The interplay between fiscal rules and market discipline
In this paper, Ethan Ilzetzki and Heidi Christina Thysen explore the complex interplay between fiscal rules and market discipline in controlling government borrowing. The authors develop a model of asymmetric information, where governments differ in their degree of present bias. Once a government is newly elected markets must infer policymakers’ type from their actions. They argue:
- Interaction Between Fiscal Rules and Market Discipline: The paper highlights that fiscal rules (like debt limits) and market discipline (through interest rates) interact in non-trivial ways that can influence government borrowing behavior. While fiscal rules are designed to limit borrowing directly, market discipline does so indirectly by making borrowing more expensive as debt increases.
- Signaling Fiscal Rectitude: Governments may use fiscal restraint to signal their fiscal responsibility to the markets. This signaling can lead to both over-borrowing and under-borrowing. Over-borrowing occurs due to present bias, where governments borrow more than is optimal because they prioritize current needs over future costs. Under-borrowing happens as governments attempt to signal their fiscal prudence to obtain better borrowing terms (lower interest rates).
Ignoring the discipline imposed by markets and policymakers’ signalling incentives, it is correct that a fiscal rule should merely attempt to replicate socially desirable policies. However, in the presence of market discipline, imposing naïve fiscal rules can lead to unintended and undesirable consequences. These outcomes may occur even when the fiscal rule isn’t binding and seemingly has no effect.
Fiscal Rules and Market Discipline
Authors: Ethan Ilzetzki, Heidi Christina Thysen
From: London School of Economics, Norwegian School of Economics
A literature survey on fiscal rules
In this paper, Niklas Potrafke, looks at new and fast growing empirical literature on fiscal rules at the national, sub-national and local level. Recent research shows:
- Reduction in Budget Deficits and Public Spending: Fiscal rules have been effective in reducing budget deficits and public spending across various levels of government—national, sub-national, and local. This effect is consistent regardless of the rigor of the identification strategy used in the studies surveyed.
- Stabilization of Borrowing Costs: Fiscal rules contribute to lowering borrowing costs for governments. This is evidenced by reduced risk premia on government bonds in countries with stringent fiscal rules compared to those with lax or no fiscal rules.
- Promotion of Economic Growth: There is empirical support for the notion that stringent fiscal rules can foster economic growth. The paper cites studies showing that GDP growth is higher in countries with constitutional fiscal rules than in those without.
- Decrease in Fiscal and Output Volatility: Fiscal rules help in reducing fiscal and output volatility, making economic outcomes more predictable and stable.
- Mitigation of Political Business Cycles: Fiscal rules can mitigate the influence of electoral motives on fiscal policies, thus dampening political business cycles where governments might otherwise increase spending or deficits to influence election outcomes.
- No Significant Decrease in Public Investment: Contrary to some concerns, the results surveyed do not suggest that fiscal rules significantly decrease public investment, which is crucial for long-term economic growth.
- Need for Future Research on Unintended Effects: The paper identifies a gap in the literature regarding the unintended effects of fiscal rules, such as their relationship to creative accounting practices and the use of extra budgets. It calls for more detailed examination of these aspects in future research.
The Economic Consequences of Fiscal Rules
Authors: Niklas Potrafke
From: University of Munich
