Fiscal Rules – Help or hindrance?

Posted by Anis Chowdhury on 4 October 2012

Anis Chowdhury (United Nations Economic and Social Commissions for Asia and the Pacific) and Iyanatul Islam (International Labour Organization).

A fiscal rule represents legislated and long-term numerical limits on budgetary aggregates pertaining to debts, deficits, expenditures and revenues. In a recent IMF working paper1, Schaechter et al (2012) have reported on a database of fiscal rules in use around the world. It shows an increasing number of countries adopting some kind of fiscal rules since the early 1990s. In 1990, only five countries—Germany, Indonesia, Japan, Luxembourg, and the United States—had fiscal rules that covered at least the central government level. That number surged to 45 by March 2012. If both central and regional/provincial governments are considered, then 81 countries were found to have some kind of fiscal rules.2

Providing a credible medium-term anchor to fiscal policy seems to be the obvious motive for adopting or strengthening fiscal rules after the 2008-2009 financial crisis. An additional reason is the need to support currency unions, especially the Euro zone which is threatened by serious debt crises in a number of member countries. The proponents of fiscal rules base their arguments on fiscal or debt sustainability and credibility of fiscal policy. By restraining expenditure or overall deficits, it is argued that fiscal rules keep public debt within a sustainable level and hence improve the credibility of the fiscal authority in the eyes of financial markets from where a sovereign authority has to borrow. The IMF’s Fiscal Affairs Department paper (2009, p. 4) notes, “The credibility of the needed fiscal adjustment will be essential to anchor longer-run expectations about government solvency.”3

While the argument is very appealing, especially when a good number of advanced countries are currently facing debt crises and forced to borrow at high interest rates, this commentary aims to highlight some likely deleterious consequences of such rule-based policy making. They can pose a risk to democracy and development.4

First, the underlying philosophical rationale for fiscal rules lies in the distrust of politicians or governments as can be found in an earlier IMF working paper by Koptis (2001)5. The author interprets fiscal rules as potential instruments to depoliticize the policy framework. Schaechter et al, (2012) also observe that fiscal rules are important for “correcting distorted incentives and containing pressures to overspend, in particular in good times, so as to ensure fiscal responsibility and debt sustainability”. Fiscal rules, as in the case of independent central banks operating within an inflation targeting framework, are seen by its advocates as necessary to enhance the credibility of macroeconomic policies by removing discretionary intervention of politicians.6

If the intention is to remove discretion from politicians, then how can they implement their election manifestos? The national budget is an important instrument for fulfilling promises made by political parties. By removing this instrument, fiscal rules can potentially undermine accountable governance, especially in new democracies. Therefore, one may ask, “credibility for whom” – electorates or financial markets? Thus, by trying to enhance the credibility of governments in the eyes of financial markets, fiscal rules can undermine the credibility of a democratic polity.

Fiscal rules can also distort political discourse, as elections are fought on the agenda of debts and deficits. As parties or presidential candidates try to out-bid each other on their credibility with regard to “sound” finance, the political debate becomes narrowly focused. Electorates are presented with a choice to elect a party or candidate based on who can convince them in being more committed to cutting expenditure, instead of who has a better social or economic programme for the country.

Fiscal rules are likely to reflect the visions or manifestos of the party in power at the time these rules are legislated and would disadvantage the party that may form a government at a later date. In theory, this bias can be circumvented if rules are based on some international norms, but this would vitiate the principle of designing fiscal rules in line with country-specific circumstances.

As noted, the main aim of fiscal rules reviewed in Schaechter et al is solvency and sustainability. The guidelines for the fiscal rules developed by the IMF’s Fiscal Affairs Department (2009) are aimed at developing credible strategies to strengthen public finances. They basically relate to budgetary aggregates and follow accounting rules of balancing government revenue and expenditure over a medium term in a double-entry book-keeping framework without due consideration for the composition of government expenditure. Thus, this ignores fiscal policies’ developmental role. It is assumed that fiscal solvency and sustainability is both a necessary and sufficient condition for growth and poverty reduction.

This view is influenced – at least implicitly - by the belief that fiscal deficits crowd out private investment and/or are offset by increased savings by private agents in anticipation of future tax burden (the so-called Ricardian equivalence theory). Hence fiscal policy is ineffective in influencing aggregate output and employment. But none of these propositions have any robust empirical basis, especially in developing countries.7

However, the solvency and stabilization view still dominates policy discourse. As the ECB notes, “Upholding trust in the soundness of public finances enhances confidence among all economic agents and thereby contributes to sustainable growth in consumption and investment.” (ECB Bulletin, November, 2003, p. 6). This raises a fundamental question, whether the policy-making process should become hostage to the “confidence game” in which evidence-based policy-making is replaced by a band of amateur psychologists seeking to read the collective mood of financial markets. When this happens, fundamental macroeconomic policy errors are likely to be committed with serious consequences for poverty and development, as the mishandling of the 1997 Asian financial crisis by international financial institutions has shown.8

So-called bench-marks, such as public debt limits of 60% of GDP for advanced countries and 40% of GDP for developing countries, are not rooted in any widely accepted theory of optimal debt. For example, the 60% limit was based on the median public debt levels at the time of the framing of the Maastricht Treaty. In fact, the authors of a recent IMF study on fiscal space go to great lengths in emphasizing that the debt limit found in their research “is not an absolute and immutable barrier ... Nor should the limit be interpreted as being the optimal level of public debt.”9 According to this study of 23 advanced countries, the estimated debt limits, using the historical interest rate–growth rate differential, range from about 150 to 260% of GDP, with a median of 192%. The authors suggest that, for prudential reasons, governments should aim for fiscal targets ‘well below’ the estimated debt limit, but do not provide numerical magnitudes. It is noteworthy that the study finds that ‘de jure’ fiscal rules have a ‘statistically insignificant’ impact on ‘fiscal reaction functions’.10

There is an IMF study that recommends an external debt limit of 40% of GDP for developing countries. Yet, it emphasizes that “a debt ratio above 40 percent of GDP by no means necessarily implies a crisis – indeed … there is an 80 percent probability of not having a crisis (even when the debt ratio exceeds 40 percent of GDP).”11

Macroeconomic stability is necessary for growth, but it is not sufficient. The Development Committee of the IMF and the World Bank in its 2006 report drew attention to the forgotten fact that in a development context, fiscal policy is not only an instrument of macroeconomic stabilization, but also an instrument to achieve growth and poverty reduction objectives. Therefore, “the design of fiscal policy needs to identify and also incorporate the transmission channels through which fiscal policy influences long-term growth. This requires that attention be focused on the likely growth effects of the level, composition and efficiency of public spending and taxation. Fiscal policy that neglects these effects runs the risk of achieving stability while potentially undermining long-term growth and poverty reduction…. The fiscal deficit is a useful indicator for purposes of stabilization and for controlling the growth of government liabilities, but it offers little indication of longer term effects on government assets or on economic growth” (Development Committee, 2006, p. i).12

If fiscal policy is designed following the above principle to ensure that fiscal policy serves its growth objective, then it can also address the sustainability and solvency problem. This was pointed out more than half a century ago by Evsey Domar (1944).13 This principle would also imply abandoning the accounting concept of “sound” finance and embracing the developmental concept of “functional” finance as argued by Abba Lerner in the 1940s.14 Had the European governments worried about deficits and debts, they could not rebuild Europe from the ruins of war, nor could they build welfare states that blunted the appeal of socialism and helped consolidate democracy.

As a concluding observation, it is worth reiterating that the literature on fiscal rules completely ignores the financial imperatives of meeting core development goals. These goals might be national adaptations of the Millennium Development Goals (MDGs) and/or the social protection floor initiative adopted by the UN system in 2009. The available empirical evidence suggests that without a determined resource mobilization strategy, there will be significantly unmet financing needs in developing countries.15 It also appears that fiscal policy loses its capacity to combat inequality if it is de-linked from a developmentally-oriented strategy of raising revenues on a sustainable basis and in improving the benefit incidence of tax and spending instruments.16

Authors' note: Views expressed herein are personal and do not reflect the views of the UN or any of its agencies.

1 Schaechter, Andrea, Tidiane Kinda, Nina Budina, and Anke Weber (2012), “Fiscal Rules in Response to the Crisis—Toward the ‘Next-Generation’ Rules. A New Dataset”, IMF Working Paper, WP/12/187
2 However, five countries (Argentina, Canada, Iceland, India, and Russia) no longer had a fiscal rule in effect at end-March 2012. So, the number of countries with a fiscal rule stands at 76. Schaechter et al (2012) summarized pros and cons of different kinds of fiscal rules and find that new generation of fiscal rules with escape clauses are complex.
3 IMF (2009), “Fiscal Rules—Anchoring Expectations for Sustainable Public Finances”, Fiscal Affairs Department
4 Critics of first generation fiscal rules often point out the danger of rigidity; i.e. fiscal rules constrain governments from responding to extra-ordinary circumstances such as natural disasters or external shocks or financial sector crises. However, the new generation fiscal rules, especially those designed in the wake of the recent financial crisis, do include escape clauses. The problem here is that fiscal rules with escape clauses, especially when the “extra-ordinary” situations are not well defined or try to cover all conceivable future events, they become complex and hence loses their credibility defeating the very purpose of them. Hence the IMF seems to prefer a simple rule, “…so that it can be readily operationalized, communicated to the public, and monitored” (IMF, 2009: 4).
5 Kopits, George (2001), “Fiscal Rules: Useful Policy Framework or Unnecessary Ornaments?, IMF working paper WP/01/145
6 While fiscal rules in countries such as Germany or Indonesia were motivated by their experience of hyper inflation caused by excessive government expenditure financed by printing money, the empirical rationale for recent enthusiasm perhaps can be traced to Dornbusch, Rudiger and Sebastian Edwards (1990), “The Macroeconomics of Populism in Latin America”. Journal of Development Economics 32:247-277, which attributed the Latin American debt crisis in the 1980s to profligate governments driven by populist policies, although the crisis was due to much more complex reasons. To begin with, oil shocks of the 1970s forced the Latin American governments, like others, to borrow. They also found commercial banks in the US, flushed with money deposited by oil exporting countries, too eager to lend at cheap rates. The debt crisis was triggered by sudden and steep rise of interest rates in the US and the UK due to fight inflation first policies of President Reagan and Prime Minister Thatcher. The theoretical rationale for rule-based policy came from the work of institutional economists, such as Douglas North.
7 See Hemming, Richard, Michael Kell and Selma Mahfouz (2002). “The effectiveness of fiscal policy in stimulating economic activity – a review of the literature”, IMF Working Paper, WP/02/2002.
8 Krugman, Paul (2002). The Return of Depression Economics, New York: Penguin Books.
9 Ostry, Jonathan, Atish R. Ghosh, Jun I. Kim, and Mahvash Qureshi (2010). “Fiscal Space”, IMF Staff Position Paper, SPN/10/11, September 1(p.3).
10 Ostry et al (2010, pp. 10-11)
11 IMF (2002). “Assessing sustainability”, May 28, Washington D.C, p. 25
12 Development Committee (2006), “Fiscal Policy for Growth and Development: An Interim Report”.  Prepared by Poverty Reduction and Economic Management, World Bank
13 Domar, Evsey (1944), “The ‘burden of the debt’ and the national income”. American Economic Review,
34(4): 798-827. Also see, Domar, Evsey (1993), “On deficits and debt.” American Journal of Economics and Sociology. 52(4): 475-478
14 Lerner, Abba (1943), “Functional finance and the federal debt” Social Research, 10(1): 38-57
15 ILO (2009) Social Security for All, Social Security Policy Briefings, Paper No.7, Geneva; Markandya, A. Setboonsarng, S., Yu Hui, Q., Songkranok, R., and Stefan A. (2010) ‘The Costs of Achieving the Millennium Development Goals through Adopting Organic Agriculture’ ADBI Working Paper Series No. 192
16 Bastagli, Francesca, Coady, David, Gupta, Sanjeev (2012) ‘Income Inequality and Fiscal Policy’, IMF Staff Discussion Note, September 27, SDN/12/08