Sunday, 9 December 2012

Some Thoughts on Fiscal Rules


In one area macroeconomic policy in the UK is well ahead of the US or the Eurozone: the use of fiscal rules. The US seems to prefer cliffs to rules - yes, I know that is a cheap jibe, but you know what I mean. In the Eurozone fiscal rules now come in packs, the individual parts of which are of variable quality and may not be consistent with each other. By contrast, the surviving UK fiscal rule (or ‘mandate’) makes some limited sense, as did Gordon Brown’s predecessors. It says the government should achieve structural (cyclically adjusted) balance, excluding investment spending, within five years - where that five year period rolls forward.

What is good about this rule? Its main advantage is that, by having a rolling target, nothing is adjusted too quickly. One thing that stands out from the literature is that, as long as you are able to sell debt, fiscal adjustments should be slow, and the government’s deficit should act as a shock absorber. The analogy with consumption smoothing is pretty close. Now it is true that a rolling target could allow a government to keep delaying adjustment, but that is hardly a problem right now.

Two additional features of the UK rule are the use of the cyclically adjusted deficit and the exclusion of investment. Although cyclical adjustment gets talked about a lot, for this particular rule it would in normal times be largely irrelevant, because we would expect to have a zero output gap in five years time anyway. Right now it is not irrelevant, but I will have more to say about the current conjuncture below. Whether it is right to exclude spending on investment is a difficult question, which I will leave for another post.

Where the rule is more problematic is the focus on the deficit, and the idea that ‘balance’ for the current deficit is a meaningful target. Ultimately we are concerned about government debt. We want to stop debt rising relative to GDP, and then we want to get it down. The speed at which that is done will imply a path for deficits, but these deficits will almost certainly be varying over time, and there is no magic in zero (i.e. balance). The rule that an economist would naturally think of (and which is commonly used in academic work) is to adjust instruments in proportion to the difference between actual debt and its target level. However, a zero deficit over the medium run will imply a reduction in debt (as the OBR shows), so at least its moving us in the right direction.

While for the macroeconomist as scientist there is plenty of scope for exploring these issues, I think they miss the two major problems that the macroeconomist as engineer has to deal with. The first is whether we are designing rules for a (roughly) benevolent government, or for a government that departs from benevolence in particular ways. Second, good rules will inevitably involve making guesses about the future, and many people find it difficult to get their head around this.

As an example, we only need to look at the reaction to the Autumn Statement in the UK. Whether the measures taken by the Chancellor are sufficient to meet his rule depends on where you think the economy will be in five years time. Given the current uncertainty about the output gap, the Chancellor could be being too optimistic or embarking on unnecessary austerity. (See Ian Mulheirn on the implications of alternative assumptions.) Commentators, particularly those political commentators for whom the long run is after the next election, but also in my experience some macroeconomists, yearn for rules or targets that are not conditional in this way. Why cannot we have something straightforward like an inflation target? I mention all this not because I think these concerns are legitimate (I have argued against unconditional inflation targets), but because if fiscal rules are to command public confidence, they may need to take this into account. Perhaps concerns like these explain why most rules focus on deficits rather than debt.

However, there is one point that has to be made if we are discussing fiscal rules in relation to current events, and that is that all the discussion above presumes that monetary policy is unconstrained, and in particular that interest rates are not at the Zero Lower Bound (ZLB). This is a very familiar point, that Paul Krugman has made again and again: at the ZLB things are very different. Monetary policy has lost much of its power, and it has certainly lost its claim to predictability and superiority. We need fiscal policy to help in eliminating excess supply. In this situation, if we need a fiscal rule at all it is more likely to look like a Taylor rule than a rule involving a debt or deficit target. However, when there is no danger of hitting the ZLB, there is no need for fiscal policy to be concerned about the output gap or inflation at all - if we are talking about an economy with a floating exchange rate. The conventional assignment can apply.

Some fiscal rules attempt to address this point by having terms in both debt stabilisation and output gap stabilisation. Now while this might make sense under fixed exchange rates, it is a pointless compromise under flexible rates. If the effectiveness of monetary policy is quite different at the ZLB, then optimal fiscal policy is also bound to be very different at the ZLB. So the main problem with the UK government’s fiscal mandate has nothing to do with cyclical adjustment or any of the other things discussed above. It is just inappropriate for the situation we are now in. 

8 comments:

  1. 'Given the current uncertainty about the output gap, the Chancellor could be being too optimistic or embarking on unnecessary austerity'
    ... and so he has chosen a path that is far less austere than Ireland, greece, spain etc.. but yet also begins to deal with the ubnsustainable nature of UK's balence sheets.
    Sir, is there any chance that we might see work and numbers that would try and suppose a scenario in which the UK emulated ireland for example?

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  2. Some other thoughts.

    1. EZ is completely different from the rest. Several rules are in place to assure that one country cannot bring the others in danger. Not that these are working very well, they don't, but that was the idea behind it. Something countries like the UK donot have.
    The rules were supposed to be written in stone as they are part of the treaty which is difficult to nearly impossible to change. Which is different from say the UK were the rules are more guidelines given.

    2. It will be nearly impossible to deal with all sort of situations especially in crisis (when action could be most needed). So rules need to give some room, especially the not frequently used ones.
    On the other hand however we see that most governments try to stretch the rules also under normal circumstances.
    These 2 things bite each other.
    The balance between the 2 is what is required, but....

    3. The set up of the monetary system in a country (including the mandate of the CB) are effectively part of the social contract between citizen and state (to use very ancient terminology). Not to be overdramatic but say on inflation most people have an expectation what to expect. Not meeting this expectation might be legally possible but will simply have negative consequences for the credibility of both government and CB with the population as a whole.
    What a population sees/feels as being part of the contract can differ from country to country. Giving Germany or Switzerland 5% inflation for a couple of years would likely create a revolution. In the UK in a crisis this might just still be acceptable as we see.
    So one has to be careful when overstepping the unwritten rules, especially the ones that are part of the expectations of the general public. A lot of the rules are simply unknown so there will be more room there.

    4. Having rules usually takes away some uncertainty (risk) for eg investors. Which might be benificial for investment eg by making interest most likely lower.

    5. Re the EZ. I liked the original version of the Maastricht criteria better as that had a max. spread in it. That is probably the clearest sign that something is wrong. Also for non monetary union countries.
    However the problem is that look at say Italy spreads can rise several times more quickly than anyone could make the market required adjustments. Allthough in the EZ imho by purpose they kept the timebomb ticking under the Euro, by clearly communicating to markets that there was some sort of mutual liability. While legally and as we see now there was not. The North thought it would not hurt them and the South liked the low interest. The moment that any country would get into trouble this timebomb was likely to explode as it did.
    Another lesson even legal rules sometimes donot work if you give off other signs as well. So as a government or CBer you will have to stick to especially the most important written rules (also for your general credibility, which is for governments very low at the moment).

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  3. Prof Simon: Your claim that the “UK fiscal rule (or ‘mandate’) makes some limited sense” is too flattering. I suggest it makes zero sense.

    First, assuming the national debt and monetary base are to remain constant relative to GDP (which they do over the very long term), they’ll have to be topped up continuously via a deficit. Reason is that both are constantly shrinking relative to GDP because of (first) inflation and (second) growth. So in the long term, “balance” is out of the question, which in turn means that balance over any medium term period you like to choose is unlikely.

    Second, if over some sort of medium term (let’s take your 5 year period) the private sector remains cautious and/or wants to hold a bigger stock of net financial assets (i.e. monetary base or government debt), then government will just have to supply that, else we get paradox of thrift unemployment. Conversely, if the private sector goes into irrational exuberance mode for five years, government may well have to run a surplus to dampen things down.

    In short, what makes far more sense than the fiscal rule / mandate is Keynes’s dictum: “Look after unemployment, and the budget will look after itself”.

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  4. Some other thought.
    Basically it is a political problem not an economic one. Politicians are likely to abuse it for other purposes. You want to stop that not say a stimulus (as that it will likley be) used in an effective way and without jeopardizing other things. The thing you probably assume but which is seldom the case.
    Probably you can only stop abuse by taking the decision away from politics and dump it with a really independent agency. Which will be nearly impossible and politically unacceptable.
    Economic rules will only partly do that job. Estimates can be played with and 'overdraft can be hidden in the budget by too low estimates also for other things.

    Going from there: imho likely building a buffer first will do most of the job. But still not all. Or demand an approval from an independent agancy to be created (preferably non political as the EZ/EU wants to do a similar thing and that looks still mainly political and technical knowledge and statistic agencies (ECB and Eurostat)look awful.

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  5. Textbook economics tells us that in the case of a SOE operating under a flexible exchange rate, fiscal policy is effective, but only if operates in the nontradable sector.

    From here it follows that as long as Britain is an SEO and its fiscal policy is directed at expanding the demand for nontradable goods (goods that don't compete with imports and are not exportable), expansionary fiscal policy will be effective and this regardless if monetary policy is or is not against the ZLB. Of course that monetary policy may be arguable more effective, but in the current conjuncture there seems to be only a single option left, fiscal expansion directed at the nontradable sector.






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  6. I loved all of these posts. A lot of these things we have, but I got some really great ideas.

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  7. The speed at which that is done will imply a path for deficits,

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  8. The thing you probably assume but which is seldom the case.
    Probably you can only stop abuse by taking the decision away from politics and dump it with a really independent agency.

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