Fiscal rules instead of fiscal discretion?

Discussions in economics about rules versus discretion have gone on for a long time and will continue to do so but perhaps such a discussion might be fruitful in a Latvian context? Just a little quip about that.

Here monetary policy is highly rules-based: There is a fixed exchange rate, it is supposed to remain fixed at the current parity of 0.702804 LVL/EUR until euro adoption which is envisaged for 2014 and to ensure this rules-based monetary policy Latvia has a highly independent central bank, see e.g. article 22 in the Law on the Bank of Latvia.

Fiscal policy, on the other hand, is highly discretionary: There is no specific target for the budget deficit (except, one should expect, somewhere the 3% deficit criterion stipulated by Maastricht) and Latvia certainly never adhered to the recommendations from the ECB of aiming at a budget surplus during the economic cycle – when overheating was at its height there was still a budget deficit here.

But might a fiscal rule be better? They are certainly not unheard of – there is the example from the ECB above and the US has now and again suggested balanced budget amendments. Our Northern neighbours have a rule not too dissimilar and although one may argue that aiming at a budget deficit inside the Maastricht limits during a recession as severe as this one is the Mother of All Tight Fiscal Policies it has its benefits: Estonia may (or may not, it all looks very messy right now) be on its way to the eurozone and it certainly will emerge from this recession with much less debt than Latvia and thus with fiscal policy options Latvia won’t have.

Adopting a fiscal rule ties the hands of policy makers but sometimes that is exactly what is needed, namely where untied hands might seek to increase spending or lower taxes without considering sustainability issues. The upcoming election is test case for this, I guess (and fear).

Greece is the example par excellence of a country where short-sighted fiscal discretion has always dominated but (finally) it seems to be pay back time. Latvia’s fiscal policy was, as has been repeated a zillion times, highly discretionary and in no way focused on the long run during the ‘fat years’ but might it then not be an idea to prevent that from happening again by introducing a fiscal rule? The current situation is precarious but I don’t want to see it also ‘turn Greek’ one day.

Morten Hansen is a Head of Economics Department, Stockholm School of Economics in Riga