Fiscal Rules and Discretion in a World Economy

Abstract:

We consider a world economy in which all governments have time-inconsistent preferences with a present-bias toward government spending. Fiscal rules are borrowing limits which trade off the desire to commit to not overspend against the desire to have flexibility to react to shocks to the value of spending. We compare fiscal rules which are decentralized and independently chosen by each country to fiscal rules which are centralized and chosen jointly by all countries. In contrast to decentralized rules, centralized rules take into account that less flexibility affects all countries by reducing global interest rates. If the present bias is low, centralized rules are tighter than decentralized ones since countries choosing rules independently do not internalize the redistributive effect of lower interest rates. In contrast, if the present bias is high, centralized rules are slacker than decentralized ones since countries choosing rules independently do not internalize the disciplining effect of higher interest rates. In this case, if a subset of countries can freely adopt tighter rules than those imposed centrally, then interest rates decline, which worsens fiscal discipline for the rest. Tighter fiscal policy by this subset of countries ultimately results in tighter centralized rules and lower flexibility for everyone.