Friday Flyer: Are Fiscal Rules Made for Breaking?
The long tussle between rules and discretion in policy-making moved decisively towards rules in the 1980s. A generation of monetary economists have subsequently concerned themselves with the development of a commitment technology for central banks. By which it is meant mechanisms that would lead households and firms to believe that a given objective will tend to be hit. And almost in tandem, plans were developed to ensure that fiscal policy co-ordinated with monetary policy under the Medium Term Financial Strategy of 1980 and to a varying degree have formed part of the policy strategy for every successive government. The advantages of rules seemed clear because they fixed expectations about inflation or debt and allowed private sector plans to be formulated that incorporated these expectations. Think of how much easier it is to plan a dinner if everyone plans to arrive hungry at the same time.
The monetary policy prescription for an independent central bank pursuing a politically set inflation target is being debated not only because of a question mark over inflation as a sole objective but also as a result of some controversy over the specific advisory role of an independent central bank: is it purely operational or does it have a role in explaining risks from other government policies? The question is muddied and made even more complicated by the additional objectives for a central bank to consider financial stability. Under some scenarios this additional objective might involve trade-offs for inflation against financial stability. Just as following a negative shock to output the central bank has to decide whether to trade-off some output losses against a temporary inflation overshoot. We might have an inflation rule but there will be an element of discretion as to how flexibly it is implemented.
Fiscal policy is also an area to consider interactions. The first duty of the fiscal authority is to ensure that concerns over fiscal sustainability do not undermine the ability of the central bank to control price stability. The avoidance of what is called fiscal dominance was arguably the main achievement of the fiscal settlement following the accession of William III in 1688 and it was this settlement that allowed the market for public debt to develop. The second duty is to ensure that public debt is used to allow the economy to adjust to temporary income shocks. If we instead were to fund temporary public expenditure increases by raising taxes we will be imposing tax costs on consumers and firms when they can least afford to bear them. So far so good. The traditional view was then that fiscal architecture must then seek to explain how debt will be reduced in the future so that the second duty does not conflict with the first. So as we face a debt to GDP level of some 90% up from around 30% in 2008, which represents the highest peacetime increase in public debt since 1688, the reasonable question one would therefore reasonably wish to ask how fiscal policy will bring that level of debt down.
But the financial crisis has posed some difficult questions of that level of debt and the adjustment to more normal levels of public debt. First, the shock to income looks more permanent than temporary as productivity performance suggests that we are faced with a permanently or semi-permanent lower level of income after the financial crisis. Unfortunately to the extent the shocks to income are permanent then it would be better to raise taxes to fund higher public expenditures rather than increase borrowing. Secondly, the costs of funding a given level of debt has fallen markedly which means that it is easier to fund what are now high levels of public debt. These two offsetting forces might help us understand why it has remained so hard to reduce debt. Taxes may not need to be increased because costs of funding have fallen. We are poorer but the cost of borrowing is cheaper so why not smooth the path to lower income by issuing more public debt until it is clear that we can afford to pay it down?
The very real complexities also help us understand why government have increasingly tended to spell out fiscal rules and also turn to independent fiscal councils to assess their strategies. Such rules are unfortunately either the results of crises or widely perceived biases towards running excessive budget deficits over time. But they are also hard to conform to as we have just seen in the UK. The fiscal charter of 2015 for a fiscal surplus by the end of this Parliament has already been replaced by a statement, rather than a plan, to reduce debt in the first year of the next Parliament. The statement is not credible because it is not clear how this Chancellor or subsequent Chancellors will bear any costs from missing this target in five or so years' time. And so unfortunately the fiscal architecture has no foundation. And given that inflation is jointly determined by the monetary-fiscal plan, we have returned to discretion. Might discretion turn out to be the better part of fiscal valour?