The Role of Expenditure Reform in Fiscal Consolidations

July 6, 2010


The financial crisis has resulted in a dramatic change in the fiscal situation faced by most countries. The first part of the decade was marked by improvement in the budget balance of a large number of countries – with the marked exception of the United States whose fiscal situation deteriorated between 2000 and 2007. In many cases, public indebtedness had stabilized as a share of GDP, and a growing number of countries had undertaken significant reforms of their public pension and health care systems to at least slow the projected rise in government expenditures on the aged. However, as shown in table 1, there has been a large and widespread deterioration of the fiscal situation during the past two years. The deficits are both a response to the crisis as governments introduced coordinated stimulus programs as well as a result of the recession which reduced revenues and increased social welfare payments. Table 1 summarizes the fiscal situation for a group of 44 major economies drawn largely from IMF data files.

On average, the fiscal balance deteriorated by 4-5 percent of GDP between 2007 and 2010. For the ten G-20 countries classified as emerging market economies, the fiscal balance shifted from a small surplus in 2007 to a deficit of 3.1 percent of GDP in 2010. The changes were larger for the nine advanced economies of the G-20 where the average deficit grew from 1.7 percent of GDP to 7.3 percent. Most of the change has been on the expenditure side of the accounts: expenditures rose by 3 percent of GDP in the emerging market economies and 5 percentage points in the advanced economies.

These fiscal measures highlight the unprecedented magnitude of the fiscal challenge that is facing the advanced economies. Yet, there is an equally important concern that a preoccupation with the deficit could lead to a premature scaling back of the stimulus efforts in an economic situation where many countries are still vulnerable to continuing high levels of unemployment or sliding back into recession. With short-term interest rates near zero and rising fears among debt holders, the policy options for responding to a renewed crisis in the near term would be extremely limited. A clear priority needs to be assigned to achieving a strong and sustained recovery. At the same time, one reason for developing a credible program of fiscal consolidation is that it can stabilize expectations even if the concrete measures are conditional on an assured future economic recovery.

The purpose of this note is to examine the options for reducing the fiscal imbalances through a scaling-back of government expenditures. The first section is devoted to providing some details about the relative magnitudes of government expenditures, their composition across the G-20 countries, and potential magnitudes of targeted adjustments. The second section reviews the experiences of Canada and Sweden, who undertook major fiscal consolidations in the recent past, in order to determine if they offer any useful lessons for the current situation. The United States’ experience with a major shift from deficit to surplus in the last half of the 1990s is also examined. The third section focuses on some differing approaches or rules that might be used to guide governments in a scaling back of the fiscal stimulus on the expenditure side of their budgets.