way of achieving fiscal targets. Taxation, if it gets too high, inhibits entrepeneurship and stimulates tax-dodging, while low spending leads to low interest rates: this is a self-reinforcing mechanism which improves business expectations and confidence in the future.
Q2 A lobby group suggests a constitutional amendment to the effect that government budgets must be balanced, arguing that allowing politicians discretionary power leads to large deficits and escalating debt. Analyse this proposal.
This proposal targets one of the main limits of fiscal activism: political interference into fiscal policy management. In theory, it is possible to manage fiscal policy in a way that budget deficits in recession are followed by budget surpluses in boom, keeping an overall stability in the public debt burden. Empirical evidence does not support the theory: the debt : GDP ratio tends to rise in periods of recession but does not fall in periods of expansion. Two main reasons can be highlighted:
i) Budget deficits are more popular than budget surpluses. A government asking for austerity in a boom period to reduce the public deficit is not politically popular; people (until few years ago) were less concerned about the long term and future costs of borrowing.
ii) Discretionary management of fiscal policy leads to a political rather than economic timing. Governments tend to exhibit fiscal activism before elections (hoping to win another term in office) and fiscal consolidation after elections (hoping that the public's recollection of their actions might have receded by the time of next elections). Therefore fiscal activism risks becoming pro-cyclical rather than counter-cyclical leading to economic instability. This can have serious consequences when the size of the government sector reaches 50% of the GDP as in most European countries.
Limiting the discretionary power of politicians over fiscal policy would have the positive effect of eliminating (or diminishing) the costs above mentioned. A constitutional amendment would forbid governments from using fiscal policy in order to gain their political survival. Another positive effect would be on the government's credibility: financial markets will reward consolidation policies when they are trustworthy, and such a constitutional amendment would be a sign of strong credibility. Through a decrease in interest rates and expectations of lower taxes in the future, this would create an expansionary effect in the economy.
Unfortunately there is also a downside. In periods of deep recession, fiscal policy still has a role to play. When external disturbances or domestic shocks happen, fiscal expansion can be the medicine to avoid dramatic costs in terms of unemployment, although the fiscal instrument is now less effective than in the past (mainly for small countries and for single countries initiatives).
The Maastricht criteria, with their emphasis on a 3% limit in the budget deficit of member countries, attempt to curb the discretionary power of EU governments. The aim is to gain a reward in terms of lower interest rates from the financial markets, to start a spiral of expansionary fiscal contraction and to provide a stable single currency to