Fiscal Rules and Discretion in a World Economy

NBER WORKING PAPER SERIES

FISCAL RULES AND DISCRETION IN A WORLD ECONOMY

Marina Halac Pierre Yared

Working Paper 21492 http://www.nber.org/papers/w21492

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2015

We would like to thank Roozbeh Hosseini, Navin Kartik, Emi Nakamura, Facundo Piguillem, Tano Santos, Ali Shourideh, Steve Zeldes, and seminar participants at Carnegie Mellon, Columbia, EIEF, Rochester, and Stanford for helpful comments. Sergey Kolbin provided excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.

NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

© 2015 by Marina Halac and Pierre Yared. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Fiscal Rules and Discretion in a World Economy Marina Halac and Pierre Yared NBER Working Paper No. 21492 August 2015, Revised September 2015 JEL No. D02,D82,E6,H1,P16

ABSTRACT

Governments are present-biased toward spending. Fiscal rules are deficit limits that trade off commitment to not overspend and flexibility to react to shocks. We compare centralized rules — chosen jointly by all countries — to decentralized rules. If governments' present bias is small, centralized rules are tighter than decentralized rules: individual countries do not internalize the redistributive effect of interest rates. However, if the bias is large, centralized rules are slacker: countries do not internalize the disciplining effect of interest rates. Surplus limits and money burning enhance welfare, and inefficiencies arise if some countries adopt stricter rules than imposed centrally.

Marina Halac Columbia University 616 Uris Hall, 3022 Broadway New York, NY 10027 [email protected]

Pierre Yared Columbia University Graduate School of Business 3022 Broadway, Uris Hall 823 New York, NY 10027 and NBER [email protected] Governments often impose fiscal rules on themselves to constrain their spending and borrowing. Fiscal rules can be decentralized — chosen independently by each country — or centralized — chosen jointly by a group of countries. In 2013, 97 countries had fiscal rules in place, a dramatic increase from 1990 when only 7 countries had them. Of these 97 countries, 49 countries were subject to national rules, 48 to supranational rules, and 14 to both types of rules.1 For example, Germany was constrained not only by the guidelines of the European Union’s Stability and Growth Pact (SGP), but also by its own constitutionally mandated “debt brake” which imposed a tighter limit on the government’s struc- tural deficit than the SGP.2 This paper studies the optimal design of centralized fiscal rules and how they compare to decentralized fiscal rules. Are centralized rules tighter or more lax than decentralized rules? How does this depend on governments’ deficit bias? What happens if some countries — like Germany in the case of the European Union — can adopt fiscal constraints to supplement those imposed centrally? Our theory of fiscal rules is motivated by a fundamental tradeoff between commitment and flexibility: on the one hand, rules provide valuable commitment as they can limit distorted incentives in policymaking that result in a spending bias and excessive deficits; on the other hand, there is a cost of reduced flexibility as fiscal constitutions cannot spell out policy prescriptions for every single shock or contingency, and some discretion may be optimal. Under decentralized fiscal rules, each country re