Transparency of Government (Part 2) - Transparency in Fiscal and Monetary Policies

In the previous article (Part 1),I emphasized that government transparency is the single mostimportant prerequisite for enabling citizens to provide effectivegovernance to the government, and that enhanced transparencycan be a breakthrough that evolves into dynamic forces forchanging the "shape" of a nation, including its politicaland administrative systems. In this second article in theseries, I focus on two specific issues - fiscal transparencyand central bank transparency - in analyzing a specific exampleof government transparency.

Why focus on "transparency" in fiscal and monetary policies?Normally, fiscal and monetary policies are discussed in thecontext of macroeconomic policies. By shedding light on thepolicymaking system and processes which are related to policytransparency, we can discuss the effectiveness of fiscal andmonetary policies from an angle that is different from thosein conventional policy debates. Secondly, international comparisonscan be made. On the subject of fiscal transparency and centralbank transparency, many countries - particularly those belongingto the Organisation for Economic Co-operation and Development(OECD) - have created numerical indicators gauging the degreeof transparency of various items, and a series of empiricalanalyses based on international comparison have been publishedin recent years. By comparing the degree of transparency inJapanese fiscal and monetary policies with those of othercountries, we can objectively assess where Japan stands amongindustrialized countries as regards overall transparency levelsand, particularly, in which specific areas problems exist.In this article, I first analyze fiscal transparency and thendiscuss central bank transparency. Finally, I examine whatit takes to improve transparency in fiscal and monetary policiesby highlighting common problems between fiscal and centralbank transparency.

Fiscal transparency needs to be discussed in the contextof how citizens, as a "principal," provide governance to thefiscal authorities, expending agencies and politicians who,as an "agent," undertake fiscal activities. Fiscal disciplineoften becomes important because fiscal expenditures innatelyhave an institutional tendency to become lax. More specifically,while the expenditure programs proposed by the agencies andpoliticians responsible for outlays can bring benefit to thespecific agency or constituency to which they belong, thecost of these expenditures is born broadly and thinly by allthe taxpayers. This means that the costs are not internalizedand thus pressure to boost expenditures on these respectiveprograms tends to grow easily. This is a type of moral hazardknown as a "common pool problem" (Weingast, Shepsle and Johnsen,1981; Chari and Cole, Chari, Jones and Marimon, 1997). Insuch a situation, a government and politicians often try topursue their personal interests by executing budgets for purposesother than those for which they were originally intended.They might employ tricks to try to hide or justify excessiveexpenditures. Improved fiscal transparency is expected tohelp prevent such behavior and provide effective governanceto a government and politicians undertaking fiscal activities.

Three viewpoints concerningfiscal transparency: institution, accounting, and projections
There are various viewpoints when discussing the specificsof fiscal transparency. Here, I analyze the issue based onthe theory of Kopits and Craig (1998), which comprehensivelytakes it up from the three viewpoints of "institutional transparency,""accounting transparency" and "transparency of indicatorsand projections."

First, let us take a look at "institutional transparency."The important point is how to provide effective monitoringand governance to a government, which acts as an "agent" inundertaking the planning and execution of budgets, in a waythat best benefits the general public, who are the "principal."As a specific means to realize this, Kopits and Craig (1998)propose that a government set forth fiscal targets and policypriorities, explain them in budget documents, ensure transparencyin executing the budget, and disclose the results of performanceassessment and financial audit. At the same time, they alsocall for the establishment of an independent monitoring bodythat has wide investigative authority over government activities.

Let us move on to the second viewpoint, "accounting transparency."Normally, a government submits budget documents to the legislature.In this regard, it is fair to say that the details of a governmentbudget are fully disclosed to the public. By natural necessity,however, budget documents of a national government are extremelycomplicated and far from being easy to understand in the eyesof the general public. What is worse, politicians and bureaucratsmay intentionally make them more "complicated" than necessaryand use "ambiguity" to hide lax fiscal expenditures in thepursuit of personal interests. A typical trick is to makecentral government deficits appear smaller than they actuallyare through complicated transfers of funds between generalaccounts for financing central government activities and thoseof other fiscal entities; for instance, off-budget entitiessuch as local governments and public corporations. Therefore,with regard to "accounting transparency," it is importantto provide comprehensive information, including budget breakdownsfor each entity as well as on inter-entity fund transfers,in a way that is true to the reality. As to the scope of governmentdisclosure based on financial accounting standards, Kopitsand Craig (1998) say that a general government budget includingbudget breakdowns for central and local governments, shouldalso go as far as detailing off-budget funds such as socialsecurity funds, as well as public corporations' quasi-fiscalactivities. Furthermore, as measures needed to improve accountingtransparency, they cite the adoption of accrual accounting(as with cash accounting, a system focusing on the physicalflow of money, used only supplementarily), adequate assessmentof government assets and liabilities (thus of net assets),and the inclusion of breakdowns by economic entity and function,as well as revenue breakdowns.

Finally, there is "transparency of indicators and projections."A typical technique to which government officials and politiciansresort in justifying excessive fiscal expenditures is to provideoptimistic projections for economic growth and tax revenuesbased on optimistic predictions of the economy. Therefore,it is extremely important to ensure "transparency in projections."That is to say, a government needs to always present realisticfigures by eliminating intentional optimism when providingmacroeconomic projections and forecasting the fiscal impactof each government policy. These measures would provide foundationsfor judging the relevance of budget size. Also, as a precondition,information on various economic indicators must be providedextensively to enable the public at large to adequately understandand analyze the current state of government fiscal conditions("transparency in indicators"). Kopits and Craig (1998) recommendthis not only for direct indicators of fiscal conditions -such as those concerning fiscal balance, gross and net governmentliabilities - but also that indirect indicators - such asestimates of analytical indicators concerning structural and/orcyclical fiscal balance, fiscal sustainability (the levelof primary balance at which government debt ratio can be stabilized),and net accrued liabilities - be disclosed to the public.Also, in order to ensure transparency in short-, mid- andlong-term fiscal projections, they say that such projectionsmust be based on realistic suppositions and that a distinctline must be drawn between baseline scenarios (in the caseof no changes in government policy) and scenarios in whichpolicy changes are incorporated.

Transparency as a preconditionfor reforming budget processes
In addition to enhancing fiscal transparency through theimplementation of the measures described above, we may tryto directly solve the "common pool problem" by providing governanceto fiscal management. Some countries have done this and producedsome positive results. Specific measures implemented by thesecountries include: (1) mandatory reduction of deficits bysetting numerical targets and/or introducing balance budgetlegislation, and (2) concentrating the authority for makingbudgetary decisions on the finance minister and/or prime minister- they do not represent the interests of any specific industryor region, and thus can be deemed to have been elected froma constituency where the "average" taxpayers reside (Alesinaand Perotti, 1999).

In either type of budget process reform, ensuring fiscaltransparency is vital. The former case (mandatory reductionof deficits) allows much room for manipulation because a governmentwould be able to achieve numerical targets quite easily bymeans of "creative accounting" or optimistic predictions forthe economy. Transparency (information disclosure) must beensured to prevent this. With regard to the latter (concentrationof authority), the "common pool problem" - a key reason forlax fiscal management - would be efficiently avoided, forinstance, under a situation in which the finance ministryof a single-party government holds authority over budget formulationin a centralized manner. However, it must be remembered thatthe concentration of authority over fiscal expenditures inone division of a government means that information requiredfor decision-making also concentrates in that division, resultingin an uneven distribution of information within the government.Should this happen, transparency in the whole budget processmight be hampered, rather than improved. Transparency is morelikely to improve when more players are involved in the budgetformulation process, because they negotiate and share information.Therefore, when there is a greater concentration of decision-makingauthority in the course of the budget formulation process,it is all the more necessary to make efforts to enhance fiscaltransparency.

International comparisonof fiscal transparency
The first attempts at a comprehensive empirical analysisof fiscal transparency, by developing indicators for fiscalinstitutions and procedures to examine their impact on fiscalperformance, can be seen in Von Hagen (1992) as well as inVon Hagen and Harden (1994). They analyzed the situationsof eight member states of the European Union by using "accountingtransparency" as a prime indicator of transparency. Specifically,they examined: (1) whether special account budgets are explicitlyincluded in government budget documents, (2) whether budgetdocuments are provided in one book, (3) self-assessment offiscal transparency, (4) whether budget documents are linkedto national accounts, and (5) whether government loans tonongovernment authorities are explicitly provided for in budgetdocuments. According to their estimates, Germany is the mosttransparent of all, while Italy and Ireland are the least.The results largely correspond to these countries' respectivefiscal performances, for instance, in terms of debt ratio.Likewise, Alesina, Hausmann, Hommes, and Stein (1999) analyzedthe impact of fiscal institutions and procedures on fiscalperformance, focusing on Latin American countries. Transparencyindicators used in this study, however, are limited to debtrelations between a central government and other organizations,the degree of fiscal independence of local governments andpublic corporations, and so on, thus covering only part of"accounting transparency."

On the other hand, Alt and Lassen (2003) focused on "institutionaltransparency" and "transparency of indicators and projections,"rather than the "accounting transparency" emphasized in existinganalytical works. They carried out empirical analysis, froma very comprehensive viewpoint, on fiscal transparency in19 OECD countries, including Japan, by focusing on 12 items,which are: (1) midterm audit of fiscal reports, (2) reviewingof economic assumptions by an independent organization, (3)submission of a supplementary budget at least once a year,(4) use of accrual accounting, (5) inclusion of nonfinancialfiscal performances in budget documents, (6) pre-electionannouncement of special report on fiscal projections, (7)periodic announcement of long-term fiscal projections, (8)periodic disclosure of contingent liabilities, (9) mandatoryinclusion of budget documents of expenditures and projectionsfor the next fiscal year onward, (10) mandatory ex-post disclosureof deviations between projections and actual results, (11)explicit disclosure of impacts on tax revenue attributableto changes in major economic assumptions, and (12) periodicannouncement of accrual-based projections on matters relatedto social security programs. (Of these, the first three itemsconcern "institutional transparency," the fourth and fifthitems "accounting transparency," and the remaining seven items"transparency of indicators and projections.")

When the aggregate score of the above terms are viewed asan index (with 12 items, or points, as full marks), New Zealandtops the list of transparency by scoring 11 points, followedby the United States (9), the United Kingdom (8), and Australia(6), all of which are English-speaking countries. Meanwhile,continental European countries generally score low - Belgium(3), Germany (3), Italy (3), Switzerland (3), Denmark (3),and Norway (2) - whereas Japan (1) is the least transparentcountry. It should be noted that these results may be somewhatbiased as implied by the positioning of Germany which is fartoo low compared to where it stands in Von Hagen (1992). Still,the results of cross-section data analysis show that significantcorrelations do exist between transparency and fiscal performance,specifically, with both debt and fiscal expenditure levelslower in countries that score high on transparency points.

For Japan, the implications of Alt and Lassen (2003) arethat there remains substantial room for improvement, particularlywith regard to "transparency of indicators and projections,"compared to other countries. I will discuss the issue in moredetail at the end of this article. Meanwhile, with regardto "accounting transparency," improving transparency in termsof links to special account budgets and national accounts,as focused on by Von Hagen (1992), is an important policyagenda for Japan. Japan's budget structure features complicatedfund transfers - such as those involving special accountsand the fiscal investment and loan program (FILP) - and hasmuch in common with Italy, which was classified as the leasttransparent in Von Hagen (1992) due to its expansive use ofspecial accounts and off-budget accounts. Also, explicitlyproviding the link to national accounts is another importantissue because without this the macroeconomic impact of fiscalexpenditures - for instance, the level of impact an increasein expenditures on public works projects would bring to overallpublic investment in terms of gross domestic product (GDP)- is hard to tell.

Why is central bank transparencynecessary?
Next, let us take a look at central bank transparency. A centralbank is operated for public purposes and its functions includeserving as a bank for the government. Also, in some countries,a central bank is fully funded by the government. Nevertheless,however, a central bank is not part of the government. Rather,it is regarded as a separate entity independent from the governmentand the legislature. In the light of its public nature, centralbank governance is provided by the government and/or the legislature,which are supposed to represent the general public, throughthe appointment of the head (governor, etc) of the centralbank.

From the viewpoint of governance and transparency, it mayappear that resolving information asymmetry between a centralbank and the government/legislature contributes to the improvementof central bank governance. As discussed in detail below,however, it must be noted that providing governance in theform of strong control and intervention by the government/legislatureis not desirable. It is an internationally-accepted idea thatit is appropriate to grant a certain level of independenceto a central bank by transferring authority over monetarypolicy (central bank independence). The revised Bank of JapanLaw, implemented in 1998, is also based on such an idea. Acentral bank is required to further improve transparency andfulfill accountability in return for the independence grantedit, which is a case of transparency quite different from thatof ordinary public organizations.

Then, why does a central bank need to be granted independence?It is because decisions on monetary policy require highlycomplex and technical expertise (Stiglitz, 1998 and 2001)as well as a long-term perspective (Blinder, 1998), and therefore,the risk of falling prey to shortsighted political interventionsand failing to implement desirable policy is far greater fora central bank than for other organizations in charge of nonmonetarypublic policies. By transferring authority over monetary policyand granting independence to a central bank, political interferenceand pressures can be removed. This is particularly importantbecause the actual procedures of monetary policy implementation- basically, guiding overnight call rates up or down - arequite simple despite the level of expertise required to makepolicy decisions as to when and by how much the target rateshould be moved up or down. In addition, costs incurred bychanges in monetary policy are to be born broadly and thinly.All these unique features make monetary policy vulnerableto "undue interference by politicians," such as demandingthe easing of monetary policy while disregarding the policycosts involved, and this is another important reason why theindependence of a central bank must be ensured.

On the other hand, however, it is also true that such independenceweakens the direct governance function of the government/legislature.Even though independence is granted, this does not eliminatethe need for a governance mechanism for central banks. Somekind of checking functions must be in place so as to preventa central bank from pursuing self-serving goals. Here, thefunction of governance must be undertaken by a large and indiscriminatenumber of entities including the general public and participantsin financial markets. Central bank transparency and accountabilityare crucial prerequisites for the proper functioning of governanceby "voice." In other words, a central bank's transparencyand disclosure of information, as a condition of independence,must be ensured more thoroughly than those of other publicorganizations.

Five important aspects concerningcentral bank transparency
As is the case with fiscal transparency, there are variousviewpoints from which central bank transparency can be analyzed(See Fry et al, 2000), but in focusing on each stage of thepolicymaking process, Geraats (2002) has provided the fiveaspects listed below. Meanwhile, Eijffinger and Gerrats (2002)further classified each of these five aspects into three toexamine the specific degree of transparency of nine industrializedcountries, including Japan, and thus developed a comprehensiveindex for central bank transparency (with 15 points as fullmarks).

• Political transparency: Disclosure of institutional agreements that explicitly sets out policy goals and monetary policymakers' motives. (Formal objectives of monetary policy, numerical targets for main objectives of monetary policy, and institutional arrangements between a central bank and the government ensuring its independence.)
• Economic transparency: Disclosure of economic data and information, based on which monetary policy is decided upon. (Timely announcement of the data necessary for selecting monetary policy, disclosure of macroeconomic models used in policymaking, and announcement of the central bank's projections for inflation and economic growth rates.)
• Procedural transparency: Disclosure of the process and debates through which monetary policy has been decided. (Disclosure of explicit strategy for monetary policy, minutes of policymaking meetings, and the respective choice made by each voting member of the policy board.)
• Policy transparency: Disclosure of adopted policy. (Quick disclosure of policy decisions, sufficient accounts of the adopted policy, and explicit presentation of prospective policy.)
• Operational transparency: Disclosure concerning the implementation of monetary policy. (Errors in controlling instrumental variables, macroeconomic destabilizing factors that could not be predicted in the process of transmitting monetary policy, and policy evaluation in terms of the fulfillment of macroeconomic goals.)

International comparisonof central bank transparency
The table shows how thenine industrialized countries compare to each other in termsof central bank transparency based on the index of Eijffingerand Gerrats (2002). New Zealand is the most transparent ofthe nine industrialized countries, scoring 13.5 points inits comprehensive index, followed by the U.K. with 12.5 points,and Sweden with 12 points. As is the case with fiscal transparency,New Zealand and the U.K. demonstrate substantially high centralbank transparency. However, unlike the case of fiscal transparency,there is no clear tendency for the central banks of English-speakingcountries to be more transparent than others, with the U.S.falling into the middle level of transparency and Australiainto the low level. Switzerland, Japan and Australia - scoring7.5, 8 and 8 points respectively - are all categorized ascountries with central banks that have a low transparency,as is the case with fiscal transparency. An aspect-by-aspectcomparison of indices shows that each country's scores aregenerally well-balanced. For instance, if a country scoreshigh in one aspect, it scores high in others. The U.S., however,is an exception. While scoring the highest mark in "economictransparency" (2.5) and "policy transparency" (3), the countryhas the lowest mark in "political transparency." The "politicaltransparency" of the U.S. is judged low because (i) its policygoals are multifaceted and have not explicit focus, (ii) nonumerical targets, such as inflation targets, are set, and(iii) no explicit arrangement or contract exists to ensurecentral bank independence.

Transparency of Bank of Japan
Japan's transparency is relatively low in all of the areasmentioned above. However, in "procedural transparency," itscores a relatively high 2 points with appreciation givento the relatively prompt disclosure of policy board meetingminutes and voting results. On the other hand, Japan scores1.5 points in "political transparency," the second lowestfollowing the U.S. Also, on "policy transparency," with 1.5points, Japan falls into a group with the lowest level oftransparency along with some other countries. Thus, Eijffingerand Gerrats (2002), though acknowledging the recent improvement,stress that the Bank of Japan still has room for improvementin these two fields.

Inflation targets as meansto improve transparency
In the transparency index of Eijffinger and Gerrats (2002),there is an undeniable bias giving relatively high pointsto countries adopting inflation targets, which are not onlygiven full marks in "political transparency" but also positivelyevaluated in "procedural transparency." It is important toremember that the setting of inflation targets is just oneway to improve central bank transparency. Indeed, there isa tendency for countries that set inflation targets to scorehigh on other fronts. Yet, the U.S. provides an exception.Therefore, it is quite possible for the BOJ - even withoutsetting any inflation targets - to improve its transparencyto the same level as the US Federal Reserve Board in otherfields, thereby, demonstrating a more favorable monetary policyperformance. Actually, empirical analyses (Neumann and VonHagen, 2002; Ball and Sheridan, 2003) show that there is littledifference in macro performance between countries having adoptedinflation targets in the 1990s and those which have not, aslong as various other factors are put under control. Conversely,it is imperative for the BOJ to strive to improve transparencyin other fields if it is not to adopt inflation targets.

Thus far, I have introduced some empirical analyses thatprovide international comparisons on the fiscal and centralbank transparency of various countries including Japan. Thereare various ways of thinking when selecting a transparencyindex and there is room for subjective judgment when measuringconditions with numerical values. Therefore, the implicationsof analysis results must be interpreted in a broad sense.Yet, the fact that Japan is classified in the group with thelowest level of both fiscal and central bank transparencymust be taken seriously. Of course, there may be the biasthat figures for Japan tend to become low due to the waysin which indexes have been selected. At the same time, however,these analyses provide useful information for Japan as towhere its transparency problems exist.

Japan's problem, commonly illuminated in the above argumentsand international comparisons, is that Japan, while securinga certain level of transparency with regard to the accountabilityof adopted policies, lags behind other countries in improvingtransparency with regard to: (1) "assumptions for projectionsand policies" (as well as analysis for acknowledging the currentstate), (2) "projections and future policy directions," and(3) "ex-post evaluation of projected figures and policy effects."In fiscal transparency, these items are classified into thecategory of "transparency of indicators and projections" and,as described above, Japan's transparency in these areas isextremely low compared to the level of other countries. Inthe case of central bank transparency, for instance, the BOJ'sproblems, as pointed out by Eijffinger and Gerrats (2002),apparently include: nondisclosure of the macroeconomic modelthat serves as a basis for policy analysis and projections,insufficient disclosure of economic projections (only twicea year at the moment), nondisclosure of future policy directions,and an absence of ex-post evaluation as to whether or to whatextent operating targets, projections and/or policy goalshave been achieved.

Departure from "myth of governmentinfallibility" is needed
In presenting projections or speaking about future policies,policymaking authorities must assume risks because opinionson the future are numerous and they are constantly exposedto the uncontrollable risk of environmental changes. As longas policymakers are bound by the "myth of government infallibility,"under which they are allowed to make no mistakes, they wouldtry, at all cost, to avoid making a commitment in terms of"projections or future policy directions." Naturally, theywould not want to show their "own cards" - such as "assumptionsthat serve as a basis for their projections and policies."Moreover, it is no wonder that policymakers lack incentivesfor conducting "ex-post evaluation of projected figures andpolicy effects," which is tantamount to forcing them to acknowledgetheir own faults.

In order to improve transparency in these areas, the importanceof transparency should be preached to policymakers. Not onlythat, it is also necessary, as discussed in the previous column,for policymakers and the general public to set themselvesfree from the "myth of government infallibility." They mustnot fear "missing the mark," that is should the actual resultsturn out to differ from projections or predicted policy effects.The problem begins when policymakers try to hide or becomereluctant to convey their "forward looking analysis" - whichforms the basis of macroeconomic policy - to the general public,for fear of making mistakes. Should their projections turnout to be wrong or should a certain policy fail to produceits intended results, it is all the more important to carryout thorough ex-post evaluations and find out the reasonswhy. In order to conduct such ex-post evaluations, it is importantto disclose "assumptions of projections and policies" in thefirst place because this way one can specifically identifywhich of the assumed factors had been wrong.

As such, through the implementation of a sequence of processes- sufficient disclosure of assumptions and policies, followedby the presentation of projections and future policy directions,and then ex-post evaluation of their implementation - publictrust in the policymaking authorities would begin to increaseand policymakers would no longer feel impelled to hide theirfailures or keep things vague. Also, since improved transparencyon the part of the policymaking authorities enables thirdparties to evaluate policies more easily, policy competition- such as policy proposals from other organizations - wouldlikely be activated, eventually leading to the improvementof policy quality. A breakaway from the "myth of governmentinfallibility" and improved transparency in forward-lookingpolicy and its analysis would enable policymakers to conveytheir policy intentions to the general public more clearly.At the same time, "policy quality" would be enhanced and greaterpolicy effects would be derived. The BOJ is the entity thatbears the responsibility for enhancing transparency in Japan'smonetary policy. As for measures to improve "transparencyof indicators and projections," the Council on Economic andFiscal Policy - not the Ministry of Finance - should takecharge. It is worthwhile considering repositioning the councilas an independent organ for improving transparency in overalleconomic policy, rather than limiting its scope to fiscaltransparency.

July 22, 2003

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