Institutionalizing fiscal policy

Historically, while there has been a well-established architecture, both in terms of institutions and formal rules, for taking monetary policy decisions, none exists for fiscal policy actions. Interest rates are set by Central Banks (and their Monetary Policy Committees) using the standard Taylor Rule framework, or one of its variants, with reference to prevailing macroeconomic parameters like inflation and unemployment rates.

While price stability, embodied in low long-run inflation rates, is more or less an accepted part of public debates, debates about an acceptable level of public debt and deficits raise several controversies. Further, the re-distributional side of fiscal policy and its attendant political dimensions introduces a strong political economy aspect into fiscal policy decisions. Unlike the largely apolitical interest rate decisions, those on whom or what to tax (and their respective rates of taxation) and what and where to spend or cut expenditures are of deeply political nature.

The Great Recession and the resultant need for fiscal expansion, at a time when economies across the world are fiscally strained with massive and unsustainable debt burdens, has spot-lighted attention on the inadequacies of the standard fiscal policy toolbox. Unlike monetary policy, apart from being deeply political, fiscal policy decisions are mostly ad-hoc and piecemeal, with rarely any objective and independent assessment of future costs and returns.

In this context, at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Symposium, Eric M. Leeper argued about the need for both fiscal research and fiscal policy practice to becoming more scientific. He makes the striking point that while "the macro policy dimensions of monetary policy — output and inflation stabilization — have been largely depoliticized, virtually no aspect of fiscal policy is insulated from politics".

Leeper draws the distinction between micro fiscal decisions (that are ground out by the give and take of politics) and macro fiscal issues (that can be treated as primarily scientific matters), and argues that once the overarching macro issues are settled, the politically determined micro questions would be constrained. He poses a series of questions that fiscal policy makers should address in their quest to making their task more objective and scientific

1. Should there be a long-run target for the debt-GDP ratio? What should it be?
2. Are there circumstances under which deficits (surpluses) should be permitted to permanently raise (lower) the debt-GDP ratio or should debt always be retired back to some long-run target?
3. Should government spending, taxes, and monetary policy be adjusted to stabilize debt?
4. How rapidly should the debt ratio be retired back to the target ratio?
5. What are the macroeconomic effects of certain government spending and tax changes in well-specified thought experiments?
6. What are a country’s fiscal limits and how much government debt can it support before markets deem the debt to be risky?
7. What happens as the economy approaches its fiscal limit?
8. What policies can keep the economy well away from its limit?
9. What are the are the macroeconomic consequences of alternative policy responses to the era of fiscal stress?
10. Should monetary and fiscal policy behave in fundamentally different ways in an era of fiscal stress than they do in normal times?

Nominal fiscal rules that place targets on fiscal deficits and public debts are amongst the commonest and simplest form of scientific fiscal policy practice. Many countries, notably Chile, Sweden, and New Zealand have nominal targets on these fiscal parameters. The most famous example of such fiscal rule is the European Union's Growth and Stability Pact that prescribed clear fiscal deficit and public debt targets for members.

India too adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004, aimed at disciplining government expenditures. The FRBM mandated elimination of revenue deficit (by reducing it by 0.5% of GDP every year for five years beginning 2004-05) and fiscal deficit be lowered to 3% of GDP by 2008-09 (by annual reduction by 0.3% of GDP). The FRBM rules have mid-year targets for fiscal and revenue deficits, at 45% of budget estimates by the end of September each year. In case of a breach of either of the two limits, the Finance Minister will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit. See this excellent analysis of India's FRBM Act.

Fiscal councils are the other preferred institutional answer to the conduct of fiscal policy. Simon Wren-Lewis (via Amol Agarwal), who has an excellent website on Fiscal Councils, writes that such councils, which though funded by the government are independent, and provides macroeconomic policy advice, especially on the likely course of national budget deficits. They make the budget more transparent and credible, by providing independent analysis of the budget numbers, and checking the Government’s policy, budget projections, and growth assumptions for consistency.

It is believed that an independent fiscal council would promote counter-cyclical fiscal policies and reduce the deficit bias that governments are vulnerable to. They could provide independent and accurate (eliminating window dressing through off-balance sheet accounting) assessment of the current and future deficit projections implied by current policies. It would act as a possible restraint, working through public pressure and moral suasion, on the spending-happy, short-term biased populist governments. Further, it could also act as a "co-ordination mechanism that forces individual spending ministers to recognise the overall budget constraint".

Sweden, Hungary and Netherlands are among those with relatively well-functioning councils, though the US CBO has some of its features. Sweden has an independent fiscal policy council whose chair testifies before the Parliament, which in turn has succeeded in generating productive public debate about the trade-off between sustainability and fiscal stimulus, which the Swedish government and most others have been facing. In Netherlands, the government-run Central Planning Bureau (or Bureau for Economic Policy Analysis) has sufficient credibility as an independent evaluator that political parties feel compelled to have their fiscal plans vetted by the Bureau.

On similar lines, Tim Besley and Andrew Scott (via Amol Agarwal) have advocated setting up "independent fiscal policy committees to institutionalize fiscal transparency and restore credibility to governments’ long-term public finances", especially given the legacy of current expansionary policies and unsustainably large debts across many countries.

In the context of India, Niranjan Rajadhyaksha has argued for the establishment of a fiscal council, similar to the CBO, given the political difficulty of setting up any independent fiscal authorities. For a start though, the Finance Ministry would do well to try answering Eric Leeper's aforementioned set of ten questions.

Update 1 (22/4/2011)

Lars Calmfors and Simon Wren-Lewis argue that, with the right guarantees of their independence in place, independent fiscal councils can make a significant positive contribution to fiscal policy.

MFIs and their higher interest rates

In the past two decades, micro-finance (and self-help groups) has almost acquired a reputation of being the closest to a magic bullet in development policy-making. One of the distinguishing features of microfinance is the higher interest rates charged by microfinance institutions (MFIs). Esther Duflo and Abhijit Banerjee have an article in the Journal of Economic Perspectives that highlights this,

"These fixed costs of administering a loan can explain why interest rates for small loans are so high, why they vary so much across borrowers, and why the poor pay higher interest rates. Since borrowers with little wealth must get small loans, the fixed administrative cost has to be covered by the interest payment, which pushes the interest rate up. But high interest rates exacerbate the problem of getting borrowers to repay. Total lending therefore shrinks further, pushing up interest rates even more, and so forth, until the loan is small enough and the interest rate high enough to cover the fixed cost for even a small borrower. In other words, the presence of fixed costs introduces a kind of multiplier into the process of determining the amount lent and the rate charged... And if the borrowers are poor enough or the fixed administrative cost is high enough, the interest rate could become infinite: these borrowers will be unable to borrow at all."

The sequence of events goes something like as follows

1. The lender has to incur a fixed cost on maintaining a large recovery machinery and general administration of the loan. In view of the large numbers of these borrowers and the specific nature of such loans (no collateral loans to those without any prior credit history), the fixed enforcement costs (due to more enforcers, need to collect information on a larger number of people etc) are likely to be large. The larger fixed costs coupled with smaller loan amounts means higher interest rates.

2. Higher the interest rates, the less credit-worthy borrowers will "crowd-out" the more credit-worthy ones, and an adverse selection effect will be generated. The higher interest rates would attract borrowers who are intrinsically more likely to default. This too adds to the administration cost at the margins.

3. Higher interest rates will naturally lower the size of loans. This also means that the absolute interest repayments will form a larger percentage of the loan principal. In other words, smaller loans means that the fixed costs as a percentage of the loan amount will be higher, thereby driving the interest rates even higher up.

Here is a graphical illustration of how the high administration charges of micro-loans drives up the rates, crowds out the best borrowers, lowers average loan amounts, and thereby forces rates even further up.



The moral hazard is amplified by the presence of multiple and competing lenders. The cost of a likely default is often lowered by the possibility of another lender waiting in the wings to step up when the need arises again. In this context, it would be interesting to examine the moral hazard effect on private micro-lenders arising from the presence of government micro-finance (if they default there, they can always fall back on the government)?

The cost of default has to be higher than the interest payment so as to minimize the possibility of default. As Banerjee and Duflo point out, the incentive of a continuous relationship with the bank/micro-lender often provides the deterrent against default.

The fundamental issue being raised here is this. Micro-finance has emerged as one of the major sources of channeling credit to poor people. It is arguable that even as micro-finance has grown in importance, it may have had unintended effect of taking away the focus from penetration of conventional banking into rural areas and among the poor.

However, as the aforementioned reasoning/modelling suggests, micro-finance services only a specific category of customers among the poor. While regular consumption needs and business working capital requirements (with their focus on adequacy and timeliness) are optimally serviced by micro-loans, small-business capital investments (which need larger and longer tenor loans) would require conventional banking.

Conventional banking will always be the preferred choice for customers borrowing higher amounts with longer tenors. Further, there will be a large share of the poor who cannot afford the higher rates charged by the micro-financiers. Under the circumstances, the total consumer welfare among the poor can be maximized only if micro-loans complement, and not substitute, conventional banking sources.

Debts, unemployment, deflation and recovery - lessons from history

The logic in favor of fiscal expansion when faced with a recession, in which aggregate demand has tanked precipitously, unemployment is high, business investments have dried up, and debt-to-GDP ratio is rising (and when monetary policy has run into the zero-bound) is that it utilizes idle resources (labor and capital), sustains (and even boosts, depending on the size of the stimulus) demand, and prevents government revenues from declining (and thereby increasing the debt/GDP ratio). It also provides the required traction for the economy to climb the steep slope of recession and return to normalcy.

Temporary deficit-financed, fiscal expansion, has been opposed by the "austerians" on the grounds that it would amplify the already large debt stock and deficits, drive down market confidence, crowd-out private spending, and finally unleash an inflationary spiral that would only serve to worsen the precarious economic prospects of an economy fighting a recession. These posts - here, here, and here - are among those replying to this argument.

However, as with all economic theories, the true test of its utility lies in its application to real world events/issues. In this case, what has been the historical experience with countries facing similar macroeconomic conditions? The two big comparable events are the post-Depression (including wartime) US and Japan during the nineties. I have already blogged about them here.

This comparison of the total US debt (public plus private) from 1929 to 1948 in billions of dollars and the total debt as a percentage of GDP shows how a robust economic recovery can quickly wind down the debt/GDP ratio and lower the real debt burden. While from 1929 to 1933 when everyone was trying to pay down debt, the debt/GDP ratio skyrocketed thanks to contraction and deflation, whereas during and immediately after WWII, despite the massive borrowing the GDP grew faster than debt, and the debt burden ended up falling.



As a recent WSJ article opined, the persistence of decade-long fall in consumer prices in Japan had raised questions about the dynamics of deflation. The inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump.

However, though standard Phillips curve models claim that falling inflation results in rising unemployment, the experience of Japan with rising unemployment in the nineties led to a surprisingly mild, long drawn-out deflation instead of the expected deep, destructive and concentrated (depression-style) deflationary spiral. Japan's bitter and frustrating experience with economic stagnation and slowly falling prices since the early nineties raises fears that the US too could be stuck in the groove of sustained gradual deflation.



There is also mounting evidence that "prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates". Further, as the inflation rate goes toward zero, it seems to get "sticky", and as in the case of the US now, slight positive inflation persists in the face of an obviously depressed economy. Krugman has written that this slow movement towards deflation is also in keeping with theories of downward nominal wage rigidity (probably due to bounded rationality, there’s some downward inflexibility in prices and wages even after expectations have had time to fully adjust).



See also this episodic comparison of recessions in the US which shows that inflation falls with rising unemployment. However, as the aforementioned nominal wage and price stickiness theory would suggest, the decline in inflation (or disinflation) has been muted when the core-inflation rate has been low.



Update 1 (14/10/2010)

Jon Hilsenrath has this excellent account comparing Japan and the US.

Fiscal multipliers for tax cuts and spending

I have blogged here and here about fiscal multipliers for different policy choices. Among the different fiscal stimulus spending choices, there is heated debate on the relative effectiveness (in terms of its bang for the buck or fiscal multiplier) of tax cuts and direct spending.

In the US, with the controversial Bush original tax cut in place since June 2001, set to expire by end of this year, there is an intense debate raging about its future. Republicans expectedly want them to continue and made permanent, whereas Democrats are broadly converging to the view that it should expire for those with incomes beyond $250,000.

Mark Zandi has this revised and latest examinaton of the fiscal multipliers of various stimulus measures.



As can be seen, direct government spending - through unemployment benefits, food stamps, work sharing or infrastructure spending - top the list, giving more than a dollar's worth of stimulus for a dollar's worth of spending, while cuts to taxes affecting businesses and upper-income individuals - such as the corporate, dividend, capital gains and alternative minimum taxes - gives much less.

However, since tax cuts are politically easier to push through, tax rebates aimed at those likely to spend (as against save it), jobs tax credit to spur investment and hiring, and cuts in payroll tax (which finances Social Security and Medicare and is paid by both businesses and workers) may be the most effective.

See also this paper by Alan Auerbach and Yuriy Gorodnichenko who find that "large differences in the size of fiscal multipliers in recessions and expansions with fiscal policy being considerably more effective in recessions than in expansions" and that "controlling for predictable components of fiscal shocks tends to increase the size of the multipliers".

Update 1 (25/9/2010)

Analysis show that the 2008 Bush tax cuts failed.

China's forex management and RMB revaluation imperative

The last decade has seen spectacular growth in China's external trade, and the ballooning trade surplus has resulted in an exponential growth in its foreign exchange reserves. Management of this, now more than $2.5 trillion, has been a source of much controversy and one of the biggest challenges for policy makers in Beijing.

What makes the management of its forex reserves an even bigger challenge is the expectation of the inevitable renminbi (RMB) appreciation, which while making foreign investors loath to borrow in RMB and invest abroad (for fear of losses when the RMB eventually appreciates) also encourages hot money inflows into China for investing in RMB assets (in expectation of higher returns when RMB finally appreciates).

As Ronald McKinnon writes, China has used four strategies to manage its forex reserves - liquid official reserves in the State Administration of Foreign Exchange (SAFE); sovereign wealth funds (like the China Investment Corporation) which invests overseas in bonds, equities, or real estate; encouraging Chinese state-owned firms to invest abroad in oil, power, rail, or other construction sectors; and quasi-barter aid programs in developing countries which generate a return flow of industrial materials.

In managing its forex reserves, China has taken lessons from Singapore, whose own currency is not used for international lending and whose government tightly controls overseas financial intermediation. Its large savings and foreign exchange surpluses are lent to two giant sovereign wealth funds - the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate - who minimize systemic currency risk from international investing.

Being government government owned and therefore backed by large forex reserves, these agencies are best positioned to cushion any currency shocks. Further, since the foreign assets are held by the government agencies, the possibility of capital flight when the currency appreciates is ruled out. Also, the Singapore Dollar is managed through a gentle "float" against the US Dollar, whose stability anchors Singapore's national price level.

With dollar prevailing as the global currency of choice, China, despite being the world's largest creditor nation, cannot use its own currency to finance foreign investments. Apart from the fact that dollar is the universal currency of clearing international payments, what makes China an "immature creditor" nation is the fact that the Chinese domestic financial markets are not fully developed, have interest rate restrictions and residual capital controls.

In view of all this, foreigners prefer not to borrow from Chinese banks in RMB or issue RMB denominated bonds in China. Therefore, apart from Chinese corporations investing abroad, the only way in which foreign private investors take shares (or buy into) in China's massive forex surplus is through Chinese banks, insurance companies and pension funds' acquisition of dollar-denominated liquid foreign exchange assets.

But this generates a currency mismatch risk for Chinese investors - their domestic liabilities (bank deposits, annuity, or pension liabilities) are all RMB denominated while foreign assets are dollar denominated. The threat of a dollar devaluation (or RMB appreciation), which is inevitable, therefore carries considerable risks for these Chinese investors. Private Chinese investors would therefore find it unattractive to hold dollar assets, thereby leaving the central government to do the financial intermediation of China's massive foreign exchange surpluses in the global markets.

While this hedges against any risk of capital-flight induced by currency appreciation, it hinders the deepening and diversification of the Chinese financial markets. In other words, so long as the RMB remains over-valued, or atleast the perception persists, Chinese private investors would be deterred from investing abroad and private foreign investors would think twice before raising debt in China. Yet another reason to get done with revaluation of the RMB.

Addressing incentive distortions in urban housing

I have blogged earlier that instead of granting home ownership rights, urban housing programs should focus on providing for an adequate supply of housing stock that can be rented out.

Apart from their poor quality, the commonplace problems of urban housing include ineligible beneficiaries, sale by originally allotted owners and their reversion to squatting elsewhere, and capture by local musclemen who in turn rents them out. Most unfortunately, since ownership rights gets allotted, the allotment process itself becomes high stakes and liable to be captured by the local leaders. There are numerous housing units completed but lying unoccupied in many cities for lack of agreement about the beneficiary list (and all this despite the presence of an original beneficiaries list!).

In view of the general migratory nature of urban poor, an approach that relies on allotment of ownership rights, upfront or deferred, cannot effectively address these problems. Instead, a policy of constructing and adding to the urban housing stock and then renting them out to migrant workers will help mitigate many of the aforementioned issues.

The fundamental attraction (and resultant incentive distortion) of ownership right on a housing unit is the opportunity to exit with a huge payout by selling it. This in turn generates a series of incentive distortions among all stakeholders - original allottees, prospective buyers with greater need, and local muscle-men - that results in inefficient outcomes. Rental housing eliminates this incentive straight away.

Apart from not having to make any upfront payment, the obvious advantage with rental housing is that though assured of inhabitation, the beneficiary is not inflexibly yoked to his house. In other words, it does not hinder labor mobility, both in search of better livelihood opportunities to other places and to larger houses at other locations in same city as incomes improve.

The monthly rent payment reduces the likelihood that a local leader can extort an additional ransom. Any additional payment by the beneficiary would then be, atleast partially, a reflection of their willingness to pay (and this premium on the rent will in any case be a much smaller amount, if the rent is reasonably close to market clearing value). Without any ownership rights, the allottees can only transfer habitation rights, which in any case is legitimate and the new occupant can in turn formally get himself registered and pay rents. Even an informal transfer, wherein the original allottee makes the rental payment while collecting a higher rent from the new buyer, is efficient in so far it allocates housing to those most in need.

Either way, if the rents fixed are market clearing, then the magnitude of such incentive distortions can be minimized. However, even if the rents are not high enough and the supply not adequate, such informal dynamics would only serve to allocate houses to those with the highest willingness to pay.

The only administrative challenge with this approach would be the collection of rents. Here too, I am inclined to the opinion that once the house is allotted upfront clearly on a rental basis (through rental vouchers or some other mechanism), unlike ownership conferred on them, the households are psychologically primed to make their monthly rental payments.

Critics would argue that these outcomes, while economically efficient are not fair, in so far as it would deprive the poorest and those with the lowest purchasing power. Here are three observations on that. One, if the quality of housing is with the most basic specifications, the actual occupant will always be one of the poorest. Second, there is no sharp socio-economic distinction between the poorest and the remaining poor, who are the most likely occupants of such houses. Third, given the population of large Indian cities, those belonging to this category are too large for any urban housing program to saturate demand. Therefore, even after building a massive stock of housing, atleast for the foreseeable future, large numbers of urban poor will always be in search of housing (and therefore the aforementioned possible incentive distortion effect due to them cannot be eliminated).

The other criticism about the original allottees moving elsewhere to squat does not hold much ground. Given their quality, only the poorest (and thereby eligible) will generally occupy these houses. If Ram, who sold the house to Ravi, and reverted to squatting, had not sold it, then Ravi would have been squatting. The critical issue here is only the net addition to the housing stock, the rate of which has to be higher than the rate of immigration of urban poor.

In any case, the public policy challenge was to design a policy that would be both more efficient and fair, while being more transparent and easier to administer, than the present one. It cannot be denied that even with all its residual problems, a rental housing scheme will have less likelihood of those aforementioned incentive distortions.

See also this article which explores how a rental housing program can be administered.

What assets to purchase in QE?

Even as double-dip looms large and fiscal policy paralysis continues in the US and other developed economies, much of the attention in recent weeks has focused on efforts to get monetary policy to stimulate demand.

In his speech at the annual Federal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyomoing, last week, Fed Chairman Ben Bernanke signaled his commitment to doing everything to keep the economy from falling into a deflationary spiral. He pointed towards four options - purchase more government debt and long-term securities; communicate intent to keep short-term rates low for even longer than the markets currently expect; lower interest paid on reserves (funds held at the Fed); and raise medium-term target for inflation - of which, he felt only the last was unviable.

The last meeting of the FOMC had also reiterated that the prevailing economic conditions "warrant exceptionally low levels of the federal funds rate for an extended period". It also affirmed a continuation with the quantitative policies (QE),

"To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature."

This commitment to continue with unconventional monetary policy responses by way of asset purchases naturally raises the question about which assets to buy. Nick Rowe advocates that the Fed buy pro-cyclical assets - whose prices rise if enough people believed that the US economy was moving back onto its desired long-run equilibrium path.

In so far as asset prices are forward looking, reflecting expectations of future value, he sees a possible Tinkerbell principle (of self-fulfilling prophecy) at work, with varying outcomes for pro-cyclical and counter-cyclical assets. In case of the former, the causal chain from policy to outcomes works with Tinkerbell, while for the later, it works against her. He writes,

"If the Fed buys an asset, the direct effect of the purchase will be to raise the price of that asset. The increased price of that asset, plus the increase in the money supply used to purchase that asset, will have a direct effect on the economy. But there's also an indirect effect, via Tinkerbell's credibility...

Suppose the Fed buys a counter-cyclical asset. If the price rises, people may interpret that rise as a sign that monetary policy is having the desired effect. Or they may interpret it as a sign the economy is getting weaker. Depending on how people interpret the rise in price of the counter-cyclical asset, and the relative strengths of the direct causal effect and the Tinkerbell effect, the net effect on the economy is ambiguous. Also, if people thought that monetary policy was having the desired effect, and was not impotent, any increased optimism about the future path of the economy would tend to lower the price of the counter-cyclical asset, which would tend to make monetary policy look less effective, and snuff out that optimism.

Suppose the Fed buys a pro-cyclical asset. If the price rises, people will interpret that as a sign that monetary policy is having the desired effect. Or they may interpret it as a sign the economy is getting stronger. Both effects work in the same, desired, direction. Also, if people thought that monetary policy was having the desired effect, and was not impotent, any increased optimism about the future path of the economy would tend to raise the price of the pro-cyclical asset still further, which would tend to make monetary policy look more effective, and reinforce that optimism."

I have three issues here.

1. Government bonds (whose yields will rise, and therefore prices fall, as economy recovers and nominal interest rates go up from the present zero-bound), are most certainly counter-cyclical. However as Nick Rowe acknowledges, the net impact of the increase in bond prices depend on the relative strengths of the direct impact on the real economy of lower real interest rates (and expectations for a long period and other related consequences) and Tinkerbell effect (people thinking that rising prices of counter-cyclical asset bodes ill for future).

In this context, I am inclined to the argument that whatever the attenuating role of expectations (and they are undeniably important), in a balance sheet recession (as is the case now, with firm and household balance sheets badly bruised) the primary objective should be to repair them. And higher bond prices, and lower resultant yields and long-term interest rate expectations that come with it, can accelerate the restoration process.

2. Though real estate and equities are among the major standard pro-cyclical assets, it may be too much of a stretch, especially given their role in the sub-prime crisis, to expect the Fed to indulge in massive purchases of those assets to inflate a rally (with potential risk of resource mis-allocation and an ultimate bubble) in those assets.

3. Are there any truly pro- and counter-cyclical assets? Both equities (in March-May) and bonds (for sometime now) have exhibited similar characteristics even as the prospects of the real economy has remained bleak.