This Layman's Guide explains why a government's fiscal strategy is important for New Zealanders, and explains the factors that are generally taken into account when developing a robust fiscal strategy.
Introduction: What is a fiscal strategy?
A government's fiscal strategy is a plan for managing its finances, which includes spending, revenue and the portfolio of assets and liabilities on the Crown balance sheet. New Zealand governments frequently express their fiscal strategies using goals for public debt and the gap between spending and revenue (that is, whether the annual budget is in surplus or deficit).
It is a requirement under the Public Finance Act 1989 (PFA) for governments to produce a fiscal strategy every year and to set it out in a transparent way.
Part 1 of this pamphlet explains why a government's fiscal strategy is important for New Zealanders. Part 2 explains the factors that are generally taken into account when developing a robust fiscal strategy.
A key part of the current Government's fiscal strategy is to reduce net core Crown debt to no higher than 20% of national income (GDP) by 2020 and, after that, to keep net debt in the 10-20% range over the economic cycle. In the short term, the current Government's focus is on returning to surplus by 2014/15 and increasing surpluses thereafter.
Part 1: Why is a fiscal strategy important?
Fiscal policy is not an end in itself. It is a means to help achieve important social and economic objectives. The choices governments make about their finances affect people's living standards both directly and indirectly. The taxes we pay and the services we get in return have implications for equity and economic performance. Decisions about public spending, tax and the balance between them is one of the most direct levers a government has to influenceeconomic and social outcomes.
For example, how much a government borrows can affect the wider economy with social implications. If the government is borrowing a lot, that debt may be perceived as riskier. This could mean that investors demand a higher interest rate to compensate for the higher risk. The consequence would be higher interest rates across the whole economy, putting upward pressure on the exchange rate and potentially discouraging investment by the private sector.
It is not only government borrowing that affects the economy. Governments impact the level and composition of activity in the economy by spending more or less than they receive in revenue. For example, looser fiscal policy - where governments increase spending or reduce taxes - stimulates consumer demand. In a downturn, this may be appropriate. However, when the economy is already operating at or near capacity, stimulating demand tends to push up inflation, which can prompt the Reserve Bank to put up interest rates, leading to higher exchange rates than would otherwise be the case. In other words, in an upturn, looser fiscal settings could do more economic and social harm than good.
At the extreme, a government that runs an imprudent fiscal strategy exposes its people to serious risks. For example, New Zealand's public debt rose to high levels during the 1980s and early 1990s, with net core Crown debt reaching over 55% of GDP in 1992, exposing New Zealand to considerable risks. Over this period New Zealand's sovereign credit rating was downgraded twice. Governments eventually had to take abrupt measures to live within their means, involving socially disruptive policy adjustments. Since then, successive New Zealand governments have been committed to keeping government debt at more prudent levels.
More recently, in Greece, decades of allowing expenses to exceed revenue contributed to a debt crisis which forced the government to make drastic cuts to various public services. The unplanned nature of these cuts was detrimental to living standards. Unemployment rose steeply with accompanying negative impacts on well-being arising not only from the immediate loss of income but also the increased level of uncertainty for those remaining in employment.
Part 2: What factors do governments take into account when setting fiscal strategies?
When setting its fiscal strategy, a government needs to ensure that it complies with the principles of responsible fiscal management as set out in the PFA. For more detail on the fiscal policy framework, you can read the companion pamphlet An Introduction to New Zealand's Fiscal Policy Framework on this topic.
2.1 How much Crown debt is prudent?
The PFA requires governments to maintain debt at prudent levels, but the law does not define what a prudent level is - this is for the government of the day to determine and explain.
The PFA also requires that governments aim, on average over time, to ensure that they fund current expenses such as of the health, welfare and justice systems out of current revenue without needing to borrow. If current expenses cannot be funded by current revenue, these expenses need to be funded by borrowing, at least in part. Debt-funding pushes the costs of repayment onto future generations, even if it is people today who are getting most of the benefits.
However, borrowing for capital investments in assets, such as on bridges, roads and buildings, can be desirable. This is because it allows governments to spread the costs of that capital spending across the generations that will benefit from it. This cost-sharing could be considered fair. It also tends to create better incentives for current generations to spend an appropriate amount, as people who must fund the whole cost of an investment yet will only see some of the benefits might be tempted to under-invest.
Regardless of what the borrowing is used for, when public debt levels get too high it exposes a country to higher risks. For example, economic shocks will often lead to higher spending (eg, on unemployment benefits) and lower tax revenue and, thus, often result in the government needing to borrow more. But, an already high level of debt might restrict its ability to borrow more.
Even in the absence of shocks, a high level of public debt might make lenders start to doubt a country's ability to repay its debt, leading to higher interest rates. And higher interest rates, coupled with the higher principal to which those rates are applied, means that interest payments form a higher share of current expenses, potentially crowding out more valuable spending or requiring higher taxes.
There is no precise science to identifying the point at which public debt is "too high", or to determine a level that is prudent. A number of factors affect this judgement, so we might expect different governments to come to different conclusions based on the specific circumstances they face.
Vulnerability to shocks:
- New Zealand is unusually vulnerable to natural disasters (particularly earthquakes). As a small, open economy with a significant agricultural base we are also vulnerable to a range of other domestic and international shocks. For example, droughts or lower demand for our exports can have significant impacts. Increased vulnerability to shocks implies that a lower level of public debt is prudent as a fiscal buffer.
Shocks are part of life in New Zealand
Here is a brief sample of some shocks that had significant negative economic or fiscal impacts for us over the past 40 years:
- Oil price shocks in 1973, 1979, 1990, and 2002.
- Decline in commodity prices in 1974.
- Global sharemarket crash of 1987.
- Asian Financial Crisis 1997/98.
- Droughts in 1973, 1992, 1998, 2008 and 2013.
- Global Financial Crisis in 2008/09.
- Canterbury earthquakes in 2010 and 2011.
- The level of private borrowing and how it is held can also affect how much debt it is prudent for a government to hold. In New Zealand, the private sector's saving rate as a whole is not sufficient to fund all its investment, so firms and households borrow from foreigners (via the banks) to close the gap. These capital inflows mirror our large current account deficit, and imply an overall vulnerability for New Zealand. This is because, in a crisis situation, there is the risk that foreigners could start to lose confidence in lending to us, forcing a sudden contraction in economic output. In addition, the Crown can also end up taking responsibility for debts that are not strictly speaking its own (see the box on page 9 for an example). Of course, to reduce this risk, the Reserve Bank and the Treasury promote policies to ensure a sound financial system. Lenders take into account all these factors when deciding whether to lend to governments, meaning that even a country with apparently low levels of public debt can seem like a risky proposition, potentially limiting that country's ability to borrow when it needs to.
Ireland: private debt → public debt
In 2008, following the onset of the global financial crisis, some of Ireland's major banks found themselves about to fail. To avoid a financial meltdown, the Irish Government stepped in and recapitalised its major banks. Even that was not quite enough, and one bank, the Anglo Irish Bank, was nationalised in 2009. The impact on the Irish Government's books was dramatic. From a slightly positive fiscal balance in 2007, Ireland moved into deficit in 2008, with the deficit peaking at 30.5% of GDP in 2010 (IMF). The debt story was similar: gross government debt was just under 25% of GDP in 2007, but rose quickly following the bank recapitalisations. In 2013 gross government debt reached around 116% of GDP. While not all of this debt increase is attributable to the government taking on private debt, a substantial proportion of it was.
- The Global Financial Crisis put government and private debt into the spotlight. The prospect that governments might default on loans looms larger in lenders' minds than it did prior to the global financial crisis. Most New Zealand government debt is held by non-residents. Debt held by non-residents is generally thought to be riskier to refinance than debt held by residents. However, as a country with a history of repaying its debt on time and successive governments that seem to take fiscal prudence seriously, the government is likely to be able to carry a higher level of public debt if the need arises, at least in the short-term. This is because lenders will trust us more. Maintaining a low level of public debt, in general, is part of that equation.
The unique combination of being very vulnerable to shocks (economic and natural disasters) and high private debt has led successive New Zealand governments to hold a lower level of debt than foreign governments. This helps to ensure New Zealand maintains a reputation for repaying debt on time and provides a buffer against future shocks.
In spite of the broad consensus to maintain prudent debt levels, over time different New Zealand governments have come to different conclusions about what level of debt is prudent. For instance:
- In 1994, the first year that the government was required by legislation to express a long-term debt objective, the government had a goal to reduce net debt from over 40% of GDP to between 20% and 30% of GDP (measured on a slightly different basis from the net core Crown debt measure we use now).
- This goal was amended to below 20% of GDP in 1995 and to 15% of GDP in 1998.
- In 2000, a net debt objective of 20% of GDP was re-introduced, although in fact debt continued to decline below that level.
- From 2002-2008 the government used a gross debt objective of 20% of GDP - essentially a stricter target.
- After the Global Financial Crisis hit and debt began to rise, the government stated that net debt would be reduced back towards 20% of GDP. By 2012 this goal was refined to no higher than 20% of GDP by 2020.
- In 2014, the government further clarified that after the 20% of GDP target is reached, it would maintain net debt within the range of 10-20% of GDP over the economic cycle.
- New Zealand's prudent levels of public debt in the lead up to the Global Financial Crisis helped New Zealand cope with the shock much better than comparator countries, despite the further shock of the Canterbury earthquakes.
2.2 What is happening in the broader economy, and how might the fiscal strategy affect it?
Determining a prudent level of government debt is part of deciding a fiscal strategy, but it is only a starting point. Governments also need to consider the economic cycle and the implications for how fiscal policy should operate.
On average over time, current expenses should not exceed current revenue. But we would not expect exact balancing each year.
In a downturn, it is reasonable for expenses to exceed revenue, in order to compensate for depressed tax revenue and to allow for some temporarily higher expenses, like spending to support people who have lost jobs.
Conversely, in an upturn, we would expect revenue to exceed expenses. Excess revenue can be used to pay down public debt and build up other financial buffers. Paying down government debt when times are good means that debt can rise when times are bad; the country can manage a temporary period of expenses exceeding revenue with no lasting ill effects.
There are other reasons why fiscal policy should generally be tighter in an upturn and looser in a downturn.
For example, looser fiscal policy during an upturn, when the economy is already operating at or near capacity, will further stimulate demand, prompting the Reserve Bank to increase interest rates further. This will put more upward pressure on the exchange rate than would otherwise be the case, and hurt the competitiveness of our exporters. Economists refer to the relative looseness and tightness of fiscal and monetary policy as the "macroeconomic mix". In general, during an economic upturn, tighter fiscal policy (larger surpluses) and looser monetary policy (lower interest rates) is a better macroeconomic mix than the reverse. Even though the economic growth rate may be similar in either scenario, the composition of output will be different. Economic downturns are a better time for loosening fiscal policy (eg, by raising spending or lowering taxes) as the magnitude of interest rate and exchange rate cycles would not be exacerbated.
Governments often come under pressure during upturns to spend more money or cut taxes due to the appearance of large surpluses. At the time it is happening, an unusually strong period of economic growth can look permanent, making it seem harder to justify maintaining large fiscal surpluses. However, it is important that governments resist this pressure to spend surpluses during economic upturns, both for reasons of enhancing exporter competitiveness - as discussed above - and so that the government is better placed to respond to the next downturn, when it comes.
2.3 What about building up other assets in preparation for a rainy day?
If you are going to make the argument that in the bad times - such as when a big earthquake or a recession hits - the Crown should borrow money to stimulate or support the economy, then logically, in the good times, you've got to prepare for another rainy day.
Reducing debt is not the only thing that governments can do to build buffers and prepare for a rainy day. Just as households may have separate saving accounts for different things, or income protection insurance to guard against accidents or a health scare, governments also do similar things. The different options for preparing for a rainy day are sometimes referred to as different "jam jars" into which the government can choose to save.
One example of a government jam jar is the National Disaster Fund (NDF), which is financed by New Zealanders' insurance EQC levies. The fund was used up in the aftermath of the Canterbury earthquakes in helping reimburse home and business-owners for damages. There are now questions about how quickly the fund should be rebuilt, and what priority rebuilding it should have, compared to other uses of Crown revenue. In the meantime, in the NDF's absence, the low debt buffer becomes particularly important for helping to cope with the next natural disaster.
The New Zealand Superannuation Fund (NZSF) is another jam jar on the Crown's balance sheet. Where the NDF provides insurance against a risk we cannot predict (earthquakes), the NZSF is designed to help society prepare for the known future expense associated with demographic ageing. As the population ages there will be an increase in government spending on New Zealand Superannuation entitlements.
Part 3: Further reading
"The Austerity vs Growth Debate and How NZ is Different" (May 2012), Monthly Economic Indicators, Special Topic 2, The Treasury, http://www.treasury.govt.nz/economy/mei/may12/04.htm.
"Fiscal Indicators and the Financial Statements" (2014), The Treasury,
"Fiscal Strategy Report" (2014), Hon Bill English, http://www.treasury.govt.nz/budget/2014/fsr.
"Government and economic growth: Does size matter?", (2011), D. Cook, C. Schousboe and D. Law, New Zealand Treasury Working Paper 11/01, http://www.treasury.govt.nz/publications/research-policy/tp/govtsize.
"IMF Article IV Consultation - Staff Reports", annual IMF reports on New Zealand.
Treasury "Investment Statement" (2014), http://www.treasury.govt.nz/government/investmentstatements/2014.
"Modelling Shocks to New Zealand's Fiscal Position" (2011), C. Fookes, New Zealand Treasury Working Paper 11/02, http://www.treasury.govt.nz/publications/research-policy/wp/2011/11-02.
Papers presented at "New Zealand's Macroeconomic Imbalances - Causes and Remedies Policy Forum", 23 and 24 June 2011, http://www.treasury.govt.nz/publications/research-policy/conferences-workshops/macroeconomicimbalances.
"Recapping New Zealand's Recent Fiscal Policy" (June 2013), Monthly Economic Indicators, Special Topic 2, The Treasury, http://www.treasury.govt.nz/economy/mei/jun13/04.htm.