Fiscal consolidation and its effect on economic growth
In December 2002, the CNB published a document The Czech Republic and the euro - Draft accession strategy defining the starting points and basic economic policy measures for fostering greater economic integration after accession to the EU. The concluding part of this document speaks in support of the Czech Republic's fast entry into the eurozone, since the positive effects of this choice outweigh the potential risks. Joining the eurozone is conditional on fulfilment of the Maastricht criteria, including the criteria in the fiscal area. Sound fiscal development, aimed at achieving balanced public budgets, will create the necessary fiscal-policy room to implement stabilisation measures, helping the Czech Republic to reap the benefits and minimise the risks arising from membership of the monetary union.
However, the past developments and the immediate outlook for the public budgets in the Czech Republic are characterised by opposite trends, i.e. widening deficits, increasing debt and a loss of the stabilising function of fiscal policy. In the medium term, the widening public finance deficit may be accompanied by a loss of the growth trend and by dramatic signs of external imbalance. These trends are unsustainable in the long run, so consolidation of public budgets must be a fiscal policy priority. The obligations and requirements arising from the Czech Republic's accession to the European Union, and the subsequent preparations for adopting the single currency, thus represent only one, formal, aspect of the problem. The key argument is that consolidation of public finances is a necessary condition for sustainable macroeconomic growth and improved performance of the Czech economy.
For the central bank it is important to analyse the impacts of the consolidation process on the economy. The consolidation will pass through - via various transmission channels - into GDP and its components, into unemployment, inflation and the exchange rate, and into many other economic indicators at both the macroeconomic and microeconomic level. This in turn will require an appropriate monetary policy response. For this reason, a simulation analysis of fiscal development has been conducted at the CNB, focusing primarily on the period 2004-2006. This period was chosen for reasons of comparability with Ministry of Finance documents and bearing in mind the necessary degree of credibility of macroeconomic predictions and, last but not least, the economic and political consequences of the Czech Republic's accession to the EU.
The analyses show that the problem with the public budgets lies on the expenditure side, and in particular in the extremely high and ever-growing proportion of mandatory expenditures, which is expanding out of step with economic growth. On the revenue side, the possibilities for change are limited by the risk of a loss of tax competitiveness, since increasing the tax burden above the level in neighbouring countries could dissuade foreign investors from operating in the Czech Republic. The model analysis of the impacts of public finance consolidation takes this fact into account and concentrates on corrections to the expenditure side of the budgets. Although in reality numerous combinations of reform measures are possible, each having a different impact on the structure of public expenditure, for monetarypolicy purposes it is sufficient to consider two marginal alternatives based on the fact that inefficient spending can be cut either selectively or across-the-board. These scenarios are not reform proposals in the area of public finances. They are merely points of reference intended as a starting point for modelling the impacts of different fiscal trajectories on macroeconomic growth with implications for monetary policy.
The scenario of an across-the-board reduction in expenditure is based on the principle of expenditure being reduced by the same proportion in all the budget chapters. To achieve the objective of balanced budgets in the medium run, it is vital that the nominal growth in expenditure is only slightly above the inflation level. This real expenditure stagnation is in essence divided equally between all the expenditure items.
In the scenario of a selective reduction in expenditure, two possibilities were analysed: that of making a large oneoff correction in the selected expenditure items at the start of the period, and that of spreading this correction over the whole period. The second possibility also incorporated an assumed slowdown in the growth rate of transfers to households to the level of inflation, so as to simulate the need to intervene in the "mandatory" expenditures and to achieve, as an intermediate target, fulfilment of the Maastricht budget criteria at the end of the given period.
For comparison, the scenario of "inertia" in the public budgets was also analysed. This envisages that no major reforms will be implemented and that the present trends will continue into the future. On the expenditure side it is assumed that there will be no substantial change in structure and that the key expenditure items will grow at the same pace, equal to the growth in GDP. The main characteristic of the inertia scenario is that the public finance deficit will reach 8% of GDP and public debt 50% of GDP at the end of the period.
All the above scenarios were based on the Czech Ministry of Finance's outlook for public finances in 2003 as contained in the State Budget Bill. On the revenue side it was assumed that the tax quota would remain at the initial year's level for the whole period. For each scenario it was also assumed that the immediate savings in expenditure will be reinforced with reform measures in the pension area to foster sustainable development of public finances in the medium and long run.
The above scenarios formed the basis for a more detailed assessment of the impacts of public finance consolidation on Czech economic growth. In the first phase of the analysis, the direct demand impact of implementing each scenario was quantified using several approaches. The overall impact of consolidation quantified in this way was a short-term slowdown in growth (of about one percentage point).
In the second phase of the analysis, the monetary policy response to the changes in fiscal policy defined in each scenario was also estimated. The logic was as follows: a reduction in public budget expenditure leads to a decline in GDP growth, a subsequent reduction in interest rates, a depreciation of the koruna and an improvement in net exports.The extent of the monetary policy response under these conditions depends - via the risk premium - on the degree of fiscal consolidation. With a high growth rate of public budget indebtedness, an increase in public debt will probably lead to greater mistrust on the part of foreign investors and, in the parlance of uncovered interest parity, to a rise in the risk premium. By contrast, sound fiscal development will be reflected in a decrease in the risk premium and hence in lower interest rates.
These effects were quantified in two steps. The first step was based on the use of a small QPM model for reactive monetary policy. This allows us to show the consistent course of macroeconomic fundamentals such as inflation, GDP, the exchange rate and interest rates in relation to the fiscal consolidation scenario. In the second step, a control of the consistency of the previous simulations was performed using a HERMIN structural model. The inputs to this model were the individual fiscal consolidation scenarios together with the appropriate course of real interest rates and the exchange rate. The results of the model simulations show that despite a relatively large loss of growth in 2004 there is a rapid recovery thereafter, with GDP growth higher at the end of the period than in the case of the inertia scenario. This is achieved amid lower nominal (and real) interest rates, which thus promote growth in non-fiscal consumption and investment and gradually replace the missing fiscal expenditure.
The general conclusion of the analysis of the impact of public finance consolidation on the economy is that in the immediate future this process may be accompanied by a slowdown in growth. Overall, however, sounder public budgets will have a positive effect on economic performance in the medium run, as is clear from the model considerations incorporating reactive monetary policy. It turns out that timely consolidation incurs lower macroeconomic costs than deferred consolidation. With an appropriate monetary policy response from the central bank, the loss of output is only a short-term affair and is soon offset by higher economic growth.