response to shocks: incorporating flexibility in fiscal rules manmohan s. kumar fiscal affairs...
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Response to Shocks:Response to Shocks: Incorporating Flexibility in Fiscal RulesIncorporating Flexibility in Fiscal Rules
Manmohan S. KumarManmohan S. KumarFiscal Affairs DepartmentFiscal Affairs Department
May 5, 2009May 5, 2009
OutlineOutline
Credibility-flexibility trade-offCredibility-flexibility trade-off How to make fiscal rules flexibleHow to make fiscal rules flexible
Choice of targetChoice of target Combination of rulesCombination of rules Escape clauses; Contingency fundsEscape clauses; Contingency funds
Features of existing fiscal rules Features of existing fiscal rules
Fiscal rules and the crisisFiscal rules and the crisis
Main elementsMain elements MechanismMechanism placing placing durabledurable constraintsconstraints on fiscal discretion through on fiscal discretion through
numerical numerical limitslimits on budgetary aggregates (budget balance, public on budgetary aggregates (budget balance, public debt, expenditure, revenue)debt, expenditure, revenue)
Needed only when the commitment to sustainable public finances Needed only when the commitment to sustainable public finances lacks credibility because of well-identified bias in the design and lacks credibility because of well-identified bias in the design and implementation of fiscal policyimplementation of fiscal policy
Any fiscal policy rule is made of 3 parts:Any fiscal policy rule is made of 3 parts:
A A numerical target or ceiling numerical target or ceiling delineating the range of adequate fiscal delineating the range of adequate fiscal policies in terms of a specific fiscal indicator (or a combination thereof).policies in terms of a specific fiscal indicator (or a combination thereof).
An explicit An explicit costcost to be incurred by policymakers if they deviate from the to be incurred by policymakers if they deviate from the rule.rule.
A A monitoring/enforcement proceduremonitoring/enforcement procedure ensuring that the costs are felt by ensuring that the costs are felt by policymakers when deviations occur.policymakers when deviations occur.
Credibility-Flexibility Trade-OffCredibility-Flexibility Trade-Off Debate between rules and flexibility familiar:Debate between rules and flexibility familiar:
Rules can help in Rules can help in attaining and sustaining credibilityattaining and sustaining credibility with regard to with regard to the soundness of macroeconomic policy the soundness of macroeconomic policy
But while But while requiring adjustment to persistent shocks, need flexibility to requiring adjustment to persistent shocks, need flexibility to deal with temporary shocksdeal with temporary shocks
Degree of flexibility that may be available in the context of a Degree of flexibility that may be available in the context of a
rules-based framework depends on:rules-based framework depends on:
Design of the rule itselfDesign of the rule itself Extent to which there is sufficient credibility to begin withExtent to which there is sufficient credibility to begin with Scope for action: e.g. higher scope for discretionary expansion in Scope for action: e.g. higher scope for discretionary expansion in
bad time if buffers built up in good timesbad time if buffers built up in good times
Types of ShocksTypes of Shocks Ideal is to have adequate degree of flexibility, allowed for Ideal is to have adequate degree of flexibility, allowed for
in an in an ex ante and transparent manner, to deal with the ex ante and transparent manner, to deal with the different types of shocks that would not compromise the different types of shocks that would not compromise the underlying sustainability of budgetary positionsunderlying sustainability of budgetary positions
Country specific considerations Country specific considerations
What shocks?What shocks? Output Output revenue impact revenue impact “automatic” stabilizers “automatic” stabilizers
• Question: what role for discretionary policy over the cycle? Question: what role for discretionary policy over the cycle? Interest rate and exchange rate Interest rate and exchange rate debt service (especially if large debt service (especially if large
short-term / forex debt);short-term / forex debt); Inflation Inflation indexed expenditure items (wage bill, social transfers, indexed expenditure items (wage bill, social transfers,
…) and revenue (non-indexed tax brackets vs. nominal tax debt);…) and revenue (non-indexed tax brackets vs. nominal tax debt); Realization of contingent or implicit liabilities (e.g. banking sector Realization of contingent or implicit liabilities (e.g. banking sector
crisis, non-performing public enterprises, call of loan guarantees,crisis, non-performing public enterprises, call of loan guarantees,…);…);
Other shocks: natural disasters, wars,…Other shocks: natural disasters, wars,…
Responding to output shocks: Responding to output shocks: Choice of TargetChoice of Target
A A debt ruledebt rule, while constraining fiscal policy to sustainable debt dynamics, , while constraining fiscal policy to sustainable debt dynamics, lacks flexibility in the face of shocks: could force undesirable policy lacks flexibility in the face of shocks: could force undesirable policy adjustments. May also be too flexible (i.e. incapable of preventing policy adjustments. May also be too flexible (i.e. incapable of preventing policy bias) if one is well below the ceiling.bias) if one is well below the ceiling.
Since medium-term debt objective is critical, it can be used in conjunction Since medium-term debt objective is critical, it can be used in conjunction with other ruleswith other rules
An An overall budget balanceoverall budget balance rule with an annual target, or nominal deficit rule with an annual target, or nominal deficit target, has a number of useful features. But, if focussed on annual target, target, has a number of useful features. But, if focussed on annual target, would not provide flexibility with respect to cyclical developments. It cannot would not provide flexibility with respect to cyclical developments. It cannot prevent procyclicality in good times so it inevitably "imposes" procyclicality in prevent procyclicality in good times so it inevitably "imposes" procyclicality in bad times. bad times.
Expenditure rule: Provides room for automatic stabilizers to operate freely, Expenditure rule: Provides room for automatic stabilizers to operate freely, but does not map into specific debt target (issue of sustainability). Helpful if but does not map into specific debt target (issue of sustainability). Helpful if the main policy bias is procyclicality (not sustainability). Works best in the main policy bias is procyclicality (not sustainability). Works best in combination with a deficit/debt ceiling and in the context of an MTBF combination with a deficit/debt ceiling and in the context of an MTBF (Sweden, Netherlands, Finland).(Sweden, Netherlands, Finland).
Over the CycleOver the Cycle Limits of nominal targets led to consideration of “balance over the Limits of nominal targets led to consideration of “balance over the
cycle” type of rule, or Cyclically adjusted balance (CAB) targets. cycle” type of rule, or Cyclically adjusted balance (CAB) targets. Example of each include:Example of each include:
Balance over the cycle:Balance over the cycle: Sweden, UK (1997-08), Australia Sweden, UK (1997-08), Australia Cyclically-adjusted balanceCyclically-adjusted balance: Chile, Netherlands, SGP: Chile, Netherlands, SGP
Advantages of “balance over the cycle” are:Advantages of “balance over the cycle” are: Medium-term orientation for fiscal policyMedium-term orientation for fiscal policy Allow for automatic stabilizers and discretionary response to shocksAllow for automatic stabilizers and discretionary response to shocks Promotes sustainabilityPromotes sustainability
But challenges with regard to dating the cycle: But challenges with regard to dating the cycle: No established methodology for judging start and end pointsNo established methodology for judging start and end points Sensitive to assumptions about trend and latest data (eg. Current crisis)Sensitive to assumptions about trend and latest data (eg. Current crisis) Data lags and revisions to GDP dataData lags and revisions to GDP data
Interest rate and exchange rate shocksInterest rate and exchange rate shocks Interest rate and exchange rate Interest rate and exchange rate overall balance overall balance
through debt service, especially if debt is short-term and through debt service, especially if debt is short-term and forex-denominated. forex-denominated.
A rule based on overall balance would force sharp fiscal A rule based on overall balance would force sharp fiscal policy adjustments in response to such temporary policy adjustments in response to such temporary shocks. [Response will be needed if they are persistent.]shocks. [Response will be needed if they are persistent.]
Primary balance target helps to the extent that shocks Primary balance target helps to the extent that shocks are transitory.are transitory.
Issue: under an overall balance rule, falling public debt Issue: under an overall balance rule, falling public debt and debt service makes space for primary expenditure and debt service makes space for primary expenditure increases. Question: allow for larger spending or put increases. Question: allow for larger spending or put savings in a fund for future generations (eg.if aging is an savings in a fund for future generations (eg.if aging is an issue), or a stabilization fund (buffer for future shocks)? issue), or a stabilization fund (buffer for future shocks)?
Combination of rulesCombination of rules Combine a fiscal rule as an intermediate target with an Combine a fiscal rule as an intermediate target with an
anchoranchor
Flexibility in the intermediate target, based on budget Flexibility in the intermediate target, based on budget balance, primary balance, or expenditure, can be balance, primary balance, or expenditure, can be provided as long as debt ratio remains below a specified provided as long as debt ratio remains below a specified thresholdthreshold
In response to exogenous shocks, allow limited In response to exogenous shocks, allow limited deviations from the anchordeviations from the anchor
Pronounced deviations would require tightening of the Pronounced deviations would require tightening of the intermediate target intermediate target
Escape ClausesEscape Clauses
An essential requirement is to have a pre-An essential requirement is to have a pre-determined, credible & transparent determined, credible & transparent mechanismmechanism Desirable to have limited discretion in Desirable to have limited discretion in
providing interpretation of eventsproviding interpretation of events Range of factors that allow escape Range of factors that allow escape
clauses to be triggered clauses to be triggered Returning back to the ruleReturning back to the rule Issue of credibilityIssue of credibility
Swiss “debt brake” principle Swiss “debt brake” principle
Requires structural fiscal balance ex-ante every year. Requires structural fiscal balance ex-ante every year.
Implementation: one year ahead ceiling on central government Implementation: one year ahead ceiling on central government expenditure, equal to the corresponding projected cyclically expenditure, equal to the corresponding projected cyclically adjusted revenueadjusted revenue
Ex-post, structural balance accrues on a fictitious account. Negative Ex-post, structural balance accrues on a fictitious account. Negative balance on the account can never exceed 6 percent of federal balance on the account can never exceed 6 percent of federal expenditure GDP. Positive balances on the account (cumulative expenditure GDP. Positive balances on the account (cumulative structural surpluses) provide room for structural deficits.structural surpluses) provide room for structural deficits.
The rule requires the government to eliminate any negative balance The rule requires the government to eliminate any negative balance in the account: no timeframe is specified, unless the negative in the account: no timeframe is specified, unless the negative balance exceeds 6 percent of annual federal expenditure (about 0.6 balance exceeds 6 percent of annual federal expenditure (about 0.6 percent of GDP), in which case the account must be brought down percent of GDP), in which case the account must be brought down to below 6 percent within three years—hence the debt-break to below 6 percent within three years—hence the debt-break mechanismmechanism
Contingency FundsContingency Funds
Rationale Rationale Issue of transparency; activationIssue of transparency; activation Key featuresKey features
Accumulation of reserves in the fund during Accumulation of reserves in the fund during “good” times; to be drawn down during “good” times; to be drawn down during downturns or other shocksdownturns or other shocks
Rainy Day fundsRainy Day funds
Increasing recourse to rulesIncreasing recourse to rules
Number of fiscal rules by category of countries: 1990-2008
0
10
20
30
40
50
60
70
80
1990 1995 2000 2008
Industrial
EU-27
Emerging
LIC's
Type of ruleType of rule
Fiscal Rules
Multiple rules; 68; 77%
Single rule; 20; 23%
Country variations in single vs. Country variations in single vs. multiple rulesmultiple rules
13%
18%
34%
88%
82%
66%
Industrial Emerging LIC
SingleRule
MultipleRules
Evolution of different types of rulesEvolution of different types of rules
Number of countries with at least one fiscal policy rule (by type of rule)
0
10
20
30
40
50
60
70
80
1990 1995 2000 2008
Budget balance
Debt
Expenditure
Revenue
Expenditure and revenue rules are thus relative newcomersExpenditure and revenue rules are thus relative newcomers
Median duration of existing fiscal rules (in years)
0
1
2
3
4
5
6
7
8
9
10
Budget balance Debt Expenditure Revenue
Budget balance rules appear stronger and have wider coverageBudget balance rules appear stronger and have wider coverage
Selected features of rules-based fiscal frameworks by type of rule (common features only)
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Independentenforcement (relative
frequency)
Independentmonitoring (relative
frequency)
Coverage (medianrelative to maximum
possible score)
Statutory basis (medianrelative to maximum
possible score)
Budget balance
Debt
Revenue
Expenditure
Features by country groupsFeatures by country groups
Selected features of rules-based fiscal frameworks (relative frequencies by country groups)
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Independentenforcement
procedure (allrules)
MTEF(relative to
BBR and DR)
Independentforecasts (all
rules)
FRL (all rules) Provision(s)for fiscal
stabilization(relative to
BBR)
Exclusion ofhigh-quality
spending(relative to
BBR and ER)
Independentmonitoring (all
rules)
Industrial Emerging LIC's Resource-rich
Large shockLarge shock
Output gap (in percent of potential GDP)
-10
-8
-6
-4
-2
0
2
4
1996A1 1997A1 1998A1 1999A1 2000A1 2001A1 2002A1 2003A1 2004A1 2005A1 2006A1 2007A1 2008A1 2009A1
United States
United Kingdom
Japan
Germany
Type of responseType of response
Was the rule changed?Was the rule changed? If so, why?If so, why?
If not, why not?If not, why not? Flexible numerical constraintFlexible numerical constraint Flexible time frame for adjustmentFlexible time frame for adjustment Escape clausesEscape clauses
No change, but conflict?No change, but conflict? ChangeChange
In numerical constraintIn numerical constraint AbeyanceAbeyance
Response by different country Response by different country groupingsgroupings
Industrial Industrial
Low IncomeLow Income EmergingEmerging
72%
3%
24%
No Need No but Conflict Yes
50%
26%24%
No Need No but Conflict Yes
25%
75%
0%
No Need No but Conflict Yes
Overall responseOverall response
51%
32%
17%
No Need No but Conflict Yes
Unchanged rulesUnchanged rules
No Need because:No Need because: CountriesCountries
Flexible Numerical Flexible Numerical ConstraintsConstraints
AustraliaAustralia BelgiumBelgium BrazilBrazil CanadaCanadaCape Cape VerdeVerde
ColombiaColombia
EcuadorEcuador FinlandFinland IcelandIceland IndonesiaIndonesia LiberiaLiberiaLuxemboLuxembourgurg
MauritiusMauritius NorwayNorway VenezuelaVenezuela
Flexible Time Frame for Flexible Time Frame for AdjustmentAdjustment
EU27 EU27
Equatorial Equatorial GuineaGuinea
New New ZealandZealand
Escape ClauseEscape ClauseAustriaAustria
Czech Czech RepublicRepublic
FranceFrance GermanyGermany IndiaIndia KenyaKenya
NigeriaNigeria RomaniaRomania
Unchanged but tensionUnchanged but tension
No change in rules but strong conflict between the rule and desirable policy responsesNo change in rules but strong conflict between the rule and desirable policy responses
BeninBenin BotswanaBotswana Burkina FasoBurkina Faso CameroonCameroonCentral African Central African RepublicRepublic
ChadChad ComorosComoros CongoCongo Cote d'IvoireCote d'Ivoire DominicaDominica
GabonGabon GeorgiaGeorgia GrenadaGrenada Guinea BissauGuinea Bissau IsraelIsrael
JapanJapan KosovoKosovo MaliMali NigerNigerPakistanPakistan
PanamaPanama SenegalSenegal Sierra LeoneSierra Leone
Rules changedRules changed
Yes, Numerical Constraints ChangeYes, Numerical Constraints Change Yes, Rule ChangesYes, Rule Changes
PermanentlyPermanentlyTemporarily Temporarily with Specific with Specific TimeframeTimeframe
Temporarily Temporarily without without Specific Specific
TimeframeTimeframe
Permanent Permanent AbolitionAbolition
In Abeyance In Abeyance with Specific with Specific TimeframeTimeframe
In Abeyance In Abeyance without without Specific Specific
TimeframeTimeframe
22 44 00 00 55 44
33%33% 67%67% 0%0% 0%0% 56%56% 44%44%
GermanyGermany ChileChile AustriaAustria ArgentinaArgentina
MexicoMexico ItalyItaly Costa RicaCosta Rica FinlandFinland
NamibiaNamibia NetherlandsNetherlands LithuaniaLithuania
PeruPeru RussiaRussia SpainSpain
UKUK
Response, and public debtResponse, and public debt
Debt ratio end-2008Debt ratio end-2008
51
37
5748
196
7665
113
59
21
0
40
Industrial Emerging LIC Total
In
percen
t o
f G
DP
No Need No but Conflict Yes
Response, and change in overall Response, and change in overall balancebalance
2008 20092008 2009
-1.6
-1.1
0.5
-0.7
-3.0
-0.9 -0.9
-1.6-1.4
-2.1
0.0
-1.8
Industrial Emerging LIC Total
Cha
nge
in O
B
No Need No but Conflict Yes
-4.6
-2.1
-5.6
-4.1-4.3
-0.9
-3.8
-3.0
-4.0 -4.0
0.0
-4.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
Industrial Emerging LIC Total
Ch
ange
in
OB
No Need No but Conflict Yes
Response, and GDP growthResponse, and GDP growth
2008 20092008 2009
0.8
3.5
7.3
3.9
-0.6
3.5 3.4
2.1
1.0
4.5
0.0
2.7
Industrial Emerging LIC Total
Gro
wth
in p
erce
nt
No Need
No but Conflict
Yes
-4.0
-3.0
2.0
-1.6
-6.2
0.0
2.3
-1.3
-4.3
-2.2
0.0
-3.3
Industrial Emerging LIC Total
Gro
wth
in p
erce
nt
No Need No but Conflict Yes
Case study: UKCase study: UK UK activated an escape clause that allows for an open-ended return to UK activated an escape clause that allows for an open-ended return to
discretion. discretion. Rule suspended and a "temporary operating rule" put in place:Rule suspended and a "temporary operating rule" put in place:
To "improve the cyclically-adjusted budget each year, once the economy 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 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 proportion of GDP once the global shocks have worked their way through the economy in full”. economy in full”.
Timeframe moved from 2015/16 to 2017/18 between November 2008 and April 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 2009 Budget, and the projected peak level of debt-to-GDP increased from 59 to almost 80 percent.almost 80 percent.
““The government’s ‘temporary operating rule’ offers it considerable flexibility 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 in setting fiscal policy, but it may not be seen as much of a constraint on tax and spending decisions”. and spending decisions”.
Contrast with the notion of escape clause under the SGPContrast with the notion of escape clause under the SGP Right arrangement is probably somewhere in between (e.g. escape clause a 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 la UK should be made perishable after 2 years, with a reactivation requiring a super majority...) a super majority...)
Uncertainty in emerging marketsUncertainty in emerging markets
30
35
40
45
50
55
2007 08 09 10 11 12 13 14
Public Debt (in percent of GDP)Emerging Market G-20 Countries
Baseline Scenario
Lower growth and contingent liability shock
Uncertainty in advanced countriesUncertainty in advanced countries
70
80
90
100
110
120
130
140
150
2007 08 09 10 11 12 13 14
Public Debt (in percent of GDP)Advanced G-20 Countries
Baseline
ConclusionsConclusions
Rules that are perceived to be excessively “rigid” may not be sustainableRules that are perceived to be excessively “rigid” may not be sustainable
Appropriate amount of flexibility can enhance credibilityAppropriate amount of flexibility can enhance credibility
Contours of flexibility need to be decided beforehand, be transparent, and Contours of flexibility need to be decided beforehand, be transparent, and reflect country-specific circumstancesreflect country-specific circumstances
Increasing reliance on rulesIncreasing reliance on rules
Response to recent shocks reflected inbuilt flexibility, credibility, and existing Response to recent shocks reflected inbuilt flexibility, credibility, and existing spacespace
Large uncertainties ahead need to be taken into account in the design, and Large uncertainties ahead need to be taken into account in the design, and timing of implementationtiming of implementation
Type of Country Rule Changed? Number of Countries In percent
Industrial No Need 21 72
No but Conflict 1 3
Yes 7 24
Emerging No Need 17 50
No but Conflict 9 26
Yes 8 24
LIC No Need 6 25
No but Conflict 18 75
Yes 0 0
Total No Need 44 51
No but Conflict 28 32
Yes 15 17