response to shocks: incorporating flexibility in fiscal rules

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%


25%

75%

0%


Overall responseOverall response

51%

32%

17%


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


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


Cha

nge

in O

B


-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


Ch

ange

in

OB


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


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


Gro

wth

in p

erce

nt


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


Yes 0 0

Total No Need 44 51


Yes 15 17

response to shocks: incorporating flexibility in fiscal rules

Documents

fiscal policy rule

fiscal discretion

fiscal rulesmanmohan

output shocks

flexibility familiar

specific fiscal indicator

specific debt target

public debt