Saturday, February 25, 2012

Golden rule or golden straightjacket?

by Karl Whelan


February 25, 2012

Europe’s Fiscal Compact is being widely sold as the essence of prudent fiscal management. But this column argues that the rules in the Fiscal Compact severely restrict a country’s ability to use fiscal policy to stabilise its economy and will often require debt levels far below those considered sensible. The rules should be changed before they become a straightjacket.

Economists have long debated the question of whether macroeconomic policy should be set on the basis of a pre-specified set of rules or whether policymakers should be allowed discretion to set policy as they see fit. Personally, I am a sceptic regarding legally binding macroeconomic rules.

As a professional macroeconomist, I think it is important to admit the limits of our knowledge. Governments can face policy challenges that even the most complex rules may fail to anticipate. We should also acknowledge that our understanding of how the macroeconomy works is, at best, incomplete.

For these reasons, macroeconomic rules that constitute ‘frontier macroeconomic thinking’ at one time can end up being viewed later as overly rigid and outdated (see for example Kirkegaard 2012 on this site). The adherence of international policy makers to the Gold Standard during the 1930s provides a good example.

What is noteworthy about the new EU Fiscal Compact, however, is that it does not even correspond to current mainstream thinking among economists as to how an ideal fiscal policy framework should operate.

I suspect most economists would agree that such a framework should have two key elements.
First, it should guide an economy towards a moderate and sustainable level of public debt.

Second, it should keep public debt fluctuating around this moderate level in a countercyclical fashion, with higher-than-usual deficits in times of recession being offset by improvements in the fiscal position during expansions.

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