Lori Janjigian, Grace Devlin, Thomas Goujat, Eleanor McEnaney and Ryan Werffeli Against the use of Fiscal Policy Rules

Argument Against the Use of Fiscal Policy Rules All rules-based macroeconomic strategies share a single feature – they seek to remove discretionary intervention (Koptis). This relationship between rules-based strategies and discretionary policies comes heavily into play in governmental fiscal policy. Though rules-based policies may be “à la mode,” the assumption that adhering to strict rules will benefit the economy is not universally accepted. In fact, in studying historic recessionary times, it becomes clear that sticking to hard-and-fast fiscal rules is potentially harmful to the economy. Therefore, governments should stick to discretionary fiscal policy rather than fiscal policy rules. Historically, deviations from the golden rule and even deficit targets have been successful both politically and economically. Of the many examples, the most striking is from the period between the Great Depression and WWII (1932-1946) when the US deficit averaged well above 5% for over a decade (FRED). During this period, the country’s GDP more than doubled. FDR’s New Deal has been attributed to preventing a total collapse of the American economy, and in hindsight we can see that even he did not go far enough. Demand growth during this period even with the New Deal spending was not enough to outpace the growing population and shrink unemployment (Sdsj). Thus, we encounter a similar problem to what was faced during the aftermath of the Great Recession, with GDP growth not leading to a strong jobs recovery (recent drops in the unemployment rate have more to do with workers leaving the job market than with more jobs being available) (FRED). If the government’s main responsibility is to its people as a whole, and not just the 1%, the golden rule mind-frame restricts stimulus spending enough so that the “trickling down” effects may not be felt. Recency bias causes politicians to underestimate the likelihood of these types of major crisis from occurring. While rules-based macroeconomic strategies operate fairly well within a normal range of economic circumstances, once in a century financial crises do occur. The rules that are in place are unfit to deal with these crises, and even when they allow some degree of

flexibility, they create a paradigm whereby taking the necessary actions to combat extreme circumstances is discouraged. Even if they work well most of the time, discretionary strategy is in fact the better option. Evidence goes to show that while fiscal rules are too rigid, fiscal targets are much more effective. Targets allow for action to be taken that exceed or fall short of the goals during times of extenuating circumstances. In contrast, fiscal rules do not allow for this kind of flexibility. To understand the significance of this difference, one needs to look no further than the recent recession of 2008. By allowing some flexibility in fiscal practices, the United States was actually able to recover from the recession quickly in comparison to the European Union. In the EU, rigid adherence to fiscal rules led to increases in debt ratios in most of their countries. The United States eased on interest rates and saw timely recovery. The EU quickly tightened their budget and, as a result, saw a decline in GDP growth. The severity of the fiscal rules in the EU did not allow any room for the economy to adjust itself and therefore cast the Union into further struggle. One important role of fiscal policy rules is to help governments gain credibility, yet “credibility is not built at a uniform speed (Koptis),” and the ability to achieve it varies based on different economic policies. This fact is exacerbated by fiscal policy rules that have, in the past, prevented governments from exercising the best possible policy frameworks, which has resulted in non-transparent practices across the EU. The guidelines on and the implementation of fiscal policy rules vary by country, which incentivizes interpretation in order to circumvent the rules. Examples of this discrepancy in fiscal policy rules range from the United States, to the Netherlands, to Italy. Transparency is wholly necessary when it comes to economic policy – whether it be discretionary or rules-based policy. Yet in the face of fiscal policy rules, the pressure to comply has resulted in creative accounting and unlawful operating procedures that have further depressed economic situations (Koptis). Lack of transparency resulting from fiscal policy rules is mainly driven by the existence of off-budget operations, the drafting of two separate budgets (the ordinary budget and the investment budget), and the lack of reporting from other government parties that are not included in the central government (Kaplanaoglou, Rapanos). Greece, for instance, practiced repeated revisions of its fiscal statistics in order to meet the fiscal deficit target set by the EU. These revisions increased

the 2009 deficit figure five-fold, from initially less than 3% of Greece’s GDP to a final figure of more than 15%, accompanied by severe market reactions. The Greek sovereign debt crisis is an example of fiscal policy rules resulting in creative accounting and the risks associated with this for the Eurozone, and for the stability of economic unions overall. Worryingly, Greece is not the only country to have misreported its financial statistics (Alt, Lassen, Wehner). In conclusion, for fiscal policy rules to truly work, the presence of loopholes must be dealt with through better design and implementation across EU countries, and a better institutional infrastructure must be developed to force countries to practice transparent economic policy--Until this is made possible, the risks associated with fiscal policy rules are far too great. Along with transparency, another main goal of fiscal policy is to build trust in the economy by enabling discretionary policy intervention. Indeed, if fundamentals are guaranteed by regulation, investors operate in a safer long-term environment. However, not all countries are equal in the face of trust and some may not need such fiscal rules. This is the case for countries that already achieve trust through prudent macroeconomic management. For example, since the mid-1990s, the US has had fiscal discipline with a steady level of growth, low inflation and budget surpluses, with no policy rules imposing unnecessary restrictions or precise targets. This is because generally speaking, the credibility of a country’s economy can be obtained regardless of fiscal rules, especially when this country has a proven record of good macroeconomic performance. That is why Germany has remained credible even though it has never managed to meet the golden rule (the fact for a government to only borrow for investment and not current spending) or the M3 target (a money supply growth target) since the 1970s. In all, it is clear that using a discretionary fiscal policy allows for a government to build trust, have greater flexibility, and practice more transparency. This not only has a positive effect on the economy, but also helps to strengthen the government. Therefore, it is clear that governments should avoid using fiscal policy rules and, rather, they should choose to use discretionary policy.

Work Cited

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