Debunking ‘fiscal alchemy’: The role of fiscal councils

Roel Beetsma, Xavier Debrun

The success of independent central banks is often used to argue in favour of independent fiscal councils with the aim of promoting sound fiscal policies. But unlike central banks, fiscal councils have no policy levers to pull – they can bark but never bite. This column explores the theoretical foundations and practical implications of fiscal councils. The evidence suggests that independent councils can mitigate the deficit bias. They do this by subjecting the ‘fiscal alchemy’ to systematic, rigorous, and highly publicised scrutiny.

The historically high public debt levels seen in many countries did not come all at once as a result of the Global Crisis of 2008-09. The main culprit is governments’ apparent penchant for deficits since the 1970s. Looking at a sample of 22 OECD economies, the frequency of general government deficits has increased markedly since the 1960s (Figure 1). The exception is the pre-Crisis period (2000–08), reflecting revenue booms related to bubbly asset prices and robust growth. Of course, the fiscal scars of the Crisis remain – 13 out of these 22 governments have been and are expected to remain in deficit every single year between 2009 and 2017.

The literature suggests that weak public financial management and distorted political incentives explain deficit addiction. Political distortions include the tendency of policymakers to pay insufficient attention to the medium and long term. Moreover, distributive conflicts entail the ‘common pool’ problem whereby political constituencies use available resources for their exclusive benefit without regard to the overall budget. The deficit bias can also reflect time inconsistency, as governments find it difficult to credibly commit to saving revenue windfalls in good times.

Figure 1. OECD-22 – Median frequency of overall fiscal deficit above 0.5% of GDP (in years)

Notes: OECD-22 includes Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States. IMF forecasts are used for 2015–17.

Sources: Mauro et al. (2013), IMF, OECD, and national authorities.

The rising tide of red ink and widespread perceptions that fiscal policy results “from unsystematic speculations grounded more in politics than economics” (Leeper 2010) could easily spook voters and financial markets. Can public sector balance sheets take another hit? Is the impact of population ageing fully understood and reflected in the conduct of today’s fiscal policy? It is hard for the public to even start answering these questions when only a handful of countries actually publish comprehensive public sector balance sheets and the basic analysis that goes with them. The lack of sufficiently accessible information leaves fiscal expectations without an anchor.

Aware of the risks involved, governments have sought to strengthen fiscal institutions to make fiscal policy more predictable and shore up the credibility of commitments to financial sustainability. Following a wave of fiscal rule adoptions in the 1990s, some countries tried to further boost credibility by setting up fiscal councils to foster transparency and accountability. The rise of fiscal councils started in earnest after the Global Crisis, reflecting in part provisions of the Treaty on Stability Coordination and Governance signed by most EU member states (Figure 2). Compliance with the Treaty also explains why a large number of fiscal councils have been mandated to monitor budgetary forecasts and compliance with fiscal rules.

Figure 2. Number of countries with fiscal rules and fiscal councils

Sources: IMF (2015a, b).

Anchoring fiscal expectations: The potential contribution of independent fiscal councils

While an extensive literature discusses the optimal design and effectiveness of fiscal rules, analyses of fiscal councils remain largely descriptive and based on heuristic arguments. However, the fact that, unlike central banks, independent fiscal councils are not responsible for fiscal policymaking puts a premium on understanding how they can influence policy outcomes in a predictable manner.

In recent work, we develop a simple model in which the voting public cannot observe the true level of ‘competence’ of myopic politicians, leading to a deficit bias (Beetsma and Debrun 2016). We formalise the conventional narrative according to which non-partisan economic analysis and public communication about fiscal policy can help voters and all other stakeholders in the budget process to understand the distance between actual and desirable fiscal policies. For instance, the fiscal council can issue reports summarising and clarifying information that would otherwise be buried in official documentation or distorted by ideologically charged arguments exchanged in the political arena.

Doing so, the fiscal council strengthens the signalling value of public information about fiscal policy, mitigating the consequences of information asymmetry. In that simple setup, we show that a fiscal council can raise social welfare through two channels. First, it helps voters to elect competent governments more often. Second, it encourages elected policymakers—regardless of their intrinsic competence—to select deficits closer to the social optimum. That second channel shows that an official watchdog without control over policy levers can tame the deficit bias by encouraging governments to signal a high level of competence through better policies (in this case, lower deficits).

Built to work?

In practice, the effectiveness of a fiscal council depends on two preconditions. The first is that the mandate and tasks of the council aim at addressing the most relevant sources of deficit bias (von Hagen 2013, Debrun et al. 2013). Second, the council should be equipped to ensure that public information about the budget sends a clear signal of politicians’ genuine intent and actions. Our model focuses on the second precondition and informs the construction of a ‘signal enhancement capacity’ (or SEC) index for existing fiscal councils. The presumption underlying this exercise is that the design features of a council allows assessing whether they were conceived as smokescreens or as genuine attempts to reduce informational asymmetries.

The SEC index encompasses four elements:

A broad mandate that covers the main sources of informational asymmetry between the public and the government, such as the accuracy of budgetary forecasts; The ability to communicate to the public, such as the publication of freely accessible reports; The possibility to directly interact with participants in the budget process, such as the obligation for governments to explain why official forecasts deviate from the FC’s own; and Independence from politics, which is essential to guarantee the signal-enhancing value of the council’s activities.

We calculate two variants of the SEC: one in which each of these dimensions gets an equal weight, the other in which political independence is a necessary condition for effectiveness. A higher value of the SEC indicates a higher signal-enhancing capacity of the fiscal council.

The results are the following. First, both the unweighted and independence-contingent indices reveal significant heterogeneity among fiscal councils in terms of their a priori ability to provide clear and consistent signals about fiscal policy (Figure 3). Second, fiscal councils that were particularly well equipped to clarify policy signals were also given the political independence to do so. This is evident in Figure 4, in which we identify four quadrants, using the cross country averages for two sub-indices as demarcation lines. The better designed institutions are located in the north-east quadrant, which we extended to the shaded rectangle to capture borderline cases (within half a standard deviation below the mean for each sub-index). By that simple metric, almost two thirds of fiscal councils appear to be relatively well-designed.

Figure 3. Assessing fiscal councils’ signal-enhancement capacity: An index

Notes: The entry for Germany refers to the German Council of Economic Experts, an institution that only performs some of the functions of fiscal councils. Sources: IMF (2015b) and authors’ calculations and corrections.

Figure 4. Independence and signal-enhancing functions

Source: IMF (2015b) and authors’ calculations.

Concluding remarks

Fiscal policy is often perceived as very hard to read and even harder to predict. This ‘fiscal alchemy’ (Leeper 2010) complicates the formation of expectations regarding future paths for public debt and deficit. Independent fiscal councils can mitigate the deficit bias by subjecting the fiscal alchemy to a systematic, rigorous, and highly publicised scrutiny. As better informed voters elect competent governments more often, social welfare increases. In addition, greater voters’ awareness encourages any elected official—competent or not—to bolster re-election chances by mimicking the policies of a competent policymaker. Greater political stability and stronger incentives to stick to sound fiscal policies can contribute to anchor fiscal expectations. Looking at the data, we conclude that a substantial majority of fiscal councils exhibit features—political independence and relevant remit—that allow them to clarify existing signals about fiscal policy. Nevertheless, a number of institutions would benefit from stronger guarantees of independence to join the group of potentially highly effective councils.

Authors’ note: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

References

Beetsma, R and X Debrun (2016) “Fiscal councils: Rationale and Effectiveness”, CEPR Discussion Paper 11140, and IMF Working Paper No 16/86.

Debrun, X, T Kinda, T Curristine, L Eyraud, J Harris, and J Seiwald (2013) “The functions and impact of fiscal councils”, IMF Policy Paper.

IMF (2015a) Fiscal Rules Dataset, http://www.imf.org/external/datamapper/FiscalRules/map/map.htm

IMF (2015b) Fiscal Councils Dataset, http://www.imf.org/external/np/fad/council/.

Kopits, G (ed) (2013) Restoring public debt sustainability: The role of independent fiscal institutions, Oxford University Press.

Leeper, E (2010) “Monetary science, fiscal alchemy”, Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, 361-434.

Mauro, P, R Romeu, A Binder and A Zaman (2013) “A modern history of fiscal prudence and profligacy”, IMF Working Paper No 13/5, Washington, DC: International Monetary Fund.

Von Hagen, J (2013) “Scope and limits of independent fiscal institutions”, in Kopits, George (ed) (2013), Restoring public debt sustainability: The role of independent fiscal institutions, Oxford University Press.