We don’t know when, and we don’t know exactly what will trigger it, but a financial crisis is bound to come to one of the world’s largest economies. In the modern era, it is impossible for this crisis not to affect Romania as well.

It happened in 1991, and in 1997, and in 2008, and it will happen again. The paths we followed before those crises should have taught us that the impact on our economy was stronger, the greater our internal and external imbalances were.

Each time, our economy got off on the wrong foot, meaning that in the periods leading up to the crisis, macroeconomic imbalances were exacerbated by the wrong policies. In particular, in all periods up to the mentioned years, our fiscal policy contributed to the growth of the budget deficit, which meant that its use in the conditions of the future crisis was almost impossible.

Lesson not learned

We didn’t learn that lesson, so we’re in a similar situation now. Although there have been signs over the past 1-2 years that a possible recession or financial crisis may be relatively close in some of the world’s relevant economies, we have allowed our budget deficits to remain relatively large, or as happened in the first five months of this year even increase. The budget deficit is the only major element that makes the current period similar to the periods preceding 1991 and 1997.

But there are other elements that make the current period more similar to the period preceding the crisis of 2008. Among them, along with the large budget deficit, the main element is the inflow of capital, which, as a rule, nominally increases the exchange rate of the lei. But there is also a new element, namely dense and suffocating macroprudential regulation, the existence of which is hoped to mitigate the effects of the financial crisis on economic activity.

Many analysts and politicians believe that macroprudential measures will facilitate the transfer of the future crisis and soften the recession. The experience of developed economies this spring showed us that the measures did not work and that special measures to save some banks with resources not provided for this purpose are necessary to avoid the generalization of panic. It remains to be seen how macroprudential measures will develop and how effective they may be in limiting contagion in Romania when it does.

Until then, foreign capital continues to flow into the country (portfolio investments are an important component), and the budget deficit grows above programmed levels. This is where the government should step in. The point of the intervention would be to make room for the development of the private sector, that is, to be able to expand its investments.

To be more clear, I remind you that the inflow of capital contributes to the development of the private sector, as well as to the increase in the external deficit of this sector, which thus increases the current account deficit of the country. The latter is the sum of the external deficit of the private sector and the deficit of the state budget. In order for the private sector, which creates our wealth, to be able to increase its own deficit by increasing investment faster than saving, without increasing the country’s current account deficit, the government must reduce the budget deficit. That is, the budget sector should save more.

If not adjusted in time, the government will have to make tougher adjustments during the crisis. An economy going into crisis would mean that output would shrink from an inflationary gap that, I wouldn’t be surprised, is now well above 4 percent, to a minimum that could reach, say, a minimum of minus 4 percent of potential GDP. This means that the structural budget deficit will increase to 7-7.5% of GDP. This level under these conditions would require drastic reduction action, because otherwise almost no one would want to finance it, and those who would would demand very high risk premiums. In other words, if it doesn’t tighten as much as needed now, the fiscal sector will tighten it later, as it did after the 2008 crisis.

Monetary policy will also have problems

On the one hand, until the emergence of a possible crisis, the inflow of capital will continue to put pressure on the revaluation of the lei. With an overvalued lei, the structural current account deficit will continue to worsen, reflecting a loss of external competitiveness. From this point of view, lowering the interest rate would help to the extent that the inflow of capital depends on the interest rate differential (the difference between our interest rate and the interest rate of the countries from which the capital flows).

On the other hand, in the private sector, with an overvalued lei and relatively high inflation, credit in foreign currency will continue to be cheaper than credit in lei, which is reason enough for continued rapid growth, creating risks to financial stability, according to the already known model period of 2004-2008. The growth of loans in foreign currency cannot be restrained without lowering the interest rate. In addition, as the budget deficit in the public sector grows, relatively high inflationary expectations in the economy will continue to rise, requiring interest rate hikes to ease them.

Thus, monetary policy will continue to face the dilemma of what to do with the interest rate, a dilemma that is likely to continue until the global crisis emerges.

As in 2008, the onset of recession will not mean that the central bank will be able to cut interest rates immediately and sharply. As then, inflation will remain above the target level for some time, its deviation from the target will continue to be supported by inflationary expectations and excess demand, which will not disappear, but will gradually decline from today’s relatively high positive levels (see my article “Response to criticism of the Monetary credit policy in Romania in the decade around the 2008 financial crisis (2004-2013)”, RJEF, XXIV (4), pp. 39-58, 2021).

A sharp interest rate cut would do little to mitigate the fall in output if it led to a significant depreciation of the lei, which would boost exports, but would create panic and strain the balance sheets of firms with relatively high external debt, slowing growth.

What will the government do?

Over time, options for measures to reduce the budget deficit narrow. Under these conditions, the decisions that will become inevitable will not be the best, but those that can be quickly implemented. The best solution is to cut costs if they are only wasteful or the result of unfair rules.

It is necessary to start with the rejection of the populist mixing of the budget sphere with other state institutions, which are self-financing, that is, do not receive resources from the budget, and which have no other relationship with the budget sphere, except for the payment of taxes. As soon as this aspect is clarified, the government should reduce those budget expenditures which, upon careful analysis, are nothing but extravagance or spending due to unjust laws.

Raising tax rates on the basis that we should aim to achieve a share of income that is at least equal to the EU average would be wrong. In terms of the coming crisis, this will only mean that the public sector is being bailed out at the expense of the private sector, reducing the latter’s economic freedom to produce our incomes and wealth on which the government bases its redistributive policies. Although raising taxes is not a desirable solution, existing tax breaks should be abolished.

Time passes, and nothing happens, as the experience of the government in 2009 shows, tough decisions will be inevitable. Then, in 2009, the budget situation deteriorated so much that the government decided to cut salaries by 25 percent, which, including various bonuses, resulted in a 40 percent reduction in income. In addition, VAT was increased to 24 percent.

Now again, a significant reduction of the budget deficit is needed. The cause of the problem lies in the period of 2016-2019, when the governments of that time carried out a policy of raising wages at the same time as lowering taxes. This policy was completely wrong! Caught up in the Covid-19 pandemic with a deficit of almost 5 percent of GDP, we were forced to increase the deficit from this level, while other countries were increasing it due to the same pandemic from 1-2 percent of GDP.

This time there is no need to cut the salaries of state employees.

The political economy of the problem shows us that other expenses will not decrease either. For example, there is a war, and therefore it is no longer possible to reduce state investments, as it was usually done. The whole political economy of the problem (please consider the meaning of this sentence), well understood, shows that it is becoming increasingly clear to political leaders that it is necessary to abolish the reduced VAT quotas, which would be right, and to increase the VAT.

I’m not saying that VAT should be increased, I’m just saying that along with the increase in excise and other indirect taxes, it may have become an inevitable decision. Progressive taxation of the wage fund will not bring revenues and will not solve the problem, it will only lead to an increase in public spending for some at the expense of others. This is a way to bring public debt to 100 percent of GDP or more, as many developed countries have already done.

An increase in VAT will solve the problem of the budget deficit, but superficially. This is a superficial solution, because it does not address the root cause, namely how, without being guided by the right principles, current costs in the budget area are increasing. This is as superficial as the decision to grow the economy through wage growth policies in 2016-2019. This is not a structural solution.

It is an unacceptable excuse that if these wrongdoings have been made, then we have to cover them by raising tax rates. Once such a morality is adopted, it will inevitably lead to increased spending, with subsequent increases in taxes and so on. Until the cultural and legal conditions are in place for conducting fiscal policy in accordance with the right principles, an increase in tax rates, even if significant, will not lead to a significant increase in the share of tax revenues in GDP, nor to an increase in the quantity and quality of public goods provided by the government. This will only increase tax evasion.

The political difficulty with raising VAT, if it becomes inevitable, is that it causes inflation. Inflation, which the public will quickly learn, is created by the government. Politicians will have a hard time explaining that this excessive deficit, which can no longer be sustained, “took the place” of consumer goods inflation, that they were largely the same thing, that they were one and the same.

I believe that any decision to reduce the budget deficit that is made will show once again how the wrong policies of the past, not guided by the right principles, create “necessities” that governments must solve by putting government, as Hayek explained to us. on a road it does not control, although the government lives under the impression that it makes the decisions it wants.

N.Ed: Lucian Croitoru is the chief adviser on monetary policy to the head of the National Bank of Romania