Restraining Yourself: Fiscal Rules and Stabilization

Restraining Yourself: Fiscal Rules and Stabilization
by Tamim Bayoumi and Barry Eichengreen

Restraints on the fiscal autonomy of budgetary authorities are very
much in the news. In Europe, the Maastricht Treaty on Economic Union
specifies ceilings or reference values for the debts and deficits of EU
members that participate in the monetary union. In the United States, the
Gramm-Rudman-Hollings Act and subsequent legislation limit the U.S.
Congress' leeway to legislate increases in the federal budget deficit.

Most previous research on statutory and constitutional fiscal
restrictions has focused on their effectiveness in limiting debts and
deficits. Many investigators have used data across U.S. states, all of
which, aside from Vermont, are subject to statutory or constitutional debt
and deficit limits. Since the stringency of these provisions differs, they
offer a natural experiment on the effects of fiscal constraints on behavior.
Political economy analyses which emphasize the roles of log-rolling and
pork-barrel politics in creating excessive debts and deficits imply that
fiscal restrictions designed to bring about their reduction are desirable.

This paper suggests, however, that there is another side to this coin.
Fiscal restrictions that limit U.S. state debts and deficits are also found
to reduce the responsiveness of state budgets to the cycle by up to
40 percent, and hence weaken the fiscal stabilization that could otherwise
be provided by U.S. state budgets. These results are then used to estimate
the potential effect of fiscal constraints on the level of stabilization
provided by national governments. Simulations indicate that a reduction in
national fiscal stabilizers of the magnitude estimated here for U.S. state
governments could lead to a significant increase in the variance of output,
on the order of 20 percent.

These findings have implications for several contexts in which the need
for fiscal restraints has been mooted. The paper ends by considering the
example of the Maastricht Treaty's ceilings on budget deficits. The U.S.
experience suggests that such restraints, if vigorously enforced, could
significantly diminish the stabilization afforded by national budgets.
Since the EU budget will probably remain small compared with the national
budgets, if the treaty does in fact inhibit national governments from
adjusting their budgets to the cycle, post-Maastricht Europe could enjoy
significantly less fiscal stabilization than does the United States.