What is the relationship between fiscal rules and cyclical activity? This is the question addressed in Discussion Paper No. 1029 by Research Associate Tamim Bayoumi and Research Fellow Barry Eichengreen. State budgets in the US played a significant macroeconomic role in the 1970s and 1980s, and the level of cyclical responsiveness was affected by the severity of statutory and constitutional fiscal restraints. Moving from no fiscal restraints to the most stringent restraints lowered the fiscal offset to income fluctuations by around 40%. Simulations indicate that a reduction in aggregate fiscal stabilizers of this size could lead to a significant increase in the variance of aggregate output. Moreover, the results indicate that for the US, state budgets provided about one-seventh of the total fiscal offset to income fluctuations in the 1970s and 1980s, with the rest being provided by the federal budget and social security. This pattern is also found in other countries.

In Europe, this has implications for monetary union, which provides for ceilings for the budget deficits of the nations that participate. US experience suggests that such restraints, if vigorously enforced, could significantly diminish the stabilization afforded by national budgets. If the provisions of the treaty in fact inhibit national governments from adjusting their budgets to the cycle, post-Maastricht Europe may enjoy significantly less fiscal stabilization than the US economic and monetary union.

Restraining Yourself: Fiscal Rules and Stabilization
Tamim M Bayoumi and Barry Eichengreen

Discussion Paper No. 1029, September 1994 (IM)