Policy Coordination
I'll Spend if you Will

This paper investigates the desirability of international fiscal policy coordination in the presence of a domestic political distortion. The domestic distortion results from the inability of the current policy-maker to enter into a binding agreement with future policy-makers about the composition of public spending. This distortion generates a bias towards budget deficits. International coordination can exacerbate this bias, and thus reduce social welfare at home and abroad. The reason is that international coordination enables the domestic and foreign governments to form a coalition that excludes future policy- makers. This international coalition reduces the cost of running a budget deficit, and thus enhances the adverse effects of the domestic political distortion.

In virtually all analyses of international policy coordination, the policy-maker is modelled as a benevolent social planner, who, by assumption, always chooses the right economic policy, that is, the policy that is socially desirable from the point of view of the domestic economy (or of the world economy, if there is policy cooperation).
Domestic political institutions may, however, create incentives to pursue socially inefficient economic policies. In this paper policy is not set by a social planner who maximizes a given and stable welfare function. The policy-makers respond to domestic political incentives and constraints. These domestic political factors may induce the government to choose the wrong (socially inefficient) policy from the point of view of both the domestic and world economy. When this happens, does international policy coordination tend to correct or to exacerbate the distortionary effects of the domestic political system?
The paper focuses on international coordination of fiscal policy in a two-country, two-period model. The domestic government can at no cost transform the domestic output in two non storable public goods. The only difference between these two public goods lies in the utility that they provide to different consumers. These public goods can be thought of as, say, bridges and weapons. The government chooses the composition of public expenditure during each period. It is constrained in this analysis to set the sum of the present value of public expenditure in the two periods equal to a predetermined amount: this restricts the realm of the strategic interaction between the domestic and foreign government exclusively to the intertemporal profile of fiscal policy, as opposed to the overall size of public spending. This restriction could be dropped, at the price of substantial complications, as long as taxes were assumed to be distortionary rather than lump sum. The overall level of public spending in the last period is determined by this constraint, and does not depend on which party is in office.
Two political parties can hold office. The parties are the political representatives of different groups of consumers and have different preferences about the composition of the public good. It is further assumed that the preferences of the two parties do not change over time and that a barrier prevents the entry of a third party. An essential crucial feature of the model is that neither the domestic nor the foreign government is certain of winning future political elections. Moreover, each government knows that if it loses the elections, it will be replaced by future policy-makers with different preferences concerning the composition of public spending. This awareness induces the current policy-makers to act strategically with respect to future policy-makers. Specifically, it provides both the domestic and the foreign government with an incentive to run a fiscal deficit.
We first compute as a benchmark the policies that would be chosen by a hypothetical world social planner. This amounts to characterizing the Pareto frontier of the world economy along which the marginal cost and benefits of issuing debt are equal. The marginal cost is equal to the discounted marginal utility of the public expenditure that has to be foregone in the final period in order to repay the debt. The benefits arise from the marginal utility of the extra public consumption purchased with the debt and a term reflecting the social welfare effect of the rise in the world real interest rate caused by the debt issue (which can be positive or negative). The socially optimal policy from the point of view of the world economy is not to issue any public debt. This result also holds when fiscal policy is set by each of the governments without cooperation, provided that both governments are certain of being reelected in the future.
The central result of the paper is that the bias towards overaccumulation of public debt, resulting from the electoral uncertainty, may be larger in the presence of international policy coordination. If either government unilaterally runs a fiscal deficit its real exchange rate appreciates today and depreciates tomorrow. The explanation is simple: a larger domestic fiscal deficit implies more public consumption of the domestic good in that period, and less of it in the subsequent period. This tends to appreciate the price of the domestic good relative to the foreign good in the first period and to depreciate it subsequently. Since public debt is by assumption indexed to the price of the composite commodity, the private sector is sheltered from this temporary change in the terms of trade, but its effects are felt by the public sector. In particular, the temporary change in the terms of trade drives a gap between the world real interest rate (measured in units of the composite commodity) and the home real rate faced by the domestic planner (measured in units of domestic output). For a given world real interest rate, the home real rate faced by the government rises with a larger deficit and this increases the marginal cost of issuing public debt. This feature of the model, that a unilateral expansion of budget deficits has an adverse welfare effect at home through the terms of trade change, is a general one. Such exchange rate behaviour is suboptimal and this tends to limit the deficits.
We then consider the equilibrium when the domestic and foreign governments cooperate internationally but face uncertain reelection outcomes. When the two countries coordinate policies, they perceive no change in their terms of trade, and therefore the adverse welfare effects of unilaterally increasing the fiscal deficit vanishes. As a result, through this mechanism the marginal cost of issuing public debt is smaller if the two countries cooperate, and this tends to increase the fiscal deficit in the cooperative equilibrium relative to the case of non-cooperation. The comparison between the cooperative and the non-cooperative equilibrium also involves a second term, representing the welfare effect of changes in world real interest rate; in the cooperative equilibrium the welfare effects on the foreign country are fully internalized. This term can be either positive or negative, and hence the marginal gain from issuing public debt can either be larger or smaller if the two countries cooperate.
What can be said about the size of the deficit in the cooperative equilibrium relative to the equilibrium with no cooperation? If the terms of trade effect dominates, then the deficit is clearly larger in the presence of cooperation and international cooperation is socially undesirable. If the real interest rate effect dominates, and works against the terms of trade effect, then international cooperation can reduce the size of the deficit relative to the noncooperative equilibrium.
Intuitively, international cooperation can weaken the resolve of each government to pursue a balanced fiscal policy. It does so by eliminating the adverse effects of the fiscal imbalance on the time path of the terms of trade. As a result, by coordinating with the foreign country, each government can be induced to pursue policies that are more inefficient from the point of view of the domestic economy. Note that the governments currently in office at home and abroad are actually made better off (in an ex ante sense) by cooperating with each other. However, this happens at the expense of future policy-makers and of all the citizens that disagree with the current government about the desired composition of the public good.
This paper suggests a more general lesson. Domestic political institutions can distort the incentives of a sovereign government. The policies implemented as a result of these political distortions, in turn, can have positive or negative effects on the welfare of foreign governments. If they are negative, then international coordination may be desirable, since internalizing these externalities offsets the domestic distortion. If on the other hand the externalities are positive, then international coordination may be counterproductive, since it exacerbates the effects of the domestic distortion. The model of this paper provides an example of this phenomenon, but other examples could be easily constructed. For instance, expansionary monetary and fiscal policies motivated by a political business cycle could have positive externalities abroad, and thus be reinforced (rather than discouraged) by international coordination.