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.

A European Monetary Fund

Sapir and Schoenmaker at Bruegel have a discussion of what a European version of the IMF might look like and do. Here are my thoughts on the sovereign debt (not banking) side, which I am sure will be regarded once again as radical and will therefore be ignored.

I think some new Eurozone institution is necessary, but not for the reason that most people might think. The idea that the Eurozone might have a common fund that lends to Eurozone countries in fiscal difficulties with associated conditionality, as the IMF does, is a terrible idea. We know it is a terrible idea because of Greece.

Think of the following scenario. A country getting into difficulties is lent some money by the EMF. That sum increases as existing private investors take fright. For whatever reason the ‘recovery plan’ imposed by the EMF goes wrong, and it becomes clear to all neutral observers that the country needs to default on its debts, including those to the EMF. As the EMF loan is regarded as ‘our money’ by a good part of the EZ electorate, this default is resisted and punitive austerity is imposed on the country so that the EMF can get its money back. This does not happen to the IMF because the electorate in any individual country do not think of their loans as ‘their money’, but it is naive to believe that wouldn’t happen with an EMF. It is exactly what happened in Greece, and it is also why moves to a political union are far too premature..

This raises an obvious question: why have an EMF, when we have an IMF? The wrong way of thinking about that question is that the Eurozone needed to supplement the IMF during the last crisis. The last crisis is not a good example because the ECB did not operate OMT until September 2012. The right way to think about the past is what would have happened if OMT had been operating from the start.

The ECB is (rightly) only prepared to operate OMT for a country that is returning its financing to some sustainable level. For some countries that may not be possible, or desirable, without default. That was the case for Greece. For others that will be possible without default, as Ireland and Portugal have shown. You need somebody, or some institution, to decide which category a country finds itself in. But whether default is needed or not, a recovery plan (austerity) has to be put in place to return the public finances to sustainability and once that plan is in place OMT then operates.

Once that happens, I think any lending should be done by the IMF for the reason I have already given [1]. However it may well be that as long as the austerity is sensibly mild and drawn out [2], private sector lending will resume because of OMT.

I think a new institution to do both the job of initially deciding about default and to create the recovery plan would be a good idea. But both decisions have to be kept as far away from politicians as possible. The reason again comes from history: the loans to the government that may require default are likely to be from banks or institutions in other EZ countries. That creates a serious bias towards ‘lend and pretend’, as we saw with Greece. 

How can you achieve such independence in the EMF? In addition, how do you justify giving an institution staff and resources when it hopefully will be hardly ever needed? One answer could be to use the IMF, although at the moment the IMF is not sufficiently independent of EZ politicians. Another is to utilise the network of independent fiscal institutions or fiscal councils that every EZ country now has. If those institutions live up to their name, they should be independent of politicians. In addition, they have exactly the expertise to decide on any default and to put together a recovery plan.

Now the great thing about this set-up is that it allows fiscal autonomy in countries that have not got into fiscal difficulties. Fiscal discipline through the market is restored, because there is a clear default risk (but not the self-fulfilling default risk that operated before OMT). There would be less of a feeling in countries like Germany that they had to worry about fiscal policy in other EZ countries because they will pick up the tab because there will not be any tab to pick up. In that sense the no bail out rule is restored. 

What would the Brussels machinery that currently monitors each EZ country do? Am I proposing to put some Brussels bureaucrats out of a job? Not necessarily. A potential problem with the system I suggest is that fiscal councils will be captured by their governments. Brussels could ensure that the fiscal councils are independent, which would involve checking their assessments and forecasts (or even supplying them with forecasts).

I can predict with almost certainty that some comments will be that I am taking crucial decisions away from democratically elected politicians and giving them to technocrats. We have enough of that in the Eurozone as it is they will say. There are two simple responses. First, in the absence of the Eurozone, governments that were no longer able to borrow would face the technocrats at the IMF. Second, we have tried the democratic route and it has failed spectacularly for reasons that will not go away in a hurry. 

There you have it. A feasible plan to increase sovereignty in the Eurozone and mitigate another Eurozone crisis and avoid another Greece. Now tell me why we have to move to fiscal and political union.

[1] Obviously in that case the IMF would also have to approve the recovery plan.

[2] A short sharp shock will almost inevitably lead to damaging negative feedback on output, perhaps creating another Greece.