Budget institutions can reduce fiscal indiscipline

By: Guntram Wolff, Deutsche Bundesbank, University of Pittsburgh

 

The debt level in the countries of the Euro area has risen from less than 30 percent of GDP in 1970 to around 70 percent today. Clearly, if this trend continues, future generations will have to face mounting debt services restricting their freedom of choice. Also, sustainability of public finances will be endangered with potentially severe negative effects on the economy. Can fiscal institutions help to counteract this fiscal indiscipline?

 

Fiscal rules have gained considerable prominence over the last decade. Especially in the countries of the Euro area, where policymakers and voters are concerned about large and persistent deficits, fiscal rules are often seen as a way to enhance fiscal policy sustainability. However, economic research has shown a significant number of operations by governments to circumvent the spirit of fiscal rules by reverting to creative accounting.[1] Thus, reliable data and the enforceability of fiscal rules are both crucial conditions for the success of these rules. In Europe, persistent high deficits and weak compliance with the fiscal rules have initiated a debate about additional institutions capable of reducing deficits.

 

Which institutions are capable of counteracting fiscal indiscipline? To answer this question, we need to be aware of the underlying causes of fiscal indiscipline. In a seminal paper, von Hagen (1992)[2] argues that excessive deficits and excessive spending result from a common-pool resource problem. In this view, politicians and constituencies benefit from specific spending programs, while imposing the costs on a common pool. Due to this negative externality, the individually rational strategies generate budgets that are sub-optimal from the perspective of the group. The predicted outcome is an inefficient excess appropriation of the common pool of revenues. In an inter-temporal version of the model[3], spending will be high and financed by deficits leading to even higher tax costs to future generations.

 

Accordingly, fiscal institutions should be designed to address this incentive problem underlying excessive deficits and debt levels. More precisely, von Hagen shows that the institutional framework of budgetary processes has important effects on fiscal outcomes. In particular, a centralized budget process will help to better match the costs and benefits of individual spending programs thereby internalizing the negative externality. Since the central figure in the budget process has to reconcile decentralized spending demands with the available resources, the overall fiscal discipline will be enhanced. Thus, institutional features of the budget process that strengthen the power of the central figure, such as stronger veto rights of the finance minister, should positively affect budget discipline.

 

Empirical results show that budget procedures that are conducive to reducing collective action problems are indeed associated with more fiscal discipline. This can be shown for Europe and Latin America. More centralized budget institutions are thus connected with better fiscal performance, i.e. lower debt levels.[4] But do budget institutions really cause better fiscal performance?

 

In this context, it is often stated that institutions per se do not change budget outcomes but rather reflect society’s preferences. Only those societies, that wish to have sustainable fiscal policy, will opt for centralized budget institutions, so the argument. Obviously, it is very difficult to change institutions without having the required majorities. But does this imply that institutions, once in place, are ineffective in restricting policies? Certainly not! Many institutions are derived from constitutional law and are therefore very costly and difficult to change. In the every day business of negotiating budgets and spending laws, they therefore exert a significant pressure on policymakers.

 

In a further criticism, it is argued that the positive link between fiscal discipline and the degree of centralization of the budget process results from reverse causality as institutions are changed when fiscal policy needs to be changed. This endogeneity bias, however, should bias the coefficient towards zero. The significant regression coefficient in this respect should thus represent a lower bound of the true beneficial effect of budget institutions.

 

To shed further light on the causal and beneficial effects of budget institutions, Mark Hallerberg and I investigate the impact of institutions on risk premia in European government bond markets.[5] The paper contributes to the debate in three ways.

 

First, we are able to show that countries with more centralized fiscal policy budget processes have to pay lower risk premia. In our regression analysis, we control for the debt and deficit levels of the respective countries. This allows us to measure the beneficial effects beyond the direct effect of fiscal institutions on the fiscal performance in a given year. Thus, an improvement in the budget institution leads to a clear default risk re-assessment of that country by financial investors. Moreover, the results indicate that budget institutions suitable to the political needs of a country are especially rewarded by financial markets.

 

Second, we find that annual deficits are less important in countries with better institutions. This shows that financial markets know that deficits in countries with centralized institutions are not driven by a systematic bias but rather reflect temporary effects. These empirical results are strong evidence of the beneficial role of budget institutions.

 

Third, our approach overcomes the problem of potential reverse causality, in which institutions are changed because of fiscal conditions. Since it is indeed not very likely that financial markets are determining the set-up of budget institutions, the econometric results show that the beneficial effect of institutions is indeed causal. After controlling for the deficit and debt levels of a country, institutions thus still play a risk reducing role. Financial markets therefore acknowledge the beneficial role of institutions beyond their direct impact on fiscal performance.

 

Overall, financial markets are clearly aware of the role budget processes play in overcoming common pool problems in budgeting. Our results lend strong support to the hypothesis that budget institutions are an effective way of reducing deficit biases. The empirical evidence thus clearly shows that fiscal institutions matter for fiscal budget outcomes. Moreover, the literature shows that institutions and procedural rules need to be designed to address the underlying causes of persistent deficits and increasing debt to be effective. Sustainable public finances can be achieved more easily, if policy makers focus their reform efforts on understanding the causes of deficits. Once the reasons for deficits become apparent, institutions need to be designed to address these policy failures.

 

 

Guntram Wolff is an economist in the Economic Research Centre of the Deutsche Bundesbank and a research fellow at the European Union Center of the University of Pittsburgh. The opinions expressed in this article are the author’s personal.

 

 

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