Catenarian fiscal discipline

Hans Gersbach 04 January 2014

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Limiting the accumulation of public debt in democracies has always been a problem, but it has become a particularly pressing one in the last few decades. While there are normative justifications for public debt-making – such as letting automatic stabilisers and tax-smoothing measures operate (Barro 1979) – political processes tend to push public debt to levels that are likely to be socially undesirable.

The reasons for this tendency are well known and well explored: fragmented governments, political uncertainty, time-inconsistent public debt policies, rent-seeking and increasing the advantages of incumbency – to say nothing of shifting the burden of public debt onto future generations – can all lead to excessive debt accumulation.1

Many suggestions as to how to limit such accumulation have been put on the table, and several of them have been implemented. The Maastricht Treaty, for instance, contains explicit limits on budget deficits and debt that may not be exceeded.2 Other ways of putting the brakes on the issue of new debt, and of accumulating rainy-day funds, were also discussed at length. Such fiscal rules should be both credible and flexible; but strict fiscal rules are not credible, and the constraints imposed by flexible ones are, in practice, often too weak – if effective at all. In a recession or a banking crisis, for instance, no elected government would – or should – adhere to strict fiscal rules, no matter how harsh the resulting sanctions. If the fiscal rules are loose and allow a wide range of interpretations, they will be exploited and so have little or no bite. To deal with this problem, we suggest a new rule for democracies that rewards current office-holders who exercise fiscal discipline and ensures its continuation under their successors, while maintaining the flexibility necessary to stabilise shocks via adjustments to the level of public debt.

Bridling the successor

Let us start from a representative democracy with a parliamentary system, in which a party or a coalition of parties has a parliamentary majority and forms the executive branch.3 The rule we suggest would be to add the following article to the constitution:

If the incumbent government is voted out of office or has stepped down, but has proven disciplined in fiscal matters, it will be given the power to impose an upper bound on the level of public debt in the first year of the next government’s office-term [or possibly in both of the first two years].4

This rule aims not only to reward fiscally disciplined current office-holders, but also to instil fiscal discipline in their successors. How to measure this discipline is an important matter. For example, a government would be defined as fiscally conservative if, over a given period, public debt grew more slowly than GDP.

Benefits

Allowing well-performing governments to limit their successors’ debt-making for a certain length of time promises several benefits.

  • The rule we propose promotes current as well as future prudence, for a fiscally disciplined government would also be rewarded through its power to limit its successor’s profligacy. The former government could ensure that its performance is sustained, in part at least, after its own time in office, and so be able to enjoy the harvest of its fiscal efforts beyond its term. If a new government is prevented from squandering this legacy at the start of its term, there is a greater chance that it will choose not to do so later on. For this new government will then have an incentive to remain on a fiscally disciplined path, as it knows that its direct fiscal power will outlast its term in office.
  • The opportunity to create a legacy is attractive for current office-holders, as it increases their chances of being perceived as ‘statesmen’ – an accolade that is highly valued by politicians and citizens alike – in the long run, at least.5
  • In a downturn, or even in the event of an expected crisis, a government that is allowed to set debt limits after its term in office still has the option of loosening them in the present, for instance, by allowing automatic stabilisers to operate. This option is, however, limited by any desire to meet the standard of ‘fiscally prudent’ while in office.
  • If during the first period of its term, a new government faces a debt limit set by its predecessor, it may have greater incentives to be fiscally prudent, as the time left after this period for substantial debt-making with the aim of getting re-elected is limited.

Problems and variants

Allowing governments to bind their successors’ hands through the exercise of fiscal prudence would require constitutional changes and would fundamentally alter the workings of democracy. Thus, a number of potentially problematic issues must be addressed.

  • If a ruling coalition is replaced by one from the other end of the political spectrum, there may be an incentive for the former to set excessively tight fiscal limits in order to injure the latter. While competition in fiscal discipline is welcome in principle, such punitive actions may be hindered by relaxing our basic rule. For instance, the next government could choose the year (or years) during which its predecessor sets the fiscal limits. Nor should those limits be arbitrarily tight – for example, the coming debt limit may not be lower than the average ruling during the predecessor’s own term.
  • If, during its first year in office, a new government faces a downturn which could not have been foreseen before its taking office, a debt limit imposed by the previous government may be too tight, and may prevent automatic stabilisers from functioning. This could be addressed by the weaker variant as outlined above.6
  • Allowing the current government to constrain its successor might be viewed as violating the basic principles of democracy. Yet, any government that undertakes irreversible long-term projects, or initiates policies that are hard to reverse, or incurs excessive public debt, also constrains the actions of future governments in various ways, despite fresh elections. It is well known, for instance, that governments that indulge in debt-making constrain their successors by forcing the latter to restrain public expenditures because of the inherited debt. Our proposal involves only a partial direct constraint, as the debt limit for the next government would merely be set for the first part of the term. Moreover, it would be the good behaviour of the present government that imposes limits on what its successor can do. Still, allowing a direct, constitutional constraint to be imposed on the current government by its predecessor is an entirely new way of assigning competences and responsibilities in a democracy – across a succession of office-holders. Such a concept requires that we broaden our notion of representative democracy, by recognising the fact that a current government already has various implicit ways of limiting what its elected successors can do.
  • Governments will certainly find ways to shift debt across time to weaken the impact of debt limits imposed by their predecessors. Still, our concept might map out a path to fiscal stability in a democracy.

Conclusion

We cannot, of course, address all the intricacies and consequences of our rule in this short column. Nevertheless, this first round of thinking suggests that our rule has all the attributes of an institutional innovation that calls for further rounds, followed by experimental trials in democratic decision-making. 

References

Barro, J (1979), “On the Determination of the Public Debt”, Journal of Political Economy 87, pp. 940–971.

Battaglini, M (2011), “The Political Economy of Public Debt”, Annual Review of Economics 3, pp. 161–189.

Buchanan, J (2000), “Debt and Taxes”, in The Collected Works of James Buchanan, Vol. 14, Indianapolis, IN: Liberty Fund.

Buti, M and M Larch (2010), “The Commission Proposals for Stronger EU Economic Governance: A Comprehensive Response to the Lessons of the Great Recession”, VoxEU.org, 14 October. 

Cooley, T F and R Marimon (2011), “A Credible Commitment for the Eurozone”, VoxEU.org, 20 July. 

De Grauwe, P (2010), “Why a Tougher Stability and Growth Pact Is a Bad Idea”, VoxEU.org, 4 October. 

Drazen, A (2000), Political Economy in Macroeconomics, Princeton, NJ: Princeton University Press.

Fuest, C (2011), “Will the Reform of the Institutional Framework Restore Fiscal Stability in the Eurozone?”, CESifo Forum 12(2), pp. 34–39.

Gersbach, H (2013), “Government Debt-threshold Contracts”, Economic Inquiry, forthcoming. Article First Online DOI: 10.1111/ecin.12038.

Gersbach, H (2012), “Contractual Democracy”, Review of Law and Economics 8(3), pp. 823–851.

Gersbach, H (2009), “Voting Twice: A New Approach to the Limitation of Government Debt Accumulation”, VoxEU.org, 17 June. 

Gersbach, H (1999), “Statesmen, Populists and the Paradox of Competence”, University of Heidelberg Discussion Paper No. 301.

Kirkegaard, J F (2012), “Europe’s New Fiscal Compact Treaty Does not Outlaw Keynesianism and Is a Stepping Stone to More Progress”, VoxEU.org, 6 February. 

Persson, T and G Tabellini (2000), Political Economics: Explaining Economic Policy, Cambridge, MA: MIT Press.

Whelan, K (2012), “Golden Rule or Golden Straitjacket?”, VoxEU.org, 25 February 2012. 

Wyplosz, C (2012), “Fiscal Discipline in the Monetary Union”, VoxEU.org, 26 November 2012. 


1 See the surveys of Drazen (2000), Persson and Tabellini (2000), Buchanan (2000), and Battaglini (2011). See also Gersbach (2013).
2 The Stability and Growth Pact has been violated over and over (Wyplosz 2012). There is considerable uncertainty whether the stricter version of the Pact, called the Treaty on Stability, Coordination and Governance, will achieve its aims (see for example Whelan 2012, Kirkegaard 2012, Buti and Larch 2010, De Grauwe 2010, Cooley and Marimon 2011, and Fuest 2011).
3 This rule can be applied, mutatis mutandis, in any kind of representative democracy, but requires a more sophisticated implementation in democracies in which the powers of government are separated.
4 This rule is a specific ‘Political Contract’ in the sense of Gersbach (2012). For other unconventional suggestions of how to improve fiscal discipline in a democracy, see Gersbach (2009).
5 For a first formal analysis of such properties of politicians, see Gersbach (1999).
6 A more delicate and controversial solution would be to allow the current government to renegotiate the debt limit with its predecessor.
 

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Topics:  Macroeconomic policy

Tags:  democracy, fiscal policy, debt, time inconsistency, fiscal discipline

Professor at CER-ETH - Center of Economic Research at ETH Zurich and CEPR Research Fellow