Maintaining national monetary and fiscal discipline

Large fiscal deficits are often at the root of both external and internal macroeconomic imbalances. External imbalances express themselves as current account deficits, capital flight and rapidly expanding external debts. Internal imbalances take the form of high real interest rates, falling private investment and rising inflation. Domestic savers respond to unsustainable fiscal deficits by sheltering their assets abroad, this capital flight worsening the debt problem. Prudent fiscal policy - that is, fiscal deficits consistent with low and stable inflation, a sustainable level of foreign debt and a favourable climate for private investment - is indispensable to stabilization and adjustment. It guards against the risks of excessive foreign debt and overvalued currencies. Furthermore, reforms in many other areas - financial liberalization, currency devaluation, price deregulation, trade reform and so on - can work only if the fiscal implications are taken into account. Public finance offers many opportunities for budgetary reform. The ways in which governments raise revenue can substantially affect economic efficiency. Similarly, the quality and composition of public spending strongly influence development.

Countries with commodity booms are a special example of the importance of prudent fiscal policy. Mistaking a temporary boom in revenue as permanent carries heavy long-term costs, because it can take years to cut spending and reverse the accumulation of debts incurred during the boom. By contrast, erring on the side of caution - treating a permanent boom as temporary - is easily put right later. Boom revenue can then be used to accumulate external assets or repay debt, thus avoiding the risk of inflation and an appreciating exchange rate. In many countries during the 1970s, public revenues accelerated rapidly as the export prices of commodities soared. The windfall encouraged governments to increase spending - sometimes by more than the windfall, as higher domestic revenues were leveraged through foreign borrowing. However, much of this spending went to higher consumer subsidies or investment projects of dubious economic merit. After the boom, spending kept rising while revenue contracted sharply. The resulting fiscal deficits led to fiscal and external debt crises that finally forced spending cuts. Some commodity exporters - Botswana, Cameroon, and Indonesia, for example - managed to avoid destructive boom and bust cycles by cautious fiscal management of the boom revenues. They moderated spending increases during the boom and used the rise in public savings to accumulate external assets or repay external debt. They also adjusted rapidly to the end of the boom by cutting spending and maintaining low inflation, stable exchange rates and solid performance in other exports.

Countries like Indonesia, the Republic of Korea and Thailand had sustainable fiscal policies during the 1970s. They accumulated smaller stocks of public debt in relation to their capacity to service it. They also adjusted their fiscal policies quickly in the early 1980s and took steps to prevent their real exchange rates from rising excessively. As a result these countries - which might easily have joined the problem debtors - steered clear of debt troubles.