Credibility vital for Labour-Greens fiscal council

Labour and the Greens’ Budget Responsibility Rules could presage for fiscal policy what the Reserve Bank Act did for monetary policy, writes Dr Chris Eichbaum

Last week saw two important and related events.

The first was a function at Parliament marking the publication of two books from Jonathan Boston, Professor of Public Policy in Victoria University of Wellington’s School of Government.

The “weightier” of the two is Governing for the Future: Designing Democratic Institutions for a Better Tomorrow (Emerald Publishing) and the other Safeguarding the Future: Governing in an Uncertain World (Bridget Williams Books). At the risk of doing a disservice to what are finely honed and sophisticated arguments, Professor Boston’s thesis is that, for a variety of reasons, policymakers operate within a timeframe that is too much about the short term, with insufficient attention paid to issues that fall outside the horizons given by electoral cycles and what happens to interest the public at any given moment. The phrase he uses is that policymaking is hostage to a “presentist bias”.

Economists have advanced their version of this thesis for some time. The literature is voluminous but is captured by the notion of “dynamic inconsistency”. In essence, this means a decision I make now — perhaps for short-term political advantage — may have a detrimental effect on the economy and society in the medium term.

This is sometimes referred to as a tension between rules and discretion. The classic expression of the argument would have it that if politicians can exercise discretion they may use it to advance their interests — for example, increasing their chances of re-election — even though the consequences may not be in the best interests of society. The remedy is to take away the discretion and replace it with a rule.

Perhaps the most prominent example of this in academic literature and the design of public institutions is central banks and the conduct of monetary policy.

This year marks the 30^th anniversary of Government Management, the New Zealand Treasury’s advice to the Fourth Labour Government as it commenced its second term. There is much in that document that goes to the problems of dynamic consistency. In terms of monetary policy, the result was the passage of the Reserve Bank Act.

The oft-used justification at the time was this would “Muldoon-proof” the economy. So an independent central bank would be insulated from political meddling — rules would trump discretion. In practice, however — as a former Governor of the Reserve Bank of Australia once remarked (to the annoyance of some economists, one senses) — effective monetary policy is an art, not a science. And as the minutes of committees tasked with making monetary policy decisions attest, disagreement as to what a central bank should do is not uncommon. Models and equations have their limits.

Last week’s second major event came a day after the first, with the joint launch by the Labour Party and the Greens of a set of Budget Responsibility Rules. There are five of them. They are important in their own right but no less so than a coda, which forms part of the statement and reads as follows:

“The credibility of our Budget Responsibility Rules requires a mechanism that makes the government accountable. Independent oversight will provide the public with confidence that the government is sticking with the rules.

We will establish a body independent of Ministers of the Crown who will be responsible for determining if these rules are being met. The body will also have oversight of government economic and fiscal forecasts, shall provide an independent assessment of government forecasts to the public, and will cost policies of opposition parties.”

This is significant. One might venture to observe that it presages for fiscal policy — at least in some respects — what the Reserve Bank Act did for monetary policy. The language is one of rules, independent oversight and accountability.

These kinds of bodies have a name — they are called fiscal councils. They have been established in several countries. Posed in terms of “if fiscal councils are the answer, what is the problem?”, the answer typically is “deficit bias” — governments spending more than they earn, or, to return to Professor Boston’s thesis, deferring payment to (or allowing costs to fall on) future generations.

This particular rock is one that social democratic parties find it more difficult to climb out from under, given the somewhat clichéd view that the left tends to tax and spend (and presumably the right to reduce tax and the size of government).

The issue is one of credibility, and the left faces a more significant credibility problem than the right. Although one needs to add that the last Labour-led Government was less about deficit bias and more about the size of the surplus and then-Finance Minister Michael Cullen’s reluctance to lead a tax-cut lolly scramble. (History will record that navigating the Global Financial Crisis was helped by the war chest Cullen amassed.)

Some of these fiscal councils are advisory, while others can set expenditure rules and enforce them. Labour and the Greens are suggesting advisory, but with teeth. The Treasury undertook some work in this area in 2011 but stopped short of advocating the kind of institution Labour and the Greens are now proposing. One of the arguments against such an institution was that fiscal policy is by its nature highly distributional and thus inevitably political — and it is. But it would be naïve to assume (although many do) that monetary policy is not distributional too.

Just what a fiscal council would look like under a Labour-Green Government is unclear. And it would be premature to expect a high level of detail at this stage. It will need to be a credible organisation. It will need to speak as much to the public at large as to those behind the flickering screens in the finance markets. It will need to have an open line of communication with the Reserve Bank. The institutional “sweet spot” is where endowments of credibility are matched with endowments of legitimacy.

Labour and the Greens are to be commended for taking the policy lead in this area. Let the conversation continue.