In an era of ballooning budget deficits at the federal level, fiscal policy restrictions often force American states to play by very different rules. Many state governments must, by self-imposed law, balance their annual budgets. Fiscal policy restrictions, however, have in many instances been blamed for unduly and irresponsibly restricting the ability of state governments to react adequately and quickly enough to business cycle fluctuations.
Consequently, the adoption of quantitative restrictions is often seen as directly leading to increased macroeconomic volatility. Advocates of such limitations argue that the negative affects of any such legal limitations can be easily outweighed by at least two positive results: ironclad restrictions preventing untenable debt levels, and a severe lowering of the possibility that fiscal policy itself could be a major source of macroeconomic volatility.
Professor Antonio Fatás and Associate Professor Ilian Mihov, both of INSEAD's Department of Economics, employ extensive sets of data gathered from 48 American states to examine how such budgetary rules affect fiscal policies. The authors' previous research, involving data samples from many countries, has revealed that governments facing less obligatory political restrictions when dictating their budgets overwhelmingly tend to add more volatility to their business cycles.
In the American context, their analysis of the direct effects of budgetary constraints on fiscal policy consequences is conducted at two levels. First, they study how such limitations affect the abilities of state governments to introduce discretionary changes into fiscal policy. Second, they document how such constraints influence the ability of governments to react to changes in economic conditions.
Fatás and Mihov's main findings reveal that stricter budgetary restrictions lead to lower policy volatility, (i.e., less aggressive use of discretion in conducting fiscal policy) and an overall better behaviour of fiscal policy. Such mandatory limits may also help reduce budget deficits and aid the creation of more sustainable longer-term budgetary planning.
However, there are also costs, as fiscal restrictions tend to reduce the responsiveness of fiscal policy to output shocks, primarily through directly impairing the ability of state governments to engineer counter-cyclical fiscal policy.
The article expands the authors' extensive research into the behaviour of governments, according to the freedoms they are afforded in setting their own fiscal policy courses. In both European and American governments, Fatás and Mihov have quite consistently found that governments forced to deal with fewer mandatory restrictions when setting their budgets tend to "misbehave" more. This may often come in the form of instituting short-term changes in fiscal policies which have the unintended effect of adding unwanted volatility in longer term business cycles.
Journal of Public Economics, January 2006