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Saturday 19 Aug 2017 | 09:46 | SYDNEY
Saturday 19 Aug 2017 | 09:46 | SYDNEY

Fiscal rules and the Golden Straitjacket



9 June 2010 10:17

One potential solution to the budgetary credibility problem I posted  on last week is the use of fiscal rules. They've certainly become more popular over time: according to the IMF, in 1990 only seven countries had fiscal rules. By early 2009 that number had risen to 80:  

Fiscal rules are intended to impose permanent, numerical constraints on fiscal policy by placing strict limits on budgetary aggregates. The latter could include the budget balance itself (headline, structural or cyclically adjusted) as well as various measures of government debt, expenditure or revenue. The most popular choices appear to be rules covering debt and the fiscal balance:

A potentially important problem with this solution is that fiscal rules are only as good as the government that implements them. This makes them at best an imperfect response to the credibility problem: the Fund reckons that the GFC has seen about one quarter of those economies with rules either modify them or put them into abeyance.

This shortcoming has led some economists to advocate a move to independent fiscal agencies. There is an obvious analogy here with the solution to monetary policy credibility offered by central bank independence, although the usual idea is that these fiscal bodies would discipline governments via increased transparency (naming and shaming), rather than by having their hands directly on the levers of policy in the way that central bankers set short-term interest rates. 

The new UK coalition Government has set off down this route with its announcement of a new Office of Budget Responsibility (OBR), although sceptics have already noted that the OBR's North American counterpart, the Congressional Budget Office, has had strictly limited success in disciplining US fiscal policy.

Adopting an independent fiscal agency, like opting for an independent central bank, can be seen as an example of what Thomas Friedman has described as donning the Golden Straitjacket: that is, following the relatively narrowly circumscribed set of policies deemed necessary to secure the approval of the financial markets, or, as Freidman describes them, the electronic herd. 

According to Friedman, to fit into the Golden Straitjacket a country must, among other things, set about 'maintaining as close to a balanced budget as possible, if not a surplus.' Friedman goes on:

As your country puts on the Golden Straitjacket, two things tend to happen: your economy grows and your politics shrinks...the Golden Straitjacket narrows the political and economic policy choices of those in power to relatively tight parameters.

In other words, governments can try to gain credibility by effectively reducing their degree of control over the levers of economic policy. Fiscal rules and independent fiscal authorities are ways that governments can try to do this with respect to fiscal policy.

In a follow-up post, I'll look at a model that seeks to explain this choice in the context of the changing nature of the global economy.

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