2 Crown risk and crisis management

2.1 Sovereign risk management

The Crown provides services and holds assets on behalf of taxpayers and citizens. Crown risk management has two aspects. First, the Crown has a fiduciary duty to manage public resources effectively. Second, the Crown seeks to provide predictability about future tax rates and spending as a way to partly insulate taxpayers and citizens from unexpected variability (risk) in their net after-tax incomes[1]. This paper focuses on the question of whether current and projected government debt levels provide policy predictability by allowing the government room to respond in a crisis.

The ability to respond to risks as they materialise, despite an immediate decline in cash flow, requires financial strength. In this way, Crown risk, the balance sheet, and fiscal policy are closely interconnected (refer Figure 1). Vulnerabilities in the domestic or international economies create risks around the Crown's cash flow. The government can respond to a decline in cash flow in two ways. First, if net worth is sufficient, the government can cover deterioration in its cash balance by temporarily allowing the Crown balance sheet to decline in value, usually through increased borrowing or perhaps through running down assets. Conversely, the government could change taxes or spending immediately to take into account movements in its cash flow over time.

Changes in the Crown balance sheet can be used to reduce short-term risk for taxpayers, but the government cannot totally insulate taxpayers from risk. The requirement that the future value of tax receipts exceed the aggregate cost of future spending implies that the Crown must eventually pass the cost of a fiscal shock onto taxpayers. That is, while governments can ‘smooth' adjustment costs, taxpayers remain the ultimate bearers of risk.

While a stronger balance sheet cannot totally insulate taxpayers from risk, a strong balance sheet is still seen as beneficial from a risk management perspective. A sufficiently strong balance sheet allows the government to minimise the cost of a fiscal contraction in three ways. First, implementing changes in a gradual and well signalled way allows private agents time to plan and adjust. Second, governments can also avoid contracting the budget in a downturn (pejoratively referred to as pro-cyclical policy for its role in deepening a cyclical downturn). Third, a more active role in trying to stabilise the economy is possible, for instance through fiscal stimulus or through targeted support for the private sector.

Figure 1: The interaction between fiscal policy and the balance shee

Source: The Treasury

The benefits of predictable fiscal policy are discussed at length in the tax smoothing literature (Barro, 1979). Tax smoothing suggests that governments can minimise the detrimental impact of fiscal adjustments by setting tax revenue at a level that allows tax rates to remain unchanged over the economic cycle. To do this, the government runs budget deficits in downturns that are repaid through surpluses in economic booms. The issue internationally in the recent financial crisis has been that the fiscal cost of maintaining policy through the recent crisis has far exceeded many governments' fiscal buffers. This is, perhaps, a consequence of not running sufficient surpluses through better times.