On government policies

Policy decisions to preserve fiscal prudence

In this paper, Halac and Yared argue that “the historical accumulation of government debt across advanced economies is not fully accounted for by normative models, but is consistent with long-term political trends and political economy incentives that promote greater debt accumulation.” In order to study the dynamic interaction between successive deficit-biased governments, they propose a political economy mechanism that explains the presence of fiscally responsible and irresponsible regimes as they arise during periods of crisis. They show that:

• The economy endogenously transitions between a fiscally responsible regime and a fiscally irresponsible regime, with transitions occurring during crises when fiscal needs are large.
• In the fiscally responsible regime, governments limit their spending to avoid transitioning to fiscal irresponsibility.
• In the fiscally irresponsible regime, governments spend excessively even relative to their biases, precipitating crises that lead to the reinstatement of fiscal responsibility.
• Fiscal policy depends on history and cannot be explained by contemporaneous variables alone: the threat of transitioning to the fiscally irresponsible regime sustains the fiscally responsible regime, and the promise of returning to the fiscally responsible regime sustains the fiscally irresponsible regime.

A Theory of Fiscal Responsibility and Irresponsibility
Authors: Marina Halac, Pierre Yared
From: Yale University, Columbia University

Policy decisions to preserve price stability

Some economic shocks have sharp economic impacts and require costly social adjustments and fiscal spending. As the crisis abates,  policymakers are presented with a choice of either making the  fiscal adjustment now or making a deeper adjustment in the future with some probability, in the case the economy fails to improve sufficiently. In this paper Corsetti and Maćkowiak frame this choice as a policy decision gamble on the economic recovery. To study the trade-offs of such gamble they use a model in which the outcome naturally depends not only on luck but also on expectations of private agents. In their model, the government aims to preserve aggregate price stability. After a one-time unanticipated budget deficit assumed to be caused by a recession, the fiscal imbalance will be growing over time, because after new debt is issued to finance the deficit, the new debt will be rolled over at a strictly positive real interest rate. In this case, the policy of price stability will be unsustainable and inflation will have to “pay” for the deficit, unless a fiscal correction takes place in a future period with some probability, so that price stability can become sustainable again. Their model shows that in equilibrium:

• If a correction occurs soon enough, price stability is maintained indefinitely;
• If a correction is delayed the economy experiences a delayed jump in the price level that is larger than if the policy of price stability had been abandoned right away;
• The outcome of the policy gamble depends also on private agents’ expectations so the model has multiple equilibria.

For the same sequence of exogenous shocks, the policy of price stability may continue indefinitely if private agents expect it to continue, and it may fail if private agents expect it to fail. A shift in inflation expectations can be self-fulfilling because it feeds into the state of the economy (government bond prices change, which affects debt issuance for a given deficit and thus the size of the required correction) and from there to policy behavior (the probability of a correction changes). The gamble to preserve price stability may well be worth taking, but it makes the economy vulnerable to a self-fulfilling shift in expectations

Gambling to Preserve Price (and Fiscal) Stability
Authors: Giancarlo Corsetti, Bartosz Maćkowiak
From: European University Institute, European Central Bank