At his last European Council summit meeting, at least for the time being, Italian Prime Minister Mario Monti gave some parting advice to his fellow leaders. Written up as a four page letter and reported on in the FT, Monti argued that the main problem with austerity policies is that there was too big a lag between the positive effect of reforms and their negative bite. Giving his own version of the old adage that things have to get worse before they get better, Monti explained that this doesn’t fit very well with the rules of the electoral cycle. The promise of austerity and supply-side reforms is that they bring gains by way of employment and growth in the long term. The difficulty is that politicians are judged according to pain they bring in the short-term. Something needs to be done to bridge the gap in order that reform agendas are not derailed, as he thinks they have been in Italy. From the perspective of the European Commission or the German Bundesbank, the issue is how to make sure that in the time in between enacting reforms and feeling their positive effects, susceptible policymakers are not tempted to give up on earlier promises and go for quick fixes, like expansionary fiscal policy or other Keynesian pump-priming tricks.
This discussion raises a number of issues. As a trained economist, Monti no doubt knew that his argument was a restatement of what macro-economists call the problem of time inconsistency. This is the notion that policy rules – such as a commitment to balance budgets over the medium term – lack credibility when they are made sequentially. As soon as a firm commitment is spread over a length of time, the possibility arises that short-term considerations will assert themselves. Such policy commitments are thus time inconsistent – they fail to hold over time and thus need to be insulated as much as possible from political pressures.
If this is Monti’s analysis, two questions arise. The first is what if the policy rule has no credibility in the first place – irrespective of whether we are talking about the short, medium or long-term? The commitment of EU member governments is that austerity combined with supply side reforms equals a return to growth. We are into our fifth year since the outbreak of the current crisis in 2008, austerity policies have themselves been in place for a number of years, up to three to four years in some countries. Austerity is nothing new, nor is the idea that supply side reforms boost growth and employment, and yet these policies are not being seen to deliver. Monti’s analysis of current difficulties in Italy and elsewhere, that rests upon the idea of extended lag between introducing reforms and securing their rewards, in fact places a great deal of faith on the idea that these reforms will eventually work. At issue today is not people’s short-termism. It is the more fundamental issue of whether cutting spending and raising taxes in a recession is any way to stimulate growth.
The second question is about what Monti suggests we should do. If we return to the idea of time inconsistency, then we find a very clear recommendation. Institutions should be created that make it as difficult as possible to renege on a policy commitment. This is the famous recommendation to favour rules over discretion. These institutions should be given the responsibility for contentious political agendas – like keeping down government spending, being hawkish on inflation, reform labour markets – in order that legislatures and electorally accountable executives are not tempted to go for short-term fixes.
The problem is that we are not in the 1970s anymore. Profligate legislatures have not been driving today’s budgetary crises. The contrary is true, as we see from the Netherlands through to the UK and Spain. Moreover, today’s crisis happened in a world of rules, not of discretion. Problems of sequential policymaking were hived off to independent central banks, independent budgetary offices, fiscal councils and an array of European rules and regulations in the field of macro-economic policy. As a result, the problem surely lies in something deeper and more fundamental than simply the institutional environment for elected policymakers. This won’t stop European commissioners and national politicians arguing for the strengthening of European rules. In fact, as the Fiscal Compact has shown, this seems to be the dominant framework with which European policymakers are working today. We should be wary of such explanations. A policy framework dedicated towards the curtailment of expansionary policies has given us a European continent saddled with debt and a global debt crisis. There is something more to this than the theory of the time inconsistency of optimal policy rules.