Reforms will only work if they reduce the deficit bias says new CEPR/ICMB report

The financial crisis has focused attention on debt sustainability and fiscal consolidation: markets are impatient, and time is short. 'Public Debts: Nuts, Bolts and Worries' takes a longer-term perspective. The Report looks at US, Europe and Japan. It begins with a detailed analysis of how each country reached its current position and then looks at the long run, when existing demographic pressures will worsen an already difficult debt situation.

The Report argues that the long run problem arises from the "deficit bias" in democracies. There are always constituencies for higher spending or lower taxes, and those who benefit from spending are not the same as those who pay taxes. Governments need to please voters to be elected and so tend to spend more than they can collect in taxes. Tackling public debt requires adopting institutions and rules that reduce the deficit bias.

Because electoral systems differ in the US, EU and Japan, no single institutional reform will work. As the Report notes, "there is no magic formula for successful fiscal consolidation". But something needs to be done, and the Report points the ways forward:

• In Japan, the level of social benefits paid to older people is far too high. Reducing these benefits is difficult: older people tend to live in rural areas, which are overrepresented in the Diet. Electoral reform is needed.
• In the US, on the other hand, the problem is insufficient tax revenue and an inefficient health system, but the checks and balances built into the US political system have so far made it impossible to agree on adequate measures. A constitutional amendment would work, the Report notes, but would need to allow for countercyclical fiscal policies, effective enforcement and for overrides by a Congressional supermajority.
• In Europe the problem arises from high government expenditure and the moral hazard created by bailouts. The Report argues that each euro area member needs to adopt rules and institutional arrangements appropriate to its own political circumstances. The European Commission should judge whether these national arrangements reduce the deficit bias. Only countries that pass this test would have their debt instruments accepted as collateral by the ECB.

'Public Debts: Nuts, Bolts and Worries', by Barry Eichengreen, Robert Feldman, Jeff Leibman, Jürgen von Hagen and Charles Wyplosz, will be published by CEPR and ICMB on Friday 16 September 2011. Advance copies are available under embargo from Anil Shamdasani.

Contacts
Charles Wyplosz, Professor of International Economics, Graduate Institute, Geneva and Director, ICMB - charles.wyplosz@graduateinstitute.ch, +41 79 417 8267

Anil Shamdasani, Publications Manager, CEPR - ashamdasani@cepr.org, +44 20 7183 8809