Romanian fiscal policies: do they fight or exacerbate the crisis?

• Author: Nutu, Ana Otilia
• Position: Report

Introduction

It is now undisputed that the world faces the most serious economic downturn since the Great Depression. There are more and more voices calling for action against the financial crisis, and expectations on governments worldwide grow accordingly. In the past months several fiscal measures and stimuli packages were proposed to help the ailing economies. Most notably, the IMF issued a note proposing a coherent fiscal stimulus package, to tackle in an effective manner the economic and financial crisis. However, the extent to which these proposed measures could possibly be applied in Romania remains uncertain, mainly because of the poor institutional setup of the public sector overall (systemic inefficiencies, governance and transparency issues), but also the costly commitments made in the elections year 2008, which have recurrent effects (wage increases, improperly targeted social spending).

The following paper examines the applicability of an effective fiscal package in Romania, and suggests improvements in the existing institutions to enhance the Government's control over its own instruments--budget revenues and public spending. Contrary to the widespread, more pessimistic views, we believe that the crisis is an opportunity for reform: as revenues drop in proportion to the economic downturn, a wise Government would have the best incentives to reduce inefficient spending and understand the importance of a longer term vision. Or--luckily, this is our case--it would be forced to do so by foreign aid conditionality. However, there is a downside risk as well: since 2009 is again an elections year, the pattern of wasteful spending to attract votes could be maintained, while cuts are operated in the most important areas: the investments in complex programs and infrastructure. The following paragraphs describe the general recommendations for the use of fiscal instruments against the crisis. What can fiscal policies do against the crisis?

The IMF suggested approach (1)

The IMF suggests a policy package to address both the financial crisis and the fall in aggregate demand simultaneously. Such a two-pronged policy is needed to address issues which are complementary in nature: on one hand, the recapitalization of banks would improve credit flows, and aggregate demand would be further boosted by targeted measures such as support for the housing market. IMF recommends that the fiscal stimulus be timely, large, durable as to last over the period of recession, with diversified measures, and, maybe most importantly, sustainable as to avoid excessive debt or other short-term catastrophic effects. The fiscal measures which are most likely to lead to good results consist of increased spending (preferred to tax cuts), and at the same time spending instruments need to be diversified to limit the risk that fiscal multipliers are not estimated correctly during crisis.

Indeed, increasing spending is a challenge in many country environments, as the most obvious risk is to simply waste public funds allocating them for issues which are not a priority. In order to avoid this, the best solution regarding major public works is to allocate funds for the "first-under-the-line" public programs (in a budget based on priorities, these are the programs which have been appraised and would be the top priority projects sustainable with a budget increment). Other measures could be targeted directly at consumers, to fight the three major causes of the plummet in consumer demand: loss of wealth, credit constraints, "under-the-mattress" savings in times of uncertainty. The solutions proposed are tax cuts and transfers to mitigate the hardships generated by credit constraints; and a clear commitment for government support against uncertainties.

The IMF however warns that whatever fiscal policy instrument is used, it must be sustainable in the medium term. Crucially, such measures should be implemented without generating serious macroeconomic and fiscal imbalances, such as excessive debt or recurrent spending that cripples the fiscal sector in the long run. An increase in public sector wages, for example, would not be advisable because for the same amount spent from the public budget it has less impact than other public spending, and the wages could not be reduced in the future. Debt or tax amnesties for companies in trouble prove to be distortionary, ineffective, and unfair on the market. In essence, the recommendation is that measures be reversible, countercyclical, based on solid medium-term frameworks (and covering public works that are conducive to long-run growth), and at the same time ensuring fiscal accountability and governance.

But where does Romania stand in this picture? Given the current conditions, could the Government use the fiscal policy and the budgets as an effective countercyclical instrument? The following section demonstrates that consistent reforms are needed to ensure that public finances are kept in check.

Background

In December 2008, the European Council endorsed the European Economic Recovery Plan, in which the European Commission called for a fiscal stimulus against the looming economic downturn. The stimulus would be differentiated across EU members according to the public finance sustainability and competitiveness of each member state, and would be reversed when the economic prospects improve. But just like many of the other new EU members, Romania has little space for a fiscal stimulus, and the best one could hope is that the widening fiscal gap could be embedded in a wider medium-term fiscal consolidation (2). The whole region (Eastern Europe and former Soviet countries) has seen in 2008-2009 the largest growth reversal in the past two decades (and Romania in particular experienced a 7.1% GDP growth in 2008 and expects a 4.1% contraction in 2009).

Romania's additional problem is that the fiscal policy of the recent growth years was completely unpredictable, widening the macro imbalances, while still pending structural reforms were left aside. The public sector continues to contribute over a third in the GDP, because privatizations came to a halt lately, and Romania lags behind the other new EU member states in terms of the transition to a market economy, in some respects even behind Bulgaria (3). The country missed the opportunity to finalize the fiscal consolidation and reform the budget process when the economy was booming; the Government conducted policies leading to a deficit as high as 5.4% in GDP while the economy grew 7.1% in real terms in 2008. The government spending doubled from 2005 to 2008, while the public sector share of economic activity grew from 31 to 37% of GDP (4).

One of the main messages of the present paper is the following: it is overly optimistic to expect that fiscal policy in 2009 or 2010 could act as an effective instrument against the crisis. On the contrary, the strong pro-cyclical fiscal stance has overheated the economy and exacerbated imbalances. At best one could hope the fiscal policy in 2009-2010 will not act as a deterrent while the economy is slowly recovering. In the worst case scenario, however, the need to cover absurd, inefficient public spending will crowd out the productive sector, eating up the little available liquidity on the market, and this could happen despite the strong conditionality of EU, IMF and the World Bank. Fiscal policies have been poorly managed in the past two years, as will be explained, and it is no wonder that Romania is the only country from the EU10 (new member states with a socialist past) which now practically has no fiscal stimulus package but only austerity measures (5). Because of the little room for maneuver, Romania is one of the three countries in the region which applied for a substantial multi-donor crisis package (Hungary and Latvia being the other two, while support for Poland is under discussion with the IMF). All of these are direct consequences of the conditions that prompted the European Commission to launch the excessive deficit procedure against Romania in April: the Commission explicitly states that the fiscal policies pursued by the Romanian Government were procyclical and outright chaotic during the period 2005-2008, fiscal gaps have widened to 5.4% of GDP in 2008 despite the fact that GDP growth averaged 6.5% per year and demand was booming (6).

Unfortunately, the quality of the budget process is far from what could be called best practice. As the public sector share is still so high in the economy, the impact of poor management of public funds is amplified. Deficiencies can be spotted everywhere: in the low capacity to prepare a coherent program, both in the Ministry of Finance and the line ministries; in the overestimation of revenues and expenditures by up to 10%. Decision makers are tempted to allocate important shares of the budget for ad-hoc social measures, for public sector wages, for pensions, without a proper assessment of the financial impact on the other programs or in the long run. In addition, since public budgets are in fact public statements on political priorities, the manner in which the fiscal policy was prepared these years offers a fairly accurate overall picture of public governance in Romania.

Looking at what has gone wrong in the fiscal policy is useful, while the crisis unfolds, for two reasons. First, we would know what to expect, realistically, from what the Government can actually do in the following months. Second--maybe even more importantly--the crisis is in itself an opportunity to reform under pressure, but on fast track, our public finances, just like the sheer bankruptcy in the second half of the '90s has triggered the transition to the market economy. But unfortunately, there is also a downside risk: the economic crisis can be an excellent excuse for bad governance, for frequent exceptions from the rule, and for opaque, corruption-generating policies. We are totally in tune...