagion. As the national banks responded with caution, the credit squeeze transformed into a full-­blown banking crisis along with deterioration in market

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and consumer confidence in financial institutions (leading to massive cash withdrawals and a crisis in deposits), and banks began to refuse to lend to each other. The overnight interbank lending rate (the London Interbank Offered Rate, LIBOR; and TED spread) skyrocketed from around 0.5 per cent to 4.65 per cent by October 2008, as the awareness of increased credit risk and liquidity problems intensified. Some commentators began to argue that the LIBOR was the rate at which banks would not lend to each other because none were doing so. As some of the biggest financial institutions began to teeter, or collapsed entirely as in the case of the Lehman Brothers bank, Bear Stearns, and the Icelandic online bank, the first waves of unemployment commenced and collapses in consumer confidence swept many nations in both the advanced and the developing worlds. Nations that had no particular connection to the commanding heights of international finance across Europe, Asia and North Africa were suddenly confronted with an unexpected and massive economic downturn. In some nations the crisis took the form of a domestic food crisis, with escalating food prices and street riots comprised of entire cross-­sections of the community, spreading into Northern Africa as a prime catalyst for the so-­called ‘Arab Spring’ risings. In other countries, such as Ireland, Spain, Portugal and the Mid-­West states of the US, the financial and economic crisis quickly laid bare housing bubbles, which led to the collapse of housing markets and putting at further risk financial institutions heavily involved in the housing sector. The globalization of these macroeconomic crises rebounded on the fiscal problems of governments, further contributing to increases in unemployment not seen since the Great Depression, leading to economic and budget crises. The abrupt and continuing tightening of fiscal policy in many countries, after the immediate Keynesian stimuli had been attempted, reinforced the continuing economic and fiscal crisis. Austerity measures imposed by fiscally embattled governments on severely weakened economies were perversely anticyclical, worsening the prospects of recovery by reducing household spending and eroding market confidences. Gradually, some nations began to frame the crisis as a bifurcated event: a credit and banking crisis requiring government guarantees and increased regulation, and a macroeconomic crisis warranting fiscal injections of cash. In short, many countries experienced their own distinct crises, which affected the mix of fiscal and policy responses, but also the quickness and pacing of their responses. In Australia, New Zealand, Canada, Denmark and Sweden there was less concern about the failure of financial institutions or deflation in real estate prices, and much more concern about the impact of the international economic downturn on domestic economic growth and employment, with a concomitant interest in stimulus



Conclusions and implications ­317

programs. In other countries – such as Portugal, Spain, Ireland and the US – the international financial crises accentuated the already difficult structural deficits and lack of fiscal discipline in those countries. For many countries the global financial crisis presented itself as a crisis of financial institutions, flowing from the exposure to lax regulation and oversight of financial institutions, requiring governments to bail out the ‘at-­risk’ financial sector. Matters were even worse in countries with overheated real estate markets – such as the US, Ireland, Spain – where tight credit and the collapse of financial institutions precipitated the collapse of housing bubbles. Many countries experienced multiple dimensions of these ‘crises’ (as we noted in Chapter 1 and Figure 1.2), often in unique combinations and waves. There was generally no single cause to the crises, but a complex interplay of factors with global spillovers. This complicated the problems domestically and made it difficult for governments to read the signals. In turn, the complexity of the crises, together with the different ideological predispositions of political leaders, made it harder to develop appropriate policy and political responses, and the later crises had to be handled with new mixes of interventions. Indeed, for many governments their version of the ‘crisis’, – whether it was some mix of an economic, financial, housing, or sovereign debt crisis – quickly led to a bona fide political crisis, such as Greece, Spain, Ireland, Japan, Canada and US. Dealing with political crises – in the form of brinkmanship, hard bargaining or the fall of ­governments – often greatly complicated how governments could respond to various crisis mixes.

HANDLING THE CRISIS: CONCERTED, TENTATIVE OR SLOW RESPONSES? By mid-­2008, as the subprime mortgage crisis materialized and the GFC began to manifest itself with rapid speed, governments recognized these challenges with varying degrees of perspicacity and skill. Here we review the national responses according to whether they were strong, moderately strong, uneven or weak, recognizing that nations had governments of different political complexions, and crises of differing scope and character to address (see Figure 12.2 for a summary of national responses). The earliest and most concerted responses occurred in Australia, New Zealand, Sweden, the United States and the Netherlands. The most precipitous actions were taken by the three countries which arguably had the least to worry about: Australia, New Zealand and Sweden. By May 2008 the Australian Treasury was working on an expansionary budget (for example, lower interest rates, big tax cuts, new spending) and committed

318

Strong economy, government finances, and budget system

Underlying weakness in budget system, regulation or economy

Underlying weakness in budget system, regulation or economy

Canada

Sweden

Denmark

Netherlands

Weak fiscal monitoring, budget and regulatory frameworks

Weak fiscal monitoring, budget and regulatory frameworks

Weak fiscal monitoring, budget and regulatory frameworks

Weak fiscal monitoring, budget and regulatory frameworks

Ireland

Portugal

Spain

Greece

?

E

E

EC

Collapse of Lehman Bros

2008

2008

? R

2009

E

E

C

ER E

2009

Figure 12.2  ‘Going-­in’ positions, interventions and consequences

Start of Global Credit Crunch

2007

Underlying weakness in budget system, regulation or economy

Japan

system, regulation or economy

United States Underlying weakness in budget

Strong economy, government finances, and budget system

Strong economy, government New Zealand finances, and budget system

Australia

2007

Strong economy, government finances, and budget system E

R

R

E

C

R

2010

E

R E

E

E

2010

2011

E

ER

E R

E R

E

CR

E

2011

2012

E E

2012

E

Natural disasters ? Unsure of date

C Political Crisis

E New Coalition

E Government Falls

R Institutional Reform E Government Returned E Government Leader Falls

Push for Fiscal Consolidation

International Intervention

Key Crisis Response



Conclusions and implications ­319

$73 billion in four stimulus packages over four months starting in late 2008.2 New Zealand responded with similar speed across a range of policy and regulatory fronts, although its preference was against cash stimuli to households. The Swedish government responded promptly in October 2008 despite its conservative record of fiscal prudence, years of economic growth and a strong banking sector. Besides its modest fiscal measures it also opted to privatize some government functions and provide work incentives. The government lowered income taxes, allowed the krona to deflate markedly, provided banking assistance and guarantees, and provided loans and investment assistance to key industry sectors in the face of levelling economic growth and higher youth unemployment. Targeted measures flowed to the auto industry along with new spending on infrastructure, education and social security. These interventions were time-­ limited to 2010, in anticipation of the national election. In the US and the Netherlands, the crisis was more deeply felt in real terms and concerted government action was set in motion. The US had a significant structural deficit heading into 2008 and experienced rapid declines in GDP, housing prices and employment. Concerted monetary policy action was taken by the Federal Reserve Board based on a ‘lend freely’ policy by the central bank to stabilize markets. The Reserve provided guarantees and special liquidity to financial institutions from October 2008, followed by large-­scale asset purchases and quantitative easing to lower interest rates. The US Treasury acquired and assisted ‘failing’ financial institutions, as well as selected major industries such as automobile manufacturing. President Obama’s federal fiscal stimulus assisted the automatic stabilizers on the revenue and spending sides of the budget. The US (along with Korea) introduced the largest stimulus packages among the OECD nations,3 which included supporting state and local governments, while the nation’s public debt increased from 40 per cent to 67 per cent of GDP. These interventions were approved despite strong Republican resistance, reflecting the political capital of the newly elected Obama administration and public opinion. In the Netherlands, a small but open economy with a more liberal approach to financial regulation, the government quickly recognized the exposure of its substantial banking sector. To avert a political crisis, a center-­right coalition was formed to assume nationalization of Dutch banking which included deals with the Belgian government and its financial institutions, costing some €80 billion, and the introduction of a stimulus and stabilization package in late spring 2009. Formal repertoires for budget-­making were set aside, with the parliament giving the Minister of Finance a much freer hand to establish crisis teams and to deal with particular European circumstances and other international organizations.

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The global financial crisis and its budget impacts in OECD nations

Governments in Canada, Denmark, Japan and Ireland were more tentative, but followed with moderately strong responses: ●●

●●

●●

●●

In Canada, the minority Conservative government was largely uninterested in fiscal stimulus measures or compromise with the opposition parties, reflecting its ‘small government’ stance. It took substantial negative public reaction to its indifferent November 2008 economic statement, which was rapidly outstripped by events as it went to press, and a political crisis, to precipitate intensive work and consultation on a new budget stance, leading to a stimulus budget delivered in January 2009. This turnaround was remarkable, driven by the Prime Minister and Minister of Finance, and became part of a successful campaign strategy in the lead-­up to the next election. In Denmark, the process was more deliberate and measured, with the government introducing its stimulus package in February 2009, followed by spending agreements with local governments in June that same year, combined with central government tax cuts and additional investment spending. EU strictures framed the Danish response and laid the foundations for long-­sought-­after liberalization reforms, but with less effort made to support distressed financial institutions also led to the demise of many small banks after 2008 (although five government guarantee bank packages were announced). In Japan, the governing LDP did not act quickly at first because it thought the Japanese economy immune to the international crisis, but acted concertedly with three stimulus packages in the autumn of 2008 and another in late 2009, invoking previous repertoires and motivated as ‘pre-­election’ announcements. In Ireland, the key challenges stemmed from the country’s prior economic success as a ‘Celtic Tiger’, high expectations of citizens and governments, and its status as European exemplar of market growth. Ireland showed less interest in exploring the possibilities of downside risks of its success, and the Department of Finance had not sufficiently warned political leaders about the housing bubble or the excessive spending. Successive coalition governments had negotiated social partnership agreements which locked in expenditure outlays, creating a looming structural deficit once revenues declined. Once Ireland realized that it had a major financial crisis and economic collapse on its hands, the government moved quickly with international support, introducing revenue-­raising and expenditure reduction measures to the budget in early July 2008, followed by guarantees for assets, creditors and bondholders, and further budget



Conclusions and implications ­321

announcements in October 2008, and an emergency budget in April 2009 with more spending cuts and tax increases, financing its commitments with assistance from European Financial Stability Facility (EFSF) and loans from the International Monetary Fund (IMF) and several countries. These four cases stand as remarkable examples of budget and governance systems which, although they were not anticipatory and proactive, demonstrated considerable resilience, concerted action and adaptability in the face of the governments’ respective challenges. The responses from the remaining countries we reviewed – Spain, Portugal and Greece – were weak, often complicated by domestic political considerations, as well as negotiations with European and international financial authorities. Reflecting the malaise in these countries, we find certain common patterns recurring: ●●

●●

●●

Spain’s actions came in response to packages initially coordinated by the EU in 2008, which included rescue measures to stabilize the financial sector (for example, guarantees to banks for debt and for account holders, and the provision of restructuring funds). It followed a sharp decline in the real economy and property markets, and with the national budget rapidly moving from surplus to more than 10 per cent deficit by 2009, and public debt increasing from 37 per cent to 69 per cent, then to more than 80 per cent of GDP. Several relatively large stimulus and bailout packages were negotiated with the EU and key provincial and local governments and private sector stakeholders in 2009, followed by a consolidation strategy in early 2010, looking forward three years. In Portugal, although political instability had contributed to worsening public finances, even the IMF did not recognize the effect of the GFC until late 2008, or that a full recession might occur in April 2009. Following the EU lead, in October 2008 the government moved quickly to get backing to offer loan guarantees and to nationalize the Portuguese Business Bank (BPN)4 and provide a fiscal stimulus programme. But a lack of discipline and political instability led to increases in government outlays, which compromised domestic fiscal policy and led to the March 2011 bailout request and a package of €78 billion provided in financial assistance. For Greece, the first acute crisis occurred much later during November 2009 to April 2010, after the arrival of the centre-­left Panhellenic Socialist Movement (PASOK) government, since the previous New Democracy government had not taken any corrective

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The global financial crisis and its budget impacts in OECD nations

policy actions and financial markets started recognizing the risk. The new Prime Minister’s draft 2010 budget submitted to the European Commission (EC) in November 2009 triggered a domestic political crisis. In early 2010, Germany’s reluctance to agree to bailing-­out Greece led to bond prices increasing steeply, triggering a banking crisis by April 2010. The Prime Minister requested aid from the EU and International Monetary Fund (IMF), with the negotiated package narrowly approved by the Greek parliament in May 2010, leading to dramatic political upheaval and further decline in Greece’s financial markets. In these latter cases, government prevarication or inaction meant that more proactive interventions were not taken, eventually leading to larger budgetary challenges, bigger intervention packages requiring international support, and significant political consequences. However, as we note in the next section, even governments that responded with concerted and early responses to the GFC were not left off the hook from grappling with longer-­term fiscal and budgetary pressures. What explains the readiness of many countries to act, even when the GFC was not easily predictable, and before significant economic consequences materialized? First, many finance departments or central Treasuries had strong monitoring capabilities and were aware of underlying weaknesses in public finances and the economy and, as in the Australian case, had already undertaken scenario-­based exercises to test bureaucratic reflexes. Such departments were better prepared to provide advice to governments. Second, many countries had developed political cultures which valued balanced budgets as a necessary condition for longer-­term prosperity, giving their governments scope to act. Third, those countries with weak or delicate economies and public finances were open to persuasion and inducements from European and international banking agencies. Finally, the initial government responses to the GFC were conditioned and sometimes limited by the unique political configurations in each country, but in the immediate months that followed the actions taken and not taken by governments and international organizations had political consequences. Some of the governments covered in this volume had minority or coalition status, or were already in election-­ready mode, and immediate political or ideological considerations weighed heavily on them; in some cases much more than the imperatives of addressing the country’s crisis on its own terms. The Canadian, Japanese and Greek cases stand as examples of governments allowing political considerations to colour early responses. Predictably, most incumbent governments caught up in the crisis did



Conclusions and implications ­323

not come out of the GFC better-­regarded than before, and many were swept away by their deeply disaffected constituents. However, what became somewhat more surprising was that even governments which took early decisive action – such as Australia, New Zealand and the US – did not receive credit from the electorate or from their political party colleagues for doing so.5 While the wealthy leaders of financial institutions were publicly vilified early on in the crisis – the stockbrokers and derivative traders on Wall Street and in the ‘City’, the executives of the major banks and mortgage lenders – eventually the community and business groups came to criticize governments for not anticipating and preventing the crisis, for not properly regulating institutions, for choosing which groups received bailouts or other forms of support, and for running up deficits and sovereign debt as part of bailout and stimulus packages. Paradoxically, elected governments were rarely praised and rewarded for stepping in, helping communities to cope, or taking various actions of amelioration or austerity. Governments played a crucial role in managing the crisis in whichever ways it manifested itself, yet failed to translate this financial management into political support. It seems that politicians and governing political parties recognized that governments were expected to provide a backstop and stabilize the situation, serve as the guarantors of last resort, and move their economies back to the ‘new normal’. Nevertheless, competent and comprehensive responses would not insulate governments from citizen judgements on how well they handled their next round of challenges. Conspicuously, civil societies in some countries exhibited stoic calmness and dedication as governments and other authorities went about addressing their crises, while others incurred considerable civil strife and violent protest, often against surrogate targets (such as government departments, police and security forces, shops, local banks and vehicles) rather than the more likely suspects (international banks, financial regulators, stock markets). Countries such as the UK, Canada, New Zealand, Australia, Japan, Ireland, the Netherlands, Sweden and Denmark proceeded to address their respective crises with broad public consent, even if the national political debate was often vigorous and governments tended not to receive overt gratitude for the interventions. Communities in other countries, by contrast, engaged in massive demonstrations, violent riots and other forms of protest when confronted with the consequences of their national plight: for example, Greece regularly descended into anarchistic street battles, fire-­ bombing and looting; Spain and Portugal briefly erupted in mass demonstrations and paralysing strikes, and the US spawned the ‘Occupy’ movement on New York’s Wall Street and in other US cities.6 Such populist protests, which arguably reflected cultural and ideological antipathy to externally imposed measures, often

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The global financial crisis and its budget impacts in OECD nations

exacerbated the crisis for the economies of those countries. For example, tourism to Greece initially increased as the euro eased against other currencies, but later suffered due to the violent protests and political instability, dropping by 5 per cent or 1 million tourists in 2012.7 Likewise, countries with considerable civil strife and political upheaval tended not to be viewed as safe places to make financial investments (a problem of sovereign risk). Observing that the GFC had international dimensions is tautological because of its initial global spread and spillover effects affecting almost all countries. But for many countries the international dimension was also an important feature conditioning government responses. Many countries had to rely on international banks and supra-­sovereign institutions to advise on policy responses, and for financing stimulus packages or eventual ­bailouts; and these international institutions – the G7 and G20, the European Union and European Commission Bank, the International Monetary Fund, World Bank, Asian Development Bank, and so on – sought to coordinate multinational interventions in order to have the desired stabilizing impacts. In many cases international institutions without close links to domestic constituencies insisted on ‘punitive’ actions that some governments may not have been inclined to take themselves. When calling for and providing support to countries in dire straits, they were in a strong position to call for specific mixes of interventions, including whether a government should increase revenue-­raising, impose expenditure cuts and sell off publicly owned assets. Countries within the Economic and Monetary Union (EMU) – such as Spain, Portugal, Greece, Ireland and the Netherlands (but not Sweden, Denmark or, for that matter, the UK) – choosing fiscal policy settings to navigate the crisis were particularly constrained. As members of the common-­currency EMU, these countries could not simply devalue their currencies as part of a readjustment, forcing domestic rationalization of budgets and fiscal policy, and strict new budgetary frameworks. It was easier for countries such as Australia, New Zealand, Canada and the US to adjust their economies by allowing their respective dollars to weaken in value or by quantitative easing to lessen interest rate pressures. European countries such as the UK, Denmark and Sweden benefited by their own domestic currencies as an additional response instrument; and this most recent financial crisis will cause some reflection in those countries previously interested in joining the euro. For countries in the eurozone, there was an additional dynamic at play: the EU assisted some countries to address their financial, budgetary and economic vulnerabilities quickly, but there soon appeared to be clear limits as to how many countries could be handled at a time. The initial focus for strategic reasons was on Iceland,



Conclusions and implications ­325

Ireland, Italy, Spain and the UK; later, more attention was paid to countries such as Greece, Portugal and Cyprus. To reiterate, the diverse responses of governments to the 2007–09 global financial crisis arose from differences in how the crisis manifested itself across countries; in the ability of national Treasury or finance departments to anticipate and aggressively advise governments; in the political perceptions of the extent of threat to the economy and government finances; and in whether governments were in strong or more tenuous political positions. Economic fundamentals dictated the room for manoeuvre of governments for their interventions and whether international assistance might be required. Generally, most national governments saw the early troubles in the US as not affecting their country’s fortunes, reflecting generalized confidence in international and national economies, and were quickly proven wrong; and even the decisive early responders to the crisis soon found that developing longer-­term strategies for restoring fiscal balance would be more difficult than they imagined, a challenge which will shape the priorities of national budgeting systems for the foreseeable future.

HOW DID BUDGETARY AND GOVERNANCE SYSTEMS ADAPT? The global financial crisis may retrospectively have been inevitable and perhaps even predictable, but it surprised all governments at the time. We might now anticipate that the stronger ones would be less surprised today, given that they have built more capable systems, have stronger governance and budgetary systems, and have adopted better fiscal policy performance and frameworks that are gradually restoring economic growth and prosperity. We would also anticipate that such governments would now be more likely to act quickly and more decisively; less likely to require significant reform; and in the wake of the crisis, more likely to develop new focus, galvanize resources to that end, and lean more firmly in those directions. Conversely, we would expect that countries which were greatly surprised and deeply affected by the GFC would consider more significant reforms of budgetary systems, including instituting new processes, building capacities and, if necessary, looking beyond budget systems to deal with broader issues of financial sustainability and improved governance systems. Here we explore what adjustments were made to budgetary governance systems as part of the initial responses to the crisis; how governments developed strategies to cope with slower internal economic growth, tighter budgets and tough choices; and began to prepare for the longer-­term budgetary challenges facing their nations. In short, how governments

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The global financial crisis and its budget impacts in OECD nations

were preparing to allocate their scarce public resources in both the present and future. Once again, using the same country groupings from the previous section, we consider how proactively and concertedly each country responded to the crisis. Robust Budget Systems: Making Adjustments After the GFC Stress Test Those countries that entered into the crisis with strong government finances often found it unnecessary to change their basic budgetary systems or processes. For instance, Australia’s budget response was initially considered exemplary by international standards, with the Rudd government retaining its main budgetary architecture while introducing a series of politically driven mini-­budgets. However, in its haste to act it soon experienced political grief over two components of its stimulus packages: criticisms of both the slipshod home insulation programme, and lack of value for money over educational facilities spending. Mounting criticism fanned leadership tensions in the governing Labor Party, and caucus revolt led to the ousting of Rudd in June 2010, and his replacement by his deputy, Julia Gillard, who failed to win the August 2010 election and was reduced to minority government supported by Independents and Greens. Gillard’s government was then far more politically constrained and had less budgetary room available for addressing new priorities due to increasing expenditures and declines in expected tax revenues as international commodity prices fell, forcing cuts to programmes, often expediently announced. In 2010 the government committed itself to returning to a budgetary surplus by June 2013 with the debt-­to-­GDP ratio rising to 7.2  per cent; however, the deficit continued to expand to between $40 billion and $50 billion by 2012 with the debt–GDP ratio increasing to 11.4 per cent, and with the date for returning to surplus moved out to beyond the 2016–17 fiscal year. Its neighbour New Zealand was financially more constrained than Australia and its Treasury more surprised by the crisis, and neither the outgoing Clark Labour government nor its successor, the fiscally neo-­liberal Key government, mustered enthusiasm to support a comparable stimulus programme. Instead, New Zealand focused on business support measures and selective tax reductions. However, its more limited intervention programme stabilized the economy over five quarters and provided a better foundation from which to work towards achieving fiscal balance. In contrast to Australia and Canada, which both extended the date by which they would return to surpluses, New Zealand pushed forward with its fiscal consolidation programme to deliver budgetary balances by 2014–15. During this time the New Zealand government did not introduce significant



Conclusions and implications ­327

reforms to its budget systems, but did review existing expenditures closely, raise indirect taxes, and manage according to firm expenditure targets. Canada’s Conservative minority government initially resisted introducing a stimulus package, but regrouped and introduced a highly interventionist stimulus budget announced in early 2009. The Economic Action Plan became a centre-­piece of its electoral campaign strategy, leading to a slim majority in the May 2011 election, during which the government promised a return to fiscal balance in 2014–15 along with several new programmes if the latter was achieved (Curry 2013). Despite initial denials of a structural deficit, the timeline for securing a balanced budget was extended out, due to lower resource revenues and slow US economic growth. The Harper government initiated strategic reviews of suites of programmes, announcing cuts and targets (but not specifying where they would occur) and not replacing departing staff. More emphasis was put on cost containment, including strategic programme review initiatives, reprofiling selected programs and bringing some arm’s-­length agencies back into core government – efforts to reduce outlays or reprofile funding to the provinces and territories. Most recently, the Minister of Finance declared that the budget will return to surplus in the 2015–16 fiscal year. Sweden had already learnt extensively from its previous financial crisis, which led to institutional reforms and a more disciplined and inclusive public sector expenditure management regime, including central expenditure ceilings and local government balanced budget requirements. Going into the 2008–09 crisis, Sweden benefited from economic growth and a strong banking sector, while the government focused on fiscal controls (potentially depressing economic growth rates) accompanied by privatization of some functions of the Swedish government and incentives for work. Growth slowed, but net public debt stabilized at below 50 per cent of GDP. The independent Swedish Council of Fiscal Policy, along with other watchdogs, could externally review the budget and fiscal policy framework with an eye to restoring longer-­term fiscal balance. In none of these cases did national budget systems require overhaul; indeed, normal budget and fiscal management processes were adapted to prepare and announce strategic decisions and later to develop medium-­to long-­term goals along with expenditure reductions and revenue-­raising measures. However, even these arguably well-­ performing governments and budget systems have found it difficult to achieve fiscal balance in the medium term, learning that returning to surplus in a slow-­growth environment will require sustained political resolve and perseverance.

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The global financial crisis and its budget impacts in OECD nations

Resilience Followed by Significant Reforms Several other countries emerged from the global financial crisis in comparatively good shape, but early on had to make significant interventions and process adjustments. Hence, prior to the GFC, the Danish government handled budgetary matters with relatively informal fiscal and budgetary guidelines, but the crisis propelled the Ministry of Finance to re-­emphasize budget and fiscal discipline and management, paving the way for reforms long sought after by the right-­of-­center government. As part of its exit strategy the government announced in May 2011 a medium-­term consolidation and reform package consistent with EU limits on spending programs, along with policy and institutional reforms for regional and local government councils four years in advance. While the coalition government survived the 2011 election, the proposed budget bill intended to anchor these reforms in law was deferred, but eventually passed in March 2012. In the Netherlands the government used massive interventions to stabilize the economy and shore-­up key financial institutions. Preparing for the future, the government focused its 2010 budget on working towards more sustainable public finances, announcing expenditure reviews and introducing a Budget Framework Commission. A new right-­of-­centre minority government was elected in October 2010, focusing on stabilization and restraint. The US economy has experienced slow growth since the advent of the subprime mortgage crisis and the failure of several financial institutions. Government has been wracked by bouts of ‘fiscal brinkmanship’ simulated over budgetary posturing, revealing the precariousness of national finances after the Bush tax cuts and outlays funding the ‘War on Terrorism’ in Iraq and Afghanistan. Despite massive interventions by the expansionist Obama administration dragging along a reluctant Congress, there followed protracted political bluster with the Congress over spending proposals and especially over raising the debt ceiling, leading to a compromise agreement and a commission to identify further reform packages. The US President and Congress have continued to engage in political brinkmanship over the structural deficit and debt burden, both before and after the November 2012 election. The result has tended to increase market nervousness and hinder economic recovery, while generating a disillusioned public. Japan’s unprecedented stimulus intervention was complicated by hung and ‘twisted parliaments’, the instability of Liberal Democratic Party (LDP) and Democratic Party of Japan (DPJ) governments, and revolving prime ministerial leadership (six Prime Ministers in six years). In the lead-­up to the August 2009 election, the LDP government made rash



Conclusions and implications ­329

promises which were not scrutinized for sustainability, and many were not implemented by ministries and agencies. The incoming DPJ government had to renege on some of its election promises but succeeded in dissolving the LDP’s key advisory councils, replacing them with its own. The DPJ reprofiled the Economic and Fiscal Policy Council, and put in place the National Strategy Bureau under the Prime Minister and the Council for Government Revitalization, and later established a National Strategy Council and a Tax System Council. However, these institutional adaptations were seen more as expressions of DPJ mistrust of the establishment actors inside and outside government than a desire to create a better budget system. In annual budget terms, Japan did not fare worst across the OECD (with annual deficits exceeding 8 per cent for three years from 2009) but its prior history of public indebtedness saw gross public debt rise to more than 200 per cent by early 2011. Each of these countries had to deal with significant surprises and, in varying degrees, responded with significant reforms of key processes, stimulus packages or regulatory interventions. In this cluster, Japan stands out as indulging in more symbolic or populist responses which did not appear to be directly connected with implementing the stimulus or building sustainable finances (although a deferred Goods and Services Tax, GST, increase was passed in 2012). From Crisis Comes Opportunity: Building New Budget Systems The countries with fundamentally weak fiscal monitoring and regulatory frameworks going into the GFC – Ireland, Portugal, Spain and Greece – had not only to negotiate international interventions to buttress public finances and private financial institutions but also to rebuild fiscal policy, financial regulation and budget office capabilities in varying degrees. For instance, the Irish government made concerted institutional reforms once it recognized the seriousness of the crisis: it effected a leadership change in the central bank, adopted a new regulatory financial structure, and conducted a review and restructuring of the Department of Finance. The budget process was fundamentally reformed with the creation of a new Department of Public Expenditure and Reform and supporting committees and councils, with a stronger fiscal framework (more disciplined budgetary estimates, performance budgeting, medium-­term planning, spending reviews, expenditure ceilings and tougher fiscal rules). The Portuguese government’s bailout and structural adjustment package led to several budget process reforms including the establishment of a Council of Fiscal Policy to forecast and assess programs, a Budget Framework Law setting limits on expenditures and deficit targets out to

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2015, and clearer rules for the budget process. The June 2011 election resulted in a majority government, which had to strive for fiscal balance while restructuring an uncompetitive economy and considerable exposure to external sovereign debt markets. It introduced a wide-­ranging and detailed long-­term reform strategy designed to increase international competitiveness in different sectors (financial regulation, labour market, education, goods and services, housing, judicial, and so on), as well as a series of fiscal consolidation measures (privatization, national and regional/local expenditure constraints, and revenue-­raising). In Spain, in addition to economic and budgetary challenges, coalition arrangements weakened how the government could respond to the crisis. This was compounded by a decentralized federal system where regional and municipal governments largely controlled their own budgets. Following the 2009 bailout package, the government announced a plan in January 2010 for fiscal consolidation and a deficit under 3 per cent by 2012, including new budget rules for regional governments, implementation of a Parliamentary Budget Office, and executive commissions focusing respectively on spending policy analysis, programme analysis, ministerial budgets and revenue. These reforms were superimposed onto existing budget institutions and processes. The government’s implementation of these reforms and securing additional financial relief have been affected by more recent political scandals, and denial that the country is receiving structural adjustment. Greece’s parliament narrowly approved the May 2010 fiscal and budget reform package, but civil and political strife ensued, further worsening financial markets and bond spreads, despite further interventions from the European Central Bank (ECB) and EC. Political gyrations included a further cabinet reshuffle in June 2010, further austerity measures in October 2011, the Prime Minister’s referendum gambit and eventual resignation in early November 2011, with the PASOK and New Democracy parties forming a leaky coalition with other parties and announcing a second Memorandum of Understanding (MoU). All of the major parties lost ground in the May 2012 election, but another shaky coalition government emerged, followed by further financial chaos and another election in June 2012. Once public finances and markets stabilized somewhat (but with net debt now hitting more than 170 per cent of GDP), the ‘Troika’ of the EC, the ECB and the IMF asked for the implementation of Greece’s commitments. There has been no evidence of fundamental institutional and policy reforms by the Greek governments other than those imposed by external agencies, reflecting weak governance and opposition from unions and professional groups and more radicalized citizens. These countries (the so-­called PIIGS – Portugal, Ireland, Italy, Greece,



Conclusions and implications ­331

Spain) relied heavily on international interventions to stabilize their public finances and economies, and much still remains to be done to achieve fiscal and financial independence. Whether their respective crises emerged as a result of political blinders about the long-­term implications of unsustainable fiscal and economic policies, insufficient or unheeded advice from budget and other officials, or more deep-­seated cultural antipathies towards governance, paying due taxes or meeting social obligations, is not merely an academic question: the more all of these explanations hold, the more extensive and deep the reforms required. Such reforms include: ensuring elected governments and aspiring parties better appreciate the need for fiscal balance (whatever the level of taxation and expenditure outlays they might prefer); developing better technical budgetary expertise, processes, and ‘hard’ medium-­term frameworks; and engaging the public about the need for greater fiscal balance, which might require cultural change. Greece, Portugal and Spain have the additional challenge of having relatively large informal economies operating outside the regular tax system, high dependence on public sector outlays for pensions, and considerable public resistance and strife in reaction to structural adjustment packages negotiated with European and other international organizations. In such instances, the credibility of ruling governments was often at issue when proposing policy and budgetary reform; longer-­term financial sustainability and independence will require some form of political transformation and cultural change when it comes to public finance.

LOOKING AHEAD: BUDGET CHALLENGES FOR ALL COUNTRIES Our cases indicate, above all else, that regardless of the fiscal strength and political, budgetary and cultural maturity of countries entering into and emerging from the global financial crisis, several significant challenges will test all jurisdictions. Even strong performers can become complacent and struggle with meeting these challenges. The most pressing challenges include the following: Learning to Deal with Lower Revenue Streams Government revenues have not rebounded as much as anticipated (or hoped for), reflecting the sluggishness of slow-­growth economies. Many aspects of economic life slowly recovered after 2010 (for example, employment, house prices, share market indices), but the restoration of revenues to expected levels has proven incredibly stubborn. This may be due to a

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natural caution of consumers, less business investment, more saving and less spending on credit purchases. Rational consumers may be cautious and reserved, spending on essentials not luxuries, careful with money or even spendthrift, and sections of the worst-­affected countries have become generationally poorer. But the challenge going forward is that government expenditures have not generally come down in most countries, even in countries considered as financial and budgetary ‘basket cases’. If governments cannot rely on rising income and corporate taxes (and suffer various forms of tax avoidance), will they shift to more immobile taxes and user charges (for example, indirect taxes, land taxes, co-­payments for hospitals, aged care facilities, increased fees for university degrees)? Introducing Tighter Fiscal Policy and Budget Regimes There is a particular paradox here. There is evidence that the GFC resulted in some countries adopting tougher fiscal rules, creating new fiscal institutions (regulatory, monitoring), and better budget systems, including new institutions, or that they have tried to better control finances and risks. However, other nations may not have changed their fiscal rules much at all, let alone their practice. Generally, the nations that had the tougher rules at the start of the GFC were more likely to toughen them during the GFC and its aftermath (for example, the Netherlands; New Zealand, Australia; and also the UK, Germany and perhaps Ireland). Yet, analytically, there does not appear to be any close causation or correlation between those cases with a weak fiscal position and lax institutional rules, and their propensity to discernibly tighten those rules; indeed, the contrary position may be observable. Strengthening Budgetary Discipline and Expenditure Management Governments have found it incredibly hard to achieve fiscal consolidation. Most advanced nations came out of the GFC with a structural deficit problem. Expenses continued to trend upwards while revenues remained flat. In the short term, counter-­cyclical spending was not considered problematic; but longer-­term profligacy may suggest that governments have a mindset problem or suffer from asymmetrical incentives. Governments do not like cutting spending or reducing benefits, or sharing the pain across their communities, but nor do they like taxing to pay for sustainable public provisions. The GFC appears to have weakened the slender link between expenditures and revenues; so what prospect is there for tighter budgetary disciplines? Some countries such as Canada and New Zealand are now requiring prudential (discounted) forecasts for revenues and



Conclusions and implications ­333

long-­term liabilities as a means to limit expenditure growth. Independent verifiability can be used to prevent expedient padding of expected revenues ­(something of which many governments have been accused post-­ GFC). Small unitary countries such as Sweden and Korea have imposed expenditure management through tough statutory expenditure ceilings that can only be exceeded when higher revenues are actually received. In economically volatile economies, such as Chile, governments have imposed disciplinary measures that require spending to be held below the five-­year rolling prudential forecasts of revenues, with any achieved surplus earmarked for debt repayment. All these techniques are contextual attempts to ensure that planned expenditures cannot exceed expected revenues. Such arrangements will suit certain nations, but not others; imposed limits will align with certain national characteristics and cultures, but not others. Internationally imposed expenditure limits, such as with EU fiscal rules, will work for some members but be disregarded by others. Temporal expenditure limits may only prove to be effective while a sense of crisis persists, but not once the main emergency has passed. Moreover, governments still face huge expenditure pressures from demographic strains, ageing and health care, migration and lower levels of labour force participation. These factors imply that governments will be unlikely to reduce their commitments or exposures into the future. Again this underscores the importance of budgetary discipline to deliver sustainable finances into the future. Addressing Structural Problems in Domestic Economies The GFC crisis exposed structural problems and misallocations of economic resources in many advanced nations. The problems were most acute in nations with protected labour markets, protected industries and uncompetitive industries; or those that were heavily reliant on certain industry sectors (for example, Mediterranean tourism), or had experienced overheated but unproductive property booms. Many countries as a result of the GFC committed themselves to dealing with these structural problems decisively and repairing their economies, but much of this intent quickly dissipated and reforms were fudged when governments were faced with the expediencies of realpolitik. Thus, both Spain and Japan announced extensive programmes of economic reform, but beyond drawing up a long list of intentions seem to have consigned reform into the ‘too hard’ basket. With smaller public sectors and social transfer payments, both Ireland and New Zealand addressed structural domestic problems as part of a recovery strategy. International requirements associated with liquidity assistance or bailouts seeking structural reform generally appear to have had less effect than domestic commitments to reform.

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Avoiding Housing Bubbles and Real Estate Speculation Property booms and speculative investments in real estate have been a common cause of much of the financial grief. Ireland became a classic case of resource misallocation, massive waste and harm caused by a misguided property boom. Likewise, UK, French and German investors pumped up the Spanish real estate market and caused hyperinflation but few real jobs. The ‘no documentation’ loans to credit-­risk customers inflated property markets in many US cities, only to leave them as repossessed ghost towns after the crash. These cases suggest that unregulated property markets are prone to get out of control, become damaging to the wider economy, and circumvent government oversight because of market forces and the limited availability of supply. Ought governments to more thoroughly regulate their property sectors, and perhaps return to older regulatory modes by forcing banks to limit lending on housing, say to no more than 50 per cent of the net value of a property), or require a proportion of bank funds to be invested in productive outlets and commercial developments not merely housing and real estate – ‘capital rules’? Paying Off the Debt Debt levels have risen to historically high levels over almost the entire developed world. The immediate consequences of this are that higher servicing charges reduce the amounts governments can allocate to essential services. The longer-­term consequences are that entire generations of future taxpayers will be paying off debt accumulated in the 2008–13 period, with much of the bad debts ‘gone’ on recurrent spending and bank guarantees. High debt levels (some well over 100 per cent of GDP) will intensify the pressure to inflate to erase the magnitude of borrowing, encouraging the quantitative easing of currencies, allowing domestic inflation to rise higher than 2 per cent per annum, feeding into further property and asset bubbles into the future, and even eating into household incomes as wages struggle to keep pace with cost inflation. Banks could be ‘levied’ additional amounts (fees) for deposit guarantees, liquidity assistance and nationalizations. Some countries have proposed charging banks for public support (for example, Australia), but these countries will find that capital is highly mobile, and it is not clear how governments might charge the banks (by turnover, balance sheet position, profits, and so on). Can the debt owed to overseas institutions be ‘repatriated’ by, say, having local banks take over the debts gradually, or even selling government bonds to repay overseas debt and repatriate debt to the local community (Japan has tended to do this through



Conclusions and implications ­335

its regular bond-­raising practices which provide retirement incomes for older citizens)? Sovereign Debt and Financial Crises It is unlikely that most bailouts provided during the GFC will ever be repaid. Many of these loans were themselves either provided by governments or guaranteed by them. The history of countries defaulting and refusing to repay loans implies that moneylenders write down bad debts, but then stringent fiduciary requirements apply to those defaulters. Many defaulting countries in the past have been welcomed back once they were financially viable again. If one European country defaults – as some of the authors in this volume have speculated is a possibility – will others follow? What collateral or securities have the receiving countries given, beyond a political agreement to repay? In retrospect, was it a problem that international bailouts were given in cash loans (often with conditions of austerity measures) and not provided on condition of purchasing national assets (for example, historical sites in Greece, Ireland or Spain, national parks, railways, public enterprises)? This latter option seems to have been considered inappropriate, yet when some US cities have been declared bankrupt, the administrators have often sold off assets as one of the first steps in refinancing. During the GFC many countries seemingly exploited their status as sovereign nations to avoid the asset purchase option being put on the table. Managing Pension and Demographic Liabilities Going forward, governments face an enormous problem in managing their pension liabilities and entitlement dependencies. What will governments be forced to do about this problem, and how will they manage the risk? Presently, most pensions are sustained by the public sector, not self-­insured pension schemes. Yet people are living longer, working for less years, retiring for longer periods and requiring more care. In such circumstances, how do governments set pension levels: fix a stipulated cash level, fix them to a proportion of the minimum wage, offer tapering-­off pensions (higher initially, then less later), and allowing people to have, say, 15 years of pension and then no more entitlement? Many countries have begun to increase the pension age closer to 70 years or, like Denmark, experiment with floating pension ages set at the average life-­expectancy minus 15 years, so the pension age will tend to creep up. Governments will be tempted to insist on reverse mortgages so that the family home can be used as a source of income in later life. Already some nations are

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requiring aged citizens to sell their family home in order to enter aged care facilities, with a proportion of the asset sale being used to pay an entrance fee to the aged care provider. Access to pensions may go the same way, and Italy has already indicated that it might move in this direction and might not be paying significant amounts in public pensions in five, ten or 20 years’ time. The US has long imposed capped entitlements for unemployment benefits, a policy option that still sounds extreme to European welfare states. Addressing Long-­Term Unemployment and a Lost Generation Slow economic growth, limited job opportunities, a recovery less based on job creation, and the overhang of sovereign debt crisis, have arguably adversely affected the younger generation across the developed world more than any other (especially those in their late teens and twenties). Some countries such as Ireland have faced a ‘brain drain’ as younger workers and the unemployed have sought better prospects elsewhere. The question for governments is: when and how will this discouraged generation rejoin the labour market? How will governments balance the need to educate and create opportunities for youth, as they address mounting public debt and pension liabilities? And why are some countries better positioned to take on these challenges?

FINAL WORDS: IMPLICATIONS FOR RESEARCH AND HOW WE THINK OF BUDGETARY SYSTEMS These are daunting if not intractable challenges, even for those jurisdictions which had governments that performed well in the crucible of the 2007–09 global financial crisis. For many countries, the challenges entail significant cultural change across many areas of civic life. They will require cultural change in political leadership, party representation, interest group behaviour, collective behaviour, civic education and issue awareness, and, most importantly of all, in civil society more generally. We propose that our next volume explore the progress which has been made in these regards. We presume that jurisdictions with pragmatic, forward-­looking governments, informed by capable officials and budgetary systems, and with well-­thought-­out policy regimes (for example, fiscal policy, financial regulation, housing, labour market) and fiscal prudence in the form of medium-­term planning frameworks and early warning systems (which might include rules and limits, and some flexibility as required) will be better able to address these challenges and make the necessary adjustments



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as new circumstances arise. But we have yet to witness this transformation internationally. Having reviewed our case studies and identified several lessons and future challenges, we want to conclude by considering the implications of our general and preliminary ‘readiness–response–resilience’ framework for evaluating and theorizing about budget systems and processes. A time-­honoured way to learn about organizations and political systems is to examine how they respond to shocks and crises; so too with budgetary systems. However, there are design and performance considerations where budgetary systems are concerned, such as the ability of leaders and experts to anticipate and recognize shocks, and to mobilize a response appropriate to the particular circumstances for stabilization and longer-­term recovery. Such shocks test the quality of budgetary systems, provide opportunities for governments to determine whether budget systems need to be strengthened or reformed, open the door for altering other settings in other policy sectors, and provide reminders and educational opportunities for politicians, officials and citizens on the need for sound fiscal and budgetary regimes. Policy and budgetary innovation and learning can result. In Chapter 1 we noted that Allen Schick (2009, 2010) provided several propositions about how budget systems respond to crises. He predicted that budget processes and budgetary authorities might get overwhelmed (leading other actors such as Prime Ministers to take charge) and that extraordinary measures would need to be put in place even though these might be susceptible to misuse or abuse. He then predicted that budget systems would revert back to their pre-­crisis routines and traditions of incrementalism. Our case studies suggest that, even though the global financial crisis surprised central budget authorities and political leaders, and variously had real effects on financial institutions, the real economy, and budgetary deficits and public debt, there were few instances of countries being totally overwhelmed by the crisis. We make several observations in this regard. First, budget systems were generally not reinvented in extraordinary ways, but rather, available decision-­making processes were generally used in orderly ways to address the challenges as they emerged. Second, the extraordinary measures that transpired took the form of either massive policy interventions such as bailouts and fiscal stimulus (as opposed to budgetary process innovations), or non-­budgetary reactions more focused on political survival than budgetary reform, such as the Canadian government’s proroguing of parliament to buy time in order to reformulate its budget stance and political strategy, and the Japanese government’s effort to reform central advisory institutions; neither, we believe, had much to do with reconstructing the core features of the budgetary process. Third, Schick is undoubtedly right that, despite the need for

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national governments and budget authorities to control or reduce public debt and deficits (particularly due to the slow recovery of real economies), budget systems would revert back to routines and incremental approaches associated with restraint (for example, program reviews, across-­the-­board cuts, tax increases). In many jurisdictions there emerged a ‘new normal’, where improved external monitoring, internal tracking, and sterner fiscal discipline were burnished into the normal budgetary processes and routines. In this sense, while there was a reversion back to less dramatic non-­ incremental policy decision-­ making, budgetary systems and processes emerged from the GFC generally operating in a more disciplined way. More fundamentally, as Aaron Wildavsky (1964) noted some years ago, budget systems are intimately related to governance systems: if the former are not effective and lose resilience, political and governance problems will eventually arise, surfaced by economic or financial deterioration, whether through accretion or shocks. The need for prudence and resilience on the budgetary front of governance has long been understood, whether from domestic or international institutions. However, building such awareness typically occurs experientially, on a country-­by-­country basis, as political and economic fortunes rise and fall. The GFC essentially functioned as a real-­time global ‘stress test’, engaging all countries in varying degrees. Such dynamics around resilience should be more directly factored into our understanding and models of budgetary systems, and wider lenses beyond budgetary and fiscal health should be applied given the implications of key sectors (housing, tourism, financial regulation, informal economy, and so on). We think that such comprehensive approaches have been applied by international organizations to developing and at-­risk countries when considering support and structural adjustment regimes, but in light of recent experience, they should be applied when analysing all countries. Moving from resilience to response, a key insight from our case studies is that budget systems and key decision-­makers, even when highly capable, can and will be surprised by outcomes. Moreover, budgetary officials cannot make short-­term adjustments and then implement new strategic directions and repertoires without the full engagement and support of governments; even when technically competent, government support and leadership is a necessary condition for action in challenging times. This fusion of bureaucratic capability and political leadership from governments and support is often tested even in the best of times, when electoral considerations may supersede fiscal, budgetary and other policy advice. This relationship and lines of communication need to be cultivated in the better times, along with the nurturing quality of bureaucratic technical and system competence, and allowing officials to fearlessly speak frank truths to power. Having an arc of confidence between key political leaders and



Conclusions and implications ­339

budget officials is crucial for not only dealing with crisis, but also developing longer-­term fiscal frameworks and working with them, since those political leaders are pivotal influencers and educators within their parties and of civil society. In this connection, we think that Schick’s theory of crisis budgeting could be strengthened in this regard, and that further theoretical and empirical research should focus more carefully on this critical lynchpin of the political and bureaucratic in governance systems. Our case studies, not surprisingly, pointed to the crucial role that international institutions, such as the European and other international banks, had in stabilizing the financial systems of many countries and providing bridges to allow governments to put new budget, fiscal and other policy regimes in place. In these cases, these international institutions provided much-­needed resilience when countries had lost their room for manoeuvre. Our case studies did not allow us to delve into the communications and coordination across these institutions as well as many governments with the resources to assist other governments (for example, G20, international and national banks, and OECD Senior Budget Officials meetings), particularly with respect to the timing of bailout and stimulus packages, but we have noted limitations on such interventions: only so many can be handled at any point in time, which may allow the finances of at-­risk countries judged to be of less international importance to further deteriorate. Conversely, even less exposed countries encountered international pressure not only to intervene but to do so with certain magnitudes and timing. There should be further empirical research and explicit modelling of the international linkages in public budgeting – ranging from the flow of financial support, to coordinating interventions, to the sharing of economic intelligence – which may simply require better linking of the literature on international financial institutions, structural adjustment interventions, and the workings of domestic budget systems. Our case studies also suggested that embracing a multilevel governance perspective on public budgeting should extend in the other direction to lower orders of government. In some countries, fiscal and structural budgetary imbalances arose at the subnational level (regions and urban governments with some financial autonomy) with national governments unable or unwilling to rein in the expenditure growth in the run-­up to the global financial crisis. After working with international entities to stabilize national public finances and private financial institutions, governments in countries such as Spain and Portugal then had to turn to introduce new fiscal planning frameworks and fiscal rules to constrain spending and ensure it was consistent with national fiscal policy objectives. Making such adjustments, particularly in more politically decentralized countries, can be difficult, but we note that many other strong performers such as

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Australia, Canada and Germany also have decentralized federations. There should be more empirical and theoretical explorations of multilevel budgetary dynamics and fiscal federalism, as well as their intersections with the international level, since reform of federal fiscal arrangements may only be politically possible with the threat or realizations of international interventions. One lesson emerging from our case studies is not to plan fiscal policy and calibrate budget systems to fight the last fiscal crisis, whether domestic or international in nature. The 2007–09 global financial crisis was not only different from previous crises and challenges, but also manifested itself in different forms across jurisdictions. Moreover, even relatively well-­performing budget and governance systems, which either anticipated or responded well to a significant shock, may nevertheless have to reposition economic and budget policy for a global economy which continues to evolve, and often quite rapidly, continuously throwing out new challenges. Further research should explore how well officials, political leaders, international institutions, and researchers in think tanks and universities work to imagine and identify different potential challenges, which may be new for some jurisdictions and not for others. In reviewing our case studies and the directions for future research, we cannot help but see that the scope of what we term ‘budgeting’ and ‘budgetary systems’ has broadened considerably. Since the 1960s, the modern field of budgeting always recognized and embraced the political level as well as the community and systems of budget officials, and connected policy in all domains to budgets and resourcing, which is what made it intriguing and worthy of sustained study. In practice and study of international development and public finance, international agencies and scholars have long recognized that putting national finances on a sustainable footing require comprehensive interventions, going far beyond fiscal policy and sound budget practice as narrowly understood. The 2007–09 global financial crisis fundamentally demonstrated that sustainable budgeting goes well beyond good technical practice and systems, and will continue to be linked to: good governance regardless of political disposition of elected governments; monitoring of many different policy domains (for example, financial institutions, housing, pension benefits and liabilities, selecting and controlling infrastructure investments); nurturing the relationships among political leaders and officials as well as with colleagues in other jurisdictions; and better anticipating and monitoring budget risks from international and subnational directions. This means that government advisors and critics must have their eyes wide open to new challenges and a willingness to debate, listen and prepare. Such broad understanding poses the risk that we will further dilute what



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we specifically mean by ‘budgeting’, but that is both appropriate and what makes the practice and study of budgeting so intriguing. There is increasing need for more encompassing analytic frameworks in which to locate and connect the many facets of budgeting; we hope that this volume, presented on the complexities of coping with the GFC, has begun this intellectual mission, and we hope that with this encouragement we will stimulate others to take on this challenge.

NOTES 1. In Canada these were targeted to certain programme areas, such as the Millennium Scholarship Fund which, among others, came in for criticism by the Auditor-­General for lack of parliamentary accountability, later wound up by the Harper government. See Aucoin (2003). 2. The stimuli occurred in late 2008 and early 2009, initially including a small cash injection ($10 billion) and an infrastructure package ($4.7 billion), then in February a further $43 billion more spending was released (for households, educational infrastructure, retrofitted home insulation, social and defence housing, business and road infrastructure). Following these packages the 2009–10 Budget in May committed a further $22.5 billion for hospitals, universities, clean energy, transportation, and a national broadband network. 3. Chapter 11, on Ireland, argues that it had the biggest interventions relatively speaking when compared to other countries. 4. In Chapter 9 on Portugal, Pereira and Wemans note that the IMF had predicted recessions in Iceland, Ireland, Italy, Spain and the UK. 5. There were two exceptions. Canada’s Conservative government – which was browbeaten into a more substantial response, prorogued Parliament, reintroduced a budget, and consolidated its political position – managed to improve its minority government status (2006–12) into a full majority in 2012. The Swedish government introduced time-­limited interventions in October 2008 before a planned election in 2010, which was deferred for a year and strengthened the governing party. 6. Riots were also seen across North Africa, in Italy and in some parts of Central Europe. By contrast there was virtually no rioting in Asia as a consequence of the GFC. 7. Compare this response with Ireland’s, which had considerable reason to mount popular demonstrations but instead, led by its government, opted to invest in massive international tourism promotions (under the banner ‘Come to the gathering’) that led to an actual increase in tourism-­related sectors in 2012.

REFERENCES Aucoin, Peter (2003), ‘Independent Foundations, Public Money and Accountability: whither ministerial responsibility as democratic governance?’, Canadian Public Administration, 26 (1), 1–26. Curry, Bill (2013), ‘Ottawa on Track to Reduce Deficit by about $7 Billion this Year’, Globe and Mail, Canada, 30 August. Schick, Allen (2009), ‘Crisis Budgeting’, paper prepared for Working Party of Senior Budget Officials, OECD Conference Centre, May–June, Paris: OECD.

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Schick, Allen (2010), ‘Post-­crisis Fiscal Rules: Stabilizing Public Finance while Responding to Economic Aftershocks’, paper prepared for Working Party of Senior Budget Officials, Athens, June, Paris: OECD. Wanna, John (2010), ‘The Work in Progress of Budgetary Reform’, in J. Wanna, L.  Jensen and J. de Vries (eds), The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Wanna, J., L. Jensen and J. de Vries (eds) (2010), The Reality of Budgetary Reform in OECD Nations: Trajectories and Consequences, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Wildavsky, Aaron (1964), The Politics of the Budgetary Process, Boston, MA: Little, Brown.

Index Abe, Shinzo (Prime Minister, Japan) 124–5, 127 accountability 60, 75–6 Afghanistan (war) 38, 80, 304, 328 Africa (Northern ‘Arab Spring’ risings) 316 American International Group (AIG) 4, 11, 40, 47, 240 Argentina 100 Asia/Asian financial crisis 5, 6, 24, 94, 96, 315, 316 Asian Development Bank 6, 324 Aso, Taro (Prime Minister, Japan) 119, 125 asset rescue packages 40, 43–5, 55, 71 austerity measures 7, 27, 105–9, 131–3, 212, 213, 214, 215, 216, 229, 248–9, 251–3, 267, 270, 271, 306, 316, 323, 335 Australia 4, 6, 8, 25, 26, 88, 92–117, 312–13, 316, 317–19, 322, 323, 324, 326, 332, 334, 340 financial institutions/regulators 92, 95, 97–9 Treasurer/Department of Treasury 93, 95–6, 98, 101–2, 104, 105–6, 108, 109–10, 313, 317 Austria 260 Aznar, José M. (President, Spain) 206 bailouts, national/financial assistance measures to countries 24, 27, 40–43, 47, 51, 97, 168, 231, 232, 244–6, 249, 250–51, 252, 268–72, 285, 321–2, 329, 335 Balkenende, Jan Peter (Prime Minister, Netherlands) 150–52, 154, 165 Bank of America 4–5, 11 bankruptcy 3, 4, 5, 10, 11, 47 banks and banking systems 39, 45, 62, 64–5, 96, 149–50, 154, 181, 183,

185, 189, 208–9, 242, 243, 274, 279, 284, 298, 315 bank nationalizations 4, 5, 26, 97, 100, 155–7, 243, 319 banking crisis/threats 4, 43, 44, 98–9, 118, 121–2, 149–50, 155–7, 208–9, 268–9, 285, 287, 292, 316 central banks, role of 3, 4, 10, 11, 36, 40, 41, 44, 47, 55, 67, 97–9, 100, 149–50, 189–90, 231, 236, 242, 243, 246, 249, 252, 260, 266, 267, 269, 275–6, 278, 279, 298, 319, 324, 330 deposit guarantee 98, 99, 103, 111, 122, 156, 166, 186, 209, 238, 240, 243, 289, 292 Barroso, José (Prime Minister, Portugal) 235, 236 Bear Stearns 3, 4, 10, 40, 97, 238, 239, 240, 316 Belgium 5, 149–50, 154–6, 240, 260, 319 Bernanke, Ben (Chairman, US Federal Reserve) 44 BNP Paribas Securities 4, 5 bond markets/bond yields/bond spread 35, 121, 123, 133, 134–6, 139–42, 157, 245–6, 249, 255, 264–8, 269–71, 334–5; see also TED Borg, Anders (Finance Minister, Sweden) 194 Bos, Wouter (Finance Minister, Netherlands) 155, 161 Brazil 97, 100 Brown, Gordon (Prime Minister, United Kingdom) 100 budgets, budgeting 8–9, 16–19, 21–4, 34–5, 60, 79–82, 84, 86, 87, 105–7, 114, 138, 145–7, 148, 149, 151–3, 157, 160, 169, 175, 176, 179–80, 343

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182, 192, 193–4, 196, 206, 218–23, 226, 249–50, 284, 293–7, 299–305, 309, 311, 321, 325–31, 332–3, 340–41 balanced budgets 32–4, 36, 59, 61, 64–5, 70, 78, 81, 93, 151, 166, 189, 194, 198, 206, 258, 303, 306, 322 budget deficits 1, 11, 12, 21, 22, 31–2, 33–4, 36–7, 38, 40–42, 51–3, 64, 65, 70, 79–81, 85, 104–5, 109, 112–13, 123, 150, 158, 162, 163, 166, 171, 172, 174, 178, 184, 187, 188, 191, 207, 209, 212, 213, 214, 220, 223, 227, 232, 244, 252, 258–9, 266, 267, 269, 303, 314 budget surpluses 33, 35, 36, 61, 65, 81, 93, 104–5, 106, 110, 111, 113, 114, 153, 175, 178, 184, 185–6, 194, 195, 209, 218, 309, 312 budgetary resilience 21–3, 27, 61–4, 84, 93, 96, 110, 145, 146, 147, 154, 172, 180, 183, 226, 241, 311, 312, 332–3, 338–9 ‘crisis budgeting’ 13–15, 26, 43–5, 67–71, 73–5, 82, 99–103, 111–13, 120–21, 133–6, 148, 161–2, 189, 195, 207, 209, 214, 267, 337–9 increased spending 31, 33, 36–8, 44, 46–7, 51–3, 70–72, 77, 83, 97, 100–101, 103–4, 109, 112, 122–3, 128, 135–6, 139, 158, 176–7, 184–5, 232, 234, 245, 258, 287–8, 293–4, 314 spending cuts 32, 35, 54, 59, 80, 82, 85, 105–9, 128, 131–3, 165, 168, 172, 186, 188, 189, 197, 212–14, 215, 223–4, 226, 237, 245, 250–51, 267 Bush, George H.W. (President, United States of America) 35 Bush, George W. (President, United States of America) 4, 36, 37, 38, 43, 48, 54, 100, 314 Canada 4, 8, 25, 26, 59–91, 111, 240, 286, 301, 304, 312–13, 316, 317,

320, 322, 323, 324, 326, 327, 332–3, 340 Auditor-General (Sheila Fraser) 73, 75–6, 77, 84 Finance Minister/Ministry 59, 60, 64–6, 67–8, 70, 72, 73, 75, 77, 78, 79–80, 84, 86, 320 Parliament/Parliamentary Budget Office 60, 63–7, 78, 79–81, 84–5, 86 Privy Council Office 73, 77 Treasury Board/Secretariat 73–4, 80, 84, 85 Chile 333 China 6, 11, 95, 97, 100, 104 Chrétien, Jean (Prime Minister, Canada) 59 Clinton, Bill (President, United States of America) 35 Coelho, Passos (Prime Minister, Portugal) 235, 250 corruption/fraud/informal economy 125, 207, 223, 227, 261–2, 315, 331, 332 Costello, Peter (Treasurer, Australia) 93, 95 credit ratings/agencies 3, 32, 55, 59, 175, 246–7, 249, 267, 269, 310 credit squeeze 5, 17, 39, 40, 44, 45, 46, 68, 69, 95, 96, 97, 98, 99, 186, 189, 208, 238, 266, 274, 279, 315 Cyprus 6, 11, 325 debt, sovereign debt/public debt/debt crisis 12, 17, 21, 27, 53–4, 57, 59–60, 62, 63, 105, 110, 111, 112, 139–43, 150–51, 153, 157, 158–9, 162–3, 174, 181–2, 186, 205, 212, 213, 214, 215, 219–20, 224, 226, 231, 232, 234, 244–6, 251, 252, 258–9, 262, 264, 267–9, 271–2, 279, 284, 303, 314, 321, 334–5 demographic pressures and social problems 27–8, 31, 79, 128, 151, 176–7, 178, 181, 183, 188, 193, 214, 225, 228, 237, 251, 255–6, 269, 276, 277, 293–5, 333, 335–6 Denmark 8, 25, 26, 174–204, 285, 291, 312–13, 316, 320, 323, 324, 335



Index ­345 Economic Council 177, 181, 186, 191, 197, 313 Finance Minister/Ministry 175–6, 178–9, 186, 328 Prime Minister 176, 181–2

232, 233, 237, 285, 291, 293, 302, 305 ‘Troika’/EC, ECB and IMF 231–2, 248, 249, 253, 268, 270, 271, 330

economic implications of GFC (macro) 5–6, 9–10, 17, 27, 31, 39–40, 49–50, 61–2, 64–5, 67, 72–3, 77, 80–81, 82–3, 92, 96, 104, 106, 107, 109, 110–11, 113, 118–19, 123, 133, 139, 147, 150–51, 155, 163–5, 171, 175, 179, 181–2, 195, 205, 206, 209, 214, 215–16, 225, 239, 242, 246, 255, 256–8, 265, 267, 275, 284–5, 289, 292, 294, 316, 320–21 economic implications of GFC (micro) 71, 74, 112, 114, 121, 190, 193, 207–8, 217–18, 225, 234, 250, 251, 259–61, 275, 278, 281, 333 Europe/European Union 5, 6, 7, 12, 13, 14, 23, 24, 26, 94, 97, 118, 148, 157, 160, 162, 167–9, 180, 184, 187–8, 191–3, 198, 205–7, 209, 210, 211, 214, 217, 218, 220, 224–6, 229, 231, 234, 237, 239, 243–4, 252, 255, 256–9, 268, 278, 284–6, 289, 300, 304, 311, 315, 321, 322, 324, 328 European Central Bank 148, 149, 231, 246, 249, 252, 260, 266, 267, 269, 278, 279, 324, 330 European Commission 157, 160, 169, 171, 184, 231, 239, 243, 248, 249, 252, 267, 291, 322, 330 European Council 167, 211, 240, 252 European Economic and Monetary Union (EMU) 99, 152, 168, 174, 184, 206, 215, 238, 245, 251, 256, 259, 260, 265, 268, 273, 276, 277, 278, 279, 280, 281, 286, 324 Eurozone/‘euro crisis’ 6, 12, 23, 27, 99, 152, 167–8, 170, 171, 174, 198, 206, 239, 245, 251, 253, 257, 270, 271, 274–6, 278–81 Stability and Growth Pact 14, 152–3, 159, 166, 167, 168, 170, 172, 207, 213, 214, 217, 218, 220,

Fannie Mae 2, 4, 11, 97, 239, 240 financial institutions 2–5, 17, 39, 43–7, 60–62, 71, 92, 93, 97, 118, 121–2, 129–31, 147, 148, 149–50, 154–6, 167, 181, 238–9, 243, 286, 310, 314, 316 financial systems/markets 5–6, 10–12, 61, 62, 64–5, 68, 69, 71, 78, 82, 96, 97–9, 121, 148, 154, 155–7, 163, 172, 176, 183, 189–90, 208–9, 214, 216, 217, 226, 227, 229, 231, 238–40, 241, 245–6, 248, 313, 317 Finland 175, 260, 286 fiscal policy/strategies/interventions 8, 11, 15, 23–4, 26, 39, 43–4, 48–50, 55, 61, 67–73, 82, 85, 86, 92, 95, 100–104, 110, 111–12, 114, 119–21, 122–3, 125, 127–8, 129–31, 141, 145, 155–9, 169, 178–80, 183, 184, 186, 188, 190, 191–2, 195, 198, 205, 209–14, 220–22, 224, 236, 238–40, 246–7, 256, 268–9, 271–3, 284, 287, 289–90, 292, 297, 311, 317–25, 327–9 fiscal consolidation 7, 15, 16, 24, 27, 35–6, 51–5, 78–82, 87, 92–3, 104–10, 113, 114, 123, 131–3, 136–9, 147–8, 163–5, 170, 175, 191–3, 205, 211–16, 228, 232, 236, 245, 246–51, 280, 297, 310, 311, 328, 332 fiscal discipline, fiscal framework and rules 34–6, 59, 60, 63–4, 79–81, 83, 84, 85, 93, 104, 106, 112, 113, 130, 135, 138–9, 151–3, 159, 160, 164–6, 168–9, 170–71, 174, 176, 178, 179, 180, 182, 191, 192, 193–5, 197, 206, 207, 213–14, 216, 218–19, 224, 226–7, 228, 229, 250, 251, 258, 285, 299, 301–5, 310, 311, 312–13, 316, 327, 329, 332

346

The global financial crisis and its budget impacts in OECD nations

fiscal institutions/regulatory bodies 44–5, 55–6, 67–8, 70, 73–5, 84, 85, 94–6, 129–31, 137–8, 147, 177, 191–3, 194–5, 196–7, 210, 217, 220–22, 225, 239, 252, 261, 275, 276, 281, 292–3, 295–7, 298–9, 304–7, 310, 322–3, 328–30, 332–3 fiscal ‘readiness’ before crisis 15–21, 25, 32–4, 36–8, 60–64, 82, 92–100, 146, 148–54, 174, 206–8, 232–4, 236–8, 240–43, 256–8, 264–8, 310, 311, 312–15, 321–2, 326 fiscal stimulus measures 4, 10, 11, 16, 18, 31, 40, 42–7, 48–50, 55–6, 63, 70–72, 74–5, 83, 100–105, 119–23, 157–9, 185, 186–8, 190, 209–13, 239, 240–44, 290, 316–17, 319–20 France 4, 5, 7, 10, 62, 63, 97, 99, 119, 167, 168, 211, 232, 260, 268, 271, 334 Freddie Mac 2, 3, 4, 10, 11, 97, 239, 240 Fukuda, Yasuo (Prime Minister, Japan) 125 Germany 62, 63, 97, 99, 119, 155, 168, 211, 232, 240, 245, 248, 255, 260, 268, 271, 273, 285, 315, 322, 332, 334, 340 Gillard, Julia (Prime Minister, Australia) 101, 102, 106, 326 global financial crisis beginnings of/triggers 2–3, 18–19, 38–9, 60, 82, 92–3, 94–100, 110–11, 118–19, 174–8, 207–9, 232–40, 256–62, 285–9, 315–17, 325 crisis deepens 4–6, 13–14, 36–43, 51, 66–71, 97–100, 104–5, 111, 119, 123, 154–9, 183–91, 209–11, 239–43, 244–7, 264–74, 290–91 nature of crisis 6–8, 15–16, 17–18, 60–61, 118–19, 136, 139, 143, 145–7, 155, 292–5, 310–11, 315–17, 340 post-crisis/aftermath 14, 19, 24, 26,

50–54, 77–82, 104–6, 109–10, 113, 136–9, 146, 148, 162–6, 187–8, 190–98, 210, 211–18, 249–51, 274–80, 297–305, 306, 331–6 government, role of in crisis 12–13, 22–3, 31, 32, 44–5, 55, 57, 59, 62–3, 64, 73–5, 84–7, 96, 119–20, 123, 125, 128–9, 130–31, 145, 146–7, 155–6, 157–8, 160–62, 170–71, 175–7, 187–8, 206, 228, 231, 239, 243, 310–11, 313, 316, 317–23 government guarantees/guarantors of last resort 5, 40, 46, 98, 99, 103, 111, 122, 155–7, 166, 171, 186, 208–9, 238, 240, 243, 289, 292, 316–17, 323, 335 government, regional/state/local 43, 50, 55–6, 68, 70–71, 74–5, 77, 101, 102, 107, 153, 175, 179, 180, 186, 187, 190, 194, 195, 196, 197, 198, 206, 208, 210, 213, 215, 216, 218, 219–20, 224–5, 226, 227, 228, 232, 245, 320, 330 Great Depression/New Deal response 5, 12, 32–3, 55, 73, 316 Greece 6, 8, 11–12, 25, 27, 103, 148, 168, 180, 212, 213, 225, 231, 248, 252, 255–83, 314–15, 317, 321–2, 322, 323, 324, 325, 329, 330, 335 Finance Minister/Ministry 269, 273 ‘Grexit’ 256, 272, 274–6, 277, 278, 279–80, 281 Parliament/political party competition 255, 264–7, 268, 269–74, 276, 281, 321–2, 330 Greenspan, Alan (Federal Reserve Chairperson, United States of America) 36 Group of 7 (G7/G8) 7, 62, 63, 78, 80, 97, 99, 162, 324 Group of 20 (G20) 7, 11, 68, 70, 80, 100, 148, 157, 162, 167, 209, 311, 324, 339 Gruen, David (Treasury Official, Australia) 1 Guterres, Antonio (Prime Minister, Portugal) 235



Index ­347

Harper, Stephen (Prime Minister, Canada) 26, 62–3, 64, 66, 69, 71, 72, 73, 75, 77, 79–80, 81–3, 313, 320 Hatoyama, Yukio (Prime Minister, Japan) 126, 127, 129, 133 housing boom/property bubble 2–3, 17, 38–9, 94, 154, 155, 181, 183, 186, 196, 206, 234, 241–2, 286–7, 289, 292, 310, 314, 315, 317, 319, 334 Hungary 304 Iceland 11, 103, 156, 240, 242, 316, 324 Ignatieff, Michael (Leader of the Opposition, Canada) 66, 71–2, 81 India 97, 100 Indonesia 100 international co-ordination/ co-operation 6, 11, 23, 167–9, 170, 171, 239, 240, 243–4, 248–9, 256, 267–9, 270–73, 278–80, 285, 291, 300, 310, 319, 321, 322, 324–5, 329–31, 339–40 International Monetary Fund (IMF) 6, 12, 59, 65, 70, 77, 78, 89, 160, 162, 168, 192, 209, 215, 226, 231, 232, 242, 249, 255, 258–9, 285, 287, 289, 291, 298, 304, 306, 321, 322, 324 Iraq (war) 38, 44, 328 Ireland 8, 11, 12, 25, 27, 99, 103, 148, 168, 231, 240, 242, 243, 245, 246, 252, 260, 284–308, 314–15, 316, 317, 320, 323, 324, 325, 329, 332, 334, 335, 336 Economic Management Council 298, 305 Finance Minister/Ministry 292, 295–7, 299, 301–3, 306–7, 320, 329 fiscal capacity/fiscal advice 285, 287–9, 292, 295, 297–305 Parliament/political party competition 295, 297, 298, 299–300, 320 Italy 12, 62, 63, 148, 168, 180, 211, 242, 260, 325

Japan 5, 8, 11, 12, 25, 26, 62, 63, 118–44, 314, 317, 320–21, 322, 323, 328–9, 333, 334–5 Finance/Economic/Fiscal Ministers/ Ministries 118, 126, 127, 128–30, 132–3, 134, 135, 137, 138, 139, 141, 143 fiscal planning/revitalization institutions (EFPC/NSO) 128–31, 137, 138, 329 Parliament/political party competition 123–8, 131–2, 143, 328–9 JP Morgan Chase 4, 10 Kan, Naoto (Prime Minister, Japan) 126, 127, 129–30 Kato, Hideki (Secretary-General, CGR, Japan) 130–31 Key, John (Prime Minister, New Zealand) 326 Keynes, John Maynard (Keynesian) 33–4, 39–40, 92, 93, 157–8, 170, 274, 287, 316 Koizumi, Junichiro (Prime Minister, Japan) 124, 125 Korea 6, 43, 319, 333 Latvia 240 Layton, Jack (NDP Leader, Canada) 66, 71, 81 Lehman Brothers bank collapse (shock) 4, 11, 97, 118–19, 121, 122, 123, 125, 133, 136, 139, 155, 238, 239, 240, 266, 316 Lopes, P.S. (Prime Minster, Portugal) 235 Luxembourg 5, 155, 240, 260 Maastricht Treaty 233, 237, 252, 305 Martin, Paul (Prime Minister, Canada) 62 Merkel, Angela (Chancellor, Germany) 248, 271, 273 Merrill Lynch 4–5, 11 Mexican peso crisis 59 monetary policy 40, 61, 63, 97, 98–9, 168, 179, 260–61, 262, 265, 274–5, 279–80, 319

348

The global financial crisis and its budget impacts in OECD nations

Mulroney, Brian (Prime Minister, Canada) 59 Netherlands 5, 8, 25, 26, 145–73, 181, 240, 260, 312, 317–19, 323, 324, 328, 332 Finance Minister/Ministry 145, 147–8, 149, 151–2, 154, 155, 157–8, 160, 161, 162, 163–5, 170–71, 319 financial institutions/regulators 149–50 ministerial guardians/Prime Minister’s increased role 162 Parliament/political party competition 153–4, 160–61 New Century Financial Corporation 3, 10 New Zealand 8, 11, 25, 26, 92–4, 110–14, 312–13, 316, 317–19, 323, 324, 326–7, 332–3 Finance Minister/Treasury 110, 111–12, 113, 326–7 Noda, Yoshihiko (Prime Minister, Japan) 127, 130, 137, 138 Northern Rock Bank/Crisis 4, 10, 97, 100, 240 Norway 175 Obama, Barack (President, United States of America) 32, 37, 38, 42, 43, 45, 48, 50, 53, 54, 77, 319 OECD 2–3, 8–9, 12, 14–15, 17, 24, 42–3, 56, 61–2, 78, 88, 93, 94, 100, 139, 141, 170, 184, 185, 190, 192, 205, 248, 262, 263–4, 286, 291, 292, 304, 309, 311, 319, 329, 339 Papademos, Lucas (Prime Minister, Greece) 271, 272 Papakonstantinou, George (Finance Minister, Greece) 269–70 Papandreou, George (Prime Minister, Greece) 267, 268, 270, 271 Parliamentary Budget Office 60, 65, 78, 79, 81, 84, 85, 221, 223, 304, 330 Persson, Göran (Prime Minister, Denmark) 176

PIIGS/Southern European economies 6, 148, 175, 198, 214, 225, 313, 314, 325, 330–31 political crisis 13, 14, 15, 17, 18, 26–7, 32, 34–6, 45, 48, 53, 55, 64–6, 73, 82, 83, 124–7, 136, 137, 154, 168, 180, 188, 196, 208, 234, 235–6, 244, 248–9, 252, 255, 264–8, 271–4, 276–8, 317, 319, 322–3, 326 Portugal 6, 8, 11, 12, 25, 27, 103, 148, 168, 231–54, 260, 314, 316, 317, 321, 323, 324, 325, 329–30, 331 economic stability programs 248, 250 Finance Minister/Ministry 244–5, 248 Fiscal Policy Council 250, 329 Parliament/political party competition 234, 235, 244, 247–9, 321 privatization 124, 157, 183, 190, 232, 250, 251, 269, 319, 327, 330 ‘property bubble’, see housing public sector size/employment/freeze/ reductions/salary cuts 43, 60, 66, 73, 82, 85, 94, 178, 206, 212, 214, 215, 223, 228, 236, 237, 244, 245, 247, 251, 258, 259, 262, 267, 277, 288, 291, 294, 301, 306, 333 Rajoy, Mariano (President, Spain) 208, 216, 222, 228 Rasmussen, Anders Fogh (Prime Minister, Denmark) 178, 182 Rasmussen, Løkke (Prime Minister, Sweden) 178 recovery plans/relief packages 4, 5, 6, 10, 18, 32, 38, 40, 43–5, 48–50, 94, 110, 119–23, 133–6, 147, 158, 163–5, 184, 187–8, 189, 190, 209–13, 239–44, 267, 268–72, 278, 289–91, 299–302, 311 Reinfeldt, Frederik (Prime Minister, Sweden) 176, 183, 188 revenues 32, 35, 137–8, 166, 178, 181, 184, 187, 188, 197, 211, 213, 227, 247, 251, 252, 267, 284–5, 288, 291, 294, 306–7, 331–2 collapse in revenues 42, 106,



Index ­349

107, 136, 141, 244, 258, 288, 331–2 revenue-raising measures 35, 60, 108, 109, 126, 127, 138, 187, 213, 215, 223, 245, 247, 251, 267 tax cuts 35, 36, 37–8, 42, 54, 60, 70, 71, 95, 97, 101, 103, 104, 110, 112, 113, 177, 181, 187, 190, 191, 194, 197, 211, 213, 223, 244 Romania 240 Rudd, Kevin (Prime Minister, Australia) 95–6, 100, 101, 102, 105, 326 Russia 97 Samaras, Antonis (Prime Minister, Greece) 255, 272–3, 274, 276, 278, 281 Sarkozy, Nicholas (President, France) 7, 271 Saudi Arabia 100 Scandinavia 26, 175–6, 181, 195 Schick, Allen 8, 13–15, 100–101, 304, 337–9 Schmidt, Helle Thorning (Prime Minister, Denmark) 198 Singapore 6 Sócrates, José (Prime Minister, Portugal) 231, 235, 236, 244, 247, 248, 249 Spain 6, 8, 11, 25, 26–7, 148, 149, 168, 205–30, 242, 243, 246, 260, 314, 316, 317, 321, 323, 324, 325, 329, 330, 331, 333, 334, 335 economic stability programs 205, 206, 207, 211–12, 214–15, 216–17, 219, 224 Federation of Municipalities and Provinces 210, 212–13, 220 Finance Minister/Ministry 222 Fiscal and Financial Policy Council 210, 213, 216, 219, 220 Ministry of Economy and Finance 216, 220, 221, 222, 225 Parliament/political parties 207, 208, 210, 217, 218, 220, 221 Stability and Growth Pact, see European Union sub-prime mortgage crisis (United

States of America) 2–4, 44, 94, 238, 240, 242, 315, 317, 328, 334 Swan, Wayne (Treasurer, Australia) 93, 95, 101, 102, 105–6, 109, 115 Sweden 8, 11, 25, 26, 174–204, 240, 285, 291, 312–13, 316, 317–19, 323, 324, 327, 333 Finance Minister/Ministry 176–7, 179–80 Fiscal Policy Council 177, 190–91, 194–5, 197–8, 313, 327 Prime Minister 183 Switzerland 4, 240 Tanner, Lindsay (Finance Minister, Australia) 101, 102 taxation, see revenue TED 11, 316 unemployment/job redundancies 5, 6, 17–18, 27, 39, 49–50, 96, 104, 110, 113, 150, 163, 165, 178, 185, 186, 187, 191, 196, 209, 211, 226, 227, 229, 255, 269, 273, 274, 276, 316, 319, 336 United Kingdom 4, 7, 10, 62, 63, 97, 98, 100, 149, 167, 211, 238, 240, 242, 285, 291, 296, 301, 316, 323, 324, 325, 332, 334 United States of America 2–5, 6–9, 10–11, 25, 26, 31–58, 62, 63, 67, 77, 78, 94–5, 97, 98, 100, 118, 119, 150, 154, 175, 225, 238, 240, 313, 314, 315, 316, 317–19, 323, 324, 325, 328, 334, 336 ARRA 40, 43–4, 48–50, 55 Congress/political party competition/gridlock 34–6, 44–5, 47, 48, 53–4, 55, 314, 319, 328 Congressional Budget Office 35–7, 40–42, 47, 50, 51–2 Emergency Economic Stabilization Act 5 Federal Reserve 3, 4, 10, 11, 36, 40, 41, 44, 47, 55, 319 Government Accountability Office (GAO) 51, 52 Great Recession (US) 38, 39, 42, 43, 51, 55

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The global financial crisis and its budget impacts in OECD nations

TARP 5, 11, 40, 43–7, 48, 50, 55 Treasury 32, 36, 40, 45, 47, 55, 319 Wanna, John 8, 17, 309–10

Wildavsky, Aaron 32–3, 160, 338 World Bank 6, 262, 298, 324 Zapatero, José L. Rodriguez (President, Spain) 207, 208