Fiscal policy at a crossroads: The need for constrained discretion

Antonio Fatás, Ilian Mihov 17 June 2010

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The Eurozone is at a difficult juncture when it comes to fiscal policy.

  • Members’ debts are at levels not seen since World War II.
  • Default risk is on the rise for some of the Eurozone governments.
  • Financial markets have pressured governments to adopt concrete plans for reducing debts and deficits levels in the short and medium term.

But the need for massive fiscal adjustment comes at the wrong time. The economic recovery is weak and many voices call for additional fiscal stimulus. The difficult task facing Eurozone finance ministers is to “strike the right balance” between the short-term demands of stabilising aggregate demand and the long-term need for sustainability.

A history of failed balancing acts

Recent decades have shown that governments are not good at striking the right balance between conflicting goals. When short-term economic needs and electoral interests converge, long-term sustainability issues are forgotten. After all, today’s high debt levels are not only, or even mainly, due to the global crisis. With few exceptions, OECD governments increased their indebtedness ratio from 1980 to 2007. This is not limited to the Eurozone.

In this sense, Europe’s recent problems are just a wakeup call. Governments have been sleepwalking their way into troublesome debt-to-GDP ratios. It is time for governments to address long-term sustainability issues that have been debated, and largely ignored, since the 1980s.

The temporary improvement in public finances during the 1990s, which in some cases led to overoptimistic scenarios of adjustment, was partly behind the relaxation of fiscal discipline in the years that followed.

This inability to keep debt under control has led to the need for frequent large adjustments (fiscal consolidations) with significant macroeconomic consequences. Today we seem to have gone one step further. Policymakers and observers debate whether in some cases fiscal consolidation is not feasible at all and the only remaining resolution mechanism is a sovereign debt crisis.

Fiscal indiscipline and external constraints

The inability of governments to maintain discipline in fiscal policy is not new. Scholars have been studying it for decades (Fatás and Mihov 2003 and 2006, Larch and Turrini 2008, and IMF 2009). There is abundant empirical evidence showing that constrained governments tend to deliver better fiscal policy. Explicit or implicit constraints on budgetary processes have been shown to produce better discipline – less volatility in terms of discretionary changes in fiscal policy. There is some evidence that this discipline creates a virtuous cycle, boosting GDP growth rate in a way that boosts sustainability. There is also evidence that the existence of constraints increases the likelihood of successful fiscal consolidation.

But what type of constraints works best?

We are today witnessing in some countries a call for strict numerical budget rules aimed at ensuring that future fiscal plans are sustainable. Germany is the leading example, having imposed a constitutional debt cap. By 2016 the government has to reduce the structural deficit to less than 0.35% of GDP. Impressive, certainly, but are strict numerical constraints the solution?

There is no doubt that such constraints provide an anchor, or backbone, that helps governments ensure sustainability. Recent experience in the Eurozone and several US states, however, shows that numerical rules are far from optimal. There are two problems.

  • Either the rules are abandoned due to political demands (i.e. they cannot be enforced),
  • Or they produce highly procyclical policy during downturns and further exacerbate the collapse of demand during recessions (as in the case of some US states).

Additionally, many numerical constraints on deficits tend to be completely ineffective in generating the necessary surpluses during good years. For example, most of the EU economies saw their budget balances hovering just slightly above the –3% limit during the expansionary years from 2004 to 2007.

The need for judgement

Our view is that effectiveness requires an element of independent judgement. Constraints on fiscal policy need to ensure discipline while allowing for the flexibility (and feasibility) of the entire fiscal policy framework and over the entire business cycle. This is what we call constrained discretion. It differs from rules because it allows for discretionary decisions, but it provides the necessary checks and balances to ensure sensible policy in the long run.

The Eurozone’s Stability and Growth Pact illustrates the limitations of numerical constraints. We have witnessed a tension between the need for simplicity (as expressed by the numerical limit on deficits) and the need to enforce a reasonable policy on an annual basis that leads to a sustainable outcome in the long run.

The problem is that numerical limits on deficits and debt are not sufficiently informative to discipline budgets on an annual basis. Judgment is still required to assess budget proposals. For example, are the macroeconomic forecasts accurate? Are the assumptions about tax revenues correct? Do current budget policies take into account the looming fiscal crisis due to demographic shifts? Government must answer these questions if they are to implement a simple rule.

Combining judgement and discipline: Independent fiscal policy councils

Academics have proposed several ways of bringing “judgment” to numerical rules. Most involve the creation of institutions – often called “independent fiscal policy councils” – to provide the judgment from outside of the realm of politics. Constraints on fiscal discretion imposed, monitored, and enforced by an independent body like a fiscal policy council will produce a superior outcome relative to the current situation.

Examples of these proposals can be found in Wyplosz (2008), von Hagen and Harden (1995) or Fatás, Siebert, Hughes-Hallet, Strauch and von Hagen (2003); some countries have already started moving in this direction (e.g. Chile and Sweden).

In the case of Sweden today, we can see how an independent body can allow for flexibility in times when there is a clear trade-off between sustainability and stabilisation. And if good fiscal behaviour is ensured in good times, the nation has more room for flexibility in bad times. It is too early to proclaim the Swedish example a success, but it is instructive to understand the behaviour of these institutions during crises. Here is a paragraph from the last report of the Fiscal Policy Council (2010):

Swedish fiscal policy also faces a trade-off between long-term sustainability and short-term stabilisation. However, the situation in Sweden differs sharply from that in most other countries… Sweden is also one of the few EU countries that is not subject to an excessive deficit procedure…Sweden has had substantial room for manoeuvre in using fiscal policy as a stabilisation policy instrument in the crisis.

The time for reform is now

Is now the right time to push for the implementation of these proposals, or should Europe wait until the crisis is over? We believe that now is the time for two reasons.

  • First, it seems that in good times there is never sufficient political will to implement the idea.
  • Second, a good institutional framework ensuring fiscal policy sustainability would lessen pressures on governments to produce quick, large, and possibly suboptimal fiscal consolidations to calm the fear of default.

Europe should not waste the current crisis. The time for institutional reform is now.

References

Fatás, Antonio and I. Mihov (2003). "The Case for Restricting Fiscal Policy Discretion" Quarterly Journal of Economics.

Fatás, Antonio, Jurgen von Hagen, Andrew Hughes Hallett , Rolf R Strauch and Anne Sibert (2003), Stability and Growth in Europe: Towards a Better Pact. Monitoring European Integration 13. CEPR.

Fatás, Antonio and I. Mihov (2006). "Restricting Fiscal Policy Discretion: the case of U.S. States" Journal of Public Economics.

IMF (2009), Fiscal Rules – Anchoring Expectations for Sustainable Public Finances. International Monetary Fund, Fiscal Affairs Department.

Larch, Martin and Alessandro Turrini (2008), “Received Wisdom and Beyond: Lessons from Fiscal Consolidations in the EU”, European Economy, Economic Papers No 320.

von Hagen, Jürgen, and Ian Harden (1994) National Budget Processes and Fiscal Performance: European Economy. Reports and Studies 3: 315–418.

Wyplosz, Charles (2008). “Fiscal Policy Councils: Unlovable or just Unloved”, Swedish Economic Policy Review 15.

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Topics:  EU institutions

Tags:  fiscal policy, Eurozone crisis, constrained discretion, Eurozone rescue

Professor of Economics at INSEAD

Professor of Economics, Novartis Chaired Professor of Management and Environment and Dean of Research, INSEAD

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