Fiscal Policy in a Monetary Union

Recently, I read a post about the desirability of the various UK austerity programs within the UK monetary union.  What is special about the countries in the UK monetary union is that they are, to a certain extent, a fiscal union as well.  Scotland, Northern Ireland, Wales all have voting power within the English parliament at Westminster.  However, England does not have voting power in the parliaments of the other states, and therefore they still have some degrees of freedom to pursue their own fiscal policy, including the power to finance the policy through bond markets.  What this means is that fiscal policy, in a sense, can be devolved from the “federal” government to the individual countries.  Such a possibility is discussed by Brian Ashcroft when he calls upon the Scottish government to pursue policy to counteract the effects of fiscal austerity.

Well, first, it suggests that an independent Scotland as an accepted part of the UK sterling monetary union should be able to adopt a different fiscal policy stance to stabilise GDP than rUK. However, it also suggests that providing the degree of fiscal devolution is sufficient to allow changes in tax and spend that can influence aggregate demand then this option is also available within the UK political union. Further academic research is required on the appropriate form and degree of fiscal devolution for effective stabilisation but there is little doubt that stabilisation at the level of nations and regions within the UK is feasible. 

Moreover, if an independent Scotland is part of the sterling monetary union the Bank of England and rUK government will almost certainly require that the Scottish government abide by a set of fiscal rules - see this earlier post. The fiscal framework could be little different under devolution from that under independence. Under devolution, Scotland could have a separate stabilisation policy as well as the benefits from the risk pooling arrangements e.g. social security, bank bailouts etc. that are available as part of the UK. It is true that the high levels of trade with the UK would make it difficult for fiscal policy to chart a radically different stabilisation path from rUK but that would apply to an independent Scotland too.

Based on this concept, what if fiscal policy were devolved in the United States?  This concept of devolution would allow each state to design a fiscal policy appropriate for the macroeconomic conditions in each state.  Such a policy would be somewhat consistent with the concept of Market Preserving Federalism (MPF).  MPF was originally used by Weingast in the context of public choice; how do subnational units efficiently provide public goods to their citizens?  Samuelson argued that it was impossible, and that due to cross-border externalities, the central government had to intervene.  However, Weingast, building on Tiebout, argued that the subfederal units could be thought of as firms, and that they could compete against each other to reach optimal public good bundles.  For this to occur, five conditions must be met:

1. 1.    There exists a hierarchy of governments with a delineated scope of authority (for example, between the national and subnational governments) so that each government is autonomous in its own sphere of authority.
2. 2.    The subnational governments have primary authority over the economy within their jurisdictions.
3. 3.    The national government has the authority to police the common market and to ensure the mobility of goods and factors across subgovernment jurisdictions.
4. 4.    Revenue sharing among governments is limited and borrowing by governments is constrained so that all governments face hard budget constraints.
5. 5.    The allocation of authority and responsibility has an institutionalized degree of durability so that it cannot be altered by the national government either unilaterally or under the pressures from subnational governments.

Each of these five conditions are important to supporting MPF.  Without a hierarchy of governments (1), there is no federalism; the unitary state cannot be differentiated from the federal unit.  If subnational governments don’t have primary control (2), then they can’t properly compete against each other.  Without factor mobility (3), there is no competition.  As MPF was originally formulated in the context of public choice, the factors of production must have choice in where they are located.  Subnational control over factor mobility in the common market would prevent this.  Without (4), transfer payments can be used to smooth over competitive differences, limiting efficiency.  Finally, without (5), there is too much policy uncertainty, and the MPF regime may fall apart.

In devolved fiscal policy, the public good is no longer something concrete like transportation infrastructure or police protection; it’s aggregate demand management.  AD policy truly is a public good, as when the macroeconomy is doing well in an area, nobody can opt out of it (nonrival), and the government cannot effectively exclude, outside of arbitrary jailing, any citizen from the benefits.  Yet in the provision of this public good, the fourth condition, the hard budget constraint, becomes very problematic.  A hard budget constraint substantially limits the ability of the sub-federal units to pursue counter-cyclical fiscal policy such that, in recessions, the sub-federal units are forced to cut spending.  As a result, the economy suffers due to the shortfall in aggregate demand.  This is confirmed by data from the 2008 recession: over the course of the downturn, state and local spending collapsed, effectively counteracting the effect of the federal stimulus.

So what happens if the fourth condition is loosened; what if state and local governments were allowed to borrow?  In effect, there then would be fifty states with sovereign fiscal policies in a common monetary union; a situation quite similar to that in Europe.  During the construction of the European monetary union, the United States was often used as a model in the literature to help describe how Europe would work.  In this case, Europe can be used to help evaluate a hypothetical United States, in which sub-federal, and not the federal, units have borrowing power.

In Europe, the concern was that, in the absence of borrowing rules, the fiscal policies of the individual European states would err towards fiscal irresponsibility.  Since prices for most goods would not be affected by an individual country’s fiscal policy, aggregate supply would be much more elastic, heightening the effect of expansionary fiscal policy.  As a result, each state would have an incentive to boost its output through government spending and push the debt to the future.  However, once every state decides to pursue fiscal expansion, the aggregate supply relation puts the brakes on output growth, resulting in higher inflation instead.

Would the same thing happen for devolved fiscal policy in the United States?  According to analysis by McKinnon, the answer is “not necessarily.”  Because of Ricardian equivalence, a state’s decision to take up higher levels of debt can be interpreted as an obligation to raise taxes or cut spending on other programs in the future.  Assuming sufficient factor mobility to cause horizontal competition between states, the taxes to finance the debt spur firms to move away from indebted states to move towards lower debt states.  Consequently, debt financed expansions would be limited to public goods that have a positive return in the state, as those would be the only programs for which firms would be willing to pay taxes.  Note that these public goods can include education and health care systems as well.  If workers are drawn to the state by the productive investments in human capital, firms will have more opportunities to find talented workers in that state.  These local public goods would also be the answer to the spillover effect of fiscal stimulus.  As per open economy models of fiscal stimulus, simple increases in consumption have a high probability of being spent in other states.  On the other hand, local investments contain more of the stimulatory effect within the state.  As a result of competition between states, there is more likely to be efficiency within states.

What is particularly attractive about this arrangement is that it forces aggregate demand management in recessions to function as quasi-aggregate supply management.  As “easy” stimulus would diffuse across borders, so the more onerous task of improving the capital stock, both human and traditional, becomes the key mechanism through which to achieve macroeconomic stability.  This also creates exciting possibilities with regards to the interaction between each subnational unit’s fiscal policy and national monetary policy.  If the price level is pushed down as a result of an increase in aggregate supply, it may force the hand of an inflation targeting central bank that is otherwise unwilling to fill the output gap.

Some may point to Europe as an example of why this system would not work; devolved fiscal policy under a monetary union has only led to severe debt crises there.  However, one key difference is the extent of factor mobility in Europe as compared to the United States.  Much of the empirical literature on the Eurozone has pointed out the limited mobility of labor within the Eurozone.  Although many of the de jure barriers to immigration have been removed, the de jure barriers are still very problematic.  Moving from Germany to Portugal is not quite as simple as moving from Maine to California.  One has to learn a new language, use it effectively in a job, and then be aware of new cultural mores to truly fit in.  Consequently, labor mobility in the Eurozone has been estimated at about one third of that in the United States.  After adding high levels of transfer payments between countries, there is very little competition between the European countries for labor; there is no “factor-price equalization.”  As a result, firms cannot easily relocate, giving individual countries more space to pursue inefficient levels of government spending.  The threat of future taxes embodied by present debt is not strong enough to spur firms to move.

With Scott Sumner proudly proclaiming a market monetarist end to macro, it is time to turn our attention to what we can do afterwards.  In a world in which knowledge is increasingly dispersed, and centralization is unequipped to deal with the complex nature of economic policy, devolving policy domains, such as fiscal policy, may be the answer.