This chapter begins from the premise that budgeting procedures have important consequences for fiscal stability. A budgeting procedure that enables a government to commit itself to fiscal discipline is an essential condition. Commitment mechanisms are important during the three levels of the budget process – preparation of the budget within the government (including planning), passage of the budget law through parliament, and execution of the budget.

We examine this proposition in two versions. Following the fiscal institutional approach discussed in the previous chapter, we begin with a consideration of the “centralization” of the budget process in all countries. Specifically, dominance of the prime minister or finance minister over the spending ministers in setting budget parameters, limitations to modifications of the budget proposal by the legislature, and limitations to budget changes during the execution all centralize the budget process.

The previous chapter also developed the concept of “fiscal governance,” which considers whether some set of fiscal institutions is appropriate for one set of countries but not for another. Specifically, some countries benefit from a discretionary system where the finance minister is the most important player at all stages of the budget process. Such countries are known as delegation states because other players in the budget process delegate to the finance minister the power to set, monitor, and correct the budget. Other countries benefit most from setting multi-annual targets that include clear fiscal procedures for what to do under a variety of contingencies.

The first four chapters concentrated on the design and effect of forms of fiscal governance in the countries that composed the European Union until 2004. The fifth chapter discussed why those countries adopted the fiscal institutions that they did. The focus was on the effects of deep fiscal crises, the competitiveness of the political system, and ideological distances within the government, which affect the choice of one form of fiscal governance or the other. Here we broaden the study to include the Central and Eastern Europe countries that joined the EU in May 2004, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia, as well as Bulgaria and Romania, which became members in January 2007.

This is a particularly interesting sample for our purposes. Government budgeting in the sense the term is used in modern, market economies did not exist under central planning, and the countries we consider had to create new legal frameworks, organizational modes, and decision-making structures from scratch. This makes the sample uniquely interesting for a study of institutional choice, because, unlike in the countries considered in the previous chapter, the weight of history and tradition in shaping the new institutions is very low. At the same time, we observe a fair degree of variation across the budgeting institutions of the countries. This raises the question of how the variation can be explained.

This chapter begins with a discussion of the evolution of budgeting institutions in the ten sample countries.

This book has developed a theory of fiscal governance. By “governance” we mean the package of rules, norms, and institutions that structure the way governments make a budget. We argue that the way governments decide on budgets affects the content of the budgets that are implemented. Decentralized fiscal governance, which we refer to as fiefdom, leads to more spending and larger budget deficits than the decision makers themselves want. The reason for this is the existence of a common pool resource problem. When such a problem exists, policymakers consider the full benefits of their spending decisions but only part of the tax burden. Centralization of the decision-making process reduces the size of the common pool resource problem.

We indicate that there are two ideal forms of fiscal governance that can provide this budget centralization. Delegation occurs when decision makers delegate power to one central player in the budget process who has the responsibility to consider the full tax burden. In practice, this person is usually the finance minister. Our study indicates that delegation is especially strong in countries such as the United Kingdom and France. Fiscal contracts occur when the political parties that form the government commit themselves to targets that are intended to last the life of the coalition. Such contracts are especially strong in the Netherlands and Finland.

The choice between these forms of fiscal governance depends upon the underlying political structures of a given country. There is a potential principal-agent game that affects how a form of fiscal governance functions.

The European Monetary Union (EMU) includes a new framework for the fiscal policies of its member states. The need to create a genuine institutional framework to deal with public finances in EMU was recognized already in the Delors Report (1989), which called for institutional safeguards of fiscal discipline in the monetary union and argued that a lack of fiscal discipline might undermine the stability of the new currency. The fear that high and rising public debts would undermine the central bank's ability to deliver price stability has left its mark on all important documents and political decisions on the way to EMU.

In terms of technical economic analysis, fiscal policy and monetary policy are indeed linked through the “intertemporal budget constraint,” the requirement that, in the long run, the discounted sum of a government's expected expenditures cannot exceed the discounted sum of its expected revenues. Given an expected stream of expenditures, governments in EMU must adjust taxes to assure that the intertemporal budget constraint holds, since they cannot use the printing press freely to monetize their debts. Otherwise, they will be forced at some point to default on their debts. A fiscal crisis would arise, and pressures would rise on the European Central Bank to bail out the troubled government.

This reasoning leads to the conclusion that EMU needs a fiscal framework preventing the national governments from running up excessive levels of debt that could threaten the common good of EMU, that is, price stability.

A culture of public spending was pervasive in the political scene. Politicians scored points against their opponents by promising more and more spending for policies benefiting specific groups of voters, and the amount of spending they managed to obtain for their ministries, often despite what had been foreseen in the budget, was a measure of success for individual cabinet members. The government was often in minority and had to secure the support of one or more opposition parties in the parliament. In such situations, governments simply “bought” the support of an opposition party to ensure the passage of the budget through greater levels of spending. When economic growth was robust, none of this provoked much concern in the public debate. But when the crisis hit, the currency crashed, and public debt rose from a seemingly comforting 42% of GDP to over 72% within three years, it became obvious to the population that the country had to change the way fiscal policy was conducted.

A person widely respected for his knowledge and expertise served as finance minister, and he proposed a series of austerity measures to rein in the deficit. Despite his rhetorical ability and the respect he generally commanded, his cabinet colleagues refused to support his proposals, and he soon resigned. The government proposed a more scaled back version, yet parliament balked at even these measures, and soon the government itself resigned.

We evaluate here the effects of fiscal institutions on fiscal performance. The previous chapter catalogued the norms and rules found at different stages of the budget process for European Union countries from 1985 through 2004. It created indices to match the theoretical expectations detailed in Chapter 2. The delegation index tests the proposition that the same sort of centralization of the budget process is appropriate in all states. According to the fiscal governance approach, the delegation index should matter most in countries with low ideological distances and low office-seeking competition. In countries with high ideological distances and high office-seeking competition, the fiscal target and contract indices should be most significant.

The most common way to measure fiscal discipline is to look at some sort of measure of the gross debt burden or the budget balance. Consistently with these studies, we expect the various indices to matter most for changes in the gross debt burden over time as well as in the overall budget balance.

While the results confirm that the delegation indices matter most for expected delegation states and the contracts indices the most for expected contract states, there is an important finding about the effectiveness of those institutions that emerges. The very effectiveness of a given set of fiscal institutions can be undermined if the underlying ideological distance changes. That is, institutions that seem to guarantee a strong role for the finance minister work when there is a one-party government but become increasingly ineffective as policy differences among coalition partners increase.

For much of the post–World War II period, budgets remained roughly in balance over the economic cycle in industrialized countries. There were exceptions, such as in Fourth Republic France, but most countries performed well. The Bretton Woods system played an important role in keeping fiscal policies in line. European countries were pegged to the U.S. dollar and under the supervision of the International Monetary Fund. With strong and effective capital controls in place, weak finances meant that a country would have to borrow from the Fund.

Once Bretton Woods collapsed in the early 1970s, however, many countries liberalized their capital accounts and the IMF ended its role as a fiscal supervisor. There were two oil shocks, and one would have expected some increase in deficits and debts resulting from macroeconomic stabilization policies. Yet what one observes are high, and rising, levels of public debts and deficits in many countries through a much later period, or the early 1990s. The general government debt figures as a percentage of GDP are particularly revealing – while the average debt level for the European Union-15, the United States, and Japan was only about 28% of GDP in 1973, it increased in virtually every year to a high of 73% of GDP in 1996. The average then dropped to about 65% by 2000 and stabilized at that level through 2004. These figures, however, mask a divergence in budgetary performance.