Economic Models - Convex Optimization

96 Andrew Hughes Hallet
restraint mechanism. Because it is a flow and not a stock, it has no inherent
persistence. Moreover, a larger part (the current automatic stabilizers,
social expenditures, and tax revenues) will be endogenous, varying with the
level of economic activity and with the pressures of the electoral cycle. It is,
therefore, much harder to use as a commitment device with any credibility
in the long term. If we assume that it can be pre-committed, as in the leadership
scenario, then we get good results of course. But, if this assumption
is likely to be violated (or challenged), then the fact that the results are so
much worse than in the simultaneous moves case shows how difficult it
is to pre-commit deficits in advance. Being only a small component in a
moving total, it does not have the persistence of a cumulated debt criterion
because violations are not carried forward. So, when policy conflicts arise,
the deficit either fails its target or it has to be restrained to such a degree
that it starts to do serious damage to overall economic performance.
7. Conclusions
I conclude this chapter with the following observations:
(a) Fiscal leadership leads to improved outcomes because it implies a
degree of co-ordination and reduced conflicts between institutions,
without the central bank having to lose its ability to act independently.
This places the outcomes somewhere between the superior (but discretionary)
policies of complete co-operation; and the non-co-operative
(or rule-based) policies of complete independence.
(b) The co-ordination gains come from the self-limiting action of fiscal
policy when fiscal policy is given a long-run focus in the form of a
(soft) debt or deficit rule. Leadership is the crucial element here; these
gains do not appear in a straight-forward competitive regime with the
same debt or deficit rule.
(c) The leadership model predicts improvements in inflation and the fiscal
targets, without any loss in growth or output volatility. In addition,
leadership requires less precision in the setting of the strategic or institutional
parameters. It is easier to implement.
(d) Debt ratios will increase in a policy game without co-ordination, but
do not do so under fiscal leadership. Likewise, deficit rules without
co-ordination to restrain fiscal policy imply larger deficits (and more
expansionary policies) than do debt rules of a similar specification
because deficits (being a flow not a stock, and with less natural persistence)
are less easy to pre-commit credibly. These two results explain