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A Defense against Fiscal Crises: Fiscal Rules

A Defense against Fiscal Crises: Fiscal Rules

LEE Dong-WonMoon Weh-SolLEE Jong-KyuRHEE Tae-Hwan

Sept. 6, 2011

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Originally released on July 27, 2011

The drawn-out fiscal crises in major economies including the US and the EU have posed a threat to the global economy since the global financial crisis. Things are not looking up for Korea either: population graying and diminishing potential economic growth are expected to undermine Korea 's fiscal conditions. As of now, though Korea's national debt is 33.5% of GDP, a moderate level compared to the OECD average of 97%, Korea's national debt could near 130% of GDP over the long run (by 2050), raising the possibility of a fiscal crisis. Once a fiscal crisis strikes, it invariably takes time to recover, making prevention a wiser policy. Therefore, fiscal rules and regulations should be adopted when fiscal conditions are relatively favorable so as to establish fiscal disciplines. The government will find it increasingly difficult to discretionarily manage its public finances which are expected to grow due to population aging and demographic changes. Fiscal rules are specific numerical targets for fiscal indic ators such as the budgetary balance and public debt. Since fiscal rules are legally binding, they are an effective tool for establishing fiscal discipline through long-term numerical goals.

Desirable fiscal rules will help a nation achieve the conflicting goal of securing fiscal soundness and sustainable economic operation in a balanced manner. The stricter the fiscal rules, the better the fiscal soundness. The cost, however, is that growth in taxes could crimp the economy. If simple and easy-to-monitor fiscal rules (e.g. balanced budget rule, primary budget balance rule and 3% deficit rule) are introduced, public debt as a percentage of GDP can be taken down to the safe 60% range. Analyses of the macroeconomic effects of fiscal rules by using an overlapping generations model (OLG) showed that when the 3% deficit rule (less strict than balanced budget rule) is adopted, GDP would be 3% higher than when the balanced budget rule is put in place. Thus, the 3% deficit rule was deemed to satisfy the conditions for fiscal soundness while maintaining the GDP at a high level.

As a matter of fact, while nations who responded flexibly to short-term business cycles with specific policy goals succeeded in their fiscal plans, those who set excessive goals with disregard for business cycles failed without exception. Sweden , the Netherlands and Australia fall into the fortunate group, while the US , Japan and the EU furnish unsuccessful examples. Korea has to adopt fiscal rules before population graying goes into full swing. Once a fiscal crisis occurs or opportunities for fiscal reform are missed, it can be very difficult to undo the damage. Recommendable fiscal rules would be the ones that help a nation maintain fiscal soundness and minimize the negative effects such as decelerating economic growth. Application of fiscal rules entails constraints on fiscal operation, so social consensus should be speedily attained . In addition, attention should be paid to curbing structural factors that aggravate fiscal deficit and ways to raise potential growth rates should be hammered out.

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