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Response to Shocks:
Incorporating Flexibility in Fiscal Rules
Manmohan S. Kumar
Fiscal Affairs Department
May 5, 2009
Outline
 Credibility-flexibility
trade-off
 How to make fiscal rules flexible



Choice of target
Combination of rules
Escape clauses; Contingency funds
 Features
 Fiscal
of existing fiscal rules
rules and the crisis
Main elements

Mechanism placing durable constraints on fiscal discretion through
numerical limits on budgetary aggregates (budget balance, public
debt, expenditure, revenue)

Needed only when the commitment to sustainable public finances
lacks credibility because of well-identified bias in the design and
implementation of fiscal policy

Any fiscal policy rule is made of 3 parts:



A numerical target or ceiling delineating the range of adequate fiscal
policies in terms of a specific fiscal indicator (or a combination thereof).
An explicit cost to be incurred by policymakers if they deviate from the
rule.
A monitoring/enforcement procedure ensuring that the costs are felt by
policymakers when deviations occur.
Credibility-Flexibility Trade-Off

Debate between rules and flexibility familiar:



Rules can help in attaining and sustaining credibility with regard to
the soundness of macroeconomic policy
But while requiring adjustment to persistent shocks, need flexibility to
deal with temporary shocks
Degree of flexibility that may be available in the context of a
rules-based framework depends on:



Design of the rule itself
Extent to which there is sufficient credibility to begin with
Scope for action: e.g. higher scope for discretionary expansion in
bad time if buffers built up in good times
Types of Shocks

Ideal is to have adequate degree of flexibility, allowed for
in an ex ante and transparent manner, to deal with the
different types of shocks that would not compromise the
underlying sustainability of budgetary positions

Country specific considerations

What shocks?

Output  revenue impact  “automatic” stabilizers
• Question: what role for discretionary policy over the cycle?




Interest rate and exchange rate  debt service (especially if large
short-term / forex debt);
Inflation  indexed expenditure items (wage bill, social
transfers,…) and revenue (non-indexed tax brackets vs. nominal
tax debt);
Realization of contingent or implicit liabilities (e.g. banking sector
crisis, non-performing public enterprises, call of loan
guarantees,…);
Other shocks: natural disasters, wars,…
Responding to output shocks:
Choice of Target

A debt rule, while constraining fiscal policy to sustainable debt dynamics,
lacks flexibility in the face of shocks: could force undesirable policy
adjustments. May also be too flexible (i.e. incapable of preventing policy
bias) if one is well below the ceiling.

Since medium-term debt objective is critical, it can be used in conjunction
with other rules

An overall budget balance rule with an annual target, or nominal deficit
target, has a number of useful features. But, if focussed on annual target,
would not provide flexibility with respect to cyclical developments. It cannot
prevent procyclicality in good times so it inevitably "imposes" procyclicality
in bad times.

Expenditure rule: Provides room for automatic stabilizers to operate freely,
but does not map into specific debt target (issue of sustainability). Helpful if
the main policy bias is procyclicality (not sustainability). Works best in
combination with a deficit/debt ceiling and in the context of an MTBF
(Sweden, Netherlands, Finland).
Over the Cycle

Limits of nominal targets led to consideration of “balance over the
cycle” type of rule, or Cyclically adjusted balance (CAB) targets.
Example of each include:



Advantages of “balance over the cycle” are:




Balance over the cycle: Sweden, UK (1997-08), Australia
Cyclically-adjusted balance: Chile, Netherlands, SGP
Medium-term orientation for fiscal policy
Allow for automatic stabilizers and discretionary response to shocks
Promotes sustainability
But challenges with regard to dating the cycle:



No established methodology for judging start and end points
Sensitive to assumptions about trend and latest data (eg. Current crisis)
Data lags and revisions to GDP data
Interest rate and exchange rate shocks

Interest rate and exchange rate  overall balance
through debt service, especially if debt is short-term and
forex-denominated.

A rule based on overall balance would force sharp fiscal
policy adjustments in response to such temporary
shocks. [Response will be needed if they are persistent.]

Primary balance target helps to the extent that shocks
are transitory.

Issue: under an overall balance rule, falling public debt
and debt service makes space for primary expenditure
increases. Question: allow for larger spending or put
savings in a fund for future generations (eg.if aging is an
issue), or a stabilization fund (buffer for future shocks)?
Combination of rules

Combine a fiscal rule as an intermediate target with an
anchor

Flexibility in the intermediate target, based on budget
balance, primary balance, or expenditure, can be
provided as long as debt ratio remains below a specified
threshold

In response to exogenous shocks, allow limited
deviations from the anchor

Pronounced deviations would require tightening of the
intermediate target
Escape Clauses
 An
essential requirement is to have a predetermined, credible & transparent
mechanism

Desirable to have limited discretion in
providing interpretation of events
 Range
of factors that allow escape
clauses to be triggered
 Returning back to the rule
 Issue of credibility
Swiss “debt brake” principle

Requires structural fiscal balance ex-ante every year.

Implementation: one year ahead ceiling on central government
expenditure, equal to the corresponding projected cyclically adjusted
revenue

Ex-post, structural balance accrues on a fictitious account. Negative
balance on the account can never exceed 6 percent of federal
expenditure GDP. Positive balances on the account (cumulative
structural surpluses) provide room for structural deficits.

The rule requires the government to eliminate any negative balance
in the account: no timeframe is specified, unless the negative
balance exceeds 6 percent of annual federal expenditure (about 0.6
percent of GDP), in which case the account must be brought down
to below 6 percent within three years—hence the debt-break
mechanism
Contingency Funds
 Rationale
 Issue
of transparency; activation
 Key features


Accumulation of reserves in the fund during
“good” times; to be drawn down during
downturns or other shocks
Rainy Day funds
Increasing recourse to rules
Number of fiscal rules by category of countries: 1990-2008
80
70
Industrial
EU-27
Emerging
60
LIC's
50
40
30
20
10
0
1990
1995
2000
2008
Type of rule
Fiscal Rules
Single rule; 20; 23%
Multiple rules; 68;
77%
Country variations in single vs.
multiple rules
88%
Single
Rule
82%
Multiple
Rules
66%
34%
18%
13%
Industrial
Emerging
LIC
Evolution of different types of rules
Number of countries with at least one fiscal policy rule (by type of rule)
80
70
Budget balance
Debt
Expenditure
60
Revenue
50
40
30
20
10
0
1990
1995
2000
2008
Expenditure and revenue rules are thus relative
newcomers
Median duration of existing fiscal rules (in years)
10
9
8
7
6
5
4
3
2
1
0
Budget balance
Debt
Expenditure
Revenue
Budget balance rules appear stronger and have wider coverage
Selected features of rules-based fiscal frameworks by type of rule
(common features only)
1.00
Budget balance
Debt
0.90
Revenue
0.80
Expenditure
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Independent
enforcement (relative
frequency)
Independent
monitoring (relative
frequency)
Coverage (median Statutory basis (median
relative to maximum
relative to maximum
possible score)
possible score)
Features by country groups
Selected features of rules-based fiscal frameworks
(relative frequencies by country groups)
1.00
0.90
Industrial
Emerging
LIC's
Resource-rich
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Independent
M TEF
Independent FRL (all rules) Provision(s)
enforcement
(relative to
forecasts (all
for fiscal
procedure (all BBR and DR)
rules)
stabilization
rules)
(relative to
BBR)
Exclusion of Independent
high-quality monitoring (all
spending
rules)
(relative to
BBR and ER)
Large shock
4
2
0
-2
-4
United States
-6
United Kingdom
Japan
Germany
Output gap (in percent of potential GDP)
-8
-10
1996A1 1997A1 1998A1 1999A1 2000A1 2001A1 2002A1 2003A1 2004A1 2005A1 2006A1 2007A1 2008A1 2009A1
Type of response

Was the rule changed?


If so, why?
If not, why not?



Flexible numerical constraint
Flexible time frame for adjustment
Escape clauses

No change, but conflict?
 Change


In numerical constraint
Abeyance
Response by different country
groupings
75%
72%
50%
26%
24%
24%
25%
3%
0%
No Need
No but Conflict
Industrial
Yes
No Need
No but Conflict
Emerging
Yes
No Need
No but Conflict
Yes
Low Income
Overall response
51%
32%
17%
No Need
No but Conflict
Yes
Unchanged rules
No Need because:
Flexible Numerical
Constraints
Countries
Australia
Belgium
Brazil
Canada
Cape
Verde
Colombia
Ecuador
Finland
Iceland
Indonesia
Liberia
Luxembo
urg
Mauritius
Norway
Venezuela
Equatorial
Guinea
EU27
Flexible Time Frame for
Adjustment
New
Zealand
Austria
Czech
Republic
Nigeria
Romania
Escape Clause
France
Germany
India
Kenya
Unchanged but tension
No change in rules but strong conflict between the rule and desirable policy responses
Benin
Botswana
Burkina Faso
Cameroon
Central African
Republic
Chad
Comoros
Congo
Cote d'Ivoire
Dominica
Gabon
Georgia
Grenada
Guinea Bissau
Israel
Japan
Kosovo
Mali
Niger
Panama
Senegal
Sierra Leone
Pakistan
Rules changed
Yes, Numerical Constraints Change
Permanently
Temporarily
with Specific
Timeframe
Temporarily
without
Specific
Timeframe
2
4
33%
67%
Germany
Mexico
Yes, Rule Changes
Permanent
Abolition
In Abeyance
with Specific
Timeframe
In Abeyance
without
Specific
Timeframe
0
0
5
4
0%
0%
56%
44%
Chile
Austria
Argentina
Italy
Costa Rica
Finland
Namibia
Netherlands
Lithuania
Peru
Russia
Spain
UK
Response, and public debt
Debt ratio end-2008
No Need
No but Conflict
Yes
In percent of GDP
196
113
76
65
59
57
51
48
40
37
21
0
Industrial
Emerging
LIC
Total
Response, and change in overall
balance
2008
2009
1.0
0.5
0.0
0.0
0.0
Emerging
Change in OB
-1.1
LIC
-0.9
-0.9
Total
-1.4
-1.6
Industrial
-0.7
-1.6
-2.1
-3.0
Emerging
-1.0
-1.8
Change in OB
Industrial
LIC
-0.9
-2.0
-2.1
-3.0
-3.0
-4.0
-4.0
No Need
No but Conflict
Total
Yes
-3.8
-4.0
-4.1
-4.3
-5.0
-4.6
No Need
-6.0
No but Conflict
Yes
-5.6
-4.0
Response, and GDP growth
2008
2009
7.3
2.0
2.3
No Need
No Need
No but Conflict
No but Conflict
Yes
Yes
0.0
3.9
3.5 3.5
3.4
2.7
2.1
0.8
Growth in percent
Growth in percent
4.5
Industrial
-2.2
-3.0
-4.3
0.0
LIC
Total
-1.3
-4.0
Emerging
LIC
-1.6
1.0
Industrial
-0.6
0.0
Emerging
Total
-6.2
-3.3
Case study: UK

UK activated an escape clause that allows for an open-ended return to
discretion.
 Rule suspended and a "temporary operating rule" put in place:


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
proportion of GDP once the global shocks have worked their way through the
economy in full”.
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
almost 80 percent.
“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
and spending decisions”.
 Contrast with the notion of escape clause under the SGP
 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 a super majority...)

Uncertainty in emerging markets
55
50
Public Debt (in percent of GDP)
Emerging Market G-20 Countries
45
Lower growth and
contingent liability shock
40
35
Baseline
Scenario
30
2007
08
09
10
11
12
13
14
Uncertainty in advanced countries
150
Public Debt (in percent of GDP)
Advanced G-20 Countries
140
130
120
110
100
Baseline
90
80
70
2007
08
09
10
11
12
13
14
Conclusions

Rules that are perceived to be excessively “rigid” may not be sustainable

Appropriate amount of flexibility can enhance credibility

Contours of flexibility need to be decided beforehand, be transparent, and
reflect country-specific circumstances

Increasing reliance on rules

Response to recent shocks reflected inbuilt flexibility, credibility, and existing
space

Large uncertainties ahead need to be taken into account in the design, and
timing of implementation
Type of Country
Rule Changed?
Industrial
No Need
21
72
No but Conflict
1
3
Yes
7
24
No Need
17
50
No but Conflict
9
26
Yes
8
24
No Need
6
25
No but Conflict
18
75
Yes
0
0
No Need
44
51
No but Conflict
28
32
Yes
15
17
Emerging
LIC
Total
Number of Countries
In percent