Many of the points discussed in this and the following section are summarised in Leith and Wren-Lewis (2006) and Kirsanova, Leith and Wren-Lewis (2007).
Can Fiscal Stabilisation Policy Improve Welfare?
For more than two decades, monetary policy has been seen as the primary or only policy instrument for business cycle stabilisation. However the reasons for this have generally concerned factors outside a standard macroeconomic model, such as implementation lags or political economy concerns. In Eser, Leith and Wren-Lewis (2009) we show that in a New Keynesian model where social welfare is derived from agent's utility, and monetary policy is unconstrained, there is no role for changes in government spending to assist monetary policy in demand management. In other words, there is no social cost in assigning only monetary policy to demand management. The paper shows that this result is robust to a number of model extensions.
There are two important caveats to this result. First, as Eser et al (2009) show analytically, and Leith and Wren-Lewis (2006), also quantify, there is an important supply side role for taxes in a model involving both price and wage rigidity. Second, Leith and Wren-Lewis (2006) show that if monetary policy is constrained because the economy is part of a monetary union, government spending can partially substitute for monetary policy. This updates earlier research using less microfounded models (see Driver and Wren-Lewis (1999)) for example), which also found that fiscal stabilisation could be very useful under EMU.
Fiscal Rules, the SGP and the UK
Wren-Lewis 2003a compares the fiscal rules adopted by the Labour Government in the late 1990s with the early versions of the Stability and Growth Pact of the Eurozone. The paper suggests that in important respects the UK rules are superior to those of the SGP. Furthermore, the idea that each Euro member country should be subject to the same rules does not make sense. Wren-Lewis 2003a also argues that Euro governments should be allowed to be exempt from the SGP if they meet two key conditions. First, they have in place rules of their own which ensure sustainability. Second, the European Commission believes that the government is following its own rules. If a government passes the first test, but subsequently fails the second, it then becomes subject to the SGP again. This proposal would allow countries to design fiscal rules and institutions that are appropriate for their own national circumstances, and take ownership of those rules. It adds an additional incentive to keep to its own rules. It preserves the principle of subsiduarity. The alternative currently being explored by the Commission is to modify the rules of the SGP in a number of ways. While each of these modifications may be an improvement, taken together they are likely in practice to involve the Commission in much more detailed inspection and bargaining over individual country's fiscal plans. This leads to an unnecessary reduction in subsiduarity, and adds to poltical tensions.
A more stylised alternative to the SGP is examined in Kirsanova, Satchi, Vines and Wren-Lewis (2006). Here fiscal policy can follow simple rules to help stabilise an economy in the face of asymmetric shocks. The paper examines the consequences for welfare of restricting these rules in various ways.
New institutional arrangements for fiscal stabilisation policy
The role, if any, for fiscal policy as a cyclical stabilisation device is discussed above. There it was noted that, even when monetary policy was unconstrained, tax changes could compliment monetary policy in influencing key relative prices. If monetary policy is constrained, fiscal policy had a clear demand management role. The effectiveness of different fiscal instruments is examined in Wren-Lewis (2000). It notes why indirect tax changes like VAT may be much more effective than other tax changes. (The UK government enacted a temporary cut in VAT as part of their efforts to combat the 2008/9 recession.)
Nevertheless, governments may be reluctant to pursue a stabilisation policy alongside a monetary authority, or it may be believed that governments might abuse this role by operating it only when fiscal expansion is required. Wren-Lewis (2003b) argues the case for a new institutional structure, where an independent authority is mandated to carry out limited and temporary fiscal changes to selected fiscal instruments to help meet an inflation target. This institution could be the central bank.
In a short piece in the Financial Times: 'Trust the Old Lady' 5/02/2002 I argue for allowing the Bank of England temporary and limited access to selected fiscal instruments. This proposal is politically controversial, as was evident when I gave evidence to the Treasury Select Committee's 10 year review of the Monetary Policy Committee.
These arguments for institutional change relate to short term stabilisation policy, and are in principle quite separate from the arguments for a Fiscal Council to monitor long term government debt discussed here.
References
Kirsanova, Leith and Wren-Lewis (2007), Optimal Debt Policy, and an Institutional Proposal to help in its implementation, in J. Ayuso-i-Casals, S. Deroose, E. Flores, and L. Moulin (eds) The role of fiscal rules and institutions in shaping budgetary outcomes, European Economy Economic Papers 275, April. (article, earlier version)
Leith, C. and Wren-Lewis, S. (2006) The Costs of Fiscal Inflexibility
Wren-Lewis, S (2003a), Changing the rules, New Economy, vol 10,pp 73-78