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Reinventing Fiscal Policy

Practising policy-makers have not been tardy in jettisoning new classical-new Keynesian wisdom when called upon to do so. It turns out that in the industrial world, stabilisation policy, defined as the minimisation of squared deviations of output around potential, has never been far from the concerns of monetary authorities. There has been a concerted move away not just from monetary policy rules but also from the limits of flexible discretion that theory would permit.

HT Parakh financa forum

Reinventing Fiscal Policy

Practising policy-makers have not been tardy in jettisoning new classical-new Keynesian wisdom when called upon to do so. It turns out that in the industrial world, stabilisation policy, defined as the minimisation of squared deviations of output around potential, has never been far from the concerns of monetary authorities. There has been a concerted move away not just from monetary policy rules but also from the limits of flexible discretion

that theory would permit.


A Common VocabularyA Common VocabularyA Common VocabularyA Common VocabularyA Common Vocabulary

ny policy regime worth its salt must be ground out of the account of an economy driven over time by the goals of self-interested agents or classes. The behaviour of citizens generates the economy and the latter, in its turn, is information that loops back to determine the actions of people. Thus, in one line of research, the set of all players is subdivided into workers and firms and their repeated tussle over the accumulation of capital is studied. The time-consistent or “cheating-free” social contract is unlikely to be efficient. There is scope for a leader, outside the traditional antimony of the two protagonists, to announce an optimal investment plan that makes all parties, at least weakly, better off. The equilibrium is feedback in the sense that each agent waits to finds out the state of the world and only then announces her action. Economic modelers to date have been slow to appreciate that outcomes vary depending on assumptions made about the information recalled by agents when making their decisions. If, for example, consumers, producers, and so on, are “memoryless” as well as do not avail of “anticipating” information, that is, only utilise information available in the moment, the equilibrium that resultsis“weakly time consistent” [Basar and Olsder 1995]. In other words, since this is not the best of all possible worlds, at any point of time there is an incentive for any of the parties to the compact to “renege” on it, thereby potentially making everybody not worse off. Credibility and reputation are at a discount. The officers of the state are players in the game. Their preference functions are no different from the agents they represent. If their role is regarded as symmetrical with others, they need not be the ones that renege. For example, the institutional milieu might be ripe for the working class to push the economy into a superior equilibrium.

Lost in TranslationLost in TranslationLost in TranslationLost in TranslationLost in Translation

While the language sketched above is general and extensively used to compute solutions, only a particular dialect, a stochastic general equilibrium model, is heard. One popular result is that the strong arm of the state is regarded as the monetary authority. The instrument is a benchmark interest rate like the bank rate. For a purist, the onus on the interest rate is troublesome because economic science has no satisfactory theory of the determination of the interest rate [for quick fixes see Amato 2005]! The task is to combine a subjective discount rate-founded story with the structural requirements of a rate of interest connected with the rate of profit. The moderns are uninterested in the job unlike their forefathers a century ago. The target which this weapon is assigned to hit is inflation, one end of a venerable seesaw. The Phillips curve, however, continues to elicit a mixed response with the profession, its shape, both in the short run and the long, eluding capture. When this writer last looked, it was flat. Finally, many are deeply uncomfortable with another sacred tenet of the conventional canon, the natural rate of output or employment.

Practising policy-makers have not been tardy in jettisoning new classical-new Keynesian wisdom when called upon to do so. It turns out that in the industrial world, stabilisation policy, the other end of the trade-off, defined as the minimisation of squared deviations of output around potential, has never been far from the concerns of the monetary authorities [Friedman 2006; Yellen and Akerlof 2006]. There has been a concerted move away not just from monetary policy rules but also from the limits of flexible discretion that theory would permit. The clamour of members of the European Union, reeling from unemployment, for freedom from the chains of the Stability and Growth Pact has become deafening. Developing countries have been only a little less courageous in dealing with the sway of imperial ideas. For example, in most poor countries prices are stable. Yet, these nations have not woken up to the degree of freedom provided thereby to focus on growth and employment. A few, however, while not taking an eye off fiscal rectitude, have worked out dynamic fiscal paths according to which fiscal deficits will be generated in the future but are an unavoidable concomitant of responses to shocks impacting today [Gottschaik 2005]. Chile, for example, has a counter-cyclical component in its fiscal policy framework. The key statistic is the structural deficit, which is the difference between the actual fiscal position and the cyclical component of the balance. The deviation between the two generates an automatic negative feedback expenditure response. The strategy is perfectly credible.

The H T Parekh Finance Forum is edited and managed by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

Economic and Political Weekly June 10, 2006

Even on its own terms, recent work with the standard model has resulted in nonstandard results. Buiter (2006) works with a generic model and concludes that price stability is not a property of optimal monetary policy if price setters learn or the tax authorities can implement a simple feedback rule for the indirect tax rate. He works out both an “unconstrained optimal fiscal policy” where tax rates are a function of microeconomic data and “constrained optimal fiscal policy” in which tax rates depend on aggregate information [Buiter 2006:5]. The interesting fiscal instruments arrived at are non-lump sum taxes and transfers. He derives a novel blend of indirect and direct taxes, which, if the authorities are sufficiently informed and flexible, can completely undo the suboptimal outcomes generated by price setting and indexation practices. If, on the other hand, the taxes are confined to simple feedback rules, enough of the inefficiencies are eliminated to ensure that real outcomes are invariant to alternative inflation rates. However, the results are not robust to any constraints on the ability of the authorities to impose lump sum taxes and make lump sum transfers. Yellen and Akerlof (2006) show that if welfare depends non-linearly on unemployment, losses from output variability might exceed Lucas’ calculations. As aggregate unemployment goes up, the utility loss of an “unemployment week” increases and the utility gain of an “employment week” increases. Unemployment weeks appear with distressing frequency in long duration unemployment spells. If a week of unemployment is part of a long haul and the share of long-term unemployment in total unemployment is increasing with the aggregate unemployment rate, then welfare declines non-linearly as unemployment rises. With higher unemployment, the severity of the unemployment week rises. In other micro-founded work, the impact of counter-cyclical fiscal policy is heightened [Leith and Wren-Lewis 2005]. Taxes matter because they influence relative prices. For instance, income taxes change the returns from supplying labour.

The expectation, then, is for the two organs of the state to rejoin the body politic on the stabilisation front. The details of the working relationship are yet to be worked out. In all scenarios it must not be forgotten that “fundamentally” the central bank is the “junior partner” to the fiscal authorities in the nexus [Buiter 2005:C1]. There is no meaning to an independent central bank. Expectedly, the time rigidities normally associated with fiscal actions will have to be compared with the overnight facility of monetary policy. Welfare-based analysis can be used to measure the degree to which stickiness in the implementation of tax rates and government spending run counter to the benefits of fiscal consolidation. On the other hand, even in models where Ricardian equivalence holds, that is, the thesis that the attempts by policy-makers to change the inter-temporal pattern of consumers’ income has no effects is valid, fiscal policy will have real effects. Furthermore, its impact is different from monetary policy and varies between different fiscal instruments.

Finally, there need be no conflict between short-run stabilisation and longrun stabilisation of government debt. The chief reason is that the optimal speed of debt stabilisation is slow and, conditional on the use of discretionary fiscal instruments to stabilise debt over a multi-period horizon, some drift in debt is called for.

Rules and DiscretionRules and DiscretionRules and DiscretionRules and DiscretionRules and Discretion

If use of the Phillips curve is hazardous, all that remains of the two-equation macroeconomic model in town is the good old IS curve. Furthermore, if the interest rate is too weak a reed on which to hang demand functions, partly for the cited reasons, the policy instruments are G or T or a combination of both. At least, the theory of optimal taxation is relatively well settled and government expenditure multipliers can be worked out. Sceptics will instantly protest that the neat optimisation exercises written out above have no place in a democracy in which there is a confusion of interests. Policy is likely to be of a flimflam character, changing arbitrarily in response to pressure tactics. Thus, frequent changes in expenditure programmes are inefficient and the need to constantly adjust behaviour in response to changing tax rates will be costly [Solow 2005]. Temporary changes in tax rates will be relatively inefficient in influencing private sector expenditure because they have negligible effects on permanent income or life cycle decisions.

On the other hand, temporary, reversible, decisions are the defining trait of stabilisation policy. Besides, who is naïve enough to believe that the government represents the interests of the people, even if a combination of their disparate preferences is possible? But then, surely a central bank reaction function with a negligible weight on the employment variable is as biased as anything else!

Harking back to the foundations, multiple constituencies are the foundation of dynamic analysis. Indeed, it trivialises the institutional framework to reduce it to a representative agent problem. All that is required is for the players and their objective functions to be common knowledge. Period-by-period changes are the essence of feedback policies. For example, the charge of transient, reversible policies can be met, Solow (2005) answers, by a consensus that they be confined to sales tax or VAT. Over a business cycle horizon there is no reason why a multiparty equilibrium cannot endogenise an automatic stabiliser package which, for example, is unchanging over a 10- or 12-year period. The principle here is that instead of choosing tax rates that generate discrete increases in revenue in response to changes in income or output, triggers are built into the system that will change tax rates themselves in response to information about the economy. Dates for the reconsideration of the package can be set in advance or target zones can be set whereby fiscal policy is activated if the boundaries are breached. One illustration, not different in spirit from its counterpart monetary policy, is a fiscal policy rule. The simplest rule that ensures solvency is a balanced budget rule. However, the detrimental effects the formula has on short-run stabilisation are severe. The point about a feedback equilibrium made earlier is that there is always scope for any one of the players, who is not imprisoned either by the past or by the future, to respond to the realisation of an unexpected event, for instance, and take Pareto-improving corrective measures.

Countries may be trapped in an inferior equilibrium for no fault of their own. A coalition of all players might choose to run a series of deficits and increase the country’s debt in order to, say, implement a nation-wide rural employment guarantee scheme. The UK government, for example,

Economic and Political Weekly June 10, 2006 explicitly violates its rules equilibrium. Under specified conditions, debt rises to finance investment. Secondly, similar to the Chile case, the debt-to-GDP ratio is stabilised over the cycle rather than at a particular time point. Within a wide range, there is considerable leeway to engage in counter cyclical fiscal policy over the course of the cycle. If persistent, unemployment, that is, unemployment that is not only caused by stochastic shocks, is the target, two ideas are salient [Blanchard 2006]. The capital accumulation game must be solved. If, for instance, due to an oil price shock, bargained wages do not adjust fast enough, unemployment rises. When employment falls, so does the rate of profit. As long as the profit rate is below user cost, capital decumulates over time, leading to a further decline in employment in a vicious spiral.

The other requirement is the development of a framework that is drawn from the mode and relations of production in an economy that may not only be deeply polarised but also be rocked by incessant change. An emerging common framework that applies is a view of unemployment that is the outcome of gales of creative destruction. The present generation of models writes large flows of workers into the labour market and the complex matching and bargaining process between workers and managers that results. The worker can threaten to quit, but her bluff is idle in a situation of generalised unemployment. Thus, a high level of unemployment weakens workers and strengthens firms. One interesting hypothesis is that differences in trust between workers and firms can explain differences in unemployment rates across countries. Measures of trust like strike intensity have explained a large fraction of the contrasting experience of European countries.




Amato, Jeffrey D (2005): ‘The Role of the Natural Rate of Interest in Monetary Policy’, CESifo Economic Studies, Vol 51, No 4, pp 729-55.

Basar, Tamer and Geert Jan Olsder (1995):Dynamic Non-cooperative Game Theory, Academic Press, London.

Blanchard, Olivier (2006): ‘European Unemployment: The Evolution of Facts and Ideas’, Economic Policy, Vol 45, pp 7-59.

Buiter, W H (2005): ‘New Developments in Monetary Economics: Two Ghosts, Two Eccentricities, a Fallacy, a Mirage and a Mythos’, The Economic Journal, Vol 115, No 502, pp C1-C31.

– (2006): ‘The Elusive Welfare Economics of Price Stability as a Monetary Policy Objective’, International Research Forum on Monetary Policy, Working Paper 609.

Friedman, Benjamin (2006): ‘The Greenspan Era: Discretion, Rather than Rules’, NBER Working Paper 12119.

Gottschaik, Ricardo (2005): ‘The Macro Content of PRSPs: Assessing the Need for a More Flexible Macroeconomic Policy Framework’, Development Policy Review, Vol 25, No 4, pp 419-42.

Leith, Campbell and Simon Wren-Lewis (2005): ‘Fiscal Stabilisation Policy and Fiscal Institutions’, Oxford Review of Economic Policy, Vol 21, No 4, pp 485-508.

Solow, Robert (2005): ‘Rethinking Fiscal Policy’, Oxford Review of Economic Policy, Vol 21, No 4, pp 509-14.

Yellen, Janet L and George A Akerlof (2006): ‘Stabilisation Policy: A Reconsideration’, Economic Inquiry, Vol 44, No 1, pp 1-22.

Economic and Political Weekly June 10, 2006

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