Do fiscal policymakers know what they are doing? A modern view of the merits and demerits of fiscal activism

Andrew Hughes Hallett, Kerstin Bernoth, John Lewis 14 April 2008

a

A

For more than 40 years, at least since the publication of Dow’s (1964) scathing review of British post-war economic policy, there has been a debate among economists about the wisdom, desirability and effectivess of fiscal policy as a stabilisation tool. Two issues have long dominated this debate: a) whether the discretionary fiscal policies have been countercyclical in practice and b) how strong the automatic stabilising effects are, relative to the discretionary interventions around the cycle or over the longer term.

Both questions stem from uncertainty about the effects of fiscal policy: uncertainty about implementation lags and uncertainties about the size, speed, and maybe even the sign of the impacts when they come. It is entirely possible that a stabilising fiscal action could have its impact later than intended, exaggerating the cycle and turning a downturn into a slump or an upturn into inflation. Similarly, the impacts may be stronger or weaker than anticipated. This has led some to argue that we should rely on the automatic stabilising effects that are built into the tax and unemployment benefit rules of any fiscal system; and deny oneself the right to intervene directly for fear of making things worse rather than better. A succinct and modern view of this argument is given in Taylor (2000).

Another strand of the literature argues that fiscal policy makers are malintentioned or even incompetent. On malintentions, this view contends that fiscal policies are deployed to achieve political and electoral goals, particularly in the larger countries and where monetary discipline has increased or where the central bank has become independent of the political process [see Buti and van den Noord (2004), Hughes Hallett et al (2004)]. That has been the case in nearly all advanced economies in recent years, and one should expect increasing demands for fiscal policy to meet the preferences of local populations as a result. In fact, one should expect rational voters to use the electoral mechanism to drive their governments harder to achieve those goals, even if they conflict with the policies of the central bank [Demertzis et al (2004)].

Concerns about incompetence arise from two factors. First, fiscal objectives may not be aligned with the policymakers’ short-term horizons. Fiscal policies typically have longer run targets (sustainability, low debt), are not easily reversible (public services, social equality), and are not easily used for stabilisation purposes if consistency and credibility is to be maintained. Frequent adjustments and inconsistencies over time or across the government’s stabilisation objectives, can easily give rise to a sense of incompetence (that the policy makers don’t know what they are doing). Second, it is well known (Dixit and Lambertini, 2003) that monetary policy cannot be committed with any credibility if fiscal policies cannot be committed at the same time. It is not hard to find ways to pre-commit fiscal policies1; but in their absence opportunistic changes will occur and may undermine other policies. Whether this is really incompetence, or just opportunistic behaviour, is a moot point.

A new approach to old questions

The new development that enables us to answer some of these questions is the use of real-time data. If the goal is to discover what the policy makers were trying to achieve (as opposed to what ended up happening as a result of their decisions), we must use the data that the policy makers had at their disposal at the time, not the ex-post data which shows what happened afterwards. That distinction has been applied to monetary policy by Orphanides (2001) and has spawned a considerable literature. But its application to fiscal policy is new. This emerging literature seems to be showing that the discrepancy between what the policy makers have tried to do, and the final outcomes, is larger in the fiscal policy case.

A common finding in the older literature based on ex-post data is that discretionary fiscal policies have been pro- or acyclical2. From this it is usually concluded that the policy makers are, for myopic reasons, or for electoral or opportunistic reasons, not really concerned with counteracting the cycle3, and in any case not very interested in following a path consistent with monetary discipline or long-term public expenditure plans. However, this may be a non-sequiteur. It could be that fiscal policy makers are neither ill-intentioned nor incomptetent but merely misinformed. That is, they are trying to run counter-cylical fiscal policies, but have been unable to do so because of the limitations of real-time data.

A real-time data set allows us to test which of these hypotheses is correct. If the problem is one of ill-intentions or opportunism, then the real-time reaction functions will look a lot like their ex-post counterparts. But if the problem is misinformation then the real-time functions will reveal countercyclical responses not evident in the ex-post functions.Using fiscal policy reaction functions for 14 EU countries over the period 1994-2006, we find that pro/acyclicality only arises in the ex-post data, not in the real-time data, which suggest countercyclical policies (Bernoth et al,2008). In that case, the lack of (ex-post) countercyclicality must have been caused by misinformation rather than mal-intentions. It seems that the policy makers tried to be countercylical, but were defeated by the inherent uncertainty and inaccuracies in estimating the state of the economy and its trend or potential output level.

A second consequence of this approach is that we can use a combination of ex-post and real-time data to separate out the automatic fiscal adjustments from the “active” or dis-cretionary interventions at any point around the cycle. Conventionally this is done by using ex-post data to derive cyclically adjusted budget figures from estimates of trend or potential output. But the latter estimates are notoriously unreliable, and typically heavily dependent on the detrending technique chosen (Canova 1998). Simply smoothing the deficit time series may smooth away some of the short term cyclical responses. In add-ition, if the cycle is incomplete or incorrectly estimated it would inappropriate to assume that the “cyclical” components must add to zero over the sample. Conventional methods would therefore tend to overestimate the degree of automatic stabilisation.

Using real-time data we can utilise a different method altogether. Specifically, we exploit the property that discretionary policy has to respond to the real-time output gap, whereas the automatic tax and benefit/expenditure flows react to the ex-post output level. Using ex-post budget data to estimate the latter, and the sum of discretionary and automatic interventions to obtain the combined effect, we get the former by subtraction. We find, as expected, the automatic effects to be small: about 20 cents on the Euro, as opposed to 35 to 50 cents as conventionally estimated (HMT 2003, EC 2002). This is important because it means that a policy or relying on automatic stabilisers to stabilise output (Buti et al 1998, van den Noord 2000) is unlikely to be helpful or sufficiently stabilising. That may go some way to explaining why the stability pact proved to be ineffective.

Third, the evident unreliability of real-time data for predicting the eventual outcomes of fiscal policy must imply that fiscal oversight, as an early warning device, is far more problematic than originally thought. Tests on the Stability Pact’s 3% deficit limit, on the European Commission’s “close to balance or in surplus” criterion, and on their 0.5% improvement critrion, showed that errors in the real-time data (which the policy authorities must perforce use) created as many false alarms or missed alarms as genuine alarms. This means those in charge will miss as many offenders as they catch; and that they will be crying wolf as often as they catch an offender [Hughes Hallett et al, 2007]. In the long run, such a control device can have no credibility. It is no surprise to find that Jonung and Larch (2006), Buti and van den Noord (2004), and Pina and Venes (2007) all report evidence that output forecasts are routinely biased to present an overly optimistic picture of the state of public finances; game theory says policy makers would naturally do this to give themselves extra room to overstep the fiscal restrictions. It seems ill-intentions are indeed present in fiscal policy making, but they survive in the forecasts of the fiscal position (which are harder to police) rather than in the fiscal actions as such.

References

Alesina, A., and G. Tabellini (2005), “Why is Fiscal Policy Often Procyclical”, NBER Working Paper 11600, Cambridge, MA.
Balassone, F. and M. Francese (2004), “Cyclical Asymmetry in Fiscal Policy, Debt Accumulation and the Treaty of Maastricht”, Bank of Italy, Temi di discussione, No.531, Rome.
Ballabriga, F. and C. Martinez-Mongay (2003). Has EMU shifted monetary and fiscal policies?. In Marco Buti (Ed.). Monetary and Fiscal policies in EMU. Interactions and Coordination. Cambridge: Cambridge University Press.
Bernoth, K., Hughes Hallett, A. and J. Lewis (2008) “Did Fiscal Policymakers Know What They Were Doing?”, CEPR Discussion Paper 6758
Buti, M. and P. van den Noord (2004), “Fiscal Discretion and Elections in the Early Years of EMU”, Journal of Common Market Studies 39 (4), 737-56.
Buti M, D Franco and H Odegna (1998) “Fiscal Discipline and Flexibility in EMU: an Implementation of the Stability and Growth Pact”, Oxford Review of Economic Policy, 14, 81-97.
Canova, F. (1998), “Detrending and Business Cycle Facts”, Journal of Monetary Economics, 41(3), 475-512.
CEPII (2005), “Has the Stability and Growth Pact Made Fiscal Policy More Pro-Cyclical?”, La Lettre du CEPII, No. 247.
Demertzis, M., A. Hughes Hallett, and N. Viegi (2004), “An Independent Central Bank faced with Elected Governments: A Political Economy Conflict”, European Journal of Political Economy 20:4, 907-922.
Dixit A, and L. Lambertini (2003) “Interactions of Commitment and Discretion in Monetary and Fiscal Policies,” American Economic Review, 93(5), 1522-1542.
Dow J. C. R. (1964), The Management of the British Economy 1945-60, Cambridge: Cambridge University Press.
European Commission (EC 2002) Public Finances in EMU:2. European Economy: Studies and Reports 4, European Commission, Brussels
Galí, J. and R. Perotti (2003), “Fiscal policy and monetary integration in Europe”, Economic Policy, 18, 533-572.
HMT (2003) “Fiscal Stabilisation and EMU”, HM Stationary Office, Cmnd 799373, Norwich; also available from www.hm-treasury.gov.uk
Hughes Hallett A., J. Lewis and J. von Hagen (2004) Fiscal Policy in Europe 1991-2003: an Evidence Based Analysis, An Evidence Network Report, Centre for Economic Policy Research, London.
Hughes Hallett, A., R. Kattai, J. Lewis (2007) “Early Warning or Just Wise After the Event? The problem of Using Cyclically Adjusted Budget Balances for Fiscal Surveillance in Real Time”, Nederlandsche Bank, Working Paper 124, Amsterdam.
Hughes Hallett, A (2008), “Coordination without Explicit Cooperation: Monetary-Fiscal Interactions in an Era of Demographic Change” European Economy: Economic Papers 305, European Commission.
IMF (2004), World Economic Outlook 74, Washington DC.
Jonung, L. and M. Larch (2006), “Improving fiscal policy in the EU: the case for independent forecasts”, Economic Policy 21 (47), 491-534.
Orphanides, A. (2001), “Monetary Policy Rules Based on Real-Time Data”, American Economic Review, 91, 964-985.
Pina, A. and N. Venes (2007). The Political Economy of EDP Fiscal Forecasts:An Empirical Assessment, Working Paper, WP/023/2007/DE/UECE, ISEG/Technical University of Lisbon.
Taylor, J. (2000), “Reassessing Discretionary Fiscal Policy”, Journal of Economic Perspectives 14(3), 21-36.
Van den Noord, P. (2000), “The Size and Role of Automatic Fiscal Stabilisers in the 1990s and Beyond”, OECD Economics Department Working Papers No. 230.
Wyploz C. (2006) “European Monetary Union: the Dark sides of a Major Success”, Economic Policy, 21 (46), 207-61.


Footnotes

1 See for example Hughes Hallett (2008)
2 See Gali and Perotti (2003), IMF (2004), CEPII(2005), Wyplosz (2006), Balassone and Francese (2004), or Ballabriga and Martinez-Mongay(2002) for the most recent illustrations of that result.
3 Alesina and Tabelini (2005) have a political economy model of why policy makers may prefer pro/acyclical policies.

 

a

A

Topics:  Macroeconomic policy

Tags:  fiscal policy, activism

Professor of Economics and Public Policy, George Mason University and CEPR Research Fellow

Economics and Research Division, De Nederlandsche Bank

Economist in the Research Department at De Nederlandsche Bank

Events

CEPR Policy Research