This is an extensive summary of the address by Central Bank governor Michael C. Bonello at the annual dinner of the Institute of Financial Services - Malta last night:

Inspired by the words of George Washington that "There is no practice more dangerous than that of borrowing money", mine is essentially an appeal to the country to leave behind its spendthrift ways and to learn to live within its means. I shall therefore make a case for fiscal reform.

How and why have fiscal deficits become a problem? In the first decades after World War II, governments came to play a key role in promoting economic growth and social development. Perhaps the most important tool governments use to pursue these objectives is public expenditure.

Government intervention in the economy has important implications not only for competitiveness and growth but also for the promotion of the social dimension of development. It is thus essential to ensure that society obtains full value for the resources devoted to public sector activities.

Now whereas in the private sector failure to deliver value for money eventually results in bankruptcy, there exists no such effective sanction in the public sector.

There are a number of factors that reduce the incentive to use resources efficiently.

In the welfare system, the size of the expenditure can easily exceed that required to maintain social cohesion and the focus be diverted away from genuine needs.

There are a multitude of pressures to increase government expenditure over time. And as tax revenues often prove unable to keep pace with such commitments, fiscal deficits emerge leading to an accumulation of debt. In turn, this produces a growing debt-servicing burden, creating a vicious circle in which unproductive outlays effectively crowd out the scope for productive expenditure.

Fiscal deficits are also the result of inadequacies in the design and implementation of tax structures.

Continued fiscal deficits and increasing public debt levels are a symptom of inefficiency or inappropriate policy choices.

At worst, the inefficient use of resources can threaten the viability of the economy itself. Many a financial crisis has been sparked off by the behaviour of profligate and inefficient governments. In today's globalised financial markets, the retribution for such excesses is quick and unforgiving.

It would appear that, like all human endeavours, the benevolent, interventionist role of governments was developed with the best of intentions but, as often happens, something went wrong along the way. Judging by the present state of its public finances, Malta is no exception.

For a start, fiscal deficits have become a permanent feature of the economic landscape, which suggests that they do not reflect temporary slippages or cyclical downturns, but rather fundamental policy choices and inefficiencies. Since 1990 the annual shortfall between revenue and expenditure has averaged six per cent of GDP, or Lm1 out of every Lm16 earned by the economy. This year, as explained in Malta's Convergence Programme 2004 - 2007, the general government deficit is expected to fall to just above five per cent of GDP, which is still, however, one of the highest ratios in the EU.

The persistence of the fiscal deficit has resulted in a rapid accumulation of government debt, which as a percentage of GDP trebled between 1990 and last year to about 70 per cent. There is clearly no alternative to the fiscal consolidation envisaged in the Convergence Programme because, if the deficit is left unchecked at this year's level, the debt to GDP ratio would exceed 80 per cent by 2010.

Also undesirable is an increasingly unmanageable debt-servicing burden. This year the government is spending Lm1 out of every Lm8 of tax revenue merely to service its debt. Debt-servicing costs now amount to about 95 per cent of expenditure on health and 90 per cent of that on education.

If the deficit were left unchanged at this year's expected level of Lm95 million, it is estimated that debt service costs would rise from Lm85 million today to almost Lm120 million by 2010. In other words, the government would have to register a surplus on its recurrent operations and borrow money just to service the debt.

This unsustainable situation is a symptom of another feature of our economy, the high level of government expenditure. At 51 per cent of GDP, this is the sixth highest in the EU. The government, moreover, employs 27 per cent of the labour force and the entire public sector absorbs over one-third of Malta's labour supply.

This is not to say that nothing has been done. Fiscal consolidation and structural reform have in recent years become key features of the government's drive to enhance the productive potential of the economy. The Convergence Programme targets a fiscal deficit of 1.4 per cent of GDP by 2007, compared to 5.3 per cent this year. This improvement is to be attained mainly through a reduction of about six percentage points, to 44 per cent, in the ratio of government expenditure to GDP.

What does this target mean in terms of the savings that need to be made? The average annual increase in expenditure over the next three years must not exceed Lm5 million, which is just one-tenth of the present growth rate. This implies that measures must be put in place now that would, by 2007, reduce expenditures by Lm150 million. The attainment of this objective clearly requires extensive reforms and I would like to propose some policy orientations which would help to reduce the deficit to the planned level.

This year over 20 per cent of total spending, some Lm200 million, will go towards wages and salaries and another 10 per cent will go to public sector bodies. In short, the public sector wage and salary bill absorbs close to one-third of total budgetary expenditures.

It is imperative that the current negotiations for the renewal of collective agreements in the civil service and in the public sector recognise the need to cut spending. It is important that any wage increases be matched by measurable productivity improvements.

It is equally necessary to make better use of the human resources available by strengthening both the management culture and work practices. The public sector cannot continue indefinitely to carry the cost of employees who are effectively redundant. A time limit must be set beyond which this burden will no longer be carried and training and redeployment schemes should be strengthened in the meantime to facilitate the transition.

Another third of government expenditures is absorbed by social security benefits. Malta has a welfare system which is certainly generous but which is not socially just in the sense that it does not allocate the relatively larger share of resources to those who are most in need.

The time has clearly come for a radical welfare reform which reconciles the objectives of social cohesion and intergenerational equity with financial sustainability. Non-essential transfer payments should be cut. Means-testing in the provision of social benefits should not be ruled out on the grounds of possible abuse. Consideration should also be given to indexing all benefits to inflation, including those currently linked to wages. The system for granting certain benefits should be reviewed to prevent abuse, especially in the case of invalidity pensions. It is furthermore essential to speed up a review of the unemployment benefit system to transform it into an effective instrument of employment creation rather than of social dependence.

Finally, the range of services offered by the public health system should be critically assessed in the light of budget constraints. Beneficiaries should be required to shoulder part of the costs involved.

Thus, outlays on wages and salaries and on social security benefits together account for fully two-thirds of government spending. A further tenth is absorbed by the interest on the public debt.

The present favourable interest rate scenario is unlikely to last much longer. And since a one percentage point rise in the rate of interest is estimated to increase debt-servicing costs by some Lm3 million, it is clear that slowing down the pace of debt accumulation should be a priority. Any receipts from the privatisation programme should be used for this purpose.

The only elements of government expenditure susceptible to a measure of discretionary control are capital outlays, operational expenditures and other programmes, mainly consisting of Malta's contribution to EU-funded projects. About one half of the required cost savings during the next three years will come from a reduction in capital expenditure. This, however, still leaves the need for expenditure cuts by 2007 of about Lm70 million.

Unpalatable as it may sound, the truth is that difficult but crucial decisions must be made without delay regarding the size and the cost of both the public sector and the welfare state.

Recurrent expenditure, which this year amounts to almost Lm740 million when the interest on the public debt is excluded, is distributed thus: education, health and activities related to the promotion of economic growth - about 39 per cent; welfare benefits - 43 per cent; the remaining 18 per cent represents the cost of general administration.

The imbalance evidenced by these shares raises serious questions about the rationale governing the use of public funds, a fair proportion of which are borrowed not earned. We need to ask, for example, whether the allocation of such a substantial budget to social security is promoting a culture of dependence rather than self-help and of reliance on the State rather than the kindling of economic initiative.

One could also ask whether enough resources are being allocated to priority areas such as tourism, IT and the development of industrial areas.

Returning Malta's public finances to a sustainable basis also requires careful consideration of the revenue generation mechanisms.

There is good reason to suggest that the taxation system be further refined in order to enhance the degree of compliance and to shift the tax burden away from productive activities.

Global GDP is likely to increase by up to five per cent this year, its strongest pace for a generation. Emerging economies as a group are enjoying their fastest growth for at least 25 years. In sharp contrast, the Maltese economy is again this year likely to post one of the slowest growth rates in the EU.

Returning the economy to a sustainable growth path closer to its potential rate must, therefore, be a priority objective. There are no quick fixes or painless options that will produce greater economic efficiency, enhanced welfare and higher living standards. We must simply work harder and longer and give more value for money.

The temptation to postpone decisive action must be resisted. We should be encouraged by the knowledge that other countries have succeeded in overcoming similar, even tougher challenges. In all cases, an indispensable ingredient of success has been an honest acknowledgement of the problem accompanied by the genuine desire of all the social partners to work out an effective solution in the national interest.

Sitting on the fence is not a responsible option. There is the danger that anybody unwilling to be part of the solution will be perceived to be part of the problem. I, therefore, feel obliged to call on all the social partners to adopt a long-term perspective and sign up to a substantial reform package which would lay the foundations for renewed growth and sustainable development.

A thriving economy is the best social policy.