Thought of the Week - Fiscal rules are good rules

This is indeed a major problem for Germany because it forces the government to introduce significant austerity measures right when the country is in recession and needs added investments to reorient its economy away from Russian gas and Chinese demand. And lo and behold, the German Council of Economic Experts that advises the government suggested two days ago the German debt brake should become more flexible.

The German situation is lamentable and certainly a problem for the country in 2024 and 2025, but that doesn’t mean that debt brakes and similar strict fiscal rules are a bad idea. If you look through the literature on the impact of spending rules at the national and subnational levels, the picture that appears makes me want to see fiscal rules implemented anywhere and everywhere.

Fiscal rules take on many different forms. The strictest ones on a national level (as far as I know) are those implemented in Germany, Austria, and Switzerland, which require a government to have a balanced budget in the medium term, with exceptions only permitted during emergencies like the pandemic years.

In the UK, meanwhile, the fiscal rule imposed on the government is practically non-existent because it only requires the government to propose a budget that has the debt/GDP level decline at year five and thereafter. Like the budget rules in the US, where tax laws can be changed as long as the projections by the Congressional Budget Office show that additional expenses or lost revenue are made up with additional revenue by the end of year ten. In other words, politicians can do whatever they want as long as they promise to increase taxes or reduce spending at some point long after the next election. Such fiscal rules may as well not exist because all they encourage is creative accounting rather than enforcing fiscal discipline.

On a sub-national level, there are typically more stringent fiscal rules in place, like the balanced budget rules in 44 US states, where the governor of the state must submit a balanced budget. In 37 states, the rules even state that the state legislature has to enact a balanced budget. Fiscal rules of varying strictness are also imposed on different Canadian provinces or Swiss cantons and German states.

Surveying the many studies on the effectiveness of fiscal rules, Niklas Potrafke from the German ifo Institute shows that fiscal rules have the following impact:

• Borrowing costs for countries and states with fiscal rules are significantly lower. Introducing a fiscal rule on government finances on average reduces borrowing costs for advanced countries by 1.2-1.8ppt and the risk premium for government bonds vs. US Treasuries declined by 1.5% to 1.8% when a budget or spending rule was in place and by 1.1% to 1.2% when a debt limit rule was in place.
• Political business cycles, where politicians start to run larger deficits in the run-up to an election, largely disappear.
• GDP growth is stronger for countries with stricter fiscal rules. On average, in the long run, countries with fiscal rules anchored in their constitution have an economy that is 15% larger than those with no constitutionally anchored fiscal rules. The volatility of GDP growth is smaller for countries with stricter fiscal rules, while laxer fiscal rules lead to no reduction in economic volatility and may sometimes lead to increased economic volatility.
• Stricter fiscal rules are clearly superior to laxer fiscal rules on every measure.

In particular, the result for long-term GDP growth impresses me. Yes, it may sometimes seem that fiscal rules are a hindrance to an economy, especially in a recession, as the case of Germany shows. But hundreds of years of experience on the national and sub-national levels in high-income, middle-income, and low-income countries all show one thing: Fiscal rules work.

We have known for a long time that politicians cannot be trusted with monetary policy. This is why we took the ability to print money out of politicians’ hands and gave it to unelected technocrats called central bankers. People may be frustrated with the poor performance of central bankers in recent years, but you only need to pick up a book on the history of inflation and hyperinflation to understand that letting politicians decide on monetary policy is catastrophic.

But if we wised up on monetary policy, wouldn’t it be good to discuss taking fiscal responsibility out of politicians’ hands and giving it to unelected technocrats? Or can we at least limit the freedom of politicians with a hard numerical limit on spending? I, for one, would be all for it.

Thought of the Day features investment-related and economics-related musings that don’t necessarily have anything to do with current markets. They are designed to take a step back and think about the world a little bit differently. Feel free to share these thoughts with your colleagues whenever you find them interesting. If you have colleagues who would like to receive this publication please ask them to send an email to [email protected]. This publication is free for everyone.