Tuesday, September 30, 2014

The Crisis of Fiscal Imagination

CAMBRIDGE – Greedy banks, bad economic ideas, incompetent politicians: there is no shortage of culprits for the economic crisis in which rich countries are engulfed. But there is also something more fundamental at play, a flaw that lies deeper than the responsibility of individual decision-makers. Democracies are notoriously bad at producing credible bargains that require political commitments over the medium term. In both the United States and Europe, the costs of this constraint on policy has amplified the crisis – and obscured the way out.

Consider the US, where politicians are debating how to prevent a double-dip recession, reactivate the economy, and bring down an unemployment rate that seems stuck above 9%. Everyone agrees that the country’s public debt is too high and needs to be reduced over the longer term.

While there is no quick fix to these problems, the fiscal-policy imperative is clear. The US economy needs a second round of fiscal stimulus in the short term to make up for low private demand, together with a credible long-term fiscal-consolidation program.

As sensible as this two-pronged approach – spend now, cut later – may be, it is made virtually impossible by the absence of any mechanism whereby President Barack Obama can credibly commit himself or future administrations to fiscal tightening. So any mention of a new stimulus package becomes an open invitation to those on the right to pounce on a Democratic administration for its apparent fiscal irresponsibility. The result is a fiscal policy that aggravates rather than ameliorates America’s economic malaise.

The problem is even more extreme in Europe. In a futile attempt to gain financial markets’ confidence, country after country has been forced to follow counter-productive austerity policies as the price of support from the International Monetary Fund and the European Central Bank. Yet requiring deep fiscal cuts, privatization, and other structural reforms of the type that Greece has had to undertake risks greater unemployment and deeper recessions. One reason that interest-rate spreads in financial markets remain high is that distressed eurozone countries’ growth prospects look so weak.

Here, too, it is not difficult to discern the broad outlines of a solution. Stronger countries in the eurozone must allow these spreads to narrow by guaranteeing the new debts of countries from Greece to Italy, through the issuance of Eurobonds, for example. In return, the highly indebted countries must commit to multi-year programs to restructure fiscal institutions and enhance competitiveness – reforms that can be implemented and bear fruit only over the medium term.

But, once again, this requires a credible commitment to an exchange that requires a promise of action later in return for something now. German politicians and their electorates can be excused for doubting whether future Greek, Irish, or Portuguese governments can be counted upon to deliver on current leaders’ commitments. Hence the impasse, with the eurozone becoming mired in a vicious circle of high debt and economic austerity.

Democracies often deal with the problem of extracting commitments from future politicians by delegating decision-making to quasi-independent bodies managed by officials who are insulated from day-to-day politics. Independent central banks are the archetypal example. By placing monetary policy in the hands of central bankers who cannot be told what to do, politicians effectively tie their own hands (and get lower inflation as a result).

Unfortunately, US and European politicians have failed to show similar imagination when it comes to fiscal policy. By implementing new mechanisms to render the future path of fiscal balances and public debt more predictable, they could have averted the worst of the crisis.

Compared to monetary policy, fiscal policy is infinitely more complex, involving many more trade-offs among competing interests. So an independent fiscal authority modeled along the lines of an independent central bank is neither feasible nor desirable. But certain fiscal decisions, and most critically the level of the fiscal deficit, can be delegated to an independent board.

Such a board would fix the maximum difference between public spending and revenue in light of the economic cycle and debt levels, while leaving the overall size of the public sector, its composition, and tax rates to be resolved through political debate. Establishing such a board in the US would do much to restore sanity to the country’s fiscal-policymaking.

Europe, for its part, requires a determined step toward fiscal unification if the eurozone is to survive. Removing national governments’ ability to run large deficits and borrow at will is the necessary counterpart to a joint guarantee of sovereign debts and easy borrowing terms today.

Yet this cannot mean that fiscal policy for, say, Greece or Italy would be run from Berlin. A common fiscal policy implies that the elected leaders of Greece and Italy would have some say over German fiscal policies, too. While the need for fiscal unification is increasingly recognized, it is not clear whether European leaders are willing to confront its ultimate political logic head-on. If Germans are unable to stomach the idea of sharing a political community with Greeks, they might as well accept that economic union is as good as dead.

Politics, it is said, is the art of the possible. But possibilities are shaped by our decisions as much as they are by our circumstances. As matters currently stand, when future generations place our leaders in historical perspective, they will most likely reproach them, above all, for their lack of institutional imagination.

Hide Comments Hide Comments Read Comments (2)

Please login or register to post a comment

  1. Portrait of Michael Heller

    CommentedMichael Heller

    Dani, you say:

    “… certain fiscal decisions, and most critically the level of the fiscal deficit, can be delegated to an independent board. Such a board would fix the maximum difference between public spending and revenue in light of the economic cycle and debt levels, while leaving the overall size of the public sector, its composition, and tax rates to be resolved through political debate.”
    I agree this ‘board’ certainly would be an important institutional step forward. I’m less sanguine than you about the political debate that would follow. I believe it would be several degrees more intense than it is currently. But at least your proposal is far more realistic than waiting for Democrats and Republicans to agree on constitutional amendments of the kind that James Buchanan proposed (since the 1970s) to place a legal cap on budget/fiscal deficits.
    It would be advisable, however, to simultaneously hammer out a new institutional consensus that limits government discretion in, among other things, entitlements. Really radical redefinitions of the scope of government discretion would logically go in hand with establishing a board that fixes fiscal deficits in law (of the kind you suggest). Rules-based principles have much to offer in monetary and fiscal policy. But logically this also implies rules about the scope of government. (Industrial policy, for example!).
    I’m gradually coming to the view that the institutional root of the present crisis of capitalism, which perhaps distinguishes it from previous crises, is the extraordinary level of excess capacity in politics relative to available economic resources. One implication would be that it is a mistake to delay cutbacks in the belief that there can be a future balance point at which recovery will be orderly. The balance point for future growth may never arrive by this path, and the resulting problems would be greater. 

    I’d sum it up in this way -- In the extent to which government has taken upon itself the responsibility of providing so much of the protection against individual risk in society, politics has overloaded itself. Democracy is the best system, but it can have some unfortunate effects that need to be faced. One of them is to bring about political overload. It was a German sociologist who brilliantly discussed this effect with respect to the growth of the welfare state way back in the 1980s. If that problem of political excess capacity can be dealt with alongside the establishment of non-discretionary rules-based fiscal and monetary policy, hey presto, equilibrium is restored. Predictability would be enhanced. The markets would have a party. And growth would roar into gear. No?
    Michael G Heller
    Capitalism, Institutions, and Economic Development (Routledge)


  2. CommentedPaddy Patrick

    There are so many good ideas being put forth by many talented academics and economists which could help soothe the economic crises afflicting the world... but it becomes increasingly more frustrating by the day to see the lack of political will to implement any of them. The biggest challenge will be to undue the lack of trust and the skepticism which is deeply ingrained in the public, now.