The Crisis of Fiscal Imagination

Sep 12, 2011 Dani Rodrik

Greedy banks, bad economic ideas, incompetent politicians: there is no shortage of culprits for the economic crisis in which rich countries are engulfed. But when future generations place our leaders in historical perspective, they will most likely reproach them, above all, for their lack of institutional 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.

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0 Comments on this paragraph, 2 Comments on this article

Michael Heller Mar 19, 2012

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)

http://tandf.net/books/details/9780415694452/
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Paddy Patrick Sep 14, 2011

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.
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