A Fiscal Rule That Has Teeth: A Suggestion for a "Fiscal Sustainability Council" Underpinned by the Financial Markets

Petr Hedbavny, Ondrej Schneider () and Jan Zapal

No 79, Working Papers IES from Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies

Abstract: In this paper, we set out to examine an efficient fiscal-policy framework for a monetary union. We illustrate that fiscal policy’s bias toward budget deficit only temporarily ceased at the end of the 20th century as European countries endeavored to qualify for euro-zone membership, which compelled strict limits on budgetary deficits. We then explore which mechanisms might instill a sense of fiscal disciple in governments. We find that most mechanisms suffer from the incentive-incompatible setup whereby governments restrict their own fiscal-policy freedom. We argue that even multilateral fiscal rules, such as the EU’s Stability and Growth Pact, suffer from the same endogeneity flaw. Consequently, we argue that a fiscal rule must incorporate an external authority that would impartially assess fiscal-policy developments. Using U.S. debt and bond-market data at the state level, we show that financial markets represent a good candidate as, vis-á-vis the American states, they do differentiate state debt according to the level of debt. We thus argue for a fiscal institution - what we call the Fiscal Sustainability Council - that would actively bring financial markets into the fiscal-policy process, and we explain the technique whereby this could be effected.

Keywords: fiscal policy; European Union; sustainability (search for similar items in EconPapers)
JEL-codes: E6 H6 H87 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2005, Revised 2005
New Economics Papers: this item is included in nep-cba, nep-mac and nep-pbe
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Related works:
Journal Article: A Fiscal Rule that Has Teeth: A Suggestion for a “Fiscal Sustainability Council” Underpinned by the Financial Markets (2007)
Working Paper: A Fiscal Rule that has Teeth: A Suggestion for a ‘Fiscal Sustainability Council’ underpinned by the Financial Markets (2005)
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