Mr. Paul R Masson, Mr. Morris Goldstein, and Mr. Jacob A. Frenkel
This study identifies the key characteristics of a successful exchange rate system. It focuses on regimes in the industrial countries and consider the implications for the operation of the international monetary system.
What are fiscal policy rules? What are the principal benefits and drawbacks associated with various fiscal rules, particularly compared with alternative approaches to fiscal adjustment? Can fiscal rules contribute to long-run sustainability and welfare without sacrificing short-run stabilization? If so, what characteristics of fiscal rules make this contribution most effective? And in what circumstances and contexts, if any should the IMF encourage its member countries to adopt fiscal rules? This paper seeks to identify sensible fiscal policy rules that can succeed, if chosen by a member country, as an alternative to descretionary fiscal rules.
The member states of the European Community (EC) and the European Free Trade Association (EFTA) have a special relationship based on geographic proximity, a shared history, common values and—as many see it—a shared destiny.1,2 They are also each other’s most important trading partners (Charts 1 and 2). The EC countries account for over 50 percent of the EFTA countries’ exports and more than 60 percent of their imports. Indeed, the EFTA countries trade as extensively with the EC countries as the EC countries trade among themselves. On the other hand, the EFTA countries by themselves do not constitute a cohesive area. Intra-EFTA trade is—with the exceptions of trade between Switzerland and Austria and between Finland, Norway, and Sweden—insignificant relative to the trade of individual EFTA countries with the EC.
Switzerland, through a long tradition of banking and finance, has developed into a major center for international financial transactions. In recent years, however, significant institutional changes in most large capital centers have challenged Switzerland’s traditional role as a financial center. Deregulation of domestic banking in other countries has reduced its comparative advantage of having a universal banking system. The creation of new offshore banking facilities and the repeal of the withholding tax on interest income of nonresidents in the Federal Republic of Germany, France, and the United States in 1984 have changed the competitive environment. In addition, capital controls have been relaxed in several countries, including France and Japan, while Germany and the Netherlands have taken measures to strengthen the international competitiveness of their financial markets.
Growing interest in fiscal policy rules is in part attributable to the deterioration in fiscal performance, the so-called deficit bias, experienced for more than two decades by a large part of the IMF membership. In many countries the deterioration recently has been reversed—in a number of cases, as part of the convergence toward meeting fiscal rules. Still, some advanced economies face a major task in managing a sustainable fiscal policy over the medium to long run, given uncertainties in the macroeconomic outlook, structural rigidities, and the aging of populations. Equally worrisome are the prospects for developing and transition economies, as continued vulnerability to macroeconomic imbalances prevents realization of their full growth potential, especially in the absence of predictable and sound fiscal policies. In the light of these considerations, in its September 1996 Declaration on Partnership for Sustainable Global Growth, the Interim Committee of the Board of Governors of the International Monetary Fund attached particular importance to “achieving budget balance and strengthened fiscal discipline in a multi-year framework” (IMF, 1996b, p. xii).
The issue of economic and political integration has been on the Western European agenda since the end of World War II (Siegler, 1961). The first step toward forming the European Communities (EC) was taken in 1951, when Belgium, France, Germany, Italy, Luxembourg, and the Netherlands formed the European Coal and Steel Community (ECSC) with a supranational administrative body, the High Authority.6 In 1955, following the failure of plans to form a European Defense Community and a European Political Union, the same six countries agreed in principle to form a common market, which envisaged the free movement of goods, services, labor, and capital—the “four freedoms.” The founding document of the European Economic Community (EEC)—the EEC Treaty, signed in March 1957—embodied a vision for broadly based economic integration going well beyond simple cooperation on trade issues.
Switzerland has a long tradition of capital exports. As domestic savings exceeded domestic spending, Swiss financiers and governments were already actively engaged in international finance in the eighteenth century. Net capital exports continued into the twentieth century, except during periods of the nineteenth century, when domestic credit demand increased with industrialization and the building of railroads, and for a time after World War I. The excess of domestic savings was largely a result of financially sound governments in the cantons and towns and was in marked contrast to the large financing needs of many other European governments, which resulted from continuous engagements in war. The financial performance of both the Swiss governments and the private sector was based on several factors. First, the country maintained political neutrality and thereby did not incur large war expenses. Neutrality was a consequence of the multiconfessional and multilingual character of the Confederation, the strategic location in the center of Europe, and the small size of the country.2 Second, Switzerland was able to maintain trade with the belligerent countries and also benefited, on a large scale, from income earned from Swiss military service abroad, through treaties concluded with foreign sovereigns. Finally, in the early stage of industrialization, Swiss exports of cotton and silk products prospered because of little competition from abroad.
Against the backdrop of fiscal developments in recent decades, this section reviews the major arguments that have been put forth to adopt fiscal policy rules. It then discusses the institutional aspects of existing and proposed rules, the encompassing statutory instruments, the authority responsible for enforcing or monitoring compliance, and the actual means of enforcement.
Binding fiscal policy rules are likely to influence the level and composition of government expenditure and taxation. In addition, fiscal rules have major macroeconomic consequences for inflation, external indebtedness, and economic growth. Of particular concern is the effect of balanced-budget rules on the short-run variability in output and income. Given the limited experience with fiscal rules, some of these effects must be examined with the help of simulations. By comparison, it is noteworthy that, in the monetary policy area, experience with inflation targeting, applied since the early 1990s, has been even more limited.
A number of institutional and legal issues arise as a result of efforts toward intensified EC-EFTA cooperation. There is a need for increased mutual recognition in civil law, particularly with regard to commercial judgments, and the institutional changes that may be required as part of the creation of the EES. Other relevant issues include corporate law and industrial and intellectual property.