Take the politics out of fiscal policy

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Even though there is a case for leaving the responsibility of fiscal policy to the government, there is an even greater need for achieving the discipline and the same kind of objective assessment that has worked so well for monetary policy

Around the world today, there is quiet satisfaction with the management of monetary policy. Politicians in Germany and the US long ago handed over the setting of interest rates to technocrats in the Bundesbank and the Federal Reserve. Although ultimately politically accountable, these organisations were insulated from day-to-day pressures of popularity and ideology. This proved a success. So similar procedures have now been adopted by the European Central Bank and in Britain and several other countries.

It is impossible to feel similarly comfortable about fiscal policy. The tax and spending plans of the Bush administration are detached from reality, apparently driven by an ideological belief that tax cuts are so unquestionably a good thing that no adverse consequences can ever follow. The European Union, meanwhile, cannot realistically fine France and Germany for violating the budgetary limits of the growth and stability pact and must therefore find ways to “reinterpret” it – setting a poor precedent for future discipline.

Britain has recently seemed to manage its public finances well. But future projections are based on a wing and a prayer rather than disinterested analysis. And, more seriously, the appearance of prudence has been maintained as increasing amounts of public borrowing are taken off the balance sheet. Privatisation came first; more recently, liabilities have been transferred to special-purpose vehicles under the private finance initiative.

Different countries, different issues, a common problem: politics interferes with honest budgeting. There is a growing case for bringing to fiscal policy the detachment that has worked well for monetary policy. At first sight, this seems inconceivable. The right to tax is the fundamental prerogative of democratic government. It was over this issue, after all, that the US declared independence from Britain.

But, on more careful analysis, the idea is less radical than it seems. Politicians and legislators already see the benefit of limiting their discretion in fiscal policy. The balanced budget has long been an objective of the US Congress, even the subject of a proposed constitutional amendment. Britain has declared adherence to the golden rule of neutral fiscal policy over the whole economic cycle. And the purpose of the European stability and growth pact is to rein in irresponsible financing by individual states.

So there is no problem of principle about mechanisms that restrict fiscal autonomy. The difficulty is to find mechanisms that are both acceptable and effective. The devices we have at present are neither. On the one hand, they are too restrictive – there is nothing inappropriate about Germany’s desire to reflate its economy. Yet on the other they are too lax, in that they are too easily circumvented to impose substantive restraint on fiscal irresponsibility. Look at the devices employed to justify US fiscal policies over the past year.

Decisions on the structure of taxation must remain in the hands of elected legislatures. But what if there were a fiscal policy commission, with a role analogous to that of a central bank? Its job would be to assess the overall level of taxation needed to meet the government’s declared goals: fiscal stability, cyclically adjusted budget balance, consistency with the policies and practice of a common currency zone. This would probably best be expressed as a recommendation on the required standard rate of value added tax. Some alternative would be needed for the US, the only big state now without such a tax.

This is not a new idea: versions of it have been proposed in the US by Alan Blinder, the economist, and more recently by the European Economic Advisory Group at CESifo, the economic research network. The aim is to make fiscal policy as boring as Mervyn King, the Bank of England’s governor-designate, hopes monetary policy will soon become.

The fiscal policy commission should, in the first instance, be a purely advisory body. But if it acquired expertise and reputation, as it should, it would become increasingly difficult for government to ignore it without political damage and adverse reaction from financial markets.

Governments have found a means of avoiding the Scylla of weak monetary policy. The task now is to tackle the Charybdis of fiscal indiscipline.

A. Blinder Is Government Too Political? Foreign Affairs, 1997

John Kay is a member of the European Economic Advisory Group at CESifo, the authors of the Report on the European Economy 2003

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