There is a growing call for balanced budgets to be introduced after the financial and sovereign debt crises. Bernadette Mill investigates the merits of such a system

In its concluding statement of the mission on Euro-Area Policies in June, the International Monetary Fund urged member states in the European Union to strengthen their deficit reduction plans by moving to a balanced budget model.

It said: “The Commission’s calls for a stronger focus on medium-term debt sustainability in the excessive deficit procedure, and the early peer review of budgets and reform plans are particularly apposite.

“However, member states should also face stronger incentives to comply with common rules. One avenue is through greater national ownership, by adopting rules-based fiscal frameworks with a strong legal basis and effective enforcement at the national level. It would be essential to anchor national rules in the key objective of the Stability and Growth Pact, namely a balanced budget in structural terms, and possibly more ambitious debt reduction.”

In the US, this system is already in place. All states, except for Vermont, have a balanced budget rule. California has a rule to ensure that all deficits are eliminated but is flexible as to how the State chooses to achieve a balanced budget.

Similarly, the Republic of Georgia introduced a balanced budget rule to revive its failing economy which saw GDP per head nearly triple between 2004 and 2008. These measures limited government expenditure and meant that the Georgian economy grew even during the global economic downturn. The success of these measures has caused the Georgian President, Mikhail Saakashvili to propose incorporating them into the Georgian Constitution.

These measures would comprise of limiting government expenditure to 30 per cent of GDP and the budget deficit at 3 per cent of GDP. The proposals also include capping the level of national debt at 60 per cent of GDP. The Georgian government is showing a keen determination to tackle rising debt as it is also proposing to ban off-balance sheet accounting and ensure that spending and borrowing limits are honoured over a fixed three to five-year period.

The German Government introduced a balanced budget rule into the Constitution last year. The legislation requires that both the federal government and Länder (States) balance their budgets. The federal government cannot run a deficit that is more than 0.35 per cent of GDP in a normal economic climate from 2016. German Länder will also be prohibited from running any deficit from 2020.

There is a growing appetite for balancing national budgets within eurozone countries. French President Nicolas Sarkozy recently announced that his Government would be introducing a rule to this effect. Although details of the new proposal have not been revealed, Sarkozy has alluded that from 2012, all sitting governments will be required to set out a five-year binding strategy for reducing the nation’s structural deficit. There is also a requirement that a government would have to set a date for when it would be expected to balance its budget.

Professor Joerg Bibow of Skidmore College, New York says: “In Germany we have tried to consolidate the budget rather unsuccessfully since reunification. Balancing the budget was successful in the 1980s, as a result Germany became obsessed with balancing budgets. Germany’s approach relies on the wider deficit; the euro was not around so Germany essentially started to consolidate the budget.

“Over time Germany became more competitive because inflation was higher in other countries. Other European currencies pegged their rates to the Deutschmark – which provided external growth stimuli. This was successful because Germany was doing it alone – therefore it provided a growing export market. Policymakers were not so obsessed with cutting spending at the time.

“Germany’s success was dependant on others not doing it. Germany only focused on cutting the deficit, which only came down for short periods in 1999 and the early 2000’s. We now have a deficit of 5 per cent of GDP.”
Professor Bibow says he believes Germany’s approach ignores the fact that sustainability relies on growth. He says there needs to be a stable debt to GDP ratio.

He says: “Policymakers should focus on both GDP growth and deficit and look at the ration of deficit over GDP growth. If you try to reduce the deficit and GDP growth you will be worse off. GDP growth is nominal and real GDP growth has declined over the last 20 years.

“Germany has inadvertently crushed domestic demand without successfully reducing the deficit. Germany’s approach is adverse to growth. The deficit declined temporarily when exports were booming.”

Professor Bibow argues that the federal government is still committed to reducing the deficit but the rate at which it is prepared to do this has become more aggressive. He says that many European nations are trying to balance their budgets at present and that examples of small countries that have balanced budget rules are irrelevant as these economies cannot be accurately compared to larger nations like Germany. He believes that countries cannot all go for austerity at the same time as that may kill the recovery.
It could be argued that austerity measures at the state level can be offset at the federal level.

The Obama stimulus plan illustrates that a considerable amount of funds were paid as grants to US States in order to help them to balance their budgets.

Without federal money they would have been under immediate pressure to cut spending and increase taxes. This may still occur as the economy has not recovered to a state where the stimulus can be withdrawn from next year.
Adam Smith Institute director Dr Eamonn Butler thinks an Economic Responsibility Act should be passed in the UK to enhance fiscal discipline.

He says: “The act would put a cap on accepted levels of the deficit and would limit public spending. It would place legally binding restrictions on government spending at one third of GDP, a cap on the budget deficit at 3 per cent of GDP and impose a cap on the national debt at 40 per cent of GDP.

“It would also ensure that governments were only permitted to borrow for investment purposes in capital projects and that off-balance sheet obligations were declared and calculated. Politicians spend wildly in the knowledge that the consequences of their actions will be someone else’s problem.

“The low rates of interest over the last 15 years caused an economic boom that invariably lead to bust. The problem with the sustainable investment rule was that nobody knew when the cycle starts or ends. Economic crises occur due to a lack of oversight and it is for this reason that I support balanced budget rules.”

Dr Butler argues that these measures would prevent the government from spending one pound out of every three pounds earned by the population. He says that this should be calculated as a third of past GDP outcome.

Under these proposals, the future spending commitments of governments would be public knowledge. Future costs may include the consequences of an ageing population and therefore the costs of future state pension payments, for example. Dr Butler says these measures could prevent the short-termism that has occurred in previous governments’ budgetary plans.

The concept of borrowing only to invest requires that governments do not use funds to settle debts or finance unsustainable levels of consumption. This resonates with the utilitarian principle that borrowing should only be used to invest in programmes or infrastructure for the greater benefit of society.
There is a general consensus that higher taxes make a nation less attractive for investment, migration and general commerce.

Research by the IMF, the European Commission and the Organisation for Economic Co-operation and Development suggest that the best route to balancing budgets is through a reduction in public spending rather than raising taxes.

Dr Butler also argues for restraint on increasing taxes and proposes a public referenda or the creation of a fiscal policy committee, before any changes to the rates of taxation. This would be similar to the monetary policy committee at the Bank of England. The proposed fiscal policy committee would therefore set levels of taxation in line with economic growth and investment.

This could result in lower tax levels in countries that successfully balance their budgets. Louis XVI’s finance minister, Jean-Baptiste Colbert once said: “The art of taxation comprised of plucking the goose so as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”

If balanced budget practices are more widely implemented around the world, there will be greater pressure for larger economies such as the UK and China to follow suit.