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Independence, fiscal rule and credibility
In democracies, governments in power naturally have concerns about getting reelected. Studies on political economics reveal that aiming for reelection can lead to arrangements that distort economic stability. In the realm of economics, institutional regulations that will minimize such arrangements which distort economic stability and go against the opposition parties to fit those within the scope of democracy are frequently discussed.
Setting the main target of central banks as sustaining price stability, prohibition of extending credits to the public sector and introducing new assignment and dismissal regulations preventing political impact, in short the independence of central banks was a natural outcome of such discussions. Particularly beginning with 1990s the majority of democratic countries introduced such amendments in central bank code.
Fiscal policy, like monetary policy, can also be used to distort stability. A study published in 2009 draws attention to an interesting point: Think of all countries as an integrated whole. Over the last three decades, budget deficit corresponded to 3 percent of world's output. It is clear that the governments in power have a tendency to have budget deficits. Permanent budget deficits make countries responsive to all kinds of 'trouble'. We have felt this severely on the way towards the 2001 crisis; so I will skip it now.
So, how can we prevent such practices under fiscal policy? The task gets complicated here, because in democracies, independent fiscal policy authority like the independent monetary policy board and independent monetary authority is not achievable. There are some academic studies who advocate such regulations, but those were not implemented in any part of the world.
There is a need for an institutional transformation geared to reduce stability distorting practices. However, it is also evident that this should be accomplished in line with democratic customs. Under these circumstances, the first option that comes to mind is to introduce a fiscal rule and legislate that rule. The same could have been also done for monetary policy, but no country chose such an option.
Why? Because the rules reduce significantly the flexibility of policies. Particularly given that changes in monetary policy can immediately be realized, it becomes clear why introducing monetary policy rules is not desired. In addition, how can you design a rule for any condition that can be encountered? Therefore, central banks are given complete independence in acting in line with the legally defined targets, almost in the complete opposite direction with a rule based monetary policy arrangement.
On the other hand, many countries introduce rule based fiscal policies. First, as also mentioned above, we cannot reverse the rule based policy practice and establish an independent fiscal policy. Second, rules for fiscal policy are not as binding as those for monetary policy. If you want to introduce a monetary policy rule, you might for instance say that real interest rate has to stay below this level or cannot increase above this amount. So, the rule becomes highly binding. This is not the same for fiscal policy, however. For instance consider that Turkey introduced a rule on budget deficit. How binding will that be? Assume that the ratio of budget deficit to the national income is 1 percent. You can fulfill this target either by increasing or reducing expenditures and revenues at high levels. Which one will you choose? You can set the composition of expenditures however you like. Or you can also reduce the budget deficit by introducing new taxes on fuel or gasoline. So, which option will you choose?
Therefore, fiscal rules are not as strict as rules on monetary policy. In this context, harsh criticisms about rule based policies are not generally valid for fiscal rules. However, this is actually where the problem begins. To serve to a purpose, fiscal rule should be credible and should reduce future ambiguities. So, how can an unbinding rule reduce ambiguities?
We need a different regulation. The question I asked on Monday was as to how this regulation can be. So, I still could not answer that question. I will try it next Monday if the agenda does not change until then.
This commentary was published in Radikal daily on 04.03.2010