Response to Shocks: Incorporating Flexibility in Fiscal Rules

1. Response to Shocks:Incorporating Flexibility in Fiscal Rules Manmohan S. Kumar Fiscal Affairs Department May 5, 2009

2. Outline • Credibility-flexibility trade-off • How to make fiscal rules flexible • Choice of target • Combination of rules • Escape clauses; Contingency funds • Features of existing fiscal rules • Fiscal rules and the crisis

3. Main elements • Mechanism placing durableconstraints on fiscal discretion through numerical limits on budgetary aggregates (budget balance, public debt, expenditure, revenue) • Needed only when the commitment to sustainable public finances lacks credibility because of well-identified bias in the design and implementation of fiscal policy • Any fiscal policy rule is made of 3 parts: • A numerical target or ceiling delineating the range of adequate fiscal policies in terms of a specific fiscal indicator (or a combination thereof). • An explicit cost to be incurred by policymakers if they deviate from the rule. • A monitoring/enforcement procedure ensuring that the costs are felt by policymakers when deviations occur.

4. Credibility-Flexibility Trade-Off • Debate between rules and flexibility familiar: • Rules can help in attaining and sustaining credibility with regard to the soundness of macroeconomic policy • But while requiring adjustment to persistent shocks, need flexibility to deal with temporary shocks • Degree of flexibility that may be available in the context of a rules-based framework depends on: • Design of the rule itself • Extent to which there is sufficient credibility to begin with • Scope for action: e.g. higher scope for discretionary expansion in bad time if buffers built up in good times

5. Types of Shocks • Ideal is to have adequate degree of flexibility, allowed for in an ex ante and transparent manner, to deal with the different types of shocks that would not compromise the underlying sustainability of budgetary positions • Country specific considerations • What shocks? • Output  revenue impact  “automatic” stabilizers • Question: what role for discretionary policy over the cycle? • Interest rate and exchange rate  debt service (especially if large short-term / forex debt); • Inflation  indexed expenditure items (wage bill, social transfers,…) and revenue (non-indexed tax brackets vs. nominal tax debt); • Realization of contingent or implicit liabilities (e.g. banking sector crisis, non-performing public enterprises, call of loan guarantees,…); • Other shocks: natural disasters, wars,…

6. Responding to output shocks: Choice of Target • A debt rule, while constraining fiscal policy to sustainable debt dynamics, lacks flexibility in the face of shocks: could force undesirable policy adjustments. May also be too flexible (i.e. incapable of preventing policy bias) if one is well below the ceiling. • Since medium-term debt objective is critical, it can be used in conjunction with other rules • An overall budget balance rule with an annual target, or nominal deficit target, has a number of useful features. But, if focussed on annual target, would not provide flexibility with respect to cyclical developments. It cannot prevent procyclicality in good times so it inevitably "imposes" procyclicality in bad times. • Expenditure rule: Provides room for automatic stabilizers to operate freely, but does not map into specific debt target (issue of sustainability). Helpful if the main policy bias is procyclicality (not sustainability). Works best in combination with a deficit/debt ceiling and in the context of an MTBF (Sweden, Netherlands, Finland).

7. Over the Cycle • Limits of nominal targets led to consideration of “balance over the cycle” type of rule, or Cyclically adjusted balance (CAB) targets. Example of each include: • Balance over the cycle: Sweden, UK (1997-08), Australia • Cyclically-adjusted balance: Chile, Netherlands, SGP • Advantages of “balance over the cycle” are: • Medium-term orientation for fiscal policy • Allow for automatic stabilizers and discretionary response to shocks • Promotes sustainability • But challenges with regard to dating the cycle: • No established methodology for judging start and end points • Sensitive to assumptions about trend and latest data (eg. Current crisis) • Data lags and revisions to GDP data

8. Interest rate and exchange rate shocks • Interest rate and exchange rate  overall balance through debt service, especially if debt is short-term and forex-denominated. • A rule based on overall balance would force sharp fiscal policy adjustments in response to such temporary shocks. [Response will be needed if they are persistent.] • Primary balance target helps to the extent that shocks are transitory. • Issue: under an overall balance rule, falling public debt and debt service makes space for primary expenditure increases. Question: allow for larger spending or put savings in a fund for future generations (eg.if aging is an issue), or a stabilization fund (buffer for future shocks)?

9. Combination of rules • Combine a fiscal rule as an intermediate target with an anchor • Flexibility in the intermediate target, based on budget balance, primary balance, or expenditure, can be provided as long as debt ratio remains below a specified threshold • In response to exogenous shocks, allow limited deviations from the anchor • Pronounced deviations would require tightening of the intermediate target

10. Escape Clauses • An essential requirement is to have a pre-determined, credible & transparent mechanism • Desirable to have limited discretion in providing interpretation of events • Range of factors that allow escape clauses to be triggered • Returning back to the rule • Issue of credibility

11. Swiss “debt brake” principle • Requires structural fiscal balance ex-ante every year. • Implementation: one year ahead ceiling on central government expenditure, equal to the corresponding projected cyclically adjusted revenue • Ex-post, structural balance accrues on a fictitious account. Negative balance on the account can never exceed 6 percent of federal expenditure GDP. Positive balances on the account (cumulative structural surpluses) provide room for structural deficits. • The rule requires the government to eliminate any negative balance in the account: no timeframe is specified, unless the negative balance exceeds 6 percent of annual federal expenditure (about 0.6 percent of GDP), in which case the account must be brought down to below 6 percent within three years—hence the debt-break mechanism

12. Contingency Funds • Rationale • Issue of transparency; activation • Key features • Accumulation of reserves in the fund during “good” times; to be drawn down during downturns or other shocks • Rainy Day funds

13. Increasing recourse to rules

14. Type of rule

15. Country variations in single vs. multiple rules

16. Evolution of different types of rules

17. Expenditure and revenue rules are thus relative newcomers

18. Budget balance rules appear stronger and have wider coverage

19. Features by country groups

20. Large shock

21. Type of response • Was the rule changed? • If so, why? • If not, why not? • Flexible numerical constraint • Flexible time frame for adjustment • Escape clauses • No change, but conflict? • Change • In numerical constraint • Abeyance

22. Response by different country groupings Industrial Emerging Low Income

23. Overall response

24. Unchanged rules

25. Unchanged but tension

26. Rules changed

27. Response, and public debt Debt ratio end-2008

28. Response, and change in overall balance 2008 2009

29. Response, and GDP growth 2008 2009

30. Case study: UK • UK activated an escape clause that allows for an open-ended return to discretion. • Rule suspended and a "temporary operating rule" put in place: • To  "improve the cyclically-adjusted budget each year, once the economy emerges from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full”. • Timeframe moved from 2015/16 to 2017/18 between November 2008 and April 2009 Budget, and the projected peak level of debt-to-GDP increased from 59 to almost 80 percent. • “The government’s ‘temporary operating rule’ offers it considerable flexibility in setting fiscal policy, but it may not be seen as much of a constraint on tax and spending decisions”. • Contrast with the notion of escape clause under the SGP • Right arrangement is probably somewhere in between (e.g. escape clause a la UK should be made perishable after 2 years, with a reactivation requiring a super majority...)

31. Uncertainty in emerging markets

32. Uncertainty in advanced countries

33. Conclusions • Rules that are perceived to be excessively “rigid” may not be sustainable • Appropriate amount of flexibility can enhance credibility • Contours of flexibility need to be decided beforehand, be transparent, and reflect country-specific circumstances • Increasing reliance on rules • Response to recent shocks reflected inbuilt flexibility, credibility, and existing space • Large uncertainties ahead need to be taken into account in the design, and timing of implementation