Academic journal article National Institute Economic Review

Fiscal Policy: Institutions versus Rules

Academic journal article National Institute Economic Review

Fiscal Policy: Institutions versus Rules

Article excerpt

Fiscal discipline is as much needed as monetary discipline. Many countries have attempted to counter the deficit bias by adopting fiscal rules that typically set a limit to their annual budget deficits. The record is not satisfactory: rules are either too lax or too tight and then ignored. This article suggests that the solution is to adopt the approach followed by inflation targeting central banks, with great success. Independent and accountable Fiscal Policy Committees, given the task of achieving debt targets and the authority to decide--or recommend--annual deficits, will be free from the deficit bias. This will allow them to exercise discretion in the short run while delivering debt sustainability in the long run.

Key words: Fiscal policy; policy rules; public debts; policy institutions; time inconsistency.

JEL classification: E61, H62

I. Introduction

Faith in the ability of macroeconomic policies effectively to erase business cycles has long been oscillating. From the enthusiastic hopes of the 1960s that we could erase business cycles (Tobm, 1972) to the view of the 1980s that policies are ineffectual, (1) the pendulum seems to be moving to an intermediate position that emphasises incentives and institutions.

This evolution can be traced back both to facts and academic research. Double-digit inflation and record levels of peacetime public debts have exposed the excesses of unconstrained policymaking and prompted a rejection of activism. Academic research has exposed the limits of discretion following the discovery by Kydland and Prescott (1977) of the phenomenon of time inconsistency. In parallel, the effectiveness of macroeconomic policies has been questioned. In the field of monetary policy, Lucas (1972) and Sargent and Wallace (1975) have concluded that "only unanticipated money matters". In the field of fiscal policy, Barro (1974) established the principle of Ricardian equivalence which denies any stabilising role to discretionary actions.

Both results have been questioned. Clarida et al. (1999) and Woodford (2003) have shown theoretically and empirically that systematic monetary policy can be effective without necessarily leading to high inflation. The verdict on Ricardian equivalence remains largely undecided after a massive research effort spread over more than two decades. (2) On the theory side, the assumptions required for fiscal policy to be ineffective are too demanding to be met in practice. (3) Ricardian equivalence fails in the presence of such realistic features as uncertain lifetime, non-altruistic bequest motives, credit rationing and distortionary taxation. On the other hand, the picture that emerges from a host of empirical studies is muddy; some Ricardian effects are not rejected although complete equivalence is rarely found.

A further influence has been the growing recognition that governments may not always serve the public interest. This view, championed by Buchanan and Tullock (1962), has been refined by the political economy literature (Drazen, 2000; Persson and Tabellini, 2000). In the presence of government failures, policies justified by the existence of market failures may do more harm than good. The implication seems to be that governments can help out but only if properly constrained.

The impact of these ideas on monetary policy has been profound. The initial result that only monetary surprises matter has led to the adoption of rules, mostly monetary growth rules championed by the Bundesbank and taken up bv the Federal Reserve in the early 1980s. But growing dissatisfaction with rigid rules has led to a more subtle emphasis on incentives. Central banks have been made independent and given a very precise mandate, price stability, along with the recognition that they have an output stabilising role to play. This has led to the strategy of flexible inflation targeting, pioneered by the Reserve Bank of New Zealand and developed in Svensson (2003). …

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