{"id":1054,"date":"2019-03-01T18:09:46","date_gmt":"2019-03-01T17:09:46","guid":{"rendered":"http:\/\/www.dezernatzukunft.de\/?p=1054"},"modified":"2024-03-05T17:37:13","modified_gmt":"2024-03-05T16:37:13","slug":"why-is-fiscal-policy-so-difficult","status":"publish","type":"post","link":"https:\/\/dezernatzukunft.org\/en\/why-is-fiscal-policy-so-difficult\/","title":{"rendered":"Why is fiscal policy so difficult?"},"content":{"rendered":"\n

It is three\ndimensional chess<\/strong><\/p>\n\n\n\n

First, there are real\nfunding needs of the state<\/strong>. Think social security, schools, bridges. One key question is the\ndivision in consumption (ongoing expenditure) and investment spending, a second\nhow to target funding well without excessive bureaucracy. Finally, absorptive\ncapacity, i.e. how much money an organisation is actually able to spend in a\nsensible way is often a bottleneck when suddenly increasing funds (e.g. German\ndefense spending). <\/p>\n\n\n\n

Secondly, there is the\nmacroeconomic state of the economy[1]<\/strong><\/a><\/strong>. If demand is weak, more government\nspending will help to put more people into work. If demand is already strong,\nhigher government spending eventually translates into inflation or at least\nsector specific price increases (e.g. construction in Germany) and may start\ncompeting for resources (e.g. labour force) with the real economy. Whether that\nis a good thing or not, depends on the specific case and the policy goals of\nthe government, but there are certainly significant effects. <\/p>\n\n\n\n

Thus, fiscal policy ideally combines top down\nand bottom up planning. The difficulty of this becomes very obvious when governments\neither try to execute a fast stimulus by dialing up investment (building a\nsolid road takes time) or try to quickly reduce spending by dialing down\nconsumption (e.g. by reducing social security payments, which reduces peoples\u2019\nincomes and immediately hits demand). <\/p>\n\n\n\n

Third, there is the financial circuit<\/strong>. When the government spends money, it usually transfers money from its account at the central bank to the account of the recipient at a commercial bank. This increases reserves in the banking system[2]<\/a> lowering the interbank interest rate[3]<\/a>. The government may also issue bonds. When this happens, the buying bank pays for the bond by transferring reserves to the government\u2019s account at the central bank. This drains reserves from the system increasing the interest rate[4]<\/a>. <\/p>\n\n\n\n

Hence, fiscal policy has an effect on monetary conditions[5]<\/a>. It also affects the financial system beyond that: Government bonds play a key role in financial markets, being generally regarded as a safe, highly standardized and liquid asset. Banks use them for instance to deposit them at the central bank in exchange for reserves, and pension funds or insurers like investing in them as risk is low. If there is a scarcity of government bonds, the market may jump in to produce safe assets itself. This can end in tears as it did in the case of mortgage backed securities in the US<\/a>.  If the supply of bonds is very large \u2013 as is currently the case for the US where Fed sales of bonds bought during QE coincide with the fiscal expansion of the government[6]<\/a> \u2013 investors might require a premium to hold them (the issue here is not government debt levels<\/em>, but the specific supply and demand relationship<\/em> in the market for government bonds). The growing inventories of primary dealers in the US certainly indicate that selling US Treasuries certainly hasn\u2019t gotten easier recently<\/a>. <\/p>\n\n\n

\n
\"\"
Daten: New York Federal Reserve<\/a>. <\/figcaption><\/figure><\/div>\n\n\n

Thus, fiscal policy makers somehow need to straddle\ntogether real spending needs, the macroeconomic state of the economy and the\nimpact on money and financial markets (as well as navigating the extremely\npolitical waters of drawing up a budget). <\/p>\n\n\n\n

Different dimension,\ndifferent optimal rule<\/strong><\/p>\n\n\n\n

At the micro-level\ncompetition for limited funds is optimal: <\/strong>Every government department requests funds. In\ndoubt, these will exceed the available resources, if only for negotiation purposes.\nNot all funding proposals will be well targeted, thought through or ready for\nimplementation. Spending government money well and on time is difficult and\nrequires effort. Thus, a certain degree of competition for funds seems key to\nensure resources are deployed in a useful way. A fiscal rule, credibly limiting\nthe size of the envelope promotes such competition.  <\/p>\n\n\n\n

One may view this as efficiency obsessed bean\ncounting, especially in the context of reasonably well-developed institutions. Research\non public investment (which is easier to evaluate than recurrent spending)\nsuggests otherwise: According to a\nstudy by the Hertie School of Governance<\/a>, the average cost overrun\nfor large infrastructure projects in Germany between 1960 and 2014 was 73\npercent. But not only are projects more expensive than initially calculated,\npoorly planned projects often end up being delivered far behind schedule. Given\nhow hard (maybe impossible) outcome monitoring is in the public sector,\nincentive compatibility really matters.<\/p>\n\n\n\n

Yet, at the\nmacro-level no fixed rule is optimal: <\/strong>As outlined above, the right amount of spending\nis state dependent. There has been the attempt to fix this by making rules\nresponsive to states.  Under structural\ndeficit rules, governments can spend more when the economy operates below\npotential and less when the economy runs above potential. The crux is: Economic\npotential is unobservable and we have not yet found a reasonable way of\nestimating it (for a discussion of the European estimates see for instance the work of\nPhilipp Heimberger and Jakob Kapeller<\/a>). <\/p>\n\n\n\n

Hence, in the end, at the macro level, the only\nargument for a rule that tends to remain is \u201ca rule beats no rule\u201d. Why that\nis, especially when rules have very severe consequences on the lives of people,\nremains unclear. But not only do the rules limit the space for a government to\nact, they also kick the can down the road to unelected central bankers and\nbanking regulators: No state can afford a prolonged economic slump, so if the\ngovernment cannot spend, other valves will be opened to fire up credit issuance\nto the real economy (which may have happened in the US pre-financial crisis).<\/p>\n\n\n

\n
\"\"
Data: BIS, US Treasury via FRED, Federal Reserve Bank of St. Louis. <\/figcaption><\/figure><\/div>\n\n\n

Thus, there is a serious tension between the\nrequirements at the micro- and the macro-level. One possible way out of the\nrules conundrum may be focusing on a combination of (1) improving processes for\nallocating funds, (2) increasing transparency and accountability and (3)\nstrengthening the capacity and performance focus of the public sector. <\/p>\n\n\n\n

Finally, there is also\na foreign policy dimension to fiscal policy<\/strong>: On the one hand, fiscal rules help\ngovernments to insulate themselves against demands of other countries or\ninternational organisations to contribute to shared projects. On the other\nhand, such rules may make governments dependent on external debt or even force\nthem to sell off assets. One prominent example is the sale\nof the port of Piraeus to a Chinese shipping group<\/a>. <\/p>\n\n\n\n

Inadequate terminology\nand analytical toolbox<\/strong><\/p>\n\n\n\n

Beyond the above,\ninadequate terminology makes precise thinking about government debt very\ndifficult<\/strong>. The\nbiggest problem is mixing up domestic and foreign currency debt[7]<\/a>.\nThe two are fundamentally different: While a currency sovereign cannot default\non debt issued in his own currency, a country borrowing in a currency it does\nnot produce can default and\nisn\u2019t even that unlikely to do so<\/a>. Any sensible discussion requires\na clear-cut separation between debt in the currency a country can issue and all\nother debts. <\/p>\n\n\n\n

The key indicators we look at to determine whether debt is sustainable or not mean very little<\/strong>: When we look at \u2018debt\u2019 we normally mean \u2018gross debt\u2019. Singapore\u2019s gross debt to GDP is 112 percent, while net debt is -118 percent (Singapore has far more financial assets than liabilities). Another example is the US, where a lot of debt is held by the state. When it \u2018pays back\u2019 this money, it simply shifts funds from the left to the right pocket. <\/p>\n\n\n\n

We then compare debt to GDP resulting in a ratio\nof a stock to a flow which, as Olivier Blanchard, former chief economist of the\nIMF, put it<\/a>,\n\u201cis of no particular significance without information about the interest on\ndebt.\u201d If one is interested in the ability to repay, looking at the ratio of\ninterest expense to revenues is probably more useful. If one is interested in\nfinancial health looking at the complete<\/em>\nbalance sheet of the state rather than an arbitrary subsection makes sense:\nThis needs to account for all assets as well as all financing sources,\nincluding bonds and money[8]<\/a>.\n <\/p>\n\n\n\n

As if things were not difficult enough, there is a tendency to conflate logical and\ninstitutional laws regarding fiscal policy<\/strong>: While every cent spent indeed\nneeds to originate somewhere and go somewhere, the state does not need to\nfinance itself by collecting taxes. It is an institutional convention to\nprohibit governments from printing money (which may exist for a good reason)\nbut it is not a necessity. How can governments need to collect taxes to have\nfunds to spend, if they are the ones issuing the currency in the first place? <\/p>\n\n\n\n

The challenge ahead<\/strong><\/p>\n\n\n\n

At the moment, following the discussion on\ncentral banking is like an ongoing intellectual Berlinale with Claudio Borio\nand Beno\u00eet C\u0153ur\u00e9 as main characters, complemented by V\u00edtor Const\u00e2ncio\u2019s Twitter\ncommentary. There is no comparable discourse on fiscal policy. Given the\nlaundry list of problems aired above, it may be time to change that. A few\npreliminary ideas we would love to debate further are: (1) Should we move away\nfrom oversimplifying, meaningless targets and be a lot more serious about the\nprocess for spending money? (2) If we set targets, should achieving those\ntargets itself not have value and (3) isn\u2019t the right fiscal policy framework\nhighly context dependent (given the state of the economy, financial markets,\nmonetary policy and the international environment) and thus cannot be designed\nat a theoretical level or be static in nature?
<\/p>\n\n\n\n

\n\n\n\n

[1]<\/a> With a key question being the\naccurate definition of an \u201aeconomy\u2018. This is particularly complicated in the\nEurozone where the national definition has limited meaning given a shared\ncurrency and integrated markets.<\/p>\n\n\n\n

[2]<\/a> For a detailed description of\nthe process in the case of the US see here<\/a>.<\/p>\n\n\n\n

[3]<\/a> Assuming there were not\nexcess reserves in the system before.<\/p>\n\n\n\n

[4]<\/a> Assuming there were not\nexcess reserves in the system before.<\/p>\n\n\n\n

[5]<\/a> For a detailed description of\nthe interdependence, see here.<\/p>\n\n\n\n

[6]<\/a> More precisely there is a comparatively\nlarge supply of Treasury Bills, as the Fed is selling bills and buying long\nterm bonds, the increase in interest rates has increased hedging costs for\nforeign investors, which leads to lower demand from abroad and Treasury focused\nits debt issuance in 2018 on bills (for more detail see Zoltan Pozsar, Global\nMoney Notes #20, Credit Suisse)<\/p>\n\n\n\n

[7]<\/a> By domestic currency we mean\na currency the debt issuing country issues as well. By foreign currency we mean\na currency the debt issuing country does not issue itself, whether that is a\ncommon currency like the Euro for Germany or a \u2018proper\u2019 foreign currency like the\nUS Dollar in the case of Argentina. <\/p>\n\n\n\n

[8]<\/a> All<\/em> financing of the state issued represents\nclaims to assets part of the national economy; in the case of money, those\nassets are of any nature, in the case of debt, those assets are money<\/p>\n\n\n\n

Picture credit: Pixabay.<\/p>\n","protected":false},"excerpt":{"rendered":"

It is three dimensional chess First, there are real funding needs of the state. Think social security, schools, bridges. One key question is the division in consumption (ongoing expenditure) and investment spending, a second how to target funding well without excessive bureaucracy. Finally, absorptive capacity, i.e. how much money an organisation is actually able to spend in a sensible way … Read More<\/a><\/p>\n","protected":false},"author":42,"featured_media":2763,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":"","_links_to":"","_links_to_target":""},"categories":[160],"tags":[55],"class_list":["post-1054","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-explainers","tag-fiscal-policy"],"acf":[],"yoast_head":"\nWhy is fiscal policy so difficult? - Dezernat Zukunft<\/title>\n<meta name=\"description\" content=\"Institut f\u00fcr Makrofinanzen\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/dezernatzukunft.org\/why-is-fiscal-policy-so-difficult-2\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Why is fiscal policy so difficult? 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