Let's not be overoptimistic about the state of the economy November 13, 2015

Keeping the public finances in order means sticking to the fiscal rules

It is not permissible to start playing games with the fiscal rules warn Fiscal Council members Raul Eamets and Martti Randveer. The Estonian economy would be best off at the moment running a small budget surplus to protect itself against uncertainty in the future.

The budget discussions this autumn have been calmer than usual. The debate about raising tax rates was mostly held in the spring and the continuing good tax revenues this year are making the complicated budget negotiations a little easier. This makes it possible to focus attention on long-term questions too.

One such question is the suggestion made by analysts from the IMF following their recent visit to Estonia that the Estonian fiscal rules should be made more flexible, especially the requirement that the budget should be in structural balance or surplus. This recommendation is not aimed exclusively at Estonia, and the IMF officials have been suggesting in several countries that government spending should be increased. In countries like Sweden where the government has been aiming for a budget surplus, they are recommending that budget balance should be the aim, while in places where governments are trying to close a budget deficit quickly, the advice is not to rush. It is certainly not being recommended that all spending should be boosted indiscriminately, but it is said that governments should primarily invest to raise productivity.

In one sense this is quite understandable because demand is too low in the global economy as a whole and one way of lifting it is to increase spending from government budgets. In advising this, the IMF has to treat all countries equally regardless of their size, as it cannot suggest that Estonia can just do whatever it wants while at the same time wagging a finger at larger countries that are not permitted to ignore the condition of the world as a whole. It is however something of a paradox that those countries that are able to borrow often do not need to do so to revive their economies, while those that need to do that are prevented from borrowing because their sovereign debt is so large.

Within Estonia we must recognise that with the best will in the world, increased spending by the Estonian government will not be enough to stimulate the economies that have fallen into difficulties in neighbouring countries. In other words, increased spending by the Estonian government will not noticeably help our exporters. It is also interesting to note that some international organisations are trying to improve the outlook for the global economy by recommending more borrowing, even though excess debt was one of the causes of the general crisis that struck the world at the end of the last decade. There are competing points of view about whether it is markets or governments that should breathe new life into growth in the economies around the world, and what the role of governments should be; should they seek to boost economies through their active fiscal policies or through structural reform?

In reviewing the fiscal rules it must not be forgotten that they were introduced not to control the excessive saving of the government and the efforts to build up unreasonably large reserves, but rather exactly the opposite. The state budget in France, for example, has been firmly in deficit for the past twenty years by an average of four per cent a year, however fast growth may have been. For this reason the recently tightened rules should not be lightly loosened again for the sake of the policy of the moment. In this light the position of our Ministry of Finance that there will be no reason in the coming years to change the fiscal rules we have only had for eighteen months is entirely reasonable.

One of the hardest jobs in Estonian fiscal policy, now and in the future, is to estimate reliably the current position of the business cycle. This estimate is needed for calculation of the structural budget position, which is the anchor of the fiscal rules in the European Union and in Estonia. In simplified terms, those rules take the principle that government spending can exceed income in bad times when unemployment is high, but the budget should be in surplus when unemployment is low.

Although it is hard to assess the current cyclical state of the economy in any country, estimates by various institutions have been extraordinarily inaccurate for Estonia. This can best be seen in the years 2005–2007 before the boom ended, when the position of the economy was seriously underestimated. The actual degree of overheating in the economy only became apparent well after the fact. It was as if the weather forecasters had been saying that the temperature was warm enough to cause a mild thaw, when in fact we were experiencing a record-breaking heatwave.

There are several figures that indicate we are too optimistic about our economic future. One indication is that wage rises have outstripped rises in productivity for the past three years and unemployment is well below our long-term average. The low level of unemployment and strong wage growth are a sure sign that the economy is not currently at a weak position within the business cycle.

Another indication is that the rapid growth in state budget revenues has been helped by private consumption and rising wages. These both have a particularly strong impact on tax revenues and have grown substantially faster than the economy as a whole. Over the long term we cannot assume this faster growth will continue. At some point companies will run out of resources and if productivity has not risen or new markets have not been found, jobs will start to be lost. We have seen this happen relatively recently, when the economy was hit by a large wave of redundancies in 2008 and unemployment jumped up in a short space of time from four per cent to around twenty.

Keeping the public finances in order means sticking to the fiscal rules in the good times and in the bad, and not rushing to make changes to them too lightly. It is also important that estimates of the position of the economic cycle look at the broadest set of factors possible. If the estimates change, the government should review its own plans, while ensuring it complies with the fiscal rules. Overall the Fiscal Council finds that the Estonian economy would be best off at the moment running a small budget surplus to protect itself against uncertainty in the future.

Published: 05.11.2015
Published in: Postimees