Fatih Özatay, PhD - [Archive]

Fiscal rule and independence 31/08/2009 - Viewed 1347 times

There is a vast literature for the economic policies implemented for politic purposes and the results of those policies. Numerous theoretical studies have been conducted in this field. In addition to this, the relation between the practical results and developed theories has been investigated intensively. Common findings of studies that are widely known and that thus turned into 'classics' in this field is:

Administrations at the office target at stimulating economy 'sufficiently' before elections. They believe that this way, more economic activities will take place in the market and thus higher number of people will be employed. These potential developments mean 'more votes' for them. This is not limited to developing countries. On the contrary, earliest studies on this issue were conducted for developed countries.

You can ask "how is this bad?" if the economy will be stimulated as a result. However, on a second thought, you start to suspect: "If it was possible to stimulate the economy, why did not you implement them before but waited for election time?" This is one of the questions that come to mind. Taking departure from this point, it is possible to think that such policies disturb economic balances and that the fruitful results are not permanent.

In fact, these doubts prove correct. Both theoretical and practical studies show that, when all effects are taken into account, such policies pose more damage in social terms. So, the first question that comes up is: If these policies lead to undesired outcomes, how can we form the mechanisms to prevent the implementation of these policies without compromising democracy?

Concept of central bank independence comes up as a result of these studies. Independence also increases the credibility of the policies implemented by central banks. Of course, certain central banks might be found not credible for different factors. However, beyond those factors, independence forms a solid infrastructure for credibility. In that case, targets of a monetary policy regime implemented by an independent central bank become more credible if other conditions are also convenient. With other conditions, we refer for instance to disciplined fiscal policy or sound financial sector. But even if the fiscal policy is disciplined and financial sector is healthy, targets set by a dependent central bank might be not credible as the policies will be prone to politic purposes mentioned above.

If we reduce the issue to specifics, independence is an important prerequisite for inflation targeting regime. If other factors are convenient, independence makes the targets more credible. It is thought that, if inflation does not move in line with the targets; central bank will increase interest rates and this action will not encounter a political obstacle.

Such framework is necessary also for medium term fiscal rule. Assume that a fiscal rule was introduced on budget expenditures and set a certain budget expenditure limit for the coming three years. For this target to be credible, public must be convinced that measures to compensate for the deviations from the target will be introduced and implemented. However, the body to take the decisions and implement the policies is the governments. For instance, do governments adopt compensatory fiscal policies at the down of elections? Here, credibility is weaker. In terms of monetary policy, this problem could be solved by granting independence to central banks. Nonetheless, it took decades for central banks even to win legal independence. It seems that there is a need for a legal framework to ensure that compensatory mechanisms considering fiscal rule will step in automatically. We must discuss this issue.

This commentary was published in Radikal daily on 31.08.2009