Budget deficits, fiscal councils and authoritarian regimes

Budget deficits are a constant temptation for politicians. If you want to cut some taxes it is politically easier to do this by borrowing than by raising other taxes or reducing spending. If the electorate were fully informed this should not be the case, but they are not fully informed. We have clear evidence that many (not all) politicians succumb to this temptation: economists call it the problem of deficit bias. Running deficits are attractive because in most cases they do no immediate harm. In the past I have likened them to drinking or eating too much: do it once and no great harm is done, but do it repeatedly and problems arise, if only because taxes have to increase to pay the interest on the mounting debt.

This point about no immediate harm is vital to understand. It means that if there is a good reason to run large deficits that increase government debt, like an economic downturn (automatic stabilisers), or fighting a deep recession (interest rate lower bound) or high return public investment projects or disasters (natural or man made), then you should do so. Like eating too much, you can always eat less later. Fear that you might not eat less later should never be a reason for not using fiscal policy to fight a recession, or undertake much needed investment. It would be like stopping Christmas because you might eat too much.

If that is all obvious to you then skip the next three paragraphs. Some MMT economists or their followers sometimes argue that deficits never matter. If monetary policy cannot control demand and inflation and fiscal policy has to do it instead, then this is correct. It is the fighting a deep recession point above. But in reality, outwith the interest rate lower bound, interest rates are used to control demand and inflation. MMT would like fiscal policy to control inflation always, in which case the deficit is whatever it needs to be to do that task, but for the moment monetary policy is used instead. That means that the need to control inflation is not a direct constraint that removes the deficit temptation for politicians.

That is why we had deficit bias in most countries before the global financial crisis, and it is why Trump is cutting taxes and raising the deficit now. To say mounting government debt as a result of deficit bias does not matter is not credible. Even if you think the higher taxes required to cover servicing higher debt has no disincentive effect, the political consequences of high taxes cannot be favourable. To say that governments could pay for tax cuts by creating money misses the point that the bond/money mix is delegated to central banks for inflation control.

I can completely understand where MMTers are coming from. We have just been through a period where politicians have pretended the deficit was all important, and this pretense has inflicted great harm. But that does not make the opposite point of view that the deficit never matters right. As so often happens, the political right have abused economics (pretending the government is like a household) for political ends, and some on the left have reacted not by pointing out what economics actually says, but by saying we need a new economics.

Fiscal councils are a vital part of combating deficit bias for many reasons.They are no longer the oddball idea that a few of us kept going on about just 15 years ago, but as this VoxEU ebook shows they are now a standard part of how fiscal policy is done in (almost?) every advanced economy. My chapter in this ebook argues that they are a necessary part of what I call the consensus assignment. In most places they work with fiscal rules rather than being a substitute for them. They are necessary because sometimes governments try a cheat fiscal rules (PFIs in the UK) and sometimes simple fiscal rules need to be broken for some of the reasons outlined earlier.

Fiscal councils are almost always advisory bodies. (Although the more politicians do the wrong thing with fiscal policy, the greater will be calls to change this.) They have no power to tell governments what to do, and their only influence comes from their ability to adequately scrutinise what the government is doing, which in turn depends on both the voice they have within the political system, their competence [1] and their independence. Establishing that, preserving that and sometimes enhancing that are a constant battle, precisely because these bodies take away the ability of politicians to pull the wool over the voters’ eyes.

Because an effective fiscal council acts as a watchdog over the decisions of finance ministers, they become vulnerable to political attack. We now have networks that can help defend them. Fiscal councils within the EU have established their own Network. In addition within the EU the new Fiscal Board has a dual role, of both being a kind of fiscal council for the European Commission, but also to act as a champion of independent, effective EU fiscal councils as Michal Horvath suggests here. It was therefore good to see this Board warn and the Network warn against moving the Danish fiscal council away from Copenhagen. The OECD also conducts valuable assessments of fiscal councils (see Spain here), although whether the OECD has the ability and agility to defend a fiscal council under attack outside the EU is less clear.

These defences are important, because it is so easy for governments to compromise fiscal councils, by denying them information and resources, or by appointing political heads. Governments that go even further and dismiss existing fiscal councils are even more worrying. The first time I became aware of what was happening in Hungary, as I relate here, was when they abolished a strong and very active fiscal council lead by George Kopits. Far worse has happened since in Hungary, but perhaps from this experience abolishing a fiscal council is a good early warning signal of authoritarian regimes. We have also seen unprecedented attacks on the CBO by Republicans in the United States. Ironically these attacks show us that fiscal councils in some cases have become, and in other cases can become, a vital part of a pluralist democracy.

[1] That competence includes understanding when high deficits are sensible and when government debt should rise. Any fiscal council which only ever advises deficits should be lower will lose any reputation for competence.