Fiscal Discipline: Inflexible Rules or Flexible Institutions?

Ashby Monk

In the wake of the global financial crisis, many countries around the world have been looking to set up new SWFs to help buffer their economies from the volatility of global markets (see Chile). But before a country can set up a sovereign wealth fund, it has to have some fiscal surplus to serve as the W in the SWF. As such, the creation of new SWFs is often preceded by the writing of fiscal rules, which determine how much money will be spent today and how much will be set aside (in a SWF) for tomorrow. In short, a fiscal rule is a mechanism that constrains the fiscal discretion of the government — this is done through numerical limits on expenditures and debt in the context of the country’s fiscal revenues.

Alright, hopefully you now see (if you didn’t already) the importance of fiscal rules, so you’ll understand why I wanted to flag up Charles Wyplosz new NBER paper entitled “Fiscal Rules: Theoretical Issues and Historical Experiences.” It’s an interesting paper that critiques hard and fast fiscal rules with a view to improving their implementation. Here’s a blurb:

“In theory, if they are well designed and implemented, fiscal rules can eliminate the deficit bias. In practice, however, rules are often disappointing. A first difficulty harks back to the old debate on rules vs. discretion, and the time inconsistency problem. Because rules can never be fully contingent, situations may arise that would make any rule very costly to respect. The financial crisis, which has led to debt increases of some 30% of GDP in many developed economies, is a case in point.”

Indeed. Ironically, then, while the crisis showed governments the utility of having a SWF to buffer their local economies, it also demonstrated the fallibility of the fiscal rules underpinning those same SWFs.

“Fiscal rules are rather brutal instruments. When they bind, policymakers are likely to try and evade them. Policymakers can look for loopholes, they can just ignore the rule or they can change them. Rules can be made less brutal through the adoption of escape clauses, but then they are unlikely to be effective. The nature of the common pool problem is that policymakers often find it politically rewarding not to be fiscally disciplined.

And this is where countries start to get into trouble, as the best practice for fiscal rules calls for simplicity above all else in the design of these mechanisms. So what does all of this imply for fiscal rules?

“This all implies that fiscal rules are unlikely to be a panacea and this is indeed what the evidence suggests…”

Okay. Fiscal rules won’t solve all our problems. Fair enough. What can we do instead?

“The limits of rules may be seen as making fiscal institutions an attractive alternative. Defined broadly to include non-numerical rules, fiscal institutions include the (possibly partial) delegation of the budget process to an independent body, intra-governmental agreements, multi-year programming and codes of good behavior…Institutions have a mandate to establish fiscal discipline in the long run, and they involve people who can think. If these people are sufficiently independent and competent, they should do better than rules.”

Sounds good to me, but, once again, we run into trouble with the design of these institutions. As such, Wyplosz suggests a hybrid approach:

“There is a tendency to consider rules and institutions as substitutes. Yet, the limitations of each approach suggest that combining them may help. Because they can never be adequately contingent, rules are too rigid and therefore time inconsistent; they simply cannot be respected in some situations. Fiscal institutions may be seen as too open-ended and therefore time inconsistent in the sense that they may be too flexible in the face of unforeseen events. But fiscal institutions that apply and interpret not fully contingent rules are promising. Like a Supreme Court that applies and interprets laws voted by the Parliament, or like a central bank that follows a flexible inflation-targeting rule, fiscal institutions can appeal to a rule to guide and justify their actions. Rules can be deviated from when needed without losing their credibility if an independent and competent institution authorizes such deviations.”

Anyway, I know many among you probably think this is a bit (or even a lot) dull. But I honestly think this stuff is fascinating and important (e.g., rules v institutions, fiscal discipline, SWFs, saving v spending, etc). And, dear reader, if you’re actually still following along, it means you may agree. So we should probably hang out some time. We’re sort of a rare breed you and me. Have a nice weekend!

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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