Danish lessons for Polish fiscal reform
Lars Christensen is a senior analyst at Danske Bank Polska.
The World Bank recently hosted a seminar on public finance reform in Poland, where Finance Minister Grzegorz Kołodko was the keynote speaker. His speech offered some interesting insight into his economic thinking. It is well known that Kołodko is highly influenced by the Keynesian school of economic thought. To simplify, Keynesian thinking suggests that a tightening of fiscal policy - that is higher taxes and/or lower public expenditure - will lower economic activity, while looser policies will increase economic activity. Kołodko has never denied his Keynesian sympathies, and fully displayed them at the World Bank seminar.
In its report on fiscal reform in Poland, the World Bank recommended a significant tightening of the country's fiscal policy to stop the serious deterioration of public finances. At the seminar, Kołodko acknowledged that there is a need for fiscal reform; however, in accordance with his highly Keynesian thinking, he stated that a significant tightening of fiscal policy would be unwise and would not help to reduce the problem of rising public debt. Kołodko's argument goes as follows: A significant tightening of fiscal policy will markedly reduce economic growth and increase unemployment, thereby increasing and not decreasing the country's public finance problem.
Most professional economists would tend to agree at least partly with Kołodko in that under normal circumstances a tightening of fiscal policy would tend to decrease the rate of economic growth - at least in the short term. However, Poland is not in a "normal" situation, defined as one where economic growth stays fairly close to trend growth, where interest rates are not unnaturally high, and where public debt is on a sustainable path. Rather, the country is in an exceptional situation with its growth significantly below trend, with high real interest rates and highly negative public debt dynamics. This means that public debt as a ratio to GDP is growing year by year, and there is significant risk that the situation could turn into a crisis where public debt as a ratio to GDP explodes.
The worst possible outcome would be a crisis like the Russian crisis of 1998 or the Turkish crisis of 2001. In those cases, a negative development in public debt kicked off a significant weakening of the currencies, sending interest rates skyrocketing and making it nearly impossible to service the two countries' debts. The situation in this country is not as bad as in Russia in 1998 or Turkey in 2001, but the path of public debt is clearly unsustainable and could turn into a nasty crisis if there were not a tightening of fiscal policy.
Recent history clearly shows that the normal Keynesian "results" do not necessarily apply in a situation where the public debt is deteriorating markedly. Recent academic economic literature offers us two examples: the Danish fiscal reform in 1982 and the Irish fiscal reform a few years later. Both cases were somewhat similar to the situation in this country at the moment, with low growth, high real interest rates and very negative debt dynamics. But unlike the situation here, the finance ministers of Denmark and Ireland embarked upon a significant consolidation of their state budgets.
In the midst of major economic and financial crises in 1982, the Danish government started a complete overhaul of public finances by announcing a major austerity package that resulted in a tightening of fiscal policy by more than 2% of GDP - pretty close to the size of fiscal adjustment recommended for Poland by the World Bank. The interesting thing about the Danish experience is that contrary to the traditional Keynesian thinking - and contrary to many Danish economists' thinking at the time - the tightening of fiscal policy did not lead to a slowdown in economic activity. Instead, it resulted in a significant pickup in economic growth. In the period 1982-1986, following fiscal tightening, yearly GDP growth averaged more than 3.5% and consumption growth was more than 4% a year. Ireland went through a similar experience in 1986-1989 - a tightening of fiscal policy was followed by a significant pickup in economic growth.
These precedents of "expansionary fiscal contractions" provide a number of interesting insights that Kołodko can learn from as he pushes forward with fiscal reform. Briefly, fiscal tightening is most likely to be expansionary in a situation where public debt is high or growing rapidly. Furthermore, the outcome of the fiscal tightening depends on the size and the persistence of the tightening. A larger fiscal tightening is more likely to be successful than a smaller fiscal tightening. Similarly, a permanent tightening is more likely to have an expansionary effect on the economy than a temporary change in fiscal policy. And last, the composition of the tightening is important; a cut in public consumption and social transfers is more likely to be expansionary than an increase in taxes or a cut in public investment.
What's crucial is how the implementation of fiscal reform affects the expectations of consumers, investors, labor unions and financial markets. It seems to be very important that policy makers make a clear commitment to reform. If the policy makers are seen as not being committed to reform, the likely outcome will probably not be as positive as in the Danish or Irish cases.
What does this tell us about fiscal reform in this country? First of all, fiscal reform should focus upon reducing government spending and not on increasing taxes or reducing investment. Furthermore, the fiscal measures should be permanent and trustworthy. Hence, "magic tricks," such as improving public finance by fiddling with the National Bank of Poland's revaluation reserves, will not be helpful. Instead, the government should embark upon a substantial reform of the country's welfare and pension systems. Reform of the Farmers Social Insurance Fund (KRUS) and disability pensions, in particular, seems to be needed. And finally, without strong political backing, the reforms will probably not be seen as permanent, and a repeat of the positive Danish and Irish cases would be less likely.
