Searching for New Rules of Fiscal Policy
Since 1995 at least, there has been a continuous decline in real interest rates, which are unlikely to return to pre-crisis levels (see e.g. Gottfries and Teulings 2015 for the United States and Europe and Fujita and Fujiwara 2016 for Japan).[76] The causes of this decline range from increased global savings and a reduction in global demand for investment to changes in potential output and productivity growth.
Regardless of the cause, the decline raises difficulties for conventional monetary policy. The need for either unconventional measures and/or fiscal policy then arises.17
On the side of the latter, the impending issues deriving from high public debt have raised the need for revising the rules limiting fiscal policy and devising more proper ones. We are used to speaking of fiscal policy in terms of public balances and debt. However, neither of these variables is a policy instrument. Both are endogenous, as their values depend on the effects on GDP of the true fiscal tools (e.g. tax rates). In addition, both are usually assessed not in absolute terms but rather in relation to the GDP itself or to other indicators such as - for the value of debt - the value of total financial assets.
Projections of these ratios are to be considered from both short- and long-term perspectives. The short-term perspective is certainly useful and is the one that often determines fiscal action, but it can be misunderstanding if its future positive or negative consequences on GDP growth are neglected. Thus, the short- and long-term perspectives must be balanced against each other by considering the consequences of each policy for both. First, fiscal stimulus has a positive short-run impact and from this point of view can improve growth if its short-run effects are high enough to have a positive impact on fiscal sustainability. This is especially true when fiscal policy is accompanied by monetary policy constrained at the ZLB, as output can rise more than debt, which is not overburdened by positive interest rates.
Financial markets have an ambiguous role in this respect, which is, however, important, considering the increased space assigned to - or taken by - them in recent decades. In fact, on the one hand, their tendency to reap shortterm benefits can raise doubts about the consistency of this conduct with long-term projections and sentiments. On the other hand, even if their telescopic ability can be questioned, they could set the market sentiments in proper perspective, considering also the positive outlook that should derive from a future growth that is higher for output than for debt. Moreover, this very short-term conduct can negatively influence long-term outcomes.18
Obviously, a rise in the budget deficit could not be accepted if it depended not on the choices of a benevolent policymaker but rather on politicians’ profligacy. Ensuring this principle motivates suggestions about rules and institutions (including the introduction of fiscal councils) in order to constrain their action. In addition, the issue of how to complement fiscal policy with other policy tools arises from the perspective of containing public debt and other policy objectives (see Section 5.5).
The following subsections deal with the proper yardstick to assess public deficits from a long-term perspective (Section 5.4.1) and to discuss golden rules for the budget and debt target rules as an alternative to more common rules in terms of deficit (Section 5.4.2). Section 5.4.3 investigates the proposal to institute fiscal councils to monitor public finances.
5.4.1 RulesforPublicBudgets
Economic research has developed an analysis of public finances that, together with that of macroeconomic disequi- libria, describes how a benevolent policymaker might use fiscal policy to respond to economic shocks that affect government debt levels, both directly and indirectly.[77] The balance between the short- and long-run implications of budget policy is rather delicate. In particular, after a negative external shock and a deliberate expansionary budget policy, returning debt to its previous level should be undertaken only slowly and carefully, as we have seen in Section 3.8.
As mentioned earlier, we want to describe the policies that would be undertaken by a benevolent policymaker who is able to make credible promises on future behaviour. In the real world, fiscal policy is typically implemented by governments facing the constraints and the incentives of the political process. For a number of reasons, this may result in a ‘deficit bias', which accounts at least in part for the rising government debt levels in many economies. Recognising the costs of such bias, it may be advisable to tie the discretionary hands of politicians by adopting some type of fiscal rule, which typically requires debt or deficits to be stabilised over relatively short time horizons.
A number of different fiscal rules could be applied. For example:
1. Balanced Budget Rules (which include the European Union's Stability and Growth Pact (SGP) and fiscal compact and can be applied to nominal or structural deficits). Recalling the endogeneity of deficits and debt, the government has only imperfect control over them. One consequence of this is that strict deficit rules are often violated, even in the absence of irresponsible or undisciplined policymakers, especially if correction is required in each year. Monitoring structural deficits (deficits averaged across the cycle), instead, has its own problems, given the difficulty of measuring potential output accurately, which requires measuring the cyclical budget deviations. Rules of this type can be manipulated or be the object of quarrels and lack credibility.
A variant of this rule is the ‘golden rule of deficit financing'. This prescribes that current revenues must match current spending over the cycle. Borrowing is permitted only to fund public investment.[78] As a consequence, growth can be enhanced, and both stability of public finances and a fair distribution of the fiscal burden will be ensured if certain conditions are met. Public investment should generate a rate of return at least equal - or in any case similar - to the private rate.
This condition is satisfied depending, on the one hand, on monetary policy reaction and the crowding-out effect and, on the other hand, on the human capital and the externalities created by public investment. The golden rule was implemented in the United Kingdom in 1997 and has been abandoned recently (2009).2. Expenditure Rules, i.e. limits on current spending in aggregate, limits to its growth, or limits in terms of a percentage of GDP or productivity. These may constrain the size of government and its fiscal agenda but will not necessarily achieve sustainable public finances unless a parallel rule places a floor under revenues and a ceiling on debt at the same time. This risks imposing costly austerity and deflationary policies at the same time.
3. Revenue Rules. These are even less easy to use. The difficulty is that revenues are both endogenous and more sensitive than spending to the state of the economy. Hence, revenues can easily collapse in a downturn when they are needed most: for example, when the budget comes under pressure in a recession, or when tax rises cause output to shrink yet further, or when austerity policies are imposed.
4. Debt Rules and Debt Targets. These imply a primary deficit control rule that needs to be agreed on in order to maintain fiscal sustainability over the medium to long term; we will deal with them in greater detail in the next subsection.
5.4.2 DebtTargetRules
Taking the steady-state level of debt out of a rule designed to maximise the rate of economic growth, subject to the golden rule of deficit financing, supplies an optimal debt target. This depends in particular on the marginal product of public capital and the discount rate. The lower the latter is, the higher is the optimal value of debt (Furman 2016). Given the tendency towards a reduction in interest rates, the optimal debt value should rise with respect to the computations of past years.
As discussed earlier, primary deficit and debt target rules could be designed in relation to the objective of maximising the rate of economic growth.
This would preserve the principle of gradual adjustments. Sustainability is then secured by a primary surplus or deficit set above the growth-adjusted level of interest payments. The degree to which that primary surplus/ deficit exceeds this threshold determines the speed of return to the debt target and hence the debt ceiling that can be tolerated before collapse. There are both benefits and costs for this approach. On the side of the former, there is first the argument that debt, unlike deficit, represents a stock, not a flow. Even if both variables are endogenous with respect to the cycle, the stock nature of debt introduces persistence in the target variable, especially in countries with high levels of public debt. Debt targets therefore can be used to pre-commit or anchor fiscal policies to a path with sustainable public finances without impairing short-run fiscal action as an effect of the flexibility ensured by the existence of a debt ceiling. Second, debt targets focus on the ultimate risk: unsustainable public finances. They should be calculated in a way to maximise the rate of economic growth, taking into account a number of variables, among which are the different productivity of public and private capital, population parameters and age-related spending.[79]21
Moreover, debt rules can have the advantage of letting automatic stabilisers operate, thus also reducing the administrative lags that impair a prompt response of discretionary fiscal policy to situations of crisis where automatic stabilisers are weak. This is the case for the United States, where this weakness places ‘much of the burden for fiscal stimulus on a political system that can be sclerotic on fiscal policy at best’, even if the fiscal system has become more progressive and universal health insurance has been established (Furman 2016: 13). In Europe, the action of automatic stabilisers is impaired by the limits introduced by the SGP and the fiscal compact, especially for some countries, such as Denmark and Sweden.
In addition to a debt target, which is the reference value for debt sustainability in the long run, a level of debt allowing for flexibility of public finances for short-term management should be set at a value that is a little higher than the debt target, ensuring an absence of fatigue or poorly sustainable policies, i.e. a debt ceiling. The space between debt target and debt ceiling then allows policymakers to absorb shocks to fiscal balances, i.e. to trade off good years against bad, conferring flexibility to action for its management. Also, because the target is a stock not a flow, this produces a structural balance rule without having to calculate accurate cyclically adjusted deficit figures. The space between the debt target and the highest permitted value will then allow debt ratios to rise in the bad years (also leaving space for costly structural reforms that could violate the rules of fiscal balances or solvency) but promote an automatic return in good years. This gives us the flexibility to contain shocks without sacrificing the discipline of monetary policy or stable public finances. Ruling out money growth, the rule to obey to stabilise the debt ratio should be (5-²) Pd = (g - r)d
where the symbols mean, respectively, primary public deficit, growth rate, real interest rate and current level of the debt/GDP ratio.
A balanced budget rule is neither necessary nor sufficient to this end. The primary budget can be positive or negative and can be geared according to the difference between the growth rate, the real interest rate and the initial value of the debt/GDP ratio. Otherwise, the debt burden will rise. Notice that neither the European Union's fiscal compact nor the United Kingdom's new Debt Commission Rule satisfy (5.1). These rules have created too much austerity, and the debt/GDP ratio has increased as an effect of their implementation (see Section 3.8).
On the side of the costs of this rule, it should be said that the level of sustainable debt (like that of potential growth, on which structural deficits depend) is also to some extent debatable, as it can be calculated only if the marginal product of public capital deriving from public investment can be identified with some reasonable approximation.
One implication of these observations is that it is easier to reduce a debt burden, or prevent its further increases, if r is reduced or if g is increased - the more so the larger is the existing debt burden d. In the Euro area at least, reducing r is problematic because monetary policy does not lie within the control of governments but pertains to an independent entity. However, debt restructuring, or announcements of aggressive moves to reduce budget deficits, will, if credible, lead financial markets to suppose that future financing requirements will fall and that the risk premia currently imposed need not be imposed on future borrowing. This would be a slow process because r refers to the average interest paid on existing debt, whereas reduced risk premia or interest rates would apply only to new or refinanced debt.
The alternative, raising g, seems more attractive. The growth rate is not a policy instrument. However, the government can influence g through public investment and structural reforms. The usual approach is to take steps to reduce the size of the public sector via wage and employment reductions; reduce the non-wage costs imposed on employers (shifting them onto employees; or using reforms to pensions or other benefit schemes to lighten the contributions levied on employers). Alternatively, we can reform the tax system to shift the burden from income, profits and employment taxes to consumption taxes or user costs; and introduce measures to encourage the private sector to limit wage settlements or increase productivity and R&D. The reductions in unit labour costs will lower domestic prices relative to competing economies (a real devaluation). Finally, public investment should be raised, in particular by creating infrastructures useful to give incentives to private investment, notably for energy, education and research. Private investment, instead of being crowded out by public expenditures, could indeed be crowded in not only for the positive effects of these policies on growth but also because of interest rates being stuck to the ZLB or, in any case, monetary policy being expansionary (Furman 2016).[80]
At this point, an analysis of alternative fiscal settings cannot omit mention of federal structures, where there is a federal fiscal authority insuring states against asymmetric regional shocks. This is done if a proportional (or, better, a progressive) income tax accruing to this authority, accompanied by cyclical (or, better, countercyclical) expenditures and transfers, can compensate the states (or regions) hit by a negative shock. The disadvantage of the states, in a nonfederal government, of having to accumulate debt incurred in a sovereign debt crisis thus would be avoided. Federalism would ensure that a currency area, possibly not satisfying the requirements of an optimal one, will survive asymmetric shocks.[81]
With reference to the United States, Sachs and Sala-i-Martin (1992) found that a one-dollar reduction in a region's per-capita personal income can trigger a reduction in federal taxes of about 34 cents, together with an increase in federal transfers of about 6 cents, i.e. a net federal contribution to disposable per-capita income of states between 33 and 50 per cent.
More recent studies have assessed the differential impact of a federal union on regions as a consequence of the asymmetric shock that hit Europe. Among them, Darvas (2010) underlines that federalism would have boosted confidence of the private sector and the political coherence of the Euro area and given scope for greater redistribution, risk sharing and a federal countercyclical fiscal policy to counteract the negative effect of consolidation in indebted countries (states). However, a note of caution on the absolute superiority of a federal design comes from Darvas himself, drawing on Aizenman and Pasricha (2010), as moral hazard about countercyclical fiscal policy also has been a major consideration in the United States. In fact, moral hazard can derive from common-pool and competitive borrowing considerations by states expecting a federal government bailout when needed; at the federal level, doubts can arise as to debt sustainability in the absence of plans for consolidation.
Henning and Kessler (2012) emphasise that any brake established on state budgets, as the Euro zone has done with the fiscal compact, being pro-cyclical, is not sustainable without a countervailing stabilisation action at the European Union's level, which needs a sufficiently high level of the central budget. In other words, any rigidity brought at the lower level that also limits the operation of automatic stabilisers should be compensated by flexibility at the higher level. From this point of view, the case of the United States is of particular relevance.
5.4.3 The Issue of Fiscal Policy Councils
Institutions responsible for monitoring the economic health of the world's larger economies (IMF, European Commission) have recommended that politicians place themselves under the scrutiny of an independent fiscal council. Such monitoring can remind policymakers of the need to take account of the long-run sustainability of public and private finances. A fiscal council would highlight this whenever the policies being pursued look likely to endanger that sustainability. The key point is that this monitoring has to be forward looking. The purpose of this type of fiscal council would be to increase credibility and commitment to a set of sustainable fiscal policies and to make politically neutral monitoring available to the economy as a whole.
The Swedish Fiscal Policy Council has a mandate to comment on and recommend improvements to existing policies, especially when there is a risk of unsustainable levels of public debt or extreme tax liabilities or when there is a chance to reach those targets more cheaply. Where necessary, it can ask for explanations of and justifications for certain types of communications and recommend improvements to them. In practice, it has availeditself of the chance to do so (Calmfors 2012). The Swedish Fiscal Policy Council is also asked to examine the prospects for growth, employment, income distribution and structural reform programmes.
The United Kingdom’s Office of Budget Responsibility is asked to provide independent forecasts of future fiscal revenues and budget positions, including the implications for growth and employment that may affect the fiscal position. It may use its own data and assumptions but only in the Treasury/Her Majesty’s Revenue and Customs (HMRC) models. It may not examine or comment on the other targets of economic policy or the merits of alternative policies. The accent here is on forecasting rather than policy efficiency. Neither this agency nor the Swedish council is allowed to be involved in policy advocacy.
Reduced tasks are assigned to the European Fiscal Board, established in October 2016, whose terms of reference are to evaluate the implementation of EU fiscal rules, to advise the European Commission on the fiscal stance appropriate for the Euro area as a whole, to cooperate with Member States' national fiscal councils and, upon request, to provide ad hoc advice on fiscal matters to the EC.
An important caveat must be added. First, adding this institution to the fiscal budget office, while supplying independent advice, also introduces another debatable source of information, as an assessment of debt sustainability now would come from two sources. It is true that one can be biased. However, no such assessment can be objective. In the end, sustainability assessments and policies are policymakers' responsibility. With respect to this, the argument can be raised as to the possibly short time horizon of governments' duration with respect to the time span needed to ascertain debt sustainability. The solution to this is twofold. On the one hand, institutional arrangements that warrant a sufficient length of duration of governments should be devised. On the other, citizens should be in a position to assess politicians' conduct and performance, which again is a task of optimal institutions, an issue we will return to in subsequent chapters.
Some independent researchers have suggested institution of fiscal councils as a way for ensuring ‘fine tuning'. They would suggest short-term adjustments to the budget, whereas democratically elected authorities would be responsible for the ‘coarse tuning' of fiscal policy (Wren-Lewis 2003; Arestis 2009).[82]
5.5