ANNUAL REPORT 2008 - Polymer Bank Notes of the World

warranted because of the need to cope with theexpenditure pressure resulting from an ageingpopulation in the decades ahead. A bindingmedium-term fiscal framework at the nationallevel, if properly designed and rigorouslyimplemented, can complement the Europeanfiscal framework enshrined in the Stability andGrowth Pact in assisting a quick return to themedium-term budgetary objectives (see alsoBox 8).Box 8THE FINANCIAL CRISIS AND FISCAL POLICYA key policy challenge is to prevent the financial crisis and the subsequent economic downturn fromundermining the credibility and sustainability of public finances. In the EU, the Stability and GrowthPact provides the appropriate framework for the conduct and coordination of fiscal policies, in goodas well as bad times. While compliance with the Pact in the initial ten years was somewhat uneven,the EU’s overall fiscal performance in terms of avoiding high budget deficits and the build-up ofgovernment debt was much better than in the decades preceding the Pact. 1A missed opportunity making the fiscal challenge unnecessarily onerousMany euro area countries entered the financial crisis and the economic downturn with weakfiscal positions. Governments had not used the opportunity presented by past years’ revenuewindfalls to consolidate their budgets. In this regard, the arguments set out in the ECB’s AnnualReport 2007 still hold and, indeed, their relevance is now magnified. 2 At the time, the ECBemphasised an important fiscal lesson to be learnt from the period 2000-01, namely that therevenue outlook can change dramatically in a short period of time. Indeed, experience shows thatthe volatility of government revenues is greater than that of the spending side and also exceedsthat of the business cycle. Taken together with the difficulty of predicting turning points forGDP growth, this presents a strong reason to increase caution in good times, i.e. to use revenuewindfalls for faster deficit and debt reduction rather than for extra spending. 3 This would allowcountries to create budgetary room for manoeuvre to absorb revenue shortfalls and deal withextra spending should conditions change. One of the fiscal policy errors prior to and during2000-01 was to mistakenly interpret budgetary improvements in good times as evidence ofstructural improvements, which were often used to motivate spending increases or tax cuts.The role of automatic stabilisersThe fiscal adjustment in response to the economic downturn reflects to a large extent the operation ofautomatic fiscal stabilisers, which contribute to smoothing economic fluctuations. This is appropriate,since this type of fiscal reaction is timely and shielded from political economy risks that can underminethe effectiveness of discretionary fiscal measures. In particular, automatic stabilisers are not subjectto time lags in the identification of measures or in the political decision-making and implemenationprocesses. Moreover, the automatic reaction of revenues and, to a lesser extent, expenditures to thecycle makes automatic stabilisers self-reversing. Finally, the impact of particular interest groups in1 See the article “Ten years of the Stability and Growth Pact” in the October 2008 issue of the ECB’s Monthly Bulletin.2 See in particular the box entitled “Learning from the fiscal policy experience of 2000-01” in the ECB’s Annual Report 2007.3 For a review of forecasting accuracy and the difficulties with turning points, see M. Blix, J. Wadefjord, U. Wienecke and M. Ådahl,“How good is the forecasting performance of major institutions?”, Economic Review, 2001:3, Sveriges Riksbank, pp. 38-68.ECBAnnual Report200877