Fiscal Policy, Economic Adjustment, and Financial Markets

INTERNATIONAL MONETARY FUND

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1989
• eBook ISBN: 9781557751188

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1 International Coordination of Fiscal Policies: Current and Future Issues

Vito Tanzi

Comment

Rudiger Dornbusch

The occasion of discussing Vito Tanzi’s stimulating and provocative paper provides a welcome opportunity to express professional acknowledgment and appreciation for the important research effort on fiscal policy over which he has presided at the International Monetary Fund. The work is welcome not only in the area of data development, but also on the side of analysis. Tanzi’s own contribution and his openness to discussion are an excellent example in an otherwise overly closed institution.

I will first take issue with some detailed points. In some instances, I wish to highlight a particular point Tanzi makes; in other there is a need to comment and disagree. Then, I shall take up the central point of my discussion—the world economy after U.S. budget cuts.

One point needs to be raised before the details come. Tanzi’s paper is wide-ranging, and it is a vehicle for letting off steam on a number of issues, principally the U. S. budget deficit. Tanzi’s beliefs are very catholic. In fiscal matters there is only one precept: get your house in order—the sooner the better. Budgets should be balanced! There is at best a reluctant recognition of a cyclical role for fiscal policy. If hard-pressed, I suspect Tanzi would confess that he thinks that, too, is an exaggerated concern.

This view leads him to argue that the U.S. fiscal expansion of 1982 and beyond was misguided, not only on domestic grounds, but also because of adverse effects on the world economy. This view is controversial. Surely it must be recognized that the monetary tightening of 1981–82, together with the fiscal expansion, brought about the high interest rate-strong dollar configuration that hurt, for example, commodity exporting debtor countries. But imagine that there had only been tight money. Interest rates would still have been high (though perhaps not quite as much), but there also would have been a deep recession. That, too, would have hurt countries abroad. Indeed, this was the case in 1982, before the tax cuts pushed the United States on a growth path. The simple fact is that the world economy was going to be hurt by the unanimous demand for an end to inflation. You cannot make an omelette without breaking some eggs.

I shall return to this point, but I want to register here my disbelief in the proposition that a U. S. recession is a good thing for the world economy. The direct effects are undesirable, and the inevitable protectionist consequences would be even more so. The problem is to find a world monetary-fiscal mix that is sustainable and consistent. I shall argue below that a world real interest rate reduction is the most likely step to reconcile the need for more balanced budgets and the overriding concern for growth.

Comment

Patrick Minford

I very much agree with Vito Tanzi’s general attack on activist fiscal policy coordination. I will comment first on some details of his analysis and then develop a case—implicitly supported by Tanzi’s paper—for nonactivist fiscal coordination, in support of monetary rules for price stability.

First, the details. Forecast inaccuracy may undermine ambitious attempts at fine-tuning, but it does not destroy the general case for rough-tuning, since, plainly, forecasts are able to track the direction of output relative to capacity with some success—even with all the errors shown in Tanzi’s tables. Nor is model disagreement fatal. Policy instruments, or some aspects of them, directed at specific targets, can generate improvement, according to a large spread of models, including those used by the coordinators. Holtham and Hallett (1987) recently explored this possibility and found a few hypothetical examples.

Of course, we have not as yet worked out measures of how large the gains could have been in practical cases. In our recent study (Canzoneri and Minford (1988)), Canzoneri and I concluded that even with a single model with large spillovers, coordination yielded gains that were small relative to the accuracy with which policy could be implemented—a form of forecast error. In practice, the objections Tanzi raises may be impossible to overcome.

Tanzi mentions the absence from many models of rational expectations, which he feels—and I agree—are the best available modeling tool for expectations. Although this situation is changing—a number of the models presented at the Brookings conference Tanzi mentions embodied rational expectations—it remains true that the models in widespread use by forecasters and policymakers do not. Again, this is a relevant problem for practical coordination.

Of the four remaining problems Tanzi lists, I rate two of them as serious. The other two—disagreement on objectives, and asymmetry of power—are not strictly problems. Coordination brings gains to participating parties, whatever their objectives, because of spillovers; the spillovers are the opportunity of trade, as it were, and the objectives define the offers to trade. Asymmetry of power will affect the noncooperative equilibrium, making it, for example, a Stackelberg equilibrium, rather than a Nash one, but cooperation will still yield gains if there are spillovers.

The inside lag of domestic policy seems to pose an insuperable problem for fiscal policy as a stabilization tool. True, it may be easy to get quick agreement from the U.S. Congress or the Italian Parliament for tax cuts and expenditure rises, but not for measures in the opposite direction.

And finally, the possibility of negative fiscal multipliers should be taken very seriously. This problem is linked to the point made earlier about expectations, in that adverse confidence effects (or their opposite, which Walters (1986) contends occurred in Britain in 1981 when the budget contraction took place in the recession trough) may well offset the usual direct effects. Of course, if the multipliers were reliably negative, we could simply change the sign of the fiscal response. But the multipliers can move around, depending on the precise future policy pattern expected, and this expectation will generally be independent of policy intentions and announcements. Our models cannot yet deal with this dimension.

I would add two arguments against coordinated fine-tuning. First, it might provide vested interests with greater opportunities to expand the size of public programs in the name of action to stimulate the economy; yet once started for this purpose, such expansions are hard to reverse, imparting an upward bias to public spending and fine-tuning.

Second, time-inconsistency is likely to be worsened by such coordination. Whereas a domestic rule can be monitored by the public, an international agreement introduces the loophole of a foreign party’s views. As for monitoring by the foreign power, what sanctions could the foreign power apply? We have seen recently how difficult it was for the rest of the Organization for Economic Cooperation and Development (OECD) to persuade the United States to reverse its budget deficit, following the expansionary spirit of the early 1980s. Essentially, coordinated fine-tuning is just discretion exercised jointly by two or more parties; and is as much prey to time-inconsistency as discretion by one government. I fear that such fine-tuning would produce stagflation, as people began to anticipate the mutual exploitation of Phillips curves (see Rogoff (1985)).

I. Non-Activist Fiscal Coordination

The case for fiscal rules at the international level is the same as that underlying the Medium-Term Financial Strategy in the United Kingdom. To build credibility for monetary control, deficits must also be limited; otherwise, monetization comes to be seen as the politically irresistible option for holding down the ratio of debt to gross domestic product (GDP). So, if major countries all wish to achieve price stability and, as a by-product, can stabilize their exchange rates, fiscal rules are the corollary, and they might as well be coordinated—that is, mutually policed—to reinforce the commitment to stability. The benefits of this regime would be the reduction of monetary uncertainty and transaction costs in international trade.

The rules would impose ranges for deficit/GDP ratios, outside which corrective action would be required for monetary reasons. The ranges would not interfere with the normal fluctuations associated with the business cycle or with unpredictable public finance needs (such as those arising from strikes or wars). For countries far from fiscal equilibrium, such as—dare I say it—Italy, there would be a transitional range, as there has been in the United Kingdom from 1979 to date.

This type of coordination is better able to confront the above-mentioned difficulties associated with fine-tuning. Forecasts and models are needed, but in an appropriate role—that of determining ranges large enough to permit appropriate flexibility, their midpoints set to reflect the savings propensities of each country. Public choice pressures and time-inconsistency should be reduced by the policing of agreed international rules. The inside lag becomes an advantage, because once agreed on, fiscal policies are less easy to tamper with.

The key obstacle is the residual political desire for freedom to inflate. I say “residual,” because most major countries played with that freedom in the 1970s and early 1980s, and have learned that it only buys trouble. Recently, we heard from some U.S. politicians that they wanted this freedom in 1988—an election year. What an irony that a supposedly conservative government should demand such a freedom! But following the dollar’s plunge in the free-fall reaction to such wants, wiser counsels have prevailed. Could it be that the United States is at last genuinely interested in playing by a set of world rules for price and exchange rate stability? If so, the last major obstacle to a proper Louvre Accord has probably been eliminated, since other OECD governments have learned—often the hard way—to prize stability. But I wonder: since John Connally tore up the Bretton Woods Agreement, the United States has always resisted allied attempts to impose half-agreed new rules whenever domestic political pressures called for such resistance. Clearly, any new framework would have to be set up and led by non-U.S. governments, and U.S. participation would have to be accepted as a bonus.

II. Conclusions

Tanzi rightly criticizes those who demand coordinated fiscal activism at the present time; notable demands for fiscal expansion have come from the Centre for European Policy Studies group originally associated with Rudiger Dornbusch (see Blanchard, Dornbusch, and Layard (1986)). Even the inclusion of “supply-side-friendly,” “right-handed” measures does not make the package seductive, since deficits today will have to be paid for later, presumably by supply-side-unfriendly fiscal contraction or by higher inflation.

I would merely add that if surpluses are likely to result from public sector reforms, for example, then tax cuts and fiscal loosening are the right actions to take. This is the situation now in the United Kingdom where privatization revenues have been used to pay for tax cuts, but only against a strongly improving trend in public finances (itself partly the result of privatization).

Tanzi favors the coordination of supply-side policy. I am not so sure; cutting top tax rates has been greatly stimulated by the United States leading the way on tax reform. But certainly there are areas, such as protectionism, where cooperation is good for consumer interests.

To conclude, coordinated fiscal discretion falls into essentially the same traps as independent fiscal discretion. Just as the latter has given way in most of the OECD countries to limits on fiscal deficits, so should discre...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content Page
• Foreword
• Acknowledgments
• Opening Remarks
• 1 International Coordination of Fiscal Policies: Current and Future Issues
• 2 The Impact of Fiscal Policy on the Balance of Payments: Recent Experience in the United States
• 3 Economic Policy and Adjustment in Denmark
• 4 Fiscal Adjustment, Debt Management, and Conditionality
• 5 Credit Constraints and Investment Finance: Some Evidence from Greece
• 6 Financial Regulation, Implicit Taxes, and Fiscal Adjustment in Italy
• Biographical Sketches of Participants
• List of Participants and Observers
• Footnotes