Fiscal rule basics from Bernanke

He reviews the basics in this speech:

Clearly, a fiscal rule does not guarantee improved budget outcomes; after all, any rule imposed by a legislature can be revoked or circumvented by the same legislature. However, although not all countries with fiscal rules have achieved lower deficits and debt, the weight of the evidence suggests that well-designed rules can help promote improved fiscal performance.11 I will discuss four factors that seem likely to increase their effectiveness.

First, effective rules must be transparent. By shining a light on the problem and the range of feasible solutions, transparent policy rules clarify the budget choices that must be made, help the public understand those choices, and encourage policymakers to recognize the broader fiscal consequences of their decisions on individual programs. In particular, transparent fiscal rules may help solve what economists refer to as a collective action problem. When faced with spending decisions, most elected representatives want to be seen as garnering the greatest possible benefit for their constituents. But if a prior agreement limits the size of the available pie, it may be easier to negotiate outcomes in which everyone accepts a little bit less. Of course, transparency is enhanced by good watchdogs. In the United States, the nonpartisan CBO has ably served that role since 1974. Nongovernmental organizations that focus on budget issues, such as nonprofit think tanks, can also promote transparency.

Second, an effective rule must be sufficiently ambitious to address the underlying problem. As I mentioned, PAYGO rules, even when effective, were designed only to avoid making the fiscal situation worse; they did not attack large and growing structural deficits. In the current U.S. context, we should consider adopting a rule, or at least a clearly articulated plan, consistent with achieving long-term fiscal sustainability. Admittedly, an important difficulty with developing rules for long-term fiscal sustainability in the United States is that, given the importance of health-care spending in the federal budget, the CBO would need to forecast health-care costs and the potential effects of alternative policy measures on those costs well into the future. Such forecasting is very difficult. However, any plan to address long-term U.S. fiscal issues, whether or not in the context of a fiscal rule, would have to contend with forecast uncertainties.

Third, rules seem to be more effective when they focus on variables that the legislature can control directly, as opposed to factors that are largely beyond its control. For example, as I noted, actual budget deficits depend on spending and taxation decisions but also on the state of the economy. As a result, when a target for the deficit or the debt is missed, ascribing responsibility may be difficult. Current congressional procedures generally require the CBO to “score” proposed spending and tax programs for their budget effects over a specified, longer-term horizon; this approach, although not without its problems, has the advantage of linking budget targets directly to legislative decisions.

Fourth, and perhaps most fundamentally, fiscal rules cannot substitute for political will, which means that public understanding of and support for the rules are critical. For example, the fiscal rules that Switzerland adopted in 2001 had overwhelming popular support; the widespread support no doubt contributed to their success in helping to reduce that country’s ratio of public debt to national income. Conversely, in the absence of public support and commitment from elected leaders, fiscal rules may ultimately have little effect on budget outcomes. Educating the public about the consequences of unsustainable fiscal policies may be one way to help build that support.

Nice insights from Fed Chair with country examples.

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