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Debt Stabilisation Policy

Much analysis of fiscal policy (including the papers on monetary and fiscal interaction cited elsewhere) assumes an explicit or implicit debt target. The implication is that any shock that raises debt will result in policy action that returns debt to its original level. I have looked at two questions that arise: how quickly should debt correction occur, and is this the optimal policy? The remaining sections look at deficit bias, and fiscal institutions (fiscal councils) designed to correct it.

Simple rules for Fiscal Feedback on Debt

One issue is how fast any fiscal feedback from debt should be. Results described elsewhere suggest that only very modest fiscal feedback is required to ensure that monetary policy can be active. In addition, Leith and Wren-Lewis (2000) and Leith and Wren-Lewis (2002) suggest that rapid stabilisation of debt may have negative consequences for inflation and output. This result is formalised in Kirsanova and Wren-Lewis (2012) (articleworking paper), which computes the optimal speed of fiscal feedback in a closed economy, on the assumption that monetary policy is determined optimally under commitment. Here government spending is adjusted as a proportion lambda of debt disequilibrium (so large lambda implies rapid debt correction), and the optimal lambda is computed. We find that the optimal value of lambda involves very slow debt correction.

Optimal Debt Policy

Two recent papers (Benigno and Woodford (2003) and Schmitt-Grohe and Uribe (2004)) have computed the fully optimal fiscal response (such that fiscal policy is not tied to any simple fiscal feedback rule) assuming that (distortionary) taxes are the fiscal instrument and that policy operates under commitment. They demonstrate a random walk result: following a positive shock to debt, the optimal response is to let debt remain permanently higher. By implication, the costs (in their case of permanently higher distortionary taxes) of leaving debt higher are less than the short term costs of returning debt to its original level. Leith and Wren-Lewis (2007) generalises this result by allowing both taxes and government spending as instruments. We also compute the optimal policy under discretion, and show that this does not imply a random walk in debt, but instead debt returns (slowly) to its steady state level. This result is explained by examining the nature of the time inconsistency involved in the commitment case. The random walk result does not imply complete accomodation of the fiscal shock: there is an attempt in the first period to reduce long run debt. This incentive is time inconsistent, and can only be removed if changes in debt are eliminated in the long run.

The random walk steady state debt result relies on the exact equality of the real rate of interest with the rate of time preference. In OLG models this will not be true in general. Leith, Moldovan and Wren-Lewis (2011) examine the optimal debt target, and optimal rates of adjustment to it, in Blanchard’s (and Yaari’s) Model of Perpetual Youth. This suggests that the optimal long run debt target is negative, but still not negative enough to eliminate the need for distortionary taxation or achieve an optimal capital stock. The optimal speed of adjustment to this target is very slow, but given the size of the total adjustment required compared to current levels, this may still imply significant reductions in debt to GDP ratios over the medium term. 

Deficit Bias

On average, government debt in OECD countries has increased substantially over the last few decades, and there appears to be no good reason why this should have happened. Some potential explanations are surveyed in Wren-Lewis (2011). One is electoral competition. It may be optimal for a party in power to raised debt levels, so that this will restrict the options of an opposition party if they subsequently come to power. This has been examined in models where debt is real, but the mechanism becomes irrelevant if debt is nominal and there are no price rigidities (because any real debt level can be achieved immediately through surprise inflation). Leith and Wren-Lewis (2009) investigate this form of deficit bias in a sticky price environment where debt is nominal. We find that, for reasonable parameters, the size of deficit bias is small, but electoral competition can generate significant political business cycles. 

Fiscal Councils: Institutions for Monitoring Debt

Wren-Lewis (1996) was the first occasion I argued that some form of independent fiscal authority might improve macroeconomic outcomes. The case for institutional reform in the context of countercyclical actions is examined here. However, there is at least as strong a case for an institution that is focused on debt stabilisation.

Kirsanova, Leith and Wren-Lewis (2007) (articleearlier version) argued that the random walk result discussed above means that simple rules for debt stabilisation will never be first best. This strengthens the case for a change in fiscal institutions to help achieve optimal debt stabilisation. Although some have argued for giving new institutions control over fiscal decisions, we make a more modest proposal, for a government financed but independent Fiscal Monitoring Commission to provide annual recommendations for aggregate tax or spending changes designed to move debt towards its optimal path. Although governments would not be required to follow these recommendations, they would be required to explain why they were not doing so. The paper compares this form of national institutional change to existing institutions in various countries, and to monitoring by the European Commission. Between 2007 and 2009 the idea for some form of independent UK fiscal watchdog gained momentum, and after the election of 2010 the Office for Budget Responsibility was established. (For a detailed account, see Wren-Lewis (2011b). An example of my advocacy of a UK Fiscal Council is here.) 

For a page devoted exclusively to Fiscal Councils, with links to existing bodies around the world, a list of papers on the subject and some simple questions and answers, go here

There are now a large number of Fiscal Councils around the world, many of which have been established in the last decade. Calmfors and Wren-Lewis (2011) (article, working paper) surveys these councils, and analyses the structure and activities of each. It asks to what extent the characteristics of these institutions can be related to the potential causes of deficit bias, and what relationship they have to fiscal rules. A more detailed examination is undertaken of the fiscal councils in Sweden and the UK. The paper draws some conclusions on the role of fiscal forecasting, ensuring independence, and the provision of policy advice. (A short summary of the paper appears here.) 

Wren-Lewis (2011) compares the delegation of monetary and fiscal policy. 


Benigno, P. and M. Woodford (2003), “Optimal Monetary and Fiscal Policy: A Linear Quadratic Approach”, NBER Macroeconomics Annual.

Calmfors, L. And Wren-Lewis, S (2011), What Should Fiscal Councils Do?, Economic Policy, Vol 26, pp 649-695 and Oxford Discussion Paper No. 537 

Kirsanova, T, Leith, C and Wren-Lewis, S (2007), Optimal Debt Policy, and an Institutional Proposal to help in its Implementation, European Economy Economic Papers No 275, April (articleearlier version)

Kirsanova, T and S. Wren-Lewis (2012) 'Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities', Economic Journal, Vol. 122, pp 238-264 (articleworking paper)

Leith, C and Wren-Lewis, S (2000), Interactions Between Monetary and Fiscal Policy Rules, Economic Journal, vol 110 pp93-108

Leith,C and S.Wren-Lewis (2002), The Macroeconomic Impact of Different Speeds ofD ebt Stabilisation in EMU, in European Macroeconomic Policies after MonetaryUnification: Fiscal Policies, Monetary Policies and Labour Markets, ed(s)  R. Beetsma, C. Favero, A. Missale, V.A. Muscatelli, P. Natale  and P. Tirelli, Cambridge University Press

Leith, C. and Wren-Lewis, S. (2007) Fiscal Sustainability in a New Keynesian Model

Leith, C and Wren-Lewis, S (2009) Electoral Uncertainty, the Deficit Bias and the Electoral Cycle in a New Keynesian Economy, Oxford Discussion Paper No. 460

Leith, C, Moldovan, I and Wren-Lewis, S (2011) Debt Stabilisation in a Non-Ricardian Economy, Oxford Discussion Paper No. 542

Schmitt-Grohe, S. and M. Uribe (2004), “Optimal Monetary and Fiscal Policy under Sticky Prices”, Journal of Economic Theory,114, February 2004, pp 198-230.

Wren-Lewis, S (1996) ‘Avoiding Fiscal Fudge’, New Economy, 3, 128-132, Institute of Public Policy Research.

Wren-Lewis, S (2011), Comparing the delegation of monetary and fiscal policy, Oxford Discussion Paper No. 540

Wren-Lewis, S (2011b), Fiscal Councils: The UK Office for Budget Responsibility, CESifo DICE Report 3/2011 (Autumn)